The Economist Magazine has published a "philosophical" piece about climate change mitigation.  I'd like to blog about a single paragraph in this piece related to the benefits of reducing global GHG emissions. A DIRECT Quote: "However, estimating these benefits means that we need to determine the value of a reduction in preventing a possible future catastrophic risk. This is a thorny task. Martin Weitzman, an economist at Harvard University, argues that the expected loss to society because of catastrophic climate change is so large that it cannot be reliably estimated."

1.  What is our definition of "catastrophic climate change"?  Does it unfold in a matter of seconds? What is the spatial distribution of this catastrophe?  Is its impact uniformly distributed?  Is this catastrophe predictable?  How much time will there be between the diagnosis of "catastrophe" and the actual effects?

2.  There are 7.3 billion people on the planet.  The total land surface area of Earth is about 57,308,738 square miles, of which about 33% is desert and about 24% is mountainous. Subtracting this uninhabitable 57% (32,665,981 mi2) from the total land area leaves 24,642,757 square miles or 15.77 billion acres of habitable land.  (source)

From the year 2000 to 2006, I was colleagues with Michael Klein at the Fletcher School. He and a co-author have released an important working paper that is discussed here.  Based on a Freedom of Information Request, they document that newer cohorts of Marines are scoring lower on a standardized test.  Why?  What are the implications of this trend?

I have now figured out how to operate my office PC and how to deposit a paycheck.  At USC Econ, I've even gotten some work done.   I'm editing the proofs for my JEL review of Jeff Sachs' new book and I'm finalizing my forthcoming Princeton Press book (joint with Siqi Zheng) focused on pollution dynamics in China's cities.  As I write this, I'm listing to Led Zeppelin's The Rover. I was unable to download a strong chess program to this office PC but maybe that's a good thing.  In 37 minutes, Prof. Antonio Bento will meet me here and we will begin to plan out activities at USC for the next year and talk about mutual research interests.   This is a new start for me.

 

Climate scientists continue to warn us that flood risk in coastal areas is increasing because of sea level rise. How do we adapt to this anticipated but vague threat?  The threat is vague because we don't know when and how severe and where will any specific flood occur. We are able to form some general predictions about times of the year when it rains hard. We know which areas are close to the sea.  What can property owners in these places do to defend their turf and reduce damage?    What can local governments do to defend the turf?  How can we design incentives to reduce the probability of government effort crowding out private household self protection?

First some specifics:  (Source) is Terry Sheridan

Safeguard in-home electrical and climate systems

Anchor and raise outdoor equipment

Modify water valves

Determine how water flows around your house

Opt for a major retrofit

• Raise your home on piers or columns so that the lowest floor is above the flood level. If that sounds expensive -- well, it would be. Experts tell FLASH that such an undertaking would cost $20,000 and up, Chapman-Henderson says.
• "Wet-proof" your home by installing foundation vents that would allow water to flow through the building, instead of rising inside and causing more damage. You'd need at least two vents on different walls. A 1,000-square-foot house would require 7 square feet of flood vents, according to FLASH.
• Do some "dry proofing" by applying coatings and other sealing materials to your walls to keep out floods.

Take last-minute measures as waters rise

• Clear gutters, drains and downspouts.
• Move furniture, rugs, electronics and other belongings to upper floors, or at least raise them off a ground floor.
• Shut off electricity at the breaker panel.
• Elevate major appliances onto concrete blocks if they're potentially in harm's way from flooding.

Read more: http://www.bankrate.com/finance/weather/natural-disasters/6-ways-protect-home-flooding.aspx#ixzz3h7woQ02P 

What does FEMA say?  Read this.

In this age of field experiments, we need to know how cost effective are each of these strategies? If you adopt 3 of the 6, how much does this reduce your damage caused by a flood? This is a test of the optimistic adaptation hypothesis.

Poorer households and "behavioral" households will be less likely to take these precautions.

Note that if coastal households believe that FEMA will bail them out if a disaster occurs, then households will be less likely to invest in these costly self protection measures.  This anticipated moral hazard effect induced by FEMA must be discussed and dealt with.

As I talk about in my 2010 Climatopolis book, I would like to see the insurance industry be allowed to engage in much more spatial price discrimination so that they can charge higher home premiums in riskier areas and created a nuanced contract that offers a cheaper premium if home owners invest in more flood precautions that can be cross-checked by the insurers.   These small ball choices represent how an urban economy becomes more resilient in the face of flood shocks.

