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