The Abuse of Probability in Economics
"One great underestimated thinker is G.L.S. Shackle, now almost completely obscure, who introduced the notion of "unknowledge"'
~Nassim Nicholas Taleb
For the Mainstream of Economics, there has been little thought of any other approach to decision making theory than probability theory. Since Leonard Savage’s development and axiomatization of the expected utility theorem to further cement the role of dogmatic laissez-faire and the logic behind the REH (Rational Expectations Hypothesis), there has been little consideration of the use of imagination in economics, rather focusing on full knowledge and the ability to plan out decisions and “rank” them before proceeding with a choice. From the EUT then, we can logically proclaim the success of laissez-faire; economic decision makers are in no way irrational, they make rational utility decisions based on full knowledge. Even presupposing that they do not have full knowledge, the use of probability in economics allows economists to get away with presupposing all, or most, economic actors are rational and make decisions based on present knowledge without any consideration for the role of imagination in economics. A look at probability distributions, and the economic agent can simply make rational decisions about the future of his business.
This obviously leads to problems, then, with the Post-Keynesian-Keynes idea of volatile expectations that are subject to radical swings in behavior. If economic actors can make rational expectations about the future using probability distributions and perfect or imperfect knowledge(1); this simply means then that the economic agents cannot be en mass mislead into making terrible financial decisions based on crowd expectations, there can be some erroneous forecasts (misreading of the objective probability distributions); but in the end as a majority economic actors cannot be mislead into financial destruction by stability or other causes, e.g., “animal spirits”. This consequently leads the New-Classical economists into a belief that economic systems are unable to cause business cycles without exogenous shocks, i.e., RBCT (Real Business Cycle Theory). The RBCT posits that the only way business cycles form is through exogenous shocks, whether it be through oil shocks or shocks induced by the Government’s failed attempts to stimulate the economy in the short run using their tools at hand. This again, leads to a laissez faire conclusion, let the market function in whichever way it wishes, any intervention will cause economic discoordination. The New-Classical economists, descended from Robert Lucas and the New Chicago School(2); can go massively awry with false probabilistic foundations. Despiste being descendants of the Chicago School, they seem to have no knowledge in the slightest of the distinctions between risk and uncertainty, first characterized by a Chicago School economist Frank H. Knight! Although this cannot be necessarily be only their fault, they flaws of the Mainstream approach is also quite predominantly dependent on the Post-War Neo-Classical Synthesis “Keynesians” such as Paul Samuelson, Robert Solow, John Hicks, and especially James Tobin, who turned Keynesian uncertainty into measurable risk for his incomprehensible liquidity preference models.
Fortunately, there are still schools of economics that do not insist on probabilistic foundations, mainly the Institutionalists and the Post-Keynesians. Even though the term “Post Keynesian” is awfully vague, there is a general acceptance that GE (General Equilibrium) models based on the REH are fundamentally wrong amongst the three dominant branches of Post-Keynesian Economics(3). Among the most focused of economists wishing to purge the probabilistic approach from economics was G.L.S Shackle, the foremost Radical Subjectivist and the Post-Keynesian who inspired many fundementalist Post-Keynesian approaches to probability and uncertainty theory, including Paul Davidson. To G.L.S Shackle, probability theory was fundamentally mistaken for real decision making theory at the centre of his kaleidic vision. It simply made little sense to proclaim that decision makers in the real economy have access to enough information to make decisions based on probability distributions, along with simply the fact that even presupposing that people could have access to the necessary information; individuals simply often do not listen to probability distributions before making their economic decisions. If this was the case, then entrepreneurship would be probabilistically irrational and would not occur at a frequency it does in the real world. The odds of the decision to engage in entrepreneurial decisions is probabilistically irrational, it’s almost impossible to foresee the outcome of the decision and the odds of it “working out” are infinitesimally small. Therefore, shouldn’t entrepreneurship cease to exist if probability governed decision making theory like the laissez-faire REH theorists seem to claim? The answer is quite simple for anyone who has been paying attention to the context; simply, economic decision makers do not make estimations of the future and consequently engage in a production process based on probability distributions, there is little regard for probability distributions for most economic actors. Even amongst corporate finance divisions who make forecasts of the future based on probability theory, they find themselves in error so much for other economic actors because as an overwhelming majority, people do not listen to statistics and make decisions based on other premises!(4) G.L.S Shackle illustrates this point, albeit a bit crudely, through the way children handle being denied from going to a party by their parents:
“Shackle (1949b, p. 345) illustrated his thinking in this respect by noting how a child who is prevented from attending a party may be impossible to console by being told that there will be plenty of other parties in years to come” (5)
