Although many of us would prefer not to think about it, the fact is that we face a variety of global catastrophic risks. Examples include an eventual climate catastrophe caused by continuing Greenhouse Gas (GHG) emissions, a major pandemic as bad as or even worse than 1918-19 Spanish Flu, nuclear or bioterrorism, or a financial crisis and economic depression as bad as the Great Depression of the 1930s. These risks are very different in nature, but they have two things in common. First, these are global risks, not local ones. Hurricanes, floods, and earthquakes can do terrible damage and lead to a great loss of life, but the impacts are local, and do not significantly affect the world economy in any significant way. Second, as discussed below, such a catastrophe would have a major global economic impact. Martin and Pindyck (2015) assess these risks and examine the problem of determining which ones should be averted and which should not. Here my objective is to clarify that these risks are real, and have major economic implications.
What are some of the major catastrophic risks we face, and what might be their economic impacts? Although people will disagree about which of these risks are the most worrisome, they would include the examples I gave above. Here is my list of major risks; readers who are more imaginative (or pessimistic) than me might want to add some others:
- Climate change. This risk has lately been getting the most attention, and it is in- deed worrisome. However, at least according to the 2014 IPCC report, a catastrophic climate outcome is unlikely to occur in the next 20 years. Over the longer term the risk gets much bigger. The economic impact could involve a substantial decrease in produc- tivity (especially in the agricultural sector), more frequent and intensive hurricanes, flooding and droughts, and associated property destruction, and increased morbidity. All of these changes would reduce the level and growth rate of GDP. Estimates of the effective reduction in (world) GDP from moderate warming over the next 30 to 50 years range from 3% to 10%. However, a catastrophic climate outcome could lead to GDP reductions on the order of 10% to 30% (Note 1).
- Pandemics. The 1918-19 Spanish Flu killed about 4% of the U.S. and European populations. (If that doesn't sound like much, if it occurred today it would repre- sent more than 12 million deaths in the U.S. alone.) Because populations today have greater mobility, a similar virus could spread more easily. According to the Centers for Disease Control and Prevention (CDC) in the U.S., the threat of future pandemics is considerable: "While we can't predict exactly when or where the next epidemic or pandemic will begin, we know one is coming." The main reasons: "Increased risk of infectious pathogens spilling over from animals to humans; development of antimicro- bial resistance; spread of infectious diseases through global travel and trade; acts of bioterrorism; and weak public health infrastructures (Note 2)." Apart from its impact on the labor force, a major pandemic would cripple transportation and retail trade.
- Nuclear terrorism. Various studies have assessed the likelihood and impact of the detonation of one or several nuclear weapons in major cities; see, e.g., Allison (2004) (who has argued that there is at least a 50 percent chance of a major attack in the next decade) and Ackerman and Potter (2008). They found the likelihood to be substantial; in fact Allison has argued that there is at least a 50 percent chance of a major attack in the next decade. What would be the impact? Possibly a million or more deaths, and a major shock to the capital stock and GDP from a reduction in trade and economic activity worldwide, as vast resources would have to be devoted to averting further events.
- Bioterrorism. Rough estimates of the likelihood of a bioterrorist attack (and the costs of reducing the risks) can be found in Nouri and Chyba (2008), Lederberg (1999), and references they cite. Bioterrorism is unlikely to result in large numbers of deaths; instead the major impact would be a shock to GDP from panic and a reduction in trade and economic activity worldwide. As with a nuclear attack, vast resources would have to be devoted to averting further attacks.
- Nuclear war. War of any kind is a major risk, but the use of nuclear weapons, even in a contained conflict, could be devastating for the world economy. It is much less likely than the use of nuclear weapons by terrorists, and not something I will dwell on here, in part because it is far less clear how it can be prevented.
- Global economic contractions. Major economic contractions are another ongoing risk, and another "Great Depression" might be caused by a financial crisis or an es- calating trade war. Economic contractions of various sizes have occurred regularly, and are an important form of "background risk," which, as explained in Martin and Pindyck (2015) and Martin and Pindyck (2017), magnifies the potential impact of the other risks.
- Other possibilities. If you feel you don't have enough to worry about, here are a few more things: robots and AI that become uncontrollable, nano-technology, cosmic gamma ray bursts, and asteroids. But we will ignore these things, on the grounds that at least at this point, they are very speculative.
With the exception of climate change, we read and hear little about these risks. So how do we know that they are real, and that there is any need to be concerned about them? Perhaps I am simply too much of a pessimist.
We know the risks are real for two main reasons. The first is that the people who study them have made very convincing arguments that they are real and, should they occur, could have devastating economic consequences. This article is too short for a comprehensive discussion of what we know and don't know about each risk, but see the examples and references in Martin and Pindyck (2015), Bostrom and Ćirković (2008) and Posner (2004).
Second, the potential for economic catastrophes enables us to reconcile our understanding of financial markets and investor behavior with fundamental economic and financial data. The "equity premium puzzle" is probably the best example of this. The equity premium—the expected return on the overall stock market minus the risk-free interest rate—has averaged somewhere in the range of 5 to 10 percent for most of the world's major equity markets, and the (real) risk-free rate has averaged about 1 percent. This high equity premium and low real risk-free rate, combined with the normal fluctuations in equity prices that we observe, are inconsistent with investors having realistic levels of risk aversion and rates of time preference. But now add something to the behavior of equity prices: the possibility of rare disasters, of the "Great Depression" variety. Because they are rare, we see little of them in the data, but they lurk in the background, and affect the perceived riskiness of equity investments. As first shown by Rietz (1988), with this addition, the high equity premiumand low risk-free rate can be reconciled with our estimates of risk aversion and rates of time preference.
This idea of "rare disasters" has been explored in a series of papers, including Barro (2006), Martin (2008), and Pindyck and Wang (2013). The catastrophic events in those papers are "generic" in nature, i.e., they could arise from any source. All that matters is that they could cause a sharp reduction in GDP and consumption, and thereby cause a sharp drop in equity prices. Introducing generic rare disasters can give us models of asset prices that are consistent with the data. Work on the potential economic impacts of specific catastrophes is more limited. Martin and Pindyck (2015) examine various types of catastrophic events, such as pandemics, nuclear terrorism, etc., that could impact GDP, and thus equity prices, in different ways. But what matters is that the risks of catastrophes — whether "generic" or specific in nature — helps us make sense of fundamental economic and financial data.
Given the economic important of potential catastrophic events, why don't they receive more attention? Perhaps we ignore some of these risks because doing otherwise is too depressing. In addition, it would force us to acknowledge the unfortunate fact that we are doing little or nothing to avert most of these possible catastrophes. For example, in the U.S. we inspect a small percentage of the containers shipped into the country, making it easier for terrorists to import nuclear devices. And we have very little in the way of a plan to react to a major pandemic. While these and other potential catastrophes cannot be averted completely, we could do much to reduce their likelihood and potential impact. But this takes political will and a forward-looking mind-set, which at this point seems lacking.
At the very least we need to be aware that these risks exist, and understand their economic implications. In debates about economic policy, these risks are largely ignored. Policy makers need to better understand what the economic impact could be if a catastrophe should occur, and how to best respond.