Knightian Uncertainty & The TARP

I highly recommend reading Frank Knight’s Book Risk, Uncertainty, and Profit however if you don’t happen to have the time, here is a short article on the Knight’s ideas and their relevance to the current TARP program.

Background On Knightian Uncertainty (Via Wikipedia)

In economics, Knightian uncertainty is risk that is immeasurable, not possible to calculate.Knightian uncertainty is named after University of Chicago economist Frank Knight (1885-1972), who distinguished risk and uncertainty in his seminal work Risk, Uncertainty, and Profit:

“Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which it has never been properly separated…. The essential fact is that ‘risk’ means in some cases a quantity susceptible of measurement, while at other times it is something distinctly not of this character; and there are far-reaching and crucial differences in the bearings of the phenomena depending on which of the two is really present and operating…. It will appear that a measurable uncertainty, or ‘risk’ proper, as we shall use the term, is so far different from an unmeasurable one that it is not in effect an uncertainty at all.”

Article Introduction (Via FT)

Financial institutions specialise in handling risk but are not nearly as efficient in dealing with uncertainty.  To paraphrase a recent Secretary of Defense, risk refers to situations where the unknowns are known, while uncertainty refers to situations where the unknowns are unknown.  This distinction is not only linguistically interesting but also has significant implications for economic behaviour and policy prescriptions. There is extensive experimental evidence that economic agents faced with (Knightian) uncertainty become overly concerned with extreme, even if highly unlikely, negative events. Unfortunately, the very fact that investors behave in this manner, makes the dreaded scenarios all the more likely. This mechanism has played an important role in the financial crisis.

The main implication of rampant uncertainty for the TARP and its relatives, is that capital injections are not a particularly efficient way of dealing with the problem unless the government is willing to invest massive amounts of capital, probably much-much more than the current TARP.  The reason is that Knightian uncertainty generates a sort of double- (or more) counting problem, where scarce capital is wasted insuring against impossible events.

Click Here To Read More About Understanding The TARP & Knightian Uncertainty

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26. November 2008 by Miguel Barbosa
Categories: Risk & Uncertainty | Leave a comment

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