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Uncertainty

from Lars Syll

Analytical Economics: 9780674281622: Economics Books @ Amazon.comIt may be argued … that the betting quotient and credibility are substitutable in the same sense in which two commodities are: less bread but more meat may leave the consumer as well off as before. If this were, then clearly expectation could be reduced to a unidimensional concept … However, the substitutability of consumers’ goods rests upon the tacit assumption that all commodities contain something — called utility — in a greater or less degree; substitutability is therefore another name for compensation of utility. The crucial question in expectation then is whether credibility and betting quotient have a common essence so that compensation of this common essence would make sense.

Just like Keynes underlined with his concept of ‘weight of argument,’ Georgescu-Roegen, with his similar concept of ‘credibility,’ underscores the impossibility of reducing uncertainty to risk and thereby being able to describe choice under uncertainty with a unidimensional probability concept.

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. 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.

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 both Georgescu-Roegen and Keynes convincingly argued, 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 many activities, relations, processes, and events are of the Georgescu-Roegen-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 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. deshoebox
    September 28, 2022 at 7:31 pm

    I have mentioned this before, but I’d like to remind readers of two things. The first is that probability cannot be assigned to individual events, only to series of events. We do not know if the probability of heads is 50 percent when we flip a coin, only that if we flip it 100 times the incidence of heads is likely to be close to fifty. The other is that non-transitive preferences are possible and that they mostly likely pertain to most of the choices we make in the real world. No economist that I know of is even willing to admit that non-transitive preferences are possible. But if there are three or more options, each characterized by at least three criteria, non-transitive preferences are easy to model, with A preferred to B, B preferred to C, but C preferred to A. There may even be non-transitive risk assessments.

  2. rsm
    September 29, 2022 at 2:59 am

    “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.”

    In financial markets (which transact at least an order of magnitude more in daily dollar volume than real markets), can’t you buy and sell insurance? What if you could purchase a $1 (say) option to buy sunglasses at your destination, then the price of that option would fluctuate depending on many factors (possibly involving intransitive preferences on the part of option dealers), so you might make enough by selling options to buy a pair of sunglasses outright, if you need them?

    In other words, hasn’t finance solved risk, with the central bank providing support as needed?

    My question has been ignored when I’ve posted it before, as this passage keeps coming up on Lars’s site (from which I seem to be shadowbanned again); may I ask if it is somehow offensive, or incomprehensible (study options markets?), or is there something obvious that I’m missing?

  3. Meta Capitalism
    September 29, 2022 at 7:53 pm

    [S]o you might make enough by selling options to buy a pair of sunglasses outright, if you need them? In other words, hasn’t finance solved risk, with the central bank providing support as needed? ~ RSM on making enough money

    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. ~ Lars on risk vs uncertainty

    I just want to add that CBOE [Chicago Board Options Exchange] in early ’70 was looking to market a new product: something called “options.” Their issue was that how you can market something that no one evaluate? You can’t! You need a model that helps people exchange stuff, turn[s] out that the BS formula … did the job. You have a way to make people easily agree on prices, create a liquid market and … “why not” generate commissions. ~ Luca Parlamento in Breaking Mathematical Sense

    • rsm
      October 4, 2022 at 10:26 pm

      Thanks for replying, Meta Capitalism; but where is the disaster, if the Fed prints enough of the world’s best money to insure us against the mistakes of private insurers?

      Lars also says in a more recent blog entry, on his site: 《In mathematics, the deductive-axiomatic method has worked just fine.》But doesn’t the existence of paradoxes such as Banach-Tarski effectively prove 1 = 2, thus by explosion you can prove anything with math?

  4. October 1, 2022 at 4:49 am

    Reblogged this on Calculus of Decay .

  5. gerald holtham
    October 4, 2022 at 11:03 pm

    Lars has got his teeth into a bone all right but I think he is chewing the wrong end of it. Economics is very poor at dealing with the pervasive uncertainty of economic life but that is not because it claims to foretell the future. It is because it too often theorises about people’s behaviour as if they were confident they could foretell the future. In fact not only do people not know about the future they are perfectly aware of that fact and have diverse opinions about it. They evolve coping mechanisms to make decisions and get on with their lives although beset by uncertainty. Traders quote option prices, insurance companies will quote you a premium, bookmakers will give you prices on the 3.30 race. They do not wring their hands about the impossibility of reducing uncertainty to risk and relapse into catalepsy. Sometimes their mechanisms will be appropriate, sometimes not. If economics is the study of human behaviour in the commercial context it is supposed to study those mechanisms and seek their predictable elements. Just because we can’t foretell the future it does not mean we cannot observe and predict how people prepare for it. Unfortunately that sort of empirical observation is regarded as “ad hoc” by some theorists who prefer to assume people behave as if they possess information that they do not and cannot have.
    We’ve known about the Knightian distinction between risk and uncertainty for about 100 years, Going on about it risks missing the point. The issue is: how can the way that people behave when faced with strictly unquantifiable uncertainty be modelled? Do they act as if they were operating on the basis of a risk calculus? Very often they do. There is no ultimate ontological basis for saying the favourite in the 3.30 is 6-4 against. But the bookmaker arrives at a number and moves it under the weight of opinions and bets. The question for the student of human behaviour is not who will win the race but given the form of the horses can I predict the ex ante odds. We’re studying behaviour not augury. Rational expectations is indeed stupid – not because it claims to know the future (a straw man) but because it supposes people act on the basis of a single confident expectation. In which case there could be no trading and no betting so it fails as an explanation of behaviour.

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