Economic uncertainty takes revenge on hubris of traders

ANALYSIS: If we paid more attention to the fundamental difference between 'risk' and 'uncertainty' we might not have a global…

ANALYSIS:If we paid more attention to the fundamental difference between 'risk' and 'uncertainty' we might not have a global financial crisis, writes Peter Lunn

ON TOP of the worry, shock and insecurity induced by this major financial crisis, there is a sense of frustration. As well as being concerned about your savings and the use of taxpayers' money for bailouts, you might also be asking in exasperation: "How could this happen?"

You may think that the financial markets are simply a world apart; that without an understanding of such things as derivatives, credit swaps and write-downs, it is pointless to try to make sense of the extraordinary events unfolding.

Don't be so daunted. Because one of the main causes of this crisis is something you probably have an instinctive understanding of. Ironically, it is something financial whizz-kids have regularly forgotten throughout economic history, often with severe consequences.

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I am referring to the difference between "risk" and "uncertainty". Even top economists have a habit of using these terms interchangeably. They should not. The two are different and failure to recognise the difference is one of the mistakes that led to the crisis.

A good way to grasp the distinction between risk and uncertainty is to consider a misleading analogy currently in circulation. Financial markets are simply not like a casino. Why? Because in a casino you know the odds you face. You know how many red and black numbers are on the roulette wheel; how many aces are in the pack. Gambling in a casino involves taking risks, but the rules of the game mean you can be certain how big the risks are.

Trading in financial markets is completely different. The value of each trader's holding ultimately depends on the fortunes of companies, the ways households choose to conduct their finances and, more generally, the performance of whole economies. The outcome depends on so many complex factors, therefore, that not even the best financial brain in the world can calculate accurate odds of profit.

Traders in financial markets play roulette without knowing how many red and black numbers are on the wheel; black jack with any number of aces in the pack. They do not face risk, something that can be accurately quantified, but genuine uncertainty, which cannot.

Although some philosophers knew it, the first economist to draw this distinction between risk and uncertainty was the American Frank Knight in the 1920s. Alas, few economists or finance professionals are taught about "Knightian uncertainty". If they were, our economy might not be in such a state.

Interestingly, however, most people seem to have an instinctive understanding of Knight's distinction. Behavioural economists study our economic decisions and have conducted experiments on how we respond when facing risk and uncertainty. The experiments usually involve games of chance, such as betting on the colour of balls to be drawn from a bag.

The consistent finding is that our behaviour is radically different when we know the odds of success precisely and when we do not - any uncertainty about the division of balls in the bag induces caution. Some people are more inclined to gamble than others, but even those who like a flutter become much more cautious when unsure of the odds they face. Our instinct is to be wary when we are missing information about possible outcomes.

Behavioural economists believe this instinctive avoidance of uncertainty has served us well in the past. For thousands of generations economic life has required people to take chances. A bias towards options about which we have the best information may well have been a positive trait.

Armed with the distinction between risk and uncertainty, let's return to those volatile markets. Modern finance theory is based on management of risk. Practitioners are trained to evaluate the risks associated with holding different assets (shares, bonds, derivatives, repackaged mortgage debt, whatever) and then to calculate the optimal set of assets to hold.

The range of potential assets is extensive and the methods for calculating the optimal holding are sophisticated. We've all seen pictures of those flickering, frenetic screens on the trading floor. The people doing the calculations are smart, knowledgeable and numerate.

The problem is that all the smartness and sophistication in the financial world cannot overcome the essential fact that the initial evaluation of risk is, in reality, no such thing. The value of the assets being traded is hugely uncertain.

As well as using all available information, the best that can be done when judging the likelihood of future company profits, predicting household behaviour or forecasting the overall state of the economy, is to use history as a guide. But history can be a poor guide. Things sometimes happen that have never happened before. More importantly for the current crisis, recent history can be an unusual period, leading traders to assume, wrongly, that the latest trends will continue.

The present crisis began with a new and sophisticated method for balancing the risk associated with granting mortgages. Had the risks been as the method assumed, we would not be in the present mess. But the risks were calculated from a period of history that was atypical. Wall Street didn't so much take too big a risk, as fool itself that it knew how big the risk was.

"How could this happen?" has a straightforward answer. Finance professionals and economists become overconfident in their economic understanding and, worse, persuade other people to part with their cash on the same basis. Periodically, we abandon our instinctive caution in the face of uncertainty and believe instead that we have mastered our economic world. Periodically, our economic world punishes us for such hubris.

• Peter Lunn is an ESRI economist and the author of Basic instincts: Human nature and the new economics(Marshall Cavendish, 2008)