Tuesday, October 28, 2014

A Beginner’s Guide to Probability Distributions, Risk and Precaution

Coincidences abound.  Last night I gave a lecture to my Cost-Benefit Analysis class on uncertainty and precaution, and this morning I see a writeup of a new article by Nassim Nicholas Taleb and his high-profile colleagues on the application of precautionary theory to genetically modified organisms.  One concern I had skimming through the article is that it seems to parallel Martin Weitzman’s Dismal Theorem, but he isn’t cited.  I don’t know the literature well enough to say anything about priority in this area, and I’d be happy to hear from those who do.

Meanwhile, on with the show.  I will leave out the diagrams because they take too long to produce.

1. A convenient property of the normal distribution.  Consider a normal distribution—any normal distribution.  What’s the probability you will be to the right of the mean?  50%.  To the right of one standard deviation (σ) above the mean?  About 1/6.  To the right of two σ’s above the mean?  About 2.5%.  To the right of three σ’s above the mean?  Less than .5%.  This is simply the Empirical Rule.  It tells us that the probability of an above-average outcome falls faster than the distance of that outcome from the mean increases.  That continues to the very asymptotic end of the distribution’s tale.  Of course, the same reasoning applies to the other side of the distribution, as outcomes become ever further below-average.

In an expected value calculation we add up the products of possible future outcomes with their respective probabilities.  For two possible outcomes we have:

EV = V(1) p(1) + V(2) p(2)

where V(1) is the value of outcome 1, p(1) its probability and so on with outcome 2.  In other words, EV is simply a weighted average of the two potential outcomes, with their probabilities providing the weights.  As more possible outcomes are envisaged, the EV formula gets longer, encompassing more of these product terms.

The significance of the empirical rule for EV calculation is that the further from the mean a possible outcome is, the smaller its product term (value times probability) will be.  Extreme values become irrelevant.  Indeed, because the distribution is symmetrical, you would only need to know the median value, since it’s also the average.  But even if you didn’t know the median going in, or if you have only an approximation to a smooth distribution because of too few observations on outcomes, if you know the underlying distribution is normal you can pretty much ignore extreme possibilities: their probabilities will be too small to cause concern.

2. But lots of probability distributions aren’t normal.  The normal distribution arises in one of the most important of all statistical questions, the relationship between a sample and the population from which it’s drawn.  Sample averages converge quickly on a normal distribution; we just need to get enough observations.  That’s why statistics classes tend to spend most of their time on normal or nearly-normal (binomial) distributions.

In nature, however, lots of things are distributed according to power laws.  These are laws governing exponential growth, and much of what we see in the world is the result of growth processes, or at least processes in which the size (or some other measure) of a thing in one period is a function of its size in a previous period.  In economics, income distribution is power-law; so is the distribution of firms by level of employment.  Power law distributions differ in two ways from normal ones: they are skewed, and they have a long fat tail over which the distance from the mean increases faster than probability declines.  If you want to know the average income in Seattle you don’t want to ignore a possible Bill Gates.
In many decision contexts, moreover, we don’t have enough observations to go on to assume they are normally distributed.  Instead we have a t-distribution.  The fewer observations we draw on, the longer and fatter are the tails of t.  True, the t-distribution is symmetrical, but, with sufficiently few observations (degrees of freedom), it shares with power law distributions the characteristic that extreme values can count more in an expected value calculation, not less as in a normal distribution.
3. Getting Dismal.  The relationship between EV and extreme values depends on three things: whether the probability distribution is normal, if not how fat the tail is, and how long the tail is.  Weitzman’s Dismal Theorem says that if the tail is fat enough that the product (value times probability) increases as values become more extreme, and if the tail goes on to infinity—there is no limit to how extreme an outcome may be—the extreme tail completely dominates more likely, closer-to-the-mean values in calculations of EV.  The debate over this theorem has centered on whether the unboundedness of the extreme tail (for instance the potential cost of catastrophic climate change) is a reasonable assertion.

4. Precaution, and precaution on precaution.  This provides one interpretation of the precautionary principle.  On this view, the principle applies under two conditions, a high level of uncertainty and the prospect of immense harm if the worst possibility transpires.  High uncertainty means a fat tail; immense potential harm (for which irreversibility is usually a precondition) is about the length of the tail.  Enough of both and your decision about risk should be dominated by the need to avoid extreme outcomes.

This view of precaution is consistent with cost-benefit analysis, but only under the condition that such an analysis is open to the possibility of non-normal probability distributions and fully takes account of extreme risks.  That said, the precautionary framework described above still typically translates uncertainty into statistical risk, and by definition this step is arbitrary.  For instance, we really don’t know what probability to attach to catastrophic releases of marine or terrestrial methane under various global temperature scenarios.  Caution on precaution is advised.

