The markets

by S. Kambayash

LORD SKIDELSKY’s excellent new book, “Keynes: The Return of the Master”, makes one striking claim about the economist’s work. “The centrepiece of Keynes’s theory”, he writes, “is the existence of inescapable uncertainty about the future.”

Uncertainty is different from risk, as Frank Knight, an economist, first pointed out in 1921. A poker player can figure out the odds of success when holding a pair of kings. But when dealing with macroeconomic events or forecasting stockmarket movements, you do not know the potential distribution of outcomes. There are an awful lot of jokers in the pack.

Most people face a future that comprises a combination of Donald Rumsfeld’s known and unknown unknowns. Choosing to buy a house, for example, involves a series of bets on land prices, interest rates, taxes, job prospects, future planning decisions in the area selected and the structural soundness of the property concerned. It is impossible for any buyer to be confident about so many variables. Any decision must be a guess.

Buyers usually accept this constraint and make the best guess they can. But when uncertainty increases substantially, the temptation is to freeze—to do nothing until the situation becomes clearer. Consumers delay their spending plans; companies halt their capital expenditure. In Keynes’s words, “animal spirits” are depressed. That was one reason he believed there was a case for government intervention: to act as the spender of last resort.

But uncertainty also has another impact. The stockmarket is used both as a barometer of investors’ risk aversion and as a lead indicator of economic health. When investors are uncertain (risk-averse), they have a preference for holding cash and the price of shares falls. That in turn feeds back to the economy through a further downward effect on confidence.
Over the past 25 years, the authorities have had a tried-and-trusted method for bringing a halt to this vicious circle: cutting interest rates. The bigger the crisis, the faster and farther they have to cut. That is why British interest rates are lower than they have been in the 300-year-plus history of the Bank of England. Traditionally, 2% was seen as the floor for short-term rates.