Uncertainty in economics

25 Jan, 2020 at 16:42 | Posted in Economics | 3 Comments

kadeNot accounting for uncertainty may result in severe confusion about what we do indeed understand about the economy. In the financial crisis of 2007/2008 the demon has lashed out at this ignorance and challenged the credibility of the whole economic community by laying bare economists’ incapability to prevent the crisis …

Economics itself cannot be regarded a purely analytical science. It has the amazing and exciting property of shaping the object of its own analysis. This feature clearly distinguishes it from physics, chemistry, archaeology and many other sciences. While biologists, chemists, engineers, physicists and many more are very able to transform whole societies by their discoveries and inventions — like Penicillin or the internet — the laws of nature they study remain unaffected by these inventions. In economic, this constancy of the object under study just does not exist.

The financial crisis of 2007-2008 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 made it conceivable?

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

0But 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 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.

4273570080_b188a92980This 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.

wrongrightSome 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 disaster.

3 Comments

  1. Prof. Syll follows Keynes in a very narrow understanding of risk and uncertainty.
    .
    A more interesting approach is:
    “we should abandon the concept of the risk-uncertainty distinction in our own thinking (and at least most communication), and that we should think instead in terms of:
    – a continuum of more to less trustworthy probabilities
    – the practical upsides and downsides of using expected probabilities, for actual humans”
    .
    See:
    https://www.lesswrong.com/posts/Lq6LMfi9ZKBKsrcFD/risk-and-uncertainty-a-false-dichotomy
    and
    https://forum.effectivealtruism.org/posts/KfqFLDkoccf8NQsQe/potential-downsides-of-using-explicit-probabilities%20I%20was%20referring%20to.

  2. The 2008 panic was avoidable: the Fed did not have to raise rates so that mortgages became more expensive, causing defaults. The Fed could have bailed out Lehman Brothers, thus avoiding a spreading panic that devalued even safe instruments. The only real uncertainty in 2008 was, would the Fed print money to get us out? They did, but a little late.
    .
    The way to manage the financial uncertainty is for the Fed to sell panic insurance upfront, so banks can properly hedge psychological, spreading panics. The Fed could also insure each of us against the financial risks of a panic with a basic income.
    .
    In other words, there was no physical uncertainty associated with the 2008 panic. The only uncertainty was psychological, and thus avoidable. Liquidity hoarding can easily be met with liquidity provisioning by the issuers of the world’s best money.
    .
    There was no physical uncertainty in 2008, as implied by the weather examole.
    .
    Also, finance would handle the weather uncertainty example by selling options. You could buy a cheap option on sunglasses. If it was sunny, you could exercise the option. If not, you let the option expire or sell it to someone else. You might pay for your sunglasses option by selling options to your friends. Pricing the options is an art, but you can hedge with volatility which has an asymmetry that you can exploit: volatility rises faster when the underlying’s price falls than it rises when the underlying’s price rises. This means you can long volatility and long sunglass option ptices and if prices go up, you are hedged because volatility went up too.
    .
    Keynes did not know about financial innovations to hedge price movements. Black-Scholes came after Keynes and revolutionalized option pricing by introducing volatility measures.
    .
    It is important to understand that physical uncertainty such as weather events can be financially hedged to remove financial uncertainty.
    .
    Japan did not suffer financially due to Fukushima, because the central bank printed money to make survivors whole. There was physical uncertainty about the tsunami’s timing, but any financial uncertainty associated with recovery can be eliminated.


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