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John Quiggin

An exercise in risk management: on what to be scared of and what to do about it

Australian Financial Review

10 September 2004

The future is always uncertain. One of the most difficult issues in planning to deal with uncertainty is that of the worst-case scenario. A decisionmaker who always assumes the worst will end up paralyzed by indecision, since almost any decision can turn out badly. On the other hand, failure to prepare for the worst case is a recipe for disaster. This article looks at worst case scenarios for a number of issues, and how to plan for them.

Security

The worst case possibility facing the world as a whole is that of a nuclear war. A thermonuclear war between Russia and the West could still arise by accident, but the likelihood of such a catastrophe has declined greatly. The period of highest risk was probably that leading up to the Cuban missile crisis of 1962. In view of what we now know about such possibilities as nuclear winter, it seems likely that a full-scale nuclear war would have wiped out the human race. All the other risks we face pale into insignificance.

The biggest current danger is that the continuing tension between India and Pakistan might erupt into a nuclear war. Other nuclear-armed powers include North Korea and (presumably) Israel.

A further serious risk is that of terrorists obtaining and using nuclear weapons. Although no terrorist group appears to have the capacity to build a nuclear weapon, there’s a significant risk that they might obtain one from Pakistan or North Korea. And unlike national governments, there are plenty of terrorists who would be keen to use a nuclear weapon if they could.

By contrast with the nuclear risk, the actual risk posed by other forms of terrorist attack, whether using ‘conventional’ methods, chemical and biological weapons or ‘dirty’ radioactive devices are quite small. A typical middle-aged Australian faces a risk of death, in any given year, somewhere between 1 in 100 and 1 in 200.

A terrorist attack on the scale of the Madrid atrocity every year would raise this risk by a factor of about 1 in 10000. That is, it would be insignificant, in terms of risk of death, when compared with the risks we face every day from accidents, heart attacks and so on. Even an attack on the scale of September 11 would have only a marginal impact on this measure. This is not to say that we should ignore the threat of terrorism. But consideration of worst case scenarios suggests we should be looking a lot harder at the possible leakage of nuclear weapons and that we not let ourselves be panicked by the threat of terrorism in general.

Global Environment

The big threat to the worlds environment as a whole is global warming. The best-bet projections prepared by the International Panel on Climate Change suggest that, in the absence of substantial action to mitigate global warming, global temperatures would probably increase by about 1 degree C between now and 2050 and by a further 1 degree C between 2050 and 2100.

This ‘best estimate’ implies environmental damage on a scale sufficient to justify an urgenr response. Of most concern to Queenslanders is the likelihood that rising sea temperatures could cause large-scale bleaching of coral reefs (the process by which symbiotic microorganisms are expelled from corals, leading to the death of the coral). A recent study by Queensland University’s Centre for Marine Studies estimated that 95 per cent of the coral cover on the reef would be lost by 2050, even under conservative assumptions about the rate of global warming.

However, many opponents of action to mitigate global warming have pointed to the uncertainties that surround climate projections to argue that the IPCC estimates may be overstated. Under favourable assumptions about such things as the feedback between climate change and concentrations of water vapour, it is possible that the temperature change associated with global warming will be less than 1 degree C, and might be swamped by natural climatic cycles. There are even some scientists (mostly not experts in the relevant fields) who deny the reality of global warming altogether.

The problem with this optimistic view of things is that it is equally important to look at the possibility that things might be worse than we currently expect on the basis of available scientific knowledge. The worst-case scenarios typically involve some sort of ‘tipping point’, with large-scale melting of the Atlantic ice shelf or a sudden change in ocean currents. Such changes can produce positive feedback leading to rapid climate change. The worst case scenarios typically involve a temperature increase of 5 degrees C.

The best strategy in this case is that of the Kyoto protocol. The reductions in emissions proposed under Kyoto won’t be enough to prevent global warming. But they provide a starting point. If new evidence over the next decade shows that the problem is not as bad as we thought, measures to implement Kyoto will be like an insurance policy on which we have not made a claim. The alternative possibility, of doing nothing, then being confronted with the worst-case scenario will involve far greater economic and environmental costs.

Droughts

There have been important changes in the way we think about droughts, especially in relation to public policy. In the past, droughts were viewed as natural disasters, requiring a public policy response, which was typically triggered when an area was declared drought-affected. This happened so often that some parts of Queensland were drought-declared one year in three. But a climate event that happens as regularly as this, can’t be regarded as an unpredictable disasters. It is simply part of the natural cycle, which farmers, water supply enterprises and others must take into account in their normal management. This is the central feature of the National Drought Strategy adopted in the 1990s, which faced its first real test in the recent large-scale drought. Although the drought was one of the worst in Australian history, most observers agree that it was handled more successfully than previous droughts that were, in purely climatic terms, less severe.

