Question: States can protect against market crises through producing laws and regulations that move situations of economic uncertainty towards situations of risk. Critically discuss this claim with reference to ONE case study of your own choosing.

 

 

Plan:

 

1. Read very widely and try to understand the issue at hand
   1. Understand the difference between risk and uncertainty
   2. Market crisis as well and how they are related to risk

 

1. 1. Understand how likely/possible is to transition from uncertainty to risk
      1. Find friction/disagreement in the literature on this
      2. Come up with original thoughts only after reading the literature
   2. Asymmetric information (leading to uncertainty)
      1. Akerlof shows that markets can collapse in the presence of asymmetric info
   3. Mistakenly thinking that uncertainty has been transformed into risk might lead to heavy relying on formal model with catastrophic outcomes (e.g. financial crisis)
      1. Flandreau, 2012
   4. Using the normal model as opposed to a “fat-tail” model
   5. Unknown unknown — we will never get rid of uncertainty
   6. Quantification of risk relies on the normal operation of markets, during a crisis by almost definition we have an unexpected shock which will inevitably distort our models of risk. Uncertainty, will also be part
   7. AI’s prospect in possibly reducing the level of uncertainty by quantifying some of the risk
   8. Quantification of risk will continue as people like quick ways to make decisions?
   9. Warren Buffett: things that we think we know (but in reality we don’t) can get us in real trouble
   10. Coordination problems: multiple equilibria, convention helping pick the equilibria?
   11. Following the terrorist attacks in London, bridges were secured. What is the right thing to do? Yes. Will it prevent the future attacks? Probably not. Uncertainty will always be there.
   12. The interlinked between market crises across different countries.
2. The case of lotteries and gambling even though uncertainty has been fully converted into risk, such ventures are always taxing the poor!
3. Define terms
4. Find relevant sources:
   1. Risk, uncertainty and Government – Pat O’Malley
   2. From uncertainty towards Risk: The case of credit rating 
   3. Uncertainty, Risk and Trust: Russian and American Credit card markets compared.
   4. 3 major financial crises: What have we learned?
   5. Uncertainty, Risk and the Financial Crisis
   6. Nicholas Bloom on uncertainty
   7. https://www.futurelearn.com/info/courses/complexity-and-uncertainty/0/steps/1824#:~:text=The%20concept%20of%20(fundamental)%20uncertainty,)%20and%20Knight%20(1921).&text=In%20case%20of%20risk%20all,actually%20materialise%20are%20unknown%20beforehand

 

To Do:

 

Based on the previous points,

• continue the below essay including the answers and filling it with the information mentioned earlier and the points in the essay
• Use the literature provided but the main one is the credit case study from From uncertainty towards Risk: The case of credit rating. Then you could use the Risk, uncertainty and government. continue using the remaing literature
• use as much reference from the literature provided and make sure to cover the points above and, in the essay,
• Do not change what’s already written in the below part, just add to it and make it coherent and sharp, so it flows (e.g. introduction, main body and conclusion) including all points mentioned.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Introduction

 

 

Uncertainty has been defined as not knowing the probabilities of outcomes or even not knowing outcomes all together. Risk is defined as clearly defined probabilities of bad and good outcomes. In this paper we will present these terms and their connections, look at ways governments have previously transformed uncertainties into risk and critically evaluate the scope of laws and regulations towards protecting against market crisis. We show that while laws and regulations have had a useful role in converting uncertainty to risk, no such regulations can fully protect us from market crisis. We will analyze this using the case study of credit ratings and how such ratings were useful to concern uncertainty into risk but also how limited they were, especially during the financial crisis.

 

→ in this paragraph I would give a simple explanation to what risk and uncertainty is and quote Keynes and Knight with page number!

 

→ Black swan events by Niccolas Taleb with the 3 possible description of risk

 

To give an example imagine that you invest £100 on a stock and you know for sure that there is a 50% probability your investment will increase by 20% and 50% probability it would decrease by 10%. In this situation we would say that this investment is risky (in the sense that capital loss is possible) however this investment is not uncertain. However, most investments in the stock market carry a lot of uncertainty. The investors simply can not rationally come up with all possible outcomes of the stock’s performance and their respective probabilities. Such investors will have to rely on subjective probability assignments to subjective outcomes. In short one can think of this as the confidence in the market. (find some references) In this particular situation there is a level of uncertainty that can not be removed. This will always be the case in most economic transactions. (quote article from university of Groninger — see above in sources) However, is there a role for the government to intervene and reduce uncertainty? The answer is yes. For example, in the stock market many regulations and laws (give examples) have reduced the informational asymmetries between investors and insiders of a company. However, profits exist because there is uncertainty (quote keynes on this)

 

I think that we could classify uncertainty due to two possible reasons. One is uncertainty about the future (unknown unknown, recently popularized by Niccolas Taleb) and a second category might be uncertainty about past events that have been realized but the decision maker does not have any data for. The best example to illustrate this might be the case of a borrow-lender situation. When someone borrows from a lender, the lender faces both risk and uncertainty. The outcomes that the lender is able to quantity would be classified under risk (e.g. a lender might have a very good measure of the probability that the borrower will die before the loan is paid back). In addition, the lender will also face uncertainties. We distinguish between two kinds of uncertainties. The first uncertainty would have to do with how circumstances of the borrower might change in the future that can’t be quantifiable (i.e. “black swan” events). I believe that such uncertainties, by their very nature, can not be transformed into risks. However, the second form of uncertainty (“asymmetric info uncertainty”) would have to do with uncertainty due to past events a decision maker doesn’t have data or has inability to efficiently process such data in due time (e.g. past behaviour of the borrower). I believe the government has the possibility to influence and transform this type of uncertainty to risk.

 

A section showing how asymmetric information can lead to shut down of markets. (ref: Akerlof)

 

The case study to show the above is the credit rating establishment. —> Give a summary of the credit rating emergence and summarize the main paper (from uncertainty towards risk) .

 

 

A section on the limitation of such quantifications (summarize the paper on uncertainty,risk and financial crisis):

• False sense of risk when uncertainty is still present
• Heavy reliant on formal models of risk (think financial crisis)
• The case of credit ratings during the financial crisis
  • The dependence of rating companies on the issuers of debt

 

Conclusion.

 

 

APA

 

 

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