Academic journal article The Quarterly Journal of Austrian Economics

On Conceptualizing Risk: Breaking the Dichotomy between Knightian Risk and Uncertainty

Academic journal article The Quarterly Journal of Austrian Economics

On Conceptualizing Risk: Breaking the Dichotomy between Knightian Risk and Uncertainty

Article excerpt

It is high time, however, that we take our ignorance more seriously.

(Friedrich A. Hayek, 1967)

1. INTRODUCTION

This paper characterizes and discusses different concepts of risk and seeks to define a proper meaning of the term in the realm of economics and finance. The purpose is not only to simply deepen our conceptual knowledge, but to, and this is particularly relevant to Austrianism, identify and examine the potential of going beyond the mere and rigid dichotomy of risk vs. uncertainty which Knight and Ludwig von Mises rely on. This is achieved by exploring if and how far systematization can be deemed possible in the non-probabilistic realm of uncertainty. Even though at the end we will also differentiate between Knightian risk and uncertainty (so to speak), it is important to note that we only endorse a single concept of risk which is different from Knightian risk and which will be baptized Risk I (section 5). We introduce Risk I in a deductive manner by postulating four requirements that a risk notion should meet (section 4). Prior to that, we review the literature (section 2) and turn the spotlight to Knight's and Mises' angle on risk (section 3). We close this paper in section 6 and 7 where we detail lessons from the taxonomy of risk we are proposing for Austrianism.

The absence of an accepted and appropriate definition of risk in the literature is not simply an abstract academic ivory tower issue. For example, risks in and to economic and financial systems are regarded as triggers of global financial crises (Schwarcz, 2008, pp. 193-249; Kelly, 1995, pp. 221ff.). Having lucid definitions is a fundamental requirement for management and modeling (Fouque and Langsam, 2013, p. xxviii). Without a well-thought notion of (financial) risk and approaches for measuring and managing the amount and nature of the risks, it would be difficult to effectively target indispensable (e.g., mitigating) action without running the real risk of doing more harm than good.

2. THE NOTION OF RISK IN THE LITERATURE

In non-technical contexts and contexts of common parlance, the word "risk" refers, often rather vaguely, to situations in which it is possible but not certain that some undesirable event will occur (Hansson, 2011; Heinemann, 2014). (1) More precisely, the philosopher Sven O. Hansson distinguishes five particularly important and more specialized uses and meanings of the term, which are widely used across academic disciplines and/or in everyday language (Hansson, 2011).

(1) risk = an unwanted event which may or may not occur.

An example of this usage is: "The risk of a financial collapse is vast."

(2) risk = the cause of an unwanted event which may or may not occur.

An example of this usage is: "Subprime lending is a major risk for the emergence of a housing bubble." Both (1) and (2) are qualitative senses of risk. The word also has quantitative meanings, of which the following is the oldest one:

(3) risk = the probability of an unwanted event which may or may not occur.

This usage is exemplified by the following statement: "The risk that a financial collapse will occur within the next five years is about 70%."

(4) risk = the statistical expectation value of an unwanted event which may or may not occur.

The expectation value of a possible negative event is the product of its probability and some measure of its severity It is common to use the total amount of monetary costs as a measure of the severity of a financial crash. With this measure of severity, the "risk" (in sense 4) laden with a potential financial collapse is equal to the statistically expected number of monetary costs; i.e., for example, 70% (building on the example from (3)) times USD 10T results in USD 7T of expected overall costs of a global financial crisis. Other measures of severity give rise to other measures of risk. (2)

(5) risk = the fact that a decision is made under conditions of known probabilities ("decision under risk" as opposed to "decision under uncertainty"). …

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