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April 5, 2016 4:05 pm

The enduring certainty of radical uncertainty

John Kay

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If you had described your iPhone in 1976, Friedman would not have
understood you

Bloomberg

Mervyn King

he excellent new book by Mervyn King, former governor of the Bank of England, is inevitably
noticed mainly for its views on banking regulation and the outlook for the eurozone. For me the
most important message of The End of Alchemy is its emphasis on radical uncertainty or, to quote
Donald Rumsfeld, former US defence secretary: The things we do not know we do not know.
That emphasis reflects the parallel intellectual paths Lord King and I have taken since we were
young dons 40 years ago. In a book published in 1976, economist Milton Friedman disparaged a
tradition that drew a sharp distinction between risk, as referring to events subject to a known or
knowable probability distribution, and uncertainty, as referring to events for which it was not
possible to specify numerical probabilities.

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The enduring certainty of radical uncertainty - FT.com

http://www.ft.com/intl/cms/s/0/ec5520c4-fb23-11e5-8f41-df5bd...

Friedman went on: I have not referred to this distinction because I do not believe it is valid. We may
treat people as if they assigned numerical probabilities to every conceivable event. Asked, Who will
win the war?, Churchill might have responded, Britain, with probability 0.7; and Hitler with a
similar answer but perhaps different number.
However absurd, this is what we were taught and what we passed on to the next generation of
students. It seemed an exciting time for young turks in finance; insider trading in an old-boy
network was to be superseded by a new generation of quants and rocket scientists. We had the
mathematical tools to revolutionise investment banking. Our theory came to underpin the risk
models used in financial institutions and imposed by regulators.
But Friedman was wrong. There really are limits to the range of problems susceptible to the
mathematics of classical statistics. He was, erroneously, rejecting the concept of radical uncertainty
described 50 years earlier by the economists John Maynard Keynes and Frank Knight.
By uncertain knowledge, wrote Keynes in 1921, I do not mean merely to distinguish what is known
for certain from what is only probable. The sense in which I am using the term is that in which the
prospect of a European war is uncertain...There is no scientific basis to form any calculable
probability whatever. We simply do not know.
While the long-term future of interest rates or copper prices, about which
Keynes also speculated, might be approached probabilistically, questions
about the social system 50 years hence are too open-ended, and the
outcomes too varied and insufficiently specific, to be described in
probabilistic terms.
A recent book on superforecasters, co-written by Philip Tetlock,
illustrates the point well. By trying to turn multi-faceted questions into
ones precise enough to enable those who proffer answers to be assessed
for their accuracy, he makes the questions narrow and uninteresting:
How will the Syrian war develop and How will Europe manage its
refugee crisis? become: How many Syrian refugees will land in Europe
in 2016?

There is a world of
difference between
low-probability events
drawn from the tail of a
known statistical
distribution and
extreme events that
happen but had not
previously been
imagined

More fundamentally there are things we do not know because we cannot imagine them. If you had
described your smartphone to Mr Friedman in 1976 he would not have understood what you were
talking about, far less been able to speculate intelligently on the probability that it would be invented
or bought. These are the black swans Nassim Taleb has described. The reader who once asked me
which black swans were most likely to materialise in the next five years could not have missed the
point more comprehensively.
There is a world of difference between low-probability events drawn from the tail of a known
statistical distribution and extreme events that happen but had not previously been imagined. And it
is usually the latter that give rise to crises and opportunities.
johnkay@johnkay.com
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06/04/16 08:11

The enduring certainty of radical uncertainty - FT.com

Don't panic (but do start to

worry a little)

http://www.ft.com/intl/cms/s/0/ec5520c4-fb23-11e5-8f41-df5bd...

US shuts door on tax

inversions

Sterling's burst of nerves

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