Many pundits and policymakers think that asset prices have deviated from “fundamental values” and that this deviation is part of the problem affecting financial institutions. For example, if mortgage and credit assets, which banks hold in plenty, are currently priced below “fundamental values,” then banks will be assessed larger losses than they otherwise would. This in turn can lead to concerns of banks defaulting, etc. In other words, the dysfunctionality of asset markets is part of the problem in the current financial crisis.
Financial institutions specialize in handling risk but are not nearly as efficient in dealing with uncertainty1. To paraphrase a recent secretary of defense, risk refers to situations where the unknowns are known, while uncertainty refers to situations where the unknowns are unknown. This distinction is not only linguistically interesting, but also has significant implications for economic behavior and policy prescriptions. There is extensive experimental evidence that economic agents faced with (Knightian) uncertainty become overly concerned with extreme, even if highly unlikely, negative events. Unfortunately, the very fact that investors behave in this manner, makes the dreaded scenarios all the more likely. This mechanism has played an important role in the financial crisis.