Risk, uncertainty, hedging Posted on Wed Nov 16, 2016 at 08:55:56 AM EST In https://dontsuemebro.com/story/2016/11/5/92451/7274 I wrote about risk and uncertainty: risk follows the law of total probability but uncertainty includes infinite possibilities such that you can't have probabilities that add up to one. Risk defines all possible states but uncertainty admits new states that cannot yet, or haven't yet, been defined. An example of Knightian uncertainty is language: you can't predict what new words will become part of the vocabulary. Try to define probabilities for irc nicks for example. Try to predict all the possible nicks and their probabilities. You might define a state space by taking the Cartesian product of all permissible letters and the allowable nick length but new meanings for letter combinations that are currently not in any dictionary will screw up your predictions. In unrestricted natural language, you have no constraints on alphabet (Prince's symbol name, for example, or emojis) or length; thus there is an infinite state space for natural language. Therefore natural language is an example of Knightian uncertainty. Reddy in the Advanced Microeconomics for the Critical Mind MOOC talks of G. L. S. Shackle ( https://en.wikipedia.org/wiki/G._L._S._Shackle ). Shackle challenged mainstream economic assumptions about savings = investment and that investment was the result of rational calculation. From the wikipedia article: Neoclassical economics relies on the idea that agents will act rationally; but this rationality is effectively synonymous with saying that agents know the future. Shackle pointed out that in order for agents to act "rationally"--in the sense that neoclassical economists understood that word--they would have to logically know what actions all other agents were going to undertake. This, Shackle, claimed was effectively the same as assuming that they knew the future. Shackle maintained that the way that neoclassical economics had smuggled in this strong assumption was in its use of simultaneous equations. --- The wiki article also quotes Keynes on uncertainty: By "uncertain" knowledge ... I do not mean merely to distinguish what is known for certain from what is only probable. The game of roulette is not subject, in this sense, to uncertainty ... The sense in which I am using the term is that in which the prospect of a European war is uncertain, or the price of copper and the rate of interest twenty years hence, or the obsolescence of a new invention ... About these matters there is no scientific basis on which to form any calculable probability whatever. We simply do not know! --?John Maynard Keynes, The General Theory of Employment, Interest and Money --- I think hedging can mitigate uncertainty; one can hedge against all possible outcomes. The Financial Engineering and Risk Management MOOC ( https://www.coursera.org/learn/financial-engineering-1 ) outlined how to use linear algebra to hedge everything. Thus the price of copper 20 years hence can be hedged by including all possibilities for copper prices in a vector. Or simply represent future copper prices as +, -, or =. Then use linear optimization techniques to solve Ax=b. b would be the desirable outcomes. There would be a state space of b vectors representing different combinations of future prices. You then figure out what trades to make, how much insurance to take out, etc. so that you get to a desirable b vector outcome. In 2008, the big banks failed to take out enough insurance but this was a choice, not a necessary failing of risk models. Also, even when Goldman Sachs took out enough insurance to hedge against falling house prices, AIG couldn't pay them; the Fed stepped in to create money to pay off Goldman Sachs. Shackle highlighted the importance of choice: "Deliberative conduct, choice, the prime economic act, depend for their possibility, when they go beyond pure instinctive animal response to stimulus, upon the conceptual power of the human mind." --- Thus mainstream economics justifies private money creation and public money creation only when it serves the private sector. We must challenge the constraints that mainstream economics places on public money creation. Mainstream economics can only justify predictions based on money creation by an appeal to wildly unrealistic mathematical models that assume choice will be constrained. But the banks' decision not to fully insure was not rational. Once we debunk the mainstream economics view that public money creation is bad, we can fund a basic income with created money.