UPDATE: I pasted in some images of probability distributions from the web.

Corporate Inversions and the Revolving Door of Tax Attorneys

My inbox had some long winded story from Bloomberg BNA about some candid remarks from a tax attorney names Hal Hicks on how corporate inversions became such a hot topic:
Hicks epitomizes the world of high-level Washington lawyers who have played a behind-the-scenes role in helping these tax-driven address changes proliferate. Top federal tax officials, many of them career corporate lawyers, have sometimes closed tax breaks only after companies slipped through them. And former officials like Hicks use skills and contacts honed in office to help companies legally outmaneuver the government. Until this year, when address-shifting by more than a dozen companies worth $100 billion caught policy makers’ attention and President Barack Obama clamped down again, inversion rules had for a decade attracted little notice outside the small community of international tax lawyers in Washington. At the Treasury Department and the Internal Revenue Service, officials—many on hiatus from private practice—crafted the rules in dialogue with top corporate law and accounting firms. While some European nations have historically relied on career civil servants, the top ranks of the U.S. tax administration have swapped staff with industry for decades. It’s a low-cost way to provide government with the best legal talent, said Gregory Jenner, a former acting assistant Treasury secretary, who calls it an “incredibly beneficial tradition.” “Putting rookies into these jobs—they would be overwhelmed,” Jenner said. “It’s too high-level, too sophisticated, too complicated.” The risk, critics say, is that some government lawyers may continue to sympathize with corporate interests, or be swayed by former colleagues.
I can see some conservatives reading this and saying that this is due to the overly complex nature of U.S. tax laws governing multinationals. I can see some liberals reading this and saying this is what we get when we let the representatives of multinationals write our tax laws. I would say – they are both right.

Monday, October 27, 2014

Daisy Chain Time Travel Macro

For some reason, my comments never show up on Simon Wren-Lewis’ blog, Mainly Macro.  Maybe they were not meant to be.  But today I will use this site as a soapbox to reply to his (and Nick Rowe’s) argument that public borrowing can impose a burden on future generations.

You can read the original, but the basic idea is that lending money is a form of deferred consumption that wends its way through time like a daisy chain.  People live for two periods, with overlapping generations.  They buy bonds during the first period and sell them during the second.  Thus in each period the debt is neatly handed off to the following generation.  But there is an end time, when public debt must be retired.  At that point, instead of allowing the final generation, in the bloom of period 1, to purchase and thereby rollover the debt of their ancestors, the government taxes them to retire it.  So behold, the borrowing of government from generation the first is a delayed charge against generation the last.  And that is why paygo pension systems are an intergenerational crime.

The logic is impeccable, in the sense that if you accept the premises you must accept the conclusion.  The question is whether the premises correspond in any meaningful way to the world we inhabit.

One obvious problem is the assertion of an end time.  The Greatest Generation, as we know, ran up what was at that point the Greatest Debt; in fact, gross federal debt (including the portion held by the Fed) topped out in 1946 at just under 120% of GDP.  Those living today are heirs to that borrowing “binge”.  But we haven’t suffered for it, since (1) that specific chunk of debt has become much smaller in relation to our incomes today due to inflation and real growth, and (2) we continue to roll over principle and interest, since the end time is not nigh.  As long as we don’t go crazy, and keep our current and future borrowing on a sustainable basis, the end time need never come.  (And I’m abstracting, as Simon and others do, from the benefits financed by borrowing—like saving the world from Hitler or, more mundanely, all those nice CCC-built parks—that are also legacies for the future.)

The second is less recognized.  The consumption-smoothing life plan at the heart of the standard OLG model, simply does not reflect the facts.  Here, for instance, is the 2011 average household net worth (not including home equity) by age of household head, as estimated by the Census Bureau:

Except for those over 75, older people have more net income-generating assets than younger people, and even the geeziest geezers hold more assets than those under 45.  They die with their financial boots on, making the daisy chain of deferred consumption a false depiction.

The bottom line is that the generation is not a meaningful unit of accounting when it comes to the distributive effects of public deficits.  How about shifting attention to the decision to sell bonds to the rich instead of taxing them?

Frack = Defect

The New York Times today has an informative article on BASF, the German chemical giant, centered on the effect that fracking in the US has on business decisions in Europe.  To sum up, natural gas prices in the US have plummeted due to the widespread use of this dubious technology, which affects chemicals in two ways—lowering the cost of fossil fuel feedstocks and the energy needed to process them.  BASF has responded, logically enough, by shifting new investment from Germany to cheaper energy locations, including the US.

But this has an effect on energy policies in Europe too.  It shifts the political economic balance away from a decarbonizing energy transition (Energiewende), which raises costs there even as they are tumbling here.  In other words, by pushing fracking and generally supporting (non-coal) fossil fuel production, the Obama administration is undercutting foreign efforts to respond to the climate crisis.  In the global collective action game of planetary sustainability, the US is a defector.

