Speculations on uncertainty: A respectful response to Hannes

from Peter Radford

Whoops. When I gave my off the cuff response to Paul Davidson little did I realize that would bring upon myself the scorn of neoclassical folks. I didn’t think they bothered with us little people.

Apparently my assertion that uncertainty is cause for the existence of firms and money is lacking in stringent support. I need to go a bit further. Please. Allow me to vent a little here.

Let’s begin by quoting Lucas. In “Studies in Business Cycle Theory”, on page 224, he says: “in cases of uncertainty, economic reasoning will be of no value”.

No value?

This, to me, is a cataclysmic problem. It eliminates economic thinking from the real world. Totally. On this basis alone we can safely ignore all and every word written by the likes of Lucas as they pertain to real world economies. For, if Lucas is right, economic reasoning is a perversion of reality and has no place there.

Why?

Because the real world is riven through with uncertainty. It is the fundamental property of reality that motivates life itself.

Let me explain.

In my non-orthodox view of things any human enquiry has to take place within reality. And our understanding of that reality rests, in very simple terms, on two major bases. The theory of matter, and the theory of evolution. Nothing we talk about, discuss, theorize, debate and generally go on about, can violate the reality as understood through those two theories. They provide us with the “ontological box” within which we exist.

What’s in that box?

We understand, again in simple terms, that all the stuff around us is comprised of bits we call particles. What these things are is still the subject of intense debate within physics, but experiment supports the idea that everything is made up of such particles. So all the more coarsely grained phenomena we take for granted resolve back to these smaller bits. Particles are held together by forces. Of which there are four. We now know this to be sufficiently proven that we accept it as a good working hypothesis of reality. Further, some of the systems of particles comprise life. Not all systems are alive, only a few. Very few. Those that are alive all are subject to evolution. That is they adapt and either succeed or fail with respect to their environment. Success or failure being simply defined as survival. Life is thus epistemological in nature.

It is necessary for live things to adapt because the environment changes. That is the systems created by the four forces are degraded by entropy. Just as the forces create, so entropy degrades. This degradation gives the illusion of the passage of time, but reality is more subtle: change is just the constant reconfiguration of matter, energy and so on as the universe plots a course through its state space. Since this state space has infinitely more disordered states than ordered states it is statistically more likely that the future will be less ordered than what we observe now. If that appears grim, cheer up because the pathway the universe plots is not random: it is path dependent. There is sufficient stability in higher order systems that they don’t, in their next configuration, disassemble completely. The loss of order is more gradual, which is why we experience lifespans in smooth gradations and not violent jerks. Entropy delimits the extent of order. The four forces smooth out the trajectory towards disorder by trying to create new order. The tussle is constant, but unfortunately for us, life always loses the battle to stave off entropy.

Notice, also, that within this enormously simplified view time itself is a man made institution: it is simply a placeholder for us to manage our experience of the pathway through state space and to impose order on the constant reconfiguration around us. It isn’t a property of the universe. We merely imagine it to create an illusory order.

Next we can observe that this reality imposes itself on us through its manifold properties. Two of which we need to note: first, reality is complex; second, it is uncertain. The two are related, but not the same. For our purposes we can view complexity as the presence of order, self-organization, and emergence all of which allow us to extract information from the system in question. Uncertainty is the absence of order or the total absence of information. Also notice that this entire structure is relative. Order can appear at a higher level of granularity where it is not apparent at a lower level.

In this context we can make this observation: we can specify relationships within a very simple system; we can partially specify them within a complex system, limited by the possibility of emergence, and so on, that places a constraint on our ability; and we cannot specify an uncertain system at all. In life we confront all three, and we need to be able to deal with all. More to the point, life itself is a complex system and occupies the space between simplicity and uncertainty. In a sense it is the bridge between the two. In order elucidate my later comments on economics: it is not possible to extract information from chaotic systems, whereas it is possible to do so from either simple or complex systems. This is because in chaotic systems there is no way to compress the information into a subsequently expandable algorithm. There is no shorthand for chaos. It just is. The frontier between complex and chaotic systems represents, for our purposes, the boundary between what is accessible to us and what is uncertain.

Lastly as we ramble through this ontological box we have to note that humans, being complex themselves, have developed strategies for dealing with the reality of uncertainty: I mentioned the artifice of time. Others are our senses through which we acquire information. Our cognitive capacity allows us to process that information. We are able to walk and move around to push backs the limits of the uncertain environment around us. We have learned to speculate, theorize, and explore. We have added technologies to extend our senses – we can see further, smaller, etc. We have been able to overcome the enormous limitations of are evolved state: we can “see” light wavelengths that our eyes do not. We can “hear” frequencies that our ears do not.

What we have not been able to do, however, because we cannot, is to eliminate uncertainty. It is an irreducible feature of the universe. So it is a constant part of the reality within which we live.

This is why Hume taught us to be humble about the limitations of our knowledge, and why, more recently, Popper spoke about conjecture as a component of learning. In the face of uncertainty there can be no absolute truth, and reason is highly constrained.

This is, of course, a ridiculously compressed account, and I realize I have done great violence to centuries of physics, chemistry, and biology, but we need to get it before us in order to attack economics, because economics is situated within this reality.

