Re: Uncertainty and Liquidity Preference

[Ted Winslow <winslow@xxxxxxxx>]

Chip, Paul, John, David:

My question isn't about liquidity preference in general.  It's about the
rationality of holding money as a way of dealing with the fundamental
uncertainty of the long run future yields of capital assets, i.e. the Qs in
Keynes's definition of the marginal efficiency of capital. Keynes claims
these are fundamentally uncertain in the sense that they are usually
unknowable i.e. "about these matters there is no scientific basis on which
to form any calculable probability whatever.  We simply do not know."

This is not uncertainty in the sense of "weight".  Weight is a measure of
the completeness of the _relevant_ evidence on which rational calculations
of probability are based.  In the case of these future yields, however,
Keynes claims there isn't enough relevant evidence to allow such
calculations to be made.

Some interpreters, Runde for instance, try to justify interpreting
uncertainty in this context as "weight" by interpreting "calculable
probability" narrowly to mean numerical probability.  This attributes to
Keynes the idea that expectations of future yield take the form of rational
non-numerical degrees of belief based on relevant evidence.  If this is
what Keynes means, however, he is contradicting himself by stating it
equivalently as "we simply do not know".  Rational non-numerical degrees of
belief based on relevant evidence are knowledge.

This problem is avoided by interpreting "calculable" to refer to any
"calculus", any formal logic, which enables us to pass from relevant
evidence to reasonable degrees of belief, numerical or non-numerical, an
interpretation consistent with Keynes's own use of the term "calculus of
probability". According to Keynes, the amount of evidence relevant to
forecasting the long run Qs is so small that we can't reach "any calculable
probability whatever", numerical or non-numerical, in this way.  "We simply
do not know."

To me it makes no sense to treat "no scientific basis on which to form any
calculable probability whatever" as capable of degree.  What would "more"
and "less" mean here?

To claim that "today is still the best predictor of tomorrow's conditions"
where tomorrow is the long run is, it seems to me, to deny the existence of
fundamental uncertainty in the above sense. Keynes grounds his belief in
its existence in ontology and direct experience.  You can't refute him with
mathematics alone.  As Keynes points out in the _Treatise on Probability_,
however, "the more complicated and technical the preliminary statistical
investigations become, the more prone inquirers are to mistake the
statistical description for an inductive generalisation." (VII, p. 361)  He
quotes Whitehead in support of this: "There is no more common error than to
assume that, because prolonged and accurate mathematical calculations have
been made, the applications of the result to some fact of nature is
absolutely certain." (Whitehead, Introduction to Mathematics, p. 27)  The
mathematics training of the "quants" at LTCM appears to have ignored this
point.  Keynes makes this "common error" a characteristic feature of
conventional forecasting practices.

Keynes assumes conscious awareness of fundamental uncertainty provokes
paralyzing anxiety in most decision makers.  They escape from this anxiety
by denying the awkward fact that provokes it. They "hide from themselves
how little they foresee" by using mistaken and irrational methods to
forecast the Qs.  The methods (as set out e.g. in VII, p. 152) assume that
"the existing state of affairs will continue indefinitely, except in so far
as we have specific reasons to expect a change" and that "calculated
mathematical expectations" are possible (even though "philosophically
speaking ... our existing knowledge does not provide a sufficient basis"
for this). They also mistakenly and irrationally base expectations on "all
sorts of considerations" that "are in no way relevant to the prospective
yield" - ignoring the requirement that rational calculations  be based
solely on _relevant_ evidence. The first method (which explains the effect
of increased saving on the MEC pointed to in the first para of chap. 16 of
the GT) is mistaken and irrational because "the future never resembles the
past - as we well know" so that it is "contrary to all likelihood" "to
assume ... that the future will resemble the past."  (XIV, p. 124)

Since the expectations that result from these methods are not rational
calculations based on relevant evidence, "weight" (a measure of
completeness of the _relevant_ evidence on which rational calculations are
based) is not an applicable concept.  Liquidity preference as a method for
dealing with the fundamental uncertainty of prospective yield can't,
therefore, be explained as a rational way of dealing with low "weight".
There is in Keynes a kind of rational liquidity preference connected to the
weight of rational expecations but this isn't it.

Paul claims Keynes assumes that people know the future is fundamentally
uncertain and act rationally on the basis of this knowledge.   This, I take
it, is what he means by his claim that Keynes assumes people are
"sensible".  This assumption underpins his interpretation of Keynes's
account of the conventional practices used to forecast prospective yield
and of the connection between liquidity preference and the fundamental
uncertainty of prospective yield.

In earlier posts I've pointed out, as I've just done again, that Keynes
does not treat conventional expectations as "sensible" in Paul's sense.

The well known passge I quoted in my most recent response to Paul, a
passage in which Keynes connects the fundamental uncertainty of prospective
yield to liquidity preference by pointing to a "conventional or
instinctive" "feeling about money" operating at "a deeper level of our
motivation" which enables the "possession of actual money [to] lull our
disquietude" when the "higher, more precarious" forecasting conventions we
have been using to "hide from ourselves how little we foresee" break down,
seems to me to show that Keynes also doesn't treat this kind of liquidity
preference as "sensible" in Paul's sense.

Keynes doesn't make rational "faith" in the optimistic hypothesis the usual
basis of business motivation.  The optimism arising from "animal spirits"
is not rational optimism; it's based on hiding from ourselves how little we
foresee.  As early as 1922 Keynes was describing the typical business man
as "a creature of instinct and of nature, primitive in his self-expression,
unsophisticated in self-knowledge". (IV, p. 24)  Rational optimism fully
faces the fact of fundamental uncertainty and is unshakeable; the usual
business kind "overlooks this awkard fact" and "is based on so flimsy a
foundation, it is subject to sudden and violent changes .. etc." (XIV, pp.
114-5)  For an illustration of what Keynes means by rational "faith" in the
optimistic hypothesis look at his use of the word "faith" in his obituary
for Julian Bell. (X, p. 360)

Ted


Ted Winslow                          E-MAIL: WINSLOW@xxxxxxxx
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