Re: Uncertainty and Liquidity Preference

[Ted Winslow <winslow@xxxxxxxx>]

Paul wrote:

>You, like Runde, Carabelli, O'Donnell and others, want to hold Keynes to
>the language of the TREATISE ON PROBABILITY and worry about "weights".  I
>am trying to complete Keynes's taxonomy which certainly was still evolving
>after 1936-- as he wanted to write a book on footnotes to the GT , until
>his heart attack and  the war intervened.  Skidelsky, in his
>"Acknowledgment" to the second volume of his biography of Keynes admits to
>his Post Keynesian interpretation of Keynes (p.xi) and his differences with
>O'Donnell on the need for strict consistency over decades of writing.
>(Don't you think Keynes learned anything since the original undergraduate
>TREATISE ON PROBABILITY--.

I'm hardly in the continuity camp Paul.  I've been arguing for years that
Keynes abandoned the foundational ideas of the _Treatise on Probability_:
the atomic hypothesis and the idea of logical probability relations.  He
certainly retained the idea of "weight" though. It continues to mean the
completeness of relevant evidence on which rational calculations of
probability are based.  The meaning of "relevant evidence" has changed to
match the changed view of ontology and probability.

To know whether or not your improving his language, you'd have to
familiarize yourself with the ontological idea of "organic unity" which
Keynes substituted for the "atomic hypothesis" and with the theory of
induction and probability that can be derived from it.

This is found in the" philosophy of organism" developed by A.N. Whitehead.
It explains both the fundamental uncertainty of the long run and the
foundation in the short run for rational induction and rational
calculations of probability.

I gather the "axiom of ergodic stochastic process" provides a grounding for
the idea of fundamental uncertainty.  From what you say of it however this
seems to characterize both the long and the short run.  What basis does the
axiom provide for rational short run forecasting?

>In my many discussions with Robert Skidelsky
>over the years, Robert has often said to me that I come closer to the
>meaning of Keynes's GT than any one else. No wonder Skidelsky's Post
>Keynesian interpretation of Keynes was being attacked by Patinkin (see p.
>xi). Don saw the revolution of the GT in Kahn's multiplier, I believe it is
>in the axioms that Keynes overthrew which required him to search for a
>reason why people would work (which incurred marginal disutility) to earn
>income but not spend all the income they earned on goods, while, in the
>classical system, goods are the only are the only things that provide
>marginal utility.
>
>

You've made this point to me before and I've pointed out to you in reply
that Skidelsky's main interpretive hypothesis re Keynes's economics is that

"Keynes's thesis was that the engine of capitalism was driven by a neurosis
which he calls 'love of money'; but this neurosis is also the means to the
good, because it is the means to the abundance which will make capitalism
unnecessary." Vol. II, p. 236

This isn't the same as your interpretive hypothesis that Keynes assumes
agents are "sensible" is it?

If you tell me it is, I'll be even more inclined to identify your approach
to meaning with Humpty Dumpty's in _Through the Looking Glass_.

'When I use a word,' Humpty Dumpty said in rather a scornful tone, 'it
means just what I choose it to mean -- neither more nor less.'

'The question is,' said Alice, 'whether you CAN make words mean so many
different things.'

>Weight was an idea that he developed as an undergraduate.  I would
>hate to be held to ideas that I developed as an undergraduate and did not
>advance from -- and often discard.  Wouldn't you??
>

It depends Paul on whether I had uncovered good grounds for abandoning
them.  Keynes had good grounds for abandoning the atomic hypothesis and the
idea of logical probability relations.  The new ideas to which he appears
to have moved provided, however, a much more secure foundation for the
concept of weight.  Why would he have abandoned it?

In fact, there's a great deal of textual evidence that Keynes retained the
concept, including, of course, evidence in the GT itself.  All his accounts
of rational investment policy in vol. XII assume that this policy
(understood as rational "speculation") can be based on rational
calculations of probability about the future values of securities and that
weight is a relevant aspect of these calculations.  In an August 34 letter
to F.C. Scott, for instance, he says:

"As time goes on I get more and more convinced that the right method in
investment is to put fairly large sums into enterprises which one thinks
one know something about and in the management of which one thoroughly
believes.  It is a mistake to think that one limits one's risks by
spreading too much between enterprises about which one knows little and has
no reason for special confidence.  Obviously this principle ought not to be
carried too far.  The real limitation, however, on its application in
practice is in my experience the small number of enterprises about which at
any given time one feels in this way.  One's knowledge and experience are
definitely limited and there are seldom more than two or three enterprises
at any given time in which I personally feel myself entitled to put _full_
confidence."  (XII, p. 57)

This policy is based on understanding and predicting the irrationality of
other investors:

"very few American investors buy any stock for the sake of something which
is going to happen more than six months hence, even though its probability
is exceedingly high; and it is out of taking advantage of this
psychological peculiarity of theirs that most money is made." (XII, p. 78)

>Therefore those entrepreneurs who have ":animal spirits" (p.
>161) have not actually made a rational calculation but will act as if they
>had made such a calculation.

