On the Welfare Costs of Consumption Uncertainty
Satisfactory calculations of the welfare cost of aggregate consumption uncertainty require a framework that replicates major features of asset prices and returns, such as the high equity premium and low risk-free rate. A Lucas-tree model with rare but large disasters is such a framework. In a baseline simulation, the welfare cost of disaster risk is large -- society would be willing to lower real GDP by about 20% each year to eliminate all disaster risk, including wars. In contrast, the welfare cost from usual economic fluctuations is much smaller, though still important -- corresponding to lowering GDP by around 1.5% each year.
This research is supported by the National Science Foundation. I am grateful to Jong-Wha Lee for motivating me to think about this topic. I appreciate comments from Fernando Alvarez, John Campbell, John Cochrane, Xavier Gabaix, Lars Hansen, Greg Mankiw, Ian Martin, Casey Mulligan, and Ivan Werning. The views expressed herein are those of the author(s) and do not necessarily reflect the views of the National Bureau of Economic Research.