by Unquantifiable risk and financial stability Meteorologists and insurers talk about the “1-in-100 year storm”. Should regulators do the same for financial crises? In this post, we argue that false confidence in people’s ability to calculate probabilities of rare events might end up worsening the crises regulators are trying to prevent … Unwarranted faith in the odds of rare events can set the stage for far worse outcomes. No matter how hard we try, we cannot accurately quantify the chances of rare events. The reasons can be summed up in two parts: can’t know and don’t know. Putting odds on future events is inherently difficult. It’s obvious that we can’t know what will happen — nobody can predict the future. But we can’t even know everything that might
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Lars Pålsson Syll considers the following as important: Economics
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Unquantifiable risk and financial stability
Meteorologists and insurers talk about the “1-in-100 year storm”. Should regulators do the same for financial crises? In this post, we argue that false confidence in people’s ability to calculate probabilities of rare events might end up worsening the crises regulators are trying to prevent …
Unwarranted faith in the odds of rare events can set the stage for far worse outcomes. No matter how hard we try, we cannot accurately quantify the chances of rare events. The reasons can be summed up in two parts: can’t know and don’t know.
Putting odds on future events is inherently difficult. It’s obvious that we can’t know what will happen — nobody can predict the future. But we can’t even know everything that might happen. All we can be sure of is that there are things that will happen in the future that we cannot even conceive of today. And since there are possible future events that we can’t even list out, we can’t assign probabilities to them. This simple fact also means our estimates of the chances of events we can list out are likely to be wrong: a person who has never experienced snow will overestimate the chances of rain on a very cold day …
Things don’t immediately go wrong when people estimate the odds of unlikely events. They go wrong when people place unwarranted faith — or undue emphasis — on those estimates.
Policymakers should learn as much as they can from past events and do the best they can to assess the risk environment with the available historical data. But there are limits to how reliably they can estimate the chances of an extreme event. Nobody can know all the possible future events that policymakers should be concerned about. Even with a narrow focus on the things that can be measured, there isn’t much data with which to estimate the tails of the distribution – the unlikely but potentially disastrous events that macroprudential authorities are supposed to deal with.