John Maynard Keynes on probability

In this blog post, the reader will find a challenging but maybe fascinating brief treatise on the subject of economic theory, inspired by current events.

It was reported yesterday that the Eurozone is on the brink of a double dip recession after its economy shrank in the second quarter. Gross National Product (GNP) across the 17-nation block fell by 0.2% and economists believe the downturn is continuing. We are not surprised.

We have written previously on this blog about the national debt crises and its impact. It is a macro economic crisis with national governments unable to manage national debts and the inevitable effects this will cause.

John Maynard Keynes was one of the most influential economists of the 20th century and everyone knows of his ideas on macroeconomic policy. His General Theory of Employment, Interest, and Money, published in 1936, proposed increased or decreased government spending in response to economic fluctuations.

Governments have been allowed to fund themselves through borrowing since Keynes proposed that inadequate aggregate demand could lead to prolonged periods of high unemployment.

The Keynesian theory said that national governments should borrow and spend on public works in recessions to keep up demand, and thus smooth the transition to the next boom period when the national government budget should run a surplus.

The problem with the theory is that it justified the decision by many national politicians to run an almost permanent deficit. Political parties with the ambition to be re-elected are hesitant to recover the debt by running a surplus.

Step by step small and big national decisions have been taken whereby irresponsible overconsumption has continued in too many countries.

Keynes was a very intelligent man, so one may wonder, was this risk overseen by Keynes or is there something missing in the modern interpretation of the theory? Inquisitive readers may find out the truth in what follows below.

In recent months, politicians in European countries calls for centralising more fiscal policymaking in Brussels, giving the EU a veto on member states national budgets. We believe this may be one way to stop irresponsible fiscal spending but it will not help economic recovery.

We believe a sustainable path to recovery is to combine centralized fiscal control with more local initiatives.  Instead of the current overconfidence in centralisation, politicians should go for decentralisation and encourage places and regions in Europe to develop their local attraction forces and rebuild European wealth from the local places.

In parallel to the dramatic national events, we observe that local and regional place managers take initiatives to tackle the crises by new innovative strategies, and the EU is adequately responding by providing Framework program support in such initiatives. This is promising and we in Bearing do our part in supporting regional and local innovation projects.

It is interesting in this time of turbulent change, to consider how John Maynard Keynes thought about risk. In a column in the Financial Times yesterday (August 15, 2012), John Kay, visiting professor at the London School of Economics, describes his view on this.

Keynes began his career in the India Office of the British government. While working there, he spent his spare time, and even some office time, working on a theory of probability for submission as a dissertation for a King’s College fellowship. He won the fellowship in 1908. The dissertation was afterwards enlarged and published in 1921 as A Treatise on Probability.

Probability is intimately connected to the concept of risk. Risk is the probability that a hazard will turn into a disaster. Vulnerability and hazards are not dangerous, taken separately, but if they come together, they become a risk or, in other words, the probability that a disaster, or in other words negative outcome, will happen.

In the highly readable book Against the Gods: The Remarkable Story of Risk (1996), Peter Bernstein explored the role of risk in our society. Peter Bernstein argues that the notion of bringing risk under control is one of the central ideas that distinguishes modern times from the distant past. Against the Gods chronicles the remarkable intellectual adventure that liberated humanity from oracles and soothsayers by means of the powerful tools of risk management that are available to us today.

This is thought provoking to consider, in perspective of how we humans regard risk in our everyday lives.

In his column yesterday, professor Kay wrote: most people are influenced by what is outstanding and currently noticeable, rather than what is probable.

Events that are phenomenally unlikely, the winning of a large prize in the lottery or an accident while on an airplane, influence their thinking to a disproportionate degree because they grab attention.

Few people think of uncertainty in terms of statistical distributions and are able to attach probabilities that add up to one to a well defined set of disparate outcomes. People tell stories about the future instead.

