Friday, May 1, 2009

Uncertainty vs. Risk: How Policies (and Institutions) Affect Choice

Almost a month ago, I ran across this interesting post on the RealClearMarkets blog.

While the post was a plea for policy-makers to quit tinkering and let the market get on with the business of sorting winners and losers and start to repair itself; there was another important takeaway.

The author did a good job explaining the difference between risk and uncertainty, and the role both have in our decision-making psychology. While each of us has varying tolerances for risk - some are comfortable with and will accept more, others prefer relative sure things and will accept less. This manifests itself in many of our choices - whether in our financial life or other aspects of our day-to-day activities.

However, most of us have trouble with uncertainty - not knowing what will happen next. With risk, we can assess probability and decide on a course of action - from a coin flip to a decision to change careers. But uncertainty is akin to putting on a blindfold and earplugs and walking in a random direction. Not too many of us would make that choice.

As I thought more and more about the post, I ran across a couple of other posts that clarified things further - both from the Becker-Posner blog.

Gary Becker's post addressed whether banks that received funds under the Troubled Asset Relief Program (TARP) - or in some cases were forced to take those funds - should be allowed to repay the funds. This repayment would, allegedly, remove them from certain government oversight and presumably reduce the public spotlight that comes with accepting public funds.

In the course of this discussion, the government expressed some reluctance about accepting early repayment. While the reason is similar to those given when funds were first distributed - if some banks return the funds, the weaker ones will be identified - there was a sense that another concern was a concern that the government might lose some leverage. All of this followed close on the heels of a scandal about bonus payments by certain financial firms that had accepted funds. When that happened, policy-makers had responded with threats and rules designed to "encourage" bonus recipients to return their payments.

I read Becker's post to infer that by forcing healthy banks to accept funds, and by refusing to accept repayment from those same banks, one could argue their uncertainty might actually be increased. Like changing tax laws to recover income from a select group of employees, this would change the institutions or rules under which we make choices. If we see rules changed for industries on an ad hoc basis, driven by public opinion or even justifiable outrage, we may fear that the rules that form our decision-making framework are less predictable. That removes risk in our decision-making and replaces it with uncertainty. That can result in a more conservative approach to many economic and financial choices.

Richard Posner's response would seem to reinforce this idea. In his concluding paragraph, he sees numerous benefits to repayment. He points to the desire of financial institutions to remove the spotlight from their operations.

One may easily argue that if policy-makers could manage to stop changing the formal institutional structure of the economy, we might see some benefits from increased borrowing, lending and risk-taking characteristic of a recovering economy.

As always, I look forward to your comments.

This post relates to the following Keystone Economic Principles:
3. All choices have consequences.
4. Economic systems influence choices.

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