All Cambridge (U.K.) undergrads have (had?) to struggle through a chapter by chapter reading of Keynes’ General Theory of Employment, Interest and Money. Some come out of this confirmed Keynesians and even Marxists and then go on to work in the City of London. This rich irony comes at the cost of some confusion for hordes of the intellectual elite as the book is extremely hard to read. It turns out that Keynes offered a lucid synopsis of his theory in the QJE in a reply to his critics. My only quibble is that I wish he had used the odd equation here or there – he speaks in equations but does not dare spell them out presumably for fear of losing his reader. But here is a spectacular passage on uncertainty vs risk:
Why does it matter? Because it affects demand for money and hence the interest rate:
The whole article is full of amazing insights. i’s are not dotted or t’s crossed. Many papers remain to be written.
(Hat Tip: Nabil Al-Najjar)
Cheap Talk 
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October 26, 2011 at 11:21 am
Donald A. Coffin
Keynes as precursos to rational expectations? I give you this, fromt he QJE article, p. 214:
“How do we manage in such circumstances to behave in a manner which saver our faces as rational, economic men?…(2) We assume that the existing state of opinion as expressed in the prices and character of existing output is based on a correct summing up of future prospects, so that we can accept it as such unless and until something newand relevant comes into the picture.”
Keynes’s point, though, was that this was a dodge to deal with the radical uncertainty he believed truly governed our knowledge of the (distant) future.
October 26, 2011 at 11:46 am
Kelvin
I wish I knew more Bayesian statistics because I get a sense that the inability to assign probabilities to those events are a frequentist restriction, but maybe there’s still something in the Bayesian realm that can separate “risk” and “uncertainty” in a similar way.
October 26, 2011 at 3:10 pm
afinetheorem
Keynes is absolutely not a frequentist – he believes in something of a third school which is spelled out in his (earlier) book on probability. And of course the critical nature of the distinction between risk and uncertainty above is not original to Keynes – there is a reason we call it “Knightian Uncertainty” after his colleague.
I’m curious what Keynes would think of something like action on global warming. He’s dogmatic in the General Theory when discussing government’s inability to plan for the long-range future. You actually see a lot of influence from the Austrians on these points.
October 26, 2011 at 3:36 pm
Sandeep Baliga
Yes, Knightian uncertainty or now Ellsberg Ambiguity are formalizations of uncertainty as a pose to risk. But Knight was at Chicago and Keynes at Cambridge U.K. They weren’t colleagues?!
October 27, 2011 at 8:24 am
Déjà vu all over again « occasional links & commentary
[…] Sandeep Baliga rediscovers Keynes’s distinction between risk and uncertainty. […]
October 31, 2011 at 7:47 pm
k
incomplete contracts!
November 9, 2011 at 5:26 pm
Saracgil
The day after I read this post about how Keynes thinks of money holding as a measure of the degree of our disquietude, a clearing house raises deposit demands for trading Italy-related securities and among several news and analysis reported on Bloomberg today, one of them particularly caught my eye (sadly they updated the news several times and I can’t figure out which link I should post here). When asked to comment on why clearing house wants to hold more cash to do anything with Italian security, an hedge fund manager explains: well it is not that simply the volatility increased, right now with this political gridlock in Italy “we simply do not know” what is going to happen. The quotation marks added to emphasize the exact statement that appears in Keynes’ text.