Disasters Are Worth Preventing

In August I reported that economic disasters seem thin-tailed, and so are not existential risks.  Even so, it seems we should still devote more attention to them:

What is the likelihood that the U.S. will experience a devastating catastrophic event over the next few decades — something that would substantially reduce the capital stock, GDP and wealth?  …  How much should society be willing to pay to reduce the probability or likely impact of such an event?  We address these questions using a general equilibrium model that describes production, capital accumulation, and household preferences, and includes as an integral part the possible arrival of catastrophic shocks. …

We model catastrophes as Poisson events with some mean arrival rate, and an impact characterized by a one-parameter [thin-tailed] power probability distribution. … We calibrate our model so that it fits the basic data for the consumption-investment ratio, the risk-free interest rate, the equity premium, Tobin’s q , and the average real growth rate.  We thereby calculate the implied characteristics of catastrophes, and also determine how those characteristics vary over a range of values for the preference parameters. …

We found the annual probability of a catastrophe to between 0 and about .04. A reasonable estimate would be in the middle of our range, i.e., around .02. This is close to Barro’s (2006) estimate from historical data, but was obtained in a very different way. Our estimates of the impact distribution and expected loss should a catastrophe occur are tighter, but depend on the index of risk aversion (which we take to be between 2 and 4). However, the expected losses are large; about 26 to 32 percent …  We calculated … the permanent tax on consumption that society would accept to reduce the annual probability of a catastrophe by some percentage. Using the mid-range estimate of .02 for the annual probability, a permanent consumption tax of about 9 percent would be justified if it could cut this probability in half. Even if the probability is lower than .02, our results suggest that governments should devote greater resources to reducing the risk and potential impact of a global catastrophe.

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  • Does this paper have its biology right?

    Paying to reduce the risk of a disaster that affects everyone is something self-interested agents should not be expected to do. In human biology, people compete mostly with other people. It doesn’t make much difference how well the whole planet is doing (unless you fear humans will lose their races with other species) – what matters is how well people are doing *relative* to other people.

    Paying a local tax to avert a global disaster that affects everyone equally is simply bad, from this perspective: you lose money – and everyone else benefits. Self-interested agents are unlikely to vote for such things.

    What would make more sense are local efforts to reduce the impact.

    • Psychohistorian

      “Paying a local tax to avert a global disaster that affects everyone equally is simply bad, from this perspective: you lose money – and everyone else benefits.”

      Everyone else also loses money, so if you’re sincerely purely ordinal in your value of wealth, you’re not really worse off.

      • The people in the countries which are taxed lose money. If you vote against the taxes, then you are less likely to be among them.

    • Tim, however biologically implausible it sounds, people have voted for tax increases, or not tried very hard to stop them. Voting cannot be justified on purely selfish grounds. But given that one is voting, supporting the provision of public goods can be.

      • Voters approving tax increases is not necessarily biologically implausible.

        Poor people can be expected to vote for tax increases when the increases tax the rich more than the poor – especially if the poor get some of the money back in the form of welfare, eduction or healthcare.

        However, this seems like a bit of a digression.

    • John Maxwell IV

      The voters are not choosing whether they want to pay to reduce the likelihood of disaster. They’re choosing whether they want to force everyone, including themselves, to pay to reduce the likelihood of disaster.

      In other words, even if you wouldn’t cooperate in a prisoner’s dilemma in which everyone was currently defecting, you might vote in favor of a measure that made it illegal to defect.

  • Atavist

    In human biology, people compete mostly with other people.

    In evolutionary models, long-term reputational/signaling benefits can stabilize quite costly short-term self-sacrifice, even among large populations of non-kin. And there’s growing behavioral evidence in line with the predictions of indirect reciprocity and competitive altruism. People just need to be held publicly accountable more, and this is perhaps the key benefit of focusing on “local efforts.”

    • Nobody wants to be taxed. Governments could conceivably coerce each other into cooperating to impose such taxes – but since they would be uniformly unpopular among all their citizens, why would they?

  • Two points, which happen to be related. The first is that their model is basically questionable, a DSGE model that only allows for fluctuations due to exogenous shocks. This is Barro dogma, but Barro is looking pretty ridiculous right now. Just what was the exogenous shock that brought us to our current pretty situation? Does he think that bubbles are strictly due to exogenous shocks? I do not think so, and neither do many others. DSGE models cannot and do not handle them, other than saying they are “exogenous.” What a joke. Lab data shows they arise spontaneously all the time, even when people know what fundamentals are and that those will be delivered in finite time, indeed in finite time soon.

    Related to this is that I bet if they did this for only the period of say 1800-1945 they might well get a significant fat tail. It is widely observed that fluctuations have been much less since WW II when governments began making specific efforts to counter fluctuations through various policies. This paper is essentially an argument for going back to what we did before the Great Depression (or, to be more precise, did not do).

  • Jay

    It seems to me that economic events of this magnitude would be very hard to disentangle from political events, both as causes and as effects. I wonder how they handled politics.

  • This doesn’t add up. Rational to pay a 9% tax to avert a catastrophe that occurs once every 50 years? It’s better to go broke every 50 years. What kind of catastrophe are we talking about, an asteroid strike?