Knightian Uncertainty

One useful consequence of the financial crisis has been the revival of the concept of "Knightian Uncertainty." In a guest column for the Economist, Olivier Blanchard puts it thus:

What is at work is not only objective, but also subjective uncertainty, or what economists, following Chicago economist Frank Knight’s early 20th-century work, call “Knightian uncertainty”. Objective uncertainty is about what Donald Rumsfeld (in a different context) referred to as the “known unknowns”. Subjective uncertainty is about the “unknown unknowns”. When, as today, the unknown unknowns dominate, and the economic environment is so complex as to appear nearly incomprehensible, the result is extreme prudence, if not outright paralysis, on the part of investors, consumers and firms. And this behaviour, in turn, feeds the crisis.

He goes on to discuss the implications for economic policy, but the implications for economics itself are just as interesting. In a forum on Blanchard's column at Free Exchange, the Economist's Delhi correspondent writes:

Economists do not, in fact, follow Knight’s work very much. The discipline shys away from his concept of uncertainty (as distinct from risk), because it is, by definition, so hard to model. If economists could model it, then so could firms and investors. The future would be calculable, if not knowable, and there would be less excuse for bewildered inaction.

Paul Samuelson once went so far as to argue that economics must surrender its pretensions to science if it cannot assume the economy is “ergodic”, which is a fancy way of saying that Fortune’s wheel will spin tomorrow much as it did today (and that tomorrow's turn of the wheel is independent of today's). To relax that assumption, Mr Samuelson has argued, is to take the subject “out of the realm of science into the realm of genuine history”.

The scientific pose has great appeal. But this crisis is reminding us again of its intellectual costs. Knightian uncertainty may be fiendishly hard to fathom, but ignoring it, as economists tend to do, makes other phenomena devilishly hard to explain. The thirst for liquidity—the sudden surge in the propensity to hoard—is one example. If risks are calculable, then investors will place their bets and roll the dice. Only if they are incalculable will they try to take their chips off the table altogether, in a desperate scramble for cash (or near-cash). As Keynes put it, “our desire to hold money as a store of wealth is a barometer of the degree of our distrust of our own calculations and conventions concerning the future.”

Indeed. However, there is an approach known as "robust control" that seems like it could provide a way of incorporating true uncertainty into formal economic models. I haven't read much of this literature, but perhaps it is time to give it a serious look.