I was going to put a snarky comment up at Free Exchange in response to the post on economists being absolved by the sheer irrationality of recent market events, but didn't because I thought just maybe there was in fact evidence of an increase in Knightian uncertainty or "unknown unknowns."
The basic argument is this: The market is panicked and irrational. In the face of Knightian uncertainty, consumers and firms are refusing to take on profitable risky opportunities. This has led to a massive market failure.
I guess I'm just too much of a believer in markets to fall for this. It looks to me like we have an overleveraged economy that has experienced the shock that will force it to deleverage. This means that mean economic outlook for both consumers and producers is much worse than it was six months ago. In view of the poor economic outlook, firms are less willing to invest, while consumers are saving more and storing their savings in places where they're pretty sure the principal won't disappear. There's no need for uncertainty to generate either a bad outcome or, in the absence of aggressive policy, a downward spiral.
And then I realized that maybe there really is very little evidence of an increase in Knightian uncertainty. Remember Knightian uncertainty is the one we can't measure (i.e. it's not something as simple as the risk of default of an single firm), so it's pretty much an oxymoron to claim that we have demonstrable evidence of an increase in Knightian uncertainty.
The basic argument is this: The market is panicked and irrational. In the face of Knightian uncertainty, consumers and firms are refusing to take on profitable risky opportunities. This has led to a massive market failure.
I guess I'm just too much of a believer in markets to fall for this. It looks to me like we have an overleveraged economy that has experienced the shock that will force it to deleverage. This means that mean economic outlook for both consumers and producers is much worse than it was six months ago. In view of the poor economic outlook, firms are less willing to invest, while consumers are saving more and storing their savings in places where they're pretty sure the principal won't disappear. There's no need for uncertainty to generate either a bad outcome or, in the absence of aggressive policy, a downward spiral.
And then I realized that maybe there really is very little evidence of an increase in Knightian uncertainty. Remember Knightian uncertainty is the one we can't measure (i.e. it's not something as simple as the risk of default of an single firm), so it's pretty much an oxymoron to claim that we have demonstrable evidence of an increase in Knightian uncertainty.
Not only that but today I read Lloyd Blankfein in the FT: Since the spring, and most acutely this autumn, a global contagion of fear and panic has choked off the arteries of finance, compounding a broader deterioration in the global economy. Looks to me like the bankers are going to milk that uncertainty model for every penny they can get out of it.
So I think it's time to talk about some common measures of economic uncertainty that are used: the CDX-IG, or the market's measure of the likelihood that investment grade firms will default, and the VIX, or expected stock market volatility implied by the pricing of options. The basic problem with claiming an increase in these indices as evidence of an increase in Knightian uncertainty is that both of these are simple measures of risk -- they measure known unknowns, not unknown unknowns.
Thus the rise in the CDX-IG is just an indicator that expected corporate default rates have increased. This is a pretty new index, but it is surely perfectly predictable that in every recession the CDX-IG would go up. If it's a good measure of risk, it should probably start to go up before the recession starts and to go down before the recession ends, but cyclicality would simply reflect the normal operation of the economy.
Furthermore a simple review of the VIX formula will show that it's guaranteed to rise markedly when the stock market falls by half. Taking this increase as a sign of Knightian uncertainty is foolish.
Perhaps one would argue that the volatility of the CDX-IG has risen and this is a sign of an increase in Knightian uncertainty. However, the CDX-IG is a very thinly traded contract: According to the DTCC through all of the week ending January 23, there were less than 1700 position increases and 700 position decreases total in the four different vintages of the Markit CDX-IG that traded that week. (Trade in the Dow Jones CDX-IG is much smaller.) In the meanwhile on January 23 there were 16 market makers with on average just over 2,800 contracts selling protection each and on average just under 3,000 contracts buying protection each. In a market with this kind of structure, a large dealer that needs to -- or chooses to -- adjust its position is likely to have a "technical" effect on the market.
That prices would be volatile in thinly traded markets is not surprising. The real question that an increase in volatility raises is: What was going on in the two years preceding the outbreak of the crisis to repress the volatility of the CDX IG? My guess is that that financial innovation was steadily bringing new sellers of credit default protection into the market (such as school districts and Australian towns). As soon as the field of sellers stopped expanding -- and in fact shrank as schools and towns realized how much risk they were taking on -- the CDX-IG rose and its volatility returned to a normal level.
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