The Knightian dog ate my recovery

By J Saft
August 31, 2010

Remember when business and economic leaders droned on about “100-year storms,” 2008’s get-out-of-jail free card for people who missed the housing bubble?

This was the whole idea that there was no way that people could be held accountable for the crisis because the notion of there being a problem with continual double-digit house price growth and sky-high leverage was just so darned unlikely.

Well, it looks like we have the 2010 version of how the dog ate their homework again and this time it is called “Knightian uncertainty.”

Over to European Central Bank chief Jean-Claude Trichet, who in a weekend speech at the Federal Reserve’s economic conference in Jackson Hole, Wyoming more or less said there is a biggish chance that he and his peers have no idea what is going on or what will happen next.

“Today, central bankers have to take decisions in an environment marked by a degree of uncertainty in the economic and financial sphere that seems to me largely unprecedented. … The acceleration of major advances in science and technology (not only information technology), the ensuing structural transformations of our economies, the ever-growing complexity of global finance and the overall process of globalisation are itself creating a multidimensional acceleration of change,” Trichet said.

“These phenomena contribute not only to a wider degree of uncertainty in underlying probability distributions, including fat tails. They also entail a much more significant element of Knightian uncertainty — that is, the type of uncertainty in which there is no underlying probability distribution.”

So, what is this Knightian uncertainty and why is it causing the price of our shares and houses to go down? Named after University of Chicago economist Frank Knight, it is the idea that there is a distinction between risks, which you can assign probabilities to, and uncertainties, which you just can’t fathom.

Well, all praise to Mr Trichet, who made to my mind a much franker, more humble speech than Fed Chairman Ben Bernanke, admitting the central role and problematic nature of debt and deleveraging in the current economic muddle.

That said, I have a suggestion: much of this “discovery” of there being more Knightian uncertainty is really just a dawning of how little the people who are using the term knew in the first place and how foolish they were to be so over-confident in their frameworks. Uncertainty isn’t rising, not for technological reasons or any other. We are simply becoming more aware of it.


Nicholas Nassim Taleb has been properly excoriating  academically minded policy-makers for being over-confident in their own systems, like the guy who bluffs in poker and then complains that you shouldn’t have called him.

“Life is not a laboratory in which we are supplied probabilities. Nor is it an exercise in textbooks on statistics. Nor is it an urn. Nor is it a casino where the state authorities monitor and enforce some probabilistic transparency,” Taleb writes.

“The more events matter, the worse our empirical knowledge about their properties.”

The amazing thing is that central bankers, or at least some of them, are just now getting the courage to admit how little they know and knew about the forces that caused the crisis and the ones that are still operating today.

Up to a point this is because of the pressure of position; too much discussion of ignorance by policy makers might have a, shall we say, destabilizing effect. What would they do on the floor of the New York Stock Exchange if Bernanke stood up and said, “Your guess is as good as mine, fellas, but we’ll do our best”?

There was quite a trans-Atlantic contrast on view at Jackson Hole however; between Trichet who was forthright about the risks of debt and the need for a plan of reduction and Bernanke who was very much still the technocrat, reassuring us that he was standing by, ready to push the right button on the machine whatever the future might bring.

Bernanke seemed to draw comfort from the fact that consumers raised their savings rates more than previously known this year, by which I take it that he sees balance sheet repair as an event rather than a trend. My guess is that savings rates are going up to 8 or 9 percent and staying there, rather than that the U.S. consumer has to pay a little back and then borrow more later.

It seems Bernanke will have his Knightian moment a bit later than Trichet, but it is coming just the same.

Here is one more prediction: next year, when today’s corporate earnings estimates turn to dust, look for more than one executive to blame it partly on — you guessed it — Knightian uncertainty.


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Deep and brilliant article – One of the best I’ve since the beginning of this crisis.
This is an example of economic journalism at its best – a must read for every leader, businessman and economist out there who faces the unknown in its multiple, vague forms.
Other journalists may benefit from reading it as well…

Posted by yr2009 | Report as abusive

another great article..thanks, Jim, and Reuters..

Posted by gramps | Report as abusive

Well, apart from showing an interesting aspect, I don’t see anything extraordinary about this piece. The only reason why yr2009 got excited could be because he or she might not be a journalist. I am one and I know the difference. When central bankers come to admit their plight more and more openly, I wonder what would happen to those who still bestow their faith in these men to tide over the crisis. God bless the entire world…

Posted by psreevalsan | Report as abusive

A dose of reality is what we all need and what most of us get. But those who have the power to shape our perception of reality hardly ever do. Follow the money and see who is having the last laugh.

Posted by Biscayne | Report as abusive

Excellent article pointing out the uncertainty facing us and the admission that economists don’t have a clue. I wonder why they haven’t looked at our new economy as a “reset”. That is, if you look at the numbers, DOW, volumes, and corporate revenues, we have gone back to the economy of the 80’s. Corporations are making profits because they have downsized their work force and volumes are low but profitable. Our consumerism is back to the 80’s. There are other indications as well and other forces of our own making at work, but suffice it to say that we will be at this “reset” level for a while and economists and industrialists need to start dealing with it.

Posted by Leadandperform | Report as abusive

[…] Trichet recently described the world’s economic prospects as being characterized by Knightian uncertainty, which means that they are truly unpredictable and not consistent with a probability distribution […]

Posted by Knightian uncertainty: a few things we can be certain of | Report as abusive