C O N S E Q U E N T I A L & C A T A S T R O P H I C R I S K

The unusual and the unknown make us either overconfident or overly fearful.1

A wise person will not spend time installing a burglar alarm when the house is on fire.2

You know that the best you can expect is to avoid the worst.3

Practical men, who believe themselves to be quite exempt from any intellectual influences,
are usually slaves of some defunct economist.4

CONSEQUENTIAL & CATASTROPHIC RISK: For a world that will spend $1,500
billion (U.S.) this year for National Defense and over the past 64 years has spent almost
$60,000 billion (in current dollars) for this purpose, today we may be faced with more
systemic consequential and catastrophic risks than in any previous historical periods.
One factor is the overdetermining belief that military defense primarily renders a na-
tion safer (look at the nation’s spending budget to see relative priorities for what is
important). However, maybe the two primary reasons that the world has gotten risk-
ier is that: (a) technology is enabling low-cost, distributed activities heretofore previ-
ously unimagined; and (b) adequate capital has not routinely been allocated to miti-
gate these sometimes new or newly understood consequential and catastrophic risks.
Instead, traditional and conventional military-centric risks have consumed much of
the world’s capital used for risk mitigation. Adding to the concern of adequate capi-
tal allocation to mitigate new risks is a corporatist mindset that portrays risk man-
agement as government interference in free markets and eschews regulatory reform
as anathema to capitalism.5

TYPES OF CONSEQUENTIAL AND CATASTROPHIC RISK: Consequential risk

describes risks that are economically expensive should they occur. Locally, this might
entail a one-time, sudden, unbudgeted expense of ten’s of billions of dollars. Nation-
ally or globally, this might entail a sudden unbudgeted expense of trillions of dollars
in losses. Catastrophic risk typically also entails loss of bio-physical resources, often-
times directly, human lives. Locally, this might mean the sudden death of 10,000 -
100,000 humans; nationally, 100,000 to a few million humans; globally, a few million
to virtually the entirety of the six billion people presently living on the planet (i.e.
existential risks that threaten humanity in toto). Catastrophic risks always are conse-
quential. But not all consequential risks produce immediate, directly attributable sig-
nificant numbers of deaths. Any deaths from consequential risk may be indirect and
secondary. In evaluating both consequential and catastrophic risk, an appropriate
timeframe must be chosen. For example, short-term loss of human life over a few
days to a few weeks may be slight, but long-term loss of life over months or years
may become very large. Oftentimes, there is bias to consider risks that are episodic (an
event that just happens e.g. an earthquake or terrorist attack) and produce conse-
quential results over a short time span (e.g. the event fits within the attention span of
TV news shows) versus structural risks (e.g. nuclear deterrence and nuclear power

Lyle Brecht DRAFT 1.12 Sunday, November 15, 2009 CAPITAL MARKETS RESEARCH - Project Metanoia - Page 1 of 18
C O N S E Q U E N T I A L & C A T A S T R O P H I C R I S K

plants are structural risks in that they are inherently expensive when they fail. Two
billion dollars in capital investment was turned into a useless rubble of steel and con-
crete at Three Mile Island in less than 30 minutes). Other risks evolve sometimes pro-
ceeding over relatively lengthy timeframes and result in very large economic costs
(e.g the cost of global warming, if absolutely no mitigation occurs, and atmospheric
tipping points are exceeded, could be as much as $200,000 billion, but not be fully felt
for a 100-years).

Consequential and catastrophic risks can generally be classified into four distinct
categories that are independent of their potential severity (probability x harm):

Known events that are certain to happen with some known or historically rea-
sonable probability. They have happened before and most likely will happen
again at some discrete time in the future;

Known events that are certain to happen (we know this from a history of the
earth), but a probabilistic forecast of their eventuality in discrete time is uncalcu-
lable at present. We just do not understand the risk well enough to even guess at
its probability of occurrence, or even if we guess, we have little confidence in our
guess;

Known events that may or may not happen sometime in the future, depending
largely on the particular planning period of the analysis. Typically, we just do not
have enough historical data points to plot a frequency curve, or we do not un-
derstand the mechanisms of the risk event well enough to know for certain that
they will occur again in the future or with what frequency. What we do know is
that these risk events have happened in the past;

Unknown or dimly understood events that will occur with some uncalculable
probability. These are often referred to as uncalculable, rare events. Becasue they
are rare, there is just not enough understanding of the event itself, nor its fre-
quency to plot a probability curve. Sometimes these uncalculable, rare events are
referred to as Black Swans. What a risk manager must remember is that even
though a specific rare event may not be knowable either as to probability or
harm, the class of Black Swan risks is highly probable to occur in any one plan-
ning period. That is, it is almost always prudent, from a risk management per-
spective, to plan for a Black Swan and to manage systems for their resiliency to
avoid cascading failure or collapse, should a Black Swan appear during the plan-
ning period.

Against these categories of consequential and catastrophic risks, there are generally
three types of human responses available:

Lyle Brecht DRAFT 1.12 Sunday, November 15, 2009 CAPITAL MARKETS RESEARCH - Project Metanoia - Page 2 of 18
C O N S E Q U E N T I A L & C A T A S T R O P H I C R I S K

Allocating capital to mitigate this risk will likely either reduce the probability
that an event will occur or improve resiliency (ability to recover) and reduce harm
should the event occur;

Allocating capital to mitigate this risk will either be to no avail or make the risk
worse, either by increasing the probability of occurrence or the economic cost
should an event occur;

The risk is beyond human amelioration or mitigation at the present time. This
does not mean that at some future date human ingenuity may mitigate this risk,
only that at present humans are powerless to do anything about this risk

In summary: consequential and catastrophic risks can either result in only economic
losses, or economic losses with loss of lives. Possible events can be known with cer-
tainty, with some degree of certainty (probabilistic forecast), or with no certainty
(probabilities of occurrence are uncalculable). For some risks, it is possible to mitigate
the risk event. For some risks, attempts to mitigate the risk may make things worse.
For some risks, no human mitigation is possible at this time.

From a capital allocation perspective, it is imprudent to invest in mitigating only

known, tractable events of a particular class (e.g. risk of war or terrorism vs. risk of
global warming and cyberspace security). Risks that have uncalculable probabilities
of occurrence should also receive appropriate mitigation capital, given the nature of
rare events that, as a class, they regularly occur in any one planning period . It is also
imprudent to invest primarily in hardening systems against an event occurring. In-
vesting to improve system resilience, should an event occur, may also be a worth-
while mitigation strategy.

