Professor John Kay (right), world-renowned economist, talking about radical uncertainty with George Littlejohn MCSI, senior adviser to the CISI, at a CISI event held on 11 March at Willis Towers Watson in London
“People who know only economics, do not know much about economics,” say John Kay and Mervyn King in their new book Radical Uncertainty.
“We find it humbling to realise how little we know about how humans really think, humbling to see how much scientists outside economics are beginning to know, and perhaps most humbling of all, to see how little impact this work has so far made on economic science,” they write. Science operates in the real world, and constructs hypotheses that are there to be broken. Economists operate in an idealised world and hypotheses are rarely discredited; they instead simply say there has been a ‘shock’.
The authors have known each other for more than 40 years and first collaborated on a book in 1978 titled The British Tax System
. Then they went their separate ways. Kay was director of the Institute for Fiscal Studies and a professor at London Business School, where he founded the consultancy London Economics. He was also the first director of Saïd Business School in Oxford. He was for many years a regular columnist of the Financial Times
and is a Fellow of St John’s College, Oxford.
Economics should be part of the real world
In his earlier career, Lord King had a variety of economic academic appointments, moving on to become chief economist of the Bank of England in 1991 and subsequently the governor from 2003 to 2013, which meant he was in situ during the financial crisis. He is now a professor of economics and law at New York University and a professor at the London School of Economics.
It is the authors’ strong economics background that independently persuaded them they needed to write this book, which, among other things, says that economics should be part of the real world. The book explains that after the financial crisis, Queen Elizabeth II asked: “Why did no one see it coming?” Because economists were in their ivory towers, the authors suggest, not looking at the world as it is.
Furthering the ‘ivory towers’ point, the authors say economics, as practiced nowadays, talks about maximising shareholder value, households maximising their happiness and governments and policymakers maximising social welfare. The individual also has a selfish gene that leads them to maximise their income and bonuses.
The uncertainty factor
When they were younger, Kay and King followed this route too – almost everybody did in economics. Their epiphany came with the realisation that none of these economic actors could imagine having the information they would need to enable them to take a view on maximising anything.
Instead, as Kay and King write, good business leaders make incremental decisions that they think will improve their business or make the world a better place. Politicians do likewise to make improvements in society. Happy households ensure that tomorrow will be at least as good as today.
Everybody has to cope with uncertainty and it is what makes life interesting, albeit not always enjoyable. But economists cope with models that ignore uncertainty. Their models are therefore limited to what they think they know or can measure, which is a very small part of the whole. The authors say these models live in “small worlds”, whereas people actually live in the real larger world – this world of uncertainty.
People live in the real larger world – this world of uncertaintyThe authors say that the problem here is that people working with such models – businessmen, politicians and regulators – assume the models and their forecasts are true, and they act accordingly. They make decisions because of what the model says. But then uncertainty strikes in the real world and makes the model unravel; it does not do what is expected of it. The earlier business decisions become problematic or even disastrous.
The former finance director of Goldman Sachs, David Viniar, is quoted in the book. He said during the financial crisis that “we are seeing things that were 25 standard deviation moves several days in a row”. But a 25 standard deviation move is more than the life span of the universe since the Big Bang. What Viniar really means is that the moves in financial assets were much larger than his risk managers had ever experienced or thought possible. But he still believes the model that underpinned his business was right, even though it led to the financial crash.
Viniar’s beliefs show how models survive even when they should really be put in the dustbin. Rather than see their model unravel, economists say an economic shock has occurred that is out of the ordinary and could not be anticipated. Therefore, the model is largely intact and just needs a few tweaks. They then carry on as before. But, shocks occur all the time and cannot be wished away so easily.
Kay and King do have a solution. Radical uncertainty is always with us and we should embrace it, they argue. The economists should look at the real world, like scientists do, not just look at idealised models. We should use other people to see how they cope, we should use our own experiences and we should look at what has happened elsewhere.
This is in fact what people do – it is the economists who have got it wrong.