Chapter 4: Frank Knight on Risk and Uncertainty

This chapter begins with the whistleblowers of the 2008 financial crisis, who were ignored by policy makers and bankers alike. This is explained by two phenomena: regulatory capture and the dominance of the Efficient Market Hypothesis theory of finance, which ignores systematic risk, fat tails and uncertainty. The economist who introduced the important difference between risk and uncertainty was Frank Knight. His insight helps to explain the large effects of uncertainty in the economy—from financial crises to climate change. Risk can be insured, uncertainty not. The last can only be reduced by stability-enhancing institutions. The period 1933–1999 illustrates the benefits of such an institution in the US, when the Glass–Steagall Act was in place: it ensured a separation between retail banks and investment banks, which resulted in 66 years without a financial crisis.