The table below categorizes consequential and catastrophic risks by their potential
scope: local, national, regional, global, and existential (risks that threaten life on the
planet). What is not illustrated in this table is that risks that begin at the local level,
may produce cascading failures that grow to the national, regional, or even global
level. Two example s of cascading failures might include localized drought that re-
duces food production to an extent that national or regional consequential effects
occur. Another risk event that may begin locally could include a nuclear exchange
between India and Pakistan over Kashmir or between North and South Korea that
could quickly cascade to national, regional, or even global risk events involving loss
of a growing season due to particulate matter in the atmosphere, the triggering of a
new climate change regime that produces severe regional or global drought, or other
as yet unforeseen cascading failures of existing present ecosystem services that un-
derlie all the economic support systems for all the national economies of the world.

Lyle Brecht DRAFT 1.12 Sunday, November 15, 2009 CAPITAL MARKETS RESEARCH - Project Metanoia - Page 3 of 18
C O N S E Q U E N T I A L & C A T A S T R O P H I C R I S K

QUALITATIVE CATEGORIES OF CONSEQUENTIAL & CATASTROPHIC RISK 6

SCOPE CONSEQUENTIAL RISK CATASTROPHIC RISK

LOCAL drought, food contamination, terrorist WMD-attack, exist-

cyberspace viruses; hurri-
cane (e.g. Katrina); loss of
watershed protection lands,
discrimination based on
ethnicity, race, gender, etc.;
mass contagion; depletion of
Colorado River reservoirs
ing infectious disease expo-
sure, accidental escape of
genetically modified disease
organisms from laboratory,
pollution, radioactivity expo-
sure from nuclear power
plant accident, earthquakes,
cyclones, <0.5 km sized
bolide impacts

NATIONAL EMP-attack; financial deriva- nuclear terrorism; obesity;

tives risks, national debt,
totalitarianism, cyberspace
viruses; declining availability
of cheap oil; China no longer
purchases government debt
heart attacks, cancer, HIV/
AIDS, alcoholism, drug
abuse

REGIONAL freshwater availability; ge- limited nuclear exchange;

netic contamination of agri-
cultural seed stock; nuclear
electric plant accident
infectious diseases; ex-
ported gender shifters and
neurotoxins; volcanic erup-
tions; famine; interstate war,
tsunamis, 0.5-1 km sized
bolide impacts

GLOBAL Carrington event (high mag- anthropogenic climate

nitude solar storms); melt-
down of financial derivatives
market; peak oil, collapse of
globalization & trade ex-
change; pegging price of oil
in non-dollar denominated
exchange
change (best case); nuclear
war between superpowers,
large-scale vulcanism; de-
pletion of the ozone layer;
emerging pandemics; loss of
critical habitat; >1-1.5 km
sized bolide impacts

TRANS-GENERATIONAL collapse in trust of financial anthropogenic climate-

assets, abusive use of nano- change (worst case); spe-
technology cies extinctions; GM seed
modifications gone bad

EXISTENTIAL AI singularity, discovery of > 2 km sized bolide collision

extraterrestrial intelligent life w/ earth; molecular manu-
in the universe facturing; mass extinction
(various causes), nuclear
winter

Note: “If we treat risks singly, and never as part of an overall threat profile, we may
become unduly fixated on the one or two dangers that happen to have captured the
public or expert imagination of the day, while neglecting other risks that are more
severe or more amenable to mitigation.” 7 For example, the U.S. allocated inordinate
resources since 2001 to prevent another 9/11 terrorist attack, but allocated virtually
nothing to prevent the devastation of New Orleans from Hurricane Katrina. From a

Lyle Brecht DRAFT 1.12 Sunday, November 15, 2009 CAPITAL MARKETS RESEARCH - Project Metanoia - Page 4 of 18
C O N S E Q U E N T I A L & C A T A S T R O P H I C R I S K

consequential risk perspective, one might argue that preventing the devastation of
Katrina may have been an economically more rational allocation of capital, given a
probabilistic risk assessment of the risk from another 9/11 terror attack versus the
probability of a Katrina-like economic cost should a category 3 or above hurricane hit
New Orleans. From this capital allocation perspective, we will now look at: (a) set-
ting priorities as to which risks to allocate capital; (b) the possibility of estimating the
cost of systemic risk; (c) pricing this risk so as to assist in establishing rational,
analytically-based choices for where to allocate capital to mitigate consequential and
catastrophic risks; and (d) what magnitude of investment to mitigate consequential
and catastrophic risks may be warranted in any specific planning period.

CONSEQUENTIAL & CATASTROPHIC RISK MANAGEMENT PRIORITIES8

RISK PRIORITY CONSEQUENTIAL CATASTROPHIC

FIRST TIER - probabilities of
10% to 99.0% (near cer-
tainty) within 25-year plan-
ning horizon
climate change mitigation;
cyberspace security; fresh-
water resources manage-
ment; prevention of finan-
cial industry discontinuities,
regional drought, collapse of
Chesapeake estuary, Colo-
rado River reservoirs de-
pleted, health care costs at
20% of GDP in U.S. pro-
duces ICOR ongoing annual
losses of $2.3 trillion, dra-
matically lower EROEI en-
ergy sources
abrupt climate change; nu-
clear power plant accident;
bio-terrorism or industrial
laboratory accident; pan-
demic infectious diseases;
global drought causes crop
failures; unmanaged move-
ment of industrial food pro-
duction systems to lower
thermodynamic states

SECOND TIER - probabili- 9/11-type terrorist attack, nuclear terrorist attack;

ties from 0.5% - 9.99% dur- terrorist WMD attack; nu- transformative war that uses
ing a 25-year forecast clear power plant accident nuclear weapons

THIRD TIER - assignable >10m bolide impact in >10 m bolide impact in

probabilities of less than
0.5% during a 25-year fore-
cast based on stationarity
(historical data)
ocean; hurricane, cyclone,
earthquake, tsunami, vol-
cano hits unpopulated area
of developed world
densely populated area of
earth; hurricane, cyclone,
earthquake, tsunami, vol-
cano hits densely populated
area

