Hicks on probability calculus

20 Jun, 2019 at 23:05 | Posted in Economics | 21 Comments

To understand real world ‘non-routine’ decisions and unforeseeable changes in behaviour, ergodic probability distributions are of no avail. In a world full of genuine uncertainty — where real historical time rules the roost — the probabilities that ruled the past are not necessarily those that will rule the future.

Wickham, Mark, active 1984-2000; Sir John Hicks (1904-1989)When we cannot accept that the observations, along the time-series available to us, are independent … we have, in strict logic, no more than one observation, all of the separate items having to be taken together. For the analysis of that the probability calculus is useless; it does not apply … I am bold enough to conclude, from these considerations that the usefulness of ‘statistical’ or ‘stochastic’ methods in economics is a good deal less than is now conventionally supposed … We should always ask ourselves, before we apply them, whether they are appropriate to the problem in hand. Very often they are not … The probability calculus is no excuse for forgetfulness.

John Hicks 

21 Comments

  1. Probability doesn’t really matter if you are perfectly hedged. The only real uncertainty in insured (hedged) Mortgage Backed Securities is whether the Fed will act as insurer of last resort. The Fed could remove that uncertainty by selling panic insurance up front. Then financiers could hedge against emotional devaluations and liquidity hoarding.
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    Uncertainty remains but financial engineering allows matched-book agents to profit no matter what happens. If stocks go up you make money; if stocks go down you make money because you have hedges that shorted stocks.
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    Goldman Sachs, JP Morgan and others have perfected perfect hedging strategies and made money while stocks and output declined in 2008 …

    • Goldman Sachs, JP Morgan and others have perfected perfect hedging strategies and made money while stocks and output declined in 2008 …
      .
      You say that as if you think that was a good thing.
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      If, among the consequences, are homelessness, de-industrialization, job losses and so on, perhaps this is not a sensible way to run a financial system. What Goldman Sachs and others hedged was the fraudulent sale of securities, which greatly distorted the allocation of capital; the losses from the fraud were inescapable but they could and were assigned in ways that continued the upward redistribution of income.

      • Quite. Goldman Sachs were bailed out, both directly and by the US government and indirectly by the Federal Reserve. Even though there is widespread agreement that they were not penalised for fraudulent activity and other forms of excess anywhere near enough. The reason they make money without fail is because of their position in the business and political establishment. The have monopolised the market this way and cannot lose.

        But if you know anything about this firm and people who work there, as I do, you would know what a very unpleasant place it is and the way they make money has very little to do with real talent and ingenious hedging strategies.

        Robert Mitchell seems to believe financial technology can overcome financial crises. This is pre-2008 hubris. Financialisation and “the Masters of the Universe” are at the heart of our problems. It’s as if we have learned absolutely nothing.

        • “Robert Mitchell seems to believe financial technology can overcome financial crises.”
          .
          Someone in a previous argument in this forum said, “you can’t hedge risks you don’t know exist.”
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          However, if you accept that prices accurately measure the value of knowledge, you don’t have to know all the specific real-world risks: you just have to know how to hedge relative price movements. If Mortgage-backed Securities go down, you have Credit Default Swaps to replace the lost income stream. You don’t have to know or care whether MBS devalued because of real risk of defaults or because of trader panic. You just have to hedge the price movement. So you can wrap a lot of unknown risks into a simple price movement down, and take out insurance against that movement.
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          If you don’t accept Hayek’s dangerous idea that price is all you need to know, then prices become arbitrary, and output becomes as arbitrary as prices since it is measured in prices and therefore not a good goal for public policy.
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          If you don’t accept Hayek’s proposition that prices are a proxy for knowledge, then inflation becomes psychological and need be no constraint on public policies since we can maintain real purchasing power stability despite nominal inflation by printing money faster than prices rise and distributing it equally (via basic income).
          .
          Setting output maximization as a public policy goal also assumes ergodicity, since as Ole B Peters points out the aggregate output has nothing to do with my particular story, unless you assume the ensemble average equals the average of each individual.

      • The main point is that financial uncertainty can be eliminated, with help from the Fed, for everyone. There can still be real-world uncertainty but everyone can be assured that lack of money alone will not be one of the real-world uncertainties.
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        Goldman’s hedges should have worked, but there was a psychological panic. The Fed dealt with the psychological panic by supplying liquidity without capacity limits to replace the private liquidity then being hoarded.
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        The housing “fraud” can be recast as everyone getting cheap credit. If the Fed had bailed out the homeowners, it would have been better. We should tell Congress to tell the Fed to give everyone free credit (or a basic income).
        .
        The goal is to let bankers be bankers while insuring the rest of us from their mistakes.

