Uncertainty Economics for an Uncertain Time with Roman Frydman

Roman Frydman, Professor of Economics at NYU and Chair of the Knightian Uncertainty Economics Program at INET, talks to Rob about how behavioral economists model uncertainty and his critique of the rational expectations hypothesis. Frydman also discusses the work and legacy of the late University of Chicago economist Frank Knight, whose students included Milton Friedman and James Buchanan.
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Rob Johnson:

I’m here today with Roman Frydman, Professor of Economics at New York University, one of the founders and co-editors of Project Syndicate, that very valuable news organization that spreads high-level economics throughout the world and particularly penetrates into the developing world.

Roman is also the head of the Knightian Uncertainty Initiative at INET, the Institute for New Economic Thinking, and works with INET in many respects. He’s a member of our Academic Council, which evaluates research and worked earlier with Central European University at the time of the transition after the fall of the Berlin Wall and the collapse of the Soviet Union to help Eastern Europe develop an economic curriculum through CEU. Welcome, Roman.

Roman Frydman:

Thank you very much. It’s good to be here. I am delighted to be talking with you, Rob, and you know how much INET means to me and how I view INET as being extremely important.

Rob Johnson:

Well, you have been there. You’ve been a co-architect from the very beginning and yet what brings me to the table today with you is that yesterday, on April 7th, you and Ned Phelps, your colleague and Nobel laureate from 2006, you created an op-ed that was in The Wall Street Journal about the pandemic and the response, what we might call the bailout or stimulus legislation that followed in reaction to the spread of the COVID-19 challenge.

Your perspective on that, your and Ned’s perspective, was not particularly laudatory. What do you see was in that package and what do you think could have been done better?

Roman Frydman:

Let me start with a brief summary. The usual thinking about the stimulus is that it’s insufficient. That’s now agreed on by both the Congressional Democrats, Republicans, along with President Trump. But what is not clearly understood is that the government’s approach is ill-suited to the crisis. The stimulus isn’t merely the wrong dose, but the wrong medicine altogether. And let me explain this simple summary in specific terms.

Their thinking last week, and hopefully that’s changing, I would hope, is that we need to create employment because many people have become unemployed because of the crisis. Yes, people have become unemployed because of the crisis, but the policy response to the crisis can actually exacerbate it, the unemployment problem. And to make it even worse, it has exacerbated the possibility of the economy returning to something like semblance of normalcy after, thankfully, COVID-19 is contained. So, I need to be very specific about the thinking.

Instead of boosting public employment or seeking to stimulate demand, we should mobilize both the private and the public sector on all levels, including the federal level, to combat the public health crisis. Of course, no one would dispute the fact that we need infrastructure, that the infrastructure of the nation is decrepit. We do need highways and we do need airports, but this is not the time to be sending people to build highways. This is the time to fight the public health crisis. The position is that in order to contain the economic consequences of the crisis, we need to address the public health crisis. That’s the long and short of it, and that’s what the focus should be on.

Rob Johnson:

In the context of this bailout legislation, there’s a great deal of money. I believe it’s over $2 trillion that’s been specified. Is it targeting that challenge that you cite or is it used for other purposes?

Roman Frydman:

That’s simple. Out of $2 trillion, about $150 billion was allocated to healthcare. That’s 7 percent, and if we need to laser focus on healthcare in order to contain the economic fallout, that answers your question. Seven percent of the $2 trillion is allocated to healthcare.

Then there’s also another objective that needs to be met, which is insufficiently part of the legislation. How do we protect the vulnerable people, the workers, the oldest people that don’t have health insurance in the United States when they lose their jobs, when they are laid off by the firms? As you, of course, recall, one of the major sticking points of the legislation was the fight between the Republicans and the Democrats about the level of unemployment insurance, and thank God the Democrats navigated this in such a way that the level of unemployment insurance is much higher than what the Republican lawmakers originally wanted.

