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Economy, Insure Thyself

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.

Given wide publicity about international charitable relief efforts and voluntary contributions to Japan, one might think that the country’s economic loss was shared internationally. But newspaper accounts suggest that such contributions from foreign countries should be put in the hundreds of millions of US dollars – well below 1% of the total losses. Japan needed real financial risk sharing: charity rarely amounts to much.