        • If the private sector market maker cannot restore order in an important financial market, then it is the central banker who may have to become the market maker of last resort to either directly, or through providing resources to the market maker, restore orderliness. (Davidson, Paul. Who’s Afraid of John Maynard Keynes?: Challenging Economic Governance in an Age of Growing Inequality (Kindle Locations 840-842). Springer International Publishing. Kindle Edition.)

          .

          Probability doesn’t really matter if you are perfectly hedged. The only real uncertainty in insured (hedged) Mortgage Backed Securities is whether the Fed will act as insurer of last resort. The Fed could remove that uncertainty by selling panic insurance up front. Then financiers could hedge against emotional devaluations and liquidity hoarding.
          .
          Uncertainty remains but financial engineering allows matched-book agents to profit no matter what happens. If stocks go up you make money; if stocks go down you make money because you have hedges that shorted stocks.
          .
          Goldman Sachs, JP Morgan and others have perfected perfect hedging strategies and made money while stocks and output declined in 2008 … ~ Robert S. Mitchell

          And when the Fed acts as a backstop for predatory finance (or as Davidson puts it, acts as the “market maker of last resort”) or “insurer of last resort” the damage just continues. The banks are on both sides of a bet and setup the rules such that everyone scratches everyone else’s back in the food chain (banks, brokers, ratings agencies, lawyers, accountants, etc.) except those on the real end of reality where the food hits the mouths:

          Sadly, though, today’s (monetary) reflation pursued by central banks in the core capitalist countries, especially in the U.S., is considerably different to what Fisher had in mind. Implicit in Fisher’s idea of countering debt deflation through monetary reflation was that asset prices would move in tandem with the prices of goods and services. In other words, he did not foresee a scenario, similar to that prevalent in today’s U.S. economy, where monetary injections would lead (through the influence of powerful financial interests) largely to the financial sector and, therefore, to asset-price reflation without significantly affecting the real sector, or the prices of goods and services.
          .
          Contrary to impressions that Bernanke’s generous supply of cheap money is a liberal stimulus measure, the primary purpose of his easy monetary policy has, in fact, been to reflate asset prices, to make toxic assets whole and to patch up the bubble that was burst in 2008 by creating another asset-price bubble. Through a combination of massive bailout of the “too-big-to-fail” financial institutions and colossal infusion of near-free money into the parasitic financial sector, Mr. Bernanke and his collaborators in the government and Wall Street seem to have, indeed, succeeded in achieving this goal, as evinced by the soaring asset prices of recent years. According to World Bank’s biannual Global Economic Prospects report (January 2013), while real economic growth has stalled or turned negative in much of the world since the bank released its previous report in June 2012, stock prices have soared. Over the past six months, stock markets in the more-developed economies of North America, Europe and Japan have risen by 10.7 percent and in the so-called “developing countries” by 12.6 percent. The MSCI (Morgan Stanley Capital International) All-Country World Index has jumped by 17 percent since the end of 2011.
          .
          As discussed earlier in this chapter, in the aftermath of the collapse of the real estate bubble, giant financial speculators stampeded out of that sector and flocked to the commodities market, especially food and energy markets. Financial moguls such as Goldman Sachs, Morgan Stanley and Barclays are heavily involved in relentlessly betting on the price of food through complex derivative procedures that have gravely contributed to the escalating price of foodstuff in recent years. “Goldman Sachs made up to an estimated £251 million (US$400 million) in 2012 from speculating on food including wheat, maize and soy, prompting campaigners to accuse the bank of contributing to a growing global food crisis” (Ross 2013). There is overwhelming evidence that the derivatives bubble in the food market has been a major contributing factor in the rise of the price of foodstuff:
          .
          Rampant speculation on food prices by the big banks has dramatically increased the global price of food and has caused the suffering of hundreds of millions of poor families around the planet to become much worse. At this point, global food prices are more than twice as high as they were back in 2003. Approximately 2 billion people on the planet spend at least half of their incomes on food, and close to a billion people regularly do not have enough food to eat…. Goldman Sachs and other big banks are treating the global food supply as if it was some kind of a casino game. (Snyder 2013)
          .
          Pointing out how the Fed and/or government policies have helped reflate asset prices and create new bubbles in the stock market, commodities market, bond market and derivatives market, financial commentators at Washington’s Blog argue, “If you really think about it, the largest bubble in history is fraud, because it includes all of the above [bubbles]. . . . Specifically, the housing crisis was caused by fraud. The government encouraged fraud, and helped cover it up.” Likewise, “Huge swaths of the derivatives market are manipulated by fraud. .. . But instead of cracking down on the fraud, the government is backing it. And the bubble in bonds was caused by super-low interest rates,” in turn, “caused by the government’s zero interest rate policy and quantitative easing.” And the fraud bubble continues to expand: the people are told that the zero interest policy, the policy of giving virtually free money to Wall Street banksters, is necessary to stimulate the economy and create jobs. In essence, however, “zero interest rate policy is just another stealth bailout for the big banks. And quantitative easing only helps the super-elite … and hurts the economy and the little guy.” This means that “the government’s low interest rate policies were based upon a fundamental misrepresentation as to their purpose and probable effect” (2013).

