Macroeconomics à la Friedman-Savage
16 Nov, 2025 at 16:48 | Posted in Economics | Leave a comment
Is it not patently unrealistic to suppose that individuals … base their decision on the size of the expected utility?
While entirely natural and understandable, this objection is not strictly relevant … The hypothesis asserts rather that, in making a particular class of decisions, individuals behave as if they calculated and compared expected utility and as if they knew the odds. The validity of this assertion … depend solely on whether it yields sufficiently accurate predictions about the class of decisions with which the hypothesis deals.
‘Modern’ macroeconomics — Dynamic Stochastic General Equilibrium, the New Synthesis, New Classical and New ‘Keynesian’ — still follows the Friedman–Savage “as if” logic. It denies the existence of genuine uncertainty and treats variables as if they were drawn from a known ‘data-generating process’ with a known probability distribution that unfolds over time. This assumption implies that we have access to long and reliable historical time series. But if we do not assume that we know the data-generating process — if we do not possess the ‘true’ model — the whole edifice collapses. And of course it must. Who honestly believes that we have access to this mythical Holy Grail, the data-generating process?
‘Modern’ macroeconomics clearly did not anticipate the enormity of the problems that unregulated, supposedly ‘efficient’ financial markets created. Why? Because it is built on the myth that we know the data-generating process, and that we can describe the variables of our evolving economies as if they were drawn from an urn containing stochastic probability functions with known means and variances.
This is rather like saying that when you go on holiday, you know that the chance of sunny weather is at least 30%, and that this is enough information for you to decide whether or not to bring sunglasses. You are expected to compute the expected utility based on that probability and make a simple either–or decision. Uncertainty is reduced to risk.
But, as Keynes convincingly argued in his monumental Treatise on Probability (1921), this is not always possible. Often we simply do not know. According to one model, the chance of sunny weather might be somewhere around 10%, while according to another — equally plausible — model it might be somewhere around 40%. We cannot assign exact numbers to these assessments. We cannot calculate means and variances. There are no given probability distributions to which we can appeal.
In the end, this is what it all comes down to. We all know that many activities, relationships, processes, and events are of the Keynesian uncertainty type. The data do not unequivocally single out one decision as the only ‘rational’ one. Neither economists nor individuals can fully pre-specify how people will behave when facing uncertainties and ambiguities that are ontological features of the way the world works.
Some macroeconomists, however, still want to be able to use their hammer. So — like Friedman and Savage — they choose to pretend that the world looks like a nail, and that uncertainty can be reduced to risk. They construct their mathematical models on that assumption. The result: financial crises and economic havoc.
How much better — how much less likely we would be to lull ourselves into the comforting illusion that we know everything, that everything is measurable, and that everything is under control — if instead we simply admitted that we are not ‘cognitive angels’. Often we do not know, and we must live with that uncertainty as best we can
Fooling people into believing that we can cope with an unknown economic future in the same way we play a roulette wheel is a sure recipe for only one thing: economic catastrophe.
[Note: Leonard Savage broke with Friedman and the Chicago school in the 1960s as his thinking shifted away from the ‘as if’ methodology and the assumption that all uncertainty can be represented by subjective probabilities. He emphasised that his expected utility theory applies only to ‘small worlds’, where all consequences and probabilities are known, and recognised that most real decisions involve genuine uncertainty. Savage also grew uneasy with Friedman’s ideology and instrumentalist approach. This led to an intellectual and philosophical distancing from the Chicago tradition.]
