Thursday, July 31, 2008

Uncertainty in Life and Economics

Long term plans we make are all based on estimates and wild guesses and the assumption of ceteris paribus (i.e. holding other things constant). But things barely remain the same. There are so many unknowns and we adjust to them as we go along with life. The curve balls of life may throw us out of track, make us question our faith if we are religious, and lose faith in our own selves. But the bottom line is most people know (at least in the East) that there are a lot of unpredictable events in life and we need to accept them and move on. There is such wonderful economics in this. The underlying assumption is that of non-omniscience and adapting based on events.
Laura Rosslyn from Battlestar Galactica says it beautifully “We try to give simple explanations for complex events because it gives us a sense that we are in control when in reality we are not”. It sounds philosophical, but there is profound economics in that statement. Economic models try to simplify everything in an attempt to arrive at some sense of control over complex networks of events while reality is far removed and gives us very little control over events. For every controllable event, there are dozens that cannot be controlled, and several others that are not even observed. So believing that models are accurate predictors is a big fallacy. At best they could be modest indicators about the direction of any economic activity.
This reminds me of the ideas in Matrix Reloaded and Revolutions. Nothing is stand alone. Each person is connected to the other through a complex web and everything is a consequence of choices we make, and what is obvious to most of us is the immediate choice and nothing beyond that. Likewise even in economics what is obvious is only what is immediately observable and observed. There are several variables that are not even observed. So for example, with the US data, surveys collect data on mean commuting time in different cities. The data needs to be adjusted based on cities. Commuting time in Lincoln NE will be completely different from that of New York City. Trying to make a comparison between such raw data would be meaningless.
Going back to unpredictable events, once we accept that things may not always go according to plan, economic decisions would have alternative plans and arrangements or even bail-out arrangements. Once uncertainty is included in economic models things become much easier to plan for. It is surprising that people do not see the connection between planning for their own lives and that of the economy. People make contingency plans for school admission, personal financial planning and such. Why do they not think in terms of unpredictability of economic events and complexity of economic models. I think Laura Rosslyn hit the nail on the head with her statement (above) that making things simple gives people a sense of control which does not exist if they believe in the complexity of economic variables and models. However, the truth is that, how much ever we model we do not dictate the course of the economy, and even if we did have temporary measures there would be consequences for every action. Newton’s third law always bears out. At best we can build a storm shelter, but the storm does rage on outside with or without our knowledge.

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