Having already expressed my doubts about Mervyn King’s ideas on credit in his recent book, “The End of Alchemy”, I’m moved to comment on John Kay’s very positive review of it yesterday for the FT,
where for him the most important message was the stress on radical uncertainty. He describes his and Mervyn King’s parallel intellectual careers where they were together at the start, receiving and passing on what now seems an absurd idea of Milton Friedman’s – that there is no “sharp distinction between risk, as referring to events subject to a known or knowable probability distribution, and uncertainty, as referring to events for which it was not possible to specify numerical probabilities.”
Up to a point, I don’t think Friedman is being absurd, although that point is reached only a few lines further on in the text John Kay refers to (Price Theory, p. 282), of which more later. Of course there is a distinction to be drawn between these types of risk, but I don’t think it’s that sharp, because almost all financial risks have a degree of uncertainty in the sense of the distribution not being known. But now, conjuring up the idea of radical uncertainty, it suggests a qualitative boundary beyond which quantification is pointless, and that given the pervasiveness of uncertainty, this applies to most financial risk. Perhaps mundanely, I’d suggest
- there is no such boundary,
- that pretty well all financial risks have a degree of uncertainty in this sense, but
- that in general this can be reduced with some risk analysis (preferable not just collecting data about past performance), and
- a subjective estimate of the remaining uncertainty is useful for a financial risk taker.
Where I’d say Friedman crosses the border to absurdity is when he writes
Sometimes people will agree – we then may designate the probabilities as “objective”; sometimes they will not – we may then designate the probabilities as “subjective”.
In this, I think Friedman is claiming that by observing how such risk takers act on their subjective estimates, and generate a market price for the risk if there are enough of them, then it will be possible to calculate the probability implied by that price, and that this probability is “objective”. The scare quotes are still there, but so are they round “subjective”, for no reason I can see. Combine with this dogma that markets are the best possible calculating device – rather than just a signal worth having on the radar – and the intellectual path is open to the justly derided excesses of financial quantdom.
The example of Gillian Tett’s insights into CDO traders from her studies as a social anthropologist is now well known, and in retrospect we can see that this would have kept our estimates of the uncertainty – and expected value – of such products more objective – no scare quotes needed here. But so would insights from other disciplines – understanding of IT systems security, for example, and maybe even some of what still seems like financial quantdom will have a role in understanding uncertainty and reducing it.