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Irreducible Uncertainty

July 26, 2010

However indebted to Keynesian economics, policymakers in the U.S. and Europe have rejected at least one of its key tenets: irreducible uncertainty.

According to biographer Robert Skidelsky*, Keynes believed that in many situations market participants “have no basis on which to calculate the risks they face in making an investment,” but are instead “plunging into the unknown.” Likewise, Keynes argued, no amount of competence or access to data on the part of policymakers can eliminate risk entirely.

The policymakers described by this article in today’s Washington Post, have, by contrast, set out to study so as to effectively control ‘systemic risk’ — particularly “run-ups in the prices of real estate or other investments, or a quick expansion of credit and lending.” Already, recommendations that central banks prevent future bubbles by controlling interest rates and raising capital requirements for banks are being floated, and a Financial Stability Oversight Council has been created as part of the financial reform bill.

In short, economic policymakers believe that market participants cannot be trusted to manage risk effectively, but the state can. Neoclassical economics stands on its head.

Supposing Keynes is correct in asserting that not all risk can be managed, however, it follows that policymakers have deceived themselves. At the same time, Keynes’ desire to have the state manage uncertainty — which he distinguishes from risk — seems questionable. According to Skidelsky, Keynes believed that

Risk could be left to look after itself; the government’s job was to reduce the impact of uncertainty. Risky activities, Keynes implies, should be left to the market, with entrepreneurs being allowed to profit from good bets and to suffer the consequences of bad bets. On the other hand, uncertain activities with large impacts should be controlled by the state in the public interest.

The phrase “irreducible uncertainty” used elsewhere by Skidelsky would seem to imply something along the lines of Donald Rumsfeld’s famous “unknown unknowns”; it implies that the state cannot safeguard the public interest based on a determination of which types of financial activities will have disastrous impacts and which won’t, since such a determination cannot possibly be made. Yet Skidelsky, building upon Keynes’ analysis, proposes to do just that through a reinstatement of Glass-Steagall and/or higher capital requirements on banks.

So what we have is a series of substitutions — systemic risk for the individual risk taken on by firms, and “uncertain activities with large impacts” for individual and systemic risk — each time with someone professing to be in control. Keynes comes closer than the policymakers described in the Washington Post article, but finally fails to admit that there are some things no one can control.

* All Skidelsky quotes taken from Keynes: The Return of the Master, highly recommended reading.

3 Comments leave one →
  1. August 3, 2010 11:25 pm

    Your right there is a definite distinction between risk and uncertainty.
    Risk can be measured. It’s subject to a normal distribution or if your like Taleb (Which I am) subject to fat tails and black swans.

    Uncertainty is unmeasurable. Uncertainty lies at the heart of the human condition, live and death. Meaning that the only things that are certain are that one moment your alive and the next moment your going to be death…but you will never know when those moments will be.

    People have an inherent need to feel like they have control. I think this is the predominant reason for most religions, a need for control. A religion either gives control to the person (like Buddhism) or to a higher being (pretty much everything else). Either way someone or thing is in control. People just can’t handle chaos, even though chaos is omnipresent in nature.

    In politics there are two religions, the government can “fix” everything or the market will fix everything. Liberals and Neo-Conservatives tend to be in the former and libertarians tend to be in the latter. As with most religions both sides won’t accept any evidence that contradicts their beliefs. Sowell has written extensively on this as well.

    The problem, as I said above, is that people (most, not all) just can’t accept randomness. There is something about the hard-wiring of our brains that makes us incapable of accepting that things are random and we can’t do anything about it. As a result you have people that want Government to fix the uncertainty in our financial system. A system that has randomness at it’s very core.

    As regulators are busy trying to foresee the next bubble, they are incapable of seeing the one that has formed, US Treasuries.

    My problem with Keynes is that most people only read the worst thing he ever wrote, General Theory. They barely if ever have even heard of his best works, Consequences of Peace and Treatise on Probability.

  2. innocentsmithjournal permalink*
    August 3, 2010 11:43 pm

    It sounds like you, me, and Keynes more or less agree about uncertainty — imagine that! Some really great reflections here about the human need to feel in control, despite such uncertainty, and how that need manifests itself in politics and religion.

  3. August 4, 2010 12:13 am

    Well you might like this post on my friend Seth’s blog;

    Most of my thoughts come from my readings of Hayek and Sowell.

    I think most of the disdain for markets stem from the fact that no one controls the markets.

    Yes we all do agree with uncertainty. Now for other things…I’m pretty sure we all don’t agree. ha ha

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