UNKNOWN - uncalculable, over-reliance on industrial unforeseen effects of abrupt

rare events of significance
(no historical data from
which to base probabilistic
forecasts)
food production (e.g. single
source for seeds, concen-
trated meat packing, indus-
trial feed lots, etc.) causes
development of antibody-
resistant virulent pathogens
climate change; cascading
failures of ecosystem serv-
ices due to habitat loss and/
or species extinction; mass
extinction event of keystone
species due to bioaccumula-
tion of industrial pollution

Lyle Brecht DRAFT 1.12 Sunday, November 15, 2009 CAPITAL MARKETS RESEARCH - Project Metanoia - Page 5 of 18
C O N S E Q U E N T I A L & C A T A S T R O P H I C R I S K

Note: Risks respond to attention with reflexivity (human actions alter the probabilistic
risk forecast). Allocating adequate capital to address a risk may either reduce the
probability that an event occurs or reduce the harm that ensues should an event oc-
cur. Under-allocating capital to mitigate a risk will not only miss the mark in reduc-
ing the probabilistic forecast for that risk, it may actually increase the probability
and/or the harm should an event occur.

An interesting twist on risk assessment is to look at the capital structure of the econ-
omy and ask if capital is being invested productively to grow the economy in a sus-
tainable fashion.9 For example, if most other industrialized global competitors of the
U.S. can deliver the same, or better, health results for their citizens at less than 10% of
GDP, there has to be a cost to the U.S. economy for over-allocating its available capital
to health care. Given that there is only so much capital to go around in any one pe-
riod, if health care is over-consuming available capital, then less capital is available to
invest in R&D (research & development), O&M (operations & maintenance), and
R&R (repair & replacement) for other, relatively more productive sectors of the econ-
omy. Thus, there should be a hit on Incremental Capital Output Ratio (ICOR) for this
capital allocation choice to spend capital unproductively on health care. 10 If this cal-
culation was performed, and one converted % productivity loss to dollars of GDP,
one might arrive at an imputed ICOR value of ~$799.50 billion in lost (foregone) an-
nualized GDP growth as the tradeoff for spending 20% of GDP on health care when
only 10% of GDP has been amply demonstrated as adequate to keep a country’s citi-
zenry healthy enough to perform work.

A CENTRAL PROBLEM: Even if one subscribes to the rational choice theory, maybe
the central tenet of capitalism - and many do in today’s industrialized, capitalistic,
democratic economies - what is rational about today’s market prices? If the same gal-
lon of gasoline sells for twelve cents in Venezuela, forty-five cents in Saudi Arabia,
$3.00 in the United States, and $9.00 in Europe, what is the true price for gasoline? If
the economic cost of anthropogenic carbon emissions was included in the price of
gasoline, what would its true cost be then? If one believes in Peak Oil, do market
prices adequately reflect replacement costs, or are we just factoring exploration, refin-
ing, and distribution costs? 11 Should governments subsidize the true economic cost of
commodities in order to keep their economies growing? Is this subsidization game
even sustainable? Can free markets be relied on to set true economic costs of goods
and services? Or do free markets tend to get prices very wrong? Oftentimes too low,
as systemic risk is neglected or avoided.

Depending on which economist one speaks with, different answers to these questions
are proffered. Who is right? Who is wrong? Who might we trust? Can we rely on our
own ideologies and personal comfort levels to determine where we stand on these

Lyle Brecht DRAFT 1.12 Sunday, November 15, 2009 CAPITAL MARKETS RESEARCH - Project Metanoia - Page 6 of 18
C O N S E Q U E N T I A L & C A T A S T R O P H I C R I S K

issues? Yet, many agree that large problems confront our national economy and the
global economy. Many believe that present economic activities are unsustainable over
the long term for a variety of reasons. That is, it is highly probable that present eco-
nomic relations and market prices will not hold long-term. Economic reality ulti-
mately will determine whether markets are allocating capital in ways to grow the
economy are sustainable. 12 Non-sustainability is typically signaled by sharp disconti-
nuities of asset prices “largely unanticipated by market participants. For, were it oth-
erwise, financial arbitrage would have diverted it.”13 Markets (and entire economies)
regularly fail when they fail to adequately manage risk.14

Change is afoot. But who do we trust to manage this risk? Some imagine government is
the proper vehicle, others vehemently argue that only an unshackled private busi-
ness sector (along with personal responsibility) provides the dynamic capabilities and
vision for sustainable long term growth. Is the truth that both the public (govern-
ment) sector and the private (business) sector may be guilty of manipulating market
prices to such an extent that free markets rarely, if ever except in special circum-
stances, provide true-enough economic prices for a rational choice to work its invisi-
ble hand magic?

Can we even agree that the primary task of markets is to allocate capital to timely
projects that provide the technological innovation our national (and the global) econ-
omy requires for sustainable growth?15 Can we agree that another primary task of
markets is to protect the bio-physical services of the earth so that sustainable growth
can continue over the long term? Our definition of sustainable growth is simple and
straightforward: sustainability is creating real economic wealth in the world for the com-
munities we live in. 16 Economic wealth is always founded on a binary bio-physical real-
ity. Either the bio-physical systems that are supportive of life (and economy!) on the
planet are evolving toward sustainability. Or they are moving towards collapse? 17

Both the public and the private sectors are necessary to accomplish this objective for
creating real economic wealth. Both sectors are dependent on the other. Without rules
(e.g. regulations), no business could achieve long-term profits from free markets. The
more appropriate and fitting these market rules, the more profits businesses should
be able to earn. If market prices are more economically rational, businesses will have
the incentive to reallocate capital and labor to invest in those activities that produce
sustainable economic growth and that creates real economic wealth for the communi-
ties we live in.

With this definition of sustainable growth, then only when an economy successfully
accomplishes these tasks of innovation, reallocation and protection, is it accurately

Lyle Brecht DRAFT 1.12 Sunday, November 15, 2009 CAPITAL MARKETS RESEARCH - Project Metanoia - Page 7 of 18
C O N S E Q U E N T I A L & C A T A S T R O P H I C R I S K

assessing risks: maturity, liquidity, market, credit, currency, technological obsoles-

cence, and wider economic, ecologic, and political risks.

