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.
Based on the previous points,
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):