We are unlikely to see a global agreement on reducing fossil fuel use in the next several years; what can be done to at least protect the space for effective action at the national level?  At the top of the agenda should be a framework for carbon tariffs, border taxes that offset cost differences due to differences in carbon emission policies.  This would involve at the least a legal framework; ideally it should also spell out tariff-setting formulas to reduce the scope for manipulating the system to serve other ends.  If we can’t get everyone to cooperate on sensible action to forestall catastrophic climate change, at least we should try to limit the damage caused by defection.

This Just In!

I understand Governor Christie has relented somewhat on his policy of quarantining all passengers from West Africa, symptomatic or not, in tents. He is now allowing them, if they choose, to spend 21 days stuck in traffic at a bridge. What a mensch!

Sunday, October 26, 2014

"Cake without Flour" -- Duncan Foley on the Dilemmas of Economic Growth

The following excerpt is from Duncan Foley's outgoing Presidential Address to the Eastern Economics Association, "Dilemmas of Economic Growth," presented March 9, 2012 (Reprinted by permission from Macmillan Publishers Ltd: Eastern Economic Journal (2012) 38, 283–295 published by Palgrave Macmillan). The title is an allusion to Herman Daly's parody of Cobb-Douglas production function hyperbole "as implying that it is possible to bake a cake without eggs or flour as long as the cook whisks the empty bowl faster and faster."


Some growth economists might regard the considerations we have just reviewed as rather quaintly anachronistic in putting so much emphasis on the material nature of economic production. Well-established patterns of economic growth show that as incomes rise, the proportion of output as measured by such indexes as real GDP consisting of material goods steadily declines. The major sources of growth in incomes (and, given the way we measure GDP, in indexes of output) shift to the tertiary sector, particularly services. The chief input to services is human intelligence, and at least in some accounts, intelligence is an unlimited resource. So why couldn't real GDP, measured to include the use-value of services, continue to grow without limit?

There are some immediate problems with this conception. Strictly speaking the production of almost all services does require material and energy inputs, as the gigantic server farms required for information technology are a concrete reminder. Maintaining the human capital to provide a glittering array of intellectual services requires material and energy inputs, and these very likely increase as the quality of intellectual output rises.

But this vision of endless growth without material or energy inputs requires some re-examination of just what it is that we regard as output and try to measure in indexes like real GDP. Some rapidly growing service industries, such as finance, seem to be able to produce increasing measured output without much input increase, even of human employment, at all [Basu and Foley 2011; Foley 2011]. An examination of the issues raised by the growing significance of service industries, which have no measurable output, raises some deep questions about the conception of economics.

The paradigmatic economic interaction for economic theories rooted in the marginalist revolution, such as neoclassical economics and its various descendants, is a transaction in which one good moves from the possession of an agent who subjectively values it less to the possession of another agent who values it more, in exchange for another good (in many transactions money). As the familiar Edgeworth-Bowley box construction illustrates, this type of transaction puts both agents on a higher (or at least no lower) indifference curve, and thus achieves a Pareto-improvement in the allocation of existing resources. Many financial transactions are of this type, for example, initial public offerings to take companies public, real estate brokerage, insurance contracts, and other more exotic forms of financial arbitrage. It is important to remember, however, that the transfer of existing goods or assets in these transactions is not production. When financial intermediaries appropriate some part of the economic surpluses generated in these transactions as revenue, however, economic statisticians have felt compelled to regard the resulting incomes as part of national income, and to invent an imaginary product, financial services, to put on the product side of the accounts as a counterpart.

It is hard to imagine limits to the magnitude of subjective economic surpluses that could be realized through transactions of this type. If, for example, policies or the historical evolution of the division of labor increase economic insecurity by eroding the institutions of traditional societies, one can easily imagine an unlimited expansion of insurance transactions as a result. But from the point of view of classical political economy, it is the increase in material productivity of labor, not the increase in economic insecurity associated with the expansion of the division of labor, which is the source of improvements in economic welfare. This point of view is deeply embedded in the methods of national income accounting, for example, in the fundamental rule that transactions involving the transfer of existing assets do not constitute production of goods and services, no matter how much economic surplus they may represent.

The classical political economists and Marx addressed these issues through the concepts of "productive" and "unproductive" labor. In the version of this distinction, Marx distilled from his critical review of Adam Smith, productive labor (whether it produces material goods or services, since providing haircuts is hard to distinguish from making hats) returns the costs of production with a profit, while the cost of unproductive labor is paid out of revenues without any recovery or return. This classical-Marxian line of thinking puts the origin of the incomes from the production of "services," such as finance, in a different perspective.

