Insights from a rare self-reflective economist

I find economics an annoyingly smug discipline. Despite the contestable nature of much core economic theory, any critical analysis is quickly dismissed as heterodox and filed away under an appropriate sub discipline by the Serious economists. Because of this, whenever an academic economist takes a jibe at economics as a discipline, chances are their research is going to be pretty interesting.

This is what drew my attention to ecological economist John Gowdy, who begins this short talk on preferences and valuation by admitting that many of the most exciting developments in contemporary economics – such as the recognition that humans are part of social systems – are rather obvious to non-economists. 

If you have a spare 15 minutes I can recommend watching the video but, if not, here’s a quick summary.

Following his initial statement, Gowdy looks at these recent developments in a bit more detail explaining that research in behavioural economics is challenging some of the fundamental assumptions of textbook microeconomics. Microeconomics is the study of decision making at the individual or firm level and, therefore, these assumptions are often referred to collectively as the model of ‘economic man’: an individual who is purely selfish, perfectly rational and makes decisions based on a set of intrinsic preferences. Gowdy highlights research that contradicts the last of these assumptions by arguing that preferences are not constant or based on what is ‘best’ for an individual, but are influenced by a range of factors such as the opinions of respected figures.

Because individual preferences are not, therefore, innate Gowdy argues that conventional environmental valuation techniques that rely on the model of economic man are too simplistic. It may be possible to use individual preferences to derive monetary values for unpriced goods and services, but if these preferences are liable to change there is no guarantee that the calculated value is consistent with the most socially desirable outcomes.

Observing collective decision-making in rural Nigeria, he suggests that a more appropriate approach to environmental valuation would involve deliberation rather than algebra. While I agree in principle, I’m skeptical about the practicality of such deliberative valuation. Extended discussion to reach consensus may be an appropriate way to solve problems in a small rural community, but it’s not clear to me how such an approach would work when trying to establish values that are used to guide national-level decision-making.

Throughout the course of this blog I’ve noticed that this tradeoff between accuracy and practicality is a frequent problem in environmental economics. As I wrote earlier, I agree that environmental valuation is desirable in principle, as a way to highlight the social and economic importance of the environment to policy makers. However, in light of the practical issues I’ve examined I now find myself questioning the use of environmental valuation and wondering whether it threatens to do more harm than good. I’m still mulling this over so make sure you check back sometime in 2014 for my concluding thoughts. 

Until then, hope you’re all enjoying the Christmas break and Happy New Year!

Thresholds: better safe than valued

The US Dust Bowl in the 1930s – recorded so evocatively by the music of Woody Guthrie – is another instance where 

 the erosion of natural resilience by human activity had catastrophic consequences. 

Avid readers may remember this earlier post in which I introduced the concept of environmental wealth and described the collapse of southern Mesopotamian civilisation to show the severe consequences that result when environmental resilience is not adequately valued. However, if resilience is to be incorporated into comprehensive wealth accounting, simply stating that environmental resilience is ‘valuable’ is not enough as accounting frameworks require that all inputs are allocated an exact monetary value. This interesting paper by Walker et al (2010) attempts to address this considerable practical challenge, estimating a monetary value of agricultural resilience in the Goulburn-Broken Catchment to variation in the water table.

Walker et al define ecological resilience using Holling’s (1973) seminal interpretation that conceptualises resilience as the capacity of a system to remain in a particular state or ‘regime' despite temporary shocks. Holling argued that ecological systems move into alternate ‘regimes’ when a critical point is crossed and therefore resilience is primarily determined by the proximity of a given system to such a threshold. Anderies et al’s analysis of the Goulburn-Broken Catchment in South East Australia (Anderies et al 2006) found that when the region’s water table rose to 2m below the surface, natural processes drew saline groundwater upwards resulting in land salinisation and, therefore, Walker et al take this 2m level as a natural threshold.

By examining historical data on rainfall variability in the basin, Walker et al are able to estimate the probability that the 2m threshold will be exceeded, given any level of the water table in the previous period. This allows the authors to establish the level of resilience for a particular groundwater depth. The authors then use agricultural land value figures from Whish-Wilson and Shafron (1997) to attach a monetary value to the saline and non-saline states that, in turn, allows monetary values to be calculated for each resilience level. Applying their methodology, Walker et al find that between 1991 and 2001 unusually dry climate conditions caused the water table to fall from 3m to 3.5m achieving an increase in resilience worth roughly $23 million, which is equivalent to about 7% of the region’s conventional wealth.

