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Macroeconomic uncertainty

from Lars Syll

The 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.

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 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.

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 catastrophe!

  1. October 28, 2015 at 11:41 am

    Quite so. The uncertainty in the real and constantly moving economy cannot be controlled or even reduced thanks to the construction of mathematical models. Forgetting this basic truth is awfully dangerous, as it is the reason that so often economicpolicy is wrongly conceived.

  2. Paolo Leon
    October 28, 2015 at 12:06 pm

    Many macroeconomic phenomena are impossible to know for individuals, either because they are counterintuitive or because they do not reflect the individual’s preferences. What happened, as to the crisis, was, and is a very serious deterioration of income distribution, a typical macro phenomenon, leading to lower acquisition of securities by households and to lower demand for goods and services. Uncertainty is important, but even more important is ignorance.

  3. graccibros
    October 28, 2015 at 2:22 pm

    Speaking to the situation we face worldwide today, that is, late October 2015, I have said it is truly worrisome. Why? Because of the number of large countries already in recession, close to it – or worse. And the China downward pressure on commodity markets and speculation. I kept wondering why no names of particular companies had surfaced with all the commodity price declines being pushed down by the fundamentals in China, when low and behold, Glencore’s name kept popping up. But the situation has been “shored-up,” for now. Some say the world of fracking is built on something similar to mortgage backed securities, with the major US banks all in. Others counter the scale does not approach the MBS world of 2000-2007. Uncertainty.

    So I see a troubling interaction between the real economies and the murky financial ones, China especially, but also into the broader terrain in London and the other sub-capitals of finance. And I think this sketch fits well with what Lars has just written. We just don’t know, but I see a pretty shaky “foundation” (or is it fuel?) for an unexpected financial event, like Long Term Capital Management in 1998 to trigger something as large as, if not exceeding, 2008-2009, with Central Banks having much less room to maneuver, unless they want to declare L. Randall Wray the new theoretical king. That would signal the end of Neoliberalism, but I can’t imagine this happening yet. Meanwhile, Yanis Varoufakis has launched his European tour and project to overthrown Neoliberalism by popular vote: to save Greece (and others) is now a Euro wide quest. Optimists point to events in England, Canada and…Sanders. A few rays in my estimation, not a sunrise yet.

  4. Paul Davidson
    October 28, 2015 at 6:25 pm

    My 2015 book POST KEYNESIAN THEORY AND POLICY provides the reader with the basis of the [mainstream] economic theory that presumes that ,markets and decision makers know the future via the use of calculating probability distributions to ascertain an actuarial certain future knowledge. The basis of such a calculated actuarial knowledge is the ergodic axiom

    In models where the future is uncertain, an actuarial certain future can not be calculated from past and present existing probability distribution , i.e., the future is governed by a nonergodic stochastic process so there is, as Keynes has written, “no scientific method for predicting the future”.

    I then develop what these two theoretical different approaches suggest as the optimum policy for problems of unemployment, for inflation problems, for free vs regulated financial markets (and specifically what regulations), for monetary and liquidity policy, for globalization, exchange rate policy, free trade policy, and policy regarding financial capital flows across national boundaries. Also the relevance of comparative advantage with multinational firms and the same efficient production process available in most countries even though they have different climates, educational systems, etc.

    I hope some people out there will be enticed to read this book and then provide comments on what you think.

    Paul Davdson

  5. October 29, 2015 at 7:45 am

    Dear Paul — I was enticed, but found the $100 price for the electronic edition from Edward Elgar daunting. I would like to have a sample first, before I invest that much.

  6. October 29, 2015 at 7:25 pm

    “no scientific method for predicting the future”.
    Anyone that attempts to predict a future event is a fool, if by chance that prediction is correct; that fool is “JUST A LUCKY FOOL”, albeit still a fool.

    What happened during this latest great crisis was predicted by one “Just A Lucky Fool”, Frederick Soddy in 1932,
    Did Frederick Soddy see that coming in 1932? Quote from ‘The Role Of Money’-
    “…(This book) is concerned
    less with the details of particular schemes
    of monetary reform that have been advocated
    than with the general principles to which, in the
    author’s opinion, every monetary system must at
    long last conform, if it is to fulfil its proper role
    as the distributive mechanism of society. To allow
    it to become a source of revenue to private issuers
    is to create, first, a secret and illicit arm of the
    government and, last, a rival power strong enough
    ultimately to overthrow all other forms of
    government.” “The Role Of Money”
    (Entire book as a free download… http://archive.org/details/roleofmoney032861mbp )
    In four books written from 1921 to 1934, Soddy carried on a “campaign for a radical restructuring of global monetary relationships”,[15] offering a perspective on economics rooted in physics—the laws of thermodynamics, in particular—and was “roundly dismissed as a crank”.[15] While most of his proposals – “to abandon the gold standard, let international exchange rates float, use federal surpluses and deficits as macroeconomic policy tools that could counter cyclical trends, and establish bureaus of economic statistics (including a consumer price index) in order to facilitate this effort” – are now conventional practice, his critique of fractional-reserve banking still “remains outside the bounds of conventional wisdom”.[15] Soddy wrote that financial debts grew exponentially at compound interest…

    VERDICT: The private or profit banks have proven they are not trustworthy and will for greed violate the awesome responsibility of safeguarding issuance of our currency and the taxation of that currency.
    “Capitalism is the “best” system to date devised by mankind. As it is administrated, perhaps, is where the “flaw” is manifested. If capitalism used its Central Bank properly,that is for the betterment of the common good, with equality and justice for all, capitalism would be the best ways and means to help “form a more perfect union….”, Pontifical Council
    There is a solution:There is a solution. Reverse “… an economic recovery program that has privileged the recovery of financial markets and corporate profits has fueled the increase in wealth inequality, in the United States and across the world.”…the program so it fuels…”“…a more perfect Union, establish Justice, insure domestic Tranquility, provide for the common defense, promote the general Welfare, and secure the Blessings of Liberty to ourselves and our Posterity,…”

    Read more: IT ALL WENT WRONG-when the banks violated their fiduciary duty and abandoned their rights, no their obligation to “protect the asset” To keep the ‘suckers’ buying they gave up the right to foreclose to “the upper tiers” buyers! ( http://bit.ly/MlQWNs )

  7. blocke
    November 4, 2015 at 1:37 pm

    I found out long ago that the prediction business was fraught with peril, but I found out that the best way to deal with uncertainty is to have a fund of mental capital with sufficient flexibility built into it that it can cope with the unexpected quite well. What kind of educational system produces such flexibility; it is certainly not neoclassical economics.

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