There is a difference between risk and uncertainty and the market performance over the last year shows the impact when investors are faced with true uncertainty and not just higher risk.
The distinction between risk and uncertainty was first discussed by Frank Knight. Uncertainty exists when investors face events which are non-measurable. The probability of some events cannot be given a number because the event was never considered or has not been incorporated in the distribution of possibilities.
Knightian uncertainty has been popularized by Nassim Taleb with his concept of the "Black Swan". Because a black swan is not seen, does not mean it does not exits. Just because it has not been counted or observed does not mean the probability is zero. This uncertainty could be framed as a subjective probability versus what is countable or objectively knowable.
When investors face Knightian uncertainty, there will be a different market reaction than when faced with higher measurable risks. There will be a tendency to behave under the belief that a worst case market scenario is likely. That is, if there is greater potential for an unforeseen event, there will be a tendency to expect more downside. Of course, an unknowable event does not mean that the event will be bad. It is just that investors will act as if the event may have negative effects and behave accordingly.
If you do not know what will potentially happen in the market, the rational investor will guard their resources and hold onto liquidity. Given there will be a high demand for liquidity and the potential for a shortage of liquidity, there will be an increase in the selling of assets to raise funds. The flight to quality will naturally cause a further sell-off in risky assets. Some assets will not be liquid under this environment, so there will be a flight out of many normally liquid assets in an effort to increase overall liquidity. This will further exacerbate the liquidity problem as two-way trading flow is diminished. Everyone will want the most liquid assets at the same time. Similarly, there will be little reason for banks to lend under this uncertain environment as opposed to holding their liquidity in the form of excess reserves.
The policy responses during this type of event are twofold. First, there has to be a significant increase in liquidity to offset the flight to quality. The normal liquidity providers are moving to cash so the central bank has to take their place as the lender of last resort. The size of liquidity offered has to match what was previously provided from private sources. The Fed has flooded the market liquidity to offset the conservative behavior of banks.
The second policy response is to reduce the level of Knightian uncertainty. This cannot be controlled in private markets in the short run but can be reduced through offering clear policies of what government action could and will be taken. Send signals on what action will be taken before an event occurs. For example, describe what are the conditions for a Fed bail-out. The problem of allowing Lehman to go bankrupt after saving Bear Stearns created greater uncertainty. The offer of support to AIG while a positive move further created uncertainty on what bail-outs the government will undertake.
It is not clear what are the terms for a government bail-out. For example, it is uncertain whether there will be a bail-out of the auto companies. It is also unclear whether there will be Federal support of state governments. The uncharted waters of government intervention cause the flight to quality that central banks want to prevent.
If the second phase of the credit crisis began with the Lehman bankruptcy, then we are only 60 days into this new world. That is not much time to given investors a chance to reduce uncertainty. This is exacerbated by a recession that is looking worse each month and does not have an easy comparison with the past. Information flow which is relatively cheap may still be the most important policy move.
The distinction between risk and uncertainty was first discussed by Frank Knight. Uncertainty exists when investors face events which are non-measurable. The probability of some events cannot be given a number because the event was never considered or has not been incorporated in the distribution of possibilities.
Knightian uncertainty has been popularized by Nassim Taleb with his concept of the "Black Swan". Because a black swan is not seen, does not mean it does not exits. Just because it has not been counted or observed does not mean the probability is zero. This uncertainty could be framed as a subjective probability versus what is countable or objectively knowable.
When investors face Knightian uncertainty, there will be a different market reaction than when faced with higher measurable risks. There will be a tendency to behave under the belief that a worst case market scenario is likely. That is, if there is greater potential for an unforeseen event, there will be a tendency to expect more downside. Of course, an unknowable event does not mean that the event will be bad. It is just that investors will act as if the event may have negative effects and behave accordingly.
If you do not know what will potentially happen in the market, the rational investor will guard their resources and hold onto liquidity. Given there will be a high demand for liquidity and the potential for a shortage of liquidity, there will be an increase in the selling of assets to raise funds. The flight to quality will naturally cause a further sell-off in risky assets. Some assets will not be liquid under this environment, so there will be a flight out of many normally liquid assets in an effort to increase overall liquidity. This will further exacerbate the liquidity problem as two-way trading flow is diminished. Everyone will want the most liquid assets at the same time. Similarly, there will be little reason for banks to lend under this uncertain environment as opposed to holding their liquidity in the form of excess reserves.
The policy responses during this type of event are twofold. First, there has to be a significant increase in liquidity to offset the flight to quality. The normal liquidity providers are moving to cash so the central bank has to take their place as the lender of last resort. The size of liquidity offered has to match what was previously provided from private sources. The Fed has flooded the market liquidity to offset the conservative behavior of banks.
The second policy response is to reduce the level of Knightian uncertainty. This cannot be controlled in private markets in the short run but can be reduced through offering clear policies of what government action could and will be taken. Send signals on what action will be taken before an event occurs. For example, describe what are the conditions for a Fed bail-out. The problem of allowing Lehman to go bankrupt after saving Bear Stearns created greater uncertainty. The offer of support to AIG while a positive move further created uncertainty on what bail-outs the government will undertake.
It is not clear what are the terms for a government bail-out. For example, it is uncertain whether there will be a bail-out of the auto companies. It is also unclear whether there will be Federal support of state governments. The uncharted waters of government intervention cause the flight to quality that central banks want to prevent.
If the second phase of the credit crisis began with the Lehman bankruptcy, then we are only 60 days into this new world. That is not much time to given investors a chance to reduce uncertainty. This is exacerbated by a recession that is looking worse each month and does not have an easy comparison with the past. Information flow which is relatively cheap may still be the most important policy move.
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