Uncertainty, rather than just plain risk, leads to over-insurance:
A simple example can reinforce this point. Suppose two investors, A and B, engage in a swap, and there are only two states of nature, X and Y. In state X, agent B pays one dollar to agent A, and the opposite happens in state Y. Thus, only one dollar is needed to honour the contract. To guarantee their obligations, each of A and B put up some capital. Since only one dollar is needed to honour the contract, an efficient arrangement will call for A and B jointly to put up no more than one dollar. However, if our agents are Knightian, they will each be concerned with the scenario that their counterparty defaults on them and does not pay the dollar. That is, in the Knightian situation the swap trade can happen only if each of them has a unit of capital. The trade consumes two rather than the one unit of capital that is effectively needed.
This is a classic negative externality and so Caballero suggest government intervention when so-called Knightian uncertainty — the fear of unknown unknowns — rears its head (e.g. now).
Just because I have a single tracked mind… I’m wondering if the fiscal stimulus will do anything to calm fears of the unknown unknowns.