But what was ignored in the process is that the rest of the design of the package was such that it basically made layoffs more rather than less likely and didn’t tie the components of the package to stemming layoffs and then for avoiding unemployment insurance in the first place.

So, let me give a few examples, which is what you asked from the $2 trillion legislation. So, $360 billion was devoted to the small business support under what we call strong conditionality. These are guaranteed loans by the government that are conditional on the business retaining people on their payroll. If the business retains people on their payroll, the loans get converted to outright grants. One could quibble here with the idea that some small businesses don’t need this support because, depending on which industry they’re in, that it’s not means tested, but that could be maybe difficult to do. Just a little aside, the Germans have instituted such support only if your revenue has gone down.

But leaving that aside, the general thrust of the small business program is right. You want to protect the labor from both potentially the insurance and the employment point of view so when the crisis is over, these businesses could restart.

What is missing in even the small business legislation is the conditionality on whether the businesses repurpose their activity to the war against the pandemic. We should always keep in mind what the focus should be. The problem with the legislation is it lacks focus. It doesn’t understand, it doesn’t clearly embody the idea that the problem we face is healthcare. Once we understand that, everything else follows from that.

For example, a small business that produces plastic containers should be encouraged by the legislation to produce visors or other plastic equipment for medical services, and they should be given money to do that. The Danish government does it, there are examples in Denmark, there are examples in Germany. Not here. This is a big problem and it’s a problem that has very a deep ideological component, which we will come back to later, I assume. Let me just focus now on that.

The really incredible problem is the support for the corporate sector. We happen to be speaking today, the day after President Trump fired the inspector general, who’s supposed to oversee a $500 billion what was correctly called a slush fund for corporate sector, which then was supposed to be supervised by the committee and now is completely in limbo.

But let’s leave that aside and look inside that $500 billion in loan guarantees for large firms. In contrast to the small business support, they ask the large firms not to retain workers. They basically become loan guarantees for managers to maintain their positions. And yes, it’s true that the stock buybacks, dividends and bonuses were disallowed after, by the way, a huge fight, but the fact remains that the businesses have been allowed to lay off people at extraordinary rates and could still access the loan guarantees.

The effects are dramatic. So, let me just cite a few effects of this.

Rob Johnson:


Roman Frydman:

The Federal Reserve Bank of St. Louis estimates that layoffs may push unemployment as high as 32 percent, compared to 3.5 percent before the lockdowns. To put that figure in perspective, the peak unemployment rate during the Great Depression was 24.9 percent. Ten million people have sought unemployment benefits in the past couple of weeks.

Let’s now pause for a second and think about what that means. That’s not just unemployment. That’s health insurance, that’s belonging to the productive system. Many people derive satisfaction from working with other people. All of this is lost. All of it. And what just makes it worse is that the Wall Street Journal today has an article about how we’re going to go back to work, which makes a number of very valuable points about the healthcare issue, but doesn’t deal with the economic issue. It’s very difficult to reconstitute firms after you have dismantled them.

And to add insult to injury about the current plans, the current plans that as of a few days ago called for infrastructure investment, will basically take people and put them on building highways. That’s not only not feasible because of the lockdown, that would completely dismantle the industrial structure. So, where did this come from? It came from the generals fighting the last war. What is that war? I think we’ll come back and talk about the 2008 war. There’s a lot to be said on this. But this particular war is the Great Depression war. But what is the difference? The difference is that in the Great Depression there was, in fact, a collapse in demand. There was a financial crisis and there were all these things that led to the bankruptcies. So, people actually had no employment.

Here, the government policy is dismantling the industrial structure that otherwise can be kept, sort of maintained, until we can come back. It’s not only inhuman, it puts people out of work, it puts a $760 billion tag on taxpayers, $500 billion for the corporate sector plus $260 for unemployment, and on the top of it, it’s very difficult to understand if one thinks about that we are supposed to come back from this to something like any level of normalcy.