Keynes claims they do this because they can't psychologically face the fact
of fundamental uncertainty.  They are still too much "creatures of instinct
and of nature" who, for irrational psychological reasons, need to "overlook
the awkward fact" of fundamental uncertainty and to "hide from themselves
how little they foresee".

Why do they do this if, as you assume, they are "sensible" and know that
the future is fundamentally uncertain?

>
>In a similar context see footnote #2 on p.24  where he argues that if one
>sees an entrepreneur making a positive action on production Keynes means by
>"his expectations....that expectations of proceeds which if held with
>certainty would lead to the same behaviour as does the bundle of vague and
>more possibilities which actually make up his state of expectation when he
>reaches his decision".  In other words given animal spirits that move one
>to action rather than inaction, one can ex post calculate the expectation
>that would have been need to be held with certainty, in order to "justify"
>the action taken.
>

This refers of course to the _short run_ production decision.  That you
think it also has to do with "animal spirits" suggests to me that you are
assuming fundamental uncertainty applies to the short as well as to the
long run.  This isn't Keynes's assumption though he does claim that, even
though this future isn't fundamentally uncertain, many individuals, for
psychological reasons, still cling tenaciously to mistaken and irrational
forecasting methods.  They are even less "justified" in doing so here than
they are in the case of long run forecasting.

The method of using certainty equivalents to describe actual beliefs about
the future is a method of "descriptive psychology" completely independent
of whether or not the actual beliefs are rational or irrational e.g. it can
be used just as well to describe the expectation of the end of the
millenium second coming of Christ which if held with certainty would lead
the person holding it to travel to Jerusalem to be on site when it happens.

>>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?
>
>I hope my previous answer helps you here!

Hardly Paul.  That irrational expectations about the long run future can
vary doesn't explain how fundamental uncertainty can vary.


> Billingsley states "if the laws
>governing change ... remain fixed as time passes, then ergodic theory is a
>key to understanding these fluctuations" Whenever "the passage of time does
>not affect the set of joint probability laws governing experiments
>[outcomes], then the assumption of ergodicity permits regularities to be
>perceived from what might at first sight be patternless fluctuation " (p.2,
>also see 64-65).
>
>It seems obvious to me that Keynes would overthrow the assumption of
>ergodicity had he known its name (See p.16 of the GT where Keynes claims
>that there is a need in economics to overthrow the equivalent of the axiom
>of parallels in Euclidean geometry and work out a nonEuclidean theory.
>

Keynes did something more profound Paul.  He overthrew the atomic
hypothesis in favour of the hypothesis of organic unity.  The latter
hypothesis, as elaborated by A.N. Whitehead in explicit response to
Keynes's _Treatise_ (e.g.in _Process and Reality_ pp. 230-7), allows the
"laws governing change" to change in a way that permits the short run
statistical frequencies that provide the foundation for rational degrees of
belief to remain sufficiently stable in the short run to permit rational
short run forecasting, i.e. to permit the perception of regularities
sufficiently stable to provide rational grounds for limited inductive
generalization.  Billingsley is mistaken if he's claiming that the
possibility of perceiving regularities only exists if the "laws governing
change" don't themselves change.

>
>>
>>Keynes assumes conscious awareness of fundamental uncertainty provokes
>>paralyzing anxiety in most decision makers.
>
>If they have paralyzing anxiety then they will try to save in the form of
>some time machine (liquid asset).  For he who hesitates is saved to make a
>decision another day ? while he who commits his claims on the products of
>industry and their inputs, can only reverse course at great expense and loss.

This is wrong psychologically Paul.  If they're paralyzed by anxiety
they've completely lost the capacity to deal sensibly with real danger as
with students who freeze in exams, golfers who can't make clutch puts, etc.


They can avoid this anxiety through "denial" i.e. by hiding from themselves
how little they foresee.  This is better than being paralyzed by anxiety.

