EconSouth (Second Quarter 2003)

CURRENT ISSUE

Risk and Uncertainty

t the conclusion of its March 18, 2003, meeting, the Federal Open Market Committee (FOMC) released an unusual statement.

Typically, after each periodic meeting, the FOMC issues a press release. This release announces the decision the committee has made on interest rates and gives a brief rationale for the policy stance — a paragraph or two regarding the balance of risks to the economy going forward. In its March statement, the committee wrote that it did not believe it could provide a useful risk characterization of the economy because of the amount of geopolitical uncertainty present at the time. In other words, the FOMC felt that the economic uncertainties overwhelmed any judgments about risks.

This announcement was made on the eve of the United States’ invasion of Iraq, which began on March 19.

Risk . . . uncertainty—what’s the difference?
Drawing a distinction between uncertainty and risk may seem odd. The terms may be used almost interchangeably in conversation — but not by economists. In his 1921 book, Risk, Uncertainty, and Profit, Frank Knight drew a significant economic distinction between the words.

Risk, according to Knight, stems from a random, but known, process. In other words, while any one particular outcome may be unknown, the chances of that outcome can be assigned. Uncertainty, on the other hand, exists when the probabilities of outcomes cannot be assigned. When uncertainty is sufficiently small, the probabilities of any one particular outcome — the risk — can be determined and compared quantitatively to the likelihood of other possible outcomes. Essentially, risk is measurable, but uncertainty is not.

It’s like insurance
Being able to quantify risk is the basis of insurance: We do not know who will be involved in an automobile accident today, but we do know some accidents will occur. We share the risk of accidents’ costs by joining a large pool of other drivers, paying premiums in accordance with relative risks. An adult pays a lower premium than a teenager because driving record data show a higher accident rate among the teenage population.

If a new form of transportation were developed, however, there would be no immediate way to price insurance premiums with the same degree of specificity as with autos. Insurance actuaries would have difficulty setting prices not because they don’t understand risk estimation but because, with little experience with the new form of transport, there would be tremendous uncertainty about the risks entailed.

This example of Knight’s distinction between insurable and uninsurable risk demonstrates the role information, or the lack of it, plays in uncertainty. We can insure autos because the probabilities of accidents are fairly certain. We can’t insure the new form of transport until the uncertainties are resolved.

Understanding the FOMC’s announcement
The FOMC knows that its decisions are closely scrutinized by millions, including financial analysts, business people and the media. The committee’s March 18 statement signaled that the FOMC members, without recent experience in considering monetary policy on the eve of military conflict, felt that they couldn’t predict with a great amount of certainty all the possible outcomes that might arise from geopolitical uncertainty.

With the war’s outcome decided, other uncertainties about a number of issues still lie ahead. Besides the incident in Saudi Arabia in May, will there be another large-scale terrorist attack on U.S. interests? What might be the economic implications of a possible spread of the SARS outbreak?

The answers to these questions are unknown, with some possible outcomes more easily quantifiable than others. What does this uncertainty hold for gauging the risks to the U.S. economy? That question is one that the FOMC members must continually grapple with.

By Thomas J. Cunningham, vice president and associate director of research
at the Federal Reserve Bank of Atlanta