Market risk consists of the danger of mispricing assets; credit risk covers the po-
tential of financial promises not being honored; currency risk describes a mis-
match between the value of liabilities’ and assets’ respective currencies; techno-
logical obsolescence describes the technological progress in achieving more out-
put with less input of labor, capital, and time; larger economic, ecologic, and po-
litical risks refer to black swans, those highly improbable events such as global
crisis, war, political upheaval, and ecological collapse that produce massive im-
pacts on markets.

The collective characterization of these risks, taken as a whole, might be called sys-
temic risk. What characterizes systemic risk is that it is emergent (the final outcome
cannot be fully predicted by antecedent causes) and a consequent of the mispricing of
inputs to and outputs from market transactions.18 Systemic risk must be accounted
for and managed in order to produce a positive economic return on invested capital
(EROIC). 19

CONSEQUENTIAL & CATASTROPHIC RISK IS A SYSTEMS PROBLEM: Conse-

quential and catastrophic events are world-changing. 20 These events produce a dis-
ruptive non-linearity. There arises a ‘time-before’ and a ‘time-after’ the endgame
event. People may loose their lives. When that occurs, body counts often characterize
the event. However, all endgame events have an economic result. They destroy capital
(human, financial, natural, economic). For example, the 9/11/01 terrorist attacks re-
sulted in the initial loss of <3,000 lives and $90 billion in property damage. The
counter-strategy, however, resulted in ~2 million people displaced, wounded, or
killed and $3,000 billion total estimated expenditure of capital for a variety of GWOT-
related initiatives. The 2008 collapse of the collateralized debt obligation (CDO) mar-
ket in the U.S. resulted in the loss of ~$50,000 billion in asset values globally and the
need for U.S. citizens (taxpayers) to put-up $17,489 billion in reserve guarantees for
the financial institutions holding CDOs (which had become toxic assets). 21

What characterizes the above examples of consequential endgames is that in both

cases, systemic risk was left unmanaged. Systemic risk fell between the cracks. In both
cases, capital was not allocated in a manner to either reduce the risk of the endgame
consequence occurring, nor were investments sufficiently made to the underlying
systems to improve resiliency so that if an endgame event occurred, the system would
recover without undue cost. 22

In terms of potential possible consequential endgames, there are many, but maybe
WMD-T attacks and anthropogenic climate change has received the most attention. 23
Both these consequential and catastrophic risk events could be considered in terms of

Lyle Brecht DRAFT 1.12 Sunday, November 15, 2009 CAPITAL MARKETS RESEARCH - Project Metanoia - Page 8 of 18
C O N S E Q U E N T I A L & C A T A S T R O P H I C R I S K

systemic risk. For example, a nuclear WMD-T attack, its risks and consequences,
might be considered from the perspective of the cost of nuclear deterrence as a national
military strategy.24 Climate change could be thought of in terms of the systemic risk
of not pricing the use of the earth’s atmosphere as a sink for carbon and other GHG
emissions. If 350 PPM CO2 is really the tipping point for runaway climate change,
the capital allocation requirement (i.e. spending capital in one fashion rather than
another) to avoid a consequential endgame may be on the order of $20,000 billion.25
As the U.S. is responsible (on a per capita basis) for ~50% of GHG emissions, it might
be reasonably expected to cover 50% of this capital requirement. The probabilistic
global (as opposed to national) endgame consequent of not making this investment of
capital could be, on a worst-case basis, around $200,000 billion, loss of 2,000-3,000 mil-
lion human lives, and the loss of a significant number of species of life presently liv-
ing on earth.26

From this perspective, the game thus might best be framed in terms of the question:
What economic ecosystem operations and maintenance investments (O&M), and repair and
replacement investments (R&R) are needed to ensure sustainable economic growth for the
nation now and in the future? Ultimately, this translates to a binary capital allocation
assessment: (a) either capital is being employed to develop and maintain sustainable
systems that support economic growth, or (b) capital is being employed in ways that
will ultimately result in the collapse of these systems. 27

This systems coherence approach to consequential endgames is preferred to more

traditional intelligence and national security-focused approaches to risk as it captures
the full range of risks encountered toward developing a sustainable economy. The
focus on actor-driven WMD-T, malicious attacks on cyberspace, and other human-
agent initiated deliberate activities (manmade deliberate) may neglect approximately
70% of consequential and catastrophic risks. Annualized classes of threats from sys-
tem vulnerabilities using a probabilistic risk assessment methodology (PRA) to allo-
cate capital towards corrective actions might resemble the following forecasts of end-
game risk:28

• consequential disruptive events or catastrophic systems collapse from eco-

nomic ecosystem coherence problems due to lack of O&M and R&R (struc-
tural risk)= 40%;

• malicious, human-agent intermediated attacks on economic support systems

(episodic risk)= 30%; 29  

• emergent causes (high consequential, low probability, rare events) = 20%

• consequential disruptive events and/or catastrophic collapse of systems due

to natural causes (earthquakes, tornados, hurricanes, floods, etc; human

Lyle Brecht DRAFT 1.12 Sunday, November 15, 2009 CAPITAL MARKETS RESEARCH - Project Metanoia - Page 9 of 18
C O N S E Q U E N T I A L & C A T A S T R O P H I C R I S K

agents may be complicit to severity of results, but not causative agents) =

10%;

Due to the networked systems nature of the national and global economic ecosystem
and the timeliness of the consequential and catastrophic risk the nation presently
faces, traditional ways of promulgating security standards, managing initiatives to
secure the nation, and setting metrics for success leaves many gaps.30 This is often
due to the stovepipe approach to security where one department/agency’s initiatives
collide with another agency’s and neither agency’s methods constitute best practices
from the perspective of private industry or from an analytical perspective on the
amount of capital required to address a system vulnerability to a specified level of
system resilience in a definite timeframe. 31

The process whereby budgets are decided and funds employed to implement policy
across multiple, often competing jurisdictional boundaries (public and private) is not
well coordinated. The policy coordinating function may have difficulty against
agency budgeting by the politically powerful for ideas that are topical (or popular),
the private sector will be left to its own devices to allocate capital toward addressing
vulnerabilities, and the nation will be in reactive mode as crises (real or perceived)
materialize. Importantly, systemic risk of the failure to adequately manage endgame risk-
reduction initiatives may be neglected due to this poorly coordinated, stovepipe ap-
proach to improving system resilience.32

Right now is a perspicuous time to build a new-model public/private sector partner-

ship decision-making framework for investing in system resilience and creating economic
incentives for speeding-up new technology adoption in the private as well as the
public sectors. The objective is to develop improved economic support systems resil-
ience to consequential and catastrophic risk. An expanded purview of endgame risk
is needed that is broader than the present myopic intelligence-national security-
centric risk-assessment and mitigation framework.

