Wednesday, August 29, 2007

From risk to uncertainty and back again (I hope)

The facts of life in this regard are in a superficial sense obtrusively obvious and are a matter of common observation. It is a world of change in which we live, and a world of uncertainty. We live only by knowing something about the future; while the problems of life, or of conduct at least, arise from the fact that we know so little. This is as true of business as of other spheres of activity. The essence of the situation is action according to opinion, of greater or less foundation and value, neither entire ignorance nor complete and perfect information, but partial knowledge. If we are to understand the workings of the economic system we must examine the meaning and significance of uncertainty; and to this end some inquiry into the nature and function of knowledge itself is necessary.
Frank Knight: Risk, Uncertainty and Profit

When I was 11 my father decided to go back to school and study the Liberal Arts; specifically Philosophy. Thus I had the good fortune, at an impressionable age, to browse through the views of many of the noted Philosophers, in particular Locke, Berkeley and Hume.

I remember the first time I browsed (read would imply greater understanding than was evident) Hume's essay on Human Understanding. It was a humbling experience. While the book was written in English, and, according to my public school educators, I could already read at a college level, I couldn't understand the arguments. Fortunately I was young enough to not write off the essay as "unintelligible," instead realizing I needed more study to grasp the, as I later learned, important arguments therein.

I get the sense that others have encountered similar difficulty grasping complex arguments in literature, although, it seems to me, without recognizing the fact. Take President Bush's recent statement about Graham Greene's novel, The Quiet American:

The argument that America's presence in Indochina was dangerous had a long pedigree. In 1955, long before the United States had entered the war, Graham Greene wrote a novel called, "The Quiet American." It was set in Saigon, and the main character was a young government agent named Alden Pyle. He was a symbol of American purpose and patriotism -- and dangerous naiveté. Another character describes Alden this way: "I never knew a man who had better motives for all the trouble he caused."

After America entered the Vietnam War, the Graham Greene argument gathered some steam. As a matter of fact, many argued that if we pulled out there would be no consequences for the Vietnamese people.

It has been a while since I read the book but I don't recall any of Greene's characters arguing that an American pull-out would have no consequences for the Vietnamese- the book's focus was on the naiveté of going in and expecting positive results. Further, although this is a small point, Greene's argument didn't "gain steam," it became self-evident. The naive Alden Pyle's of America's ruling class had self-inflicted a wound on American prestige in international circles by opting to intervene in IndoChina. The Iraqi analog also seems self-evident, but that is just my opinion.

And opinion, personal opinion, and its effects, is the theme of this essay.

President Bush, it seems to me, assuming he read the book and is not relying on his speech writers' understanding thereof, views Greene's arguments through the self-imposed lens that American military intervention is, in both Vietnam and Iraq at least, wise. Greene's arguments fell on deaf ears in that case. One must be open to the possibility that contrary arguments might be correct, i.e. be able to entertain them, to understand those arguments. Aristotle's quote that it is the mark of an educated mind to be able to entertain an idea without accepting it comes to mind.

But I digress.

The notion of Knightian uncertainty is making the rounds again in the aftermath of recent credit and equity market volatility. In reading some of the comments referencing Knight's views, I get that same sense that the arguments of Frank Knight's Risk, Uncertainty and Profit often fall on deaf ears. This is perhaps not surprising as Mr. Knight was first a philosopher before he became an economist and understanding his views requires an understanding of epistemology, the study of what it means to know something. As he put it: If we are to understand the workings of the economic system we must examine the meaning and significance of uncertainty; and to this end some inquiry into the nature and function of knowledge itself is necessary.

If you read Knight's views without a fair bit of grounding in epistemology you may well find yourself at the impasse I found when I first read Hume, or when I try to read an advanced book on Organic Chemistry.

Alternatively, you might think you understand epistemology as, apparently, ex-Fed Chairman Greenspan did, through his familiarity with Ayn Rand's Objectivism. In that case, Knight's arguments would, unbeknownst to you, be falling on deaf ears. Greenspan's view (see below) that one never knows whether one is dealing with uncertainty or risk seems to me evidence of a lack of understanding of Knight's arguments. If you keep discovering, through the emergence of surprising outcomes, that what you thought was risk was really uncertainty, you aren't assessing risks, but fumbling in the dark.

