Uncertainty in economics and in life

"Doubt is not a pleasant condition, but certainty is an absurd one." -- Voltaire, quoted in Mervyn King, The End of Alchemy.

"At the heart of modern macroeconomics is the same illusion that uncertainty can be confined to the mathematical manipulation of known probabilities." -- Mervyn King, ibid. p.121.

As has been argued elsewhere, for example in Taleb's Black Swan and in Mandelbrot et. al. The Misbehaviour of Markets, many market analysts, economists, politicians and others, including probably most of us ordinary folk, imagine that most things stay more-or-less the same most of the time, and when things change they do so within reasonable boundaries. Those of a mathematical persuasion may further imagine that things follow a normal or Gaussian distribution, that is, events are distributed in a bell-curve, in which very few things are extreme and most things are more-or-less average.

This is the case with things like people's height, for example, or fitness, or biological variables (see my earlier blog post about the misuse of this) or workers' incomes (excluding oil billionaires and bank executives). However it is not the case with non-linear dynamic systems.

What, I hear you ask, is a non-linear dynamic system? It is any system in which there is any degree of complexity in the relation between inputs and outputs, and in which the outputs feed back as inputs. An example is the weather and the so-called butterfly effect, in which the flapping of a butterfly's wings can change the course of a tornado several weeks hence. An outcome can be radically changed by a small change in initial conditions. This is why even with much more powerful computers it is unlikely that the weather will be predictable with any accuracy more than ten days ahead, because it is simply not feasible that we could ever measure the initial conditions with sufficient accuracy.

When we come to the stock market there are so many variables and so many unknowns that long-term prediction is impossible. Someone bets on an oil company, then a major accident happens and the stock falls, or else someone announces a major breakthrough in solar power and the stock falls, or there is a war involving a major oil exporter and the price of oil rises. I such cases the unexpected occurs frequently and is better represented by some kind of fat-tailed distribution, in which uncommon events happen more frequently.

There are up-sides and down-sides to this. Our lives in general are subject to the unexpected. We enjoy the stability of relationships and our homes and jobs and we value living in a country that is not at war, if we think about it at all. But the unexpected does happen. We prefer not to think about it, other than the approximately 1 in 14 million chance that our lottery ticket will win.

The up-side of the butterfly effect, though, is that if the beating of the wings of a butterfly in China can change the course of a tornado on the other side of the world, imagine what the effect of a smile could be!