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Keynes’ core in​sight

from Lars Syll

rBut these more recent writers like their predecessors were still dealing with a system in which the amount of the factors employed was given and the other relevant facts were known more or less for certain … At any given time facts and expectations were assumed to be given in a definite and calculable form … The calculus of probability, tho mention of it was kept in the background, was supposed to be capable of reducing uncertainty to the same calculable status as that of certainty itself …

The fact that our knowledge of the future is fluctuating, vague and uncertain, renders Wealth a peculiarly unsuitable subject for the methods of the classical economic theory …

By “uncertain” knowledge, let me explain, I do not mean merely to distinguish what is known for certain from what is only probable … The sense in which I am using the term is that in which the prospect of a European war is uncertain, or the price of copper and the rate of interest twenty years hence … About these matters there is no scientific basis on which to form any calculable probability whatever. We simply do not know.

John Maynard Keynes

To understand real world ‘non-routine’ decisions and unforeseeable changes in behaviour, ergodic probability distributions are of no avail. In a world full of genuine uncertainty – where real historical time rules the roost – the probabilities that ruled the past cannot simply be assumed to be those that will rule the future. 

Time is what prevents everything from happening at once. To assume that economic processes are ergodic and concentrate on ‘ensemble averages’ is not a sensible way for dealing with the kind of genuine uncertainty that permeates real-world economies.

What is important with the fact that real social and economic processes are nonergodic is the fact that uncertainty – not risk – rules the roost. Thinking about uncertainty in terms of ‘rational expectations’ and ‘ensemble averages’ has had seriously bad repercussions on the financial system.

Keynes’ uncertainty concept has an ontological founding. Of course this also has repercussions on the issue of ergodicity in a strict methodological and mathematical-statistical sense.

The most interesting and far-reaching difference between an epistemological and an ontological view on uncertainty is that if one subscribes to the former, you open up for the mistaken belief that with better information and greater computer-power we somehow should always be able to calculate probabilities and describe the world as an ergodic universe. As Keynes convincingly argued, that is ontologically just not possible.

To Keynes, the source of uncertainty is in the nature of the real – nonergodic – world. It has to do not primarily with the epistemological fact of us not knowing the things that today are unknown, but rather with the much deeper and far-reaching ontological fact that there often is no firm basis on which we can form quantifiable probabilities and expectations at all.

We have to accept that if we really want to be able to understand and analyze real-world phenomena we have to accept them on their own premisses. Our quest for knowledge should never decide how to perceive reality.

The most important and far-reaching premiss on which modern mainstream economics builds is the assumption that genuine uncertainty is reducible to calculable risk. Since this is not the case, modern mainstream economics is also totally useless.

Take the rational expectations assumption. Rational expectations in the mainstream economists’ world imply that relevant distributions have to be time independent. This amounts to assuming that an economy is like a closed system with known stochastic probability distributions for all different events. In reality, it is straining one’s beliefs to try to represent economies as outcomes of stochastic processes. An existing economy is a single realization tout court, and hardly conceivable as one realization out of an ensemble of economy-worlds since an economy can hardly be conceived as being completely replicated over time. It is — to say the least — very difficult to see any similarity between these modelling assumptions and the expectations of real persons. In the world of the rational expectations hypothesis, we are never disappointed in any other way than as when we lose at the roulette wheels. But real life is not an urn or a roulette wheel. And that’s also the reason why allowing for cases where agents make ‘predictable errors’ in DSGE models doesn’t take us any closer to a relevant and realist depiction of actual economic decisions and behaviours. If we really want to have anything of interest to say on real economies, financial crisis and the decisions and choices real people make we have to replace the rational expectations hypothesis and calculable risk with more relevant and realistic assumptions concerning uncertainty than childish roulette and urn analogies. Or as Quetelet once declared — “l’urne que nous interrogeons, c’est la nature.”

  1. February 27, 2018 at 12:53 am

    There was a mini-methodenstreit in the early 20th century with Keynes and Knight on the side of uncertainty and Ramsey, Koopmans and DeFinetti on the side of risk — These subjectivists “showed” that rational decision making under uncertainty required treating it as risk by assigning subjecive probabilities to uncertain events. Even though this argument was fallacious, it became widely accepted, and as a result, uncertainty was removed from the picture — no longer mentioned. The fact is that this fundamental argument — that rational choice requires assigning subjective probability – is fallacious. However, the fallacy of the argument is still not known to most, who accept it as valid. My paper on “Subjective Probability Does Not Exist” provides a clearly stated argument which explains why the De-Finetti Savage arguments which “prove” the existence of subjective probability — thereby removing Keynes-Knight uncertainty from the picture — are wrong:

    • Rob Reno
      February 27, 2018 at 3:58 am

      Do you discuss this in your book “Statistical Foundations for Econometric Techniques” Asad? I have your book but have not got to reading it yet as I’m methodically working my way through the entire WEA collection.

      • February 28, 2018 at 1:30 am

        No, I dont — This is a more recent discovery, of great importance in overcoming the problem that Lars Syll has pointed out I submitted it to a top journal, which rejected the paper saying that it was trivial and obvious. This is certainly TRUE — unfortunately it is not to the vast majority of economists who are persuaded by arguments of Savage and De-Finetti to the contrary

      • Rob Reno
        February 28, 2018 at 2:27 am

        Will read your current paper from link above then. Thanks.

  2. Dave Raithel
    February 27, 2018 at 12:49 pm

    I’ve not read the book, but I’d thought I’d point to a revue….

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