Against the Gods: The Remarkable Story of Risk (44 page)

In 1921, Keynes completed a book titled A Treatise on Probability.
He had begun work on it shortly after graduating from Cambridge and
had worked on it fitfully for about fifteen years; he even took it with
him on his travels abroad, including a trip on horseback through
Greece with the painter Duncan Grant. He struggled to convey novel
ideas with the clarity he prized. He never quite broke away from his
training in philosophy at Cambridge, where, he later reminisced,
"`What exactly do you mean?' was the phrase most frequently on our
lips. If it appeared under cross-examination that you did not mean exactly anything, you lay under a strong suspicion of meaning nothing
whatever. "20

A Treatise on Probability is a brilliant exploration of the meaning and
applications of probability, much of it a critique of the work of earlier
writers, many of whom have made their appearance in the earlier pages
of this book. Unlike Knight, Keynes does not distinguish categorically
between risk and uncertainty; in less precise fashion, he contrasts what
is definable from what is undefinable when we contemplate the future.
Like Knight, however, Keynes has little patience with decisions based
on the frequency of past occurrences: He felt that Galton's peapod
analogy was applicable to nature but irrelevant to human beings. He
rejects analyses based on events but welcomes predictions based on
propositions. His preferred expression is "degrees of belief-or the a
priori probabilities, as they used to be called."21

Keynes begins the book with an attack on traditional views of probability; many of our old friends are victims, including Gauss, Pascal,
Quetelet, and Laplace. He declares that probability theory has little relevance to real-life situations, especially when applied with the "incautious
methods and exaggerated claims of the school of Laplace."22

An objective probability of some future event does exist-"it is not,
that is to say, subject to human caprice"-but our ignorance denies us
the certainty of knowing what that probability is; we can only fall back
on estimates. "There is little likelihood," Keynes suggests, "of our discovering a method of recognizing particular probabilities, without any
assistance whatever from intuition or direct judgment.... A proposition
is not probable because we think it so."23

Keynes suggests that "we pass from the opinions of theorists to the
experience of practical men." He pokes fun at the seat-of-the-pants
method that most insurance companies use in calculating their premiums. He doubts that two equally intelligent brokers would consistently
arrive at the same result: "It is sufficient if the premium he names
exceeds the probable risk."24 He cites the odds quoted by Lloyd's on
August 23, 1912, on the three-way race for the presidency of the
United States; the odds added up to 110%! The reinsurance rates in the
insurance market on the Waratagh, a ship that disappeared off South
Africa, varied from hour to hour as bits of wreckage were discovered
and as a rumor spread that under similar circumstances a vessel had
stayed afloat, not seriously damaged, for two months before being dis covered. Yet the probability that the Waratagh had sunk remained constant even while the market's evaluation of that probability fluctuated
wildly.

Keynes was scornful of what he refers to as "The Law of Great
Numbers." Simply because similar events have been observed repeatedly in the past is a poor excuse for believing that they will probably
occur in the future. Rather, our confidence in an outcome should be
strengthened only when we can discover "a situation where each new
series differs in some significant fashion from the others."25

He heaps scorn on the arithmetic mean, "a very inadequate axiom." Instead of adding up a series of observations and then dividing
the sum by the total number of observations, "Equal suppositions
would have equal consideration, if the ... estimates had been multiplied together instead of added. "26 Granted, the arithmetic mean is simple to use, but Keynes quotes a French mathematician who had pointed
out that nature is not troubled by difficulties of analysis, nor should
humanity be so troubled.

Keynes rejects the term "events" as used by his predecessors in
probability theory, because it implies that forecasts must depend on the
mathematical frequencies of past occurrences. He preferred the term
"proposition," which reflects degrees of belief about the probability of
future events. Bradley Bateman, an economist who teaches at Grinnell
College, has observed that probability to Keynes is the basis on which
we analyze and evaluate propositions. 27

If Keynes believed that probability reflects degrees of belief about
the future, and that past events are only a modest part of the input, we
might conclude that he regarded probability as a subjective concept.
Not so. Modern though he is in so many ways, he occasionally revealed
his Victorian background. At the time he wrote A Treatise on Probability,
he believed that all rational people would in time come to recognize
the correct probability of a certain outcome and would hold identical
degrees of belief. "When once the facts are given which determine our
knowledge, what is probable or improbable in these circumstances has
been fixed objectively and is independent of our opinion."28

Yielding to criticism of this unrealistic view, Keynes later began to
focus increasingly on how uncertainty influences decisions and, in turn,
the world economy. At one point in the Treatise he declares, "Perception
of probability, weight, and risk are all highly dependent on judgment,"
and "the basis of our degrees of belief is part of our human outfit."29
Charles Lange, a statistician and an old friend, once remarked that he was
pleased that "Maynard does not prefer algebra to earth."

