Friday, August 29, 2008

Uncertainty and the Economy: Some Comments

In this post I attempt to respond to some comments that were written concerning my post of August 25. ( The comments specifically related to the fact that uncertainty always exists and whether or not markets work. I wrote the post of August 25 because I believe that uncertainty is greater now than it has been for a very long time. As a consequence, the volatility of markets is extreme and will continue to be extreme as long as this level of uncertainty continues to exist. I believe that this should be a consideration in the current business and investment decisions being made.

Uncertainty exists because humans make decisions based upon incomplete information. That is, if a decision maker had complete information there would be no uncertainty about what action that individual should take because the decision maker would know precisely the outcome that would result from any action that was available. The decision maker would, therefore, take the action that would be the ‘best’ in terms of the outcome that is being sought.

Uncertainty is defined in terms of variance. That is, because a decision maker has only incomplete information to work with, he/she will not know before the decision is made exactly what the outcome of that decision will be. Usually, there is a range of possible outcomes that can occur given the choice of a particular decision. Uncertainty, therefore, is relative in the sense that a situation in which the range of possible outcomes is somewhat narrow would be considered to be less risky than a situation in which the range of possible outcomes was much broader.

Generally one argues that if the decision maker has less information, the range of possible outcomes will be greater than if there is more information available. With less information available and a consequently larger range of possible outcomes, the situation is said to be riskier than when the decision maker has more information and a resultant narrower range of possible outcomes.

Therefore, to add to my post of August 25 I would state that we are currently working with less information relative to the possible outcomes that we have to deal with than we have in quite some time. From this I infer that in the current environment that businesses and investors are facing greater risk relative to their decisions than they have in a long time. And, as a consequence of this greater risk I would argue that markets will continue to be more volatile in the foreseeable future than they have been in recent history.

There is another issue that is being stressed relative to the current uncertainty. Nassim Nicholas Teleb, in his book “The Black Swan”, writes about two kinds of situations in which a decision maker has incomplete information. The first is what most people are more familiar with. This is a situation which uses the historical information available to create statistics that people can use to make better decisions. These statistics include probability distributions, means, standard deviations, and so on. These statistics can be used in routine, repeatable cases of decision making to help the decision maker incorporate what he or she does not know into their decision making process. Gathering more information in these situations help us to refine the probability distribution related to the specific case under review and its attributes.

The second type of situation, the one that Taleb is most interested in presenting to us, depends upon what we don’t know. That is, this kind of decision does not lend itself to the use of ordinary statistical analysis because these decisions relate to situations in which we have little or no experience relating to the information we don’t know, hence nothing to guide us in our decision making. Taleb tells of the turkey being fattened up to become a Thanksgiving dinner. For 1000 days the turkey is fed very well and treated like royalty. The 1001st day, the turkey is prepared for the Thanksgiving dinner. If the only information one has is the information from the first 1000 days, the prediction for the 1001st day would be to be fed very well and to be treated like royalty. Gathering more of the same kind of information helps very little. What is needed is not known and unless one knows what types of information are missing one can gain little to help in improving one’s ability to make a prediction.

In terms of this latter type of uncertainty, one can argue that in the current situation we don’t know what questions we should be asking or what kinds of information we need. In Taleb’s terms we are in the arena of the Black Swan.

Another question has been asked about whether or not I believe that markets work. The answer to this is yes, I believe that markets work and I have long argued that one must be careful in interfering with markets because, even though the intent of the person wanting to interfere with the working of the market may be the very best, humans, by and large have done much damage to markets, and to people, by interfering with the workings of markets. If one fusses around with markets, one must be very careful, and one must attempt to work with the processes related to markets and not to the outcomes achieved by markets.

Still, I believe that it is necessary to work with markets in order to help the markets function. There are many reasons for this. One of them has to do with incomplete information and the fact that some participants in markets may have more information than other participants do. Also, the existence of asymmetric information in markets in the short run can result in things like a liquidity crises that can cumulate in a dramatic downward spiral of prices. Another reason has to do with the existence of transaction costs and the fact that due to the existence of transaction costs markets may not function as efficiently and effectively as they could, especially with respect to the time it takes for the market to work out of a disruptive situation. Furthermore, incentives can exist that lead to behavior that is dishonest and harmful to others. Human beings are vulnerable to such incentives when the apparent marginal benefit of cheating seems to exceed the marginal cost of getting caught cheating.

Human beings are problem solvers and when they see situations that have seemingly undesirable consequences they attempt to fix them. This characteristic of human beings is what makes them especially unique among living species. It is a characteristic that has substantial survival value. But, humans must be careful when attempting to apply their problem solving skills to markets. First, as I mentioned above, in working with markets, humans need to focus on processes and not outcomes. They need to focus on rules about how individuals are to perform…such as rules pertaining to the importance of full disclosure and openness…and not what results they attain…such as the amount of people that someone hires. This cannot always be done, but it is a methodology that should be strived for.

Second, the crucial issue always has to do with the balance of interference that is achieved. My belief is that humans are always going to try and make things better…help markets operate more efficiently…and so it is a question of the balance between the two extreme goals that is important. If has always been my practice to try and err on the side of less interference with markets than more interference. Furthermore, it is always the case that this balance will change with time as we learn more and as the market adjusts to any interference imposed.

Dubner and Levitt state very clearly in “Freakonomics” that anytime any kind of incentive system (rules and regulations) is set up, there will be numerous people attempting to take advantage of the new system. This, to me, is another major argument for minimizing interference in markets…interference causes people to focus on beating the new rules and regulations imposed on the market. Thus, any new rules and regulations that are set up need to minimize the payoff for beating the new system so that more people keep their focus on making the market work rather than taking advantage of the new system. The more restrictive or the greater the interference of any new rules and regulations the more benefit that can be gained from “breaking” the system. Thus, I feel that there will be interferences with markets…with the best of intentions…but extreme care must be taken when interferences are imposed.

I hope these responses help readers understand a little bit more of where I am coming from.

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