The difference between risk and uncertainty

Football can help explain the difference between risk and uncertainty.

Economist Frank Knight famously differentiated between risk and uncertainty:

Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which it has never been properly separated.... The essential fact is that 'risk' means in some cases a quantity susceptible of measurement, while at other times it is something distinctly not of this character; and there are far-reaching and crucial differences in the bearings of the phenomena depending on which of the two is really present and operating.... It will appear that a measurable uncertainty, or 'risk' proper, as we shall use the term, is so far different from an unmeasurable one that it is not in effect an uncertainty at all.

OK, so not the clearest explanation. This may help. To think about the difference consider a football game. The rules of the game are understood, so players make judgements about what is likely or not likely to work and expected pay-offs. Kick the ball to player A who is alone but not well placed or player B who is well-placed but have opposing players nearby: a risk/payoff judgement. Businesses make judgements about risks and payoffs all the time, they are a normal part of business (indeed, central to commercial activity).

If the rules of the game themselves are unclear then you have uncertainty. If you put two teams of players on a field and you tell them “you are going to play a new game, which we are not telling you what the rules are, but we will penalise people randomly with highly variable severity” not much that is useful will happen. It is the same in commerce. Risk affects commerce, serious uncertainty flattens it: particularly long-term activity such as investment.

What we have now is massive uncertainty. So, far, neither the Bush nor Obama Administrations have done much to alleviate that. Indeed, arguably Obama in particular is in the process of making it worse, given the breadth of his proposed policy changes (including massive expansion in public debt). So far, he is not doing as well as FDR did in his first 100 days. While some are arguing it is deliberate, my analytical preference is always to go for screw-up before conspiracy. A clever man in the grip of unhelpful ideas is worse than a less clever man with more helpful ones. The US elected a President with limited experience, both in range and depth. This may be part of the cost.