Davidson on Nominal Contracts and Uncertainty

From Davidson (1988):

“In the absence of money production-hire contracts over time in a nonergodic environment, entrepreneurs would be foolish to start up a long duration production process, for they would not possess any knowledge of the ultimate future costs of production! (How could a profit-maximising manager calculate the marginal cost associated with varying production flows, in a nonergodic world, without fixed nominal wage contracts?) The institution of forward money contracts where delivery and payment is specified at a future date is an institutional arrangement which permits agents to deal with, and control the outcomes of, an otherwise uncertain future. Long-lived forward contracts are the way a free market economy, in an uncertain world, builds in institutional price and wage stickiness over time. In a nonergodic world, such explicit money contractual anchors for future events are necessary conditions for encouraging entrepreneurs to carry out economic activities in a market economy” (Davidson 1988: 335).

Of course, we can add mark-up pricing/administered pricing to nominal contracts as well.

The rise of a high degree of price and wage rigidity in modern economies is, contrary to neoclassical theory, a development that many businesses actively desire because it promotes stability and increases their ability to successfully plan for the future. In that sense, contrary to Austrian and neoclassical theory, relative price and wage rigidity greatly aids economic calculation, because such rigidity allows more successful forward planning.

Both fixed nominal contracts and administered prices are simply private sector institutions to decrease the uncertainty that economic agents face when dealing with an unknown future: they have emerged from within markets, and are not some artificial or unnatural imposition on markets.

BIBLIOGRAPHY
Davidson, P. 1988. “A Technical Definition of Uncertainty and the Long-Run Non-Neutrality of Money,” Cambridge Journal of Economics 12.3: 329-337.

Davidson on “Reality and Economic Theory”

Davidson (1996) provides an important study of the nature of uncertainty, probability and decision making in economic life.

In standard neoclassical theory, rational actors must have reliable probability forecasts::

“To make statistically reliable forecasts of the future, agents need to obtain and analyze sample data from the future. Since that is impossible, the assumption of a predetermined-ergodic-reality permits the modeler to assert that sampling from past and present market data is the same thing as obtaining a sample from the future. Ergodicity implies that future outcomes are merely the statistical shadow of past and current market signals. Presuming ergodic conditions reduces the modeler's problem to explaining how and at what cost agents obtain and process existing data (in the form of ‘price signals’).

Unlike the old classical economists, rational expectations theorists do not claim that the agents in their models obtain complete knowledge of reality. Rational expectations models only require agents to use existing market price signals to calculate subjective probabilities that are statistically reliable estimates of the objective probability function describing the reality that governs future events. Subjective probabilities calculated from current and/or past market data can provide these statistically reliable estimates if, and only if, the economic system is ergodic. Hence, all rational expectations models are based on the ergodic axiom.” (Davidson 1996: 480).

Davidson proposes the following classification of the way in which mainstream and heterodox economic theories treat economic reality and human knowledge of the future:

“Concepts of External Economic Reality
A. Immutable reality

Type 1. In both the short run and the long run, the future is known or at least knowable. Examples are:
a. Classical perfect certainty models.
b. Actuarial certainty equivalents, such as rational expectations models.
c. New Classical models.
d. Some New Keynesian theories.

Type 2. In the short run, the future is not completely known due to some limitation in human information processing and computing power. Examples are:
a. Bounded rationality theory
b. Knight’s theory of uncertainty
c. Savage’s expected utility theory.
d. Some Austrian theories.
e. Some New Keynesian models (e.g., coordination failure).
f. Chaos, sunspot, and bubble theories.

B. Transmutable or creative reality: Some aspects of the economic future will be created by human action today and/or in the future. Examples of theories using this postulate are:

a. Keynes’ General Theory and Post Keynesian monetary theory.
b. Post-1974 writings of Sir John Hicks.
c. G.L.S. Shackle’s crucial experiment analysis.
d. Old Institutionalist theory.” (Davidson 1996: 485).

The Type 2 models assume that in the short-run economic agents are ignorant about the immutable reality, and have very incomplete knowledge, because there are serious limitations on the human ability to collect and analyse the time series data necessary to obtain reliable knowledge (Davidson 1996: 484). In type 2 models, economic agents are therefore subject to a type of epistemological uncertainty.

