Sunday, November 23, 2014

For the Euthanasia of Kaldor-Hicks/Cost-Benefit Pseudo-Science

J. R. Hicks "The Foundations of Welfare Economics" 1939:
"Positive economics can be, and ought to be, the same for all men; one's welfare economics will inevitably be different according as one is a liberal or a socialist, a nationalist or an internationalist, a christian or a pagan. 
"It cannot be denied that this latter view is in fact widely accepted. If it is intellectually valid, then of course it ought to be accepted; and I must admit that I should have subscribed to it myself not so long ago. But it is rather a dreadful thing to have to accept. No one will question the activity of some of our 'positivists' in the criticism of current institutions; but it can hardly be denied that their authority to advance such criticism qua economists is diminished by their abnegation, so that in other hands economic positivism might easily become an excuse for the shirking of live issues, very conducive to the euthanasia of our science
"Fortunately there is no need for us to accept it. The way is open for a theory of economic policy which is immune from the objections brought against previously existing theories..."
Just a small sample of the objections Kaldor-Hicks has been immune to over the years:
"...judged in relation to its basic objective of enabling economists to make welfare prescriptions without having to make value judgments and, in particular, interpersonal comparisons of utility, the New Welfare Economics must be considered a failure." 
"Pareto is sometimes credited with an early formulation of the ill-fated Hicks or Kaldor principles of hypothetical compensation." 
"The ethical appeal of this [compensation criterion] argument, however, is weak."  
"It turns out then that Mr. Kaldor's criterion in its most general sense has not eliminated the problem of interpersonal comparison of utility. It has only subjected utility to the measuring rod of money, a measuring rod which bends, stretches, and ultimately falls to pieces in our hands."
"...implicit assumptions about the numéraire good in the Kaldor–Hicks efficiency–equity analysis involve a 'same-yardstick' fallacy..."
"For sustainability science, the Kaldor–Hicks rule runs counter to both intra- and inter-generational concerns."
"Only later would it be realized that one did not know -- indeed, one could not know -- the value of production independent of the distribution of income and the associated price vector that provided the weights to the various physical quantities being produced."
"...in all of this prodigious elegance, rarely is there recognition that the Pareto test remains what it has always been -- an analytical construct (inconsistent and incoherent at that) with no special claim to legitimacy beyond the tautological domain out of which it
arose." 
"When the unweighted sum of net benefits from a project are used as a criterion of project evaluation, cost-benefit analysis may be sensitive to the choice of  numéraire . This is one reason, among others, why this criterion should not be used."
And yet:
"The Kaldor-Hicks criterion — a test of whether total social benefits exceed total social costs — is the theoretical foundation for the use of the analytical device known as benefit-cost (or net present value) analysis."
Not bad for an inconsistent, incoherent, ethically-weak, ill-fated tautological failure of a fallacy that should not be used!

Hicks was right. The Kaldor-Hicks theory is indeed "immune from objections."

Saturday, November 22, 2014

#NUM!éraire, Shmoo-méraire: Nature doesn't truck and barter

The commodity in terms of which the prices of all the others are expressed is the numéraire. -- Leon Walras, Elements of Pure Economics.
But the numéraire is a purely technical device, introduced simply for the purpose of making exchange values explicit. In no way does the introduction of a standard of value alter the fundamental nature of the economy in question. It remains a barter economy, since goods are exchanged solely for other goods. Andre Orlean, The Empire of Value.
In a previous post, Public Works, Economic Stabilization and Cost-Benefit Sophistry, the Sandwichman introduced David Ellerman's argument that the supposed efficiency/equity distinction underlying the Kaldor-Hicks compensation criterion is a "same-yardstick" illusion created by the tautological use of a numéraire (or "standard commodity") to evaluate its own value. One oyster is worth exactly one oyster in oysters. Ellerman demonstrated that simply switching the numeraire could have the effect of reversing which outcome is held to be efficient.

This discrepancy is not some curious foible of arcane economic theory. The Kaldor-Hicks compensation criterion is "the theoretical foundation for the use of the analytical device known as benefit-cost (or net present value) analysis" (emphasis added, Stavins 2007)

Ellerman documented the numéraire illusion (or fallacy) in a working paper dated ten years ago. Since then, he has presented several versions of his refutation of Kaldor-Hicks. According to Google Scholar, there has been one non-self citation -- in a 2014 Masters thesis -- of the five versions listed in Google Scholar.

There is a long and futile history of pointing out flaws in Kaldor-Hicks. In their 1978 review of the Kaldor-Hicks inspired "New Welfare Economics," Chipman and Moore declared it a failure, "...judged in relation to its basic objective of enabling economists to make welfare prescriptions without having to make value judgments and, in particular, interpersonal comparisons of utility." They concluded their review with the following assessment:
After 35 years of technical discussions, we are forced to come back to Robbins' 1932 position. We cannot make policy recommendations except on the basis of value judgments, and these value judgments should be made explicit... When all is said and done, the New Welfare Economics has succeeded in replacing the utilitarian smoke-screen [of technical jargon] by a still thicker and more terrifying smoke-screen of its own.
Thirty-six years on, that thicker, more terrifying smoke-screen prevails.

