End March Links

A sketch of a model of higher education
Scotland should be proud to stand alongside Ireland and Iceland
The worst type of parochial, faux 'internationalism'
Microfoundations in macroeconomics
Do illiquidity and sticky prices go together
how high gas prices triggered the housing crisis
Why quantitative easing is the only game in town
Is solar a bigger deal than people realize?
The future is another country
Tell us about the rabbits George
Regional pay the first step to fiscal federalism
How can debt affect potential gdp
Nonergodic model of business cycle
Partial equilibrium intuitions about choice - in particular the line "It is not incoherent to argue that a country might benefit from retaining talented people, and it is not even incoherent to argue that individuals who would choose to emigrate might in fact be better off themselves if they as well as all their compatriots could be persuaded to stay and contribute to development at home."
Zoning laws and property rights
Soak the rich
A rational reason for high oil prices - in particular the line "The question is not whether there is a rational reason for high oil prices, but rather whether there is a rational reason the world is not producing 100 million b/d today."

Agglomeration in action

Good news for Edinburgh and the renewables industry in Scotland with the announcement of a wind turbine manufacturing plant in Leith. This comes shortly after other relevant announcements: offshore servicing in Nigg in Easter Ross, green finance with the Green Investment Bank in Edinburgh; and follows on from news of other renewables manufacturing plants in Dundee and Methil, and renewables R&D facilities in Glasgow and Edinburgh.

As well as being fantastic news for jobs in Scotland, it is an example of economic theory in action - the theory in question being the new economic geography developed by Paul Krugman which predicts and explains clusters of related activity.

The worst policy prescription

Former MPC member Andrew Sentance, has an article in the FT today in which he recommends a 'leaning against the wind' policy of raising interest rates to curb that inflation whose underlying cause is an excess of demand for energy over the available supply. This is the worst advice imaginable and seems to be driven by (a) considering this as purely a problem of excess demand; (b) the assumption that interest rate policy has no impact upon long run supply (so that central banks can concentrate solely upon managing inflation expectations).

However, the world's oil supply has stagnated with essentially zero growth in supply since 2005. Alternatives are difficult and so we can expect an extended period with little energy supply growth. It's facile to state, as Sentance does, that the inflation is "responsible for the slowdown in global growth". This gets causality backwards: to first order, growth in output is only possible with growth in energy inputs. With constant energy inputs, we cannot expect growth in output, so strengthening demand has to lead to higher prices rather than expanded output. The supply restrictions have caused the growth shortfall and the rise in prices, rather than the rise in prices causing the growth shortfall.

If energy supply stagnation leads to higher prices, how should we respond? I would recommend whatever policy response leads to fossil fuel substitutes being incentivised as quickly as possible. Sentance's prescription is higher rates - does this work? Higher rates depress demand, lowering energy prices and hence lowering incentives to invest in fossil fuel alternatives. Higher rates provide a higher yield on alternative investments to new energy infrastructure projects, raising the hurdle rate that these projects must achieve, lowering the incentive to invest in fossil fuel alternatives.

Sentance has it backwards: raising rates may well be the appropriate response to inflation caused by domestically generated wage-price spirals, but it is completely the opposite response to that required to the problem of global energy supply stagnation. The fact that we are running into supply constraints needs to be strongly signalled through the price mechanism so that there are incentives to invest in mitigating technologies. Interest rate rises are a demand depressing response to energy supply constraints. Since energy supply constraints will get worse over time if we do not develop alternatives, a policy which causes a contraction in demand rather than stimulating an alternative supply is a prescription for long term decline.

Phase Changes in the Oil Market

There was a recent flurry of interest (see e.g. Skeptical Science and Dosbat) in response to a Nature article "Climate policy: Oil's tipping point has passed" (behind a paywall), the gist of which is that the oil market has undergone a 'phase change' from a market in which supply grew in response to price increases, to a market in which supply is essentially constant but "prices swing wildly" in response to demand changes. See diagram below. 

