Worst-Case Economics

Frank Ackerman

Description

‘Worst-Case Economics: Extreme Events in Climate and Finance’ explores the underlying causes and the remedies needed for the most serious climate and financial risks.

Why do climate and financial crises pose such extreme risks? And what does it take to respond effectively to those risks? Extreme weather events – storms and sea-level rise, heat waves, droughts and floods – seem ever more common and extreme, while scientists warn of even greater climate risks ahead. Financial failures on the scale of 2008 make a mockery of the supposed efficiency of the market economy. None of this would be possible in the world as imagined by conventional economics – an imaginary land of gradualism, equilibrium, well-informed rationality and the win-win solutions dealt by the invisible hand.

The erratic rhythm of boom and bust in financial markets could be explained either by the patterns of crowd-following behaviour among investors, or by the unequal distribution of wealth (and the impact of the largest investors on the markets). Climate crises reflect the fact that natural systems can reach tipping points or critical transitions, where gradual change gives way to large-scale discontinuous changes. The economics of climate change has lagged behind the science, understating the severity of the problem and the likelihood of a crash.

While the causes of climate and financial extremes are distinct, the implications for public policy have much in common. The frequency of extreme events, of varying sizes, means that there is no way to predict the likely size of future crises. The traditional approach to risk aversion cannot account for longstanding patterns in financial markets. Better theories of risk call for more precautionary approaches to both financial and climate policy. In the frequent cases in which potential outcomes have unknown probabilities, the best policy is based on the worst-case credible scenario. When a single catastrophic risk commands everyone’s attention, a World War II-style, costs-be-damned mobilization is the right response. There is no formula for perfect responses to extreme risks, but there are important guideposts that point toward better answers.

List of Figures; 1. Introduction; 2. Steam-engine economics; 3. Beyond homo economicus; 4. Big and dirty; 5. Pictures of improbability; 6. Trillions, or only hundreds?; 7. Zipf’s law and other stories; 8. Ants and traders; 9. Too big to ignore; 10. Climate tipping points and known unknowns; 11. Predators and prey; 12. Good enough for government work; 13. Fat tails and the failure of forecasting; 14. Misunderstanding risk; 15. Choices beyond calculation; 16. Who won World War II?; 17. Conclusion; Acknowledgments; Bibliography; Index.

Sujets

• POLITICAL SCIENCE
• Environmental policy
• Economic policy
• Public policy
• General officer
• Environmental economics
• General
• Finance

Informations

• Publié par: Anthem Press
• Date de parution: 23 octobre 2017
• Nombre de lectures: 0
• EAN13: 9781783087099
• Langue: English

Extrait

WORST-CASE ECONOMICS
WORST-CASE ECONOMICS
EXTREME EVENTS IN CLIMATE AND FINANCE
FRANK ACKERMAN
Anthem Press
An imprint of Wimbledon Publishing Company
www.anthempress.com

This edition first published in UK and USA 2017
by ANTHEM PRESS
75–76 Blackfriars Road, London SE1 8HA, UK
or PO Box 9779, London SW19 7ZG, UK
and
244 Madison Ave #116, New York, NY 10016, USA

© Frank Ackerman 2017

The author asserts the moral right to be identified as the author of this work.

All rights reserved. Without limiting the rights under copyright reserved above,
no part of this publication may be reproduced, stored or introduced into
a retrieval system, or transmitted, in any form or by any means
(electronic, mechanical, photocopying, recording or otherwise),
without the prior written permission of both the copyright
owner and the above publisher of this book.

British Library Cataloguing-in-Publication Data
A catalogue record for this book is available from the British Library.

ISBN-13: 978-1-78308-707-5 (Hbk)
ISBN-10: 1-78308-707-2 (Hbk)

This title is also available as an e-book.
To my grandson, Ronan, born while I was writing this book, too young to understand the madness of this moment. May he grow up in a sane and sustainable world.
Economists set themselves too easy, too useless a task, if in tempestuous seasons they can only tell us, that when the storm is long past, the ocean is flat again.
—John Maynard Keynes 1

1 Keynes ( 1923 ).
Contents
List of Figures

CHAPTER 1 Introduction

CHAPTER 2 Steam-Engine Economics

CHAPTER 3 Beyond Homo Economicus

CHAPTER 4 Big and Dirty

CHAPTER 5 Pictures of Improbability

CHAPTER 6 Trillions, or Only Hundreds?

CHAPTER 7 Zipf’s Law and Other Stories

CHAPTER 8 Ants and Traders

CHAPTER 9 Too Big to Ignore

CHAPTER 10 Climate Tipping Points and Known Unknowns

CHAPTER 11 Predators and Prey

CHAPTER 12 Good Enough for Government Work

CHAPTER 13 Fat Tails and the Failure of Forecasting

CHAPTER 14 Misunderstanding Risk

CHAPTER 15 Choices Beyond Calculation

CHAPTER 16 Who Won World War II?