MANAGING CONSEQUENTIAL AND CATASTROPHIC SYSTEMIC RISKS

THAT IMPACT THE ECONOMIC ECOSYSTEM: The networked information
economy may be the most significant economic change since the start of the indus-
trial age. This networked information infrastructure presently serves as the substrate
for the evolution of the post-industrial economy of the twenty-first century in ad-
vanced countries of the world:

The national and global economic system is a human-engineered complex, dy-

namical system described most accurately as a system comprised of a large net-
work of components operating with simple rules (programs and protocols) with
no central control (i.e. the system is self-organizing) that results in sophisticated

Lyle Brecht DRAFT 1.12 Sunday, November 15, 2009 CAPITAL MARKETS RESEARCH - Project Metanoia - Page 10 of 18
C O N S E Q U E N T I A L & C A T A S T R O P H I C R I S K

information processing (computational processes), adaptation, and complex col-

lective behavior. Additionally, this complex, dynamical system is non-linear in its
exhibition of emergent behavior (i.e. the behavior of the system cannot be fully
predicted from a knowledge of all its parts) and probably exhibits features of a
chaotic system (i.e. there is a sensitive dependence on initial conditions).33

More than ninety-percent of consequential and catastrophic risk to the economic

ecosystem resides in the private sector;34

Choosing what not to do to protect and defend the economic ecosystem from con-
sequential and catastrophic risks may be as important as what we collectively
decide to invest capital in to achieve improved system resilience;35

Today, both public and private sectors establish priorities to address economic
ecosystem vulnerabilities primarily by two methods: (a) the windshield method
(what is most visible and immediate), and (b) the normative risk assessment
method (choose the most probable vulnerability with the largest consequent); 36

Presently, metrics for what constitutes a reasonable level of economic ecosystem

vulnerability (how secure must the systems be, given the costs for achieving a
specified level of risk reduction/security?) for critical sub-systems do not exist;

A practicable EROIC (economic return on invested capital) metric based on a

standard risk assessment methodology to schedule investments for consequential
endgames security has not been established; 37

Lyle Brecht DRAFT 1.12 Sunday, November 15, 2009 CAPITAL MARKETS RESEARCH - Project Metanoia - Page 11 of 18
C O N S E Q U E N T I A L & C A T A S T R O P H I C R I S K

ENDNOTES
1Inusitatis atque incognitus rebus magis confidamus vehementiusque exterreamur, Gaius Julius Cae-
sar, Commentariide Bello Civili, II. 4, quoted in Vaclav Smil, Global Catastrophes and Trends: The
Next 50 Years (London & Cambridge: The MIT Press, 2008), 1.

2Nick Bostrom and Milan M. Cirkovic, “Introduction,” Nick Bostrom and Milan M. Cirkovic,
eds., Global Catastrophic Risks (Oxford: Oxford University Press, 2008), 28.

3 Italio Calvino, If on a Winter’s Night a Traveler (1979) in William Poundstone, Prisoner’s Di-
lemma (New York: Doubleday, 1992), 53.

4 John Maynard Keynes, quoted in Justin Fox, The Myth of the Rational Market: A History of Risk,
Reward, and Delusion on Wall Street (New York: HarperCollinsPublishers, 2009), xvi on defects
in neoclassical economic theory loosely based on Saint Thomas Aquinas’ (1225 -1274) ethical
notion that just prices are set by the market transactions between buyers and sellers who trade
value for value - the Golden Rule in business (Summa Theologiae, 2-2, q. 77, art. 1 ref. Fox, xiii).

5Today, corporatism, the resistance to economically productive change and preservation of dis-
economic activities may be more a threat to capitalism than socialism. The economist, Joseph
Schumpeter (1883-1950, Austria/Hungary), in his book, Capitalism, Socialism and Democracy,
discussed capitalism’s greatest strength as creative destruction - old ways of doing things are
destroyed and replaced by new ways through entrepreneurship. For Schumpeter, socialism
was no match for capitalism. However, he predicted that corporatism would threaten and
could finally undermine capitalism. See http://www.scribd.com/doc/19538880/.

6 For illustrative purposes only.

7 Bostrom and Cirkovic, 2.

8 For illustrative purposes only.

9Capital is defined in this instance as annual free cash flow from business operations available
to reallocate to technological innovation and to create new jobs.

10Incremental Capital Output Ratio (ICOR) is a metric that measures the marginal amount of
investment capital necessary for a measurable improvement in the national economy’s level of
production efficiency. The converse use of ICOR is the loss in annual GDP growth by not in-
vesting adequately in productivity efficiency.

11 See “Note to a Peak Oil Denier:” http://www.scribd.com/doc/19145966/.

12 Sustainability results from the timely process of transforming these economic systems un-
dergoing change to systems that are resilient (less susceptible to collapse) when shifting to
lower thermodynamic states. Economic systems are sustainable when thermodynamic state
shifts do not cause rapid disruptive nonlinearities - abrupt changes of the system to an unan-
ticipated, less-complex state. See
http://www.scribd.com/doc/9714755/Sustainable-Economy.

13“Bubbles seem to require prolonged periods of prosperity, damped inflation and low long-
term interest rates.... History also demonstrates that underpriced risk – the hallmark of bubbles
– can persist for years.” See Alan Greenspan, “We need a better cushion against risk,” Financial
Times (26 Mar 2009).

Lyle Brecht DRAFT 1.12 Sunday, November 15, 2009 CAPITAL MARKETS RESEARCH - Project Metanoia - Page 12 of 18
C O N S E Q U E N T I A L & C A T A S T R O P H I C R I S K

14Derivatives help to diversify risks among a multitude of counter-party relationships. These

counter-party relationships produce a more robust economic system that is able to self-correct
against small shocks. Yet, due to interconnections among parties, the economic system be-
comes more vulnerable to black swans that produce massive, tumultuous effects in markets. See
Daron Acemoglu, “The Crisis of 2008: Structural; Lessons for and from Economics’ (January 6,
2009), 3.

