The Undervaluation of Uncertainty: A Defense of Capitalism

I just read this interesting piece by Phelps in the FT. Though it is certainly worth to read all of it here some lines:

Capitalism is not the “free market” or laisser faire [..] In essence, capitalist systems are a mechanism by which economies may generate growth in knowledge [..] Any modern economy, capitalist or state-run, is a great soup of private “know-how” dispersed among the specialised participants. No one, he said [referring to Hayek], not even a state agency, could amass all the knowledge that each participant “on the spot” inevitably acquires. The state would have no idea where to invest. Only capitalism solves this “knowledge problem”. [..] Well-functioning capitalist economies, with their high propensity to innovate, could arise only when serviceable institutions were in place. Now capitalism is in the midst of its second crisis [the firts being in the interwar period].

But why did big shareholders not move to stop over-leveraging before it reached dangerous levels? Why did legislators not demand regulatory intervention? The answer, I believe, is that they had no sense of the existing Knightian uncertainty. So they had no sense of the possibility of a huge break in housing prices and no sense of the fundamental inapplicability of the risk management models used in the banks. “Risk” came to mean volatility over some recent past. The volatility of the price as it vibrates around some path was considered but not the uncertainty of the path itself: the risk that it would shift down. The banks’ chief executives, too, had little grasp of uncertainty. Some had the instinct to buy insurance but did not see the uncertainty of the insurer’s solvency.

If we still have our humanist values we will try to restructure these sectors to make capitalism work well again – to guard better against reckless disregard of uncertainty in the financial sector while reviving innovativeness in business. We will not close the door on systems that gave growing numbers rewarding lives.