Ebook Fundamental Uncertainty, Portfolio Choice, and Liquidity Preference Theory
According to Keynes (1936) uncertainty plays a crucial role for holding liquidity, especially money. Uncertainty is understood not as risk which could be presented as a singleton probability measure on the set of events, but as fundamental uncertainty about the underlying structures, economic relationships, the inferences that could be drawn from past experience, etc. Such fundamental uncertainty arises due to the uniqueness of an event, the novelty of an economic activity or technology as well as to the lack of knowledge about the underlying economic causal relationships or the fact that knowledge is inconclusive for probabilistic inferences. Some investment decisions are unique in the sense that they are not repetitive and have no long record of experience regarding the distribution of returns. Most investment decisions incorporate a specific “new” element so that accumulated knowledge is of limited use to form expectations about future outcomes. The agent has simply no objective basis to determine reasonable probability measures. In a similar fashion also Knight (1921) called for fundamental uncertainty in the sense that the agent doubts his own probability measures since they are based on vague and subjective knowledge. It is widely discussed that this fundamental uncertainty as opposed to risk and also to ambiguity requires a new route in the theory of decision making (for example Dequech (2000a), Dequech (2000b), de Carvalho (1988), Fontana and Gerrard (2004), Rosser (2001), Wray (2006)).
Some economists claim that fundamental uncertainty is an omnipresent and unavoidable phenomenon since the economic process evolves in historical time, the unknown underlying economic structures may change over time and produce therefore a non-ergodic trajectory of data (Davidson (1987), de Carvalho (1988)). This would exclude any Bayesian rationality. It should be noted, however, that nonergodicity is not proven to be an overall empirically relevant phenomenon and that it should not be invoked as a “nihilistic” argument against any form of expectation formation (Rosser (2001)). Also Keynes’ main point was to think about how a rational agent behaves in presence of uncertainty, not to disprove any rationality. But the point is not (only) the question of non-ergodicity. It is typical that among economic agents as well as among economists there exist different and partially conflicting views about reality, and the existing empirical data does not clearly rule out most of them and does not give a clear evidence for only one point of view. Thus, beliefs are dispersed which reflects fundamental uncertainty, and it is a matter of rationality that agents will respond to this fact in some way.
While Knight emphasizes the lack of self-confidence in own probability measures, which is more close to the problem of ambiguity, Keynes points out the uncertainty about inferences in case of inconcludent or missing knowledge (see Hoogduin (1987) for a detailed discussion). Or in other words: it is the uncertainty regarding the weight of empirical evidence for probability judgements versus the uncertainty regarding the weight of an argument or conclusion. The Keynesian view is a broader perspective which also includes self-consciousness about the own expectations. The latter could also be related to econometric estimation risk where the “true model” is known but its parameters are estimated from data in an unbiased way. As we will discuss later, this would open ways to deal with estimation risk in a proper econometric way. Keynesian fundamental uncertainty with absence of a ficticious “true” model is more difficult to deal with.
In Keynes’ view holding liquidity is a kind of hedging instrument against fundamental uncertainty. The interest rate indicates the marginal willingness to waive for this kind of hedging. In the presence of fundamental uncertainty the existence of money (as well as the possibility to create money via credit) and the liquidity preference have an important impact e.g. on investment behavior which results in non-neutrality of money (Runde (1994), Davidson (1988)).
Understanding fundamental uncertainty and holding liquidity as a response to it is therefore an important and broadly discussed issue from a micro- as well as from a macro-perspective which deserves a closer look from a bounded rationality perspective. We will first briefly review different ways how fundamental uncertainty is incorporated into decision theory and put forward an argument why a boundedly rational approach is more appropriate to explain behavior (chapter 2). In chapter 3 we provide a simple model how an agent allocates his financial ressources to risky asets and riskless liquidity.
It is shown how this portfolio choice is affected by fundamental uncertainty and the degree of self-confidence or self-consciousness. The rationale for adopting heuristic modifications of the portfolio approach is that it provides a higher ex post performance than naive rational decision making. In chapter 4 we analyse the case that the portfolio is partially financed by debt. We show how (the response to) fundamental uncertainty affects the debt size and the probability of debt failures. Chapter 5 concludes.
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