While Mainstream thinkers may hold this analogy in contempt, it is after all referring to a child’s behavior, this does have important implications for the disregard of probability for real decision making theory. When most individuals display contempt for probability with economic decisions, especially entrepreneurs, they are similar to the child. They cannot be consoled nor directed by probability, they are directed by something fundamentally different. To this level, Shackle came up with a brilliant theory of decision making, Potential Surprise Theory. Potential Surprise Theory (PSR) demonstrates that economic actors do not function in the way most mainstream economists believe through probability, they make decisions based on “potential surprise” and dual imagined possibilities. Essentially Shackle has abandoned the realm of probability theory, and rather, he focuses on possibility theory. Possibility theory is fundamentally subjective and not subject to mathematical elucidation as is probability theory, it focuses on potential surprise from economic decisions, which is fundamentally subjective and consequently not subject to mathematical analysis. Potential surprise, the level demonstrated through “ϕ” rather than numerical values, is quite simply, the level of expected surprise from embarking upon a certain economic decision. The decision maker does not weigh billions of probability choices in an objective probability distribution, the decision maker simply weighs two decisions, the best and worst possible situations, and makes decisions based on the expected potential surprise from these two decision sets. While this may seem ridiculous, only two decisions, Shackle did also consider the role of the subconscious in weighing choices. The mind would first divide the decisions into the “Least Likely”, “Somewhat Likely” and “Likely” categories(6); then those options in the “Least Likely” and “Somewhat Likely” would be eliminated, consequently leaving only the “Likely” possibilities. In the “Likely” possibilities, the worst and best outcomes are weighed by decision makers through simulating complex economic processes in their minds and consequently figuring out which decision brings the most psychological gratification and has the most ϕ level. The ϕ level is subjective of course, which means interpretation of the ϕ level depends on the individual too. If someone were to be surprise averse (economically speaking); the decision with the highest ϕ level would be the least appealing, and vice versa for those who are not surprise averse.
This potential surprise theory is quite useful for real world decision making, it does not necessitate the need for “bounded rationality” or “imperfect” or “perfect” knowledge; it simply necessitates the need for the imagination to bridge the present to the future. While there are some qualms that even I have with the potential surprise theory, mainly that elimination of the “Least Likely” options ignores the role of the subconscious has on determining conscious real economic decisions, i.e., there can be more than two options, the core of the PST (Potential Surprise Theory) remains untouched, economic actors do not consider entire probability distributions and make decisions based on the abuse of the ergodic axiom, they imagine possibilities and make economic decisions based on their subjective interpretation of the ϕ level. Potential surprise theory is simply brilliant in elucidating the way real economic actors work, and what is even more interesting to those who wish to study Potential Surprise Theory is the real world application of it to entrepreneurship and decision making theory! To those familiar with corporate planning, the word “Scenario Planning” might “ring a bell”. Scenario Planning(7) has multiple real world examples and demonstrates incredible similarities to Potential Surprise Theory, something even Shackle recognized, and was (is) most widely used for the Royal Dutch Shell’s corporate planning, especially after the Oil Crisis and shocks of the 1970s and early 1980s. The brilliance of Shackle in decision making theory is consequently clearly demonstrated then, rather than being an Ivory Tower theorist(8), there are multiple real world applications of Potential Surprise Theory.
What ideological and real world implications for trade cycle theory does this have? As has been demonstrated near the beginning of this essay, there has been a great deal of ideological implications of probabilistic analysis, which does point to a direction in which possibility theory does also have implications for ideology. One of the main implications are on trade cycle theory, of course, as due to the subjectivity of possibility theory, it is quite easy to be mislead by Ponzi units and false trends caused by stability due to optimistic interpretations of the ϕ levels of decisions, which means mass-scale misleading trends can occur and culminate into a recession without proper economic regulations on lending and the ability for Ponzi units to form. This does also mean that endogenous, chaotic dynamics can occur in market economies and cause business cycles, destroying the laissez-faire dogmatists’ axioms on the self reparation of market economies and the sole cause of business cycles to be exogenous.
Shackle’s Potential Surprise Theory provides heterodox economists with a viable alternative to ignorant probability theory of the New-Classical-Keynesian Mainstream, and consequently an alternative to laissez-faire dogmatism. I hope to explore this more in future essays, for such a rich topic to be done justice in a singular post is impossible.
References:
1 - Some economists, especially the Mainstream of behavioral economists operate under Simon’s “Bounded rationality theory”. While a step up, there are certainly problems with this approach, primarily; only being a form of effectively epistemological uncertainty and still viewing uncertainty in terms of informational asymmetry.
