The critical relationship between sustainability, economic growth, and risk factors that pose threats to long-term welfare

While sustainable conditions can be achieved if economic growth continues at historical rates and catastrophic risks remain moderate, it is the risks that impede growth and are not accurately reflected in market risk premia that pose the greatest threat to sustainability. Sustainability is often associated with environmental protection, but the authors emphasize that it extends beyond the environment to encompass risks such as nuclear war, pandemics, and political disruptions. In essence, sustainability means making decisions that leave future generations at least as well off as the current generation. To understand the sustainability of an economy, it is crucial to consider the fundamental factors that determine it.

Previous studies on sustainability have primarily focused on consumption and savings rates in relation to safe and risky rates of return. While this is relevant, the authors contend that it overlooks the underlying factors that drive all rates in the economy. They assert that the growth rate of the economy, the level of risk related to output and consumption, and the accessibility of borrowing and saving in financial markets are the key determinants of sustainability. Higher economic growth and greater financial depth contribute to sustainable conditions by enabling faster wealth accumulation and providing more resources for future generations. On the other hand, higher risk is detrimental to expected welfare going forward. While higher risk can be reflected in higher risk premia in partial equilibrium, there are no additional gains from a risk premium in general equilibrium. Risk, in this context, leads to pure utility loss. Therefore, financial depth plays a crucial role in mitigating large risks and achieving sustainability objectives.

The significance of long-run risks that result in persistently or permanently lower growth rates. These risks differ from disaster risks, which cause immediate output declines, as they fundamentally impact growth prospects in the long term. Long-run risks affect investors' portfolio decisions differently and have implications for sustainability. If market forces lead to overinvestment in "brown" technologies with higher growth but higher long-run risks, sustainability concerns may not be adequately addressed.

We also underscore the importance of comprehending the nature of risks faced by the world and the essential role of supply-side policies in determining the sustainability of an economy. It is crucial to foster economic growth while mitigating risks of all kinds to ensure a sustainable future for both current and future generations. By understanding and addressing these challenges, we can work towards building a more resilient and sustainable global economy.

Reference

Research, O. of F. (n.d.). Threats to sustainability stem particularly from factors that stymie growth and have high levels of risk. Office of Financial Research. https://www.financialresearch.gov/the-ofr-blog/2023/05/16/threats-to-sustainability-stem/