That is a snapshot of what I think is going on with this legislation. And to end, let me just come back to the health. It’s unfocused. $150 billion when hundreds of thousands of people may die and the medical personnel is exposed daily in a dramatic way, and the President pronounces every day how wonderful everything is, it’s something that is a complete collapse of governance in a country that had prided itself on democratic institutions and on governance. It is not really that easy to understand this and maybe you’ll have some thoughts about that, Rob, later. It really is difficult to understand this.

Rob Johnson:

Well, you had mentioned in the allocation of money, that something in the neighborhood of $150 billion goes to the health sector where the core of the problem, where the shock does not emanate from a financial sector failure like in the ’20s or in 2008. But rather, from this disruption of commerce necessary to extinguish the coronavirus.

Yet, what’s the scale on the numbers of corporate assistance for large companies and private equity? I think it was in my reading of your article and others. It was in the neighborhood of $500 billion?

Roman Frydman:

Yeah, 500 is the exact number, yeah.

Rob Johnson:

More than three times the size of what’s directed at the health system. One can look at this in a variety of ways, and I think your diagnosis of the program and what it’s intended to do is a very good one. But the question becomes, is this the failure of imagination or is this part of an organic political economy, not dissimilar to the political economy that in 2008 and 2009 found it only feasible to bail out the people who had made the mess. As Joe Stiglitz famously said, we paid the polluters rather than, in that case, mortgage reduction and other things. And people who understood what was, and the key word I underscore, what was feasible to do, had to recognize the tremendous power of the financial sector in, how would I say, unlocking or supporting legislation that did minimal harm to them and put a burden on society.

We spawned things like the Tea Party and the Occupy movement on both left and right and control of the House turned from Democrat to Republican, then the Senate turned from Democrat to Republican, then finally Donald Trump was elected. The cynicism related to government institutions. I remember Joe Stiglitz said to me one time, he thought that 2008 had gotten us over that romance that unfettered free markets were the way to organize society and we could now get back to proper boundaries and regulation and so forth. And in fact, after the bailout, the cynicism that people felt in regard to financial regulation wasn’t just confined to financial regulation. It became a cynicism and a loss of faith and trust in all aspects of governance at precisely the time we needed that.

So the question I’m asking you, Roman, is I don’t think it was a failure of imagination and if you disagree you should tell me. I think it is about a systematic commodification of social design and that economics mis-specifies the relation between markets and politics. Economics demonizes the inefficiency of government, but they don’t acknowledge that the money that is made from the manipulation and capture and rent-seeking in government is done by the private sector, and they become the designers of their own system to the detriment of the public good, in some instances.

I am, as you know, very familiar with the Dodd-Frank legislation and the savings and loan bailout, having worked with the Senate Banking Committee and worked on that very much on the inside. Are we about to learn another chapter in rancid political economy that the American people’s resentment and skepticism will be heightened once again?

Roman Frydman:

This is really the key question. Actually, that’s what I have been wondering since I started thinking about this. So, let me start with a little fact. First, let’s just focus on the $500 billion to the corporate sector, the unrestricted loan guarantees, which was basically gathered from the playbook of 2008. The only thing that was corrected was there were the bonuses, the really egregious things that, when in 2008, so egregious that it actually allowed them, both Bernie Sanders and Donald Trump, to claim that this was basically kind of a giveaway against the common people, so to speak. The kind of standard populist line.

I think that the political economy is something that needs to be thought about very carefully. So, let’s now take the $500 billion and try to look at facts as the legislation was being unfolded. I am not privy to the congressional debates, but from the press accounts, it does appear the $500 billion, came from the playbook of 2008 and the way the package was designed has a strong political economy element. So, let me try to put a finger on what I think that element is and perhaps I’m sure you’ll have a lot more to say on this and I’m not sure you agree. But I think you might. Why don’t we put conditionality on the corporate sector? Why don’t we require the corporate sector to retain workers and retain their health insurance that the government pays for? And why is that possible abroad and not possible here?

