Risk, Uncertainty and the Financial Crisis

The concept of reflexivity (see blog on reflexivity and finance for explanation) has an important implication for theories about financial markets in general and also for the current financial crisis.

This implication is that markets exist in historical time where events and situations are to some extent unique and not simply part of some timeless economic machine in which financial outcomes (e.g. the probability distribution of returns in markets) are unchanging and fixed. So there exists not only risk (the range of probabilities of outcomes indicated by past events) but also genuine uncertainty (the impossibility of knowing what the future holds even in a probabilistic sense). This is important for the formation and testing of economic/finance theories because it means:

1. The expectations and actions of markets must be conceived to rely on something other than the accurate calculation of probabilities about the future. e.g. social convention, personal experience, expert opinion.

2. That theories about economics and finance may be more relevant for some segments of historical time than others.

Uncertainty is important for practitioners in financial markets because players in these markets need to be aware that calculations of probabilities based on past history maybe radically inaccurate. Failure to understand this contributed to the proliferation of financial instruments that investment banks and other produced in the belief that the data on which their models of risk and return would remain stable over time. As taught by standard approaches to finance. Sadly practitioners did not recognise uncertainty and as the the dynamics of the economic situation turned their calculations proved to be disastrously inaccurate and lead to the technical insolvency of much of the global finance system. This episode will surely go down in history as one of the most disastrous misconceptions of the last fifty years. The ironic thing is that this mistake was made by thousands of the most intelligent people on the planet. Such are the dangers of building an edifice of knowledge on an inaccurate assumption and then leveraging your bets.