King’s End of Alchemy

Mervyn KIng The End of Alchemy: Money, Banking and the Future of the Global Economy Abacus 2017 (with a new preface)

4: Radical Uncertainty: the Purpose of Financial Markets

Coping strategies as rational behaviour under uncertainty

In a world of pure risk, where we can list possible future events and attach probabilities to them, there is a traditional view among economists of what constitutes rational behaviour – the so-called ‘optimising’ model. … in order to reach the highest level of ‘expected utility’.

Human capacity for making conscious calculations is bounded, but the ability of the human brain to engage in lateral thinking is well developed.

The fundamental point about radical uncertainty is that if we don’t know what the future might hold, we don’t know, and there is no point pretending otherwise.

The language of optimisation is seductive. But humans do not optimise: they cope. They respond and adapt to new surroundings, new stimuli and new challenges. … The challenge is to work out how a rational person might cope with radical uncertainty.

But behavioural economics assumes that deviations from traditional optimising behaviour result from the [supposed] fact that humans are hardwired to behave in a way that is ‘irrational’.

[Emotions] help us cope with an unknowable future and should not be seen as ‘irrational’.

[Heuristics] are better seen as rational ways to cope with an unknowable future.

Humans are … programmed to learn and to adapt. Coping strategies are … ‘ecologically rational’; that is, they … are well suited to the environment in which they are used. [They] are more rational than the economists’ assumption of optimising behaviour.

A coping strategy comprises three elements – a categorisation of problems into those that are amenable to optimising behaviour and those that are not; a set of rules of thumb, or heuristics, to cope with the latter class of problems; and narrative. Each heuristic … is specific to the environment in which it is used. The narrative is a story that integrates the most important pieces of information in order to provide a basis for choosing the heuristic and the motive for decision.

The heuristic must be operational and the narrative believable. … When things go wrong, as in the [2007/8/9] crisis, the cause is not necessarily irrational behaviour, nor an external shock, but possibly a mismatch between the chosen heuristic and the environment.

Financial markets and derivatives

   Talented mathematicians were recruited by banks to invent and market even more complicated instruments that often only they really understood. And even the mathematicians did not fully appreciate that all their sophisticated calculations could take into account only observable risk and not unquantifiable uncertainty. … Warren buffet described [these sophisticated instruments,] derivatives as ‘financial weapons of mass destruction’.

[Radical] uncertainty is the precondition of a capitalist economy.

The illusion of liquidity

Radical uncertainty makes it likely that from time to time there is a revision in the narrative guiding investor behaviour, or in the coping strategy as a whole, leading to sharp changes in traders’ perception of values … .

Stock prices move around because investors are trying to cope with an unknowable future. Their judgments … can be highly unstable. This instability is fundamental to a capitalist economy.

Under radical uncertainty, market prices are determined not by objective fundamentals but by narratives about fundamentals.

[Algorithms cannot easily change their strategy in the light of new information; so far only humans can rewrite algorithms, and that requires not raw computing power but judgement.

Central to a capitalist economy is the fact that the future cannot be seen as a game of chance in which the only source of uncertainty is on which number the wheel of fortune will come to rest.

Money is … a way of dealing with an uncertain future [as] generalised purchasing power, to be used in the future when unimaginable events occur.

8: Healing and Hubris: the World Economy Today

Keynesian and neoclassical economics

Radical uncertainty (“stuff happens”) means that … a market economy is not self-stabilising, lading to sharp ups and downs in total spending. Traditional macroeconomics is the economics of “stuff”. We need instead the economics of “stuff happens”.

Neoclassical economists thought the Keynesian story lacked a rigorous basis, and they proceeded to develop theories on the assumption that uncertainty about the future could be represented as a known probability distribution defined over an exhaustive lit of future outcomes. In other words, radical uncertainty was ruled out.

A common saying among economists is that ‘it takes a model to beat a model’. But this overlooks the fact that whereas a world of risk can be described by equations representing optimising behaviour, a world of radical uncertainty cannot be so described. … As a consequence, many of the statistical estimates of economic relationships turn out to be unstable, and break down during periods of crisis.

