Climate change and pandemic pose threats of uncertainty

By Stephen Mihm

Economic forecasting, a fool’s game in the best of times, has become increasingly useless.

A global pandemic, supply chain disruptions and extreme weather events have thrown conventional models into disarray. That’s led commentators to warn of growing “risks” to the global economy.

That’s wrong. What the world is confronting can’t really be reduced to the idea of risk. The actual problem is even more vexing: widespread, growing uncertainty.

This distinction between risk and uncertainty may seem purely semantic. It’s not, as the idiosyncratic economist Frank Knight recognized a century ago when he published his classic meditation on the matter. His thoughts are worth revisiting today.

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Knight was born in Illinois in 1885, one of nine children in a deeply religious family. He had few of the markings of a future academic, save for intense intelligence. He eventually broke from his family’s faith, a move that some biographers have speculated primed him to challenge other people’s cherished beliefs, especially economic orthodoxies.

He never finished high school, but managed to get to college and pursue what one biographer called a “motley education,” dabbling in chemistry, German and philosophy before graduating from the University of Tennessee. He then pursued a doctorate in economics at Cornell University. It was there that he wrote and revised his dissertation under the shadow of two radical ruptures: World War I and the 1918 flu pandemic, both of which may have contributed to his thinking about risk and uncertainty.

He published his dissertation in 1921 as Risk, Uncertainty, and Profit, taught at the University of Iowa for a few years, then joined the faculty of the University of Chicago, where he held sway for several decades. Always an iconoclast, he feuded with colleagues, reserving special contempt for economists who favored quantitative techniques and empirical models. Reading his classic work, it’s easy to understand why.

Knight’s book is unusual for many reasons, not least the fact that it offers one of the clearest definitions of the conditions necessary for that nirvana of general equilibrium that economists call “perfect competition” — and then shows how that world will never exist because of the powerful undertow of what he called “uncertainty.”

For most people, risk and uncertainty are more or less synonymous: things that are risky are uncertain and vice versa. Knight disagreed. In an exploration of these concepts that bordered on the metaphysical, Knight asked his readers to consider the fact that human beings — and entrepreneurs in particular — are necessarily obsessed with what will happen in the future. But Knight argued that future events fell into two distinct categories.

The first was what Knight dubbed risk: events that one could not know would happen — much less precisely when they would happen — but to which a certain probability could be assigned. As an example, he cited another economist who had described the making of champagne, which invariably resulted in a certain number of bottles bursting from an excess of carbonation. But the loss rate was consistent and predictable. As a consequence, wrote Knight, “the loss becomes a fixed cost in the industry and is passed on to the consumer.”

Somewhat less predictable, but still capable of control, were events that one could not predict on a case-by-case basis (a factory burning down, for example) but could be quantified as a definite risk when pooled with others drawn from the same type or category. This, explained Knight, was the insight that lay at the foundation of the insurance industry. No individual calamity could ever be foreseen, but a certain probability within a larger pool could.

“It is evident,” wrote Knight, “that a great many hazards can be reduced to a fair degree of certainty by statistical grouping.” But he warned that “an equally important category cannot.”

This was the dreaded world of uncertainty: a place where bad things might happen, but one had no ability to predict the likelihood. These could not be wrestled to the ground with modeling, statistical analysis or anything else in the toolkit of economics.

Knight thus posited a distinction between a measurable uncertainty (what he called risk) and unmeasurable uncertainty (which he called true uncertainty). He conceded that it might be possible to accumulate sufficient data to turn uncertainties into risk, though he noted, “The use of resources in reducing uncertainty is an operation attended with the greatest uncertainty of all.”

Many economists have quibbled with Knight’s analysis, with some pointing out that the distinctions between risk and uncertainty are rarely so clear. But his arguments continue to be influential and relevant, perhaps especially so now. Just as the reputation of the heterodox economist Hyman Minsky revived in the shadow of the 2008 financial crisis, Knight’s writings have a direct relevance to the present moment of radical uncertainty.

The unknowns that the world now faces — the radical disruptions of climate change, an ever-evolving deadly virus and the dissolution of carefully constructed supply chains — means that economic forecasts and predictions, which are of little use generally, should be ignored altogether.

But as Knight would tell you, the fact that nobody knows what will happen to the global economy shouldn’t be cause for despair. In fact, he argued that uncertainty is the wellspring of profit. Entrepreneurs don’t make money by assuming risks that can be quantified; they make money by bearing the cost of true uncertainty.

That means this moment of extreme uncertainty is a business opportunity of astonishing proportions. Of that, Frank Knight would have been certain.

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