Saturday, July 21, 2012

Durable Capital, Depreciation and Dr. Krugman's Pessimistic Views of Climate Change Adaptation

Krugman's blog piece on climate change adaptation is worth reading.   Here is a key quote:

"My first-pass answer is that we have a global economy that is adapted to historically normal climate — not just in terms of what is grown where, but in terms of where we locate our cities. In the long run, after a couple of centuries’ worth of urban development and infrastructure has been drowned by rising sea levels and/or made useless because previously habitable regions need to be abandoned, we might be able to reconstruct an equally productive economy; but in the long run …"

As the case of Las Vegas shows, we (even ignoring China) are completely capable of building new cities in 30 years or less.    Krugman is right that cities are long lived durable capital but this capital depreciates over time and the forward looking investor must decide whether to invest in maintenance or not.  I believe that homes built in the 1950s in Detroit in the year 2012 are in worse shape than those near Dr. Krugman's home in Princeton. Why?  This isn't a law of physics -- instead it is a question of depreciation and optimal maintenance investment.  The home owners in Detroit are aware that if they invest $25,000 today to improve their roof that this won't offer a payback in the future in terms of the resale value of the home.  The home owners thus don't make an investment that the Princeton home owners routinely make and the net effect of these "small ball" decisions is that the housing capital stock of Princeton looks a lot better than the Detroit homes even though they were built at the same point in time.  

Krugman ignores that our economy is an urbanized economy and cities insulate us from many of climate change's blows.  As an expert on international trade, he knows that the key issue related to the food supply is international correlations in yields.  If there are places on the planet where food can be grown in our hotter future with wackier more variable rainfalls then agriculture will move there and export back to the rest of the world. He also has forgotten about storage and inventories and futures markets.  If we know that the variance of climate shocks has increased then food and commodity storage technologies become more valuable.     

For a brilliant guy, he has given a lazy answer about the economics of adaptation to climate change. I worry that he is trying to use his clout (which he has plenty of) to downplay adaptation prospects because he wants mitigation now.  I want mitigation now but we need to be honest about what happens to the global economy when we don't mitigate.  As I discuss in Climatopolis,    we are going to have a smooth adjustment path to climate change over the 21th century as we simultaneously adapt and eventually mitigate our carbon emissions.  This latter effect will take place because we won't like the "new normal" and this will nudge voters to enact costly carbon pricing.    The "price" of decarbonizing will decline due to technological change (thanks to efforts such as California's AB32) and international trade with nations such as China and India who will export cheaper low carbon products.   The net effect is that even Republicans will eventually vote for a carbon tax bundled with a reduction in income taxes.  So global CO2 will rise but not to 800 ppm. Capitalism will allow us to adapt to the new normal thanks to international trade and futures markets and new entrepreneur's efforts to provide products that help people to cope with the new risks.   This was a key theme of my 2010 Climatopolis book.  For a 7 minute video about my optimism that free markets will help us to adapt to many of the challenges of climate change; watch this.

As a proud Keynesian,  shouldn't Dr. Krugman celebrate the "silver lining" of the stimulus benefits of building new cities in geographic areas that are less at risk from climate change?   Rather than burying bottles filled with cash and having the unemployed look for them, we could have this crew get to work to build the more resilient cities we will need in the future.  Real estate developers will have the right incentives to locate the geographic areas whose quality of life will suffer least and to start to build the capital stock to create the future Las Vegas and Phoenix in such areas.