Risk, Uncertainty, and Black Swans
In 2009, in the midst of the financial and economic crises, Robert Skidelsky, the acclaimed three volume biographer of Keynes, added a fourth, Keynes: The Return of the Master. It is a radical and provocative assessment of economic theory since Keynes, insisting that at its core Keynes’ s Keynesianism was about uncertainty, about the irreducible uncertainty that cannot be cast in probabalistic terms, about Donald Rumsfeld’s famous “unknown unknowns” in contrast to the “known unknowns” that pass as risk. It is this uncertainty that lies behind booms and panics and accounts for the inherent instability of markets and thus of capitalism itself. For Keynes, says Skidelsky, “the unmanaged capitalist economy is inherently unstable.” The notion that financial markets could be self-regulating, that was so prevalent amongst the poweful and within our profession only yesterday, was anathema to Keynes.
Paul Krugman, the Nobel prize winning economist who writes a widely read column in the New York Times, while recognizing the validity of Skidelsky’sÂ reading of Keynes – I have already drawn on Krugman’s lucid explanation – insists on a different and more customary reading, that Keynes is about the slaying of Say’s Law that supply creates its own demand, that because money can be hoarded and credit withheld, there can be an equilibriumÂ with unemployment, hence recessions and depressions, and a deflationary gap that needs to be closed. This was the body blow that Keynes dealt to neo-classical economics.
Skidelsky does not so much disagree with Krugman as see him as part of the problem. There has emerged in recent times, Skidelsky reminds us, the New Classical Economics of Chicago’s Robert Lucas and the rational expectations school, and the New Keynesian Economics of Princeton’s Paul Krugman and Columbia’s Joseph StiglitzÂ (all three being Nobelists) – also known in some circles as freshwater and saltwater schools. They see each other as mortal enemies, the first insisting on the perfection of markets and the second on their imperfection.Â This is most evident in their different understanding of market information, including unavoidably their perceptions about the future.
And, it must be instited upon, they are very different in terms of their political propensities, the New Keynesians being on the side of the good and the New Classicists not. Nevertheless, insists Skidelsky, at their core they are the same. They both believe that the unknown is knowable, that is, both buy into the theory of rational expectations. The New Classical Economics believes thatÂ is simply so. The New Keynesian Economics believe it can be made so as by correcting for asymmetries of information – where one side in a market transactions knows much more than the other. In effect, the New Keynesians accept the logic of the New Classicists and, as Skidelsky succintly puts in, “in economics logic is everything.”
If this seems like a harsh way to treat Krugman and Stiglitz, Skidelsky justÂ happens to believe that until economicsÂ gets it right, the real world, which is dependent on we economists for theories and models -Â in short, for ideas – can’t hope to get it right; take it as a compliment. As it is, in the World’s Biggest Casino, we, the economists, do the heavy lifting, while they, the hedgers and the speculators, spin the wheel and take in the chips.
Stiglitz in his new book, Freefall: America, Free Markets, and the Sinking of the World Economy, writes “Among the long list of those to blame for the crisis, I would include the economics profession, for it provided the special interests with arguments about efficient and self-regulating markets – even though advances in economics during the preceding two decades had shown the limited conditions under which that theory held true.” He seems to be saying that if the New Keynesians had been listened to there wouldn’t have been a crisis. “The New Keynesian solution is to say that people are rational but have information problems,” writes Skidelsky who insists that there is simply an “inescapable information deficit.”
In the 1960s, when I was alive and well, the Keynesians came to believe that they could fine-tune the economy. It turned out they couldn’t and that failure opened the door to monetarisms and its elaborations. Today the New Keynesians may believe that they can correct the imperfections of financial markets – today’s version of fine-tuningÂ – but if this can’t be done there will simply be more crises.
