Long-term expectation formation under radical uncertainty

Keynes argues that the assumption that the future is inherently unknowable in the present is both obviously true and theoretically transformational.

The outstanding fact is the extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made.

(CW 7, p. 150)

Keynes repeated this "outstanding fact" about the theory of agent choice under uncertainty in the 1937 QJE article that stressed the differences between his theory and classical theory.

[In classical theory,] at any given time facts and expectations were assumed to be given in a definite and calculable form; and risks, of which, tho admitted, not much notice was taken, were supposed to be capable of an exact actuarial computation. The calculus of probability, tho mention of it was kept in the background, was supposed to be capable of redu­cing uncertainty to the same calculable status as that of certainty itself...

Actually, however, we have, as a rule, only the vaguest idea of any but the most direct consequences of our acts. Sometimes we are not much concerned with their remoter consequences, even tho time and chance may make much of them. But sometimes we are intensely concerned with them, more so, occasionally, than with the immediate consequences.

By "uncertain" knowledge, let me explain, I do not mean merely to distinguish what is known for certain from what is only probable. The game of roulette is not subject, in this sense, to uncertainty: nor is the prospect of a victory bond being drawn... Even the weather is only moderately uncertain. The sense in which I am using the term is that in which the prospect of a European war is uncertain, or the price of copper and the rate of interest twenty years hence, or the obsolescence of a new invention, or the position of private wealth-owners in the social system in 1970. About these matters there is no scientific basis on which to form any calculable probability whatever. We simply do not know.

(Keynes 1937, pp. 212-214, emphasis added)

Keynes then argued that in the absence of true knowledge of the future consequences of our current decisions we are forced to form expectations of the future through the use of socially sanctioned behavioral or psy­chological conventions. In the QJE article and in other writings, Keynes presented a complex view of conventional expectation formation. As we have seen, in his 1937 Galton Lecture, Keynes said that people have a pro­found psychological need to reassure themselves that they can foresee the future with at least some degree of accuracy when they make choices that will significantly affect their future happiness or prosperity, even though they know at some psychologically deeper level that this is not possible.

The future never resembles the present - as we all know.

(CW 14, p. 124, emphasis added)

Keynes thus argues that even though "we simply do not know" the infor­mation that we must have to make safe decisions, we have a human need "to behave in a manner which saves our faces as rational, economic men" (Keynes 1937, p. 214), a manner that allows us the comfort of the illusion of safety and rationality. He tells us that we have a psychological need to calm our anxieties, to remove the constant stress created by forced decision­making under inadequate information, a need that is neither irrational nor socially or economically dysfunctional. We have good reason, in other words, to try to "overlook this awkward fact" that the reproduction of our economic and social status requires a knowledge of things that, in fact, "we simply do not know." In Keynes's words above: "Peace and comfort

Chapter 12 of The General Theory 243 of mind require that we should hide from ourselves how little we foresee" (CW 14, p. 124).

To help us accomplish this calming of our nerves, Keynes argues, we collectively develop a "conventional" process of expectation formation. Keynes's concept of conventional decision-making is a sine qua non of his macro theory. It is also one of Keynes's most important theoretical innovations. The dictionary definition of conventional as "arising from custom and tradition" captures Keynes's meaning to some degree. In place of the complete probabilistic information appropriate to the world of classical, New Classical, and neoclassical agent choice, Keynes substitutes an expectation-formation and decision-making process based on custom, habit, tradition, instinct, and other socially constituted practices that make sense only in a model of human agency in an environment of genuine uncertainty.²

In his 1937 QJE article, Keynes tells us that we save our faces as rational economic men and calm our nerves in the following ways, none of which are available to the mainstream fully informed "rational" actor.

(1) We assume that the present is a much more serviceable guide to the future than a candid examination of past experience would show it to have been hitherto.

