Streetwise Professor

October 29, 2008

Risk, Uncertainty–and Profit?

Filed under: Economics — The Professor @ 7:34 pm

One of the most insightful, but underutilized, observations in economics is Frank Knight’s distinction between risk and uncertainty. In Knight’s terms, “risk” relates to something that is unpredictable, but where the unpredictability that can be quantified, like mortality. It is possible to identify the states of the world, and determine the relevant probability distribution with some precision. “Uncertainty,” in contrast, refers to the unpredictable that is not quantifiable. One cannot identify even the possible states of the world, let alone quantify their probabilities.

The insight is largely ignored in modern economics because the dominant formal methodologies cannot readily handle the unquantifiable–so they ignore it. By definition, Knightian uncertainty is unquantifiable, so it is incompatible with the methodology that virtually all economists use. The closest formalism comes is probably the literature on robustness, but even that is a stretch.

In observing the financial crisis unfold, Knight’s distinction has often come to mind. Financial economists are used to dealing with risk, and have developed elegant tools to model and measure it. But “uncertainty” in the Knightian sense seems to be a much better description of financial markets at the present. Even the most sophisticated market observers and participants are at a loss to describe what could happen, let alone assign any realistic probability to those inchoate possibilities. We are out of the realm of experience, and dealing with a tightly connected system that no one understands completely. It is hard to imagine a more (Knightian) uncertain situation than that.

And most economists–yours truly included–are ill equipped to handle it.

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