Pricing the future

There was a flurry of triumphant snorts on Friday when some libertarian blogs picked up a post from earlier in the month, which had commented on the recent paper by William Nordhaus on carbon-pricing. The ASI got it from voluntaryXchange, who got it from Newmark's Door, who had spotted the original post at ReasonOnline. The excitement was because Nordhaus, described variously as "perhaps the world's leading expert on the economics of climate change" and "-the- economic expert on global warming", had done some modelling of the optimal profile of carbon-pricing, and had concluded that, as the ASI put it, "the suggestions of both the Stern Review and Al Gore don't cut it". Rather, Nordhaus estimates that the optimal level in 2010 for the price of carbon is $34 per tonne (tC), equivalent to around 9 cents per gallon of petrol (i.e. bugger all in the grand scheme of things).

Just a couple of points:

1. Apart from the original article (Reason) they conveniently forgot to report that Nordhaus was not advising a static price, but one which should increment in real terms by around 2.5 per cent per year, to $42/tC in 2015, $90/tC in 2050, and $207/tC in 2100. Those later prices would be felt more keenly, if it weren't for the likelihood that they will be dwarfed by higher fossil-fuel prices by then.

2. More importantly, although Nordhaus's paper dresses the analysis up in a great deal of elaborate academic clothing (and very much more substantial clothing than Stern and Gore, it has to be agreed), it all pretty much boils down to the usual culprit - the discount rate. If, like Stern, you believe that it is wrong, on moral grounds, to discount the costs of future disaster, then you choose a very low (almost zero) discount rate and end up with enormous present costs for future risks attributable to global-warming, and therefore a rationale for taking strong, immediate action based on a high present cost of carbon. If, like Nordhaus, you believe that close-to-zero discounting is irrational, you set a modest discount rate which, over the timescales over which the impacts of global-warming might be felt, reduces the present costs of even catastrophic events to quite low values and results in a steady-as-she-goes policy prescription.

The funny thing is that both Stern and Nordhaus can present simple illustrations that demonstrate the irrationality of the opposing perspective. Stern can say, as paraphrased by Nordhaus, that "a positive time discount rate would lead societies to ignore large costs that occur in the distant future." In other words, if one combines economists' willingness to put a value on life with a modest discount rate, one can end up with a low present value for the deaths of even millions of people sufficiently far in the future (and thanks to the wonders of compounding, not that far into the future). It follows that it isn't worth doing much now to avoid large numbers of deaths, even if our actions make those deaths inevitable, provided that those deaths are not too soon.

On the other hand, Nordhaus gives his "wrinkle experiment" illustration of the absurdity of Stern's use of minimal discounting. "Suppose that scientists discover a wrinkle in the climate system that will cause damages equal to 0.1 percent of net consumption starting in 2200 and continuing at that rate forever after", he muses. "How large a one-time investment would be justified -today- to remove the wrinkle that starts only after -two centuries-? Using the methodology of the -Review-, the answer is that we should pay up to 56 percent of one year’s world consumption today to remove the wrinkle. In other words, it is worth a one-time consumption hit of approximately $30,000 billion today to fix a tiny problem that begins in 2200."

So we have two competing approaches, both of which yield absurd results. Should we just choose the version of absurdity that we prefer? Or argue that, -in medio veritas-, the truth must lie somewhere (but who knows where) between two absurd positions? Or should we stop and consider whether the problem lies with what these two approaches have in common?

What this is telling us is that we have reached the limits of the usefulness of mathematical economics. Though it came to dominate economics over the course of the twentieth century, it was always a dead end. Now we see exactly how sterile and ridiculous is the idea that you can model human action with numbers and formulae. Climate-change theory turns out to be the perfect -reductio ad absurdam- test of neo-classical, welfare economics. And it fails.

Incidentally, the Nordhaus paper is well worth a read. It may be an economics paper, but many parts of it are eminently readable and entertaining. In particular, Nordhaus's dislike of the British political establishment is palpable, and his shots well-aimed. In his contempt for our "elite", he adopts H.L.Mencken's recommended attitude of journalists to politicians, that of dogs to lamp posts:

"The British government is not infallible in questions of economic and scientific analysis on global warming, any more than it was in its white paper on weapons of mass destruction in Iraq. External review and reproducibility cannot remove all error, but they are essential for ensuring logical reasoning and a respect for opposing arguments."

"The Review takes the lofty vantage point of the world social planner, perhaps stoking the dying embers of the British Empire, in determining the way the world should combat the dangers of global warming. The world, according to Government House utilitarianism, should use the combination of time discounting and consumption elasticity that the Review’s authors find persuasive from their ethical vantage point."

"I have always found the Government House approach misleading in the context of global warming and particularly as it informs the negotiations of policies among sovereign states."

"The normatively acceptable real interest rates prescribed by philosophers, economists, or the British government are irrelevant to determining the appropriate discount rate to use in the actual financial and capital markets of the United States, China, Brazil, and the rest of the world. When countries weigh their self-interest in international bargains about emissions reductions and burden sharing, they will look at the actual gains from bargains, and the returns on these relative to other investments, rather than the gains that would come from a theoretical growth model."

If only we had more academics in the UK who would take as robust an attitude to the lazy, patronizing assumptions of our political establishment, rather than trying to embed themselves as part of that establishment. But Oxford and Cambridge were ever thus (ask Adam Smith).

He also provides welcome doses of realism about the mechanisms that would most effectively internalize whatever social-cost of carbon is agreed, and on the appropriateness (or otherwise) of a cap. His numbers may not be any more reliable than Stern, in an area where future uncertainty is so vast, but his rational analysis (where he leaves the numbers and formulae behind) and policy prescriptions are a vast improvement on most of our academic and political establishment.