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Uncertainty in economics

from Lars Syll

kadeNot accounting for uncertainty may result in severe confusion about what we do indeed understand about the economy. In the financial crisis of 2007/2008 the demon has lashed out at this ignorance and challenged the credibility of the whole economic community by laying bare economists’ incapability to prevent the crisis …

Economics itself cannot be regarded a purely analytical science. It has the amazing and exciting property of shaping the object of its own analysis. This feature clearly distinguishes it from physics, chemistry, archaeology and many other sciences. While biologists, chemists, engineers, physicists and many more are very able to transform whole societies by their discoveries and inventions — like Penicillin or the internet — the laws of nature they study remain unaffected by these inventions. In economic, this constancy of the object under study just does not exist.

The financial crisis of 2007-2008 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 made it conceivable?

There are many who have ventured to answer that 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 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.

4273570080_b188a92980This 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 disaster.

  1. January 29, 2020 at 2:15 am

    But, Keynes is enough? Not at all! A theory on thinking processes should be the right answer, which integrate uncertainty and all other orthodox and heterodox things into a whole. Thanks!
    https://goingdigital2019.weaconferences.net/papers/how-could-the-cognitive-revolution-happen-to-economics-an-introduction-to-the-algorithm-framework-theory/

    • postkeynesian spain
      January 29, 2020 at 2:54 am

      Typical bullshit…

      • January 29, 2020 at 7:15 am

        Do you understand Algorithmical Economics?

      • postkeynesian spain
        January 29, 2020 at 12:50 pm

        Always appears crazys with “quantum economy”, “physics economy” and similar. You are alone, don’t are inportant how for read allí your paper, but i saw your mistyc point with algorithm.

      • January 30, 2020 at 12:23 am

        My god! “quantum economy”, “physics economy”, they are exactly what I oppose!

  2. January 29, 2020 at 11:42 am

    Uncertainty often arises from not knowing/being able to keep up with what is going on.

    https://www.bbc.co.uk/news/explainers-51265169

    “every time an order was placed to buy or sell, “high frequency traders” – many of them not human but computers running algorithms – would try to make their own trades milliseconds before those orders could be executed. That way, they could be the first to make money from market changes. … H]igh frequency traders all used similar software. That made the market twitchy – like a flock of sheep, all moving in the same direction. [Sarao’s] software took advantage of this by placing thousands of orders before quickly cancelling or changing them, once he had created artificial demand for other traders to buy or sell that asset. … This practice – known as “spoofing” – allowed him to make genuine buy or sell orders at a profit as the price swiftly rose or fell. …

    “Most countries, including the UK, do not specifically list spoofing as a crime. It has only been illegal in the US since 2010, with the first successful case brought against US trader Michael Coscia in 2013. … More recently, UBS, Deutsche Bank and HSBC paid a collective $46.6m (35.9m) to US regulators to settle spoofing claims.

    “These cases expose the sometimes blurred distinction between legal and illegal market manipulation. After all, a traders’ job is to exploit mispricing in the markets – that’s how they make money, although it’s supposed to be because they are taking a view on the economy or on an individual stock.

    “What’s more, algorithmic trading in itself isn’t illegal: it’s increasingly common practice in markets when you want to make a large volume of bets, because it allows you to move faster than a human trader ever could.

  3. Dave Raithel
    January 29, 2020 at 1:18 pm

    “In economic [sic], this constancy of the object under study just does not exist.” Agreed. But there being “…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%…” is not the same problem. And if they are equally good – which I dispute as coherent – then I may as well flip a fair coin… but that’s to impose a principle of insufficient reason, which I still gather from Prof Syl, is insufficiently reasonable nor empirically sustainable.

    • January 29, 2020 at 3:09 pm

      See Asad’s examples of Simpson’s Paradox.

