Adam Smith considered all economic agents to be (mostly) serving their own interests. As humans, and more importantly as ‘self-interested’ economic agents, we tend to evaluate options that we have in the present based on their future outcomes. Traditional economic theory suggests that when we choose between alternatives available to us, we decide based on the opportunity cost of choosing one of them. We always want to minimize the opportunity cost and maximize our future satisfaction from our choice’s outcome.
However, predicting and estimating the future outcome is difficult for us, as we are irrational economic agents living in a world filled with imperfect information. For example, a consumer may purchase a product based on a misleading advertisement, only to later discover that the product does not live up to its advertised claims. The consumer, in this case, tried to predict the future satisfaction received from the product, but was unable to make an accurate prediction due to the incomplete (or exaggerated) information presented to him in the advertisement. This makes it difficult for consumers to make an informed decision and can lead to market inefficiencies, as resources are allocated to products or companies that do not provide the best value to consumers.
Risk and Uncertainty - these are two terms we often come across when we hear people evaluate the future. Most of us use these terms interchangeably, even though they have totally different economic implications. Due to the numerous asymmetries that surround us, we might or might not get the desired outcome from the option we choose. Usually, we consider this probability of not achieving our desired outcome as ‘risk’. Risk as a concept is quantifiable in terms of probability and statistics. But, if we were faced with an option whose outcome we can never expect or predict because we typically have no data about what could happen in the future, then we are faced with an ‘uncertainty’.
To put it simply, sometimes we can predict the future, sometimes we know we cannot predict the future, and in the most extreme of cases, we do not know that there is a future that we cannot predict. It just hits us without any notice and disrupts our equilibrium.
We remain oblivious about the unknown unknowns, since there practically is no way to predict them. The fact that such unknowns can happen in the future forms the central concept of Knightian uncertainty. The most popular and the most relevant case in point would be the COVID-19 pandemic. None of us were prepared for it, none of us expected it to happen. We can never predict such events, nor can we plan ahead to smoothen the blow. In the words of Frank Knight, who first introduced this concept, it is true uncertainty and is “not susceptible to measurement”.
If we can never measure or predict it, why do we need to talk about it? Unfortunately, even though it is immeasurable, Knightian uncertainty plays a very important role in determining the way economies, governments and businesses function.
Since we can never predict how the future changes, Knight provides us with a different approach to the problem - identifying why we cannot predict the future perfectly. He propounds that economies change as time progresses. The changes are caused by events that are at least partly unique to the current scenario. People, technologies and institutions are never the same as they were yesterday. Therefore, even if the same chain of events occur like in the past, the end result is not always the same, because there are some elements of these events that are unique to the time and context of this period. And economists who try to predict the future using past data, can never be correct with their predictions, as their data does not reflect the idiosyncratic nuances of the current reality.
The concept of Knightian uncertainty would render prominent macroeconomic and econometric models inadequate to predict the future outcomes that might unfold. A very striking example of the inability of data and models to assess the future comes from the 2008 financial crisis. The inherent cause of the crisis was the introduction of a high risk asset - the subprime mortgages. Financial institutions were so confident about their credit risk assessment mechanisms (the FICO score that was used to assess credit worthiness of households) that they went on a lending spree, without consideration of their capital adequacy, due to insurance contracts called credit default swaps provided by large insurance giants like AIG. None of these companies were able to incorporate their present reality that is changing into their predictions and were unable to grasp the situation of Knightian uncertainty transpiring around them.
The concept of Knightian uncertainty always had increased traction amongst economists mostly in times of financial crises, as economic agents become insecure about their monetary engagements. When faced with adversity, agents grapple with how unpredictable uncertainty is. Knight’s work has heralded and influenced other major economic thinkers like John Maynard Keynes, Friedrich Hayek, and Karl Popper who further advanced this concept. Finally, if we have one thing to learn from what Knight proposed as part of his life’s work, it is that in the future, we will always face true uncertainty. And the only way to deal with it, is to accept that we cannot.
Twinkle Adhikari
