Thursday, 17 November 2016

When the World Backfires on You

The world is fundamentally uncertain, as economists from Keynes to Mises to Knight embraced vigorously. Since then, economists and their love for mathematical precision have tended to lose this conviction. Events in the world are not, as intro-level econ courses would suggest, evenly scattered into nice well-known distributions whose proportions and features we are well aware of. It is not the case that every unknown future is reducible to quantifiable risk based on long-term, long-time averages the way insurance companies meticulously gather statistics on past events to profitably guess their future outcomes. Uncertainty isn't risk, and cannot be assumed to be.

This is how Mark Thoma summarizes Knight's basic point:
risk applies to situations where we do not know the outcome of a given situation, but can accurately measure the odds. Uncertainty, on the other hand, applies to situations where we cannot know all the information we need in order to set accurate odds in the first place.
Today, a discussion about a certain President-Elect (he-who-must-not-be-named?) with a dear friend of mine reminded me of this distinction and its importance for various doomsday scenarios left and right. Trump will do things, and they will largely be marginal or even irrelevant. Yes, yes, a lot of people will be affected and they will be more than a biggie at that time, but largely he won't do much to stop what economic historians call the Hockey Stick graph; here is Gregory Clark's first graph in his immensively controversial 2007 book The Farewell to Alms:

This basic economic-history-of-the-world-in-one-graph is surprisingly telling; through democrats and republicans, through bad presidents and good ones, through revolutions and bad harvests and world wars and welfare states, the market has kept delivering the goods. Some pesky Brexits and Trumps won't do much about that. As the wonderful McCloskey puts it after some back-of-the-envelop calculations in her 2006 book Bourgeois Virtues, the increase in life expectancy at age 15
of 2 or 5 times more years, was to become equipped by the end on average with that 8.5 times more goods and services. The combination of longer and richer lives is historically unique. It is one reason that liberalism has spread. There are by now many more adults living long enough lives sufficiently free from desperation to have some political interests. (p. 19)
And the market will keep delivering the goods. But the point I'm getting at here is much more fundamental: the future is so unknownable, so fundamentally unimaginably uncertain that brilliant inventions, creative destruction Schumpeter-style and events we simply cannot imagine will matter so much more than Trump ever will. There is simple no way Trump can wreck enough havoc to do more than marginally alter the way of the universe. Let me give 4 examples that I find inspiring and still telling, apart from the obvious ones of Airplanes, vaccines & germ theories, tech revolution and the Internet:

1) Great Monetary Experiment

One of the reasons for why monetary policy right now is so exciting is the unprecedented ("unconventional") activities they are doing. Terrifying, but addictively exciting. For years people from one side or the other have been crying wolf: either Nirvana is just around the corner, or Great Massive Inflation is killing us all. Cliff Asness summerized those debates fairly well:
Economically, I think what everyone of any political or economic stripe missed, certainly including myself, was how little money would circulate, how little would be lent and then spent. In econo-geek, how low the money multiplier would be. Money kept by banks at low but positive interest rates at the Fed clearly isn't doing much of anything, creating inflation as we feared, or helping the economy as they hoped. To the extent inflation worriers like us were wrong, so were those predicting great economic benefits. The Fed clearly wanted this money lent by banks and spent by companies on investment and by people on consumption. They didn't get that, and we didn't get the inflation we feared. This is not to say that low interest rates, real and nominal, and high prices for risky assets (and the supposed "wealth effect" that comes with them) were not Fed goals. They clearly were. But it seems these intermediate goals have not had their desired effect on the real economy.
Central banks do completely unprecedented things. To the best of their abilities, economists guess high and low what their outcomes would be. Something completely unexpected happens (=Banks simply sitting on the money) and neither scenario happens. The unknowable future struck back.

2) Long-Term Capital Management & Black-Scholes Formula

In the 1980s and 1990s, brilliant financial economists Fisher Black, Myron Scholes and Robert Merton elegantly solved a problem of pricing options, which ultimate earned the latter two the Nobel Prize in economics in 1997 (see the BBC documentary The Midas Formula for the particular story). Their models were the basis of the incredibly successful financial business Long-Term Capital Management (LTCM) who initially did very well. Their models so perfectly incorporated historic risk and volatility and made tons of money out of it. Then two events occured that few people predicted, and nobody understood the consequences of: the 1997 Asian financial crisis and the Russian default the following year. These two events were completely outside of LTCM's brilliant model, representing the unknowable future slapping you in the face. They lost an incredible amount of money in an incredibly short time, and the option-pricing (though apperantly accurate) was retired as an investment strategy. The unknowable future struck back.

3) Varoufakis' story about Paul Sweezy 

I particularly like this story, because it describes the achievements of the political left. Yanis Varoufakis told us USYD students this story back in May when he visited Sydney, and it goes back to famous socialist Paul Sweezy (if you've read any Marxian economics at all, you've come across this guy). Apparently, Sweezy was running extra-curricular weekly seminars in polical economy at NYU with no more than a handful students every semester. One day, at the beginning of a semester, the halls outside his classroom were completely packed with people. In his surprise, he asked what all of them were there for. Professor Sweezy's seminar on Political Economy! All of a sudden the same-old socialist ideas were in fashion and popular again. What had happened? The Vietnam War had happened, university students were raging and the left had probably its best decade ever in terms of popular and political influence. 

People may have seen the war coming. That it sparked an incredible revival of socialist thinking, I'm sure very few people predicted. The unknowable future struck back. 

4) The Revival of the Austrian School

At some point, Murray Rothbard is alleged to have estimated the number of libertarians in the world at 25 (presumably at the heigh of #3...). The Keynesian macroeconomics was basically undisputable, all-ruling and the era of the Phillips curve and wet dreams of central planning was all-encompassing. Then the OPEC oil embargo happened, which completely invalided the simple Keynesian framework economists had been working with until then. The Stagflation of the 1970s was a combination of oil prices and monetary policy and labour markets that we hadn't seen before, producing outcomes nobody had predicted. This created a massive interest for every other school of thought. In 1974 Hayek unexpectedly won the Nobel Prize for his research into business cycles (essentially his and Mises work on the Austrian Business Cycle Theory over their careers). The rest of the decade and the 1980s saw a massive increase in interest for the Austrian school. Lots of ideas were re-ignited, re-formulated, re-developted, including the socialist calculation debate I have written on before. The unknowable future struck back.

Bottom line: the future is unknowable. Things way beyond our understanding will happen, and whatever crazy policy Trump may come up will be marginal. These events will fundamentally change our lives, much more than this or that president. 

An interesting side note for an economist or economic historian is if the never-ending hockey-stick of economic growth will ever cease to work. I believe that it won't, unless we do something very stupid to it, although consistency with the main argument here compells me to at least question it. 

No comments:

Post a Comment