To enhance adaptation, we need continuing spatial refined models of the geography of flood risk.  Which areas within a city are at the greatest risk?   Should housing in such areas be required to meet more stringent regulatory standards?   Should people who insist on living in such areas sign a form acknowledging that they will not receive a FEMA bailout if a disaster does occur?  Would such a social contract be "time consistent" or would the government renege on its original promise to the tax payers?

When I was a kid, I played Stratomatic baseball. This was a precursor to Billy Beane's Moneyball.  Now that I'm no longer a kid, I have signed up for REPEC's fantasy League and below I report my initial roster (that I was assigned at random).  I find it mildly amusing that I was randomly assigned Tomas Piketty.  I will trade him.  For those who enjoy rankings, keep an eye on my team. We are called "Diesel".  (Don't ask).

Arthur Brooks' OP-ED focuses on the politics of optimism but I would prefer to recast his focus on what should be the basis of our optimism about our collective future.  In 2015, we live in a world with roughly 7.3 billion people whose life expectancy is higher than it has every been.  Educational attainment is higher than it has ever been. Urbanization both insulates us from climate shocks and facilitates trade and learning. Anticipating a longer life time and lower infant mortality, families are having fewer children and investing more in the human capital of each child. These children (through the dynamic complementarity mechanism of learning begets learning) are more likely than previous cohorts to achieve their full potential.  While many progressives yearn for a return to 1950s America, I have argued (see this post and this post) that those days were not as great as they recall and the rest of the world was not in terrific shape then (think of China).

My optimism about our future is based on information technology keeping us aware and up to date in real time about emerging risks.  An educated world population demanding solutions to pressing challenges (ranging from climate change to cancer) and an ambitious set of entrepreneurs who seek both to become rich and to improve the world (think of Zuckerberg).  Ideas are public goods.  In a world of 7.3 billion people, what is the chance that the best idea from this large set is bad? The answer is zero.

Free markets, global connection, international markets in human capital and financial capital guarantee that the pace of progress will only accelerate.  Do the poor benefit from this emergent trend? Yes.  But, we all have to find and hone our comparative advantage within the world economy's price signals.

Jianfeng Wu, Siqi Zheng, Weizeng Sun and I have just released a new NBER paper titled "The Birth of Edge Cities in China: Measuring the Spillover Effects of Industrial Parks".

My parents joined us in Cambridge, MA this week and on Thursday morning I met them outside the Sonesta Hotel as they were reading Paul Krugman's column titled "The MIT Gang".   My father is a cardiologist at NYU and he is aware that there was a long standing debate between Samuelson and Friedman and then there was a debate between a new generation of macro guys and Robert Lucas. He wanted to know what I thought about Krugman's piece.  

On one level, Dr. Krugman's piece is wonderful. It is a love letter to MIT. He received his Ph.D. there and he wrote many path breaking papers while serving on the MIT faculty.   He starts his piece celebrating the wisdom of 5 great economists;

DIRECT QUOTE

"It’s actually surprising how little media attention has been given to the dominance of M.I.T.-trained economists in policy positions and policy discourse. But it’s quite remarkable. Ben Bernanke has an M.I.T. Ph.D.; so do Mario Draghi, the president of the European Central Bank, and Olivier Blanchard, the enormously influential chief economist of the International Monetary Fund. Mr. Blanchard is retiring, but his replacement, Maurice Obstfeld, is another M.I.T. guy — and another student of Stanley Fischer, who taught at M.I.T. for many years and is now the Fed’s vice chairman.

These are just the most prominent examples. M.I.T.-trained economists, especially Ph.D.s from the 1970s, play an outsized role at policy institutions and in policy discussion across the Western world. And yes, I’m part of the same gang."


NOW, here is the quote that I"d like to talk about;    ANOTHER DIRECT QUOTE:

"At M.I.T., however, Keynes never went away. To be sure, stagflation showed that there were limits to what policy can do. But students continued to learn about the imperfections of markets and the role that monetary and fiscal policy can play in boosting a depressed economy. And the M.I.T. students of the 1970s enlarged on those insights in their later work. Mr. Blanchard, for example, showed how small deviations from perfect rationality can have large economic consequences; Mr. Obstfeld showed that currency markets can sometimes experience self-fulfilling panic."

