More on Radical Uncertainty

Gabriel Mihalache has criticized the views of myself and others on radical uncertainty as follows:

Some people wrongly interpreted Caplan’s point as being one about markets, so they jumped at a chance to criticize a set of complete, contingent markets, but a) this is not about markets, but rather about agents; and b) neoclassical economics can be done with incomplete markets or no markets at all!

Contingent claim markets are used in models of representative agents, so I am not sure where this criticism quite fits. The problem that I have with contingent claim markets and the use of representative agents in general equilibrium theory is far too expansive for a blog post. Similarly, I do not want to get bogged down with other elements of GE theory.

First, I would point out that the world is non-ergodic (to use a term of Doug North, Paul Davidson, and others). As the quote from Keynes in my previous post as well as the work of Schumpeter on creative destruction indicates that there is no probability distribution that exists for invention, innovation, etc. Similarly, as Doug North points out, economists treat uncertainty (as defined in the Knightian sense of the word) as though it is a rare case, when in fact, “it has been the underlying condition responsible for the evolving structure of human organization throughout history and pre-history” (Understanding the Process of Economic Change, Douglass C. North, p. 14).

Thus, ignoring the misuse of uncertainty in the general equilibrium framework, let’s use the classical example of risk and uncertainty from microeconomics. An actuarially fair insurance premium would be such that:

Premium = p*L

where p is the probability of the event and L is the loss. (We can expand this to include a risk premium, but it would not embolden our analysis). Of course, in reality, there are cases where both p and L are unknown. Suppose, for example, one wanted to purchase insurance against the risk of the price of a given commodity falling over an extended period of time. What is the likely price of that commodity 5 years hence? 3 years? 1 year? 3 months? What is the probability that the price will fall? As Keynes would say, “About these matter there is no scientific basis on which to form any calculable probability…”

I am in no way trying to argue that models or risk and uncertainty should be abandoned. They are clearly useful in cases in which the probabilities and potential losses are explicitly known. However, we would do well to recognize that the world is not ergodic and that always and everywhere modeling it as such is an impediment to our understanding of complex human interaction.

4 responses to “More on Radical Uncertainty

  1. So, what are you _practically_ going to do about it? A stylized model that you might think is literally wrong is better than no model at all.

    Models are structure. You say, basically, that no structure is possible. Fine. But then _you_ come up with a quantitative theory of decision making, a theory in which “Knightian uncertainty” plays a role in determining quantities and, more precisely, the choices of agents.

    Under what circumstance will I pick option A over option B, mindful of Knightian uncertainty? And on what grounds/reasoning?

    The world might be non-ergodic (I happen to think that it’s not, properly conceived, but whatever) but even if it isn’t, it might still make sense to model it as if it were. –

  2. You may be interested in what sir John Hicks wrote about Keynes after I introduced him to the concept of a nonergodic stochastic process:

    Hicks had written [1939, pp. 1-4] that he “had the fortune to come upon a method of analysis….The method of General Equilibrium… was specially designed to exhibit the economic system as a whole… [With this method] we shall thus be able to see just why it is that Mr. Keynes reaches different results from earlier economists”. Hicks (1937) used this method to develop his IS-LM model where the real and monetary aspects of the economy are divided into independent subsets of equations. These independent subsets requires the neutral money axiom.. Accordingly, this ISLM model is merely another classical theory version of Samuelson’s neoclassical synthesis Keynesianism. It violates Keynes’s argument that his theory rejects the neutral money axiom!!

    In 1971, I met John Hicks at a six day IEA conference on the microfoundations of macroeconomics. At the conference my participation (Davidson, 1977, pp. 313-17) emphasized the importance of contracts, the existence of spot and forward markets, and the need for liquidity. In the discussion at the end of the conference I emphasized the fact that a classical “general equilibrium model was not designed to, and could not answer the interesting macroeconomic questions of money, inflation and unemployment…. if we [economists] insist on balancing Keynes’s macroeconomic analysis on an incompatible general equilibrium base we would not make any progress in macroeconomics; we would also regress to the disastrous pre-Keynesian solutions to the macro-political-economic problems” (Davidson, 1977, p. 392). By the end of the conference, Hicks informed me that the microfoundations of his approach to macroeconomics was closer to mine than to any one else at the conference (where other participants included future Nobel Prize winners Tinbergen and Stiglitz).
    Over the next few years, Hicks and I met privately several times in the UK to continue our discussions regarding the microfoundation of Keynes’s general theory. By the mid 1970′s Hicks (1976, pp. 140-41) was ready to admit that his IS-LM model was a “potted version” of Keynes. By 1979 Hicks (1979, p. 38) was arguing that economics is embedded in calendar time and a relationship that held in the past could not be assumed to hold in the future Hicks. In an article in the Journal of Post Keynesian Economics entitled “ISLM: An Explanation”, Hicks
    (1980-81, p. 139) recanted his ISLM model when he wrote : “As time has gone on, I have myself become dissatisfied with it [ the ISLM apparatus]. In this JPKE article, Hicks admitted that the ISLM formulation did not describe Keynes’s general theory approach at all.
    Finally, after reading my paper on the fallacy of rational expectations (Davidson, 1982-3), Hicks wrote to me in a letter dated February 12, 1983 “I have just been reading your RE [rational expectations] paper….I do like it very much….You have now rationalized my suspicions, and shown me that I missed a chance of labeling my own point of view as nonergodic. One needs a name like that to ram a point home”.
    Thus the author of the IS-LM analysis renounced his famous formulation of Keynes’s framework and accepted the Post Keynesian view of what was the basic analysis in Keynes’s General Theory.

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