The reason is ideological. The state, as much as it wasn’t going to intervene in financial markets, because the state obviously knew less, is now not supposed to know anything about how to intervene in a corporate sector. And this has kind of a strange element, because not only is it political economy, it’s absurd. In this particular case, the argument that the state doesn’t know what to do has nothing to do with industrial policy and champions and picking champions and picking industries. We know what to do. We need to produce for the war effort against the pandemic and therefore, the state has to come in, something that I left out from the previous one because I thought it belongs to the political economy. The state needs to tell the firms, “You are getting the loan guarantees if you maintain labor and their insurance, and if you pledge, and these are technical details how this can be done, to repurpose your production to the effort to the extent possible.”

That’s completely outside of the ideological spectrum in the United States, while in other countries, I just got a message yesterday from a high-ranking official in Germany, they’re already doing it because they don’t have this. They understand what they’re fighting. They’re fighting the war on the health front, and we need all the help we can get to do that. The public health and the private health. And it’s the political economy that’s preventing us from asking large American businesses to do that.

I’ll give you another example. Governor Cuomo every day at the press conference begs for the equipment to be sent from states in which the virus has not yet spread to states that need it, like New York. The government of Oregon had volunteered to do that, but in the package there’s tens of billions of dollars for airline relief. This must be political economy that we cannot ask the airlines to transport medical equipment from Wyoming to New York and then back if we don’t need it anymore here. This must be political economy.

Let me give you another example. The French government is transporting not just equipment but actually sick patients from Paris to Brittany using the trains. This is possible to do, it’s feasible to do, and the obstacle must be ideological and the political economy of the country as you, I think, really rightly identified. I believe that that must be the case, and all I wanted to do is illustrate your point. This requires much further study and much more thinking.

Now, there’s of course an issue about how economists think politics is something like a special field. When you do a macro model, there’s no politics in it because it’s considered to be soft. When you do psychology, that means people are irrational. I’m not sure to what extent you want us to go into that, but otherwise, this particular issue is not just political, but it’s rooted in the very methodology of economics.

Rob Johnson:

Where I’m concerned it’s not just at high levels of research. I mean, there are people like Ben Page and our research director Tom Ferguson, and others who cover the role of political economy, money and politics, how it affects elections, how it affects policy. But our textbooks, the thing that influences both our understanding of markets, it influences, how would I say, the kind of people that will be influencers, public policy officials, lawyers, business leaders. Our textbooks appear to have a rather violent blind spot with regard to the tensions.

There is a kind of parable that is taught that capitalism gets its legitimacy from being embedded within and governed by a democracy. But when the appointments of people, the laws, the regulations and enforcement become things that are bought and sold by private interests, what I call the commodification of social design, it loses that legitimacy. And furthermore, it loses what an engineer would call the kind of qualities of a feedback system, that when problems occur, there’s a feedback from the problem to a well-designed reaction for the betterment of society.

It sounded to me as I listened to you as though your perspective on this bill is it wasn’t addressing the problem, but it was shoveling out an awful lot of money in an election year. And I guess the other side of this that I would add is there’s almost now what you might call a moral hazard. Top level corporations see this bail out and they think, “Well, we can all use our money to do stock buybacks, increase the debt-to-equity ratio of our balance sheets, have no margin of safety, no cushion, and then when something occurs, we can use our power in Washington. Lobbying, PR, manipulation, campaign contributions, and we can use the public treasury to support ourselves so we can enrich the C-suite with stock buybacks and then we can, when things get fragile, blow the whistle and get Washington to deliver the money to them.”

And what it creates is a lobby for austerity to keep the contingent fiscal capacity of the United States large and at the ready for those purposes rather than dealing with the social design that would take care of the needs of the broader public. And as the cynicism deepens, as the despair deepens, as the diseases of despair, as Angus Deaton and Anne Case have illuminated and many others like Shannon Monnat, the question at some level is, will we have a democracy at all? Will we have a democracy in name that, instead of being ruled by the wisdom of crowds, the despair will fuel a madness of crowds? Will we fall into an authoritarian place and essentially not abide by all the principles upon which the United States was founded?

