Saturday, December 18, 2010

A Reply to a Smart Email About Rational Expectations and Climate Change Adaptation

This is my last blog post for a week or so.   I'm going to Berkeley.  In the post below, you will see my long winded response to this question concerning whether I really am a Rational Expectations (RE) economist?   To paraphrase Ellen DeGeneres; "Yes I am" --- But,  you don't need to have "rational expectations" in order to survive climate change.  It would certainly help your adaptation prospects if you did but I will argue below that we only need roughly 2% of the population to have rational expectations for reasons that I will sketch below.

"now on to a different subject. it seems to me, in the ongoing wake of such a broad-deep real estate screwup, it takes great -- courage -- to advance RE market resilience as a basic assumption for catastrophe planning. have any econ-savvy reviewers of your book explored that thesis?


What is "rational expectations"?   You incorporate all available information today to form your best guess about the likelihood of future scenarios.  It doesn't mean that you have perfect foresight.  An aware person will know that when predicting some future event such as the likelihood of a major flood in New York City in 2050 that you "know that you do not know".   Knowing that you do not know leads a risk averse person to plan prudently to avoid the vague threat or to learn more before making an irreversible decision (such as buying coastal property in Manhattan).

You can read my earlier blog post on this broad issue but permit me to add some more points.

I believe that we do hold heterogeneous expectations of the future. The rational expectations model imposed too much discipline by assuming that everyone has the same beliefs about future events and that on average these forecasts are accurate.  Tom Sargent has earned the right to speak for all economists on this subject. Read his interview on this subject posted here.

Let me start with a cliche example and then say some smarter things.

EXAMPLE: If Don Trump underpredicts the probability of flooding in Manhattan then he will mistakenly build billion dollar housing in flood zones. If rich people who are looking for a nice condo also underpredict this event then they will move into his objectively dangerous building and will die in the resulting nightmare.  

BUT,   I believe that climate change will not be so abrupt that one morning the Trump tower will be submerged under 20 feet of water.  As climate change becomes a real threat, the land owners in that building will learn that they are under siege and they will need to call in engineers to take steps to protect the investment or they will abandon ship.  There will be an income loss as this new news becomes common 
knowledge but I don't foresee everyone in this building dying.

If widespread urban coastal flooding becomes a reality, then engineers will try out their solutions and architects will try out their solutions, if neither of these solutions work then we will need to move inland.  I talk in Climatopolis about the future of the NYC region if parts of Manhattan are under siege.  Urban places will certainly suffer but mobile urbanites do not need to.


You can dismiss the strong assumption that all of us have rational expectations but it would be a mistake to dismiss bayesian updating when "we know that we do not know". The real climate scientists will make progress in their forecasts.  This new information will benefit all of us who will make our choices based on this new information. Armed with this information and knowing one's own risk aversion, you will see people and firms migrate away from the riskiest areas. You will see some innovators (from a law of large numbers some people will anticipate the scary future scenarios that Joe Romm sketches) making bets on future technologies that will help us to adapt and they will become very rich. We don't need everyone to have perfect foresight. Instead we need heterogeneity, experimentation nad investment and options so that when the true future unfolds that we have access to several strategies to cope with the new news.

In Climatopolis , I discuss these themes at length.   The recent housing crisis and the inability of economists to foresee it tells us nothing about how capitalism will help us to cope with climate change adaptation.  The world has not ended because of this painful recession.   In the case of the housing crisis, there all sorts of bad incentives including banks being "too big to fail" that encouraged excess risk taking.   The banking industry knew that they would be bailed out by government and this anticipation of ex-post insurance encouraged ample ex-ante risk taking --- this is moral hazard! 

In the case of climate change, you die if you live in a dangerous setting --- that is an incentive to be smart about your choices. Out of raw self interest, future urbanites will have strong incentives to make their location decisions wisely. Developers will have strong incentives to build in "safe" places.

UPDATE:   In a subsequent, e-mail I received this response

"after he  (Joe Romm) explained in detail exactly what people are concerned about 
in the near term -- unpredictable water cycle & natural resource 
shocks -- and why it would be good not to tempt fate into worsening 
that volatility,."

