Power Of Narratives And Gold

Let's face it, we live in a world of radical uncertainty. There are not only many known unknowns in the world, but the same can't be said of unknown unknowns. We simply do not known what we don't know. In other words, the problem is not risk. The notion of risk implies that we can compute the probability. This is what the mainstream economists assume: we know the odds, so there is a single optimizing solution to each problem. But the real issue is that we do not know the probabilities, because we even do not know how the world works. You see, the probability applies in a casino but not in the real world. You are certainly aware of substantial difference between roulette or weather forecasting, and the scope of new inventions or the prospect of war, elections or the asset prices. As Keynes wrote (at least once we agree with him), "About these matters, there is no scientific basis on which to form any calculable probability whatever. We simply do not know."

So how do we cope with the unknown? Mervyn King, former governor of the Bank of England, provides an answer in his interesting book The End of Alchemy. According to him, a coping strategy comprises three elements - a categorization of problems, a set of rules of thumb, or heuristics, to cope with the latter class of problems; and a narrative. The latter is key - so we focus on it.

What is a narrative? King defines it as "a story that integrates the most important pieces of information in order to provide a basis for choosing the heuristic and the motive for a decision." When we cannot write down a mathematical model with known probabilities, we can nevertheless follow some narratives.

Some examples? Sure, King provides two of them. The first is the barely known financial crisis of 1914, when the narrative that war was inconceivable was replaced by the narrative that it was here. Second, more contemporary and better known, is the economic crisis of 2008 when the narrative that trends in the household spending and in the housing market were sustainable, was replaced by the narrative that they were not. As a consequence, the housing bubble burst and the Great Recession broke out. Yes, changes in narratives can be painful. People who went through a divorce, know something about it.

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