China features state owned enterprises (SOEs) that pursue a "double bottom line".  They simultaneously seek to earn profit and to please the powerful Central Government.  Relative to their private sector counterparts, these Chinese SOE firms receive special treatment. They can often access subsidized energy, land and capital.  Facing such low factor prices such firms use more resources and this creates distortions because the opportunity cost of one firm using scarce resources is that another more productive firm does not use those resources. Macroeeconomists continue to study the implications of such misallocation for the macro-economy.

Do China's SOEs and the resulting economic growth losses offer a preview for America's future if the Federal Reserve's nascent climate initiative is pursued?   This blog post sketches out the microeconomic issues.

The Federal Reserve is taking on more and more functions in the U.S economy.  Why? One reason is Congressional gridlock.  Of course the Federal Reserve has a regulatory charge that one can look up on Wikipedia but at the end of the day, the Federal Reserve is a collection of people who have skills and incentives and what interests me here is; "what do they do all day long?" "How does their agenda affect the macroeconomy, the wealth distribution and the risks posed by climate change?"

Economists are taught to think through the "counter-factual".  What if the Federal Reserve was run by John Cochrane and there was no Climate Change Mandate?  Chairman Cochrane would likely be a vanilla Chair who would focus on committing to "rules over discretion" in order to maximize economic growth.  The Government sets clear "rules of the game" and Tom Sargent would sleep well at night.  

In such an economy,  for profit banks would focus on earning profit.  Such firms would lose profit if they make "bad loans".  The banks would not have a "double bottom line" focus. If the CEO of such a bank wants to give her earnings to purchase carbon offsets that would be fine with John Cochrane and Milton Friedman.  Chairman Cochrane would likely commit to "no bailouts"and he would commit to a learning process to transform "unknown unknowns" about emerging climate risks into "known unknowns".

Banks who bear the costs of new risks have strong incentives to learn about the emerging spatial and temporal distribution of risks associated with extreme heat, wildfires and natural disasters.   In this piece, I discuss the emerging climate risk rating agencies and how their information could help banks to make better "bets" (more below).    Researchers at the Federal Reserve of San Francisco and academic economists are actively estimating "climate effect" regressions to document such effects. Read my co-authored 2020 NBER for an example.  Watch my video here on the role of the academic as the new Paul Revere in nudging profit maximizers to anticipate emerging risks.

In lending other people's money (from deposits), banks make bets about the future.  Given that assets are tied to a place, these are place based bets. In the face of ambiguous climate change, some of these bets will prove to be "bad bets".  If Bank of America (BoA) lends me $1 million dollars to build a home in a place that subsequently floods and I then default on my loan, Bank of America has a problem.

But, this raises dynamic issues.  Why did BoA make me a fixed interest loan for 30 years?  Why didn't it make me a 15 year loan?  Why didn't it tie the interest rate to the location specific risk? Why didn't BoA require me to have a lower LTV so that I have more "skin in the game"?  Why didn't BoA co-ordinate with an insurance company to offer me a package of insurance and a loan that incentivizes me to invest in self protection so that my house faces lower risk from natural disaster?  If these microeconomic points about climate change adaptation interest you, then read my 2021 Yale Press book.

If the Federal Reserve can commit to no "bailouts" then banks actually have a greater incentive to take these actions!  Climate change adaptation is accelerated by having Chairman Cochrane in charge!    To concisely state my point, banks will internalize the consequences of climate change on their profitability if they bear the costs of not taking climate change seriously!!

One important point to note here relates to economic justice. If minority groups are physically over-represented in climate risky areas then this group's neighborhoods will now face a higher cost of borrowing under these rules.  If Matthew is Black and if I own a home in a Black majority neighborhood that faces intense climate risk, then under the rules sketched out in this Blog post, borrowers who want to buy my house will face worse loan terms and they will bid less aggressively for my home. This lowers the resale value of my home and lowers my rate of return on housing.   This is a serious issue.  In this 2021 NBER paper, I explore the general case here.   I will return to this point in a future blog post.

To conclude this blog post, I want to hear from economists concerning what is the comparative advantage of the Federal Reserve Board in "fighting" climate change?  If for profit banks believe they can please the Biden Administration's Fed by appearing to take the climate change seriously, then they become a type of Chinese SOE and the issue of the misallocation of capital arises.  

 The new issue of the Economist includes an excellent Free Exchange column titled Lose-Lose Ordeal with the heading; "New research counts the costs of the Sino-American trade war".  The article does a great job citing the new research by several top economists including my old colleague Pablo Fajgelbaum.  

Empirical research helps to understand the short run dynamics brought about by the Trump tariffs.  But, what do we know about the medium term reputation effects?

Basic game theory teaches us that if you can build up a credible reputation for sometimes not pursuing your short term interest you can improve your bargaining power.  Richard Nixon told his advisers that he wanted to build up a reputation for being "crazy".  Here is a 2017 Slate piece.

