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Black swans

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Black swans

How should governments, individually and collectively, deal with black swans? I am defining a black swan to be an event with a very small probability of occurring. However, if it does occur, the consequences might be catastrophic.

Possible examples are global warming, a pandemic, or a meltdown of a nuclear power plant.

One of the problems we encounter in trying to answer this question is that we really do not know what the probability is of any of the aforementioned black swans. In studying a possible black swan, we generally assume the existence of particular probability distributions. But we do not have sufficient data, and may never have, to determine whether our assumptions are reasonable, let alone correct, and thus what the actual probabilities might be at any point in time.

Next, we do not know the possible magnitude of any catastrophe which might occur if a black swan materializes. We only can guess, and to make the calculations even murkier, we tend to arbitrarily assign values to the losses (e.g. how much is a human life worth?).

Thus, we produce guesses of the expected losses. With some modest changes in assumptions, the magnitude of the expected losses can change substantially.

So how much should we invest in insurance when we cannot estimate with much confidence the expected losses? (Almost sounds like the credit default swap market.)

The problem is exacerbated since there likely are many ways to try to insure against a black swan. However, we do not know how effective any of them might be in reducing the expected losses. What is the most efficient form of insurance?

Copenhagen will consider the global warming black swan. Something should be done, but what? How much should be spent on insurance in aggregate and per year, on what types of insurance (including developing new technologies to mitigate the damages and/or reverse any trend), and by whom?

The World Health Organization has looked at the pandemic black swan. Some low cost forms of insurance have been recommended. But is enough being done? Is too much being done? Again, we do not know.

Should policy makers rush into implementing various insurance schemes? Or should they wait for more information and undertake more analysis, recognizing that we can never be fully informed? Or should they start with more modest forms of insurance? I am not smart enough to answer these questions. Is there a King Solomon among us?

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