The Economics of Radical Uncertainty

How do human beings truly react when confronted with conditions of genuine “unknown unknowns”? According to Frank Knight, “Uncertainty must be taken in a sense radically distinct from the familiar notion of risk, from which it has never been properly separated…The essential fact is that ‘risk’ means in some cases a quantity suscep- tible of measurement, while at other times it is something distinctly not of this character; and there are far-reaching and crucial differences in the bearings of the phenomena depending on which of the two is really present and oper- ating…It will appear that a measurable uncertainty, or ‘risk’ proper, as we shall use the term, is so far different from an unmeasurable one that it is not in effect an uncertainty at all.”

The economics literature from Knight onward is very good at laying out the propensity of markets to greatly overshoot and undershoot the fundamentals. However, economics does not adequately address the implications of “Knightean” uncertainty, because the discipline finds it hard to model this phenomenon. To get a full measure of this, one has to enter into the realm of psychology and neuroscience. That’s where the definition lies. Radical uncertainty, like so much else, is too important to be left to the realm of economics alone.