Against the Gods: The Remarkable Story of Risk (43 page)

The attitude reflected in this remark is evident in Knight's doctoral dissertation, which was completed at Cornell in 1916 and published as a book in 1921. Risk, Uncertainty and Profit is the first work
of any importance, and in any field of study, that deals explicitly with
decision-making under conditions of uncertainty.

Knight builds his analysis on the distinction between risk and
uncertainty:

Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which it has never been properly separated.
... It will appear that a measurable uncertainty, or "risk" proper ... is
so far different from an unmeasurable one that it is not in effect an
uncertainty at all.'

Knight's emphasis on uncertainty decoupled him from the predominant economic theory of the time, which emphasized decision making under conditions of perfect certainty or under the established
laws of probability-an emphasis that lingers on in certain areas of economic theory today. Knight spoke of the failure of the probability calculus to, in Arrow's words, "reflect the tentative, creative nature of the
human mind in the face of the unknown." 8 Clearly Knight was a creature of the twentieth century.

The element of surprise, Knight argued, is common in a system where
so many decisions depend on forecasts of the future. His main complaint
against classical economics with its emphasis on so-called perfect competition arose from its simplifying assumption of "practical omniscience on
the part of every member of the competitive system."9 In classical economics, buyers and sellers, and workers and capitalists, always have all
the information they need. In instances where the future is unknown,
the laws of probability will determine the outcome. Even Karl Marx, in
his dynamic version of classical economics, never makes reference to
forecasting. In that version, workers and capitalists are locked in a drama
whose plot is clear to everyone and whose denouement they are powerless to change.

Knight argued that the difficulty of the forecasting process extends
far beyond the impossibility of applying mathematical propositions to
forecasting the future. Although he makes no explicit reference to
Bayes, he was dubious that we can learn much from an empirical evaluation of the frequency of past occurrences. A priori reasoning, he insisted, cannot eliminate indeterminateness from the future. In the end,
he considered reliance on the frequency of past occurrences extremely
hazardous.

Why? Extrapolation of past frequencies is the favored method for
arriving at judgments about what lies ahead. The ability to extrapolate
from experience is what differentiates adults from children. Experienced
people come to recognize that inflation is somehow associated with
high interest rates, that moral character is desirable in the choice of
whom we play poker with and whom we marry, that cloudy skies frequently presage bad weather, and that driving at high speed along city
streets is dangerous.

Business managers regularly extrapolate from the past to the future but often fail to recognize when conditions are beginning to change from poor to better or from better to worse. They tend to identify turning points only after the fact. If they were better at sensing imminent changes, the abrupt shifts in profitability that happen so often would never occur. The prevalence of surprise in the world of business is evidence that uncertainty is more likely to prevail than mathematical probability.

The reason, Knight explains, is this:

[Any given] "instance" . . . is so entirely unique that there are no others or not a sufficient number to make it possible to tabulate enough like it to form a basis for any inference of value about any real probability in the case we are interested in. The same obviously applies to the most of conduct and not to business decisions alone.10 (Italics are mine.)

Mathematical probabilities relate to large numbers of independent observations of homogeneous events, such as rolls of the dice-in what Knight describes as the "apodeictic certainty" of games of chance.'
But no event is ever identical to an earlier event-or to an event yet to happen. In any case, life is too short for us to assemble the large samples that such analysis requires. We may make statements like "We are 60% certain that profits will be up next year," or "Sixty percent of our products will do better next year." But Knight insisted that the errors in such forecasts "must be radically distinguished from probability or chance.... [I]t is meaningless and fatally misleading to speak of the probability, in an objective sense, that a judgment is correct."12 Knight, like Arrow, had no liking for clouds of vagueness.

Knight's ideas are particularly relevant to financial markets, where all decisions reflect a forecast of the future and where surprise occurs regularly. Louis Bachelier long ago remarked, "Clearly the price considered most likely by the market is the true current price: if the market judged otherwise, it would quote not this price, but another price higher or lower." The consensus forecasts embedded in security prices mean that those prices will not change if the expected happens. The volatility of stock and bond prices is evidence of the frequency with
which the expected fails to happen and investors turn out to be wrong.
Volatility is a proxy for uncertainty and must be accommodated in
measuring investment risk.

Galton, a Victorian, would have expected prices to be volatile
around a stable mean. Knight and Bachelier, neither of them a Victorian,
are silent on precisely what central tendency would prevail, if any. We
will have more to say about volatility later on.