This perspective is perhaps most clearly articulated in Marx's analysis of wage labor and the origins of surplus value. Productive labor is responsible for the whole value added in production, but receives only a fraction of the value added in the form of the wage. The resulting surplus value constitutes a pool of potential revenue for which capitalist producers, landowners, intellectual property owners, financial firms controlling money capital, and the state compete. The implications of this analysis, which, unfortunately, is for the most part systematically excluded from the modern economics curriculum, are far-reaching. No particular capitalist firm, no matter how large in revenue and employment, can have much direct effect in increasing the pool of surplus value. Thus "money-making" in capitalist society is proximately based on taking surplus value away from others. In an economy where resources and intellectual property command enormous rents, there may be a vanishingly small connection between the revenue of any entity and its actual contribution to production of useful output.

Many people today are dazzled by the apparently magical ability of innovators to appropriate enormous revenues on the basis of ideas and their manipulation alone. This phenomenon has understandably spawned theories of a "new" economy, supposedly based on new principles of the creation of value. Classical-Marxist political economy, in contrast, locates incomes to innovation not in new principles of the creation of value, but in new (or newly important, since most of these "business models" have actually been around for a long time) modes of appropriation of surplus value. As Slavoj Žižek vividly points out, increasing returns in the appropriation of rents for intellectual property simultaneously obscure the origin of the resulting enormous incomes in the pool of surplus value appropriated from productive labor and mystify the factors behind the increasing inequality in the distribution of these revenues [Žižek 2012]. The origin of the rent of a particularly exploitable resource like a waterfall or a petroleum deposit is hard enough to understand, but at least the owner of a waterfall cannot allow an unlimited number of cotton mills to exploit the resulting usable energy. By contrast, the owner of the rights to distribute a piece of software that, due to network externalities, becomes a technical standard, can allow an effectively unlimited number of users to install the software and charge each of them a fee.

It would be, however, a peculiar political economy that convinced itself that the increasing returns in the rents to artificially created assets, such as systems software, were a remedy for thermodynamically imposed decreasing returns to resource use in material production.

Friday, October 24, 2014

Optimization and Its Discounts

Trying to reconcile cost shifting with the discounting of future climate change costs and benefits has taken me on some unexpected detours. I was initially thinking about bills of exchange and their role in the early modern era of concealing church-outlawed "usury" in the guise of a more palatable commercial transaction. Discounting was an arithmetical accounting exercise that arose out of the discounting of bills of exchange.

Both compound interest and discounting partake of the same exponential function -- from different ends of the calculation -- so it is easy (and misleading) to think of the discounting of a bill of exchange as a kind of loan. Discounting a bill of exchange is a sales transaction. The credit involved is commercial credit extended from a supplier to a purchaser. The bank then buys the bill of exchange from the supplier at a discount from its face value.

If one insists on seeing a loan from the banker in the transaction, it would only be an indirect loan to the purchaser of the goods, not to the supplier who sold the bill of exchange to the bank. But that loan would be secured by the goods that were the original object of the transaction that originated the bill of exchange... (Unless, that is, the bill of exchange was only speculative, a circumstance that Marx labeled a swindle.)

The important point is that bills of exchange originated in real transactions of goods, not in purely financial transactions. This has serious implications for the use of "discounting" in cost benefit analysis of public investments.

If the discount rate is meant as a metaphor it is a peculiarly bad one. The goods in question -- costs and benefits of climate change mitigation, for example -- have both negative and positive values but more importantly they have not been contracted for by the interested parties -- there is no "bill of exchange" to be discounted. Furthermore, the beneficiary of the discounted price is not society but the polluting firm who has shifted part of its costs to society and the environment. This perverse distribution of costs and benefits (and incentives) is concealed by the aggregate generality of the climate economy models that construe everything as one big happy economy.

Put it this way: discounting the future costs and benefits of greenhouse gas emissions provides a subsidy to the most prolific emitters of greenhouse gases that they can then reinvest at compound interest. This is hardly a matter of being "neutral" on questions of distribution. Nor is it a question of generational equity. This is simply taking the bankers' perspective on financial accumulation and proclaiming it "socially optimal."

The Passing of Fred Lee: An(other) Old Wobbly Bites The Dust

Last night (Oct. 23) at 11:20 PM, CDT, prominent heterodox economist, Fred Lee of the University of Missouri-Kansas City, died of cancer.  He had stopped teaching during the last spring semester and was honored at the 12th International Post Keynesian Conference held at UMKC a month ago. While I do not know if he was a card-carrying member of the IWW, as was a friend of mine, Bill Grogan, who died over a month  ago and about whom I blogged here then; on more than one occasion, including at this conference at UMKC last month, I heard Fred called an "old Wobbly," and I never heard him dispute this description. For any who do not know, "Wobbly" has always been the nickname for a member of the Industrial Workers of the World (IWW), a pro-working class universal union anarcho-syndicalist group.