I think that risk is very large right now and the demoralization of people if this pandemic continues and deaths continue to expand, and all kinds of people who were powerful that didn’t need it got financial support. I think it will take us a long time to recover trust and integrity in governance in the United States.

Roman Frydman:

I agree with you, but let me add something to this that is specific to this pandemic, and it has also long-term consequences. One of the casualties of the standard approach to economics is the very notion that if you want to have entrepreneurship, people have to be left alone and some very important people have pronounced that the welfare states, for example, interfere with entrepreneurship and growth, and that’s often used as an argument that we should not. That this is the cost we pay, so to speak.

So, let’s look at this from the point of view of this pandemic, another proposition. This pandemic offers actually a very interesting, to me, perspective on this question. So, when you have Knightian Uncertainty, when you have radical uncertainty and you do not know where the future lies and that’s certainly where we are and that’s where we are every time we innovate. It becomes extremely important to know what the worst case scenario is for people who innovate, and whether they’re going to fall off the cliff, maybe lose their insurance if they go off and do something useful for the society or even just innovate in the market, or whether they will not.

Many have complained that this entrepreneurship is losing its edge in the United States, and now in the pandemic we see what the issue is. The polar opposite to the United States may be Denmark. In Denmark, the enthusiasm for innovating for the pandemic has been enormous because the lower end of the society is all but assured. You do not fall off the cliff there. We lose all of it here. We lose the societal enthusiasm, we lose the collective spirit, we do not mobilize society for the effort that we need them. We only mobilize them when you hear the White House briefings to participate in the President’s 15 points of avoiding social contact. That’s valuable, let’s not knock this and it’s not, of course, the President’s idea.

But we lose all these other aspects where people will… Americans are as entrepreneurial and as creative as the Danes are, and yet our leaders are failing in mobilizing us for that effort in the design of the very policies that, I agree with you, that given our political economy, is preventing us from implementing. And the cost to this, in terms of the societal despair, as you say, the collective spirit, the trust in society and institutions is really potentially staggering. It’s difficult to fathom, but it could be enormous. To the point that the Financial Times last Friday, the Financial Times, not The Nation magazine, had called for a new social compact, lest capitalism will disintegrate in the wake of this crisis. So, think that’s our key issue, really.

Rob Johnson:

And to go back to your notion on innovation, it’s very important that innovation be channeled to what you might call real social problems. Innovation, which facilitates monopoly-centralized control, may be as evil as it is good or more. And what bothers me in our political economy, where you see the kind of what Bill Janeway calls the three part, I can’t remember what he called that, three piece model, which is basic science, entrepreneurial transformation in financial markets for the realization of the value of the firm.

Basic science, rather than being conducted for science, starts to be used to subsidize projects that venture capitalists or entrepreneurs who are very deep pocketed can lobby to create. And the public does not own an equity share, say, in pharmaceutical research. Many pharmaceutical products that are developed are what you might call expropriated by private entities. They’ll even come in and pay the government scientists million dollars to leave once they detect that something is good. I know a lot of people in private equity and hedge funds in the kind of biology and drug-related areas that camp out in Bethesda, Maryland, trying to detect things.

But even worse than that is when a company has a profitable product. They will spend money on litigation and lobbying to stop the development and the approval of something that will compete with their market share. So, when we get into the what you might call unpacking of innovation, we have to get to a place where the process of directing our public resources toward innovation, to complement, to support the developments in the private sector. It has to be channeled in a constructive direction and not just left to the whims of the market.

I’m very concerned about the political economy of being able to stifle innovation with the use of money and lawsuits to deter people or to frustrate them from getting patent rights. The big, deep pocket technology firms can play very aggressive games in deterring innovation at this point and some people, like the Kaufmann Foundation, are producing studies showing that that appears to be a symptom of our time.

