Sunday, July 6, 2014

Gillies on Probability and Uncertainty in Keynes’ Economic Thinking

Donald Gillies (2003) is a paper examining probability and uncertainty in Keynes’s economic thinking in the General Theory and later. Gillies is a philosopher and also the author of a leading book on probability theory (Gillies 2000).

Gillies (2003: 111–113) sketches the history post-WWII Keynesianism and the heterodox interpretation of Keynes’ work.

Keynes saw the aggregate level of investment as the major cause of changes in output and employment in a modern market economy, and in turn investment is dependent on two facts: (1) the prospective yield of an investment and (2) the demand price of the said investment (Gillies 2003: 113, 127).

But the problem is that the future prospective yield of an investment is a quantity subject to degrees of uncertainty and cannot be calculated objectively (Gillies 2003: 114).

Gillies points to this crucial passage in the General Theory from Chapter 12 (“The State of Long-Term Expectations”):
“The outstanding fact is the extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made. Our knowledge of the factors which will govern the yield of an investment some years hence is usually very slight and often negligible. If we speak frankly, we have to admit that our basis of knowledge for estimating the yield ten years hence of a railway, a copper mine, a textile factory, the goodwill of a patent medicine, an Atlantic liner, a building in the City of London amounts to little and sometimes to nothing; or even five years hence. In fact, those who seriously attempt to make any such estimate are often so much in the minority that their behaviour does not govern the market.” (Keynes 1964 [1936]: 149–150).
Therefore it is expected yield which becomes the crucial concept related to investment, but that depends on the state of long-term expectations (Gillies 2003: 114).

The issue of expectations, as noted by Gillies, is fundamentally related to probability theory (Gillies 2003: 114).

Gillies gives a very brief summary of the various theories of probability.

Gillies notes that Keynes’ logical theory of probability was an attempt to explain inductive logic and inductive inferences (or what Keynes called “partial entailment”), and that probability, for Keynes, is a degree of rational belief (Gillies 2003: 115).

To obtain objective, numeric point probabilities, we need equiprobable outcomes or events, but this is clearly not always possible. In A Treatise on Probability, as part of this theory, Keynes had used the principle of indifference, but Gillies thinks there are serious problems with this concept (Gillies 2003: 115–116, 122).

Another theory of probability is the subjective interpretation, developed by Bruno de Finetti and Frank Ramsey (Gillies 2003: 116). Ramsey denied that there was an objective, rational degree of belief that every person, given the evidence e, would have in some proposition h. Instead, Ramey argued that different people will have different degrees of subjective belief (Gillies 2003: 117). Ramsey went on to develop his method by which a person’s subjective degree of belief could be measured numerically (Gillies 2003: 117).

The subjectivist theory renders a person’s subjective beliefs about probability numerically determinate, and then consistent with the rules of the probability calculus by using coherent betting quotients and the “Dutch Book” argument (Gillies 2003: 118).

A variant on the subjectivist theory is the intersubjective theory, which Gillies (2003: 120) sees as intermediate between the logical theory of Keynes and the subjective theory of Ramsey (and Gillies also seems to endorse this intersubjective theory), even though Gillies does think (1) that degree of belief is not entirely personal or subjective and (2) that there are indeed some objective probabilities that do exist (which are mostly related to phenomena described by the natural sciences).

Next, Gillies considers the question whether Keynes changed his mind on the nature of probability or continued to hold the same views as in A Treatise on Probability (Gillies 2003: 120–121).

A number of scholars support the continuity thesis – the view that Keynes held the same theory of probability throughout his life – such as Lawson (1985), Carabelli (1988), and O’Donnell (1989).

Other scholars oppose this view and maintain that Keynes did change his views on probability, such as Davis (1994) and Bateman (1987 and 1996).

Gillies himself supports the view that Keynes did change his mind on the nature of probability (Gillies 2003: 121), and that Keynes repudiated the principle of indifference by the time of the General Theory (Gillies 2003: 122).

He cites Keynes’ 1931 article on Ramsey (Keynes 1931), Keynes’ article “The General Theory of Employment” (1937), and other evidence for this view, and holds that Keynes abandoned the strict logical theory of probability for an intersubjective epistemic theory of probability which was still distinct from Ramsey’s subjectivist one, and which is closer to Keynes’ original logical theory (Gillies 2003: 121–122).

This “intersubjective theory of probability” is the key, according to Gillies, to understanding Keynes’ remarks about how agents form expectations in situations involving uncertainty in his article “The General Theory of Employment” (1937):
“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 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. Nevertheless, the necessity for action and for decision compels us as practical men to do our best to overlook this awkward fact and to behave exactly as we should if we had behind us a good Benthamite calculation of a series of prospective advantages and disadvantages, each multiplied by its appropriate probability, waiting to be summed.

How do we manage in such circumstances to behave in a manner which saves our faces as rational, economic men? We have devised for the purpose a variety of techniques, of which much the most important are the three following:

(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. In other words we largely ignore the prospect of future changes about
the actual character of which we know nothing.

(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: 213–214).
That is, agents are often influenced by the general or group state of expectations (Gillies 2003: 124), and Keynes thought that such expectation about private investment could be based on “so flimsy a foundation, [sc. that] it is subject to sudden and violent changes” (Keynes 1937: 214), which in turn cause fluctuations in the aggregate level of investment.

This is the sense in which such expectations can be said to be subjective or intersubjective, but, as Gillies argues, we can still use Ramsey’s betting quotients and the “Dutch Book” method for measuring the subjective probabilities of human beings (Gillies 2003: 125), though those probabilities are not objective.

Bateman, Bradley W. 1987. “Keynes’s Changing Conception of Probability,” Economics and Philosophy 3: 97–119.

Bateman, Bradley W. 1996. Keynes’s Uncertain Revolution. University of Michigan Press, Ann Arbor.

Carabelli, Anna M. 1988. On Keynes’s Method. Macmillan, Basingstoke.

Davis, John B. 1994. Keynes’s Philosophical Development. Cambridge University Press, Cambridge.

Gillies, D. A. 2000. Philosophical Theories of Probability. Routledge, London.

Gillies, D. A. 2003. “Probability and Uncertainty in Keynes’s General Theory,” in J. Runde and S. Mizuhara (eds.), The Philosophy of Keynes’s Economics: Probability, Uncertainty and Convention. Routledge, London. 111–129.

Keynes, J. M. 1931. “Ramsey as a Philosopher,” The New Statesman and Nation, 3 October.

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

Keynes, J. M. 1964 [1936]. The General Theory of Employment, Interest, and Money. Harvest/HBJ Book, New York and London.

Lawson, Tony. 1985. “Uncertainty and Economic Analysis,” Economic Journal 95: 909–927.

O’Donnell, R. M. 1989. Keynes: Philosophy, Economics and Politics: The Philosophical Foundations of Keynes’s Thought and their Influence on his Economics and Politics. Macmillan, Basingstoke.

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