Knightian Uncertainity – Roots of the Crisis

April 17, 2009

Prof Phelps writes in the FT

Swings in venture activity created a fluctuating economic environment. Frank Knight, observing US capitalism in his 1921 book, said that a company, in all of its decisions aside from the handful of routine ones, faces what is now called “Knightian uncertainty”. In an innovative economy there are not enough precedents to be able to estimate the probability of this or that outcome. John Maynard Keynes in 1936 insisted on the “precariousness” of much of the “knowledge” used to value an investment – thus the “flimsiness” of investors’ beliefs. (Yet now he is seen as “Smith plus psychological swings”.)

…..

But why did big shareholders not move to stop over-leveraging before it reached dangerous levels? Why did legislators not demand regulatory intervention? The answer, I believe, is that they had no sense of the existing Knightian uncertainty. So they had no sense of the possibility of a huge break in housing prices and no sense of the fundamental inapplicability of the risk management models used in the banks. “Risk” came to mean volatility over some recent past. The volatility of the price as it vibrates around some path was considered but not the uncertainty of the path itself: the risk that it would shift down. The banks’ chief executives, too, had little grasp of uncertainty. Some had the instinct to buy insurance but did not see the uncertainty of the insurer’s solvency.

NNT calls this the difference between Mediocristan and Extremistan. Extremistan is where the Gaussian models breakdown. This is the world of Knightian unceratinty.

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Alchemy of Finance

March 18, 2009

Steve Waldman riffing off on a statement by Arnold Kling that the key job of the financial system is to intermediate, to transform long term risky capital into short term liquid capital. As he rightly points out, there is no magical way to do this except through a misdirection of people and an implicit government guarantee of all capital.

This goes to the heart of the current financial crisis, that an intermediary could take on all sorts of risks funded via capital which they classified to their investors as risk-free.

Steve Waldman goes on to list a number of suggestions of what can be done in the future such as dis-intemediate, through equity arrangements rather than debt. But even equity arrangements need intermediaries and as long as people are not aware of the risks that they are undertaking or the intermediary obfuscates the risk.

A big reason for this is the bank depositors, house buyers, investors, insurance buyers have been innured to the fact that they are carrying any risk. Most people don’t expect to sell their cars or electonics at a higher price than what they bought it for. These are not seen as store of value, but rather consumption goods.

What a majority of people want it a store of value which will protect them against rising cost of consumption in future. The government should issue Inflation adjusted bonds and go on a campaign that this is the only reliable store of value. In every bank branch there should be signage just like there is on cigarette packets that there money is at risk with photographs of people made destitute by foolish investments. Everytime someone buys any asset which they buy simply because they think it will go up in value, governments should proactively start a Public service campaign which talks about how asset prices tend to fall after they have gone up. They do it for cigarettes, AIDS, STDs, flu epidemics, so why not for financial epidemics. It’s not bullet proof but atleast a counter-balance to the irational exuberance of people.