Roman Frydman:

This is a very important point, once we combat this nightmare, and I think it needs to be really examined and researched a lot more than it has been. I know Kaufmann is doing some very good work, but I think that a lot more has to be done. Instead of having some simple, mechanical models of innovation and growth, we really need some real study of the innovation process, and Bill Janeway’s book is really great and it’s paving a way, but we need a lot more.

Rob Johnson:

Well, let’s turn. I mentioned at the outset the Knightian Uncertainty Initiative is something you captained within INET. I myself have worked both in the financial sector, as you know, as a partner in the Soros Fund Management years ago, and also in the regulation of finance. And the person who inspired me to become an economist, at the time he was writing a book called Manias, Panics, and Crashes, was Charles Kindleberger.

I always had a very hard time as a practitioner, an intellectual, or looking at economic history in believing in this notion of efficient markets. And most importantly, having studied the writings of Warren Buffet and George Soros and others, none of them ever claim that they can see the future. The notion of radical uncertainty or ontological uncertainty, as Keynes and Knight emphasize and is at the center of your work, is essentially anesthetized in modern discussion about finance where we act as though the best and the brightest and the oracles and the all-seeing are delivering us from evil through financial deregulation.

And the notion that the future is knowable, that there’s a terminal equilibrium that we’re all fastened to and heading toward, is a mirage that justifies the lobbying in Washington. The political economy of financial deregulation, and of the financial sector, as I call it, commodifying the social design with their massive campaign contributions and producing a very unstable and heavily subsidized financial system.

You’re trying, in your group work, not to just throw up your arms and say, “Okay, it’s uncertain, it’s not knowable.” You’re actually trying to look for ways to be systematic and understand that process. But it’s a very different mindset than what financial economics has been teaching for 40 years.

Roman Frydman:

Thanks for broaching this area. Of course, that’s something that I am extremely interested in and let me try to be brief. This is a big topic and let me just talk about the essential elements.

The essential element, of course, goes back to Frank Knight, the distinction between risk and uncertainty. So, what is that distinction? That distinction is often not clearly understood, so that’s why I’m coming back to this. So, risk is basically the probabilistic risk that everyone understands that. So, the idea is that all the future contingencies can be characterized, and chances attached to them can be assigned in some approximate way, and risk is therefore characterized, I’d say, by the variance of the resulting distribution, by the variability.

Knightian uncertainty is usually understood to be the situation where either the future contingencies or probabilities are unknown. That much is agreed on. But what offers the key to creating a framework to understand it is another fundamental insight of Knight, namely that this uncertainty arises from change that cannot be foreseen in probabilistic terms. So COVID-19, of course, is an extreme example of that change. We simply could not have foreseen that in that way, although we could have done a lot better in January when it began to appear. But that’s a different issue. And although the army had foreseen the possibility of this based on past patterns, the exact timing and the magnitude we couldn’t foresee.

What is the indication of the fact that this comes from what we call unforeseeable change and what Knight called unforeseeable change? That basically requires rethinking the foundations of economics, and that ties in with what you were talking about, what you were emphasizing, politics and psychology. So, let me explain that point and try to be as concise, as clear as I’m able, given the confines of the podcast.

The standard economic model, say, in macroeconomics used by central banks, and taught in the textbooks that you had correctly criticized, of course, is the model in which there is no unforeseeable change. If the change is allowed for, it is modeled with the probability process. So, given that we’re at time t, I can describe all future changes that will occur in future periods and attach some probabilities. I can describe the magnitudes, characterize the magnitudes, and attach some probabilities to that.

That excludes, according to our research that is published, about 20 percent of reasons why, say, the stock market, going back to financial markets, has moved over the last 20 years. So, it’s not just the big changes like the COVID-19 or the war in the Middle East. It’s also small changes. Change on the company floor, replacement of management, new legislation. All these things are part of unforeseeable change in a very precise sense, that we do not know the magnitude. We may be able to foresee certain things that will happen in qualitative terms, but we certainly do not know the magnitudes and probabilities of those changes. That’s the important thing. We do not know that. And if once we don’t know that, many things follow from this. So, let me just list them, the ones that, to me, are particularly relevant to our conversation today.

