Downturns Are Not Existential Risks

Epidemics, wars, and quakes are distributed with long tails, so that most of the expected harm from such events are in the largest possible events.  Most who are expected to die in epidemics die in events that kill much of the population.  These long tail disasters plausibly embody existential risk – a risk to the existence of civilization and humanity.

A new paper on economic downturns suggests that such events do not have long tails, and so are not existential concerns:

In the rare-disasters setting, a key determinant of the equity premium is the size distribution of macroeconomic disasters, gauged by proportionate declines in per capita consumption or GDP. The long-term national-accounts data for up to 36 countries provide a large sample of disaster events of magnitude 10% or more. For this sample, a power-law density provides a good fit to the distribution of the ratio of normal to disaster consumption or GDP. The key parameter of the size distribution is the upper-tail exponent, alpha, estimated to be near 5, with a 95% confidence interval between 3-1/2 and 7. …

We work with the transformed disaster size z ≡ 1/(1-b), which is the ratio of normal to disaster consumption or GDP. … We start with a familiar (single) power law, which specifies the [probability] density function as f(z) = Az.

For a long tail, alpha needs to be two or less.

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  • Doug S.

    Well, I guess that makes sense, as long as you don’t include economic disasters that are directly caused by things that do have long tails…

  • Willem

    So AIG can now start insuring states for epidemics, wars, and quakes.

  • Does the paper take into account the possibility that policy strategies directly or indirectly aimed at rectifying a downturn might have long tails?

    For example, a country might create a new taxation scheme that is revenue-negative, or go to war, or radically change its regulatory structure, or target a minority for persecution as the downturn’s ’cause’, or ignore infrastuctural improvements needed to prevent other disasters.

  • Jay

    The major risk in a downturn is not that the economy will go to zero, but that too many frustrated unemployed people will take down the political system.

    Alternately, the government may sense public outrage and try to distract it with a war. Since a war, to be useful, would have to be mobilize society, there’s a danger of losing it. Alternately, the war may be won, building confidence for a later truly stupid war.

  • Looks like a nice paper, and fits in with some papers I have read that claim stock market price fluctuations have alpha’s around 3.

    However, plenty of natural disasters (and human wars) have mortality alphas between 1 and 2, the domain where the average is undefined and very big disasters are fairly common. There the important question is whether there exist cut-offs (likely for landslides and flooding due to geography, but not guaranteed for epidemics or wars).

    Together, this seems to suggest that while endogenous downturns and crashes occur, they are relatively unlikely to crash the market completely. But it might be exogenous disturbances that we should watch out for, both in terms of mortality and in their market impact.

    Still, the 1918 flu did not seem to have had a very noticeable economic effect – if extremes like that doesn’t show up in the data, maybe the economy is much more resilient than we normally tend to think?

    • Doug S.

      As the 1918 flu coincided with World War 1, it would be nearly impossible to separate the economic effects of the two of them.

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