Breaking the Economy: How Climate Tail Risk and Financial Conditions can Shape Loss Persistence and Economic Recovery

Acute physical risks are becoming more frequent and severe, with future scenarios projecting further intensification. Such events can cause significant and potentially persistent economic losses, and can strain public finances due to increasing disaster response and recovery costs. However, so far, macroeconomic models have struggled to capture the impacts of climate physical risks in the economy and public finance in a consistent way. In particular, key shock transmission channels and extreme weather events are often neglected, leading to a partial assessment of disaster losses and of the recovery needs. This information, in turn, is crucial to assess the climate insurance protection gap and to design adequate and financially sound public policy response. To address this gap, we tailor and extend EIRIN, a Stock-Flow Consistent macrofinancial model of an open economy, calibrated at the country level. EIRIN is composed of a limited number of heterogeneous agents and sectors of the real economy, financial sector and market, with the real and financial side of the economy treated in an integrated way. Agents are represented as a network of interconnected balance sheet items calibrated on real data, and are characterised by bounded rationality. This approach enables us to analyse the conditions for economic disruptions to emerge and become persistent, considering climate tail risk scenario, and the role of fiscal and credit constraints as amplification mechanisms. We calibrate EIRIN on Italy, a country that is highly exposed to natural disasters, has significant fiscal vulnerabilities and high public debt. We find that extreme weather events leading to 15% of firms' capital stock loss, coupled with subsequent financial constraints on lending, can trigger large and persistent adverse effects on GDP growth and public debt levels. Negative shocks are amplified in absence of country's adaptation strategies and tailored financial policies.