This note examines the implications of adaptation by economic agents under Knightian uncertainty for the resilience of the macroeconomic system. It expands on themes I touched upon here and here. To summarise the key conclusions,
- Under Knightian uncertainty, homo economicus is an irrelevant construct. The “optimal” course of action is one that restricts the choice of actions available and depends on a small set of simple rules and heuristics.
- The choice of actions is restricted to those that are applicable in reasonably likely or recurrent situations. Actions applicable to rare situations are ignored. Therefore, it is entirely rational to take on severely negatively skewed bets.
- By the same logic, economic agents find it harder to adapt to severe macroeconomic shocks as compared to mild shocks. This is the rationale for Axel Leijonhufvud’s “Corridor Hypothesis”.
- Minsky’s Financial Instability Hypothesis states that prolonged periods of stability reduce the width of the “corridor” until the point where a macroeconomic crisis is inevitable.
- The only assumptions needed to draw the above conclusions are the existence of uncertainty and sufficient adaptive/selective forces operating upon economic agents.
- Minksy believed that this loss of resilience in the macroeconomic system is endogenous and inevitable. Although such a loss of resilience can arise endogenously, the evidence suggests that a significant proportion of the blame for the current crisis can be attributed to the stabilising policies favoured during the Great Moderation.
- Buzz Holling’s work on ecosystem resilience has highlighted the peril of stabilising complex adaptive systems and how increased stability reduces system resilience.
Uncertainty and Negatively Skewed Payoffs
In a previous note, I explained how the existence of Knightian uncertainty leads to a perceived preference for severely negatively skewed payoffs. Ronald Heiner explains exactly how this occurs in his seminal paper on decision making under uncertainty.
Heiner argues that in the presence of uncertainty, the “optimal” course of action is one that restricts the choice of actions available and depends on a small set of simple rules and heuristics. In his words,
” Think of an omniscient agent with literally no uncertainty in identifying the most preferred action under any conceivable condition, regardless of the complexity of the environment which he encounters. Intuitively, such an agent would benefit from maximum flexibility to use all potential information or to adjust to all environmental conditions, no matter how rare or subtle those conditions might be. But what if there is uncertainty because agents are unable to decipher all of the complexity of the environment? Will allowing complete flexibility still benefit the agents?
I believe the general answer to this question is negative: that when genuine uncertainty exists, allowing greater flexibility to react to more information or administer a more complex repertoire of actions will not necessarily enhance an agent’s performance. “
In Heiner’s framework, actions chosen must satisfy a “Reliability Condition” which he summarises as: ” do so if the actual reliability in selecting the action exceeds the minimum required reliability necessary to improve performance. ” This required reliability cannot be achieved in the tails of the distribution and economic agents therefore ignore actions that are appropriate only in such situations. This explains our reluctance to insure against rare disasters which Heiner notes:
” Rare events are precisely those which are remote to a person’s normal experience, so that uncertainty in detecting which rare disasters to insure against increases as p(probability of disaster) approaches zero. Such greater uncertainty will reduce the reliability of insurance decisions as disasters become increasingly remote to a person’s normal experience.”
” At some point as p approaches zero, the Reliability Condition will be violated. This implies people will switch from typically buying to typically ignoring insurance conditions, which is just the pattern documented in Kunreuther’s 1978 study.”
Note the similarity between Heiner’s analysis of tail risks under uncertainty and Kahneman and Tversky’s distinction between “possible” and “impossible” events. The reliability problem is also connected to the difficulty of ascertaining the properties of tail events through a statistical analysis of historical data.
In an uncertainty-driven framework, it may be more appropriate to refer to this pattern as a reluctance to insure against tail risks rather than a preference for “blowup risks”. This distinction is also relevant in the moral hazard debate where the actions are often characterised better as a neglect of insurance of tail risks than an explicit taking on of such risks.
