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Symposium 2015

Solution for Dealing with Radical Uncertainty

The Challenge

One of Karl Popper’s key insights about human predictive capacity was that "Quite apart from the fact that we do not know the future, the future is objectively not fixed. The future is open: objecti ...

One of Karl Popper’s key insights about human predictive capacity was that "Quite apart from the fact that we do not know the future, the future is objectively not fixed. The future is open: objectively open." But most macroeconomists and finance theorists have presumed exactly the opposite. They have increasingly come to rely on internally consistent models that fully specify in advance how market participants might alter the ways in which they make decisions and how aggregate outcomes unfold over time. Models in this spirit, such as so called "rational expectations" (RE) models have not been highly effective in predicting macroeconomic outcomes. They also do poorly at accounting for the behavior of asset prices.

Radical Uncertainty in Financial Markets

The solution proposal for the issue put forth on “Radical Uncertainty in Financial Markets” involves discarding models based on the Rational Expectations Hypothesis (REH) and other approaches that characterize the future with an overarching probability distribution. What do we replace them with? Can we still write down models that generate testable implications? In terms of analytical models, Imperfect Knowledge Economics (IKE) offers a way forward.

The key is to connect Knightian Uncertainty to structural change in processes underpinning financial market outcomes, such as asset price fluctuations. Knightian Uncertainty, or unforeseeable structural change, stems from events driving change in asset price-relationships which are too novel to be captured ex ante with an overarching probabilistic rule (Frydman et al., 2015). However, to derive testable implications researchers must say something about how change within a model occurs over time. Models based on IKE constrain this change enough to generate contingent predictions about the future. IKE argues that there may be sub-periods of time where structural change is moderate enough to be constrained qualitatively.

This approach recognizes a role for Knightian Uncertainty in financial markets by allowing for myriad probability distributions underpinning asset price-relationships at every point in time. Once we replace models based on probabilistic rules with partly open ones based on IKE we can resolve many of the longstanding puzzles in finance: different fundamentals matter during different time periods.

Partly open models of change under IKE also provide implications for regulatory policy of financial markets. The conventional adherence to probabilistic rules representing change in macroeconomic and finance models has led to a dualism regarding asset market regulation: traditional REH accounts imply unfettered markets with limited intervention, while bubble accounts of price fluctuations imply massive and expeditious state intervention. IKE proposes an intermediate view.

Financial markets serve an indispensable role aggregating the diversity of views across individuals. Because knowledge about the future is inherently imperfect and grows over time, financial markets (and regulators) too are imperfect assessors of future investment prospects and risk. Therefore, IKE suggests that asset price swings be allowed to unfold naturally within a range beyond which price fluctuations are deemed to be excessive. Several actionable policies, in addition to guidance ranges, have been proposed under this framework, including bull versus bear capital requirements and regulatory or Central Bank scenario analysis (Frydman and Goldberg, 2011)

References


Roman Frydman, Michael D. Goldberg, and Nicholas Mangee (2015). “Knightian Uncertainty and Stock-Price Movements: Why the REH Present-Value Model Failed Empirically,” Economics: The Open-Access, Open-Assessment E-Journal, 9 (2015-24): 1—50. http://dx.doi.org/10.5018/economics-ejournal.ja.2015-24

Roman Frydman and Michael D. Goldberg (2011). Beyond Mechanical Markets: Asset Price Swings, Risk, and the Role of the State, Princeton University Press.

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