Regarding decision making in the Type 2 theories, Davidson notes:

“Type 2 immutable reality models typically employ a subjectivist orientation. Agents form subjective expectations (usually, but not necessarily in the form of Bayesian subjective probabilities). In the short run, subjective probabilities need not coincide with the presumed immutable objective probabilities. Today’s decision makers, therefore, can make short-run errors regarding the uncertain (i.e., probabilistic risky) future. Agents ‘learn’ from these short-run mistakes so that subjective probabilities or decision weights tend to converge onto an accurate description of the programmed external reality.” (Davidson 1996: 486).

Davidson then draws attention to the distinction between risk and uncertainty in Frank Knight’s work:

“the practical difference between the two categories, risk and uncertainty, is that in the former the distribution of the outcome in a group of instances is known (either through calculation a priori or from the statistics of past experience), while in the case of uncertainty, this is not true, the reason being in general that it is impossible to form a group of instances, because the situation dealt with is in a high degree unique” (Knight 1921: 233).

Finally the Post Keynesian view, as derived from Keynes himself:

“For Keynes and the Post Keynesians, long-run uncertainty is associated with a nonergodic and transmutable reality concept. A fundamental tenet of Keynes’ revolution ... is that probabilistic risks must be distinguished from uncertainty where existing probabilities are not reliable guides to future performance. Probabilistic risk may characterize routine, repeatable economic decisions where it is reasonable to presume an immutable (ergodic) reality. Keynes ..., however, rejected the ergodic axiom as applicable to all economic expectations when he insisted that the ‘state of long term expectations’ involving non routine matters that are ‘very uncertain’ form the basis for important economic decisions involving investment, the accumulation of wealth, and finance. In these areas, agents ‘know’ they are dealing with an uncertain, nonprobabilistic creative economic external reality.” (Davidson 1996: 492–493).

Shackle’s concept of the “crucial choice” is also relevant here. A “crucial choice” decision is one that has a fundamental influence on the economic environment, and the conditions under which the decision is made are not repeated (Davidson 1996: 495). The transmutable economic future is created by such decisions, but often contrary to what agents intended. As Davidson notes, for Shackle, the

“future is not discovered through the Bayes-LaPlace theorem regarding relative frequencies or any error learning model.” (Davidson 1996: 499).

Furthermore,

“[s]ome economic processes may appear to be ergodic, at least for short subperiods of calendar time, while others are not. The epistemological problem facing every economic decision maker is to determine whether (a) the phenomena involved are currently governed by probabilities that can be presumed ergodic – at least for the relevant future, or (b) nonergodic circumstances are involved.” (Davidson 1996: 501).

Where economic phenomena are non-ergodic, “discovered empirical regularities in past data cannot be used to predict the future” (Davidson 1996: 502).


BIBLIOGRAPHY
Davidson, Paul. 1996. “Reality and Economic Theory,” Journal of Post Keynesian Economics 18.4: 479–508.

Degrees of Uncertainty

There is an interesting review here by Michael Emmett Brady of Gerald P. O’Driscoll and Mario J. Rizzo’s The Economics of Time and Ignorance (2nd edn; Routledge, Oxford, UK., 1996):

http://www.amazon.com/review/R25I26NGH79Y3I

Towards the end, Michael Emmett Brady states that

“Let us now turn to p. 9. The authors make the bizarre claim that Paul Davidson’s Shacklean, Post Keynesian views, that there is only certainty and uncertainty, is a continuation of those parts of the [General Theory] … that represent a true subjectivist position. Unfortunately, Shackle never got past chapter 3 of the [Treatise on Probability] … and rejected Keynes’s entire [Treatise on Probability] … approach in toto. Neither Shackle nor Davidson are followers of Keynes because Keynes totally rejected nihilism and the bizarre Shackle-Davidson claim that there are no degrees/gradations of uncertainty which Keynes spelt out clearly in his 1937 QJE article, titled ‘The General Theory of Employment’. Uncertainty is a range that can be specified in the same identical manner as Keynes’s weight of the evidence index, w. Complete and total uncertainty (ignorance) would have a w = 0. The differing gradations of uncertainty would be between 0 and 1 (0 < w < 1). Complete certainty would have a w = 1. The two authors never specify what their term ‘genuine’ uncertainty is. Their discussions of the beauty contest example (p. 156, GT), which is a continuation of a discussion started by Keynes in his introductory chapter 3 of the [Treatise on Probability] … in 1921 (1908) on the measurement of probabilities, does not fit the bill.”

I have just re-read Keynes’s paper “The General Theory of Employment” (Quarterly Journal of Economics 51 [1937]: 209–223). The crucial passage where Keynes talks about degrees of uncertainty is here:

“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. Or, again, the expectation of life is only slightly uncertain. 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 wealthowners in the social system in 1970. About these matters there is no scientific basis on which to form any calculable probability whatever” (Keynes 1937: 213–214).