But recognition of droughts as part of the natural cycle does not provide a complete answer. No matter how good your management, it is not economically feasible to prepare against the worst-case droughts. A common criterion used in water supply is to prepare plans based on a 1 in 100-year drought, that is, one that would be expected to occur once in every hundred years on average. Implicitly, though, this means that if the drought is worse than the 1 in 100 years, normal planning will fail, and some emergency response will be needed.

A further twist to the worst-case scenario is added by the process of climate change. Estimates of the 1 in 100 year drought level are based on historical observations of the climate. But climate change will make some areas drier and others wetter. In areas where average rainfall declines, severe droughts will become more frequent.

Floods

In economic terms, droughts are normally a bigger problem for Australia than floods. But the worst-case scenario is considerably worse for drought than for flood. During a 1 in 10,000-year flood event, the Wivenhoe Dam could fail catastrophically, putting between 50 000 and 250 000 lives at risk. This possibility might seem so remote as to be negligible, but for a dam with a life of 50 years, the chance of a 1 in 10000 year event occurring at some point becomes 1 in 200, enough to be a threat worth considering

Fortunately, SEQWater is currently engaged in an upgrade which should protect against this remote possibility by raising the height of the spillway and dam wall to a level that should protect against a 1 in 100 000 year event.

It might be asked how it’s possible to make any sort of rational decision about whether to spend money on risks like this. The easy answer is that anything that reduces risk is worth doing, but since it is never possible to eliminate risk completely, it’s not possible to dodge the necessity for hard choices. The best way is to work out the average number of lives saved and compared the amount that would be needed to save the same number of lives in some other way, for example, through improvements in medical care. A typical estimate is that a treatment that is just on the margin of acceptability will cost around 100 000 for each additional year of life gained, which translates to about $5 million for each life saved from a disaster such as a flood.

Economy

For the next few years, the worst-case scenarios for the world and Australian economies involve a combination of rapidly rising interest rates and rapidly declining prices for assets, particularly in housing and construction. Such an increase in interest rates could begin in the United States, if investors (particularly Asian central banks) lost faith in the capacity of the US Government to bring its burgeoning deficits under control and in the capacity of the US Federal Reserve (that is, Alan Greenspan) to keep inflation rates low. A market-driven increase in US interest rates would rapidly spread to other countries with low savings rates and high current account deficits, notably including Australia.

A plausible worst case, with US inflation rates rising to 4 or 5 per cent a year, and real interest rates returning to, or surpassing their long run historical levels, could see the US 10-year bond rate increase from its current level of 4 per cent to as much as 8 per cent (still well below the maximum values of the past). If an increase of 3 or 4 percentage points flowed on to Australia, accompanied by declining asset prices, many borrowers, particularly highly-geared investors, would be forced to default.

As worst-case scenarios go, this is not a particularly drastic one. In broad outline it’s similar to the set of events that produced the last recession from 1989 to 1992. Despite the length of the economic expansion, there is no reason at all to think Australia has permanently escaped the cycle of boom bust. After all, many commentators made the same claim about the United States during the dotcom boom, but that claim turned out to be way off the mark.

It is possible to dream up even worse scenarios, leading to economic crises comparable with the Great Depression. But there’s a lot of evidence to show that the economy has become more stable over time, particularly since the end of World War II. The main factor is the growth of the government sector which typically expands when the rest of the economy enters a recession, thereby acting as an ‘automatic stabiliser’.

The Reserve Bank and other central banks are well aware of the worst-case outcomes and are working hard to prevent them being realised. But individual investors would be well-advised to consider their vulnerability to such an outcome, and protect themselves accordingly.

Epidemic disease

As far as epidemic disease is concerned, the worst-case scenario, or something very close to it, has already happened. Since it emerged without warning in the early 1980s, the HIV/AIDS epidemic has taken around 20 million lives, and 40 million people are currently infected. In the worst-affected countries, the ultimate toll may be comparable with that of the bubonic plague, which killed around one-third of the population of Europe.

The fact that most cases have occurred in poor African countries and that, within the developed world, those affected have predominantly belonged to stigmatised groups (gay men and drug users) has contributed to ineffective and counterproductive responses. Such very different political figures as Ronald Reagan and Thabo Mbeki contributed to the disasters that continue to affect their countries disproportionately.

By contrast, the Australian experience with HIV/AIDS was a model example of public health policy. Although much criticised for misstating the risks to the ‘general community’, the famous Grim Reaper ads were successful in creating a climate where the focus was on implementing effective public health responses, rather than on striking a balance between competing political agendas. It is now estimated that infections of HIV in Australia peaked as early as 1984.

The handling of SARS, at least so far, has been another success for public health policy. Again there has been some derision over the panic regarding a disease that (at least in its first outbreak) killed less than a thousand people. But this is looking at things the wrong way around. The response should be judged against the possible worst-case consequences of a widespread epidemic. Given reports of a mortality rate as high as 10 per cent, a SARS epidemic could cause tens of millions of deaths. In the absence of a cure or vaccine, rigorous containment was the only sensible response.

John Quiggin is an Australian Research Council Federation Fellow in Economics and Political Science at the University of Queensland.

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