Coping with Uncertainty: the Red Hot Topic in Economics

After months of Trappist silence, a whole plethora of large companies has pronounced on the adverse consequences for Scotland of a Yes vote tomorrow.  The sectors span the economy, from oil to banks, from supermarkets to phone companies.  But what will be the effect of these interventions?

From the perspective of a rational economic person, they must make people more likely to reject independence.  Jobs will be relocated out of Scotland and the prices of goods and services will rise.  The public finances of the Scottish government will be weaker than is claimed, with much less oil being available. Serious doubts have been raised about the financial stability of Scotland as a whole, as problems with its currency arrangements are aired.  There is a distinct impatience amongst those who operate in this rational world with how voters seem to make up their minds. Certainly, at times this can seem bizarre. On a recent visit to Scotland, I was told in all seriousness by one woman that she was voting ‘Yes’. On a recent holiday, she had noticed on her passport the Royal Coat of Arms, in which the Scottish Unicorn appears chained to the Lion of England.

There is obviously the wider issue as to the importance of economic factors are in how people are casting their votes. But in terms of the companies’ announcements, their impact depends upon credibility. If they are perceived mainly as scare stories, their effect may be the complete opposite of what is intended, pushing people more firmly into the ‘Yes’ camp. It is the question of credibility which makes the impact difficult to assess.

Many of these issues are difficult and complicated, where even experts may legitimately disagree. The level of uncertainty around their impact is inherently high, not least because the consequences of such actions stretch far into the future.  Economists are starting to appreciate that their standard model of so-called rational behaviour may not be very helpful in describing how people actually make decisions in such circumstances. Discussion of this issue was prominent at both the Institute for New Economic Thinking conference in Toronto in April, and at the recent World Economic Forum gathering in Kuala Lumpur, each graced by the presence of Nobel Laureates. The fashionable new phrase is ‘radical uncertainty’.

An effective strategy for making decisions when outcomes are very uncertain is simply to copy what other people do. There are many nuances to this, but it is often a good rule of thumb to use. Keynes wrote about ‘the psychology of a society of individuals, each of whom is attempting to copy the other. The American economist Armen Alchian took the concept further in the Journal of Political Economy in 1950. Interest in his brilliant paper, ‘Uncertainty, Evolution and Economic Theory’, is reviving rapidly. The tools and the maths to formalise the concept did not exist in the days of Keynes and Alchian. But the question of how people decide under uncertainty is now a red hot topic in economics.

As published in City AM on Tuesday 16th September

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