by Mario Rizzo
One hears a lot about restoring confidence in the economy these days. What is that? The economy is a complex entity. In fact, Friedrich Hayek wanted to drop the use of the term and replace it with “catallaxy” that is, an abstract order of interpersonal exchanges. The word “economy” has its origins in the idea of household management and consequently of a household manager. It is remarkable how the etymology of the word is preserved in its current meaning (or, at least, connotation). Most macroeconomists seem to believe that the economy can be managed or steered out of its current difficulties. (Is it cheeky to ask how did it get into its current difficulties if management were possible?)
Now the latest is Olivier Blanchard arguing that what fundamentally ails us is “Knightian uncertainty.” If this can be made to go away then our economic difficulties would be many fewer and far less severe. To accomplish this, he proposes the usual array of stimulus. So all of that to get to the “consensus policy.”
In the first place, Austrian economists have been talking about Knightian or radical uncertainty for quite a long time. Gerald O’Driscoll and I made a “big deal” of it in the first edition of The Economics of Time and Ignorance in 1985 (and in the 1996 edition as well). In that book we argued that neoclassical and neoclassical-synthesis economists virtually ignored it in favor of mere risk or objectively measurable uncertainty. Earlier, Ludwig von Mises captured some of the same idea in his distinction between case probability and class probability (ordinary risk). Israel Kirzner made the idea of unknown ignorance central to his concept of entrepreneurship. And, of course, there is G.L.S. Shackle. It is also true that Post Keynesians and Keynes himself thought radical uncertainty is an important aspect of human decisionmaking. More recently, Edmund Phelps suggested that many of the models that were used to assess innovative financial products were paying exclusive attention to risk in the sense of variance of historical outcomes and not at all to Knightian uncertainty.
But let’s go beyond the history of thought lesson. Is radical uncertainty alleviated by covering over the misdirection of resources that constitutes the core of the recession? In other words, do agents in particular markets (say, the housing market) gain confidence – meaning the willingness to engage in exchange – by propping up prices by putatively temporary measures? The actions of the Fed/Treasury/Congress are creating their own radical uncertainty. How long and to what extent will these policies last? I am unaware of any good models that forecast this political-economic behavior under “unprecedented circumstances” (as we are told). What will be the later consequences for interest rates – and thus housing prices – of the enormous public debt we are creating?
We should make more use of the idea of radical uncertainty in analyzing economic phenomena. It is important, though, to recognize all of the sources of this uncertainty. Simplistic stimulus policies that prevent resource re-allocation will put us all in a fantasy land of distorted prices. (I agree with Tyler Cowen’s cautions about stimulating consumer and other particular forms of demand as a means of restoring confidence.) If there is a “recovery” under these consensus policies it will be illusory – ready to collapse at the next radically uncertain shock.