[‘Political economy’] variables [are] the driving force of major developments in the world economy. They represent not the random shocks of the forecasters’ models but the realisation of radical uncertainty.

Hyman MInsky [argued that] long periods of stability would … create excessive confidence in th future, leading to the underpricing of risk … .

But in the recent crisis there was no boom beforehand. … The idea that people have a psychological propensity to underestimate the probability of events that have not occurred for some time … underlies recent work on the psychology of financial crises. The problem with such explanations is that … they add complexity … without improving our ability to predict.

A different story: fuzzy budget constraints, narratives and disequilibrium

[The] concept of ‘rational’ expectations has no clear meaning in the world of uncertainty. Many economists will be reluctant to abandon the assumption of rational expectations because to do so appears to undermine the subject as a science … .But ideas that by their nature cannot be expressed as a formal mathematical model should not be abandoned out of hand.

The problem is not just complexity but also the pretence of knowledge. … Optimising over a false model is in many instances worse than the use of a coping strategy that works in your particular environment

[People] infer estimates of changes in … life-time incomes from perceptions of the sustainability of current spending rather than, as in the conventional economic models, the other way around. Second, one should revise the revise the estimate of life-time incomes only in response to individual news … or in the event of major changes in beliefs about the economy that changes the plausibility of the view that the current path is sustainability.

[Disequilibrium] may appear stable, but is not sustainable indefinitely.

[Possibly] the evolution of the economy itself creates a build-up of misperceptions and mistakes.

Causes and consequences of the 2008 crisis

The flaw with the Great stability was that that many people confused stability with sustainability.

Stability does not necessarily contain the seeds of its own destruction … . But stability accompanied by unsustainability offers only the appearance of true stability and at some point must come to an end.

[The] paradox of policy [is] where policy measures that are desirable ion the short term are diametrically opposite to what is needed in the long term.

An alternative history of the pre-crisis period

 each central bank acting on its own was faced with the invidious choice between raising interests rates sufficiently to dampen the level of domestics demand, knowing that th likely result would be a recession at home, and continuing on a path thar would in the end prove unsustainable and lead toi an even bigger recession. And even the former path would not have prevented the global financial crisis.

Long periods during which people are liable to misperceive their wealth and future income – supported by the stability heuristic – can lead to a disequilibrium that distorts [the economy]. When the narrative changes, the correction … can be violent – the economics of ‘stuff happens’ rather than the economics of ‘stuff’. [Financial] markets are only the messenger and not the cause of these misperceptions.

[A] move to a new equilibrium is what is required.

All the major economies faced a prisoner’s dilemma.

9: The Audacity of Pessimism: the Prisoner’s dilemma and the Coming Crisis

Without reform of the financial system … another crisis is certain … .

The coming crisis: debt forgiveness: necessary but not sufficient

Escaping the prisoner’s dilemma: wider international reforms

[The] ‘political trilemmas of the global economy’ … is the mutual incompatibility of democracy, national sovereignty and economic integration.

We must hope that the pressure of events will drive statesmen, even those of ‘inconceivable stupidity’, to act.

The audacity of pessimism

Spending is weak today, not because of irrational caution on the part of households and businesses … but because of a rational narrative that … consumer spending was unsustainably high … and must now follow a path below the pre-crisis trend. … Only a move to anew equilibrium consistent with the revised narrative will end stagnation.

Plotting a route to  new equilibrium is the challenge we now face.

In broad terms the aim must be two-fold – to boost expected incomes through a bold programme to raise future productivity, and to encourage relative prices … to move in a direction that will support more sustainable pattern of demand and production. … a reform programme might comprise three elements:

  • measures to boost productivity.
  • the promotion of trade.
  • the restoration of floating exchange rates.

Faith in capitalism has been badly shaken …

Inequality is one of the most important challenges to our economic system, but it was a symptom not a cause of the crisis.

As a society, we rely on [individuals, institutions and ideas]. But the greatest of these is ideas.


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