The 'phase transition' terminology is by analogy with physics (in particular, but not limited to, the physics of solids, liquids and gases) and is a phenomenon that can be seen in other complex systems (e.g. the transistion from free flowing to congested traffic). As complex systems, clearly economic systems could be subject to the same phenomena. Multiple steady state models are perhaps the best examples of economic models that could fit this analogy, and I have done some work on such a multiple steady state model of the oil market exactly to explore this issue.

I initially came to the problem after reading Prophets of doom: the secrets of Soothsaying in the New Scientist in February 2011 which outlined the technique of detecting transitions between different steady states by observing 'Critical Slowing Down'. I then did some work in December 2011 on this (see paper (it's not reached the quality required be described as a working paper yet) and slides). I did not find any evidence of critical slowing down, or by implication, of a phase change as supplies plateaued. My explanation of this (negative) result is that a phase change would be due to some change in supplier behaviour, rather than being associated with a geological inability to increase supply. The shift in supplier behaviour in such a phase change would lead to a jump in the steady state e.g. from low price high quantity, A, to high price low quantity, B, in the diagram below:

We do not see this phase change, and so (potentially) only geological explanations remain. A geological explanation is consistent with a monotonic, but at some point very (infinitely) steep, supply curve, and no phase change.

I wanted to highlight the work I had done on this for two reasons: (a) there was the flurry of interest created by the Nature article that came after I had done my work; (b) I then read Noahpinion's Sketch of a model of higher education where he says "Anyone can, of course, feel free to take this model and run with it if you like it (and if you do, feel free to include me as a co-author, or not, as you like)."

This is kind of where I am with this project: I found no evidence to support any suggestion of a 'phase change' - which I thought was an outlandish idea that might just be true. A negative result though was, I thought, equivalent to stating "No evidence found for phenomenon that no-one thought would be there anyway", which I surmised would not be a very interesting paper. However, given the Nature paper, clearly this is an idea that people are proposing and so perhaps my rejection of it is of interest? And in case I don't get round to working on this before somebody else does, this blog post is, to some extent, stating my claim to the idea. I would modify Noah Smith's quotation to read "Anyone can, of course, feel free to take this model and run with it if you like it - and if you do, please consider including me as a co-author!"

Smaller Better?

Chris Dillow had a very good post yesterday: "We need smarter people". In it he makes the case that large organisations are almost never well run by a hierarchy led by powerful individuals, and "in the case of management, the solution is to break up conglomerates or seek the wisdom of crowds by using market-based management or worker democracy." This applies to countries too and is related to a possible argument in favour of Scottish independence.

It's not that Scotland is small enough for its politicians to manage whereas Britain is not. Rather it's that if the global economy and polity consists of a few large countries, then the inevitable mistakes really really matter. Each country is not only too big to fail, but also too big to even falter. If we have a multitude of small countries then when we make poor decisions, other countries will be making good decisions. Their buoyant economies can then provide external demand when our economy is floundering, and vice versa.

Climate Change Economics

Our February energy meeting was on the subject of climate change economics and specifically the Weitzman Nordhaus debate that was conducted in a series of papers in 2009: Weitzman, Nordhaus, Weitzman.

This debate is on the treatment of low probability, high impact events in cost benefit analysis (CBA). The standard approach to climate change economics as pioneered by Nordhaus is essentially deterministic. It evaluates the price of carbon that a social planner would have to set in order to implement the policy programme that maximises their objective function (usually lifetime CRRA utility), in a world where high temperatures damage production and production in the absence of abatement technology causes high temperatures. Weitzman's contribution was to show that if instead of calculating the carbon price by putting central assumptions into a deterministic model, we took the expected value of the carbon price given our uncertainty on the assumptions, then the price should be infinite.

This is a consequence of there being some non-zero probability of catastrophe and our infinite valuation of zero consumption (which is what catastrophe equates to in this framework). That there is a non-zero probability of catastrophe seems to be unarguable (*), so if we are to argue for anything other than the entirety of current output going towards climate change mitigation and prevention, then we must be arguing with some feature of the CBA framework. This also applies to other catastrophe risk like asteroid impacts. See also Millner and Ikefuji et al for recent work in this area.