This may seem a bit technical and abstract, but Walker et al’s experimental research is important. It’s all very well saying that environmental services should be included in national accounts but for this to be possible, methods of valuing these services need to be developed. However, I think that Walker et al’s paper also highlights a fundamental problem with resilience valuation.

The author’s entire valuation exercise relies on the knowledge of a precise environmental threshold – in this case the 2m water table level – and therefore application of their valuation methodology in other contexts is only possible if significant environmental thresholds can be identified. Environmental complexity means many different types of interdependent environmental resilience exist at a range of scales. For example, the population resilience of freshwater species influences the resilience of a freshwater body to nutrient enrichment and vice versa. This means that natural thresholds are numerous and extremely hard to determine, suggesting that the perfect knowledge required for resilience valuation is highly unrealistic. 

Because the resilience of ecosystems is such a complex and contingent phenomenon, I believe that resilience valuation is unfeasible, rendering the concept of environmental resilience incompatible with comprehensive wealth accounting. Rather than using wealth indicators to inform policy intervention, an alternative way of avoiding critical thresholds would be to establish ‘safe minimum standard’ policy targets for a series of environmental parameters. Although this doesn’t overcome the problem of threshold identification entirely – as determining a ‘safe minimum standard’ inevitably requires some knowledge of what is ‘unsafe’ – exact knowledge of thresholds isn’t necessary.

Attaching monetary values to environmental resilience may offer the empirical precision so beloved by contemporary economists, but the complexities of the real world make such an approach impractical. When it comes to incorporating environmental resilience into policy decisions, therefore, I reckon it’s better to be safe than valued.

Looking glass modelling

'Mitigation tomorrow and mitigation yesterday - but never mitigation today'
Alice and the White Queen, John Tenniel, 1865.

Utility maximization, perfect competition, consumer rationality – when reading economic modelling literature, it doesn’t take long to come across some pretty absurd statements. Because of the complexity of real-world economic processes, simplification is recognised to be a fundamental tenet of economic modelling that is necessary in order to establish and examine specific economic relationships. Such simplification is achieved by making various assumptions when constructing the model and it is here that the absurdities start cropping up. It’s important to recognise that economic models shouldn’t be automatically dismissed because of these outlandish assumptions. In particular, I believe that abstract models are useful for producing benchmark results that can be compared with the real world. For example, examining model predictions that don’t hold in reality and asking why different outcomes are observed can highlight particularly important aspects of economic systems. However, economic models aren’t used solely for academic purposes and often inform policy decisions, which is when extreme assumptions start to be problematic.

Integrated assessment models (IAMs) are a particular type of environment-economy model that are often used when assessing the economic costs of climate change and mitigation policies[1]. Although specific models vary, the general framework combines an economic model of production with a simple general circulation model. Production is assumed to have a positive effect on ‘utility’ or wellbeing, as it enables consumption, but also incurs economic costs or damages by generating greenhouse gas emissions that cause atmospheric temperature increases. Mitigation is incorporated by assuming that decision makers can invest in either production or abatement technology, which has the effect of reducing the level of emissions per unit of output. Policy makers, therefore, face an inter-temporal problem: investing in abatement today is beneficial, as it causes future climate change costs to be avoided, but also undesirable, as it reduces present-day consumption and hence wellbeing. 

From this, it’s pretty clear that IAMs are gross simplifications of reality, but are these simplifications problematic? This excellent paper by Ackerman et al (2009) argues they are, outlining three issues with the IAM framework related to the practice of discounting, speculative valuation methods and the modelling of mitigation. Although the first two of these points are significant, I’m going to focus here on the third, as discounting and valuation are already highly debated topics and I believe Ackerman et al’s critique of mitigation modelling relates to topics I have discussed previously.

A popular use of IAMs is to determine an ‘optimal’ path of mitigation that achieves particular emission reduction targets while minimising the adverse wellbeing impacts of abatement investment and Ackerman et al observe that such modelling exercises often conclude the ‘optimal’ policy involves backloading investment. This observation is supported by a review of IAMs that found ‘perhaps the most surprising result is the consensus that… modest controls are generally optimal’ (Kelly and Kolstad 1999, pg 19), which directly contradicts statements made by the scientific community that argue immediate action against climate change is imperative.

