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Economy, Insure Thyself

If countries covered their risks by issuing a different kind of national debt, tied to their own GDP or a similar measure of economic success, many would have a much debt burden today. Just ask Japan.

NEW HAVEN – The basic principle of financial risk management is sharing. The more broadly diversified our financial portfolios, the more people there are who share in the inevitable risks – and the less an individual is affected by any given risk. The theoretical ideal occurs when financial contracts spread the risks all over the world, so that billions of willing investors each own a tiny share, and no one is over-exposed.

The case of Japan shows that, despite some of our financial markets’ great sophistication, we are still a long way from the theoretical ideal. Considering the huge risks that are not managed well, finance, even in the twenty-first century, is actually still rather primitive.

A recent World Bank study estimated that the damage from the triple disaster (earthquake, tsunami, and nuclear crisis) in March might ultimately cost Japan $235 billion (excluding the value of lives tragically lost). That is about 4% of Japanese GDP in 2010.

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