The Federal Reserve's experiences over the past two decades make it clear that uncertainty is not just a pervasive feature of the monetary policy landscape; it is the defining characteristic of that landscape. The term "uncertainty" is meant here to encompass both "Knightian uncertainty," in which the probability distribution of outcomes is unknown, and "risk," in which uncertainty of outcomes is delimited by a known probability distribution. In practice, one is never quite sure what type of uncertainty one is dealing with in real time, and it may be best to think of a continuum ranging from well-defined risks to the truly unknown.

Enough prologue though, let's move on to Knight's views.

As the opening quote states, the difference between risk, which Knight defines as measurable uncertainty and uncertainty proper, i.e. unmeasurable, is a matter of personal opinion, or as I like to put it, one man's risk is another man's uncertainty. A well grounded sense of the world transforms a good deal of uncertainty to risk and vice versa.

Perhaps then, one can understand Greenspan's statement that uncertainty is not just a pervasive feature of the monetary policy landscape; it is the defining characteristic of that landscape as an (I suspect unintended) indictment of Central Banking. Perhaps accepting the view that Central Bankers can make the world a better place- a view I suspect most Central Bankers accept, turns what could be defined as risk, in their minds, to uncertainty. If monetary policy rarely creates better outcomes but monetary policy makers assume it does, they will, from time to time, be surprised at the outcomes which follow their actions, that is learn that they were operating in an environment of Knightian uncertainty. Alden Pyle's naiveté might not only be evident in military interventions but economic ones as well- let's call it The Quiet Central Banker.

And these Central Bankers and other economic officials would like you to share their uncertainty. They wish to mold investor expectations through commentary and intervention such that you see the world through their lens.

Thus, it seems to me, they turn what might be apprehended as a clear risk of financial disaster into uncertainty of its probability in the minds of many and thus engender the very volatility they claim to wish to curtail . If you accept, or more cynically, believe that many others will accept the views of Henry Paulson, presented on March of this year that; We have a very strong global economy. We have a global economy with low inflation, high levels of liquidity and I feel very comfortable with the global economy, then the recent market gyrations were surprising. Equally, if you adhere to the views of those like Jim Cramer that additional Fed liquidity, which, in my view, are a cause of the problem, is likely to fix things, you may well be surprised at the outcome. If you believe that financial deregulation, which allowed banks to securitize mortgages and let derivatives grow unchecked, is an unalloyed good, you too might be operating in uncertainty, but be ignorant of that fact, and thus be surprised at the outcome.

For Frank Knight, the difference between a successful entrepreneur and a failure lies in their differences in opinion. The former operates, more or less, in an environment of risk while the latter operates, ignorantly, in an environment of uncertainty. Transforming a good deal of uncertainty to risk can be done by adopting more accurate opinions of how the world works and how we, through the medium of consciousness, interact with it..

So, in this case, to transform uncertainty to risk one should "fight the Fed." To the extent our current problems were foreseeable, and many predicted them, they are a result of risks transformed into uncertainties by faith in false doctrine.

I'll close with another excerpt from Knight: But in economics a distrust of general principles, fatal as it is to clear thinking, will be inevitable as long as the postulates of theory are so nebulous and shifting. They can hardly be made sufficiently explicit; it is imperative that the contrast between these simplified assumptions and the complex facts of life be made as conspicuous and as familiar as has been done in mechanics.

The present essay is an attempt in the direction indicated above. We shall endeavor to search out and placard the unrealities of the postulates of theoretical economics, not for the purpose of discrediting the doctrine, but with a view to making clear its theoretical limitations. There are several reasons why the approximate character of theoretical economic laws and their inapplicability without empirical correction to real situations should be especially emphasized as compared, for instance, with those of mechanics. The first reason is historical and has already been indicated. The limitations of the results have not always been clear, and theorists themselves as well as writers in practical economics and statecraft have carelessly used them without regard for the corrections necessary to make them fit concrete facts. Policies must fail, and fail disastrously, which are based on perpetual motion reasoning without the recognition that it is such.


STS said...

There may be a sort of Bayesian effect in play here: the longer the bad outcome fails to appear, the smaller the probability we assign to it.

As the course of daily events becomes more and more detached from rational economic theory (dotcom IPOs or the NASDAQ in the 90's, or credit spreads these past few years) the pressure builds on economists to adjust their theories to accommodate the "New Reality".