Whatever one thinks of heterodox economics in general, or of the views of Fred Lee in particular, he should be respected as the person more than any other who was behind the founding of the International Conference of Associations for Pluralism in Economics (ICAPE), and also the Heterodox Economics Newsletter.  While many talked about the need for there to be an organized group pushing heterodox economics in all its varieties, Fred did more than talk and went and organized the group and its main communications outlet.  He also regularly and strongly spoke in favor of heterodox economics, the unity of which he may have exaggerated.  But his voice in advocating the superiority of heterodox economics over mainstream neoclassical economics was as strong as that of anybody that I have known.  I also note that he was the incoming President for the Association for Evolutionary Economics (AFEE), and they will now have to find a replacement.  He had earlier stepped down from his positions with ICAPE and the Heterodox Economics Newsletter.

It was both sad and moving to see Fred at the PK conference last month in Kansas City.  He was in a wheelchair with an oxygen tank, with his rapidly declining health condition stunningly apparent.  There were several sessions honoring his work.  However, at one of the major ones, he spoke at the end. Although he was having trouble even breathing and could barely even speak, he rose and made his comments, at the end becoming impassioned and speaking up forcefully to proclaim his most firmly held positions.  He declared that his entire career had been devoted to battling for the downtrodden, poor, and suffering around the world, "against the 1% percent!" and I know that there was not a single person in that standing room only audience who doubted him.  He openly wept after he finished with those stirring words, as those who were not already standing rose to applaud him with a standing ovation.

Fred's own research agenda focused on developing a heterodox microeconomics, one based on the idea of markets being dominated by oligopolistic firms with price-setting powers and more.  In the Post Keynesian camp he drew heavily on the work of Alfred Eichner as well as Michal Kalecki, although he was also influenced by American Institutionalists such as Gardiner Means, hence his Presidency-Elect of the Old Institutionalist AFEE.  He wrote on many other topics as well, and in more recent years on the broader issue of the meaning and application of heterodox economics and how to develop a coherent alternative heterodox economics.  But his most famous work was and will probably remain his work on a heterodox, arguably Post Keynesian, approach to micreoeconomics.

At this point I must note that while we were always friends, and I knew Fred for a long time, we had some fairly strong differences of opinion in recent years.  A decade ago, I with David Colander and Ric Holt, wrote a book and an article, followed up by another book and some other articles, the first book being _The Changing Face of Economics: Conversations with Cutting Edge Economists_ (2004, University of Michigan Press) and the first article being "The Changing Face of Mainstream Economics" (Review of Political Economy, 2004).  We argued that "mainstream" is a sociological category, those running the show in the profession (top departments, journals, etc.), while "orthodox" is an intellectual category, the hardline version of which is widely called "neoclassical economics."  We argued that "heterodox" was both: not running things and also intellectually anti-orthodox.  This opened the door for a category of "non-orthodox mainstream economists," with people like George Akerlof being possible examples.  Several heterodox economists disagreed with this argument and viewed us as weakening the criticism of "the orthodox mainstream" with this sort of divisionist argument, and quite a few of those expressed their disagreements in print, with there actually being an entire book dedicated essentially to reading the riot act on us as a bunch of namby-pamby wafflers or worse.  Fiercest of all in this crusade, both verbally and in print, was good old Fred Lee, who saw us as undercutting and undermining and demoralizing the movement for a unified and strong heterodox economics battling that "orthodox mainstream."

I note that at the meeting in Kansas City I stood up to speak about this and to praise what I considered to be the strong and principled position held by Fred, despite our disagreements.  I also spoke to him privately afterwards, and we parted on friendly terms.  However, I note that he laid out in his public remarks a distinction between a "heretic" and a "blasphemer," both of these terms positives for him.  A heretic is someone who questions orthodox doctrine, but still at some level believes it, while a blasphemer is someone who utterly and totally rejects it.  He told me in our final private conversation that he viewed me as being a mere heretic, while he was a true blasphemer.

RIP, Fred.

Barkley Rosser

Addendum:  The book criticizing Colander, Holt, and me is "In Defense of Post-Keynesian and Heterodox Economics: Responses to Their Critics," ed. by Fred Lee and Marc Lavoie, 2012, Routledge.   In effect the bottom line may boil down to our saying that the heterodox can be the source of cutting edge ideas that the mainstream sometimes adopts, such as behavioral economics, whereas they say that any idea that can be accepted by the mainstream is simply being coopted, and that the heterodox must overthrow the mainstream orthodoxy root and branch.  This may be what separates "heresy" from "blasphemy."