15 “The transition to a clean-energy economy should be modeled not on pollution control ef-
forts, like the one on acid rain, but rather on past investments in infrastructure, such as rail-
roads and highways, as well as on research and development…. This innovation-centered
framework makes sense not only for the long-term expansion of individual freedom, possibil-
ity, and choice” but offers the best probability of achieving real, economic wealth creation of
benefit to the nation. See Ted Nordhaus and Michael Shellenberger, Breakthrough: From the
Death of Environmentalism to the Politics of Possibility (Boston & New York: Houghton Mifflin
Company, 2007), 15

16Sustainability results from the timely process of transforming these economic systems under-
going change to systems that are resilient (less susceptible to collapse) when shifting to lower
thermodynamic states. Economic systems are sustainable when thermodynamic state shifts do
not cause rapid disruptive nonlinearities - abrupt changes of the system to an unanticipated, less-
complex state. One way to think about the thermodynamic states of economic systems is in
terms of energy return on energy invested (EROEI). For example, in this context sustainability
might be more technically described as the re-engineering of economic systems to transition
from high energy return on energy invested sources to systems capable of operating at lower
thermodynamic states: in 1930, EROEI of oil, natural gas and coal was 100:1; today EROEI of
oil, gas, wind is 15:1; large hydropower 11:1; conventional coal 10:1; newly found oil, photo-
voltaic solar 8:1; clean coal 5:1 (better carbon emissions control through carbon capture and
sequestration but coal ash and heavy metals pollution); fuel cell, geothermal, nuclear 4:1 (nu-
clear’s carbon footprint is ~ 66 gCO2e/kWh, less than 960 gCO2e/kWh for conventional coal
but for every dollar spent on nuclear, 5X-6X more carbon could be reduced with end-use effi-
ciency, or renewables); oil shale and Alberta tar sands 3:1 (Athabasca Valley tar sands have
largest carbon footprint of any oil production); LNG 2:1; ethanol (from corn) 1.3:1; hydrogen
0.8:1; nuclear fusion (unknown). See, Charlie Hall, “Balloon Graph;” The Oil Drum
(www.theoildrum.com); Thomas Homer-Dixon, The Upside of Down: Catastrophe, Creativity, and
the Renewal of Civilization (Washington, DC, Island Press, 2006).

17“Perhaps the fundamental question – is how can the operating institutions for the modern
world be changed so that economic activity both protects and restores the natural world.” See
James Gustave Speth, The Bridge at the Edge of the World: Capitalism, the Environment, and Cross-
ing from Crisis to Sustainability (New Haven & London: Yale University Press, 2008), 7.

18 Market mispricing of inputs to and outputs from the economy discourages timely techno-
logical innovation, slows down technology adoption cycles, and inhibits the reallocation of
labor and capital to those more productive sectors of the economy, thus putting the entire na-
tional economy at a competitive disadvantage. In particularly egregious situations and over
time, this mispricing creates unsustainable economic conditions resulting in collapse of asset
values, markets, and/or economies that careen from one financial crisis to another.

Lyle Brecht DRAFT 1.12 Sunday, November 15, 2009 CAPITAL MARKETS RESEARCH - Project Metanoia - Page 13 of 18
C O N S E Q U E N T I A L & C A T A S T R O P H I C R I S K

19 Ever since St. Thomas Aquinas proposed that market-set prices resulted in true economic
value, this has served as an article of faith in the Christian West. Most recently, this faith-based
belief has been bolstered by mathematical formulations and economic theory (validated with
Nobel prizes for economics). However, despite the math and theory, the underlying predicates
are the tenets of the rational choice theory: human beings act rationally as if to maximize their
utility. That is, market transactions must be efficient (the Efficient Market Theory) as no person
would pay more in the transaction than their derived utility for the good or service in question.
Gene Fama summarizes the Efficient Market Theory: “The primary role of the capital markets
is allocation of ownership of the economy’s capital stock. In general terms, the ideal is a mar-
ket in which prices provide accurate signals for resource allocation.... A market in which prices
always ‘fully reflect’ available information is called ‘efficient’” (“Efficient Capital Markets: A
Review of Theory and Empirical Work,” Journal of Finance (May 1970); 383 quoted in Fox, 104)

If one subscribes to the wisdom of markets, then the following corollary is that any govern-
ment regulation of markets is bad for as Fredrich Hayek intimated in a 1945 article, “The Use
of Knowledge in Society,” “Any attempt to regulate prices or business activity was doomed to
thwart the movement of knowledge needed to make the economy run smoothly” (Fox, 91-2).
This mentality was most vigorously marketed by Milton Friedman, a professor of economics at
the University of Chicago in his Capitalism and Freedom that expresses the idea that “whatever
the government does is bad” (Fox 93-4). This Chicago School understanding of economics de-
volved into what some refer to as Disaster Capitalism: making a huge fortune specifically from
natural and planned disasters exacerbated by poverty, social tensions, environmental degrada-
tion, ineffectual leadership, and weak political institutions. Disaster capitalism’s raison d'être
may be the promotion and generation of market inefficiencies – pricing signals that distort real
prices for goods and services and their real cost to the environment, public health, and social
justice. The checkered history and deleterious results of disaster capitalism is well documented
in Naomi Klein’s, The Shock Doctrine: The Rise of Disaster Capitalism (New York: Henry Holt and
Company, 2007). The most recent result of this economic theory is the 2008 financial crisis.

20 For a discussion of endgames and use of game theory w/re to nuclear WMD-T analyses, see
http://www.scribd.com/doc/9776295/Terrorists-Endgame-Tactical-Nuclear-Games-May-2004.

21If one were assessing systemic market risk, for example, does it give one pause that ap-
proximately 75% of the agricultural seeds used to grow all the food that feeds the nation comes
from only four sources: Dupont, Monsanto, Syngenta, and Groupe Limagrain? Is this just an-
other form of banks-too-big-too-fail that may not be adequately managing systemic risk and
when (not if) collapse occurs will need to be bailed out by the public taxpayer? Of course, elec-
tronic financial chits can be created at will, but where will replacement seeds come from? The
recent film, Food, Inc. asks these questions about the entire industrialized food system that
supplies food in the U.S. For example, just one meat packer, Beef Products, Inc. (BPI), supplies
almost 70% of all the hamburger meat in the country, just a handful of chicken processors sup-
ply almost 90% of the chicken to grocery stores, etc. In all these cases, food is rendered artifi-
cially inexpensive by not including the cost of systemic risk in the price of the food good.

