jean - claude trichet : undervalued risk and uncertainty – some thoughts on the market turmoil speech by mr jean - claude trichet, president of the european central bank, at the fifth ecb central banking conference “ the euro at ten : lessons and challenges ”, frankfurt am main, 13 november 2008. * i. * * introduction ladies and gentlemen, i am very pleased to welcome you to what we consider to be the ecb ’ s flagship conference and to this dinner in these beautiful surroundings. the focus of this conference is on the lessons and challenges facing the euro, as it reaches its tenth anniversary. in recent months there has been no shortage of challenges, far from it. as for the lessons, i shall come to those towards the end of my address. this evening, i would like to share with you some thoughts about the main factors bringing about the financial market turmoil that has shaken the global economy for more than a year now, and raise some of the possible long - term solutions. ii. the calm and the storm until early 2007 we were living in a period often described as the “ great moderation ”. the world economy was growing vigorously, macroeconomic indicators were significantly less volatile and, most importantly, inflation was low. financial markets were performing strongly. many asset prices were rising, while volatilities and risk premia were exceptionally low. profitability in the financial sector was high, and banks seemed liquid and well capitalised. however, there were warning signs, even back in 2006, that global markets were “ priced for perfection ” and that even a small change in conditions could severely disrupt financial markets. 1 several policy makers had indicated to market participants that they needed to prepare for a significant correction. as chairman of the global economy meetings of central bank governors, i myself reported my colleagues ’ sentiments on this matter. at the same time, several financial stability reports – including from the ecb, the bank for international settlements ( bis ), the financial stability forum ( fsf ) and other organisations – analysed vulnerabilities and warned of emerging weaknesses. 2 we knew that a storm was brewing but, admittedly, we did not know exactly where. neither did we know what would trigger it, or when it would come. as we all know today, the turmoil erupted in august 2007 when investors around the world suddenly faced a dramatic change in liquidity conditions, and it became increasingly difficult see, among others, imf, global financial stability report

current financial situation, the root cause of the crisis was the overall and massive undervaluation of risk across markets, financial institutions and countries. this derived from two main factors. first, the probability of certain events was misjudged. this means that these events were considered highly improbable, if not “ impossible ”. second, the impact of an increase in fundamental uncertainty at the systemic level on the distribution of returns across asset classes was largely neglected. such a fundamental increase of uncertainty is what we observed with the massive shock to global confidence in midseptember. with this in mind, a useful − albeit not the only − way to characterise recent events is to employ the concept of non - measurable risk, or “ knightian ” uncertainty. 5, 6 the economist frank knight originally developed the distinction between risks, to which probabilities can be assigned ; and uncertainty, for which even these probabilities are unknown. in the last two decades this distinction has been used again in formalising economic choices under socalled “ uncertainty ” aversion. 7 many episodes of financial instability over the last decades were characterised by a sharp increase in general “ uncertainty ”. the reaction of investors is to suddenly assign very high for a detailed analysis of the sequence of events which led to the financial turmoil, see n. cassola, m. drehmann, p. hartmann, m. lo duca and m. scheicher, “ a research perspective on the propagation of the credit market, ” ecb research bulletin, june 2008 and ecb fsr, december 2008. see n. n. taleb, the black swan : the impact of the highly improbable, 2007. see also j. b. taylor and j. c. williams, “ a black swan in the money market ”, federal reserve bank of san francisco, working paper series, april 2008. f. h. knight, risk, uncertainty and profit, 1921. for other characterisations of system risk, see o. de bandt and p. hartmann, “ systemic risk : a survey, ” published in : financial crisis, contagion and the lender of last resort : a book of readings, ed. by c. a. e. goodhart and g. illing, oxford university press, january 2002. see i. gilboa and d. schmeidler, “ maxmin expected utility theory with non - unique prior