Kay and King: What's going on here?

"Probabilistic reasoning may appear beautiful and appealing, but sadly its applicability to real-world problems is limited."

In Radical Uncertainty: Decision-Making Beyond the Numbers, John Kay and Mervyn King explain that the future is not calculable and it is a mistake to assume that we can probability-weight uncertain future outcomes as part of a realistic decision making process. This book is helpful as a history of how economics has (or has not) dealt with uncertainty as well as a pretty practical guide for dealing with everyday decisions in the real world. "It is a book about how real people make choices in a radically uncertain world, in which probabilities cannot be meaningfully attached to alternative futures."

In summarizing this book I feel that non-economists might be inclined to say that everything it states is pretty obvious. For example, George Soros' explanation of reflexivity and the need for economic models to reflect real behaviors was viewed as "juvenile" by a leading academic (not an economist). But I think that critique misses the point: even if most humans understand that the world is uncertain and people don't think based on expected utility, many of the economic models used by central bankers and lawmakers simply don't get it. This book is an important step in explaining how the world of economics differs from the world.

The book is divided into 5 parts:

1. Introduction: The Nature of Uncertainty
2. The Lure of Probabilities
3. Making Sense of Uncertainty
4. Economics and Uncertainty
5. Living with Uncertainty

Kay and King explain that expressing uncertainty in probabilistic terms became increasingly common in the 17th century, and in the past two decades probabilistic reasoning has come to dominate the description and analysis of decision-making under uncertainty. In this 'decision science' for rational choice under uncertainty,

"Agents optimise, subject to defined constraints. They list possible courses of action, define the consequences of the various alternatives, and evaluate these consequences. Then they select the best available option, if necessary anticipating how others will react to their choices. People make plans for consumption across their lifetime, from education, through child rearing, through retirement. Corporations select strategies to maximise shareholder value. Governments choose policies to maximise social welfare. A moment's introspection is enough to tell us that they don't. They could not conceivably have the information required to do so ... Real households, real businesses and real governments do not optimise; they cope. They make decisions incrementally. They do not attain the highest point on the landscape, they seek only a higher place than the one they occupy now."

Essentially, we are all adaptive learners. The book contains three main propositions:

1. The world of economics, business and finance is 'non-stationary' -- it is not governed by unchanging scientific laws;
2. Individuals cannot and do not optimise; nor are they irrational, victims of 'biases' which describe the ways they deviate from 'rational' behavior; and
3. Humans are social animals and communication plays an important role in decision-making. We frame our thinking in terms of narratives.

1. Non-stationarity

Economic relationships change over time and movements in the economy reflect our expectations. Reflexivity, a term coined by Robert Merton and popularized by George Soros, essentially states that the system is influenced by our beliefs about it. As Isaac Asimov wrote in Foundation and Earth, "I knew nothing about Seldon's Plan except for the two axioms on which it is based: one, that there be involved a large enough number of human beings to allow humanity to be treated statistically as a group of individuals interacting randomly; and second, that humanity not know the results of psychohistorical conclusions before the results are achieved." Physics is in one sense easier than economics because an atom won't change it's behavior due to an anticipated federal funds rate increase.

2. Non-optimizing, non-biased behavior

Kay and King introduce two types of rationality: axiomatic rationality -- used by economists and defined based on an abstract notion of adherence to rational choice -- and evolutionary rationality -- practiced by people in the real world. They show "that the axiomatic approach to the definition of rationality comprehensively fails when applied to decisions made by businesses, governments, or households about an uncertain future. And this failure is not because these economic actors are irrational, but because they are rational, and -- mostly -- do not pretend to knowledge they do not and could not have. Frequently they do not know what is going to happen and cannot successfully describe the range of things that might happen, far less know the relative likelihood of a variety of different possible events." 

3. Narratives

"Narratives are the means by which humans ... order our thoughts and make sense of the evidence given to us." When we make a decision, whether as a juror, gambler, or insurance customer, we think in terms of narratives rather than probabilities and expected utility.

Additional thoughts

Hard, unimportant puzzles: "Economists have thrived on the difficulty of solving complex models of the economy precisely because they have been trained to tackle well-defined problems which have an answer. And (Nobel) prizes are awarded to those who solve the most difficult puzzles... Replacing complex mysteries with puzzles that have unambiguously right and wrong answers limits the interest and relevance of both problems and answers." This reminds me of Akerlof's recent article and points to a problem with how to move economics beyond its current state. Of course, an issue with economics solving hard but unimportant problems is that the models amenable to hard analysis are of course biased in some way ... "economic data and economic models are never descriptive of 'the world as it really is'. Economic interpretation is always the product of a social context or theory." [20+ neoclassical assumptions that are easier to model than other views -- from J Robinson book] Frank Knight might have put it best: "Insistence on a concretely quantitative economics means the use of statistics of physical magnitudes, whose economic meaning and significance is uncertain and dubious ... In this field, the Kelvin dictum very largely means in practice, if you cannot measure, measure anyhow!"

On a practical note: "In writing this book, we found inspiration in an anecdote from Richard Rumelt's Good Strategy/Bad Strategy, by some distance the best book on business strategy written in the last decade. Rumelt describes a conversation with a colleague at UCLA who had observed some of his case-based MBA classes: We were chatting about pedagogy ... John gave me a side-long look and said 'it looks to me as if there is really only one question you're asking in each case'. That question is 'what's going on here?' John's comment was something I've never heard said explicitly but it was instantly and obviously correct. A great deal of strategy work is trying to figure out what is going on. Not just deciding what to do, but the more fundamental problem of comprehending the situation."

Additional reading: Ramsey and Finetti vs. Keynes and Knight . Ramsey applied the math that had been used for the analysis of probabilities based on frequencies to subjective probabilities. "The winning argument which Ramsey provided to counter Keynes was that anyone who did not attach a consistent set of subjective probabilities to all uncertain events would be certain to lose money if they bet at those probabilities."

Other notes: The book clarified some things I thought I knew -- such as the issue with assuming away uncertainty in economic models. It overturned some things I thought I knew -- such as the usefulness of behavioral economics research ("biases" in the small world of experiments generally have some rational reason in the real world) and the limitations of Robert Shiller's view of narrative as simply a crisis explainer (although I haven't read his book so can't fairly comment). And it included many things I didn't know -- such as how Herb Simon's bounded rationality was "seriously misinterpreted" when it was incorporated into mainstream economics. Simon used the word 'satisficing' to describe how people approach decisions in an uncertain world by using rules of thumb to search for a 'good enough' outcome. However, "Economists have adapted the phrase 'bounded rationality' to mean something very different from Simon's description as the consequence of radical uncertainty. They have instead used it to describe the cost of processing information, which then acts as an additional constraint in an optimisation problem."