Monday, June 21, 2010

Keynes and uncertainty

Keynes in the 1937 Journal of Economics take another look at uncertainty.

By ‘uncertain’ knowledge, let me explain, I do not mean merely to distinguish what is known for certain from what is only probable. The game of roulette is not subject, in this sense, to uncertainty; nor is the prospect of a Victory bond being drawn. Or, again, the expectation of life is only slightly uncertain.... The sense in which I am using the term is that in which the prospect of an European war is uncertain, or the price of copper and the rate of interest twenty years hence, or the obsolescence of a new invention, or the position of private wealth-owners in the social system in 1970. About these matters their is no scientific basis on which to form any calculable probability whatever. We simply do not know. Nevertheless, the necessity for action and for decision compels us as practical men to do our best to overlook this awkward fact and to behave exactly as we should if we had behind us a good Benthamite calculation.... How do we manage?... (1) We assume that the present is a much more serviceable guide to the future than a candid examination of past experience would show it.... (2) We assume that the existing state of opinion as expressed in prices and the character of existing output is based on a correct summing up of future prospects.... (3) Knowing that our individual judgment is worthless, we endeavour to fall back on the judgment of the rest of the world which is perhaps better informed....

The key here seems to be a vague and embryonic outline of some of the ideas of behavioural finance. How do we deal with uncertainty when there is no basis to make an estimate of probabilities? What short-cuts can the mind use to deal with these issues? One of the things that Keynes suggests here and the The General Theory is the idea that we assume that things will be rather similar to how they have been in the past. This is probably a reasonable starting point. It is conservatism. Another thing that Keynes suggests is that we look to the opinion of others. Here we get the basis for a social construction of belief.

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