22For example, the systemic risk to the national and global economy may have been less the 9/
11 terrorist attacks than the U.S. response to those attacks. If one takes this view, then the ap-
propriate system resilience could be considered as not only the improvements to intelligence
dissemination and sharing, and homeland infrastructure protection, but also the pre-planning
of responses if such a consequential endgame event occurs, despite best efforts, so as to not re-
spond disproportionally to the threat, thus producing even greater adverse consequences.

Lyle Brecht DRAFT 1.12 Sunday, November 15, 2009 CAPITAL MARKETS RESEARCH - Project Metanoia - Page 14 of 18
C O N S E Q U E N T I A L & C A T A S T R O P H I C R I S K

23 By believing that a consequential endgame event is possible, does not mean that it is possible
to accurately assess a risk probability of the occurrence or of the consequence. Generally, rare
events exhibit an incomputability of probabilities. Nassim Nicholas Taleb (b. 1960) describes why
it is so hard for markets, on their own, to price systemic risk in his Fooled By Randomness (2001)
and The Black Swan (2007). He outlines Benoit Mandelbrot (b.1924) proofs of the incomputability
of the probability for consequential rare events from empirical observations ("black swans").
From empirical studies of risk in a time series, it appears that in the process of achieving gen-
eralizations from this data and/or deriving general rules from particular observations, hidden
properties in the data are routinely missed. Decision-makers end-up overestimating the value
of rational explanations of past data, and underestimate the prevalence of unexplainable ran-
domness in the data. The result is managing system resiliency as if a black swan will never oc-
cur, even though they almost always do.

Taleb believes decision-makers ignore black swans because humans are more comfortable see-
ing reality as something structured, ordinary, and comprehensible (i.e. rationally explainable).
Taleb calls this blindness to the Real the Platonic fallacy and argues that it leads to three ex-
planatory distortions when developing models of reality in time: (a) narrative fallacy: using
retrospective historicity to ‘explain’ the past. That is, the past occurred this way because of x, y,
and z; (b) ludic fallacy: modern probability theory, utility theory, rational choice theory, and
game theory that assumes a normal Gaussian distribution probability curve mistakes simple
models of reality with the Real; (c) statistical regress fallacy: believing that the structure of the
probability of x occurring that actually exists in reality can be fully developed and described
from a set of data.

Taleb also believes that people are subject to the triplet of opacity, through which historical de-
scriptions of reality are distilled and explained even as current events are incomprehensible.
The triplet of opacity consists of (a) a hubristic illusion of understanding of current events; (b)
a retrospective distortion of historical events to fit current socially acceptable ways of describ-
ing reality; (c) an overestimation of what constitutes factual information, combined with an
overvaluing of the value of expert knowledge (typically rendered by experts possessing certain
credentials, experience, or notoriety)) concerning the subject being discussed.

From a risk modeling perspective, these arguments recommend: (1) using a Cauchy-Lorenz dis-
tribution rather than a normal (Gaussian) distribution; (2) do not assume stationarity (the fu-
ture will be an extension of the past); and (3) new insights from behavioral economics question
the premises of rational choice theory. Thus, rational choice theory may not be a reasonable
foundation from which to engage in the game. For a more detailed discussion of these issues
see http://www.scribd.com/doc/20228926/Economic-Games-Behind-Nuclear-Deterrence.

24 Imagining that nuclear deterrence and the nation’s Nuclear Posture can be walled-off from
nuclear WMD-T is symptomatic of applying rational choice theory in a certius paribus fashion.
That is the system and decision-making regarding capital allocation decisions regarding that
system being analyzed can be ‘walled-off’ from other, interacting systems and the decision-
space adequately described, all things being equal when , this is merely a simplifying assump-
tion to make the analysis easier and does not represent contingent effects and unintended de-
terminants for WMD-T consequential and catastrophic risk. For an expanded discussion of
these issues, see http://www.scribd.com/doc/16490356/Rethinking-Nuclear-Deterrence and
http://www.scribd.com/doc/20860011/Game-Strategy-of-Nuclear-Deterrence.

Lyle Brecht DRAFT 1.12 Sunday, November 15, 2009 CAPITAL MARKETS RESEARCH - Project Metanoia - Page 15 of 18
C O N S E Q U E N T I A L & C A T A S T R O P H I C R I S K

25Pricing the systemic risk of anthropogenic CO2 emissions to the atmosphere might produce
a cost of $42.00 (U.S.) per metric ton (the U.N recommends $50.00/metric ton), with corre-
sponding prices, based on their reactivity and residence times, for heat-trapping methane, ni-
trogen compounds, low-level ozone and soot emissions responsible for half of the man-made
emissions driving climate change. This price assumes 350 ppm CO2 is tipping point for reach-
ing climate outcomes. See MIT study
http://web.mit.edu/newsoffice/2009/roulette-0519.html.
To date, existing policy w/re to anthropogenic climate change has been an abject failure. “Be-
tween 1990 and 2000 the carbon intensity of the global economy was 0.27 tons for every addi-
tional $1,000 of GDP. In the period 2001 to 2006, that intensity rose to 0.53 ton for every addi-
tional $1,000 GDP. So, during the period in which the most concern has been expressed about
the need to reduce emissions, the world has become more carbon intensive” (p. 3). See Gwyn
Prins, et.al., “How to get climate policy back on course,” Institute for Science, Innovation and
Society, University of Oxford at http://www.lse.ac.uk/collections/mackinderProgramme/
pdf/ClimatePolBackonCoursePRODUCTIONFINAL060709.pdf.
EU experience with carbon trading and offsets raise the specter of another financial meltdown
like 2008 as carbon credits are bundled into complex financial instruments more than resulting
in meaningful reductions of carbon and GHG emissions. and Sarah-Jayne Clifton, “A Danger-
ous Obsession: The Evidence against Carbon Trading and the Real Solutions to avoid Climate
Change,” Friends of the Earth England, Wales and Northern Ireland at http://www.foe.co.uk/
resource/reports/dangerous_obsession.pdf.