My friends, the first chapter of the book is titled "Too Much Gas".  I 100% agree with you that it "would be good not to tempt fate into worsening that volatility." But, I can't influence the political process.   For those of you who are interested in the political economy of carbon mitigation, read this or this.  World GHG emissions will continue to rise probably until the mid-21st century. The question is how we will adapt to this challenge.

Returning to the quote above,  this is again a case of our "knowing that we don't know" what we face with water cycles. A rational person plans by holding an inventory or having a backup technology (water desalinization) to be ready for the known unknowns. This is all in my book.  In the Los Angeles chapter, I discuss the importance of allowing water prices to rise to reflect increased scarcity and my optimism about the law of demand.  As water prices go in Los Angeles, people will demand less and the scarcity challenge will be mitigated!

Let's return to holding inventories and permit me to introduce a wacky example. I discussed dried fruit in one chapter and reviewers made fun of me for claiming that such a mundane product helps to protect us from climate change.  But, I'm serious.  Holding reserves of dried fruit is a type of inventory or insurance strategy.  Dried fruit lasts for a year and you get the vitamins you need from it even if you can't grow fresh fruit because of water cycles.  Just as a pirate ship has crates of food because they anticipate that they won't find a Starbucks in the middle of the ocean, we will act in the same way.

Now, you will say that I'm assuming rational expectations.  Yes and no. Adaptation will be easier if we all have rational expectations but even if only 1% of us are real smart, then there will be huge arbitrage opportunities for these entrepreneurs to seize the market when Homer Simpson says "duh" and realizes that Joe Romm was right. At that point there will be gains to trade and the entrepreneurs will grow rich and Homer will live on.  Every day, entrepreneurs make bets. If any of them anticipate future water scarcity then they will make investments now.   

For capitalism to help to protect us from climate change, I need 2% of the world to be informed investors who believe the climate change science and to have the financing resources through venture capital to operationalize their vision to design and bring to market products that can protect us ranging from better air conditioning to cleaner cars to safer housing structures to water supply augmentation.    Given that policy activism has not achieved a federal breakthrough,  liberal intellectuals should be working with Al Gore in encouraging green venture capital firms to invest in breakthrough technology that will help us to adapt and to mitigate our future carbon emissions.   

In the opportunities chapter of Climatopolis, this is exactly my  point.  Did the guys who created Google smell an opportunity? yes, was it a risky bet of their time and effort , yes.  Did everyone foresee how big their company would become? No.

If I'm wrong that there aren't even 2% of people with this forward looking vision, then I need households to be mobile and ready to mover to safer, higher quality of life locations when they see a deterioration in their current city's water supply, heat waves, and natural disaster risk.  It is true that I assume in Climatopolis that there will always be some "safe" places to move to either in another city or within the same metropolitan area. Remember that we can build up in tall buildings--- so we do not have to fight to the death over a plot of land.

Critics of Climatopolis' core logic  need to carefully write out your implicit assumptions about the choices of human beings that could generate your doom and gloom scenarios. You will see that the necessary ingredients to generate your pessimism is that all 7 billion people on the planet either have no anticipation of the real threats that we face or are liquidity constrained and can't act now to build the "Noah's Ark".  You also will find that you are implicitly assuming that human knowledge and innovation can't substitute for Mother Nature.  I believe that it can.  My father has treated thousands of patients with heart disease and helped them to recover.

The only case where you would be right about Doom is the following;

1. We all think we know the "true model" of the future with certainty when we are in fact dead wrong.

2. Our dead wrong expectations model leads us to underinvest in defenses and strategies to adapt.

3.  When Mother Nature strikes in 2100, she knocks us all out because we weren't ready.

We are a diverse world of 7 billion people. By a law of large numbers if 1% of 1% of people anticipate the tough days that will soon arrive,  then we will have at least 700,000 new good ideas to help us to adapt to climate change.  Given that ideas are public goods, these ideas will flow around the world and help people in Bangladesh and New York City to adapt.

I celebrate capitalism because of its inherent system for fostering learning, and experimentation and trying out new ideas.  The Soviet 5 Year Plan did not encourage such efforts.  By introducing price signals to co-ordinate dispersed economic activity,capitalism will send the signals to our nerds to incentivize them for which technological challenges they will work on. If changes in water cycles are making water more scarce, then we need to see rising water prices and our nerds will get to work.  Government can distort this price signal with price caps but this only means we need more free markets to help us to adapt.