Further Addendum:  I have been informed by email from Steve Ziliak, a former colleague of Fred's from when he was at Roosevelt University in Chicago, that like my late friend Bill Grogan, he was a card-carrying member of the IWW from 1985, and that indeed he became the Chair of the General Executive Council, with the IWW's national HQ in Chicago.  As a result of that and at that time, he ended up becoming the recipient and owner of the ashes of Joe Hill, which had apparently gone on some long odyssey.  But, given that Joe Hill was an honest-to-gosh Wobbly, maybe the most famous of them all aside from Big Bill Haywood, the IWW ended up getting at least some of his ashes, and it was Fred who was theiir overseer, at least for some time.
A link from Steve Ziliak to see Fred signing for Joe Hill's ashes on 11/18/1988, http://reuther.wayne.edu/node/12333 .

Been Discounted So Long It Seems Like Up To Me

The monks ascending the steps on the outside of the wall are growing the GDP, while the monks descending the steps on the inside are abating carbon dioxide emissions. Climate change mitigated -- emissions decoupling accomplished!

"Business profit," Schumpeter tells us, "is a prerequisite to the payment of interest on productive loans... The entrepreneur is the typical interest payer." There are three cost-reduction strategies that firms may pursue to maximize profits. The most opportunistic is cost-shifting, in which some third party, society or the environment gets stuck with the cost rather than the firm. The cost doesn't go away, it just becomes external to the accounting entity's balance sheet and thus is an "externality." Greenhouse gas emissions are such an externality. They are a cost-shifting success for the profit maximizing firm.

Carbon trading schemes and Pigouvian taxes are supposed to "internalize" those externalities so that the users of fossil fuels, for example, are made to pay the full cost -- or at least a larger proportion of the cost -- of their production processes or consumption preferences. Assessments of the costs and benefits of such policies typically discount the present value of future costs and benefits. The appropriate discount rate, it is often argued, should reflect market interest rates or else it may result in spending that is less efficient than would occur through the market. William Nordhaus in A Question of Balance:
The choice of an appropriate discount rate is particularly important for climate-change policies because most of the impacts are far in the future. The approach in the DICE model is to use the estimated market return on capital as the discount rate. The estimated discount rate in the model averages 4 percent per year over the next century. This means that $1,000 worth of climate damages in a century is valued at $20 today. Although $20 may seem like a very small amount, it reflects the observation that capital is productive [S'man: no, it reflects the assumption that capital is "productive"]. Put differently, the discount rate is high to reflect the fact that investments in reducing future climate damages to corn and trees should compete with investments in better seeds, improved equipment, and other high-yield investments. With a higher discount rate, future damages look smaller, and we do less emissions reduction today; with a lower discount rate, future damages look larger, and we do more emissions reduction today.  
Update:  But... if profitability is a function of cost shifting, the market interest rate a function of profit, the discount rate a function of the market interest rate and cost/benefit optimization of GHG abatement a function of the discount rate, doesn't said optimization embed a circular reference? No, this is both too simple and too forgiving an interpretation of the relationship between discounting and cost shifting. More on this soon...

Nordhaus, again:
In thinking of long-run discounting, it is always useful to remember that the funds used to purchase Manhattan Island for $24 in 1626, when invested at a 4 percent real interest rate, would bring you the entire immense value of land in Manhattan today. 
Professor Nordhaus here simply updates and tones down the hallucinations of Dr. Richard Price, who exclaimed in 1774:
One penny, put out at our Saviour's birth to 5 per cent compound interest, would, before this time, have increased to a greater sum, than would be contained in a hundred and fifty millions of earths, all solid gold. 
As Marx began the chapter in Capital in which he cited Price's dazzled fancy:
The relations of capital assume their most externalised and most fetish-like form in interest-bearing capital. We have here M — M', money creating more money, self-expanding value, without the process that effectuates these two extremes. 
In his discussion of discounting, Nordhaus doesn't distinguish between compound interest and the process that brings about the apparent productivity of capital that he extols. What makes this lack of distinction particularly telling is that he is supposedly discussing solutions to a problem that results from the very process that makes capital productive of profits sufficient to sustain interest payments on money capital. It is as if the greenhouse gases are unrelated to the industrial processes that emit them.

Compound interest does not emit greenhouse gases. What people do to make the profits to pay the compound interest does. Money capital does not compound itself. The discount rate is no more independent of the cost-shifting that engenders it than it is of the greenhouse gas emissions whose costs are being shifted. D.I.C.E. thrown will never annul chance.