It is indeed possible to see the concept of degrees of uncertainty, and Barkley Rosser describes Keynes’s views on the probability of future events in A Treatise on Probability (1921: 33), and how uncertainty comes in different forms:

“(i) ... there are no probabilities at all (fundamental uncertainty),
(ii) ... there may be some partial ordering of probable events but no cardinal numbers can be placed on them,
(iii) ... there may be numbers but they cannot be discovered for some reason, and
(iv) ... there may be numbers but they are difficult to discover” (Barkley Rosser 2001: 559).

There is also a literature about degrees of uncertainty, some of it by Post Keynesians (Runde 1990; Dow 1995; Crocco 2002; Dequech 1997).

At this point it is notable that Paul Davidson uses the concept of non-ergodicity to reject the view that there are degrees of uncertainty (Crocco 2002: 19). Nevertheless, there are Post Keynesians who recognise degrees of uncertainty, e.g., S. C. Dow (1994: 437). Moreover, here is Jesper Jespersen:

“Uncertainty is caused by lack of information. Therefore uncertainty might have different intensities or ‘stats of confidence’. You may feel(!) more or less uncertain, but except for rare cases all individual activities are characterized by (different degrees of) uncertainty, because one cannot know nor estimate the exact outcome. Hence, expectations are uncertain due to this inherent lack of information (and a constantly changing environment).”
Jesper Jespersen, “Post-Keynesian economics: uncertainty, effective demand & (un)sustainable development,” Paper, Dijon-conference, Dijon, 10-12 December 2009. p. 8.

It seems to me an exaggeration to say that the Post Keynesian school does not recognise degrees of uncertainty. Clearly not everyone follows Davidson.

BIBLIOGRAPHY

Barkley Rosser, J. 2001. “Alternative Keynesian and Post Keynesian Perspectives on Uncertainty and Expectations,” Journal of Post Keynesian Economics 23.4: 545–566.

Crocco, M. 2002. “The Concept of Degrees of Uncertainty in Keynes, Shackle, and Davidson,” Nova Economia 12.2: 11–28.

Dequech, D. 1997. “Uncertainty in a Strong Sense: Meaning and Sources,” Economic Issues 2.2: 21–43.

Dow, S. C. 1994. “Uncertainty,” in P. Arestis and M. Sawyer (eds.), The Elgar Companion to Radical Political Economy, Elgar, Aldershot. 434–438.

Dow, S. C. 1995. “Uncertainty about Uncertainty,” in S. C. Dow and J. Hillard (eds), Keynes, Knowledge and Uncertainty, Edward Elgar, Aldershot. 117–127.

Keynes, J. M. 1921. A Treatise on Probability (1st edn.), Macmillan, London.

Keynes, J. M. 1937. “The General Theory of Employment,” Quarterly Journal of Economics 51: 209–223.

Runde, J. 1990. “Keynesian uncertainty and the weight of arguments,” Economics and Philosophy 6.2: 275–292.

Davidson on the Austrian Concept of Uncertainty

Paul Davidson summarizes the concept of uncertainty held by some leading Austrian economists:

“Modern-day Austrian economists such as O’Driscoll and Rizzo believe in an economic world where there is an immutable external reality similar to the way nineteenth-century physicists viewed the working of the physical world. In their emphasis on uncertainty, however, Austrians often differ from mainstream Old and New Classical theorists. Many Austrians believe that the external reality may be predetermined by Mother Nature but this reality is too complicated for any single human being ever to process the information being sent out by market signals. The free market is the Austrians’ deus ex machine that provides the (in principle calculable) relevant probabilities and prediction to coordinate the plans and outcomes via a Darwinian process in a would of epistemological uncertainty and a programmed external reality” (Davidson 2002: 63).

The Austrians adhere to the concept of epistemological uncertainty, whereas Post Keynesian economics stresses the notion of ontological uncertainty (Barkley Rosser 2010: 171). This is an important difference and I will have more to say about it in the future.

BIBLIOGRAPHY

Barkley Rosser, J. 2010. “How Complex are the Austrians?,” in R. Koppl, S. Horwitz, and P. Desrochers (eds), What is so Austrian about Austrian Economics? (Advances in Austrian Economics, Volume 14), Emerald Group Publishing Limited, Bingley, UK. 165–179

Davidson, P. 2002, Financial Markets, Money, and the Real World, Edward Elgar, Cheltenham, UK.