Financial strategy: Knightians vs. Bayesians

Craig Torres from Bloomberg.com called me the other day to talk about Knightian uncertainty and Federal Reserve policymaking. He included some of my comments in his article.

The point of the article was that Fed Chair Ben Bernacke was taking a different line than former Chair Alan Greenspan. Greenspan tended to use changes in interest rates as a kind of insurance: cut rates when your instincts tell you that sharp market alterations may be on the horizon. Bernacke is more of a Bayesian: keep updating info for your models until your evaluation of the probability that something really bad is going to happen is high enough that you act. Greenspan's strategy would lead to quick cuts; Benacke's to delayed cuts.

Craig then quotes me on the Knightian origin of Greenspan's approach:

"Both [Bernacke's and Greenspan's] approaches have risks. Greenspan cited uncertainty as 'the defining characteristic' of the monetary policy landscape in an August 2003 speech. 'Only a limited number of risks can be quantified with any confidence,' he said.

"The speech was critical of models, and elevated the role of judgment. He invoked theories of Frank Knight, a University of Chicago economist from 1927 to 1955, to explain his ideas of risk management.

'Knight distinguished between risk and uncertainty: Risk is quantifiable, uncertainty is random. Managers 'would try to turn those uncertainties into knowable costs,' said Ross Emmett, a professor at James Madison College at Michigan State who has edited a collection of Knight's essays. 'They would purchase insurance.'"

My only quibble with Craig's comments about Greenspan's Knightian approach is that, for Knight, uncertainty is not random. In a random world, you can at least form a probability distribution of the possibilities. In an uncertain world, you cannot know what will happen, nor if it will be random or the result of a human action (Knight doesn't think the latter is ever "random"). You have to use judgment (Greenspan's point).

See Torres' entire article from September 13, 2007 here.

Frank Knight and the Chicago School

Peter Klein makes the following reference to my new paper on Knight and the Chicago School. My paper can be accessed at SSRN: Did the Chicago School Reject Frank Knight?

Frank Knight is generally regarded, along with Jacob Viner, as the founder of the Chicago school of economics. But Knight’s relationship to the later Chicago school of Friedman, Stigler, and Director is ambiguous. Knight’s theories of capital and competition were incorporated into the mainstream Chicago (and contemporary neoclassical) tradition but his account of profit and entrepreneurship, his quasi-Austrian methodology (inherited from his teacher Herbert J. Davenport), and his eclectic social and political theories were largely ignored or forgotten.

Ross Emmett has a new paper, “Did the Chicago School Reject Frank Knight? Assessing Frank Knight’s Place in the Chicago Economics Tradition,” exploring this in detail. The conclusion: “Without [Knight’s] initiation of eaching price theory and persistence in defending it, there ould be no Chicago tradition. Yet the methodological approach and research infrastructure which propelled the Chicago School to a central position in the economics profession owe little or nothing to him.”

(Incidentally, critics of economics often target a stylized version of Chicago economics circa 1970 (see here), but these critics often seem unaware that the Chicago school of economics no longer exists. While there is still a (top-notch) economics department at the University of Chicago, there is no longer a distinct Chicago approach. The economics taught at Chicago is the same as the economics taught at MIT, Harvard, Stanford, or any other top mainstream department.)

Thanks for reading my paper, Peter!

Spring Break 2007

Nothing special: just work as usual!

I'll spend the week writing a paper for a conference at Duke in April. The conference is entitled "Keeping Faith: Religious Belief and Political Economy" and is sponsored by the journal History of Political Economy, which is hosted at Duke University's Economics department. My paper is on Knight's seemingly strange, active religious affliation in the 1920s and its connection to his work on economics, ethics, religion and liberal democracy later in his life.

For students: yes, I'll also be grading papers. I also plan to write an editorial on Adam Smith's views on the "cool city" concept that circulates today. I will post that here when ready.