  4. ghholtham
    January 29, 2020 at 5:17 pm

    The proximate cause of the 2008 crash is well understood. When banks kept loans on their own books they did a certain amount of diligence and ensured borrowers were solvent with a good chance to repay. Once they could bundle loans together, securitize and sell them they got rid of (passed on) the risk of default. Their diligence procedures then collapsed and they started making very unsafe loans. Why did people take on debt they couldn’t repay? Because they used it to buy assets, mainly houses, they thought were bound to appreciate in price; they could always then remortgage to service the debt. Why did they think house prices were sure to appreciate? Because they had done so for the previous 70 years with only brief interruptions. Why did other investors buy the banks’ pieces of paper? Because they were mortgages and the historical default rate was less than 5 per cent. If you got the A slice of such a security you were buying the best 5 per cent of mortgages. How could those default when the best 95 per cent had never done so? So the scene was set. Any interruption in rising house prices led to defaults, forced sales of houses, further price falls, further defaults. A classic Minsky-style crisis. Some of the investors were foreign banks so the crisis spread.
    High levels of household non-mortgage debt and a doubling of the oil price in the previous years didn’t help.
    But why would anyone expect academic economists cloistered in the University of Chicago dealing with unrealistic abstract models to predict any of that? Macroeconomic models, even the sensible ones, wouldn’t predict it because they don’t usually have a variable for the quality of debt and they have the sort of dynamics that reflect mundane reality but can’t handle catastrophes or discontinuities. A number of economists did predict a crash or recession but most of them were practitioners, often operating in financial markets, who could see and understand what was going on.

    • Craig
      January 29, 2020 at 5:47 pm

      An accurate recitation of the idiotic, excessive and deluded DSGE facts. The only thing left out is the most underlying factor of all, namely the debt deflation that inevitably occurs when the scarcity ratio of costs and individual incomes manifests itself. That’s the Minsky/Keen re-discovered conclusion that has spawned a zillion theories and a handful of palliative reforms like Modern MONETARY Theory, FINANCIAL parasitism, Public BANKING, QE for the people and FINANCIAL Instability all abstractly dancing about and at least once removed from the temporal universe and individual solution, i.e. the new paradigm of Direct and Reciprocal Monetary Gifting.

    • Meta Capitalism
      January 29, 2020 at 11:34 pm

      The proximate cause of the 2008 crash is well understood. When banks kept loans on their own books they did a certain amount of diligence and ensured borrowers were solvent with a good chance to repay. Once they could bundle loans together, securitize and sell them they got rid of (passed on) the risk of default. Their diligence procedures then collapsed and they started making very unsafe loans. Why did people take on debt they couldn’t repay? Because they used it to buy assets, mainly houses, they thought were bound to appreciate in price; they could always then remortgage to service the debt. Why did they think house prices were sure to appreciate? Because they had done so for the previous 70 years with only brief interruptions. Why did other investors buy the banks’ pieces of paper? Because they were mortgages and the historical default rate was less than 5 per cent. If you got the A slice of such a security you were buying the best 5 per cent of mortgages. How could those default when the best 95 per cent had never done so? So the scene was set. Any interruption in rising house prices led to defaults, forced sales of houses, further price falls, further defaults. A classic Minsky-style crisis. Some of the investors were foreign banks so the crisis spread.

      — Gerald Holtham on Standard Narrative

      .
      This is a standard narrative in many economic textbooks that glosses over and hides the real underlying causes of the Subprime Crisis that are rooted in politics and power, greed and market manipulation, and the corrosive nature of the financialization of the real economy through first financial deregulation and then almost total regulatory capture of the SEC and other regulatory institutions in the United States.
      .

      But why would anyone expect academic economists cloistered in the University of Chicago dealing with unrealistic abstract models to predict any of that? Macroeconomic models, even the sensible ones, wouldn’t predict it because they don’t usually have a variable for the quality of debt and they have the sort of dynamics that reflect mundane reality but can’t handle catastrophes or discontinuities. A number of economists did predict a crash or recession but most of them were practitioners, often operating in financial markets, who could see and understand what was going on.