In other words economics is situated within a world riven through with uncertainty. It is an unavoidable basic fact of life.

But is it the cause of things like money and firms?

Yes it is.

Humans have been very adept at creating institutions to extend their ability to fend off uncertainty. We do this in order to offset our cognitive limitations. We attempt to explain, calculate, and otherwise deal with our surroundings. But those surroundings are in constant flux. The invention of institutions is one method that allows us to rein in the wilderness of uncertainty, and impose order even if that order is illusory. Thus we invented religions and other cultural devices to explain reality. We adhere to traditions to exert stability to offset the centrifugal forces of life. And so on.

Wow, now I have done great violence to sociology and psychology as well. All in the name of economics.

Back to Lucas.

In order to pursue the line of enquiry embodied within the neoclassical tradition we have to be able to do a number of things. We need to specify limits, constraints, resources, preferences, utilities, production and so on. It is the conjunction of production, consumption, and a fixed resource set that provides the basis for the constrained maximization that suffices as economic analysis in the post Robbins – Samuelson version of theory. In other words the economy is presumed to be a simple system, fully specifiable, fully determined, and above all static. This view expunges dynamics even if there have been subsequent attempts to revitalize the theory. I agree with Pasinetti that neoclassical thought is an inversion of classical thought, where the problem set was essentially the dynamics of production. In the modernized version all we are interested in is eliciting the equations that represent the relationships within a static world. Which means we are not explaining the world at all. Economics has become an after-the-fact explication of a system that doesn’t exist.

Why doesn’t it exist?

Because it cannot be found inside our ontological box. It doesn’t take into account uncertainty. It is a utopian vision of what might exist were there no messy stuff to worry about. It is imaginary.

Moving on.

I think it reasonable to assert that both money and firms exist. That is to say we can observe them as basic facts of our surroundings. Since they appear to fall within the purview of economic analysis any complete account of an economy must accommodate them. But, within the other world of neoclassical theory they don’t need to exist, so they remain orphaned.

Why? Because in a fully specified set there is no room for uncertainty. Plus in static analysis there are no processes. Nor is there any time. In fact all the institutions we have designed to allow flexibility, to offset cognitive limitations, to act as bulwarks against the unknown, and otherwise breath humanity into a system are eliminated as unnecessary. They are swept away as irritations. They are diminished as lacking mathematical stringency. Which turns out to be no stringency at all, since it is an act of denial of the real world.

In my version of economics, institutions like firms and money exist precisely because we humans have invented ways to deal with uncertainty. Money is a simple example: it helps us mediate transactions in the absence of full knowledge of our counter-parties, it also allows us to move transaction through time. It allows us to hedge against the uncertainties we inevitably face when we try to exchange or otherwise acquire the stuff we need or want. Only if we can specify all likely future outcomes can we attribute money to risk or search. Since we cannot, uncertainty is the residual phenomenon that, alone, accounts for the existence of money.

Firms are more complex. They exist because of the risks inherent in ownership of assets that have specificity; agency relationships; gathering the costs associated with transactions and so on. They also exist because the advances in technology have made production processes vastly more exposed to uncertainty than primitive production was. These new processes need to be enclosed within a logical or conceptual space, just as much as they need to be enclosed inside a physical space. The modern business firm is a system of thought. It is an institutional construct made necessary, not by risk alone, nor by the need to gather information about transactions, but by the basic uncertainty that threatens to undermine the connectedness of the production processes.

Why do we know this?

Ironically one way is is to employ the counter factual from neoclassical static analysis which tells us risk can be specified and thus production can take place without management within a firm. The utopian market can handle risk. It cannot handle uncertainty. Whatever neoclassical theory fails to account for, we have good reason to suppose uncertainty does account for. That neoclassical theory excludes both uncertainty and money or firms, provides us with a clue that they must be related.

Further: firms adapt to their environments by a process akin to learning. They produce and then learn if that product is wanted. If it is, they make more. If not, they either fail, or they alter their production. In other words firms are engaged in with their environment. Adaptation is a feature of the real world. It is a reaction to uncertainty. We do not learn from risk assessment, because the very act of specifying risk presumes knowledge. Learning takes place in the absence of prior knowledge. It is how we acquire knowledge by extracting information from our changing environment. And change is can only inform us if it reveals something hitherto unknown. Uncertainty is thus at the root of learning.

Frank Knight said that “change is in some sense a condition of the existence of any problem whatever in connection with life or conduct”. Since humans need to solve everyday problems, one of which is the acquisition of material, goods, and services in order to thrive, it is reasonable to expect them to have created methods and vehicles to expedite such problem solution. They have to solve these problems in the face of a reality, one aspect of which is uncertainty. And another complexity. These place enormous limitations on our problem solving capacity. So those methods and vehicles reflect and attempt to mitigate those limitations.

In any analytical system that fails to account for such limitations, in neoclassical economics for instance, of course firms and money don’t exist. In all other systems, where such limitations form the basis for theorizing, like those parts of economics connected with the reality of uncertainty, of course firms and money exist.

In fact it is why they exist.

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