Keynes's view of economics ultimately revolves around uncertaintyuncertainty as to how much a family will save or spend, uncertainty as to
what portion of its accumulated savings a family will spend in the future
(and when it will spend that portion), and, most important, uncertainty as
to how much profit any given outlay on capital goods will produce. The
decisions business firms make on how much to spend (and when to
spend it) on new buildings, new machinery, new technology, and new
forms of production constitute a dynamic force in the economy. The
fact that those decisions are essentially irreversible, however, makes
them extremely risky given the absence of any objective guide to the
probability that they will turn out as planned.

As Frank Knight observed fifteen years before Keynes published The
General Theory, "At the bottom of the uncertainty problem in economics is the forward-looking character of the economic process itself.""
Because the economic environment is constantly changing, all economic data are specific to their own time period. Consequently they
provide only a frail basis for generalizations. Real time matters more
than time in the abstract, and samples drawn from the past have little relevance. What was 75% probable yesterday has an unknown probability
tomorrow. A system that cannot rely on the frequency distribution of
past events is peculiarly vulnerable to surprise and is inherently volatile.

Keynes had no use for a hypothetical economy in which past, present, and future are merged by an impersonal time machine into a single moment. Involuntary unemployment and disappointing profits
occur too frequently for an economy to work as the classical economists had assumed it would. If people decide to save more and spend
less, consumer spending will fall and investment will decline. The inter est rate in any case might fail to fall in response to the higher propensity to save. Keynes argued that interest is a reward for parting with liquidity, not for refraining from consumption. Even if the interest rate
does decline, it may not decline enough to encourage business managers to risk investing further capital in an economic environment in
which animal spirits are lacking and in which shifting to a new set of
decisions is costly. Decisions, once made, create a new environment
with no opportunity to replay the old.

Another reason for a decline in investment spending may be that
business firms have exhausted all opportunities for earning a profit.
Keynes once remarked, "The Middle Ages built cathedrals and sang
dirges.... [T]wo masses for the dead are twice as good as one; but not
so two railways from London to York. 113' That same idea had appeared
in a song popular during the Great Depression, "Brother, Can You
Spare a Dime?" "Once I built a building, now it's done./Once I built
a railroad, made it run."

Keynes and his followers focused on money and contracts to demonstrate that uncertainty rather than mathematical probability is the ruling paradigm in the real world. The desire for liquidity and the urge to
cement future arrangements by legally enforceable agreements testify to
the dominance of uncertainty in our decision-making. We are no longer
willing to accept the guidance that the mathematical frequency of past
events might provide.

Keynes rejected theories that ignored uncertainty. The "signal failure of [the classical doctrine] for the purposes of scientific prediction,"
he observed, "has greatly impaired, in the course of time, the prestige
of its practitioners."32 The classical economists, he charged, had reached
a state where they were looked upon as "Candides, who ... having left
this world for the cultivation of their gardens, teach that all is for the
best in the best of all possible worlds, provided we will let well alone."33

Impatient with Candide-based theories, Keynes proposed a course
of action that was diametrically opposed to laissez-faire: a more active
role for the government, not just in order to substitute government
demand for waning private demand, but to reduce the uncertainties
abroad in the economy. We have discovered over time that Keynes's
cure has on occasion been worse than the disease and that his analysis has
other, less visible, faults. Yet none of that can detract from his primary
contribution to economic theory and the understanding of risk.

At the end of the single-paragraph first chapter of The General
Theory, Keynes wrote: "[T]he characteristics ... assumed by the classical theory happen not to be those of the economic society in which we
actually live, with the result that its teaching is misleading and disastrous
if we attempt to apply it to the facts of experience."34 Given the state
of the world in 1936, Keynes could hardly have concluded otherwise.
Uncertainty must provide the core of the new economic theory.