Once you cannot foresee all the changes probabilistically, the economist is unable to forecast precisely what the future holds. And therefore, the economist cannot know, also, how market participants and members of the society forecast the implication of those changes. Once that’s the case, there is no a priori notion of rationality to justify policies. The model, as Popper would put it in his famous phrase, Popper said that the real social science, the one that, of course, taught Soros, who was the first one who actually exposed me to these ideas and I’ll always be grateful to him for that, is that quite apart from the fact that we do not know the future, the future is objectively not fixed. The future is open, objectively open. Once the future is open, there is no fixed notion of rationality that economists can invoke to justify policies. The model is then opened to politics, to psychology, and all these other historical influences and that opening is natural, is part of the theory.

Let me now go back to basic economics. Have economists recognized politics? Have they recognized psychology? Yes, they have. But for theoretical economists, this recognition means that the world is irrational. People who rely on those influences do not rely on fundamentals. They’re irrational. But there’s, of course, this well-known case understood that psychology is part of rationality.

Once these things become irrational in a public mind, they become illegitimate. And what economists propose is the rational response to crises, a rational response to fluctuations, a rational response to regulation. And the most important implication of this view is that once you know what rationality is, if the market is composed of rational people according to what economists define as rationality, it becomes a matter of mathematics, not social science, to prove that the markets are efficient, unless information is imperfect, as Joe Stiglitz emphasized, but of course, only because information is imperfect. If information were perfect, markets would be perfect, and therefore that is the standard for behavioral economics.

Even for people who deviate from the basic efficient market paradigm, the standard is still the efficient market paradigm. And the problem with it is that once you allow for unforeseeable change, that standard disappears. There is no fully known standard. The economy’s evolving, the economy’s changing, and then the question becomes, how do we formally model this in a way that we can take it to the data? And that is not easy, and I wish more people were thinking about it, but that’s what we are basically really trying to do under this INET program, for which we’re obviously grateful to INET for having the foresight. It’s a funny thing to say. It’s almost pun not intended, for us to pursue the economics in which the perfect foresight is being denied at the outset.

Rob Johnson:

Well, it never occurred to me that this wouldn’t be a priority. Like I mentioned, from Manias, Panics, and Crashesfrom Charles Kindleberger to working in the office where a man produced a book called The Alchemy of Finance, meaning George Soros, and as you’ve underscored, his acknowledgement of radical uncertainty.

But I think the thing that concerned me as I was listening to you is how, as well-intended as things like behavioral economics and other things are, are they not what I’ll call Thomas Kuhn, who studied paradigms, used to say that the first thing that happens when a paradigm breaks down is people try to create patches. They patch the paradigm rather than recognizing that it has failed. Do we need to go further away in the direction that you’re going when the paradigm of equilibrium finance has, how do you say, been in such contradiction to the boom and busts and failures and bubbles that we’ve seen in recent years? Or do those disciplines come pretty close to reconciling the difference between the evidence and the pristine view of finance?

Roman Frydman:

Thank you for this question. I’d like to give an answer on a number of levels. The first level is simply empirical. There hasn’t yet been a coherent way of thinking using behavioral economics about the long swings. Behavioral economics arose from Bob Shiller’s groundbreaking idea that market prices are not mechanically linked to fundamentals.

There were two options there. One was to say that that mechanical link should be broken, that would be my answer to your question, what we need to do. So, the paradigm needs to be amended, at least, if not one is to move radically beyond the paradigm by breaking the mechanical view of markets. Another one was that there will be another mechanical view that will substitute for that mechanical view that will mechanically now model psychological influences. That is called behavioral economics.

