By Ricardo Caballero and Arvind Krishnamurthy

Financial institutions specialise in handling risk but are not nearly as efficient in dealing with uncertainty.  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 behaviour 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.