Posted by: Dirk | March 30, 2008

What Edmund Phelps knows that we know we don’t know about the economy

Edmund Phelps recently published a piece in the WSJ in which he pointed out that maybe we (Economists) thought we knew it all, but in the end we don’t:

In recent times, most economists have pretended that the economy is essentially predictable and understandable. Economic decision- and policy-making in the private and public sectors, the thinking goes, can be reduced to a science. Today we are seeing consequences of this conceit in the financial industries and central banking. “Financial engineering” and “rule-based” monetary policy, by considering uncertain knowledge to be certain knowledge, are taking us in a hazardous direction.

Predictability was not always the economic fashion. In the 1920s, Frank Knight at the University of Chicago viewed the capitalist economy as shot through with “unmeasurable” risks, which he called “uncertainty.” John Maynard Keynes wrote of the consequences of Knightian uncertainty for rational action.

This reminds me of a post by angrybear. The main issue was this graph, depicting the historical price to earnings ratio (PE) of the US stock market:

clipboard01.jpg

Let us just assume that for whatever reason, the p/e ratio will really follow the pattern shown in the graph. I think, the current valuation of the US stock market suggests that this kind of development would come as a surprise to many. And it probably would influence natural unemployment and interest rates for the years to come.

By the way: Frank Knight’s classic Risk, Uncertainty, and Profit is available online at the Library of Economics and Liberty.

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