CHAPTER 17 Conclusion

Acknowledgments

Bibliography
Index
Figures
FIGURE 1 Northwest Atlantic cod harvest
FIGURE 2 Probability distribution for the sum of two dice
FIGURE 3 Probability distribution for the sum of ten dice
FIGURE 4 The normal distribution
FIGURE 5 Height of US women, ages 30–39
FIGURE 6 Daily percentage change in S&P 500, 1950–2013
FIGURE 7 Daily percentage change in S&P 500 (bottom of Figure 6, enlarged)
FIGURE 8 Daily percentage changes in S&P 500, 2006 and 2008
FIGURE 9 Annual variation in S&P 500 and in normally distributed data, 1950–2013
FIGURE 10 The “tails” of normal and fat-tailed distributions
FIGURE 11 Normal versus power law distributions, ratio scale
FIGURE 12 The same curved line, shown in conventional and ratio graphs
FIGURE 13 Absolute value of daily percentage changes in S&P 500
FIGURE 14 The 2003 heat wave and the normal distribution
FIGURE 15 Frequency of the most common words in Shakespeare
FIGURE 16 Distribution of top incomes in the United States and Japan, 2010
FIGURE 17 Temperatures in central Greenland, reconstructed from ice core data
FIGURE 18 Policy choices as a game with nature
FIGURE 19 The maxmin criterion: a numerical example
FIGURE 20 The minimax regrets criterion: the same numerical example
CHAPTER 1
Introduction
Most of the time, there are no speculative bubbles bursting or financial markets crashing. The abrupt loss of millions of people’s jobs, homes and retirement savings is not a frequent occurrence.
Most of the time, hurricanes are not battering Houston, Miami, New Orleans and other vulnerable places. It is rare for the world to reach a tipping point into an irreversibly worse climate.
It is quite likely that none of these worst-case events are happening on the day when you are reading this book, or at any other single point in time. But none of these disasters are improbable enough to ignore.
Financial and climate crises may look like an odd couple for combined discussion. While both involve episodic crises, their rhythms of instability are different. Financial crises are fast-moving, repeated and, over enough years, reversible. Climate crisis is slow-moving, cumulative and could become irreversible on any human time scale.
Yet there are also deep similarities. Both involve rare, costly extreme events, with risks of huge losses that individuals cannot escape on their own. Both are created by short-sighted human activity, pursuing immediate economic gain at the expense of long-term consequences. 1 Both are misunderstood by conventional economics, which minimizes their importance and discourages the development of sensible public policy responses. And both face major industries with a vested interest in the status quo, a powerful obstacle to the adoption of policies that could prevent future crises.
This comparison of the two fields grew out of my research on the economics of climate change. In that research, an analysis of financial markets, focusing on the treatment of extreme risks, turned out to be remarkably useful in understanding potential climate outcomes. 2 In both fields, there is a need for a new and better economics of risk and responses. Protection against both climate and financial crises requires policies that bear some resemblance to insurance, based on a new understanding of risk and innovative ways of thinking about decision making under uncertainty.
The goal of this book is to understand the patterns of extreme events and the policies needed to address the risks related to these events. How should we respond to the fact that high-cost losses in both climate and finance are not as rare as we might have hoped or expected?
Costs of crisis
The Great Recession threw almost nine million people out of work; US employment did not return to its 2007 level until 2014. 3 And many who remained employed ended up with lower wages and/or fewer hours of work than before. Youth unemployment was particularly severe, with long-term consequences for those who entered the labor market during the downturn. Research on prior years has found that those graduating from college during a recession experience significant negative effects on wages—effects that may last for as long as 15 years. 4 Those who were already of working age during the Great Recession, meanwhile, are likely to have permanently lower retirement incomes, as their job losses and slower wage growth ripple through the formulas for future Social Security payments. 5 For those who had been saving for retirement, the problem is compounded by the collapse in the value of homes and financial assets.
More than nine million households lost their homes between 2006 and 2014; many of them may never be homeowners again. 6 House values fell by a nationwide total of $5.5 trillion; in 2011, 11 million households owed more on their mortgages than the current market value of their homes. 7 Housing is the largest asset owned by most people, so the crash in house values had a devastating effect on wealth in general. Between 2007 and 2011, one-fourth of American families lost at least 75 percent of their net worth; more than half lost at least 25 percent. 8 Losses were worst, in percentage terms, for low-income and minority households. 9
The United States has had numerous weather disasters for which the country was ill-prepared, including Hurricane Katrina drowning New Orleans in 2005, years of record-breaking drought in California, Hurricane Sandy clobbering the New York area in 2012, Hurricane Harvey inundating Houston in 2017 and floods along the Mississippi and other major rivers. Elsewhere in the world, the impact of extreme weather is even worse. The worst recent climate-related losses in high-income countries occurred in the European heat waves of 2003 and 2010, discussed in Chapter 6 . Storm damage is proportionally greater, and resources for protection and recovery are more limited, in low-income coastal countries such as Bangladesh and the Philippines, as well as in small island nations that are threatened with complete inundation.
The cause of these climate trends is well known, even though individual events are unpredictable in detail. Rising greenhouse gas emissions, primarily due to combustion of fossil fuels, are warming the world and destabilizing the climate. Larger, irreversible damage could occur in the not-so-distant future, although the timing and magnitude of such threats remain uncertain. The direction of change, however, is clear: catastrophic climate losses, although still unlikely today, become steadily less unlikely as the world grows warmer.
Beyond whispers and tweets
Imprecise predictions of extreme events are no excuse for inaction. Ample warnings have repeatedly been ignored by policy makers. Four years before Hurricane Katrina, a detailed description of the vulnerability of New Orleans and the need for improved storm defenses appeared in Scientific American. 10 Seven years before the housing, subprime mortgage and stock market bubbles burst, Robert Schiller, a prominent economist, published a widely cited book with a title that tells the story: Irrational Exuberance . 11 Alongside the puzzling origins of extreme events, there is the mystery of why public policy remains feckless in the face of such well-anticipated harms.