Sunday, November 29, 2009

Keynes on uncertainty and risk

Keynes developed his views on risk and uncertainty in A Treatise on Probability. These were further refined in the General Theory. Upon reading more about Keynes and his views. I have concluded that the central thesis of Keynes is about living in a world of uncertainty. It is the uncertainty of what the future may hold which causes the fluctuations in the economic cycle. It was described as "animal spirits", but this simple phrase does not do Keynes or his views justice. Using the view of "Animal Spirits" actually may have been used by the rational expectationist as a way deriding Keynes as being ad hoc. The animal spirits was a plug that could not be explained. A closer reading suggests that Keynes was very thoughtful about risk. It actually focuses in three types of risk.

  • Cardinal or measurable probability. This would be the domain of risk proper. The easiest would be the probability of a dice. This could also be considered actuarial risk. I would also classify this as any risks that are countable. In actual reasoning, exact measures of this kind will occur comparatively seldom. My this reasoning risk management would be very difficult because there are many risks which are just not countable.
  • Ordinal probability or relative position of the event in a ranking. Something is more likely to occur but not how much more likely. This is the domain of uncertainty or vague knowledge. Most of the risks that we face would fall into this category. It is more likely to rain today than tomorrow but I cannot say how much more likely with any precision.
  • Unknown probabilities - the domain of irreducible uncertainty. There is non-comparable premises. We cannot say what the outcome of the Iraq War. We cannot say what type of bank regulation will come out of Congress.
We move from optimism and pessimism as our confidence changes between these uncertain alternatives.

"It depends on the confidence with which we make this forecast or how likely we rate the likelihood of our best forecast turning out quite wrong. The state of confidence as they term it is a matter to which practical men always pay the closet attention."

Uncertainty will affect the impact of any statistical work.

"With a free hand to choose coefficient and time lags one can with enough industry always cook a formula to fit moderately well a limited range of past facts. But what does that prove?"

From Robert Skidelsky, Keynes: The Return of the Master

If we focus on uncertainty and not the risk of the current economy, it makes sense why there is high unemployment. We cannot measure the impact of the credit crunch, housing market downturn, or the global imbalances. The result is a pulling back of any long-term decisions or investments. The government tries to fill the gap through deficit spending, but it misses the point that private investors will not make decisions if there is an uncertain environment. The role of the government is to provide clarity concerning the environment. How can this be done? Clear policies on regulation and rules of the game. There has not been enough discussion of the the institutional environment to provide clarity for investors.

Dubai and Keynes on investing and speculation

The default by Dubai is a significant investment event which while thought about and discussed in the newspapers was never really discounted. The announcement on Thanksgiving did not give investors time to digest the news. Money poured into Dubai even while the real estate boom turned in the rest of the world. Construction continued even when oil prices declined. This should not have been a surprise.

It reminds me of the comments by Keynes on banking and expectations:

"The sound banker, alas is not one who sees danger and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way along with his fellows so that no one can really blame him."

Keynes on expectations:

"The investor will be affected as is obvious not by the net income which he will actually receive from his investment in the long run but by his expectations. These will often depend upon fashion, upon advertisement, or upon purely irrational waves of optimism or pessimism. Similarly, by risk we mean not the real risk as measured by the actual average of the class of investment over the period of years to which the expectation refers but the risk as it is estimated, wisely or foolishly, by the investor."

His view on deflation:

"The fact of falling prices injures entrepreneurs consequently the fear of falling prices causes then to protect themselves by curtailing their operations."

On speculation:

"Speculators may do no harm as bubbles on a steady stream of enterprise. Bu the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino , the job is likely to be ill-done."

On being a contrarian:

"Is not the rule for an investor to be in the minority? It is the only sphere of life and activity where victory, security is always to the minority and never to the majority. When you find anyone agreeing with you, change your mind. When I can persuade the Board of my Insurance Company to buy a share that, I am learning from experience, is the right moment for selling it."

"It may often profit the wisest to anticipate mob psychology rather than the real trend of events and to ape unreason poleptically. .. to anticipate the basis of conventional valuation a few months hence, rather than the prospective yield of an investment over a long term of years."

From Robert Skidelsky, Keynes: The Return of the Master