By Daniele D’Alvia (School of Law, Birkbeck, University of London)
Brexit and Financial Markets
After the 23rd of June 2016 different opinions started to emerge whether Article 50 TEU[i] should be activated or not. Political and economic concerns in relation to the free movement of goods and services within the single market, and plans about the future of the UK have raised many questions but provided few answers. These issues have diverted attention from the fact that Brexit has triggered a crucial point in financial markets since the 23rd of June 2016, by undermining the confidence of investors and whetting the appetite of speculators. This circumstance cannot be negotiated, opted-out or exempted. Having just started, its final results are unpredictable because Brexit has manifested its effects not only in political terms. Indeed, Brexit has contributed to a new stage of thinking in European financial markets that has elevated uncertainty as the criterion characterising financial markets instead of risk.
Therefore, this short comment aims to introduce those concepts and allow the reader to understand how the immeasurable uncertainty could constitute a ground for potential negative effects, both in terms of lending facilities and investments. In other terms, today in the UK it is not only the monetary stability to be under attack in terms of goods and services or price of financial assets, but especially financial stability as a whole.
Risk and Uncertainty
I would like to introduce here the concept of the ‘past qualification’ of risk based on a possible re-interpretation of Professor Frank Knight’s book “Risk, Uncertainty and Profit”[ii], which has developed a philosophical argument on risk instead of a pure economic theory on profit. The book has always been recognised for its outstanding contribution towards a distinction between risk and uncertainty, namely between objective and subjective dimensions of risk towards a theorisation of insurable form of hazards and true uncertainties.
To completely understand the Knight’s theory of risk, it is important to briefly outline what has been always defined as a “remarkable story on risk”[iii]. Indeed, according to Bernstein risk management is a revolutionary idea where far from being an antagonist, as the mysterious fate or the voluntas dei, the future has become an opportunity. The concept of risk-taking has been developed in Western countries from Fibonacci’s Liber Abaci (1202), Cardano’s Liber de Ludo Aleae (1525) and Galileo’s Sopra la Scoperta dei dadi (1623) through the laws of probability framed, inter alia, by Pascal and Fermat,[iv] and in particular the science of statistics of Graunt, Petty and Halley,[v] promoting the concept of insurance as a commercial tool in the eighteenth century. In other words, the story of risk was initiated by formalising its ontological meaning based on an objective dimension.
This was a necessary conclusion because from an epistemological point of view the discourse on risk can be complex. If there is risk, there must be something unknown or that produce an unknown result. Hence, the knowledge about risk is knowledge about lack of knowledge. The hendiadys of knowledge and lack of knowledge constitute the central argument of the discourse on risk, but it explains very little about the nature of risk and the reason of its existence. In this light, sometimes the discourse on risk and the recognition of that hendiadys can also produce a tautological argument. To this end, if epistemology deals with the dissemination of knowledge in particular areas of enquiry, in relation to risk it can be said that it is the same essence of knowledge related to a lack of knowledge that constitutes a limit itself.
Hence, risk should be interpreted by questioning what risk is, and then by saying what the relations and features to risk are. Furthermore, this approach can discover a new stage of thinking from an ontological point of view. Risk under this new light is the probability of occurrence of an event that may or may not occur, but risk is always a measurable uncertainty. In Knight’s words:
‘the practical difference between the two categories, risk and uncertainty, is that in the former the distribution of the outcome in a group of instances is known (either through calculation a priori or from statistics of past experience), while in the case of uncertainty this is not true (….) the best example of uncertainty is in connection with the exercise of judgement or the formation of those opinions as to the future course of the events, which opinions (and not scientific knowledge) actually guide most of our conduct’[vi].
So, it is possible to state that the knowledge about risk is the knowledge of a knowledgeable situation. In other words, the ontological discourse on risk is representing what is knowable in principle or a priori by virtue of laws of probability and the science of statistics. It is knowledge of objective facts. For this reason, the real revolutionary idea of Knight is the categorisation of risk on the past line.[vii] A reflection that has never been highlighted before by other commentators, and that also Knight does not research in depth, but that contains today all the essence of risk especially from a financial point of view in terms of financial risk within the phenomenology of contemporary financial markets. Indeed, it is further illustrated how the recognition of risk on the past line prevents the risk-taker from facing the future in terms of opportunity, as opposed to the Bernstein’s idea of risk.
Specifically today in financial markets, the concept of risk is vital to their understanding. To this end, the subjective dimension of risk in terms of uncertainty as an estimate of an estimate in Knight’s theory is particularly engaging. Before Knight, the subjective dimension of risk was initiated in 1731 by Daniel Bernoulli with the concept of risk-taking, which linked risk with the essential figure of the risk-taker, who is the human being capable of facing the future and taking its opportunities against the voluntas dei. In this fashion, the risk-taking concept has started to be seen as something that was not only related to objective facts but also to a subjective view about the desirability of the decision-making process.