For instance, the consciously anxious student who freezes in economics exam
is worse off than the obsessive student whose avoided this problem by
obsessively and uncritically memorizing the mathematics etc. and is able
without conscious anxiety to repeat it all in the exam.  This does raise
the interesting question though as to what the fully rational student able
to be critically evaluative of the material should do.  If he wants to
pass, let alone get an A+, its probably best for him to keep his critical
thoughts and judgments to himself isn't it, given the unconcious anxieties
at work in his examiners?  The strength of the latter is illustrated by
their belief that Lucas exhibits much more profound insight into human
nature than say Shakespeare, Ibsen and Keynes. ;-)

Hoarding money does the same thing in this context as "hiding from
ourselves how little we foresee" but works, like a child's security
blanket, at a "deeper level" i.e. it's an even more irrational way of
lulling anxiety and does much more damage than basing long run investment
decisions on irrationally optimistic beliefs about prospective yield.  At
this deeper level, money has an unconscious meaning which enables it "to
lull the disquietude" aroused when the "higher, more precarious" mechanism
of denial fails. Individually and collectively people who are
psychologically unable to give up their security blankets get into very big
trouble though. They haven't got hold of a sensible way of dealing with
fundamental uncertainty.

To see this let us turn again to Shakespeare.  At another point in the
_Merchant of Venice_ the Prince of Morocco has decided to try his luck in
the game of the three caskets by betting on the gold casket.  Unconscious
irrational ideas about money and gold have done him in.  Shakespeare has
placed a "carrion Death" - a death's head - in it.  In the empty eye the
Prince finds the following message.

"There is a written scroll!  I'll read the writing.

	"All that glisters is not gold,
	Often have you heard that told;
	Many a man his life hath sold
	But my outside to behold.
	Gilded [tombs] do worms infold.
	Had you been as wise as bold,
	Young in limbs, in judgment old,
	Your answer had not been inscoll'd.
	Fare you well, your suit is cold."

Keynes very frequently points to the great damage done by the irrational
"fetish of liquidity" (VII, p. 155), the "vanity of hoarded riches".

"The history of India at all times has provided an example of a country
impoverished by a preference for liquidity  amounting to so strong a
passion that even an enormous and chronic influx of the precious metals has
been insufficient to bring down the rate of interest to a level compatible
with the growth of real wealth." (VII, p. 337)

Again you don't tell me how the inescapable fundamental uncertainty of the
_long run_ has been rationally dealt with by hoarding money.

>
> >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)
>>
>
>Nevertheless if anyone is to hld any liquid asset besides money than they
>face the possibility of nominal capital loss ? .  Speculative bubbles occur
>when the fear of such loss recedes in one's mind and past capital gains are
>"expected" to continue into the indefinite future. The bull thinks he will
>know sooner than the average opinion in the market if, and when, the bubble
>will burst... That permits the bull (e.g., Wall Street forecaster Abbey
>Cohen) to sleep at night!!

The liquidity preferences of the _rational_ "speculator" (e.g. Keynes)
engaged in short run forecasting in financial markets are completely
different from the preferences of those for whom hoarding money plays the
irrational role of a security blanket protecting against the anxiety that
would otherwise be provoked by the fundamental uncertainty of the long run.
Of course not all speculators are rational.  Some are "quants" who continue
to deal with their anxiety about the future in an irrational way even
though they're focused on short term forecasting of the "psychlogogy of the
market".  They cling obsessively and tenaciously to inappropriate
mathematical and statistical methods and get a false sense of security from
diversitfication,ignoring Keynes point in the passage from the letter to
Scott, i.e.

"To carry one's eggs in a great number of baskets, without having time or
opportunity to discover how many have holes in the bottom, is the surest
way of increasing risk and loss." (XII, p. 99)

Among the mistakes such individuals are prone to make, are those arising
from their psychological inability to understand the psychological basis of
liquidity preference in financial markets.

>>There is in Keynes a kind of rational liquidity preference connected to the
>>weight of rational expectations but this isn't it.
>
>There is no rational expectations in Keynes at least as defined by the
>majority of economists.  If you continue to use the word "rational" to mean
>a different thing tan the majority, then you merely create a semantic
>obfuscation.  Thus I use sensible to distinguish real world expectations
>from economic theory's "rational expectations".  (Again note that Keynes
>was using the word "rational" before it was tied directly to the ergodic
>axiom by Lucas et al.)
>

In Keynes, "real world expectations" are usually _irrational_ as is made
obvious (to those with eyes to see ;-)) by his descriptions, one of which I
quoted at length, of the methods employed in reaching them and by his claim
that both the methods and the expectations serve the psychological function
of enabling people to "hide from themselves how little they foresee".