A solution to the problem of infinite results is is to truncate the valuation of bad events i.e. so that we value another unit of consumption when we have a very low consumption level at a high but not infinitely high rate. However Weitzman shows that this truncation becomes the dominant factor in the CBA calculation (so for example the size of the median impact does not really effect the calculation, all weight is put on the impact at the extreme downside). This may be true (avoiding catastrophe perhaps should indeed be the policy target) but it is contrary to our usual understanding of the value of an investment program (e.g. the value that we might put on a company share will be closely related to the expected income stream rather than the tail of the income stream distribution).

An interesting side-issue to this debate is that Nordhaus's 1996 paper, 'The Value of Scientific Knowledge' which has a limited monte-carlo simulation of the deterministic CBA model, produces much higher estimates for the cost. My suspicion is that the value so produced was actually a function of the size of the grid over which it was estimated, and that as the grid got larger and more representative of the distribution of the parameters of the model, the the value would also have tended to infinity.

The criticisms that Weitzman effectively makes of the standard approach to climate change economics seem valid to me. However, my main problem with these models is that they produce 'optimal' projections of output, consumption, emissions and atmospheric CO2 that leads to CO2 concentration peaking at over 650ppm (see figure 5.7 of Nordhaus's 'A Question of Balance'). Despite the claimed inputs from IPCC projections etc to Nordhaus's models, I don't believe that many climate scientists would agree that this represented an optimum (see Hansen et al 2008) - rather it's a prescription for passing tipping points which are not in Nordhaus's models.

(*) Two recommendations for books credibly outlining future catastrophe:
# Hansen 'Storms of my Grandchildren' (2009)
Hansen is a climate scientist who has basically turned into an activist because he is so concerned. Has testified to Congress on numerous occassions. Works for NASA. Very credible guy who's at the top of his profession. A section from this book is copied below (**).
# Ward 'Under a Green Sky' (2008)
Ward is a paleontologist and astrobiologist who has studied mass extinctions and concluded that most of the extinction events in the geological record are 'greenhouse extinctions' associated with anoxic oceans. An amazon review (from the above link) outlines the thesis:
"That an asteroid caused the mass extinction at the end of the Cretaceous period is widely accepted and also widely disseminated to the public. Less well known to the public are the other mass extinctions. Ward contends that they all have a common cause: climate change caused by carbon dioxide increase. This can in turn release methane (a more powerful greenhouse gas than carbon dioxide) from methane hydrates creating a runaway effect. At the end of the Permian period 250 million years ago this was severe enough to kill over 90% of all species on Earth.
Now Ward is not the first to relate the devastation of the Permian-Triassic extinction to modern day human-induced climate change to show us what could happen (see for example When Life Nearly Died: The Greatest Mass Extinction of All Time), but just when you thought that the devastation could not possibly get any worse, Ward introduces a new element into the equation: photosynthetic sulphur bacteria.
The effects of the climate change causes the oceans to become increasingly anoxic. In these conditions the only life to thrive is sulphur-producing bacteria. The boundary between the oxygenated and anoxic water comes closer and closer to the surface, to the point where photosynthetic sulphur bacteria, which use the sulphur from below, thrive in the surface waters and give off large quantities of hydrogen sulphide. Apart from being very poisonous in itself to surface life, the hydrogen sulphide also destroys the ozone layer of the Earth. Ward paints a picture of the Earth at the end of the Permian: most life is dead; the oceans are purple from a thick layer of bacteria; the hydrogen sulphide has changed chemistry of the atmosphere such that cloud formation has altered drastically - clouds form in the upper atmosphere far above where clouds normally form, giving the sky a green colour."
Also consistent with this thesis is the recent New Scientist news story that almost all the fish in the sea have fresh water ancestors.

(**) "As global warming continues, storm effects will ratchet upward in three major ways. One of these ratchetings will be the development of more powerful and destructive midlatitude or frontal cyclones. Frontal storms will be more powerful, because they depend upon the temperature difference between the cold and warm air masses as well upon the amount of moisture in the atmosphere behind a warm front. This intensification of frontal cyclones will be an effect of melting ice sheets, once ice sheets begin to disintegrate rapidly enough to keep regional ocean surface temperature from rising as fast as continental temperatures and temperatures at lower latitudes. The most important point is that there will be places and occasions in which the warm air masses will be loaded with far more water vapour than would be the case in a cooler world. ...