Nonetheless, the philosophical discourse on risk becomes more complicated when the subjective meaning of risk is exposed. In other words, it has been said that risk firstly refers to an objective status: the knowledge of the past circumstance, and hence, the knowledge of knowledgeable situation is not a subjective impression. It is not a belief. It is not the ‘desire’ of Bernoulli. In particular, theoretical economics have understood that financial markets are not only dominated by an objective conception of risk, but a subjective conception of risk is still vital for their functioning. Indeed, financial speculation (from Latin ‘speculum’ – mirror) as opposed to investment is based on a subjective belief in order to become profitable. At least Keynes in his famous book ‘The General Theory of Employment, Interest and Money’ can confirm this understanding by pointing out the difference between knowable in principle and necessarily unknowable. What is knowable in principle refers to an objective conception of risk (namely, it is an a priori knowledge), but the necessarily unknowable refers to this new subjective feature of financial markets. On this point, Keynes compared the financial markets to a beauty contest. Here the judges instead of focusing their attention on the winner, therefore, on the most beautiful girl, try to second-guess the opinion of other judges. In the same fashion, in capital markets the speculator tends to focus its effort not on an objective reality of financial assets that are sold or offered on the market, but on the information that other speculators will trade on in the near future. Hence, the evaluation of financial assets is not only based on an assessment of past performance of assets but on the uncertainty of the decision that will be taken by other speculators. To state it plainly, the objective discourse on risk does not apply alone in financial markets, because there will be always a subjective component in the final decision of the speculator. Indeed, this trade on information is vital to unwind positions early and it is also essential to set up the price of the financial asset.[viii] In this game the value of information for a speculator depends on the uncertain behaviour of another speculator (i.e. necessarily unknowable). In addition, because the markets will always present a lack of perfect information (i.e. information asymmetry) the value of the financial assets based on new information as well as erroneous information might lead to mispriced assets. The real point is that even a speculator in good faith can affect the value of financial assets in a negative way. This is why supervision of financial markets is required, but cannot definitively solve the issue.
In the end, the subjectivity of financial risk is, therefore, intelligible but not knowable due to its necessarily unknowable feature (i.e. the uncertainty),. Thus, the future at least in the phenomenology of contemporary financial markets is no more perceived as an opportunity, but as something that shall be controlled. Indeed, since the collapse of Lehman Brothers in 2008 and the start of the current global economic crisis, it is this different idea of being risk-averse to dominate the markets, and it is the management and pricing of risk that is vital to understand the markets.
The Uncertainty of Financial Markets Post-Brexit
Based on Knight’s re-interpretation of risk and uncertainty that has been explained above, the subjectivity of financial risk or in other words uncertainty as a real form of risk that is currently experienced in the UK and European financial markets by virtue of the role that is exercised by speculators can be highly perceived after Brexit. Indeed, Brexit has had and is still having a massive impact on financial markets due to opinions that investors are projecting during the standstill withdrawal procedure under Article 50 TEU. To this end, investors are becoming speculators who are second-guessing the choices and decisions of other speculators in the market.
This increasing uncertainty as a reflection of the subjective dimension of financial risk can lead to a potential deflation in the UK that can contribute to a panic selling to outside speculators, while the domestic productivity could fall due to the fact that domestic consumers have an incentive to delay purchases until the prices fall further. This is a deflationary spiral determined by a fall of price of goods and services and an increase of the real value of money. In turn, this can contribute to a liquidity trap.
Nonetheless, the starting period of deflation could easily transform in a potential trigger for long-term inflation due to the fact that Brexit is in general a decision against globalization. Inflation occurs when the demand for goods and services grows faster than the supply. Indeed, if the future negotiation of Brexit with the European Union is incapable of guaranteeing a single market for the free movement of goods and services; as a result the import tariffs will rise as well as domestic costs. This can determine a potential barrier for exports, and the productivity of English firms could be undermined. Furthermore, the lower level of immigration could generate a raise of domestic wages, but at the same time employers could face difficulties in filling positions and reduce consequently their productivity.
This scenario, can show how important was Europe for the UK economy in order to maintain lower tariff on imports and promote the productivity of domestic firms by enhancing exports and access to larger markets. Furthermore, labour outsourcing had given to the UK access to cheaper labour. This condition may not apply in the future due to the derogations that the UK would like to negotiate in relation to the free movement of persons and workers. For this reason, even the current devaluation of the pound on the import prices will not have the same impact on inflation as the hit on demand. This latter will be the real responsible trigger of inflation in the near future.
Therefore, the real challenge in the following months for the English regulators (i.e. the Financial Conduct Authority and the Prudential Regulation Authority) and for the Bank of England will be to control monetary stability and financial stability by cutting interest rates and developing a regulation of financial markets that should mitigate uncertainty and bring back financial risk to its objective dimension. Indeed, in my view, if risk is perceived in its objective dimension, namely as a measurable uncertainty, then financial stability as a whole can be attained and preserved. because the volatility of financial markets is strictly connected to the conception of uncertainty as a pure form of risk. Therefore, the divergent opinions of speculators can actually affect the formation of value of financial assets. For this reason, the subjectivity of financial risk is now manifesting on the backdrop of Brexit its negative results that are based on estimate of estimates. In other words, speculators are second guessing on the post-brexit conditions, so that the UK is living now and is going to face for the first time a real form of risk, namely uncertainty in the terms of Knight’s theory. Nonetheless, having said that such unfavourable trend can be subverted through endogenous factors such as national monetary and financial stability policy interventions as well as exogenous conditions that will be predominantly manifested through the negotiation of reasonable terms of EU exit. Specifically, only if free movement of workers is maintained as well as freedom of establishment is preserved, the UK will have the ability to soar and replace uncertainty with risk.
Brexit: Democracy, Markets and the Regions’, DELI/LGJD Joint Insta-Symposium
[i] Treaty on thethe European Union
[ii] Frank Knight (2009) Risk, Uncertainty and Profit (Cornell University Library).
[iii] Peter L. Bernstein (1996) Against the gods: the remarkable story of risk (John Wiley & Sons).
[iv] Bernstein (1996) pp 57-72.
[v] Bernstein (1996), p 92.
[vi] Knight (2002), p 233.
[vii] Knight expressly said that uncertainty is the formation of opinions as to the future course of events (i.e. a subjective belief).
[viii] M. K. Brunnermeier (2001) Asset pricing under Asymmetric Information, Bubbles, Crashes, Technical Analysis, and Herding (OUP)