“Impossible“ Events and Axel Leijonhufvud’s “Corridor Hypothesis”
Heiner also extends this analysis of the reluctance to insure against “impossible” events to provide the rationale for Axel Leijonhufvud’s “Corridor Hypothesis” of macroeconomic shocks and recessions. In his words:
“Now suppose, analogous to the insurance case, that there are different types of shocks. some more severe than others; where larger shocks are possible but less and less likely to happen. In addition, the reliability of detecting when and how to prepare for large shocks decreases as their determinants and repercussions are more remote to agents’ normal experience.
In a similar manner to that discussed for the insurance case, we can derive that the economy’s structure will evolve so as to prepare for and react quickly to small shocks. However, outside of a certain zone or “corridor” around its long-run growth path, it will only very sluggishly react to sufficiently large, infrequent shocks.”
Minsky’s Financial Instability Hypothesis and Leijonhufvud’s Corridor
Minsky’s Financial Instability Hypothesis (FIH) asserts that stability breeds instability i.e. stability reduces the width of the corridor to the point where even a small shock is enough to push the system outside it. Leijonhufvud acknowledged Minsky’s insight that the width of the corridor was variable and depended upon the recency of past disturbances. In his own words: “Our theory implies a variable width of the corridor. Transactors who have once suffered through a displacement of unanticipated magnitude (on the order of the Great Depression, say) will be encouraged to maintain larger buffers thereafter-until the memory dims…”
The assertion that stability breeds instability is well established in ecology, especially in Buzz Holling’s work as I discussed here. Heiner’s framework explains Minsky’s assertion as the logical consequence of agent adaptation under uncertainty. But the same can also be explained via “natural selection”-like mechanisms as well. The most relevant is the principal-agent relationship. Principals that “select” agents under asymmetric information can effectively mimic the effect of natural selection in ecosystems.
Minsky also argues that sooner or later, a capitalist economy will move outside this corridor due to entirely endogenous reasons. This is a more controversial assertion and can only be evaluated through a careful analysis of the empirical evidence. The assertion that an economy can move outside the corridor due to endogenous factors is difficult to reject. All it takes is a chance prolonged period of stability. However, this does not imply that the economy must move outside the corridor, which requires us to prove that prolonged periods of stability are the norm rather than the exception in a capitalist economy.
Minsky’s Financial Instability Hypothesis and C.S. Holling’s conception of Resilience and Stability
Minsky’s idea that stability breeds instability is an important theme in the field of ecology. Buzz Holling however defined the problem as loss of resilience rather than instability. Resilience and stability are dramatically different concepts and Holling explained the difference in his seminal paper on the topic as follows:
“Resilience determines the persistence of relationships within a system and is a measure of the ability of these systems to absorb changes of state variables, driving variables, and parameters, and still persist. In this definition resilience is the property of the system and persistence or probability of extinction is the result. Stability, on the other hand, is the ability of a system to return to an equilibrium state after a temporary disturbance. The more rapidly it returns, and with the least fluctuation, the more stable it is. In this definition stability is the property of the system and the degree of fluctuation around specific states the result.”
The relevant insight in Holling’s work is that resilience and stability as goals for an ecosystem are frequently at odds with each other. In many ecosystems, “the very fact of low stability seems to produce high resilience“. Conversely, “the goal of producing a maximum sustained yield may result in a more stable system of reduced resilience”. Minsky’s hypothesis is thus better described as “stability breeds loss of resilience”, not “stability breeds instability”.
The Pathology of Macroeconomic Stabilisation
“when the range of natural variation in a system is reduced, the system loses resilience.That is, a system in which natural levels of variation have been reduced through command-and-control activities will be less resilient than an unaltered system when subsequently faced with external perturbations.”
Similarly, the dominant macroeconomic policy paradigm explicitly aims to stabilise the macroeconomy. In particular, monetary policy during the Great Moderation was used as a blunt instrument to put out all but the most minor macroeconomic fire. Stabilising policies of this nature can and do cause the same kind of loss of resilience that Minsky describes. Indeed, as I mentioned in my previous note, agent adaptation to stabilising monetary and fiscal policies can be viewed as a more profound kind of moral hazard. Economic agents may take on severely negatively skewed bets not even as an adaptation to uncertainty but merely as a rational response to stabilising macroeconomic policies.