Professor Kay say we do these things not because we are irrational, in any ordinary sense of the word, or because we are mathematically illiterate, although many people who make decisions, big and small, are indeed irrational and ignorant of basic math’s.

Instead we do these things because it is impossible to cope with a complex world and the abundance of information about it that we encounter in other ways.

As stated above, everyone knows of John Maynard Keynes’s ideas on macroeconomic policy but far fewer know of his contributions to the theory of probability and risk.

Keynes believed that the financial and business environment was characterised by “radical uncertainty”. He said that the only reasonable response to the question “what will interest rates be in 20 years’ time?” is “we simply do not know”.

In economics, radical uncertainty is risk that is immeasurable, not possible to calculate.

In recent decades, most actors in the financial markets have taken excessive risk, and they have paid dearly for doing so. Would they have taken the risk if they had understood the real uncertainty of doing so? No, most likely they would not.

Financial economic theory have for close to 40 years told us that risk is manageable and that valuation theories like Black-Scholes and the capital asset pricing model could help us tame uncertainty. By now, after the recent financial crises, we know this was wishful thinking.

With this perspective in mind, it is interesting to consider that for Keynes, probability was about believability, not frequency. He denied that our thinking could be described by a probability distribution over all possible future events, a statistical distribution that could be teased out by shrewd questioning, or discovered by presenting a menu of trading opportunities.

By understanding this and avoiding unnecessary risk, Keynes made himself a fortune on the stock markets. After the first world war, he borrowed small sums of money from members of his family and invested first in foreign-exchange deals, later in commodities, and finally in stock-exchange securities. By 1937 he had built up a private fortune of over half a million pounds (£ 25,000,000 in todays value). 

In the 1920s Keynes became engaged in an intellectual battle on the issue of probability, in which the leading protagonists on one side were Keynes and the Chicago economist Frank Knight (who published his book Risk, Uncertainty, and Profit in 1921), opposed by the Cambridge philosophers, Frank Ramsey and Jimmie Savage.

In his column in the Financial Times yesterday, Kay explains that Keynes and Knight lost that debate, and Ramsey and Savage won, and the probabilistic approach of normal distribution of outcomes and rational risk assessments has maintained academic primacy ever since.

This is of significant importance to the current state of both financial markets and the macro economy.

Keynes theory on macroeconomic policy was developed from his own perspective of radical uncertainty, whereas the tools he developed have been used both in macroeconomic policy making and in economic models of financial markets, assuming a probabilistic, predictable approach to risk. The adverse impact of this is huge.

A principal reason Keynes lost the debate on the academic view of risk was Ramsey’s demonstration that anyone who did not follow his precepts, anyone who did not act on the basis of a subjective assessment of probabilities of future events, would be “Dutch booked”.

In economics, a Dutch book usually refers to a sequence of trades that would leave one party strictly worse off and another strictly better off. As Kay explains, some scholars from the Netherlands have sought, without success, to track down the origins of this offensive phrase. A Dutch book is a set of choices such that a seemingly attractive selection from it is certain to lose money for the person who makes the selection.

Professor Kay writes he used to tell his students who queried the premise of “rational” behavior in financial markets, where rational means are based on Bayesian subjective probabilities, that people had to behave in this way because if they did not, people would devise schemes that made money at their expense.

This observation may be correct but people in fact do not behave in line with this theory, with the result that others in financial markets do devise schemes that make money at their expense.

In fact, that is what a depressing proportion of financial market activity is about.

The most famous Dutch book may have been “the tulip bubble” in 1634, that escalated into a craze called tulipomania. Wild speculation in tulip stock ensued, and enormous prices were paid for single bulbs. After many people had gone bankrupt, the crisis was ended by government regulation of the tulip trade.

A more recent Dutch book would be the collection of ingenious structured products which Royal Bank of Scotland acquired when it bought the Amsterdam-based bank ABN Amro in 2007. We all know what followed.