Uncertainty, Emotions, and Economics

Dr. Michael K. Green

State University of New York

Oneonta, New York 13820 USA

Summary

1. The Human Situation: Living In an Uncertain World

2. Institutions and Emotions

Human Evolution

• Humanity's very biological and social traits arose from these attempts to manage an uncertain and unpredictable environment.– The apes arose 18-12 million years ago during a time

of great environmental change and fluctuation. – Our lineage, Homo, arose from 6.4 to 4.6 million

years ago during the Messinian crisis when the need for dealing with even greater uncertainty required the development of more flexibility.

– The foundations of modern humanity was laid approximately 130,000 years ago, and from 128,000 to 72,000 years ago, there were ten climatic reversals.

Frank Knight,Risk, Uncertainty, and Profit

It is a world of change in which we live, and a world of uncertainty. We live only knowing something about the future; while the problems of life, or of conduct at least, arise from the fact that we know so little. This is true of business as of other spheres of activity. The essence of the situation is action according to opinion, of greater or less foundation and value, neither entire ignorance nor complete and perfect information, but partial knowledge. If we are to understand the workings of the economic system we must examine the meaning and significance of uncertainty. (Knight, 1967, 199)

Emotions and Uncertainty Management

• Emotions arose most fully when mammals entered the evolutionary scene about 150 million years ago.

• The earliest mammals prowled the dark and damp night, which was filled with varied and often vicious temperatures.

• Emotions helped to navigate these uncertainties• Plutchik identifies five sets of basic emotional

polarities

Traditional Economic Theory

• economic agents are rational– unbiased processors of information– practical omniscience, i.e., perfect knowledge

Knight and Decisions Under Uncertainty

• Knight holds that “the ordinary decisions of life are made on the basis of 'estimates' of a crude and superficial character.”

• The decision is based on “judgment or intuition not reason.”

• We must act “upon opinion.”

Damasio and Brain Mapping

• Individuals with damage to certain parts of the brain so that they are incapable of emotional attitudes toward their actions become incapable of making decisions because they can assign no values to the outcomes of the various possibilities.

Economists and the Affective Dimension of Action

• Pareto’s two fundamental sentiments– Innovation– Consolidation

Knight

• In addition, there must come into play the diversity among men in degree of confidence in their judgment and powers and in disposition to act on their opinions, to “venture.” This fact is responsible for the most fundamental change of all in the form of organization, the system under which the confident and venturesome “assume the risk” or “insure” the doubtful and timid by guaranteeing to the latter a specified income in return for an assignment of the actual results. (Knight, 1967, 269-270)

Keynes

• Economic fluctuations can be partly explained by endogenous or spontaneous shifts in moods back and forth from pessimism to optimism.

Keynes

Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits - a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities. (161-162)

Keynes

human decisions affecting the future, whether personal or political or economic, cannot depend on strict mathematical expectation, since the basis for making such calculations does not exist ... it is our innate urge to activity that makes the wheel go around (162)

Bandura’s Self-Efficacy Theory

An agent’s sense of his self-efficacy, i.e., his judgment of his capability “to organize and execute courses of action required to attain designated types of performances” (391), plays a central role in his propensity to commence and to persevere in undertakings.

Institutions and Emotions

The uncertainties of the mammalian mode of existence, also favored intensive parenting so as to shelter the young from the cold and from predators – Mirror neurons– Imitation comparisons of children and chimps

Institutions and Emotions

• Institutions are repositories of trust

• Trust is based upon reliability and predictability that creates confidence.

• Trust is destroyed by inconsistencies that undermine confidence and create fear.

Institutions and Imitation

• Sherif’s autokinetic experiments

• Milgram's experiments on obedience

• Veblen’s emulative desire– emulation is probably the strongest and most

alert and persistent of the economic motives proper

• Girard’s theory of mimetic desire

Emotions and Institutions

• Life is a balancing act between preservation and expansion, fear and confidence, with different tendencies predominating at different times.

• The emotional core of these relationships is intensified and maintained by rituals that express the emotions in actions

• The emotional core is also maintained by rationalizations that provide reasons or justifications for the emotional commitments underlying the relationships.

Nonlinear Dynamics and Imitation

• There is a mutual reinforcement; we have some ideas of our own in the premises, and these agree with the views of some authority. We often if not in general believe what we do because the authority believes it, but to some extent we believe in the authority because he holds the view to which we were already inclined. In large measure we even believe in ourselves because and in the measure that we think others believe in us, though, on the other hand, again, . . . But it is enough to indicate the complexity of the relations between our own and others' opinions without attempting to set all these relations out in logical statements. The importance of indirect knowledge of fact through knowledge of others' knowledge is the point we wish to emphasize. Correspondingly, the uncertainty of the knowledge on the basis of which we act is in large measure the margin of error in our estimates of the authorities whom we elect to follow. The uncertainties of business are predominantly of this character, and the genus calls for particularly careful study. (Knight, 1967, 288)

Fundamental Sentiments

• Signs of pessimism in the early 1980s– The University of Michigan’s consumer sentiment

index was at a 13-year low.– Only 16 percent of Americans owned stock directly or

indirectly, and stocks as a percentage of household assets were at a low of approximately 12 percent.

– The price/earnings ratio was less than 9, and dividends were over 6 percent.

– Pension funds invested only 24 percent of the new money that they received into stocks.

– Cash and cash equivalents as a percentage of the market value of stocks and bonds were over 60 percent.

Signs of Optimism

• The University of Michigan’s consumer sentiment index was at an extreme.

• Over 50 percent of households participated one way or another in the equity markets, and stocks as a percentage of household assets was near 44 percent.

• The price/earning ratio increased to over 40, and dividends fell to 1.5 percent.

• Stock mutual funds held only 4 percent cash.

Signs of Optimism

• Cash and cash equivalents as a percentage of the market value of stocks and bonds hit an all-time low

• Over a 25-year period, investors increased by over 80 times the amount of money they borrowed to purchase stocks

• From the early 1980s, the savings rate began a large decline

• Americans increased their debt levels.

2005 Record High

2005-2006

2006 Record High

Record Sentiments-Instabilities

• Extreme in sentiment– the Daily Sentiment Index, which is a daily

survey of future traders, hit 95 percent bullish, the highest one-day reading since July 1999.

– On a 10-day basis, the DSI is 91.2 percent bullish, which is the highest 10-day figure in the 19-year history of the data.

– Having nine straight readings of better than 90 percent bulls is an almost unheard of extreme in any market.

CONSENSUS based on a broad mix of brokerage analysts and independent

market advisory services.

Investor’s Intelligence based on a survey of 130 investment newsletters

with a range of investment approaches.

Market Vane's Bullish Consensus based on a weighted formula applied to

an assortment of market newsletters

Minsky and Confidence in Institutions

• Excessive confidence produces unsustainable conditions in the real economy

• The unraveling of them will give rise to extreme fear and risk aversion

• The longer the excessive confidence lasts, the greater the imbalances and instabilities