The Knightian uncertainty meme is back …

The Knightian uncertainty meme is back.

[During the asset backed commercial paper crisis of 2oo7] Knightian uncertainty took over, and pervasive flight to qualities plagued the financial system. Fear fed into more fear, and caused reluctance to engage in financial transactions, even among the prime financial institutions

In response to this let me just quote an old post of mine:

Apparently the reason for this abrupt outbreak of Knightian uncertainty is that bankers have suddenly realized that there is a difference between reality and their models. As long as the world behaves according to model, bankers want to claim that they are earning profits from managing “risk,” and as soon as their models fail, risk becomes uncertainty and necessitates a government bailout.

In short whenever you read that bankers can manage risk, but uncertainty requires government intervention, you should hear: “Privatize the profits and socialize the losses.”

The truth is that bankers always have to price assets in the face of Knightian uncertainty, they have just chosen to spend the last decade pretending that this was not their job.

In response to the view that the government should insure the financial system against systemic tail risk:

… the main failure during the crisis was not in the private sector’s ability to create triple‐A assets through complex financial engineering, but in the systemic vulnerability created by this process. It is important to preserve the good aspects of this process while finding a mechanism to relocate the systemic risk component generated by this asset creation activity away from the banks and into private investors (for small and medium size shocks) and the government (for tail events).

I will refer readers to an earlier post that distinguished between systemic liquidity risk and systemic credit risk.

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Knightian uncertainty and the financial crisis

Over at Rortybomb Mike writes:  “In economics there is something called Knightian Uncertainty. In quant circles, it can be called ‘model risk.’ …”

Because Mike is reproducing an analytical mistake that is common in the financial industry, I want to discuss this.  Knightian uncertainty is unmeasurable risk.  That is a completely different entity from unmeasured risk.  If somebody puts together a bad model, they are choosing not to measure risk that can be measured by a more careful model.  Then, the problem isn’t Knightian uncertainty, it’s just poor quality risk estimation.

Mike continues:  “Now that we’ve just lived through an empirical experiment in how well the best modeling can predict tail risk, I tend to look closely at [tail risk in climate change models]. And the uncertainty there has me worried.”

I think that it is very hard to defend the view that what happened to our financial system had anything to do with “how well the best modeling can predict tail risk”.  The problem had a lot more to do with the expunging of negative data from the inputs.  Linda Lowell over at HousingWire covered this in a piece titled “Those who bury history are doomed to repeat it”.

As far as I can see there’s very little evidence of some grand human struggle with Knightian uncertainty when it comes the financial debacle.

Update 07-01-09:  Maybe Paul Wilmott agrees with me.