There’s another possibility, that one keeps the standard view. One doesn’t bring psychology and one allows for a mechanical way in which imperfect information influences outcome. That’s the imperfect information paradigm. So, you are completely correct in your assessment that these are just patches. As you know, I come from Poland, so let me give you a little example and maybe something of a hopeful sign.

How I left Poland is a very complicated story, but the important part of that story is the fact that the attempt to mechanically plan the economy simply was collapsing. The government attempted a variety of patches. Like, the Hungarian government introduced the regulation of markets but kept central control of the elements of the economy that involved radical uncertainty, like innovation. That failed. These economies failed. They went into a negative growth and that was the beginning of the end of the Communist system that happened 20 years later.

The unfortunate difference between economic theory in those countries is that a failure of these economies was demonstrable to population because the economies were unable to deliver the basic needs. The tragedy of economics is the economies now communicate in a language that is so complicated that the normal intelligent people cannot understand it. So, what passes for science is what you often told me you characterize, and of course that comes also from Hayek, scientism. People think this is science because it looks so concrete. How could this be something that is not about the world? And then when you say it’s not about the world, people say, “Yes, of course. It’s abstraction. It is not supposed to be about the world.”

But as Milton Friedman, you see, I on purpose cite people that you would not think would be critical of that. But as Milton Friedman said, abstraction is one thing but omitting things that are essential to understanding the world is another. And my answer to your question is that we’ve come a long way in developing approaches. Many of the elements, as you know, I build on, so I’m not saying all of this needs to be discarded. Not at all. But that have managed to omit something that is essential, and the essential is our inability to foresee the future in exact terms and our recognition that the future is open to both political and psychological influences and historical influences.

And if we don’t have a theory that does that, we cannot understand where markets are useful, but they’re not perfect. We cannot understand what role the government should play and that role we don’t have to accept as perfect, but there’s a very clear role. And we also do not understand something that’s very much, I know, close to your heart. How do we move our economies, so they serve the needs of the people? And all of these things crucially depend on us abandoning the paradigm that gives the economists the supposed ability to define what rational behavior is and that excludes any of these elements that I was just talking about.

Rob Johnson:

Well, Roman, knowing that you’re from Poland, I’m energized to hear your last comment because I always remember, what was his name, Alfred, how do you say his name, Korzybski. He used to say, “The map is not the territory and the word is not the thing.” And this conversation today I think has been very, very illuminating on many of the challenges that sit at the core of INET’s agenda and at the core of our society. And people can make maps or abstractions on whatever they want, but the question is, should we take them to the bookstore and file them under fiction or under non-fiction?

And the use of quantitative tools does not make something necessarily scientific. The ritual of scientism is very, very delicate and can sometimes be a form of dogmatism, a form of demagoguery, pretending that the tools take you to a more elevated place. The tools are tools and they can be quite useful, statistics and mathematical illumination of what’s the essence and important. But they can also be used to obfuscate and protect.

But as I watch you and your work, young man Morten Tabor, Anders Rahbek and others, I think you’re using those tools in a very purposeful way and you’re helping us shed light on many of the dilemmas that we’re working on.

Thanks for being with us today, Roman. To be continued.

Roman Frydman:

Thank you so much for your kind words. I really appreciate it, really.

Rob Johnson:

They’re well-deserved.

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About the Host

ROB JOHNSON serves as President of the Institute for New Economic Thinking.

Johnson is an international investor and consultant to investment funds on issues of portfolio strategy. He recently served on the United Nations Commission of Experts on International Monetary Reform under the Chairmanship of Joseph Stiglitz.


About the Guest

ROMAN FRYDMAN is Professor of Economics at New York University, Chair of the INET Program on Knightian Uncertainty Economics, and Founding Editor of Project Syndicate. Frydman’s lifelong research has focused on the implications of Knightian uncertainty for macroeconomics, finance theory, and policymaking. His early work examined the widespread belief that the Rational Expectations Hypothesis (REH) – which since the 1970s has become the core premise of behavioral and imperfect-information approaches as well – provides the appropriate standard for modeling forecasting behavior.