Knight disliked John Maynard Keynes intensely, as he revealed
when, in 1940, the University of Chicago decided to award Keynes an
honorary degree. The occasion prompted Knight to write a rambling
letter of protest to Jacob Viner, a distinguished member of the Department of Economics at Chicago. Viner, Knight declared, was the
person reported to be responsible "more than anyone else" for the
decision to honor Keynes and therefore was "the appropriate party to
whom to express something of the shock I received from this news."13

Knight grumbled that Keynes's work, and the enthusiasm with
which it had been greeted by academics and policymakers, had created
"one of my most important ... sources of difficulty in recent years."
After crediting Keynes with "a very unusual intelligence, in the sense of
ingenuity and dialectical skill," he went on to complain:

I have come to consider such capacities, directed to false and subversive
ends, as one of the most serious dangers in the whole project of education.... I regard Mr. Keynes's [views] with respect to money and monetary theory in particular ... as, figuratively speaking, passing the keys of
the citadel out of the window to the Philistines hammering at the gates.

Although most of the free-market economists at Chicago disagreed
with Keynes's conviction that the capitalist system needed a frequent
dose of government intervention if it was to survive, they did not share
Knight's disdain. They deemed it fit to honor Keynes as a brilliant
innovator of economic theory.

Knight may simply have been jealous, for he and Keynes shared the
same philosophical approach. For example, they both distrusted classi cal theories based on the laws of mathematical probability or assumptions of certainty as guides to decision-making. And they both despised
the "the mean statistical view of life."14 In an essay written in 1938,
titled "My Early Beliefs," Keynes condemns as "flimsily based [and] disastrously mistaken" the assumption of classical economists that human
nature is reasonable.15 He alludes to "deeper and blinder passions" and
to the "insane and irrational springs of wickedness in most men." These
were hardly the views of a man who was passing the keys of the citadel
to the Philistines hammering at the gates.

Knight may have been annoyed that Keynes had carried the distinction between risk and uncertainty much further than he himself had carried it. And he must surely have been angered when he discovered that
the sole reference Keynes made to him in The General Theory of Employment, Interest and Money was in a footnote that disparages one of his
papers on the interest rate as "precisely in the traditional, classical mould,"
though Keynes also conceded that the paper "contains many interesting
and profound observations on the nature of capital."16 Only this, after
Knight's pioneering explorations into risk and uncertainty fifteen years
before.

Keynes was from the opposite end of the intellectual and social
spectrum from Knight. He was born in 1883 to an affluent, wellknown British family, one of whose ancestors had landed with William
the Conqueror. As Robert Skidelsky, his most recent biographer,
describes him, Keynes was "not just a man of establishments, but part
of the elite of each establishment of which he was a member. There was
scarcely a time when he did not look down at England, and much of
the world, from a great height."17 Among Keynes's close friends were
prime ministers, financiers, philosophers Bertrand Russell and Ludwig
Wittgenstein, and artists and writers such as Lytton Strachey, Roger
Fry, Duncan Grant, and Virginia Woolf.

Keynes was educated at Eton and Cambridge, where he studied
economics, mathematics, and philosophy under leading scholars. He
was a superb essayist, as he demonstrated in presenting his controversial
ideas and proposals.

Keynes's professional career began with an extended stint at the
Treasury, including service in India and intense involvement in
Treasury activities during the First World War. He then participated as
chief Treasury representative at the Versailles peace negotiations after
the war. Finding the treaty so vindictive that he was convinced it
would lead to economic turmoil and political instability, he resigned his
post to write a book titled The Economic Consequences of the Peace. The
book soon became a best seller and established Keynes's international
reputation.

Keynes subsequently returned to his beloved King's College at
Cambridge to teach, write, and serve as the college's bursar and
investment officer, all this while serving as chairman-and investment manager-of a major insurance company. He was an active
player in the stock market, where his own fortunes fluctuated wildly.
(Like many of his most famous contemporaries, he failed to predict the
Great Crash of 1929). He also enriched King College's wealth by risktaking on the Exchange. By 1936, Keynes had built a personal fortune
from a modest inheritance into the equivalent of £10,000,000 in today's
money.18 He designed Britain's war financing during the Second World
War, negotiated a large loan by the United States to Britain immediately
after the war, and wrote much of the Bretton Woods agreements that
established the postwar international monetary system.

Ideas came to Keynes in such a rush and in such volume that he
often found himself at odds with something he had said or written earlier. That did not disturb him. "When somebody persuades me that I
am wrong," he wrote, "I change my mind. What do you do?"19