Skidelsky reminds us that there is yet a further and very real and relevant problem, that of the Black Swan as admumbrated by Nassim Taleb. Black Swans are rare and extreme events. In principle a probability attaches to them but in fact they are so improbable that they are ignored by models based on the bell curve. Though known unknowns, they are, being unpredictableÂ as to time and place, really unknown unknowns. But they happen; indeed, the Great Depression was surely a Black Swan. Skidelsky argues that the financial crisis which still haunts us is likewise one. If so, count this a further failing of orthodoxy, both New Classical and New Keynesian – though Stiglitz says that he and other likeminded economists foresaw the crisis, though not its precise date, by noting the number of financial crises that preceded it in other countries, like Mexico, Argentina, Thailand, etc.
Nor does Skidelsky see behavioural economics as any real advance. Indeed, he is dismissive of it: “The adoption of ‘irrationality’….as a general explanation smacks of theoretical panic.”
But how does this matter for what truly matters, namely, economic policy for the public good?Â Insofar as financial markets abound in innovations of fiancial instruments which ultimately rest on the assumption that probabilities are knowable which are not, the case for regulation, for deep regulation, is compelling. Better to stop the mess from happeningÂ than focusing on trying to clean upÂ afterwards. In Skidelsky’s words: “Macroeconomic policy boils down to reducing the amount of uncertainty in the economic system as a whole.” Put most bluntly: “The future is not out there waiting to be learned; we create it ourselves.”
And insofar as the costs of mismanaged risk is borne disproportionately by the innocent as collateral damage, namely, by ordinary folk, irreducible uncertaintyÂ strengthens the case for safety nets to keep the losers from falling too far. In the words of the German sociologist Ulrich Beck, “Wealth rises to the top while risk sinks to the bottom.”
PostÂ Keynesians, those who remained close to the spirit of Keynes, like Hyman Minsky and Paul Davidson, have paid the price of being marginalized within the economics profession. So, if economics itself is the problem, reform will not come easily. But, like Keynes, Skidelsky thinks that ultimately it is ideas that rule the world and that economists therefore have an obligation to change the economics that we teach and practice. Without an economics to do the math and legitimize their behaviour, financial actors will be less able to do damage. Professional hubris must cease feeding capitalist greed.
In this grossly materialist world, power speaks the language of greed and certainty knowns as orthodox economics. It is no accident that economics is the dominant discourse of business schools, that without it they would be without clothes to hide their intellectual nakedness. Deny power the language and power is humbled.
For his part Skidelsky writes: “I have come to see economics as a fundamentally regressive discipline, its regressive nature disguised by increasingly sophisticated mathematics and statistics.” “[I]t was the wrong ideas of economists which legitized the deregulation of finance, and it was the deregulation of finance which led to the credit explosion which collapsed into the credit crunch.” A little fine-tuning of the discipline will not suffice.
At the graduate level, Skidelsky thinks microeconomics, with its basis in rational behaviour narrowly conceived and in certainty of outcomes, should be sent to the business schools where it can be supplemented by wider case studies. (I personally love this one.)
Macroeconomics should be taught as one half of a double major with philosophy or history or sociology or politics, etc. etc. but not mathermatics. “A broadly based postgraduate course in macroeconomics would study not just the implications of particular policies for economic stability, growth and development, but also their social and moral implications.”
Skidelsky is not optimistic this will happen. But he cites Thomas Kuhn’s position that paradigms will crumble when the burden of anomalies becomes excessive and, with the present crisis, more anomalies have been exposed with slight evidence that the conventional wisdom, being more of the same, will lead to their correction. “The time is ripe for a new ‘paradigm shift’, which needs to build on Keynes’ original insight into the nature of behaviour under conditions of uncertainty.”
There is at least the possibility – we cannot pretend to the probability – of a more vibrant progressive economics. We who call ourselves progressive would be wise to stay our course.
(I am indebted to John Hutcheson for insisting I read Skidelsky and to Duncan Cameron for firstÂ telling me about Taleb and Black Swans, but I am alone responsible for the views expressed here.)