Friedman-Savage and Keynesian uncertainty

14 Sep, 2020 at 15:50 | Posted in Economics | 7 Comments

0

An objection to the hypothesis just
presented that is likely to be raised by
many … is that it conflicts with the way human beings actually behave and choose. … Is it not patently unrealistic to suppose that individuals … base their decision on the size of the
expected utility?

While entirely natural and under-
standable, this objection is not strictly relevant … The hypothesis asserts rather that, in making a particular class of decisions, individuals behave as if they calculated and compared expected utility and as if they knew the odds. The validity of this assertion … depend  solely on whether it yields sufficiently accurate predictions about the class of decisions
with which the hypothesis deals.

M Friedman & L J Savage

‘Modern’ macroeconomics — Dynamic Stochastic General Equilibrium, New Synthesis, New Classical and New ‘Keynesian’ — still follows the Friedman-Savage ‘as if’ logic of denying the existence of genuine uncertainty and treat variables as if drawn from a known ‘data-generating process’ with known probability distribution 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. Who really honestly believes that we 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.

wrongrightSome macroeconomists, however, still want to be able to use their hammer. So they — like Friedman and Savage — 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!

7 Comments »

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  1. Animal spirits. Humans behave out of reified theories that have been transformed into beliefs — often bad — 85-95% of the time according to some cognitive and social scientists. Those beliefs reside unconsciously and when confronted by a problem emerge as fast thinking. Few people take the time to analyze the problem in front of them — slow thinking to use Kahneman’s term — but the model you are criticizing seems not to consider those psychological factors. Thus they repeat dysfunctional patterns — both the theorists and the supposed subjects of their theories.

  2. The link to the Friedman Savage paper does not work.
    .
    The paper can be found at:
    .

    Click to access friedman.pdf

  3. The innovation of finance is that you can price options on futures and fully hedge your sunglasses exposure.
    .
    Recently, Softbank has been in the news for a “costless collar” that reportedly netted them $4 billion, or a 100% profit on $4 billion spent on call spreads.
    .
    The strategy is (warning: financial jargon ahead): you buy stock and then buy out-the-money puts and sell calls at whatever strike price balances the puts price. Hence, the “costless” nature of the option-chain “collar”. The dealers that sell you the puts delta-hedge by buying the stock you bought from you. Softbank did these trades in enough size that they moved markets as they expected, and profited. They likely sold both puts and underlying stock at 100% markups.
    .
    A recent twitter thread (quoted in https://www.zerohedge.com/markets/your-money-gone-all-gone-how-softbanks-gamma-whale-strategy-led-catastrophic-results-thread ) purports to debunk the “costless” nature of such trades by describing a similar strategy that failed in 2008, because the financial stocks used by that failed firm collapsed after Lehman Brothers failed.
    .
    But the Fed is your ultimate insurance. What if the Fed had rescued Lehman in 2008? Would today’s Fed let another Lehman collapse?
    .
    The only financial uncertainty is psychological: will the Fed print enough money? Real-world uncertainty exists, but finance is figuring out how to abstract away financial uncertainty so we need not worry about money when real-world uncertainty strikes.
    .
    One question is whether ending financial uncertainty encourages real-world reckless behavior resulting in increasing uncertainty: a system spinning out of control.
    .
    I think you should use words alone to change behavior you see as undesirable. You should not create financial scarcity by committee based on a model of human behavior. You should allow financial security for all individuals, and seek to teach by your own example how to live a calm life that does not spiral out of control, despite insured financial risk.
    .
    Another question is whether the Fed will remain top bank, but the world central bank unlimited currency swap network provides a framework for cooperation and support; currency risk is essentially insured.

    • Robert,
      .
      “Real-world uncertainty exists, but finance is figuring out how to abstract away financial uncertainty so we need not worry about money when real-world uncertainty strikes.”
      .
      No matter how much anyone hedges, someone has always got the risk, even diversifiable risk. If there is systemic crisis, as you say, the only way out is the central bank.
      .

    • Someone is paying for the risk, these companies have just found a bigger sucker

  4. The Fed is the sucker of last resort. So why not make it explicit and have the Fed sell panic insurance upfront?


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