View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

Home / Publications / Research / Economic Brief / 2021

Economic Brief
August 2021, No. 21-27

Climate Change and Financial Stability? Recalling
Lessons from the Great Recession
Article by: Toan Phan

Some argue that direct economic damages from climate-related shocks are not
big enough to have a notable impact on the economy. However, this argument
misses an important lesson from the Great Recession: amplifications in the
financial markets. In the 2007-09 recession, reactions in the financial markets
substantially amplified the initial losses directly related to household default of
subprime mortgages. Recent research found evidence of similar amplification of
direct climate damages. For instance, climate-related disasters like hurricanes or
flooding can cause housing prices to drop even in the absence of direct hurricane
or flood damages.
Does climate change have implications for financial stability? This is a relevant and
important question. In fact, many central banks around the world are directly or indirectly
monitoring and studying climate risks based on the premise that climate-related risks could
affect the stability of the financial system. (An example would be the 2021 report "Climate
Change and Financial Stability" by the Federal Reserve Board of Governors.)
An opposing view is that damages from climate change are not going to be big enough
relative to the size of the economy to affect the financial system. From a pure cost
standpoint, this view is understandable. For example, Hurricane Katrina caused about $161
billion in total damage in 2005, which was only about 1 percent of U.S. GDP that year, a
percentage too small to pose a threat to the financial system.
However, this view may be too narrow. In this Economic Brief, I'll explore the importance of
accounting for amplified costs of climate-related issues and disasters.

Climate Change and Amplification

The aforementioned view of climate-related disasters misses an important lesson from the
2007-09 recession: The amplifications of small shocks through the financial system matter. The
subprime shock triggered a far-reaching financial collapse and a global recession, even
though direct losses due to household default on subprime mortgages leading up to the
recession were estimated to be at most $500 billion, which were relatively small compared
to the subsequent loss of $8 trillion in U.S. stock market values between October 2007 and
October 2008.
The macrofinance literature has noted several important amplification mechanisms. One of
them is via balance sheet adjustments. An abrupt drop in asset prices — especially in real
estate, which is commonly used as collateral for borrowing — caused households and firms
to rapidly liquidate their assets. This then further lowered prices, leading to a negative
feedback loop that amplified the initial losses.
Another mechanism is uncertainty. For example, the 2008 paper "Collective Risk
Management in a Flight to Quality Episode" by Ricardo Caballero and Arvind Krishnamurthy
argues that the unusual losses in 2007 caused investors to question the quality of their
investments, which led to them selling off risky assets and, in turn, caused abrupt changes
in asset prices.
Could these powerful amplification mechanisms again be at play in magnifying climate
damages? This question underlies the key policy concern for central banks in thinking about
climate change. For example, as illustrated in the figure below from a recent report on
climate change and financial stability, the risk of abrupt repricing in housing and mortgage
assets is at the heart of the Fed's research into climate risks. The rapidly growing research
literature on climate economics and climate finance have yet to provide conclusive answers.

Evidence of Amplifications of Climate-Related Disasters
However, there have been some hints from looking at recent data. Recent empirical
research has found evidence that, for example, Hurricane Sandy may have amplified
declines in housing prices. The 2021 working paper "Climate Change and Commercial Real
Estate: Evidence from Hurricane Sandy" by Jawad Addoum and co-authors finds that Sandy

— which made landfall in New York and New Jersey — caused a persistent drop in the
prices of coastal commercial properties in Boston, despite being far away from the storm
and hence suffering no direct hurricane damage.
This finding echoes those in earlier studies, which found that flood events typically cause
sharp declines in the prices of vulnerable homes. Examples include the 2005 publication
"Market Responses to Hurricanes" by Daniel G. Hallstrom and V. Kerry Smith and, more
recently, the 2021 paper "Flood Risk Belief Heterogeneity and Coastal Home Price
Dynamics: Going Under Water? (PDF)" by Laura Bakkensen and Lint Barrage.
What could explain this phenomenon? The aforementioned uncertainty mechanism is one
prominent candidate:1 The direct catastrophic damage from Hurricane Sandy in New York
and New Jersey may have caused coastal property investors outside those areas to
question how exposed they were to similar climate-related risks.
In fact, the 2021 publication "Climate Change and Long-Run Discount Rates" by Stefano
Giglio and co-authors finds that real estate investors inside and outside of New York and
New Jersey increased their attention to climate risks in the years after Sandy. More
generally, as summarized in the 2019 publication "Flood Risk and Salience: New Evidence
From the Sunshine State," a growing literature has found evidence that flood risk salience
tends to spike directly following a flood event.
All together, these papers suggest that investor reaction in the real estate market may have
amplified the direct damages from a large climate-related disaster.

In summary, I believe it is premature to conclude with confidence that climate-related risks
pose no threat to the financial system.
Before the Great Recession, the dominant macroeconomic models largely ignored the role
of financial frictions and thus the possibility that small shocks can be amplified, as noted in
the 2017 article "The Great Recession: A Macroeconomic Earthquake" by Lawrence
Christiano. But as we learned, shocks that are small relative to the whole economy can be
amplified through reactions in the financial system.
And recent empirical research in climate finance has documented some early evidence that
market reactions have already amplified climate damages — for example, the amplification
of the direct damages to coastal properties due to Hurricane Sandy and other flood events.
Finally, I also believe that further investigation — both empirical and theoretical — into
amplification mechanisms of climate damages is a very promising area for future research.
So far, research in climate economics has largely ignored the role of the financial sector in
either estimating the social cost of carbon or calculating optimal policy responses.

Toan Phan is a senior economist in the Research Department at the Federal Reserve Bank
of Richmond.


Whether the balance sheet mechanism was also active in amplifying the direct damages from
Sandy is a question open for future research.

This article may be photocopied or reprinted in its entirety. Please credit the author, source,
and the Federal Reserve Bank of Richmond and include the italicized statement below.
Views expressed in this article are those of the author and not necessarily those of the Federal
Reserve Bank of Richmond or the Federal Reserve System.

Subscribe to Economic Brief
Receive an email notification when Economic Brief is posted online:
Email address


Contact Us
RC Balaban
(804) 697-8144

© 1997-2021 Federal Reserve Bank of Richmond