Macroeconomics and the Friedman-Savage ‘as if’ logic

15 Nov, 2022 at 21:38 | Posted in Economics | 6 Comments

0An 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 a 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 of 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 — 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 the roulette wheels, is a sure recipe for only one thing — economic catastrophe!

6 Comments »

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  1. May I quote from two contemporaneous articles, which are relevant to this discussion?
    .
    On the INET site, Lynne Parramore quotes Nomi Prins:
    .
    《You end up getting an unmooring between what markets are theoretically there to do in a capitalist society and from a capital-raising standpoint. There’s this other source that comes in and kind of turbo-boosts and distorts all of those relationships. […] How do we get out of it? We can’t.》
    .
    And on Zerohedge (“Top Contender To Replace Kuroda As BOJ Head Urges Removal Of Emergency Central Bank Support”):
    .
    《compared with Amamiya, Nakaso is seen more in favor of dialing back Kuroda’s radical stimulus. In a book published this year, he laid out in detail how the BOJ could end ultra-loose policy. What he left out is how JGBs go bidless, how trillions in Japanese pensions evaporate overnight, and how a global financial shockwave crushes the western financial system which is inextricably linked to the continued stability of the Japanese bond market.》
    .
    When Nomi Prins and zerohedge agree, can we accept permanent QE and embrace the disconnect between the “real” economy and finance?
    .
    In other words can we distract traders from doing real harm by letting them play in untethered financial markets, while insuring the rest of us against their manias and panics with a universal, unconditional, inflation-protected, QE-funded, generous basic income?

  2. Lars whose photo is that in the caption?

  3. Is economic catastrophe necessary, when the Fed can backstop insurers?

    • Flooding international capital markets with dollar liquidity might get a country out of a crisis, but because of the distortions it creates, it is also usually the cause of them. One thing that Friedman did get right is the dangers when monetary growth has no relationship over long periods to GNP. The Fed is right at the moment to start drawing liquidity in. The chaos we saw in Britain just highlights the dangers weaknesses in the post Brexit economy and the long standing problems related to deindustrialisation and financialisation that have created a structural trade deficit. It was an important wake up call to the fantasists.

      • Why am I reminded of President Grant vetoing the 1874 Greenback Party Inflation bill, which just delayed the inevitable, causing how much needless interim suffering God only knows, in service to a “hard money” Dear Model?
        .
        By tightening currently, how many unforeseen distortions is the Fed creating, likely far more harmful than QE caused?

        • Sure, and a drastic reduction in the money supply was indeed Friedman’s own explanation of the cause of the Great Depression. (My own view is that it is only one aspect of the story, and even only one aspect of the monetary part of the story.)

          In the end I suspect the way out of capitalism’s current malaise will be direct government activation in credit allocation and prices and incomes policies. These are not always the right policies, but sometimes they are. We just have to wait until things are bad enough that they become a political necessity. They are an anathema for the neo-classical economics profession because they believe the market should allocate resources (with the caveat that the winners compensate the losers, ie the government performs an ex-post redistributive role through the welfare system). It’s based on Utilitarian philosophy and Pareto Optimality. In reality, direct government intervention in resource allocation, including collective bargaining, does occur outside Anglo Saxon countries, of course, and in many cases has done so very successfully over long a period of time.


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