Threats to Sustainability Stem Particularly from Factors That Stymie Growth and Have High Levels of Risk

Views and opinions expressed are those of the authors and do not necessarily represent official positions or policy of the OFR or Treasury.

The tension between risk and growth raises the question of whether current economic decisions will leave future generations at least as well off as present generations. In a new OFR Working Paper, “Sustainability with Risky Growth,” OFR economist Greg Phelan and Williams College professor David Love look at what economic fundamentals determine sustainable conditions.

The authors find that if economic growth continues at recent historical rates and catastrophic risk remains moderate, the world economy is sustainable. However, the threat to sustainability comes, in particular, from risks that not only lead to persistently lower growth and welfare but that may not be accurately reflected in market risk premia.

Sustainability is often associated with climate change and environmental protection. The risks facing humanity, however, extend beyond the environment and include the threat of nuclear war, pandemics, and political disruptions (to name a few). In the broadest sense, sustainability means that the current path of decisions leaves future generations at least as well off as the current generation. It’s important to understand how fundamental factors determine whether an economy is sustainable.

Sustainability Fundamentally Depends on the Forces of Economic Growth and Volatility

Previous studies of sustainability have focused on how consumption and savings rates compare to safe and risky rates of return in an economy. The authors argue that this focus, while relevant, misses the underlying factors driving all rates in the economy. The safe and risky rates of return reflect consumption and savings rates. By taking this into account, the authors find that what ultimately matters are the growth rate of the economy, the level of risk concerning output and consumption, and how easily financial markets allow agents to borrow and save.

Higher growth and greater financial depth allow an economy to grow wealth faster by providing more resources for future generations. This is unequivocally good for sustainability. In contrast, greater risk is bad for expected welfare going forward. While in partial equilibrium, higher risk can be reflected in higher risk premia, which are good for wealth accumulation. In general equilibrium, on the other hand, the economy grows at the expected rate of growth—there is no additional gain from a risk premium. Risk has a pure utility loss consequence in general equilibrium. Financial depth, which can help mitigate large risks, can be critical for achieving sustainability concerns.

Long-run Risks Make It More Likely That Sustainability Is Constrained

An important concern is the case of long-run risks that could manifest in persistently or permanently lower growth rates. In both partial-equilibrium and general-equilibrium settings, long-run risks make it more likely that a sustainability constraint binds.

Long-run risks are categorically different from disaster risks and certainly different from the standard or typical risks facing an economy. Disaster risks are of the kind that significantly decrease output contemporaneously, whether because of destruction of capital due to a disaster or some other type of catastrophic event. While catastrophes have significant implications for the near future, they need not fundamentally affect prospects for growth going forward. In contrast, long-run risks are precisely about a decline in growth prospects going forward.

Long-run risks affect investors’ portfolio decisions quite differently from disaster risks, and they matter for sustainability concerns. If investors are considering different types of investments—such as “green” technologies with lower growth but lower long-run risks and “brown” technologies with potentially higher growth but higher long-run risks—then competitive market forces could lead the economy to overinvest in brown technologies, even if such investments do not satisfy sustainability concerns.

Growth is beneficial for sustainability, while risks of all kinds are detrimental. Sustainability requires that economic growth be high enough to offset the impact of risk. The authors’ results underscore the importance of understanding the nature of the risks facing the world, and they highlight the fundamental role of supply-side policies in determining the sustainability of an economy.