Knightian Financial Markets
| Peter Klein |
Frank Knight knew in 1921 what the world’s most sophisticated mathematical models could not capture today. That is, there is a fine line between risk with mathematical probabilities and uncertainty that cannot be measured. Although investors have no difficulty in pricing all sorts of risks, the “immeasurable” uncertainty and information asymmetries make them shy away from all forms of risk, especially in times of global anxiety. In our view, this is exactly what has happened in the past couple of weeks in financial markets, as credit risks linked to the US subprime-mortgage market spread out (through highly leveraged derivatives and structured instruments) and triggered a volatility wave across the world.
That’s Morgan Stanley’s Serhan Cevik and Katerina Kalcheva, writing in yesterday’s Global Economic Forum. Kudos to Cevik and Kalcheva for reminding investors (or, more likely, economists) that some risks cannot be measured and priced. But keep in mind that Knight treated uncertainty as ubiquitous, not some parameter that rises and falls with market conditions. “Profit arises out of the inherent, absolute unpredictability of things, out of the sheer brute fact that the results of human activity cannot be anticipated and then only in so far as even a probability calculation in regard to them is impossible and meaningless,” as he famously put it. (BTW you can get the full text of Risk, Uncertainty, and Profit online, courtesy of EconLib.)