Monday, September 22, 2008


Global Waming as an Economic Issue

Global Warming as an Economic Issue

As part of the ongoing debate about global warming there have been various studies which have tried to cast this as a problem in economics. The most comprehensive of these was created by the British Economist Nicholas Stern. The full report is available here along with various summaries.

For our purposes this is all that is required:

Using the results from formal economic models, the Review estimates that if we don’t act, the overall costs and risks of climate change will be equivalent to losing at least 5% of global GDP each year, now and forever. If a wider range of risks and impacts is taken into account, the estimates of damage could rise to 20% of GDP or more.

The way these numbers were arrived at was by doing a present value calculation. This is standard in economic discussions, how much needs to be saved now to provide the desired amount in the future.

One of the sharpest critics of Stern is the economist William Nordhaus who has made a mini industry out of commenting on the report. One of his fundamental complaints is that Stern uses an incorrect rate for future economic growth. Here's one version of Nordhaus' explanation:

Based on historical studies and projections, the inflation-corrected return on investment has been in the range of 3 to 6 percent per year depending upon time period and risk. In my modeling, I have used a 4 percent discount rate. Applying this discount rate to the trust would lead you to propose a present payment of x = $39,204. Over two hundred years, as the interest on that sum is paid and compounded, the value of the trust would reach $100 million.

This is in reply to critics who disagreed with a book review in the New York Review of Books by physicist Freeman Dyson. Here's the review: The Question of Global Warming

There have been other approaches to this problem, one of the most novel is by economist Martin Weitzman: On Modeling and Interpreting the Economics of Catastrophic Climate Change (PDF), where he argues that the economic impact of a catastrophe is so great that even if the chances of it are extremely remote steps should be taken to avoid it.

Nordhaus has managed to shift the debate to one over some parameters in an economic model.I don't think such calculations (and even assuming that compound interest will be the dominant financial growth mechanism 200 years hence) is a reliable measure for such long range projections. There are some basic assumption embedded in both papers. The idea that economies grow at an average rate has only been true in developed countries since the rise of the industrial revolution. It still isn't true in many parts of the undeveloped world, where societies tend to be relatively static (or were until modern medicine started dropping the death rate faster than the birth rate declined). There is no reason to expect that a trend that has affected 25% of the world's population for only 300 years will continue to be the norm for the next 200 years.

Second the idea of compound interest which is the basis of calculating present value only makes sense in a capitalist economy. In this type of system money is invested and what is required in return is interest. Some societies still prohibit the charging of interest. In addition compounding implies that interest received periodically can be reinvested at the same terms as the original capital. This assumes continual growth, something which is not a forgone conclusion as we enter into an era of resource shortages.

Without assumed continual growth, both arguments fall apart. We can predict nothing about how money set aside now will be used in 200 years, or even if it is possible to preserve capital over such a long period of time. The wealth of the French Aristocracy didn't last. The British taxed away the wealth of the landed gentry during the 20th Century. Things considered of high value in one era have become valueless in another. Where one would put the money that is supposed to supply the funds to ameliorate the effects of climate change in the distant future is not a simple task.

A series of recent events have shown that there is value in taking steps now to fix the known risks faced now. The effects of the series of hurricanes, earthquakes and other natural disasters could have all been minimized by adopting adequate civil engineering projects.Nordhaus things that combating the eventual effects of climate change now will only consist of reducing economic activity.
The current international approach in the Kyoto Protocol will be economically costly and have virtually no impact on climate change. In my view, the best approach is also one that is relatively simple - internationally harmonized carbon taxes.

In other words a simple economic fix will provide an incentive towards efficiency. In fact he opposes large-scale efforts altogether:

We should avoid thinking that we need a climate Manhattan Project to develop the key technology. It seems likely that new climate-friendly technologies will be the cumulative outcome of a multitude of inventions, many coming from small inventors, and originating in unrelated fields.

The best way to encourage the process of radical invention is to ensure an economic environment that is supportive of innovation and entrepreneurship.

This is not planning, it is wishful thinking. Large enterprises undertake focused R&D all the time, that's why they have research labs. When the task is too large then government funding is necessary. The idea that big ideas will occur spontaneously in someone's garage is hopelessly out of date. Societies have to decide on goals and then put the resources into achieving them. This can be levees along the Gulf Coast, earthquake resistant buildings, or looking for a cure for cancer. The libertarians in the US have promoted a free-market idea that disfavors centralized planning. As a consequence the only government central planning that takes place in the US is in the military sector. Corporations, of course, do central planning, that's why they exist, but their motives are to make a profit not save the world.

Even if it were possible to agree on a discount rate that would hold over the next 50 or 200 years, that still avoids facing the moral issues. Depending upon "entrepeneurship" to address social problems doesn't work, that's why we have destroyed cities and millions living in poverty. The moral course is to work to alleviate suffering now, and not hope that something will come along in the future.

Why can't libertarians understand that today's suffering can't wait?
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