1% chance of catastrophe

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My 6 semesters of undergraduate economics over 10 years ago is often not enough to allow me to keep up with many of Paul Krugman’s more esoteric blog posts but when the phrase “a 1% chance that catastrophic climate change will reduce world GDP by 90%” gets used, even I can understand.

Continuing today’s theme of “news and issues that are going relatively unreported,” I bring you Krugman’s post about the Economics of Catastrophe.  The catastrophe to which he refers is the potential damage to the earth caused by global climate change.

How many times have you seen a disaster movie and wondered what all of the death and destruction would mean on your ability to go to the supermarket and pick up your week’s groceries?  My mind occassionally strays to the scenario in which climate change raises sea levels, intensifies storms, destroys infrastructure and housing, and generally just wreaks havoc on my comfortable, predictable existence.

What would I do if such a thing were to happen?  The 90% drop in world GDP represented above is a way of saying that our collective standard of living would be returned to something approximating the early 1800s without roads, bridges and canals.  Or, better yet, my big city, American life would become more like East Africa.  No more clean water from a tap in my house.  No more heat and air conditioning.  No more ice.

I’ve gotten to like things like, oh, insulation, clothes dryers, ceiling fans and sidewalks.  With a 90% drop in GDP, I could probably kiss all of that good bye.

Now, will it be as bad as all that?  Not likely.  In fact, Krugman says that statistically, the 90% drop is a bit of stretch:

And here’s the thing: on any sort of expected-welfare calculation, the small probability of catastrophe dominates the expected loss. Suppose that there’s a 99% chance that Lomborg is right, but a 1% chance that catastrophic climate change will reduce world GDP by 90%. You might be tempted to disregard that small chance — but if you’re even moderately risk averse (say, relative risk aversion of 2 — econowonks know what I mean), you quickly find that the expected loss of welfare isn’t 0.5% of GDP, it’s 10% or more of GDP.

So the question remains: how can economic policies and business decisions be made in a system that has traditionally depended on a baseline of certainty.  The free market assumes at the very least that there won’t be any natural disasters and that if there are, they will be quick, localized and able to be fixed (hence, insurance).  Without that certainty, it all goes out of whack.

Economics, the dismal science indeed.

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