Against the Gods: The Remarkable Story of Risk (42 page)

rancis Galton died in 1911 and Henri Poincare died the following year. Their passing marked the end of the grand age of mea an era that reached back five centuries to Paccioli's
game of balla. For it was his problem of the points (page 43) that had
launched the long march to defining the future in terms of the laws of
probability. None of the great mathematicians and philosophers of the
past whom we have met so far doubted that they had the tools they
needed to determine what the future held. It was only the facts that
demanded attention. surement,

I do not mean to imply that Galton and Poincare finished the task:
the principles of risk management are still evolving. But their deaths
occurred-and their understanding of risk climaxed-on the eve of
one of the great watersheds of history, the First World War.

The optimism of the Victorians was snuffed out by the senseless
destruction of human life on the battlefields, the uneasy peace that followed, and the goblins let loose by the Russian revolution. Never again
would people accept Robert Browning's assurance that "God's in his
heaven:/All's right with the world." Never again would economists insist
that fluctuations in the economy were a theoretical impossibility. Never
again would science appear so unreservedly benign, nor would religion
and family institutions be so unthinkingly accepted in the western world.

World War I put an end to all that. Radical transformations in art,
literature, and music produced abstract and often shocking forms that
stood in disturbing contrast to the comfortable modes of the nineteenth
century. When Albert Einstein demonstrated that an imperfection
lurked below the surface of Euclidean geometry, and when Sigmund
Freud declared that irrationality is the natural condition of humanity,
both men became celebrities overnight.

Up to this point, the classical economists had defined economics as
a riskless system that always produced optimal results. Stability, they
promised, was guaranteed. If people decided to save more and spend
less, the interest rate would fall, thereby encouraging investment or
discouraging saving enough to bring matters back into balance. If business managers decided to expand their firms rapidly but households
failed to save enough for them to borrow what they needed for expansion, the interest rate would rise to set matters right. Such an economy
would never suffer involuntary unemployment or disappointing profits, except perhaps during brief periods of adjustment. Although individual firms and investors took risks, the economy as a whole was
risk-free.

Such convictions died hard, even in the face of the economic problems that emerged in the wake of the war. But a few voices were raised
proclaiming that the world was no longer what once it had seemed.
Writing in 1921, the University of Chicago economist Frank Knight
uttered strange words for a man of his profession: "There is much question as to how far the world is intelligible at all.... It is only in the very
special and crucial cases that anything like a mathematical study can be
made."' During the depths of the Great Depression, John Maynard
Keynes echoed Knight's pessimism:

We are faced at every turn with the problems of Organic Unity, of
Discreteness, of Discontinuity-the whole is not equal to the sum of
the parts, comparisons of quantity fail us, small changes produce large
effects, and the assumptions of a uniform and homogeneous continuum are not satisfied.'

In 1936, in his masterwork, The General Theory of Employment, Interest
and Money, Keynes flatly rejected Devon's faith in the universal applicability of measurement: "[Most of our decisions] to do something posi tive ... can only be taken as a result of animal spirits ... and not as the
outcome of a weighted average of quantitative benefits multiplied by
quantitative probabilities. "3

Faced with the tensions of the postwar years, only the most naive
theorist could pretend that all problems could be solved through the
rational application of differential calculus and the laws of probability
with well-ordered preferences. Mathematicians and philosophers had to
admit that reality encompassed entire sets of circumstances that people
had never contemplated before. The distribution of odds no longer followed the distribution Pascal had defined. It violated the symmetry of
the bell curve and was regressing to means that were far more unstable
than what Galton had specified.

Researchers sought for ways of conducting a systematic analysis of
the unexpected. Before the war they had concentrated on the inputs that
went into decision-making. Now they recognized that the decision is
only the beginning. The devil is in the consequences of our decisions,
not in the decisions themselves. As Robert Dixon, an Australian economist, has remarked, "Uncertainty is present in the decision-making
process, not so much because there is a future as that there is, and will be,
a past.... We are prisoners of the future because we will be ensnared by
our past."4 That ultimate realist, Omar Khayyam, had had the same
thought nearly a thousand years before:

What do you do when a decision leads to a result that was not even
contemplated in your set of probabilities? Or when low-probability
outcomes seem to occur more frequently than they should? Don't the
patterns of the past always reveal the path to the future?

Knight and Keynes, the first two to confront such questions in a
serious fashion, were both noisy nonconformists, but, together, they
defined risk as it has come to be understood today.

Frank Knight was born on a farm in White Oak Township, Illinois,
in 1885, the oldest of eleven children.' Though he lacked a high-school
diploma, he attended two tiny colleges, perhaps the best he could afford
in view of his family's poverty. The first was American University
(which had no connection to the university with the same name in
Washington, D.C.); this college emphasized temperance above all else
and even taught "the principles of political economy in regard to the
use of intoxicating liquors." In its national advertising it urged "parents
to send their hard-to-handle boys to American University for disciplining." The second college was Milligan. On Knight's graduation,
the president of the college described him as "the best student I have
had ... best read student ... [with] practical business capacity as well as
technical knowledge."

Knight claimed that the reason he became an economist was that
plowing was too hard on his feet. Before turning to economics he did
graduate work in philosophy at Cornell; he switched to economics after
a professor declared, "Stop talking so much, or leave the philosophy
department!" But it was not just the overuse of his high, squeaky voice
that got him into trouble; one of his philosophy professors predicted,
"He will destroy the true philosophic spirit wherever he touches it."
Knight was an incurable cynic about human nature. A more sympathetic
professor once told him, "You came out of a malodorous environment
where every man with a mind doubts everything."

Knight began teaching economics at the University of Iowa in
1919 and moved to the University of Chicago in 1928. He was still
teaching there when he died in 1972 at the age of 87; "It beats working for a living," he once remarked. His lectures were often ill prepared, delivered in a rambling, country-boy manner, and larded with
heavy-handed humor.

Despite his early exposure to religion and his continuing study of
religion throughout his life, Knight was an implacable enemy of everything to do with organized forms of religion. In his presidential address
to the American Economic Association in 1950, he likened the pope to
Hitler and Stalin. He once said that religion was responsible for his bad
sleeping habits: "It's that damned religion. I just can't get it out of my
mind."

An irascible, dedicated, honest man, he took a dim view of people
who took themselves too seriously. He claimed that economic theory was not at all obscure or complicated, but that most people had a vested
interest in refusing to recognize what was "insultingly obvious." Noting
a quotation by Lord Kelvin chiseled in stone on the social science building at Chicago-"[W]hen you cannot measure it ... your knowledge
is of a meager and unsatisfactory kind"-Knight sarcastically interpreted
it to mean, "Oh, well, if you cannot measure, measure anyhow."6

Knight's cynicism and concern for moral values made it hard for
him to come to terms with the selfishness, and frequently the violence,
of capitalism. He despised the self-interest that motivates both buyers
and sellers in the marketplace, even though he believed that only selfinterest explains how the system works. Yet he stuck with capitalism,
because he considered the alternatives unacceptable.

Knight had no interest in working up empirical proofs of his theories. He harbored too many doubts about the rationality and consistency
of human beings to believe that measuring their behavior would produce anything of value. His bitterest sarcasm was reserved for what he
saw as "the near pre-emption of [economics] by people who take a
point of view which seems to me untenable, and in fact shallow, namely
the transfer into the human sciences of the concepts and products of the
sciences of nature."