On uncertainty and international exchange

On uncertainty and international exchange March 7, 2006 One of the great errors that was made by the neo-classical mainstream when they popularized Keynes and remade his work into the neo-classical Keynesian synthesis which was the dominant orthodoxy from the first days of Paul Samuleson's text Economics published in the late 1940s until the OPEC stagflation crisis of the 1970s was their failure to recognize the centrality of uncertainty to Keynes' theory. Keynes elaborated the notion of uncertainty in his Treatise on Probability, his General Theory of Employment , Interest and Money and his article in the Quarterly Journal of Economics, in Feb. 1937, "The General Theory of Employment". It is useful to recall what Keynes wrote on this subject. Keynes distinguished what was probable in the sense that one could assign a probability statistic to the outcome from what was uncertain or definitely not knowable. In his own words: " 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 though time and and chance may make much of them But sometimes we are intensely concerned with them, more so, occasionally, than with the immediate consequences. Now of all human activities which are affected by this remoter preoccupation, it happens that one of the most important is economic in character, namely wealth. The whole object of the accumulation of wealth is to produce results, or potential results, at a comparatively distant, and sometimes at an indefinitely distant date. Thus the fact that our knowledge of the future is fluctuating, vague and uncertain, renders wealth a peculiarly unsuitable subject for the methods of classical economic theory....By uncertain knowledge, let me explain, I do not mean merely to distinguish what is known for certain from what is only probable. ...The sense in which I am using the termis 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 holders in the social system in 1970. About these matters there is no scientific basis on which to form any calcuable probability whatsoever. " But because in a real world of action and decision we are obliged to make intelligent decisions Keynes argues that we tends to overlook the awkward facts and act as 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." (p.114, vol xiv CW) We tend to cope with uncertainty by assuming that what has happened in the past will happen in the future. Thus we tend to ignore the prospect of future changes about which we know nothing. We assume that "existing opinion" about future prices and output is correct; "knowing that our own individual judgement is worthless, we endeavour to fall back on the judgment of the rest of the world which is perhaps better informed." Keynes points out that a practical theory of the future based on the above because it is a flimsy foundation will be subject to violent fluctuations. "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... .All these pretty, polite techniques, made for a well-panelled boardroom and a nicely regulated market, are liable to collapse....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." p.114-115 ibid.) Keynes goes on to relate this sense of uncertainty to decisions about the value of money and decisions about investment and future rates of return as well as decisions to hoard . Clearly what is true of investment, decisions to hoard and rastes of return applies in spades to rates of exchange and therefore to the international trading system as a whole. Hence the history of the search from the days of Thomas Mun, mercantilism and bullionism forward for a system of international trade which would benefit the merchant class and the nation state. In the twentieth century this led to the abandonment of the gold standard and the era of Bretton Woods. By the last third of the century it had led to the anarchic system of free floating rates of exchange and what has come to be relatively unstable speculation driven by the more than trillion US dollars, Yen, Euros and other significant currencies that circle the globe on a daily basis looking for the highest rates of return regardless of the consequences for global emplyment security and stable growth. (more to come)