      — Gerald Holtham on Quality of Debt

      .
      There were actually a number of unrecognized “practitioners” who saw the crisis coming; some even tried, unsuccessfully, to raise the alarm and warn those within institutions creating the crisis of the problem. Some were internal auditors; others external auditors. The SEC had been gutted of resources and undermined for decades by politicians aligned with the ideology of predatory capitalism’s propaganda of the ‘efficient markets’ and ‘market fundamentalism’. After Enron they even put the Predatory Fox (Harvey Pit) in charge of the SEC, who was the lobbyist for the Big Five accounting firms that colluded with corrupt politicians like Newt Gingrich to defang the SEC and launch an attack upon FASB itself because the FASB Board agreed with the SEC that there was a serious conflict of interest in play when the auditor was providing both auditing services and financial consulting/technology services to the same client. One the Fox was guarding the henhouse he quashed all investigations into the problem.
      .
      Before the subprime driven GFC my wife and I were daily barraged with mortgage brokers seeking to move us from a 30 year fixed into one of Wall Streets new subprime adjustable rate loans that Greenspan crowed so glowingly about. I knew this was a shell game and Ponzi scheme even then. We finally invited one of the poor ignorant salespersons into our home so we could witness their BS selling points for ourselves (never once intending to fall for this short-sighted Ponzi scheme being waged against middle class Americans with little financial education). She sat there flipping pretty pie and bar charts reciting her sales mantra (“You will save $600 a month on payments”) never once discussing the downside — when interest rates change so does your payment, or interest only payments don’t decrease the principle, or when balloon payments kick and you can’t refinance as promised was so easy, you are essentially screwed. She even thought it important to tell us she herself had one of these exotic little financial monstrosities birthed on Wall Street. I bet she lost her home (and skirt) with the rest of the fools who bought into this Ponzi scheme.
      .
      At the time I was a software engineer in Microsoft having changed careers from corporate accounting (with a passion for forensic accounting). I literally watched my fellows go out and purchase a second home to make quick profits, some even going so far as to get their mortgage license and become “third party agents” for Washington Mutual bank.
      .
      The real story is told in how institutions and markets are manipulated through politics and power to serve the interests of predatory finance. After blowing up the housing market Goldman Sachs simply moves on to find another market to manipulate and turn into a Ponzi scheme. And that is just what they did.

      • Craig
        January 30, 2020 at 5:28 pm

        Thank you Meta and ghholtham for the bloody problematic details which I as well have posted about and agree with many times.

        When will you end describing the problems and start thinking in paradigmatic terms about their solutions?

        “It’s the monetary and financial paradigm, stupid.”

  5. Jorge Buzaglo
    January 29, 2020 at 5:28 pm

    In contemporary science, the “laws of nature” are as uncertain as the “laws of economics.”

    “Our faith in physics itself as an exact science has been badly shaken by the fuzziness and indeterminacy of quantum theory. … [T]he loss of objective certainty [is one of the most distinctive characteristics of 20th century physics]. … We’ve seen a loss of absolutes and an increasing appreciation of the important role of the observer in defining reality. We’ve seen the loss of complete predictability…” p. 3 in: R. Mills, Space, Time and Quanta—An Introduction to Contemporary Physics.

    • January 30, 2020 at 10:27 am

      “We’ve seen a loss of absolutes and an increasing appreciation of the important role of the observer in defining reality.”?

      So a failure to define the definable and lack of appreciation of how much of reality we will not be able to see.

  6. ghholtham
    January 30, 2020 at 11:14 am

    The proximate cause was as I described. Some of the deeper causes are laid out by Meta. The pursuit of profit in markets when power and information are unequally distributed requires those markets to be regulated if the public interest is to be served. And the regulator must be disinterested and not captured by any of the players. That condition was not met because democracy had long become plutocracy in the US. Banks should have been prevented from offloading risk and investment banks should have been prosecuted for false selling. It’s easy to say but politically not simple to achieve.

    • Meta Capitalism
      January 30, 2020 at 12:08 pm

      Agreed. Sadly.

      • Meta Capitalism
        January 30, 2020 at 12:08 pm

        BTW, Iceland did jail the banksters.

      • Meta Capitalism
        January 30, 2020 at 12:16 pm

        And told the banks to take a hike instead of bailing them out.

    • Meta Capitalism
      March 17, 2020 at 12:04 am

      The proximate cause was as I described. Some of the deeper causes are laid out by Meta. ~ Gerald Holtham

      .
      I have been reflecting on this distinction between “proximate” and “deeper” causes for a while now since this comment was made. As I make my way through Christian Müller-Kademann’s Uncertainty and Economics some clarity is emerging. His book provides a more concise vocabulary for expressing what I was already intuiting and had seen expressed by Lars, Fullbrook, Marques, etc. Christian does a service by dealing with the concept of complexity in the larger framework of human uncertainty. I have not finished his book yet so refrain from reaching any definitive conclusions on how to define proximate vs. deeper. It seems that the term “deeper” can be better defined at least partially with Christian’s idea of uncertainty.

  7. Meta Capitalism
    March 16, 2020 at 11:50 pm

    Christian Müller-Kademann’s book is key in cutting through a lot of confusion around the difference between predictability (risk) and true uncertainty that is intrinsically human (unpredictability). This dove-tails with the idea that there is at even the most basic levels of physical reality an “important role of the observer in defining reality.” That the participant-observer cannot be ignored or removed is they fundamental philosophical insight of Quantum Mechanics. And it applies to human uncertainty too and Christian does an excellent job articulating this reality.

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