26Maybe two percent of all the species that have ever lived on the planet during four billion
years of evolution are still alive. That is how evolution works; a pure laissez-faire system. Nu-
clear weapons could end this evolutionary march in an afternoon. Other consequential end-
games might take longer, but have a similar outcomes. For additional discussion see
http://www.scribd.com/doc/19772476/Costing-Systemic-Risk-from-Doomsday-Machines.

27 This binary view of capital allocation decisions parallels how complex systems work deeply:
either the bio-physical systems that are supportive of life (and economy!) on the planet are
evolving toward sustainability. Or they are moving towards collapse. As economic wealth is
always founded on this binary bio-physical reality, sustainable economic growth might be de-
fined as: sustainability is creating real economic wealth in the world for the communities we live in.
See more on complex systems at http://www.scribd.com/doc/21804956/Macroecologics.

28 Probabilistic Risk Assessment (PRA) is an analytical process that begins with two system coun-
terfactuals: (1) the magnitude (severity) of the potential adverse consequences of system fail-
ures; and (2) the likelihood (probability) of the occurrence of each potential consequence. The
objective is not as a predictive exercise, but as a disciplined descriptive process that may iden-
tify and highlight budget requirements for a secure national economic ecosystem environment.

29 Episodic risk from malicious human-agent initiated activities (terrorism, hacking, phishing
schemes, deliberate disruptive actions, etc.) is highly visible in that it may produce numerous
deaths and significant economic consequences within the timeframes of media news cycles
and fleeting memories of the public. Thus, in may ways, there is a convenience to allocate re-
sources (budgets, manpower, and policy) to mitigating episodic risk, even as this category of
risk may constitute only 30% of the large-scale systemic risks to the national economy and to
the lives of its citizens. For example, if post-9/11 one can attribute the allocation of $3,000 bil-
lion to the prevention (mitigation) of another 9/11, one might wonder if this amount of capital
was well-allocated, given a probabilistic risk assessment of other, more-likely or higher conse-
quence risks to the economy. For example, the meltdown of the CDO derivates market, an
avoidable risk, was far more harmful to the economy than any conceivable attack by al-Qaida.

Lyle Brecht DRAFT 1.12 Sunday, November 15, 2009 CAPITAL MARKETS RESEARCH - Project Metanoia - Page 16 of 18
C O N S E Q U E N T I A L & C A T A S T R O P H I C R I S K

30 Almost all modern industrial systems are interconnected with other systems. Systems are
resilient if, under stress, they can reorganize themselves and continue to function. All systems
have a tipping point, a set of stresses (an overload beyond a threshold rate of change of inputs)
beyond which they breakdown (loose complexity and cease to function within normal ranges)
and sometimes collapse (recovery is uncertain) or suffer deep collapse (multiple systems experi-
ence synchronous failure [the concurrent collapse of multiple support systems] when systems
are tightly coupled [operate with dependencies that deplete resilience]). As failure proceeds,
moments of contingency arise (there is an absolute timeliness for rescuing the system from col-
lapse e.g. if rescue measures are applied in time x, the cost is y; if rescue measures are applied
in time x+1, the cost is 100y. Think New Orleans pre-Hurricane Katrina: the cost to strengthen
the levees to Lake Pontrain before Katrina hit was a fraction of the cost to clean-up the devasta-
tion in New Orleans post-Katrina.)

31For many consequential and catastrophic risks “there is an urgent need to move beyond the
informal, DC centered [P3] partnerships of the past.... Government needs to provide incentives
for industry to invest in security items that may not be justified by their corporate business
plans.“ A Twenty-First Century Model for Protecting and Defending Critical Technology Sys-
tems and Information,” Internet Security Alliance (2008).

32 The most glaring recent instance of markets not pricing systemic risk was costing the price
for CDOs (collateralized debt obligations) - derivatives based on the underlying asset values of
mortgages on real property. Premiums for individual tranches of CDO’s were priced at a risk-
adjusted price that assumed no systemic risk. As the CDO market collapsed, U.S. taxpayers
were required to put up approximately $17,489 billion in reserves (potential future taxes).

33The “presence of chaos in a system implies that perfect prediction... is impossible not only in
practice but in principle.” See Melanie Mitchell, Complexity: A Guided Tour (Oxford & New York:
Oxford University Press, 2009), 13, 15, 20, 23, 33).

34 In investing to better manage systemic risk from consequential endgame vulnerabilities, who
should pay, what economic incentives are available, who decides best practices, and how is ac-
countability accomplished? For example, “With tens of billions of dollars in investment on the
line.... [participants] want to know that the investments aren’t going to introduce new and
unmanaged risks.” See “Testimony of the Hon. Gary Brown, Chmn., NY State Public Service
Commission, before the U.S. House of Representative, Committee on Energy and Commerce,
Subcommittee on Energy and the Environment on behalf of the National Association of Regu-
latory Utility Commissioners” (October 29, 2009).

Lyle Brecht DRAFT 1.12 Sunday, November 15, 2009 CAPITAL MARKETS RESEARCH - Project Metanoia - Page 17 of 18
C O N S E Q U E N T I A L & C A T A S T R O P H I C R I S K

35Implied: “It is not a realistic goal to anticipate and prevent all rare events, but it may be pos-
sible to make rare events rarer, and to reduce their effect” (p. 5). “However, it is simply not
possible to validate (evaluate) predictive models of rare events that have not occurred, and
unvalidated models cannot be relied upon” (p. 7). DOD Research & Engineering’s Strategic
Multi-Layer Assessment (SMA), MITRE’s Jason report, “Rare Events” (October 2009).

36Instead of prioritizing investments to address highest probability, highest consequence cyber

vulnerabilities, it may be more productive (on an economic return on invested capital basis
(EROIC) to address vulnerabilities on the fat tail of the Cauchy that represent unlikely, but po-
tentially catastrophic consequences.

37The issue is that even as high probability/high consequence vulnerabilities are decided on as
priorities, the capital necessary to address these vulnerabilities to a specified level of system
assurance (in X timeframe) is not analyzed on an NPV basis, but left as an ‘open’ investment.
Even if the vulnerabilities are patched or Band-Aided, there are often few means to determine
on a relative basis whether this allocation of capital produced a better return on invested capi-
tal than another project. Note: there is always a limited supply of capital to complete work in
any defined period.

Lyle Brecht DRAFT 1.12 Sunday, November 15, 2009 CAPITAL MARKETS RESEARCH - Project Metanoia - Page 18 of 18