08 September 2009

Taking Uncertainty Seriously

I have just finished reading Robert Skidelsky's "Return of the Master" which is about why Keynes is still the most important economic thinker in the world. The book goes though the litany of reasons for the crash: bank institutional failures, China hoarding dollars because of uncertainty, asset bubbles in the UK and US, consumerism and hubris. But behind all of these is a a failure of ideas.

The book has two main arguments.

First, markets cannot price all forms of risk because there are some things we do not know (drumroll Donald Rumsfeld please)--what Skidelsky calls the "irreducible minimum". The models of the Neoclassical and, to a lesser extent, Neo-Keynsian economists however value "beauty over truth" (see Paul Krugman in this week's New York Times magazine). They want to cover all eventualities and the way they do that is to circumscribe all eventualities in a false set, defined by the models themselves. In this way the models don't even entertain the fact that some markets are not self correcting. They assume frictionless markets with cool calculating agents operating with perfect information. As Skidelsy notes, macroeconomics should be built on expectations that are human or conventional, not on those that are rational.

Second, economics should think of itself as a moral not a natural science. It should not be so dominated by market efficiency and the pursuit of money. Money is the "continual stimulator of our imagination creatign a perpetual sense of dissatisfaction".

The solutions?

Economics should have a "more modest role as tutor of governments"
  • A new synthesis of government and market action
  • Build financial models that can cope with irreducible uncertainty and make governments focus on reducing the impact of uncertainty
  • Develop a new global reserve currency that is not influenced by any one country's needs
This will be hard for the freshwater (e.g. Chicago neoclassicals) and the saltwater (the coastal US NeoKeynesians) economists to take but, as a Stanford economist myself, these seem like the right answers to me.

1 comment:

Dominic Furlong said...

There's a good review of the Skidelsky book, as well as "Keynes: the 20th Century's Most Influential Economist" by Peter Clarke on the New Statesman
website: http://www.newstatesman.com/.

The reviewer, Andrew Gamble, mentions the problems caused by the conflation of risk and uncertainty by economists - not sure whether this includes those from Stanford but does seem to include the saltwater and freshwater types...