Ackerman et al argue that this result occurs because the way technological change is modeled in IAMs is inadequate and causes the costs of mitigation to be overstated. While IAMs acknowledge that abatement technology will become increasingly efficient over time (meaning that a given amount of investment in abatement will achieve a greater reduction in emissions), this technological change is assumed to occur at a constant rate that can be determined from past data. As the authors state, this awesome simplification makes the optimality of backloading unsurprising:

‘Because climate change is a long term crisis, and predictable, inexorable technological change will make it easier and cheaper to reduce emissions in the future, it seems better to wait before addressing the problem of climate change’, (Ackerman et al 2009, pg 308).

Such a blithe treatment of efficiency overlooks a significant and rich literature on innovation that emphasises technological change is often path dependent and, as I have written about before, can be positively influenced by public policy. If politicians are presented with the result that the ‘optimal’ policy is to do nothing – or very little – now, the potential benefits of targeted public investment are unlikely to be realised.

Although there have been recent attempts to ‘endogenise’ technological progress, which means efficiency is no longer taken as a constant but is determined within the model, these progressive developments haven’t been applied to all IAMs. Furthermore, it is often very hard to establish what assumptions are being made in any particular model as these are often buried in technical annexes rather than explicitly stated in the main body of reports and research papers. As long as economists continue to use IAMs that treat technological change as given and discuss underlying assumptions evasively, I worry that climate policy will remain an unfulfilled promise reminiscent of the White Queen’s policy of ‘jam tomorrow’ that Alice found so frustrating in her adventures through the looking glass…

"The rule is, jam to-morrow and jam yesterday – but never jam to-day." 
"It must come sometimes to 'jam to-day'," Alice objected."No, it can't," said the Queen. "It's jam every other day: to-day isn't any other day, you know."  (Carroll 1897).

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[1] Just to give you an idea of their significance, the whole Stern Review was based on the PAGE2002 IAM (Hope 2006, Dietz et al 2007)

Hungry for social policy

At the beginning of this blog I explained the concept of a ‘green transition’ referred to two distinct changes: reducing the environmental intensity of economic activity and improving the resilience of socio-economic systems to changes in climate. My previous posts have all addressed the former topic and so today I’m going to focus on the latter and examine how experiences of past climate change can inform present efforts to increase such societal resilience.

Records of the Great Famine that spread across Northern Europe during 1315-17 exemplify the severe social effects that changes in climate can cause. While historians have been aware of the catastrophic event for centuries, thanks to the harrowing accounts recorded by medieval chroniclers, more recent analyses have reconstructed climatic conditions during the period in order to examine the causes of the crisis. The tree-ring and GISP2 ice core analyses (undertaken by Lyons in Crawford (ed) 1989 (Ch. 2) and Dawson et al 2007 respectively), conclude that Northern Europe experienced significant increases in rainfall during 1315-16 that occurred alongside an increase in Northern Atlantic sea surface temperature. This supports numerous accounts recorded during the famine period that describe prolonged downpours from 1314-1316 that decimated crops and caused severe flooding (Jordan 1996). Although the rains subsided in 1317, the agricultural crisis persisted as widespread outbreaks of livestock murrain, caused by inundated pastures, continued to disrupt agricultural markets. Jordan argues that this caused the crisis period to continue for a further 5 years with food prices returning to pre-1315 levels only after 1322.

While the climatic cause of the famine is uncontested there is evidence that the severity of the crisis was increased by socio-economic factors. Crop failures caused substantial increases in agricultural market prices causing food to become unaffordable for large sectors of the population. Within this group it was the landless poor who experienced the most prolonged and severe impacts as, unable to undertake subsistence agriculture, they were dependent on agricultural markets and therefore endured food scarcity over the entire 1315-1322 period.

By analysing historical records, Kershaw (1973) has identified two factors that caused increases in this particularly vulnerable group during the famine period:

1. Increases in the unemployed landless – Outbreaks of livestock murrain and increased pressures on manorial finances caused large landowners to considerably reduce the number of people they employed resulting an increase in unemployment among landless individuals and, hence, an increase in the landless poor.

