How can we deal with uncertainty?

When we think of our future, no matter how well we plan, we know it could turn out differently to how we imagined it. But we don’t know how different it could be. This introduces a whole different level of insecurity, one that not only makes us feel fairly uncomfortable, but is also more difficult to grasp and conceptualize mathematically.

While someone might say, "We can’t know what we don’t know, so why should we even try to understand this ambiguity," the economist Lars Peter Hansen, has not shied away from this question. He acknowledged the pervasiveness of uncertainty in all aspects of our lives, particularly with regard to economic activity, and has pushed this incredibly complex and challenging matter to the forefront of economic modeling.

Lars Peter Hansen

Awarded: The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel (shared), 2013

At a glance

Born: 1952, Urbana, Illinois, USA

Field: Econometrics, financial economics

Prize-winning work: Empirical analysis of asset prices

Way to relax his brain activity: Turn music up loudly for 20 minutes

Teaching style spiced-up by: Deadpan humor

Alternative career: Wanted to be a rock star

A new type of economic research

Uncertainty is just one of many areas of economics in which Hansen’s contribution made significant waves. It allowed him to talk to all kind of economists, from financial, to labor, to econometricians, to macroeconomists. And not only talk to but also listen to: a trait that many of his colleagues find admirable. Hansen has a very unique way of looking at economic problems, which resulted in his invention of a particular way of econometric modeling called Generalized Method of Moments (GMM). GMM helped economic research take a huge step forward by allowing economists to investigate a single aspect of a complex model without having to specify every part. Although the example that Hansen worked on dealt with particular features of asset-price data in financial markets, the method has been used across economic disciplines ever since. It also won him the Nobel Prize in 2013.

Uncertainty: ignore it or face it?

The French philosopher Voltaire once said: “Doubt is unpleasant, but certainty is absurd.” This quote is dear to Hansen, and he often uses it to illustrate the general public’s attitude towards uncertainty. The economist elaborates:

That doubt is unpleasant is the way many people think about uncertainty, it’s like: ‘wow, this is something I just want to avoid.’ But it’s out there and to pretend it’s not there is even worse.

Hansen believes we need to convince people that there are sensible ways to think about decision making in the presence of all different types of uncertainty, and that maybe they shouldn’t give up when it’s too complicated.

Why you can never be certain in your financial decisions

Not knowing where the change to our prediction might come from, in mathematical terms, means that we can’t properly assign the probability of an event (or events) happening. The problem is aggravated in different scenarios, for example if one tries to plan for the future, develop a policy, or talk about investment decisions in financial markets. But Hansen has a knack for capturing the vagueness of uncertainty with the rigor of mathematics. This rigorous way of thinking, with the purpose and intensity that the Economics Department of the University of Chicago is famous for, contributes to his rather successful way of modeling the uncertainty.

His former graduate student Jaroslav Borovicka says: "When you mention words like ambiguity, uncertainty, they sound like words that are very imprecisely defined. The nature of the research and how Lars thinks about it means you need to define terms precisely." He continues:

You face the problem of turning the loose notions of imprecision and ambiguity into mathematics, so that we can study these problems rigorously: to write models that can actually tell us something about the real world.

Modeling in a way the public can relate to

On an unusually warm October day in Chicago, hearing Hansen reflect on his work makes us want to understand how he sees the possibility for stronger connections between models and policy. "Economists are good at coming up with different models of the future," relates the laureate in his quiet but determined matter. "We don’t know which is correct or we suspect they’re all not quite correct, but we don’t know exactly how they’re wrong. So that’s the type of uncertainty that we really have to be thinking about." This poses a conundrum for economists, says Hansen. "We have to take this term - uncertainty - that means so many different things and to try to look at the consequences or implications of formalizing it in different ways. Why does that matter for the economy? How does it matter for the design of economic policy? Because unless I make something a little more formal then I’m not going to be able to analyze it. I take it as a challenge."

Taking up the challenge to model uncertainty in the most realistic way possible puts Hansen at the forefront of research in this area. But it’s his unique way of understanding how to model doubt within an already doubtful model that gives his work appeal beyond the academic world. His former graduate student and co-author Evan Anderson sheds light on the complexity of having uncertainty both outside and inside of an economic model, saying: "Lars really wants economics to be useful. He is an accomplished econometrician who knows that economic models don’t always explain the data the way we hope. He believes that individuals in the economy should take into account economic models when making decisions, but also realize that they are not perfect. Not only does Lars think that people should do that in the economy, he wants to build that into his models, so that his models of the economy have people inside the economy who doubt these models."

A road to less uncertainty through more education

How do we proceed with this awareness that doubt exists in both the future and the models? Hansen’s view is in line with being an educator and coming from a family of educators and people who valued acquiring knowledge above all. "Policy makers will naturally gravitate towards advisors who speak to them with great confidence. But that great confidence isn’t warranted, it doesn’t always result in the most prudent policy making. I can sit and blame policy makers. But a lot of it has to do with also educating public thinking about uncertainty, about how to confront it or approach it in sensible ways."

So that’s exactly what he does. Despite an intense schedule, the Nobel Laureate takes every opportunity to speak publicly. But most admirably, he goes to middle schools and talks to 4th and 5th graders about uncertainty. He explains complex ideas in a rather playful way, by drawing balls of various colors from vases and making guesses about the color of the ball that’s about to be drawn. The kids learn in a fun and non-intimidating way about the nature of probability and that there’s more uncertainty in the beginning than in the end of this game.

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Broad skills to face the challenges of a changing world

Education about doubt and preparing for an unknown future is also a way to cope with uncertainty. It’s the advice that Hansen gives to the young people as we wrap our conversation up. "When you’re going to school, you acquire a broad range of skills; you become interested in mathematics, you become interested in sciences, you become interested in literature. It gives you the flexibility to do a variety of things in the future. Because even in the first part of college, I didn’t really know what I wanted to do. But the mere fact that I had acquired multiple skills of different types gave me the flexibility to pursue different things," the economist confesses.

The nature of jobs changes over time, but the broader skill set you have, the more it puts you in a position to be able to respond to such an environment and to thrive in it.

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