Physical Risk, Fiscal Risk?

As Australia reckons with a devastating series of bushfires, the consequences of the disaster are still unfolding. Tragically, at least 28 people have lost their lives along with more than 1 billion animals. At least 17.9 million acres have burned, which, astoundingly, is almost the same size as South Korea. The economic impacts, meanwhile, are still being calculated. Besides the physical damage to private property and public infrastructure, costs include the loss of income from tourism, current and future health costs and the loss to ecosystems. Early estimates suggest that the total costs could exceed tens of billions of dollars.

As tragic as the fires have been, Australia does at least have the benefit of being a wealthy country. The outlook is considerably bleaker for less affluent countries who experience climate-related disasters. While the absolute monetary value of damage tends to be lower in less developed countries, their limited government budgets suffer greater strain from climate disasters (not to mention the even more consequential loss of life). Increasingly, climate-related physical risk may simply be fiscal risk in disguise.

Physical disasters have, in fact, played a part in economic and financial crises even in the US. The infamous panic of 1907 was set in motion by the 1906 San Francisco earthquake, which perversely prompted tighter US monetary policy and precipitated a financial bust. But the physical-fiscal risk nexus will take on modern forms in the future, such as through the mortgage market. Economists Amine Ouazad and Matthew Kahn describe a combination of increasing natural disasters and declining flood insurance protection, which could, in theory put commercial lenders at risk of loan defaults. Their research suggests, however, that such mortgages are increasingly being securitized for sale to two Government Sponsored Entities (GSEs), Fannie Mae and Freddie Mac. Essentially, risk is being transferred to the US taxpayer. Imperceptibly, physical risk has become fiscal risk, the magnitude of which could be meaningful. Susan Wachter, a professor of real estate and finance the University of Pennsylvania’s Wharton School, cautions that that mortgage market’s exposure to flooding “could be as large as the losses due to the subprime crisis.”

To be clear, we are not suggesting that climate-related physical risks are about to tip the global financial system into catastrophe. But it’s worth recalling Ernest Hemingway’s immortal line in The Sun Also Rises, in which a character named Mike is asked how he went bankrupt. Mike responds: “Two ways. Gradually, then suddenly.” Climate risk, and its attendant financial costs, may be much the same.

Additional links:

The Interchange: The Underwater Mortgage Market
Kleinman Energy Center: Is Climate Risk Insurable?