Keynes, uncertainty and interest rates

Abstract

Uncertainty plays an important role in The General Theory, particularly in the theory of interest rates. Keynes did not provide a theory of uncertainty, but he did make some enlightening remarks about the direction he thought such a theory should take. I argue that some modern innovations in the theory of probability allow us to build a theory which captures these Keynesian insights. If this is the right theory, however, uncertainty cannot carry its weight in Keynes’s arguments. This does not mean that the conclusions of these arguments are necessarily mistaken; in their best formulation they may succeed with merely an appeal to risk. “Employment was a problem because investment was; and investment was problematic because of the uncertainty of its return.” (Shapiro, 1997, 83) Keynes clearly saw an important role for uncertainty in his General Theory. However, few contemporaries agreed with him, and subsequent ‘Keynesians’ generally obliterated the distinction between risk and uncertainty. In part this was caused by Keynes’s informal presentation of his views on uncertainty in The General Theory. This paper has two aims. The first is to sketch a formal theory of uncertainty which captures Keynes’s insights about the risk/uncertainty distinction. I argue that the theory of imprecise probabilities developed in recent years best captures Keynes’s intuitions about uncertainty. In particular this theory provides a formal distinction between risk and uncertainty, and allows for an analysis of Keynes’s ‘weight’ of arguments. However, the second aim is to show that if this is right then Keynes was wrong to draw the economic consequences of uncertainty that he did. In broad terms, I argue that uncertainty is economically impotent. It only has effects in conjunction with some other feature of models or the world, such as missing markets or agent irrationality. But these features plus the existence of risk are sufficient to get the conclusions Keynes wants. These conclusions of Keynes might be right, but if so they can be justified without reference to Keynesian uncertainty. At the end of the day, uncertainty is not as economically interesting as it appears.