## Macroeconomic uncertainty

27 Nov, 2019 at 10:16 | Posted in Economics | 2 CommentsThe financial crisis of 2007-08 hit most laymen and economists with surprise. What was it that went wrong with our macroeconomic models, since they obviously did not foresee the collapse or even make it conceivable?

There are many who have ventured to answer this question. And they have come up with a variety of answers, ranging from the exaggerated mathematization of economics to irrational and corrupt politicians.

But the root of our problem goes much deeper. It ultimately goes back to how we look upon the data we are handling. In ‘modern’ macroeconomics — Dynamic Stochastic General Equilibrium, New Synthesis, New Classical and ‘New Keynesian’ — variables are treated as if drawn from a known ‘data-generating process’ that unfolds over time and on which we, therefore, have access to heaps of historical time-series. If we do not assume that we know the ‘data-generating process’ – if we do not have the ‘true’ model – the whole edifice collapses. And of course, it has to. I mean, who really honestly believes that we should have access to this mythical Holy Grail, the data-generating process?

Modern macroeconomics obviously did not anticipate the enormity of the problems that unregulated ‘efficient’ financial markets created. Why? Because it builds on the myth of us knowing the ‘data-generating process’ and that we can describe the variables of our evolving economies as drawn from an urn containing stochastic probability functions with known means and variances.

This is like saying that you are going on a holiday trip and that you know that the chance the weather being sunny is at least 30% and that this is enough for you to decide on bringing along your sunglasses or not. You are supposed to be able to calculate the expected utility based on the given probability of sunny weather and make a simple decision of either-or. Uncertainty is reduced to risk.

But as Keynes convincingly argued in his monumental *Treatise on Probability* (1921), this is not always possible. Often we simply do not know. According to one model the chance of sunny weather is perhaps somewhere around 10% and according to another – equally good – model the chance is perhaps somewhere around 40%. We cannot put exact numbers on these assessments. We cannot calculate means and variances. There are no given probability distributions that we can appeal to.

In the end, this is what it all boils down to. We all know that many activities, relations, processes and events are of the Keynesian uncertainty-type. The data do not unequivocally single out one decision as the only ‘rational’ one. Neither the economist nor the deciding individual can fully pre-specify how people will decide when facing uncertainties and ambiguities that are ontological facts of the way the world works.

**Some macroeconomists, however, still want to be able to use their hammer. **So they decide to pretend that the world looks like a nail, and pretend that uncertainty can be reduced to risk. So they construct their mathematical models on that assumption. The result: financial crises and economic havoc.

How much better – how much bigger chance that we do not lull us into the comforting thought that we know everything and that everything is measurable and we have everything under control – if instead, we could just admit that we often simply do not know and that we have to live with that uncertainty as well as it goes.

**Fooling people into believing that one can cope with an unknown economic future in a way similar to playing at the roulette wheels, is a sure recipe for only one thing – economic catastrophe!**

## 2 Comments

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” Neither the economist nor the deciding individual can fully pre-specify how people will decide when facing uncertainties and ambiguities that are ontological facts of the way the world works.”

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That is why you use derivatives to bet on all possible outcomes. You can buy an S&P 500 index, and also buy insurance on it in the form of VIX or leveraged short derivatives. If the S&P 500 goes up, you close out the short positions or let them expire unexercised, but the premium you paid for the insurance is less than you make from the S&P 500 going up. If the S&P 500 goes down, you exercise tge leveraged derivative positions and make more than you lose on the S&P 500 drawdown.

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Goldman Sachs, etc. have perfected such derivative hedging strategies. Note in the following chart how relatively high returns were available throughout the financial crisis. Even if you were long Real Estate Investment Trusts, you made a lot of money if you held onto them (or bought them cheap) for the two years they declined.

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https://ibb.co/drZkC5W (“The Asset Quilt of Total Returns”)

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The sunglasses example is woefully naive, because if you are in a financial market you can buy an option to purchase sunglasses at the destination for a few cents on the dollar. If you don’t need them, you lose a couple cents or you can sell the option on to someone else. If it turns out you need sunglasses, you can exercise the option to get the sunglasses at the strike price which you chose yourself and so were prepared to pay at the outset for eye protection.

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Economists must include finance in their models. The sunglass example has been posted several times here, but it is a bad example of fundamental uncertainty because finance has figured out ways to make it certain from the start: you know you will pay $X if it’s sunny, which you decided was fair, but if it isn’t sunny you only lose a few cents on an option premium (and you might be able to sell on that option before it expires).

Comment by Robert S Mitchell— 28 Nov, 2019 #

Tl;dr:

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Real world uncertainty exists. When I sleep outside I don’t know if it will rain, because I have experience of forecasts being wrong in the past. I can insure by setting up a tarp.

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Financial uncertainty need not result from real world uncertainty, however. Disasters such as Fukushima can be insured against. Insurance uses future financial bets that circulate as money today to pay off claims. Those future bets are also insured, thus keeping the cycle rolling over in perpetuity.

Comment by Robert S Mitchell— 28 Nov, 2019 #