2. Reduction in peasant population – Peasants (individuals who undertook subsistence agriculture on small plots of land they owned) were vulnerable to climate variations as they didn’t maintain stores of produce. Following the initial crop failures, these individuals were forced to sell their smallholdings to wealthier households securing a temporary increase in income but removing their capacity to cultivate subsistence crops when the torrential rains ended in 1317. 

The factors highlighted by Kershaw indicate that economic responses can exacerbate the social effects of climate change implying that resilience to future climate change could be increased by policies that inhibit the repeat of these responses:

1. Improving climate-resilience of smallholders – It is clear that measures designed to increase the resilience of agricultural production to climate change are critical to the improvement of broader social resilience.  In particular, policies that seek to ensure that smallholder subsistence agriculturalists are prepared to withstand future climate change and climate variability could minimise a recurrence of the most severe social impacts observed during 1315-22. Reports such as CGIAR (2012) have identified which crops are most suited to increasing food security in poorer countries while also enhancing resilience to future climate and therefore policies that attempt to increase uptake of these crops among smallholders, such as seed subsidies, could be valuable methods of increasing social resilience.

2. Rural employment guarantees – The Great Famine also shows that resilience to climate variations could be improved by reducing the sensitivity of employment to climate change. In the present context, rural workforces dependent on agriculture are most vulnerable to climate variations and therefore, policies to guarantee rural employment could mitigate the social impact of harvest failure. Economist Jean Dreze is a prominent advocate of such policies and in this interview he explains his position and defends India’s rural employment guarantee scheme.

Although it’s necessary to treat precedents from the past with some caution, as their relevance is inevitably constrained by their historical context, an understanding of the factors that have increased vulnerability to climate in the past can be insightful. The experience of the Great Famine exemplifies how economic responses can exacerbate the social impacts of climate events and emphasises that economic policies will be essential in mitigating the severe social consequences threatened by a changing and increasingly variable climate. 

Public investment please

What with financialisation and a taste for fossil fuels, it seems that the private sector is incapable of financing a green transition. But what can the government do to compensate for this?

While economic theory tends to view the public sector as a cumbersome barrier to business, with blundering government intervention likely to result in cronyism and ‘government failure’, economist Marianna Mazzucato, is out to challenge this caricature. Contrary to conventional economic wisdom, which sees the correct role of government as (at most) fixing flaws in markets leaving the dynamic private sector to get on with innovation, she argues that state investment has underpinned some of the most revolutionary technological developments of the last few decades (Mazzucato 2011). In the video below she explains her thesis and examines the iphone to reveal the many ways in which public investment enabled the creation of one of Silicon Valley’s most iconic products.

These examples are much more than just fun facts as Mazzucato argues that they show government acting as an ‘entrepreneurial state’ willing to take the biggest investment risks that scare the comparatively timid and impatient private sector. In particular, she highlights how the Defense Advanced Research Projects Agency has acted as a technology pioneer overseeing the early stages of the internet among many other important developments. Trenzel et al (2012) provide another interesting example, examining how government intervention facilitated the shale gas revolution in the US.

Listening to contemporary politicians with their mantra of ‘getting the deficit down’, you might be inclined to dismiss Mazzucato’s argument as interesting but irrelevant: government might have been able to can get things done in the past but in the wake of the financial crisis it simply doesn’t have the financial resources to take the big investment risks any more. Mazzucato also addresses this issue of financing, stating that governments in the past have been far too reluctant to reap the rewards of their investments. If the public sector stopped being so modest about its entrepreneurial role and started demanding remuneration from the companies that profit from publicly funded innovations, government investment could be self-financing. Furthermore, figures recently published by the Overseas Development Institute (Whitley 2013) show that government subsidies offered to the coal, oil and gas industries amount to £2.6bn a year, making Britain the fifth largest fossil fuel subsidiser in the world.

Mazzucato believes that the next sector waiting to benefit from public sector innovation is green tech and I agree. Britain, however, is falling behind countries like the US and South Korea where publicly-funded green initiatives have already been developed:

Taken from 'The Green Investment Gap' (PIRC 2011)

The UK government should stop subsidising fossil fuels and start an active programme of green investment. A green-investment bank simply won’t be enough as history shows that only after government has taken the biggest investment risks will the private sector start loosening its purse strings.