Risk and uncertainty

Reading John Lanchester’s Whoops! about the crash of 2007  I came across a passage where he makes the distinction between risk (something that can be quantified, it is fondly imagined, and popped into a calculation of probabilities) and uncertainty; “the more profound unknowablilities of life and history”.

You can manage risk, in the sense that you can calculate probabilities and allow for them, but you can’t really manage uncertainty, not in that precise calculable way.  Confuse risk with uncertainty, and you have made a tank-trap for yourself (p42 paperback edition).

One important observation here is that, in principle, risk, because it can have a probability associated with it,  can be insured against even if the premium is more than you wish to pay, for instance young male recently qualified drivers and hot hatches. The problem arises when the risk is in reality an uncertainty and the probability calculation and the premium based on it are meaningless. Consider Credit Default Swaps (CDS). These are insurances against defaulting debtors, for instance a package of mortgage debts sold as an investment, often a complex mixture of high grade and sub-prime. These investment products can have default risks calculated and rated by Rating Agencies that act as a guide to what are safe investments and the likelihood of default. AAA is good, for instance: “An obligor has EXTREMELY STRONG capacity to meet its financial commitments”. How they calculate default probabilities and assign a rating is rather a dark art and, in practice, it looks as if they don’t really bother over much. However, investors in these packaged products assume that the ratings are arrived at on the basis of risk assessment and the willingness of others to issue insurances on them, at a premium, is also based upon risk assessment. In the case of AAA rated investment products based on mortgage debts (or even investment products that included CDSs!) the calculation of risks was blown out of the water by the consequences of uncertainties.

So, what if the calculation of risk is only achieved by ignoring uncertainties that cannot be quantified (especially if they are unknown in the Rumsfeldian sense of unknown unknowns)? Excluding unavoidable uncertaintie (in the real world at least)  does not exclude uncertainty from their calculation of risk; it merely disguises and misnames it. Risk is incalculable uncertainty constructed and named ‘risk’ on the basis of a theory that ignores the reality of uncertainty. This has led to things happening in the real world that economics theory says are impossible. And plenty of others it cannot explain.  Economic theory, demonstrably, does not solve the problem of uncertainty by defining aspects of it, theoretically, as risk in order to quantify it and factor it into their equations.

Of course, the study of non quantifiable uncertainties is pretty well what sociology is all about. And there are ways of dealing with it strategically. But not by constructing mathematised utopias of unisolatable aspects of complex social processes.

There is reference to the role of uncertainty and economics in an earlier post that has some relevant content to this issue: http://terrywassall.org/2010/11/16/what-is-sociology-worth/

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