Acknowledge what you don't know, says Nobel economist

Complexity of economic problems sometimes calls for simple solutions, argues Nobel laureate

PUBLISHED : Friday, 11 July, 2014, 11:18am
UPDATED : Friday, 11 July, 2014, 11:57pm

Policymakers and business leaders need to embrace the unknown if they want to make better decisions, and not be afraid of publicly saying, "I don't know", Nobel economics laureate Lars Peter Hansen said.

"For some reason we can't have public discussions where people say, 'Well, here is my best guess, and here is the range I am uncertain about'," said Hansen, a University of Chicago professor.

Public thinking isn’t mature enough to handle the uncertainty component

"Somehow our public thinking isn't mature enough to handle the uncertainty component."

The public is easily swayed by the economists and policymakers who project the greatest confidence, he said. He complained that some economists prematurely rush to promote their ideas through the media.

Hansen wants to see theories and models subjected to greater academic scrutiny before being adopted by decision makers.

In recent years, models have come under increased review as supposedly once-in-a-century events, be they financial, meteorological or seismic, happened with irregular regularity.

During the global financial crisis, the international ratings agencies were criticised for rating US mortgage-backed securities investment grade. The subsequent collapse in the value of the securities surprised many analysts, but on reflection it was realised the rating assumptions for the recently invented securities were in part based on limited or non-existent historical data, Hansen said.

Part of the problem, he said, is "our probability models are off in the tail, so to speak. The things that don't happen very frequently … are hard to learn about from historical evidence.

"You don't know whether this is the one unique event or this is going to be repeated [for a] decade or two decades".

Hansen said: "It's a challenge to quantify the magnitude of uncertainty out there in our models." Models are approximations, and with so many, analysts do not know which to refer to.

People need help in "coping with the notion that your view of the world is not quite right".

Hansen was in Hong Kong this week on a four-city China speaking tour. He won the 2013 Nobel Prize in Economic Sciences alongside Robert Schiller and Eugene Fama for their work analysing asset prices.

Regulatory policy is one area of concern for Hansen. In the aftermath of the financial crisis, he became worried when policymakers rushed to draft tome-sized bills, like the Dodd-Frank Wall Street Reform and Consumer Protection Act in the US, without understanding all the inputs.

"If you take a complicated problem but operate from a limited knowledge base, then you may well want to adopt simple solutions," Hansen said.

"[Decision makers] argue: 'This is a complicated problem; therefore we have got to spin out a complicated solution.' This is not necessarily true, once you acknowledge your understanding is incomplete."

Hansen worries concepts such as "systemic risk", a term he dislikes, and "systemically important institutions", which appear in the Dodd-Frank law and in the Basel Committee on Global Supervision rules that cover bank regulation, will lead to implicit state guarantees on large-cap financial companies that could engender further moral hazard and bad behaviour while weakening market discipline.

"We have to figure out a way to let these financial institutions have even the prospect of failing without scaring the whole financial system," he said.

"We are thinking about making capital requirements on banks counter-cyclical. How much do we know about the impact of that counter-cyclicality? Our knowledge about the business cycle and the credit cycle are certainly not very sharp right now," Hansen said, referring to plans to get banks to set aside additional core capital as a guard against future economic shocks.

Instead, policymakers should simplify things for now, until the knowledge base of economists has evolved.

Hansen remains optimistic about the human capacity to understand the ever-expanding universe of financial instruments and a global economy that is increasingly interconnected.

His recent work focuses on quantifying the unknowns in financial models. If people better appreciate what they don't know, it can lead to better policy, he explained.