During the Presidencies of Bill Clinton and Barack Obama, the U.S was predictable in its interactions with China.   Has President Trump's actions helped future U.S Presidents by inserting some doubt in the minds of China's leaders? Can they confidently predict what strategy the U.S will play in future economic strategic games?

I believe that the answer is no.  So, my question for the game theorists;  when an opponent inserts some uncertainty into her rival's head -- when does this help one party in the game?  The Economist magazine gives the Trump Administration no credit for this medium term "benefit".  Is the Economist magazine, and the empirical trade economists, right to ignore the reputational effects of unilaterally raising tariffs?  

Finally some nuance. I am not saying that the Trump Trade War was "good".  I am saying that it appears to me that The Economist and the academic economists are ignoring an interesting (and hard to quantify) medium term benefit of the Trump Administration's strategic play.    

There is a certain irony that future Democrat Administrations will gain from this policy uncertainty shock.

In our new age of Machine Learning and reduced form empirics and field experiments, what insights does applied game theory offer?  If your rival predicts that you will always comply with "their proposal", what happens next in the game?  

 An excellent new NBER Working Paper titled "Mandated vs. Voluntary Adaptation to Natural Disasters: The Case of U.S Wildfires" has been published.  The authors have assembled a great data set to document that building codes cause upgrades of properties such that subsequent wildfires cause lower damage to property.  This is a highly optimistic adaptation paper and it puts Government at the center of achieving adaptation progress.  The authors argue that building codes are a binding constraint such that in the absence of this constraint that people would have chosen to build lower quality structures that would have exposed them to more fire risk.

A direct quote from the paper's abstract:  

"Despite escalating disaster losses and predicted increases in weather-related catastrophes, takeup of protective technologies and behaviors appears limited by myopia, externalities, and other factors. One response to such frictions is to mandate adaptive investment."

In this blog post, I will offer a few thoughts related to my research agenda on the microeconomics of climate change adaptation.  

First, I am thrilled that more and more young scholars are working on this topic. I am not surprised that their work highlights our economy's impressive adaptation capacity. 

Second,  I love this intellectual tension that posits that behavioral economics can explain under-investment in resilience.  In my 2015 paper, I discuss the broad issue.

1. Kahn Matthew E., 2015. "Climate Change Adaptation Will Offer a Sharp Test of the Claims of Behavioral Economics," The Economists' Voice, De Gruyter, vol. 12(1), pages 25-30, August.

 My main point is to discuss the role of the insurance industry here. In my co-authored 2017 Harvard Business Review piece, we argue that the insurance industry could be the "adult in the room" here if insurers are allowed to risk price and to "price gouge" when risks rise.   Suppose that fire risk is rising in a fire zone.  In the absence of government regulation, insurance prices for real estate will rise there.  An insurer could embrace the Ehrlich/Becker paradigm and offer a non-linear contract that lowers the fire insurance premium if the property owner takes specific precautions.  In this case, real estate developers who build new homes in the fire zone would take these safety enhancing steps in building the homes because they can sell the home for a higher price.  Why?   The present discounted value of insurance premium expenditures will be lower for the safer homes.  In my 2021 RMS interview, I expand upon these themes.  

I view government building codes and the insurance industry's non-linear pricing to be substitutes in building up our resilience to increasing climate risk.  Since the government regulates insurance and effectively subsidizes risk taking (by putting limits on insurer "price gouging"), building codes are needed to raise the average quality of the housing stock in risky places.  

Read this New York Times piece titled

California Bars Insurers From Dropping Policies in Wildfire Areas

Finally, a theme I discuss in my 2021 Yale Press book is that home owners are "amateurs".  Frank Wolak and I discuss this in our 2013 energy paper.  If more people rent their homes then professional managers would manage more of the housing stock and these profit maximizers will have the scale of assets to invest in human capital to better understand the emerging risk. If professional management companies operated our assets, then the case for the need for government mandated building codes would be weaker.

Permit me to suggest a new research topic on endogenous adaptation innovation.  Building codes serve as a commitment device. If innovators in the home construction sector see that there are new building code mandates, this acts as a "Big Push" commitment device.  Such innovators now have an incentive to invest their time to learn how to make safer homes and this shifts the production possibility frontier.

Why do so many people live in the fire zone?  If we up zone in cities, then fewer people will live in areas that face increased fire risk. Read Enrico's great New York Times piece.  

UPDATE:  I do have a question about durable capital.  Building codes affect the quality of the flow of new housing constructed in the risky area. I do not believe that building codes affect the stock of existing homes that have not burned down.  The average risk at a point in time is a weighted average of the risks faced by both sets.   In slow growing areas, the building codes will not achieve average risk reduction for a long time.

In contrast, insurance pricing that incentivizes self protection would impact all homes immediately . So, I claim that using insurance prices will more quickly flatten the climate damage function than relying on binding building codes for new homes.