In a recent column I distinguished between two very different ways in which individuals think about risk. Drawing on a contribution by John Kay, I noted that when confronted by complex alternatives many individuals resort to narratives rather than probability analysis. In effect, they view the choice as being characterized by radical uncertainty rather than as susceptible to subjective probability analysis. Put differently, they focus on beliefs rather than frequencies.
In a follow-up column (Financial Times, August 15, 2012) John Kay draws our attention to a famous debate on this very issue, during the 1920s, between internationally-acclaimed scholars. Arguing the case for radical uncertainty were Cambridge economist, John Maynard Keynes and Chicago economist, Frank Knight. Arguing the case for subjective probability were Cambridge philosopher, Frank Ramsay and Chicago statistician, Jimmie Savage.
In the judgment of a large majority of the intellectual community, Ramsay and Savage defeated Keynes and Knight in that debate and the probability approach has maintained academic primacy ever after. A principal reason behind the victory was Ramsay’s demonstration that anyone who failed to follow his precepts – anyone that is who did not act on the basis of a subjective assessment of probabilities of future events – would be ‘Dutch-booked.’
A Dutch book is a set of choices such that a seemingly attractive selection from it is certain to lose money for the person who makes the selection.
John Kay used to advise his students when they queried the premise of rational behavior in financial markets – where rational means are based on Bayesian subjective probabilities – that individuals had to behave in this way because, if they failed so to do, other individuals would devise schemes that would make money at their expense. He now views this judgment from a different perspective based on recent experience:
“I now believe that observation is correct but does not have the implication I sought. People do not behave in line with this (probability) theory, with the result that others in financial markets do devise schemes that make money at their expense. In fact, that is what a depressing proportion of financial market activity is about. The largest and most famous Dutch book would be the collection of ingenious structured products RBS (Royal Bank of Scotland) acquired when it bought the Amsterdam-based bank ABN Amro. We know what followed.” John Kay, ‘The other multiplier effect, or Keynes’ view of probability’, Financial Times, August 15, 2012
Oh, the irony of John Kay’s example! U.S. experience in the run up to September 2008 may not have included any real-world Dutch examples. But the radical uncertainty story-tellers who ran The Bank of America, Citigroup, Wells Fargo, and Morgan Stanley were completely Dutch-booked by the followers of Frank Ramsay and Jimmie Savage at Fannie Mae and Freddie Mac who set them up via a system of securitized mortgage bonds designed to take them directly to the cleaners. The story-telling CEO of Bank of America was double Dutch-booked when he additionally acquired Countrywide Financial in the worst single financial deal so far in the twenty-first century.
Only Jamie Dimon at JP Morgan Chase had the Bayesian smarts to anticipate what was afoot, and thereby to save his shareholders from the wealth losses so temptingly offered by two massively corrupt, wealth-reducing government-enterprises.