The first in a three-part series of CFA Institute articles explores “how we came to forget how to live with real uncertainty, the “profound consequences this has had on finance and what the right way to deal with true radical uncertainty might look like.”
The article cites a new book on the topic, Radical Uncertainty, by economist John Kay and former Bank of England governor Mervyn King, that describes how modern society has “succumbed to the illusion that uncertainty can be transformed into calculable risks.”
The article explains that the ancient Greeks, while gifted mathematicians, never studied probability theory because they believed “the course of events was determined by the gods,” and mathematics was “no help there.”
It wasn’t until the age of Enlightenment that probability theory was contemplated. In the 1650s, French mathematician Blaise Pascal attempted to dabble in the calculus of probability after gambler Antoine Gombaud questioned him about probability in gaming.
The next “truly transformative advance” reportedly came in 1921 when University of Chicago economist Frank Knight introduced the concept of radical uncertainty—a level far removed from “real” uncertainty. This concept was echoed by John Maynard Keynes, who believed that calculating possible results at the roulette table, for example, could not be applied to, say, broader issues like predictions of war or changes in the price of commodities.
Then came British mathematician Frank Ramsey and Italian mathematician Bruno de Finetti, who suggested that “subjective probabilities” could be calculated based on our knowledge of facts and relationships. But authors Kay and King refute this, saying such a notion assumes that all potential future situations are knowable, which of course they are not.
“In economic discourse,” the article concludes, “the scholarship of Ramsey and de Finetti prevailed over that Knight and Keynes, and the concept of radical uncertainty retreated to the margins,” adding, “how this led to the impasse in modern finance is the subject of the next installment in this series.”