          ~ ~ ~

          Snyder, M. (2013). The derivative bubble: Speculating on food prices, banking on famine. Global Research, January 24. Retrieved from http://www.globalresearch.ca/the-derivativebubble-speculating-on-food-prices-banking-on-famine/5320379 (accessed February 17, 2013).

          ~ Cited from Hossein-zadeh, Ismael (2014) Beyond mainstream explanations of the financial crisis : parasitic finance capital.

          • The main point is that financial uncertainty can be eliminated, with help from the Fed, for everyone…. The goal is to let bankers be bankers while insuring the rest of us from their mistakes. ~ Robert S. Mitchell

            .

            Robert Mitchell seems to believe financial technology can overcome financial crises. This is pre-2008 hubris. Financialisation and “the Masters of the Universe” are at the heart of our problems. It’s as if we have learned absolutely nothing. ~ Nanikore

            The sophistry of the “let bankers be bankers” argument falls down under the reality of the real ramifications of just letting “bankers be bankers while insuring the rest of us from their mistakes.” Man made famine is one of those “externalities” of letting bankers be the gangsters their really are. The only hope for modern civilization is that the younger generation wakes up to the emptiness of this sophistsry and rhetoric talking heads spew out hourly and holds such unscrupulous predatory capitalists accountable for the real damage they cause.

            • The Fed as “market-maker of last resort” is exactly right. But the Fed can also get out in front of panics by selling insurance upfront. The Fed can also make markets as needed in inflation swaps instead of manipulating rates.
              .
              The Fed should remove lack of money as a factor in man-made famines. It can do this by using its demonstrated, against market testing, power of unlimited liquidity to supply everyone with an inflation-protected basic income.
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              Public policies can further insure against man-made famines by buying back arable land and making it available for farming. Masanobu Fukuoka proved that natural farming on a quarter-acre can supply enough food for a family to live on. According to rough calculations, there is about half an acre of worldwide arable land per person in the world (14 million km2 / 7 billion). We could all be vegetarians and farm without pesticides or tractors.

    • Goldman Sachs, JP Morgan and others have perfected perfect hedging strategies and made money while stocks and output declined in 2008 …

      Here is the real way such “perfect hedging strategies” are made as revealed by the A Vignette: Option Pricing and the Black-Sholes Formula.

      • “This feat was deemed so important that in 1977 Scholes and Merton were awarded the Nobel Prize in economics [see The Nobel Factor] for their formula (Black had died two years earlier). Indeed, “Black, Merton and Scholes thus laid the foundation for the rapid growth of markets for derivatives in the last ten years”—at least according to the Royal Swedish Academy press release (1977).”
        .
        Those two “1977”s should be “1997”.
        .
        The rest of the vignette is accurate. Note that Black was aware of option-pricing (and all other pricing) arbitrariness, as you can read in his 1986 essay “Noise”. Black seems aware that financial instrument prices can become disconnected from real prices. Our challenge is to use the disconnect to give neoliberals a virtual place to play with bets and money, while keeping real provisioning in the hands of those who want to do it because they enjoy it.
        .
        Quibble: you should be able to hedge the volatility assumptions of the Black-Scholes formula using the VIX. You can make $VIX bets contrary to the assumptions, to hedge.

        • Thanks! Fixed it.

  2. The prominence in academic macroeconomics given to econometric study of aggregate time-series could only occur in a scholarly discipline with a total disinterest in epistemology, let alone methodology.

  3. Our ancestors, Homo Sapiens, survived and evolved in a dangerous and uncertain world. They had very limited and imperfect information but they were able to discern patterns and innovate to overcome difficulties. Eventually they even found ways of dealing with serial correlation in time series of data! (See Wooldridge, Greene or other textbooks on econometrics).
    .
    In ancient days there also existed Homo Not-So-Sapiens (Homo NSS). These were close close relatatives of homo sapiens but they were retarded in the evolution of intelligence and other mental attributes essential for survival.
    Homo NSS tended to be confused and overwhelmed by the complexities of the world around them. They devoted much of their time lurking in the dark recesses of miserable caves philosophising about evils called Satan, neoliberalism, “fundamental uncertainty”, “genuine uncertainty”, “non-ergodicity”, etc.
    Like modern critical realist philosophers, Homo NSS sought spiritual refuge in mystical and metaphysical concepts, e.g. supernatural powers, “God”, “Heaven” and, “deeper reality” beyond the reach of science and our natural experiences.
    .
    Most Homo NSS had shorter lives and few surviving offspring, so fortunately they are the ancestors of very few of us.