This might account for Greenspan's sloppy reading of Knight in the passage you cited. By the time he wondered aloud about Americans' reluctance to use ARMs, perhaps he no longer had any confidence in his own knowledge of the distribution of possible outcomes.

Greenspan did also remark more recently that "History has not dealt kindly with the aftermath of protracted periods of low risk premiums" so clearly he remained confident that the distribution had a nasty tail even as his estimate of its weight may have been shrinking. Does that sort of qualitative knowledge of the distribution leave us in the domain of "risk"? Or does it carry us across the line into "uncertainty"?

But when the same guy says (in effect): "go ahead, take the teaser rate on that ARM" and then proceeds to light the fuse on it by cranking the FF rate 425bps, it takes a special kind of blindness to be "uncertain" about the result.

"Cassandra" said...

I ventured upon my copy of Knight in what was the used book section at "the Economists Bookshop" at the LSE. I could barely afford the pouches of rolling tobacco I was consuming, and "a meal out" was unthinkable, had seriously abused my overdraft facility, but had no second thoughts about filling my tea-chest with well-thumbed moth-eaten tomes for 50p-a-throw.

Dude said...

Belief has been defined as that upon which a man will act. Ultimately, to the extent he was sincere and not a Randian Francisco, Greenspan believed that the deception could be maintained and the effects of its unwinding mitigated.

Anonymous said...

Uncertainty is the basis of Life.

Subatomic particles, of which all matter is composed, pop in and out of existence in a totally random way. One cannot be certain when or where these little buggers will emerge into the realm of our senses.

All of Life, other than adult humans, know and live this reality.

Adult humans, through the intellect, believe that they can overcome Life's uncertainty by creating both inner and outer cities wherein uncertainty can be controlled.

The fictitious concept of Time enables mankind try to correct the so-called "mistakes" of the past in order to perfect a predictable future. But, since this machination works against the wildness and uncertainty of Life, human adults never have complete faith in their ability to manhandle the so-called future.

The adult human concept of risk is the battlefield upon which mankind's faith in his apparent control of uncertainty struggles with his own awareness of the futility of such an encounter.

Risk does not exist in nature. Life's maneuvers occur in the realm of;

"Either you do, or you don't."

Risk suggests that there is something to win or lose. This is an adult human concept which does not exist in nature.

"Either you do or you don't."

Risk injects a bit of wildness into the ennui created by the human adult's tendency to tame himself and others by pretending that the outcome of decisions are a life and death matter. But since Life knows nothing about death, its actions always occur within the domain of;

"Either you do or you don't."

Human beings are made up of cells which are made up of atoms which are made up of subatomic particles which are neither here, nor there.

Something else (or nothing else) controls the existence and nonexistence of matter.

Something else controls whether or not tomorrow will be a "bad hair day."

Something else controls whether or not your tire hits a road hazard and postpones or cancels your appointment.

Since Life IS uncertainty, the mental concept of "risk" is moot.


Because when all is said and done we are all living outside the human a-dolt world of control, ennui and risk.

Out here nothing matters...

Until it does.


"Either you do or you don't."


Sarah said...

Thank you for the excellent discussion of risk vs. uncertainty and the philosophical underpinnings which clarified (at least for me), a nettlesome suspicion that our Masters really are clueless of the realities going on about us. Akin to the phrase "one man's junk is another's treasure (AAA CDO?)", comes to mind: "one man's risk is another's uncertainty". Not a perfect analogy but there's a parallel there somewhere.

While studying electrical engineering as an undergraduate, we had two semesters of solid state electronics. We renamed the courses "Fish's Derivations" after our prof - Dr. Fish - who spent nearly every class deriving blackboard-wide transistor and network equations. Of course the punchline was usually that you could neglect 90% of the formula as the terms weren't significant to 95% of the practical circuits and cases one would usually encouter. But of course there were (and are) applications where the usually neglected terms ARE required - if you want to get the correct solution. Otherwise, you can plod along and come up with a solution (or model) that just isn't quite right and doesn't always behave as predicted. So your choices are to cook the results and press on - hoping reliability is "good enough", or get it right. Seems to me there's at least some element of "hood enough" in many of the recent reassurances related to the building financial "hub-bub."