This first ratcheting, though, will pale in comparison to the effects of the second ratcheting: when ice sheets' rapid disintegration causes a sea level rise measured in meters. ...

Ice sheets eventually begin to disintegrate at rates of several meters of sea level per century, even with the slow pace at which natural climate forcings change. But predicting when ice sheet mass loss will accelerate in the twenty-first century is a notoriously difficult ``nonlinear'' problem. We could "lock in" disastrous sea level rise very soon, that is, create conditions that guarantee its occurrence, but it is likely to be several decades before a rapid sea level rise begins. On the other hand, we have been surprised by how fast some other climate changes have occurred - such as disappearance of Arctic sea ice ... For the moment, the best estimate I can make of when large sea level change will begin is during the lifetime of my grandchildren - or perhaps your children. ...

With the combination of a higher sea level, even of only a meter or so, and increased storm strength, the consequences of future storms will be horrendous to contemplate. ... Social and economic devastation could be unprecedented. It is not necessary to put the entire island of Manhattan under water to make the city dysfunctional and, given prospects for continuing sea level rise, unsuitable for redevelopment. ...

The timing of the third ratcheting effect of global warming, the melting of methane hydrates, is as unpredictable as the others. Warning signs are beginning to appear already, with bubbling of methane from melting tundra and from the seafloor on continental shelves. So far the amounts of methane released in this way have been small. The methane hydrates of greatest concern are those in sediments on the ocean floor, because of their great volume. ...

The flooding of the ocean floor with warmer Pacific Ocean water may have been a key factor in the melting of methane hydrates during the PETM [Paleocene-Eocene Thermal Maximum - 54 million years ago, when temperatures suddenly (i.e. over millennial rather than geological timescales) rose by between 5 and 9 degC]. Could a change of ocean circulation happen again in the near future? Global models of today's climate sometimes have a problem with spurious formation of deep water in the Pacific Ocean, which suggests that it would not take much change in the densities of ocean surface waters to alter the location of deep water formation. The instigation for such a change could be freshwater additions to both the North Atlantic and Antarctic Oceans, after the rate of ice sheet disintegration in both hemispheres has reached high levels. ...

When deep water formation begins in the Pacific Ocean, the inertia of the climate system, specifically ocean circulation, will be far too great for humans to stop, even if social systems are still in order. Once large sea level rises begin to devastate coastal cities around the world, creating hundreds of millions of refugees, there may be a breakdown of global governance. But regardless of that, if ocean circulation changes, such that warmer Pacific Ocean water begins sinking to the ocean floor and melting methane hydrates, there will be no plausible way for humans to reverse that change of ocean circulation.

While we can't predict the details of short-term human history, changes will be momentous. China, despite its growing economic power, will have great difficulties as hundreds of millions of Chinese are displaced by rising seas. With the submersion of Florida and coastal cities, the United States may be equally stressed. Other nations will face greater or lesser impacts. Given global interdependencies, there may be a threat of collapse of economic and social systems.

Physical science is easier to foresee. While the timing of the three ratcheting effects is difficult to predict, their effects are not. With methane hydrate emissions added on top of those from conventional and unconventional fossil fuels, the future is clear. Diminishing feedbacks that help to keep the magnitude of natural long-term climate changes within bounds, such as the ability of the long-term carbon cycle to limit atmospheric carbon dioxide, will have no time to counter amplifying feedbacks. The huge planetary energy imbalance caused by the high levels of atmospheric carbon dioxide and methane will take care of any remaining ice in a hurry. The planet will quickly get on the Venus Express. ...

A devastated, sweltering Earth purged of life may read like far-fetched science fiction. Yet its central hypothesis is a tragic certainty - continued unfettered burning of all fossil fuels will cause the climate system to pass tipping points, such that we hand our children and grandchildren a dynamic situation that is out of their control.''

End February Links

Money as store of wealth
Defending Independent Invention
Competitiveness is about capital much more than labor
Incentives Doublethink