Wednesday, October 22, 2014

Helicopter Money in the Midst of a PLOG

Mark Thoma and his readings have pulled together a nice collection of writing on a concept known as “helicopter money”. To be honest, as I read all the links I decided to fire off my own comment which needs a little refining. My opening line is simple:
Helicopter money means using fiscal stimulus with easy money to overcome one awful shortage of aggregate demand noting the following well established ideas.
PLOG is a Paul Krugman term for prolonged large output gap, which has been the current situation since 2008. This period has also been described as a liquidity trap where fiscal stimulus is clearly needed as traditional monetary policy has done all it can do and we still are in a PLOG. This naturally leads to my first well established proposition: We should be using fiscal policy that maximizes the bang for the buck. Which leads me to the rest of my rant:
(1) Transfer payments for the poor does so by giving income to people most likely to spend it; (2) Payments to the rich or tax cuts for the rich have no bang but a lot of bucks (Barro-Ricardian equivalence); (3) We could this with public infrastructure investments; (4) The Republican dorks running Congress are trying to cut (1) and (3) while emphasizing more of (2); which is why (5) We need to take fiscal policy out of the hands of these Republican dorks who run Congress.

Monday, October 20, 2014

Pension Funds and Private Equity

There is a fascinating piece by Gretchen Morgenson in today’s New York Times about the large investments public pensions have made in private equity funds.  The focus is on the secrecy of these deals, but the question also comes up as to whether these investments are proper given the fiduciary role that pension fund managers are supposed to play.

One thought that occurs to me is this: pension funds by their nature should position themselves overall toward relatively lower risk portfolios.  Yet pension funds pay a management fee to private equity firms, and then the first 20% or so of investment profits go to private equity as well.  For these fixed costs pension investors receive rights to the residual returns, which may be positive or, as in the case that leads the article, negative.  Present and future pensioners are paying for the opportunity to play a lottery.

It should really be the other way around.  General partners like private equity funds should pay pension funds an initial percent on investment for access to capital along with returns up to some specified level.  The private equity folks, being more risk-loving (in theory) would then grab what’s left.  In this way the risk would be allocated according to levels of fiduciary responsibility.  Why should wealthy speculators load the risk onto working class retirees?

Sunday, October 19, 2014

"From him exact usury whom it would not be a crime to kill."

The truth about usury lies somewhere beyond St. Ambrose's condemnation and Jeremy Bentham's cavalier apologetics. In a very brief but valuable essay, Francis Bacon counselled,
It is good to set before us the incommodities and commodities of usury, that the good may be either weighed out or culled out; and warily to provide, that while we make forth to that which is better, we meet not with that which is worse. 
Strictly speaking, compound interest is usury. Discounting is compound interest, ergo discounting is usury.  Bentham, who upheld usury in a series of letters addressed to Adam Smith, also was a pioneering proponent of cost-benefit analysis for public investments. Considering that usury has both incommodities and commodities, a proper cost-benefit analysis would need to evaluate the costs as well as the benefits that arise from the discounting of future value.

The typical way of handling traditional objections to usury is to cite scripture and the interpretations of it offered by religious authorities. This was the method followed by Benjamin Nelson in The Idea of Usury, whose analysis was taken up by Lewis Hyde in The Gift and by David Graeber in Debt: the first 5000 years. But the biblical injunctions are laconic and subsequent interpretations may partake more of rationalization than impetus. Bentham was right when he observed,
It is one thing, to find reasons why it is fit a law should have been made: it is another to find the reasons why it was made: in other words, it is one thing to justify a law: it is another thing to account for its existence. 
Bentham's defence of usury, though, was as verbose and meandering as the infamous passage from Deuteronomy about brethren and strangers was terse. His account of the grounds for the prejudice against usury was frivolous and dismissive. "To trace an error to its fountain head," Bentham cited Lord Coke, "is to refute it." What Bentham meant by "trace" was "assert." According to him, the prohibition of usury was motivated by the perverse asceticism of early Christians, foolish abstractions of Aristotle and ill-tempered envy toward the wealthy by the profligate debtors.

More concisely and substantively, Francis Bacon presented, in one paragraph, a catalogue of seven disadvantages arising from usury. A second paragraph elaborated on three advantages. Bacon's fourth criticism of usury is of particular interest:
…it bringeth the treasure of a realm or state into a few hands; for the usurer being at certainties, and others at uncertainties, at the end of the game most of the money will be in the box; and ever a state flourisheth when wealth is more equally spread…
In favour of usury, Bacon's second point is his most compelling:
…were it not for this easy borrowing upon interest, men's necessities would draw upon them a most sudden undoing, in that they would be forced to sell their means (be it lands or goods), far under foot; and so, whereas usury doth but gnaw upon them, bad markets would swallow them quite up.
In modern parlance, Bacon's most compelling arguments, both for and against usury, refer to what Marshall called the "external economies" -- or positive and negative externalities -- of the loan transactions. For better or worse then, compound interest is a vehicle for the shifting of costs and benefits. It is well to remember, in this connection, Joan Martinez-Alier's observation that "one can see externalities not as market failures but as cost-shifting successes."