  4. Kingsley,
    .
    It would be interesting to discover how much uncertainty can be mitigated by understanding patterns in nature. I am sure it is of some consequence, however, I am equally sure that most uncertainty cannot be so mitigated – it’s almost a matter of definition. How can a repeating phenomenon be considered uncertain? So those phenomena that are genuinely uncertain are at play.
    .
    And those of Homo Sapiens that might have survived the wrath of uncertainty I think would better be named Homo Fortunatus. I would suggest that in the end the nature of uncertainty is such that outcomes are not predictable, even if probabilities can be assigned to them. A high probability means nothing. No-one knows what the next anticipated outcome will be, no-one. It is the “lucky” ones that have survived.
    .
    As for Homo Not-So-Sapiens, he might have had a better survival rate than Homo Sapiens given he spent, as you suggest, most of his “miserable” life ensconced in a cave, out of harm’s way!

  5. Henry,
    All empirical knowledge is uncertain. Repetition of phenomena reduces uncertainty but can never entirely eliminate it. For example, Homo Sapiens knew that that rainfall has seasonal pattern, but he could never be sure about rain on a particular day or year.
    .
    Regarding your Homo Fortunatus, it is highly unlikely that pure luck that enabled him to invent atomic energy or your computer.
    Homo Fortunatus, if he ever existed, never evolved a superior brain because his survival “strategy” relied entirely on good luck. Moreover, he interbred gleefully with MisFortunata, which rapidly ended his lucky streak. Their hybrid offspring degenerated into my Homo Not-So-Habilis, which are now (almost) extinct due to inability to survive ice ages, droughts, sabre toothed tigers, etc.

    • “Homo Sapiens knew that that rainfall has seasonal pattern, but he could never be sure about rain on a particular day or year.”
      .
      Homo Financier invented crop insurance, and he profits because the premiums are invested at a higher rate of return than real crops provide (since Piketty proved that r > g).

    • Kingsley,
      .
      🙂

  6. Taking advantage of the 2008 financial crash, the financial oligarchy and their proxies in the governments of the core capitalist countries have been carrying out a systematic economic coup d’état against the people the ravages of which include the following:
    .
    • Transfer of tens of trillions of dollars from the public to the financial oligarchy—brought about through fraudulent creation of debt money, exchanged for real money when it is chalked up as public debt to be paid through brutal austerity cuts;
    • Extensive privatization of public assets and services, including irreplaceable historical monuments, priceless cultural landmarks, and vital social services such as water supply;
    • Substitution of corporate/banking welfare policies for people’s welfare programs;
    • Allocation of the lion’s share of government’s monetary largesse (and of credit creation in general) to speculative investment instead of real investment;
    • Systematic undermining of the retirement security of millions of workers and civil servants such as firefighters, teachers, school employees, and other public servants;
    • Ever more blatant control of economic and/or financial policies by the representatives of the financial oligarchy.
    .
    Despite the truly historical and paradigm-shifting importance of these ominous developments, their discussion continues to remain outside the purview of the mainstream economics. Focusing on superficial descriptions or symptomatic and instrumental factors such as deregulation, subprime mortgage lending, securitization, greed, and the like, mainstream economics does not begin to touch upon, let alone explain, these crucially important issues. It has not even explained why the financial collapse took place in the first place; except for the supposedly
    “irrational behavior of economic agents” and “invasive government policies” (neoliberal explanation), or deregulation and “neoliberal ideology” (Keynesian explanation). (Hossein-zadeh, Ismael (2014, 1) Beyond mainstream explanations of the financial crisis : parasitic finance capital.)

    • In my view, this is only true because people refuse to consider the Fed as a source of public finance. Economists have taught us that money-printing causes inflation. Experience has taught us that the private sector uses the Fed’s vertical supply curve for reserves as a backstop to create credit as they wish. Investor incomes increase faster than asset prices. We too can use the Fed to print money faster than prices rise, but distribute the money equally rather than arbitrarily as the private sector does.

      • What would that look like I wonder? Are there past historical examples?

        • Israel used indexation successfully for decades. But they got cold feet in the early 1980s and went to hard money policies when they should have doubled down.
          .
          See https://www.jewishvirtuallibrary.org/the-rise-and-fall-of-israeli-inflation
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          “Dealing with daily linkage adjustments and their repercussions was draining the time and resources of households and businesses.”
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          We have better technology now and can automate cost-of-living adjustments as often as necessary to maintain real purchasing power stability, rather than nominal price stability.


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