Dealing with the Unthinkable in Theory

Many individual decisions and economic policies take place in conditions of deep uncertainty, often without a clear knowledge of future scenarios and their possible consequences. However, the history of recent shocks, such as the 2008 financial crisis, the Covid-19 pandemic or the energy crisis, has taught us fundamental lessons on how economies and institutions can adapt to unexpected events.

Let's think of the extreme uncertainty over governing the current and future effects of artificial intelligence, climate change or geopolitical shifts. The words of former US Secretary of State Donald Rumsfeld summed up this awareness pithily:

“Reports that say that something hasn't happened are always interesting to me, because as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns — the ones we don't know we don't know.” 

How can society prepare for the latter scenarios?

Extreme ignorance can lead to immobility (not knowing what to do, I do nothing) or ignoring the very possibility of major unpredictable events. Both attitudes appear naive.

The first step is instead to recognize our ignorance, broadening the range of models used by economists. Some branches of existing economic research seriously address these issues, providing useful tools to address unexpected shifts in expectations, which are quite relevant in macroeconomics, economic policy and applied economics.

A first indication is the importance of creating easy-to-achieve ‘default options,’ which have known and predictable consequences. These provide a sort of generic insurance against extreme events. The 2008 financial crisis showed how the lack of emergency liquidity structures exacerbated the recession, while the Covid-19 pandemic highlighted the importance of resilient healthcare systems and digital infrastructures. A practical example is the e-government structure created by Estonia that effectively guarantees the functioning of the government apparatus from abroad or virtually, usable for example in the event of an invasion or cyberattack. Alternative payment systems — such as the Russian MIR and SPFS systems, or the BRICS project — are examples of ‘financial emergency exits’ that can be implemented in extreme crisis situations.

Second, flexible and resilient institutions allow to better manage unexpected events, limiting possible negative consequences while exploiting potential opportunities.

Concrete examples are the creation of precautionary stocks in critical infrastructure and, once again, the example of the digital platform for e-schooling in Estonia, which allowed a rapid adaptability of the education system during the Covid pandemic. Also the decentralization of political and economic power as in the cases of federalism with economic diversification present, such as the cases, for example, of Canada and Switzerland, reduce vulnerability to extreme shocks.

Flexibility and resilience can, in turn, be enhanced by promoting a plurality of perspectives and approaches, which improves education and enhances critical thinking.

So are economic models of little use? No, to the contrary. In macroeconomics it is well known that models are highly stylized versions of reality. Although some economists aim to exploit the expansion of computational capabilities to enrich them and integrate more and more relevant variables in them, their usefulness is not only quantitative. In their abstract form, economic models allow us to formalize analogies between situations so different that they cannot be considered similar in a statistical sense. In this way, they become essential qualitative tools to describe future scenarios and foster productive debate, achieving two crucial objectives: to make explicit the assumptions underlying the analysis and provide a common technical language, at least for the economic experts who assist policymakers.

In conclusion, a society aware of its inevitable ignorance about the future can choose to invest more massively in the ability to adapt, reorganize and thrive in the face of the unexpected. At the same time, the role of economic models in this domain could be oriented towards a more narrative description of future scenarios, in order to provide more qualitative policy recommendations.