One doesn't need to assume that cost shifting is necessarily a bad thing. Insurance, including social insurance, is a form of cost shifting. But when the project being evaluated in a cost-benefit analysis has the overt purpose of internalizing the cost of externalities -- such as in the analysis of abatement of greenhouse gas -- it is disingenuous to overlook the role of compound interest in enabling the social cost shifting in the first place and of perpetuating it over the period being analyzed. In other words, part of the value allegedly being "added" by capital in the analysis is not in fact being produced but is merely being appropriated by capital through social cost shifting.

(See also "Why Is the Discount Rate So Important?" page 9 in "More than Meets the Eye: The Social Cost of Carbon in U.S. Climate Policy, in Plain English.")

Saturday, October 18, 2014

The Biggest Nonlinearity in the Short Run Cost of Mitigating Climate Change

David Roberts, bless ‘im, has another fine post in which he sums up a pair of recent journal articles that cast doubt on estimates of the cost of stabilizing greenhouse gas concentrations.  The two main points he emphasizes are both quite sensible.  First, long-term economic prognostication is a fool’s errand.  He highlights a telling quote from one study by Rosen and Guenther:
[G]iven all the uncertainties and variability in the economic results of the IAMs [integrated assessment models] … the claimed high degree of accuracy in GDP loss projections is highly implausible. After all, economists cannot usually forecast the GDP of a single country for one year into the future with such a high accuracy, never mind for the entire world for 50 years, or more.
Precisely.  Or as Keynes put it,
The sense in which I am using the term [uncertainty] is that in which the prospect of a European war is uncertain, or the price of copper and the rate of interest twenty years hence, or the obsolescence of a new invention, or the position of private wealth owners in the social system in 1970.  About these matters there is no scientific basis on which to form any calculable  probability whatever. (The General Theory, 1937)
The second point is that economies are complex interdependent systems whose interconnections can’t possibly be modeled by analysts who know only the world as it is now, not the world as it will become.  One disturbing factor, of course, will be climate change itself, which will likely have deep, and mostly impossible to foresee, effects on many aspects of the economy.  Similarly, different technological and institutional configurations of the future economy of the planet can’t be captured by models that consider them separately, or only in light of their market connections.

Now I’d like to add two further observations to the mix.  The first is that the long run economic costs of climate change mitigation, the ones that will show up over the course of 50 or 100 years, are really irrelevant.  The case for taking action doesn’t depend on them, and future people will have to figure out how to cope with them when the time comes.  It’s the short term costs, the ones that will make themselves known during the first years of serious policy implementation, that matter.  They matter for policy, because if we can anticipate them we can take actions to minimize their impact.  Crucially, they matter for political economy, since the opposition to action on climate change is ultimately about short run costs: who bears them and how big they are expected to be.

The second observation is that the biggest nonlinearity is hiding right under our nose: the potential for writing off a portion of the capital stock.  All existing models assume that capital goods are employed until they fully depreciate, with reduced productivity of the stock related smoothly to more rapid depreciation: if a change in relative prices means a unit of capital is a bit less productive, its lifespan will be a bit shorter.

This assumption rules out a fundamental nonlinearity: each unit of capital has a tipping point, a critical balance of revenues and operating costs that separates utilizing it from abandoning it.  Consider a simple example: an airplane.  A large passenger airplane is a significant piece of capital investment.  Its profitability depends on the cost of providing air travel and the willingness of travelers to pay for it.  If the cost of fossil fuel rises due to a carbon tax or cap, airline companies have to raise prices and cope with the resulting loss of demand.  This can mean somewhat fewer flights and more empty seats.  But there is a level of price increases at which the plane is simply taken out of service: it’s no longer profitable to operate it.  Indeed, an entire company may liquidate, going from a substantial capitalization to scrap.  There is almost certainly some fuel price that triggers this discontinuity, although we don’t necessarily know what it is in advance.  The same point likely holds for many investments in transportation, shipping, real estate and fuel-intensive manufacturing.

If this view is correct, economists should put research into the short run effects of fossil fuel prices on the capital stock into high gear.  The cumulative effect of such writeoffs will be macroeconomic disruption, which we can offset through policy if we can see it coming.  Above all, identifying the investments most at risk from climate policy will tell us more about the political barriers we face than a thousand surveys about public attitudes toward science.

For more on cost, see this post from The Road from Carbonville.

A Tipping Point for Sexual Harassment

I have nothing to add to this important piece about sexual harassment and the dependence of restaurant servers on tips.  Read it yourself.  The practice of holding servers hostage to the emotional fluxes and fantasies of customers is barbaric.  Visitors from Europe, at least the ones I know, are appalled.  Surely one of the reasons for working for a living is to not have to depend on alms.

Voting in Texas

The Texas voting law just upheld by the US Supreme Court requires voters to show a picture ID at the polls and specifies what kinds qualify.  A gun permit is OK, a college ID isn’t.