“Blindness” — by Muchanu Designs
Lord Keynes over at the excellent Social Democracy for the 21st Century blog has drawn my attention to a series of posts by the Swedish Post-Keynesian economist Lars Syll on probability and economics. This is a topic that I think absolutely fundamental in economic analysis in general, but also forecasting and explaining data in particular. I have written about this topic before elsewhere, but Syll’s posts are probably going to provoke me into writing more.
Although I am still making my way through them I have come across one in particular that I think raises a very interesting issue, namely the difference between Keynesian and Knightian uncertainty. For those who don’t know, Frank Knight was a neoclassical economist who nevertheless recognised that economics agents face a world that is not reducible to probabilistic reasoning. He made this point in his 1921 book Risk, Uncertainty and Profit which is available for download from the Mises Institute. The relevant passage from the book is on page 20:
It will appear that a measurable uncertainty, or “risk” proper, as we shall use the term, is so far different from an unmeasurable that it is in effect not an uncertainty at all. We shall restrict the term “uncertainty” to cases of a non-quantitative type. (Pp20, Emphasis author’s own)
As we can see Knight makes a strong distinction between a risk — which can, like a coin tossed over and over, be subject to measure — and an uncertainty — which is, in his words, “non-quantitative”. The manner in which Keynes deals with uncertainty appears, on its face, quite similar. Here is a particularly clear exposition from his 1937 article entitled The General Theory of Employment:
By ‘uncertain’ knowledge, let me explain, I do not mean merely to distinguish what is known for certain from what is only probable. The game of roulette is not subject, in this sense, to uncertainty; nor is the prospect of a Victory bond being drawn. Or, again, the expectation of life is only slightly uncertain. Even the weather is only moderately uncertain. 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, or the obsolescence of a new invention, or the position of private wealth owners in the social system, in 1970. About these matters there is no scientific basis on which to form any calculable probability whatever. We simply do not know.
Keynes’ thoughts on uncertainty stretch back to his early work on probability, specifically his 1921 book Treatise on Probability which is available at the Gutenberg Archive. In that work Keynes laid out a view of probability and uncertainty that, I think, went far beyond what Knight is talking about in his book. Syll agrees with me in this respect and he hits the nail on the head when he writes:
Knight’s uncertainty concept has an epistemological founding and Keynes’s definitely an ontological founding. Of course this also has repercussions on the issue of ergodicity in a strict methodological and mathematical-statistical sense. I think Keynes’s view is the most warranted of the two.
The most interesting and far-reaching difference between the epistemological and the ontological view is that if one subscribes to the former, Knightian view – as Taleb, Haldane & Nelson and “black swan” theorists basically do – 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.
This seems to me a very good distinction between the two world views. The Knightian universe is one in which the possibility for knowledge of truly uncertain entities potentially exists, while the Keynesian universe is one in which the possibility for knowledge of truly uncertain entities is a priori ruled out. The Knightian perspective implicitly postulates that somewhere out there is a place or an entity that contains such knowledge (one might point out that this is somewhat similar to a concept of an omnipotent God) while the Keynesian perspective postulates that this place or entity either does not exist or is ontologically inaccessible to us mortals. For Keynes and the Post-Keynesians we are, in this sense, born blind.
The implications of this for economic theory are nothing short of enormous. In Keynesian economics, for example, investment decisions are made in the face of true uncertainty. Investors work in the dark, as it were, and investment decisions are ultimately the result of what Keynes called “animal spirits”. In Chapter 12 of The General Theory of Employment, Money and Interest — available at Marxists.org — Keynes lays out his theory of animal spirits:
Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits—a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.
Understanding the role uncertainty plays in Keynesian theory actually brings up an important point which when articulated will highlight where I think I depart from Syll. While I am not particularly familiar with Syll’s work, his Wikipedia article tells us that:
He is a critical realist and an outspoken opponent of all kinds of social constructivism and postmodern relativism.
This is the philosophical position that is often attributed to Keynes himself, although I think this attribution incorrect. To understand the importance of this we must understand Keynes’ own philosophical background. In Cambridge when Keynes was a student there were two schools of thought that vied for authority. On the one hand there were the Hegelians and on the other hand there were the Rationalists.
Both were Idealists insofar as they believed that the external world did not exist independently of the human mind — in this they were both descendents of the great Irish philosopher George Berkeley. However, whereas the Hegelians argued that the world is ultimately the product of peoples’ beliefs and is thus constructed by these beliefs, the Rationalists argued that there were actually a priori rules that governed the human mind and these rules were discoverable. In short, the Hegelians held Truth to be somewhat relative while the Rationalists held it to be absolute.
The lines that exist between the critical realists like Syll and people who fall into the so-called postmodern camp are usually pretty much the same as those between the old Cambridge Hegelians and the Rationalist colleagues. Yet, I think that read correctly Keynes’ economics is actually far closer to the old Hegelian or the postmodern position than to the Rationalist or critical realist position. I do not, however, claim that Keynes was aware of this. Nevertheless, the following paragraph from Chapter 12 of the General Theory which I would argue lies behind the animal spirits theory of investment does seem to indicate that in Keynesian economic theory the ultimate determinate of investment — and hence of economic growth generally — relies on impulses that are based purely on socially constructed belief:
[P]rofessional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.
I have written elsewhere on this important aspect of Keynesian theory and those interested on my extended thoughts can read that piece, but suffice it to say that here that this indicates a strongly relativistic position on Keynes’ part. There is no Absolute Rationality dictating economic development at all. There are simply a bunch of investors that effectively work in a sort of hall of mirrors, guessing each others’ feelings and sentiments about the future. The image presented here is much like the one in the above painting: a bunch of blind people wandering around a topsy-turvy world, groping about and constructing stories in order to get by day-to-day.
Update 09/07/2013: I just came across the following exchange between Lars Syll and Paul Davidson on the difference between Knightian and Keynesian uncertainty that largely says the same as what I have said above in a slightly different way. Davidson also goes into some of the practical implications of the Knightian worldview which are worth reproducing here:
If you believe it is an ergodic system and epistemology is the only problem, then you should urge more transparency , better data collection, hiring more “quants” on Wall Street to generate “better” risk management computer problems, etc — and above all keep the government out of regulating financial markets — since all the government can do is foul up the outcome that the ergodic process is ready to deliver.
Long live Stiglitz and the call for transparency to end asymmetric information — and permit all to know the epistemological solution for the ergodic process controlling the economy.