Abstract:

In his book about the financial crisis that led to the so-called "Great Recession," Michael Lewis tells the story of Michael Burry, a short-seller who realized that many subprime mortgage bonds were worthless if the inevitable happened—if home prices leveled off. Home prices did not need to actually fall for the financial meltdown to occur; they simply needed to level off. Models that valued subprime home loan-based derivatives did not reveal the extent of the risk because the models could not account for stable or falling home prices. Burry assumed that once this information became widespread, the market for these risky derivatives would collapse. To his surprise, even when the insight was widely shared, the party continued for years. By then, many individuals and institutions were too heavily invested in not seeing that the emperor had no clothes to change course before the meltdown began.We had a reaction similar to Burry's the first time we read one of Harvard economist Martin Weitzman's articles on the failure to include fat tailed risks in the leading integrated assessment models (IAMs) of climate change costs and benefits. The aspect of climate change most worthy of substantial attention by anyone interested in rational risk regulation is the existence of catastrophic, irreversible outcomes. Small shifts in rainfall or temperature may or may not be worthy of regulatory expenditures, but they do not pose core, long-term threats. Peer-reviewed publications by paleoclimatologists and climate scientists suggest, however, that there are disturbingly high likelihoods of temperature increases and sea level rises that could cause the kinds of systemic failures that almost brought down the financial system in 2008.