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.