(2) We assume that the existing state of opinion as expressed in prices and the character of existing output is based on a correct summing up of future prospects, so that we can accept it as such unless and until something new and relevant comes into the picture.

(3) Knowing that our own individual judgment is worthless, we endeavor to fall back on the judgment of the rest of the world which is perhaps better informed. That is, we endeavor to con­form with the behavior of the majority or the average. The psych­ology of a society of individuals each of whom is endeavoring to copy the others leads to what we may strictly term a conventional judgment.

(Keynes 1937, p. 214, emphasis in original)

All three of these conventional methods of expectation formation would be irrational in a world of agents who were, or at least believed they were, fully informed about future economic states. However, it is not surprising that they are a reasonable explanation of how psychologically complex agents make choices in the context of fundamental uncertainty.

Keynes immediately warns the reader that an economy based on these principles of expectation formation will inevitably be subject to bouts of extreme instability, especially in periods such as the late 1920s through the

mid-1980s in which financial security markets were globally integrated and lightly regulated.

Now a practical theory of the future based on these three principles has certain marked characteristics. In particular, being based on so flimsy a foundation, it is subject to sudden and violent changes. The practice of calmness and immobility, of certainty and security, sud­denly breaks down. New fears and hopes will, without warning, take charge of human conduct. The forces of disillusion may sud­denly impose a new conventional basis of valuation. All these pretty, polite techniques, made for a well-paneled Board Room and a nicely regulated market, are liable to collapse.

(Keynes 1937, p. 215)

Keynes then criticizes classical theory because it turns a blind eye to this severe flaw in the economic system by assuming away fundamental uncertainty, a criticism equally applicable to neoclassical and New Classical theory.

Tho this is how we behave in the market place, the theory we devise in the study of how we behave in the market place should not itself submit to marketplace idols. I accuse the classical economic theory of being itself one of these pretty, polite techniques which tries to deal with the present by abstracting from the fact that we know very little about the future.

(Keynes 1937, p. 215)

In chapter 12, Keynes simplified his theory of long-term expectation formation in response to institutional changes we discuss below. He argued that the long-term expectations that determine the mec were now set in the stock market and therefore had shallow roots. They were formed by extrapolation from the recent past, unless there were con­crete reasons to believe the trajectory of the economy had changed or would change in the near future. Our usual practice, he said, is "to take the existing situation and to project it into the future, modified only to the extent that we have more or less definitive reasons for expecting a change" (CW 7, p. 148).

This theory is compatible with periods of relative stability or continuity. Expectations that the economic trajectory of the economy in the recent past will continue in the foreseeable future can lead to decisions that cause it to continue. If agents expect a period of prosperity to continue, they may make decisions that cause it to continue, and vice versa. Convention­based extrapolative forecasts can thus help make possible those periods

Chapter 12 of The General Theory 245 of continuity that Keynes called "normal times" and that Joan Robinson referred to as periods of "tranquility."

However, Keynes immediately warns the reader of chapter 12 that while the convention that the future will look like the recent past extrapolated is compatible with periods of tranquility, economic history demonstrates that expectations thus formed are also inherently vulnerable to serious error.

This does not mean that we really believe that the existing state of affairs will continue indefinitely. We know from extensive experience that this is most unlikely. The actual results of an investment over a long term of years very seldom agree with the initial expectation... [P]hilosophically speaking, [the expectation] cannot be uniquely correct, since our existing knowledge does not provide a sufficient basis for a calculated mathematical expectation.

(CW 7, p. 152)

Keynes cautions the reader - as he would do again in his QJE article - that the precarious nature of an expectation-formation process built on such a fragile foundation cannot sustain persistently high investment, especially in an era in which casino stock and bond markets have a dominant role in the capital investment decision.

[I]t is not surprising that a convention, in an absolute view of things so arbitrary, should have its weak points. It is its precariousness which creates no small part of our contemporary problem of securing suffi­cient investment.

(CW 7, p. 153)