As I've pointed out above, Keynes also allows for rational expectations.
I've also specified what I mean by rational in this context.  Obviously
this differs from the meaning it has in the "rational expectations"
literature.

Your word "sensible" excludes the possibility of irrational "real world
expectations", treats what for Keynes are irrational real world
expectations as "sensible" expectations, and appears to have no room for
Keynes's concept of rational short term expectations based on more or less
weight.

>
>>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".
>
>No I mean lets use words consistently.  If the system is nonergodic then
>people ? at least in nonroutine decisions can not be acting rationally ?
>but I do not mean to say therefore they must be acting irrationally.  Hence
>the word sensible.
>

On Keynes's ontological premises, fundamental uncertainty doesn't rule out
rationality in his sense.  Your use of the word "sensible" doesn't allow
for this sense, does it?  As I pointed out earlier, the rational approach
is set out in the _Treatise on Probability_. It is "to allow caprice to
determine us and to waste no time on the debate."  (VIII, p. 32) As I also
pointed out, this claim in repeated in the 1938 correspondence with
Townshend. (XXIX, p. 294) Elsewhere he adds to this acting on rational
"faith" in the optimistic hypothesis.

"Thus the author of these essays, for all his croakings, still hopes and
believes that the day is not far off when the economic problem will take
the back seat where it belongs, and that the arena of the heart and head
will be occupied, or reoccupied, by our real problems - the problems of
life and human relations, of creation and behaviour and religion.  And it
happens that there is a subtle reason drawn from economic analysis why, in
his case, faith may work.  For if we consistently act on the optimistic
hypothesis, this hypothesis will tend to be realised; whilst by acting on
the pessimistic hypothesis we can keep ourselves for ever in the pit of
want." (IX, p. xviii)

>>
>>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 passage 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.
>
>This is a nonsequitir if I ever saw one!

We differ about formal logic Paul.  To me the following is an illustration
of a non sequitur.

Premises:

Davidson and Hicks claim that:

"sensible economic agents will disregard available market information
regarding relative frequencies, for the future is not statistically
calculable from past data and hence is truly uncertain.  Or as Hicks (1979:
vii) succintly put it, "One must assume that the people in one's models do
not know what is going to happen , and know that they do not just what is
going to happen.'  In conditions of true uncertainty, people often realize
they just don't have a clue!"

Keynes claims that:

"the necessity for action and for decision compels us as practical men to
do our best to overlook this awkward fact [that 'we simply do not know']
and to behave exactly as we should if we had behind us a good Benthamite
calculation of a series of prospective advantages and disadvantages, each
multiplied by its appropriate probability, waiting to be summed"

and that

"as living and moving being, we are forced to act.  Peace and comfort of
mind require that we should hide from ourselves how little we foresee.  Yet
we must be guided by some hypothesis.  We tend, therefore, to substitute
for the knowledge which is unattainable certain conventions, the chief of
which is to assume, contrary to all likelihood, that the future will
resemble the past.  That is how we act in practice."

Conclusion:

Keynes assumes people are "sensible" in the sense of Davidson and Hicks.


>>
>>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.
>
>Yes ? so what??

Well Paul, not only is the optimism not "sensible", its _irrational_.  One
nasty consequence rather evident these days and additional to "the natural
instability of capitalism" its "flimsiness" creates, is that its
maintenance requires the creation of "a political and social atmosphere
which is congenial to the average business man". (VII, p. 162)

>
>>  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 awkward 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)
>>
>I fail to see what Julian Bell wrote about conscientious objectors ? as
>quoted by Keynes on CWK X p. 360 has to do with rationality!

See above.  It's not what Julian Bell wrote, it's the way Keynes fits this
into his account of Bell's decision to go voluntarily to Spain in 1937 to
join the fight against fascism, a decision that cost him his life.  If you
read carefully what Keynes says, including what he says about the "faith"
expressed in the passage by Bell, you'll see I think that he represents the
decision as fully rational in his (Keynes's) sense. It attributes to Bell
rational mastery of the fear of death.

Ted


Ted Winslow                          E-MAIL: WINSLOW@xxxxxxxx
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