Point #1   Note the eagerness to introduce ideas from behavioral economics into economic policy making.   A dangerous precedent arises here.  If the "people are foolish", then this creates an ugly elitist possibility that only the wise technocrats (the MIT graduates) can protect us.   I don't like this worldview on a number of levels.     Moral hazard lurks when sophisticated investors and economic decision makers are aware that the technocrats will step in and "save the world" when ugly economic events take place (such as a plunging stock market, or rising unemployment).

Point #2:  The real difference between Chicago and MIT macro is Chicago's commitment to rules over discretion. Milton Friedman's endorsement of a constant 3% increase in the money supply was meant to minimize the chance of hyperinflation and to make running the Fed a boring job such that investors had clear expectations of how Policy would be set. When "leaders" have discretion with respect to how they set policy, they have more fun on the job but "uncertainty" increases and this reduces investment.

Point #3;    Dr. Krugman also refuses to acknowledge the power of Ed Prescott's work on time consistency and policy.  Clear rules of the game create dynamically stable rules and this fosters investment. In Dr. Krugman's short run focus on the business cycle, he ignores the long run growth implications caused by the activist policies that he supports.

Point #4;   In the absence of randomized trials, the MIT trained technocrats (the 5 people listed above)  do not actually know what policies are effective in mitigating business cycles.  If they know that they do not know how the macro economy really works, then does this affect Dr. Krugman's optimism that MIT has won the policy debates. His piece isn't that modest (or honest) about the modeling uncertainty that now exists in modern macro economics. He makes the past debates sound settled. If he attended MIT's current 1st year PHD macro sequence, he would see a variety of different models being worked on and taught and I bet that the policy conclusions are very sensitive to the modeling choices.

We are flying back to LA.  Hundreds of talented, ambitious and mostly young economists have been meeting at the Sonesta Hotel.   The week started off with environmental and urban papers and then labor studies, crime, kids and aging. Plenty of new ideas to think about.   Alan Krueger gave a great Feldstein Lecture but he needs to think some more about the implications of casey mulligan's work for his core thesis.  We also need more empirical work testing the scarring effects of unemployment.

Read Richard Freeman's and Doug Kruse's OP-ED in the New York Times today.   They argue that more companies should pay their workers with stock equity in the company. They point out that great companies such as Google and Starbucks already do this.  What they don't discuss is a simple empirical point. Which workers for which firms choose to spend their after tax earnings on purchasing shares in their own company?   If the companies would gain from having more motivated workers who now have a "stake" in the company (because they own stock equity), why don't for profit companies already offer this compensation package? Are the authors of this piece better at business than American businesses?

If workers at publicly traded firms choose to not invest their after tax earnings in these companies, is that informative about their beliefs about the company's long run profitability or do they not invest because they are impatient and they seek immediate gratification?

Now , here is my point --- What I think that Richard Freeman is really getting at here is that paying workers with stocks will force them to save more and delay immediate gratification.    This policy line is a direct consequence of his colleagues David Laibson and Bridgette Madrian's work on default options and procrastination and commitment devices.  At Harvard today, there are several leading behavioral economists who view workers as needing commitment devices to save for the long run.
If firms restructure the labor contract away from just paying a salary and now pay a lower salary and give stock options that workers must hold and can't cash out , then the workers hands are tied and they must save this part of their income.   The typical Homer Simpson will not love this in the short run as this impatient guy would prefer to buy a big TV or a bigger house now.  The behavioralists argue that this forced savings will make the middle class workers better off in the long run even though they currently do not want to follow this investment plan.

Could progressive thinkers believe that firms will not reduce salaries as they now pay stock options?  The theory of compensating differentials would reject that logic.

Note that the authors of the OP-Ed never mention behavioral economics and psychology in their piece.  They must explain why free will leads to inefficient decisions.  If stock options are so attractive to workers, why don't more firms offer them already as part of the compensation?  From the basics of portfolio theory, investors want to hold a diversified portfolio. If your wage and your equity come from the same source, you are holding a risky portfolio. If the firm's earnings collapse, you could lose your job and take a serious equity hit.

The other issue the piece doesn't discuss is tax arbitrage.  Can a firm's cost of paying compensation decline if it makes part of the compensation stock options?  Tax arbitrage plays a big role in the choices that real world firms make.  That firms are not paying in part with stock options suggests that the tax treatment would not work in their favor.  But, I'm not an accountant.