Macroeconomics and the Friedman-Savage ‘as if’ logic

from Lars Syll

0An objection to the hypothesis just presented that is likely to be raised by many … is that it conflicts with the way human beings actually behave and choose. … Is it not patently unrealistic to suppose that individuals … base their decision on the size of the
expected utility?

While entirely natural and under-
standable, this objection is not strictly relevant … The hypothesis asserts rather that, in making a particular class of decisions, individuals behave as if they calculated and compared expected utility and as if they knew the odds. The validity of this assertion … depend  solely on whether it yields sufficiently accurate predictions about the class of decisions
with which the hypothesis deals.

M Friedman & L J Savage

‘Modern’ macroeconomics — Dynamic Stochastic General Equilibrium, New Synthesis, New Classical and New ‘Keynesian’ — still follows the Friedman-Savage ‘as if’ logic of denying the existence of genuine uncertainty and treat variables as if drawn from a known ‘data-generating process’ with a known probability distribution 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 really honestly believes that we 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 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.

Some macroeconomists, however, still want to be able to use their hammer. So they — like Friedman and Savage — 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 the roulette wheels, is a sure recipe for only one thing — economic catastrophe!

  1. deshoebox
    November 18, 2022 at 2:18 am

    If you enjoy erudite bullshit, I recommend Friedman’s “Methodology in Positive Economics”. It explains fully (and, of course, erroneously) how the “as-if” method is exactly like what real scientists do. Naturally, this is is false. The essay is hilarious, from a logical point of view. Another problem is that not only do people not know the probability of consequences resulting from single decisions, it is not even theoreticallly possible to assign probabilities to individual events. If I flip a coin 100 times I am likely to get heads around 50 times, generally. If I flip a coin once, there is really nothing to say about the probability of its coming up heads. It may be 100 percent, for all I know. Or perhaps it is zero percent, for reasons I have no way of guessing at. It is high time to put this way of ‘reasoning’ behind us and work on an economics that is based on the real world and how actual people think!

  2. Edward Ross
    November 18, 2022 at 5:34 am

    reply to deshoebox last sentence “It is high high time to put this way of reasoning behind us and work on an economics that is based on the real world and how actual people think.” I COULD NOT AGREE MORE. To me this requires understanding not only how the brain works and what makes an impression on it. This requirement applies to both the people being studied and the people being studied. Here i remember David Taylor Learning to re-envisage the economy (part1and 2)as a great starting point but ignored by all who could have commented in the journal Ted

  3. Edward Ross
    November 18, 2022 at 5:38 am

    correction this should have read and the people doing the study ted

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