Economist's Notebook: Poverty and Risk

The recent earthquakes in Haiti and Chile present an interesting contrast between the deleterious effects of a major earthquake in one of the richest countries in the western hemisphere and in the poorest.  It may surprise you that Chile is (by relative standards) quite an advanced and relatively wealthy country as many Americans, I think, have a tendency to view all of Latin America as a poor region.  According to the CIA, the per-capita GDP in Chile in 2009 was $14,700 while Haiti was $1,300 - so while Chile is far from US or Western European standards of living, it is a much wealthier country and Haiti.  In both cases the earthquake (and subsequent tsunami in Chile) were devastating disasters, but the scope of the tragedy in Haiti was, it appears, much, much worse.

Part of this difference was the proximity of Port Au Prince to the epicenter of the Haiti quake but part of it was the ability of the relatively much wealthier Chile to prepare for their quake through the creation and enforcement of strict building codes, and their ability to mount a significant response in the aftermath. And this illustrates a major difference in how people in low-income nations live as compared to those in the high-income world: the susceptibility to, and management of, risk.  [This also just so happens to be the subject of my lecture last week in ECON 455/555: Development Economics]

Poorer countries are particularly vulnerable to risk largely due to a lack of infrastructure or quality of infrastructure to cope with variability and shocks.  Agricultural households that do not have modern irrigation, for example, are quite vulnerable to adverse weather shocks.  The poor quality of the built environment, like we saw in Haiti (and Pakistan before it) makes it more vulnerable to weather and natural disaster. And the poor quality and size of emergency services leave low-income countries even more vulnerable still.  

On top of the lack of ex ante investment that could help residents cope with adverse shocks, the poor also tend to have inadequate savings to deal with adverse shocks to income or wealth and they are often unable to afford risk insurance and do not have access to credit - the two main institutions of risk management.  In fact, in poor countries these markets, for insurance and credit, often simply don't exist for a large part of the population even if they could afford it.  Add to this the lack of social safety nets (unemployment insurance, basic medical care, etc.) and you get an idea of just how vulnerable the poor in low-income countries are to risk and how desperately they need our help when disaster strikes.

As a development economist I constantly have to defend economic growth as a goal.  Growth itself is not the goal, of course, but it is the means to just about all the ends most people identify as important: education, health and welfare, risk management, etc.  The traditional life is not a bucolic as some would make it out to be: infant mortality rates that are an order of magnitude larger than in high-income countries, life expectancy rates 30 or more years younger, high morbidity rates, low levels of education are all facts of life in low-income countries.  I am not denying that there are adverse affects of modernization by any means, but the reality of abject poverty is extraordinarily grim.

Economist's Notebook: Risk

Nobel winner Michael Spence gave a talk on the current crisis that inspired this rumination on risk.

Risk in the case of the meltdown of the balance sheets of the world’s most important financial institutions is quite different than the type of risk that financial institutions and insurance agencies were used to dealing with. What characterizes what we might term “normal risk” are three things: it is exogenous, stationary and uncorrelated. What this means is that risk is not affected by the actions of the participants in the market, that the risk is not changing through time and that the risks are not correlated with each other. House insurance is like this. Consider an insurance market for hurricane risk in the Gulf of Mexico. The risk of Hurricanes is not affected my the actions of participants (though the risk of loss is due to moral hazard – those with insurance are less likely to do things to prevent damage when there is severe weather –but this is fairly straightforward to deal with), global warming aside, the risk of a hurricane is fairly stationary meaning it is not changing through time very much, and risks are uncorrelated (a hurricane in Florida does not make a different hurricane in Texas more likely) thus the market works through diversification (no company should concentrate on only one location like, e.g., Homestead Country in south Florida).

The risks involved in securitizing assets and insuring them had none of these aspects. They were endogenous – the behavior of participants in the market significantly altered the risk profile of the assets, from underwriters to credit rating agencies to the institutions themselves. They were non-stationary – the risks were getting worse and worse through time (and quite rapidly). And they were correlated – more risky MBSs made for more risky CDOs and on and on. Thus these institutions were faced with new and non-standard risks that one could argue they were simply not able to deal with. But I think the true answer was that there was such strong short-term pressure to be willfully ignorant that this is what they remained. The profits made on these new securities were so large that to not take part in the market or to pull back at or near the peak would have been very difficult (especially for publicly held companies). This risk was also poorly understood by credit rating agencies and regulators - even when some in the industry raised the alarm, they were largely ignored. Understanding this mew type of risk is key to understanding the way forward.