In a paper published in 1997. Kjell Arne Brekke presented an analysis that highlighted a different aspect of the importance to the outcome of cost-benefit analysis of the choice of numéraire. Brekke showed that, when public goods are involved, the sign (plus or minus) of the sum of net benefits is not independent of the choice of numéraire.

Brekke's discussion is marred by the peculiar conclusion that "[t]he choice of money as numéraire is systematically favourable to those who value money the least, relative to alternative numéraire." "Why do money and not environmental units as numéraire favour the environmentalist?" Brekke asked. His answer confuses the result of incoherent calculations with actual outcomes:
The net benefits of the project is positive for the environmentalist. If this net benefit is expressed in money terms, then it becomes a large number because money is of low value to the environmentalist. However, if the net benefit is expressed in environmental quality units, then the net benefit would be a small number, since environmental quality is important to the environmentalist.
Contrary to what Brekke argued, the choice of numéraire makes no difference to the net benefits from a project -- it only changes how those benefits are represented. In fact, by (mis)representing an environmentally-harmful project as unduly financially-beneficial, such "positive" results would support a decision that is less favourable to the environmentalist. Brekke also crucially misstated the Kaldor-Hicks compensation criterion as "the winners should compensate the losers."

In a commentary on Brekke's article, Jean Drèze acknowledged that "Brekke’s interpretation of his own result is indeed somewhat misleading" but argued none-the-less that these lapses shouldn't detract from the important insight that, "[w]hen the unweighted sum of net benefits from a project are used as a criterion of project evaluation, cost-benefit analysis may be sensitive to the choice of numéraire." With regard to the ethical status of the [Kaldor-Hicks] compensation criterion, Drèze observed that "[i]f compensation is only hypothetical, it is irrelevant. If it is actual, it should be counted as part of the project, which becomes a Pareto-improving project so that its desirability is not an issue." In a passage, Drèze speculated on the reasons for the persistence of the ethically vacuous, analytically incoherent "aggregate benefit criterion" (ABC) touted by the compensation criterion:
In short, Brekke’s analysis does highlight a major problem with the ABC criterion, which adds to its other theoretical flaws. In the light of these flaws, it may be asked why the ABC criterion is so widely used in practice. Several possible reasons come to mind. First, the practitioners may not appreciate these flaws. Second, they may be aware of them, but use the ABC criterion for convenience. Third, they may be reluctant to contemplate the value judgments involved in choosing distributional weights. Fourth, they may hold the normative view that marginal social utilities are equal in terms of their chosen numéraire. Fifth, they may simply be siding with the rich.
Drèze missed a sixth possible reason: acknowledging these iatrogenic flaws in the aggregate benefit criterion may have profound implications for the theoretical foundations of neoclassical economics that can't be papered over with distributional weights, as Drèze seems to think, or by reversion to an "actual" Pareto-improving standard instead of a hypothetical one. To put it bluntly, all the stuff and nonsense about numéraires proceeds from the a priori assumption of a barter economy -- that "goods are exchanged solely for other goods."

As Orlean puts it, Leon Walras's numéraire "is a purely technical device..." What "counts" is not money but some presumably intrinsic value that is held to inhere in the goods themselves -- "behind the veil of money," so to speak. "Real money," Orlean continues, "money that 'not only supplies a unit of account but also actually circulates and in addition functions as ‘a store of value'—does not exist." The incoherence of the aggregate benefit criterion and its corollary of hypothetical compensation is a symptom of the fundamental incoherence of the barter metaphor. "The most serious challenge that the existence of money poses to the theorist," according to Hahn (1982), "is this":
...the best developed model of the economy cannot find room for it. The best developed model is, of course, the Arrow-Debreu version of Walrasian general equilibrium. A world in which all conceivable contingent future contracts are possible neither needs nor wants intrinsically worthless money.
One has to wonder, though, just what is "best developed" about a model of the economy that can't find room for the existence of money. In his review of Hahn, Minsky referred to that model more bluntly as "rubbish that prevents the flowering of new theory."

Of Sealing Wax and Cell Phones...


Arguing against perfect foresight is as embarrassing as it is futile. To borrow Robert Solow's image, it's like debating cavalry tactics at the Battle of Austerlitz with a lunatic who thinks he's Napoleon Bonaparte. But the hypothetical prescience of the numéraire is both fundamental and lethal to the Kaldor-Hicks compensation criterion. The mix of commodities available in the future will be radically different than the commodities available today, just as today's commodities are radically different from those of fifty or a hundred years ago.

Without perfect foresight (and without money -- real money) prices in a barter economy existing sometime in the future would be incommensurable with prices in a barter economy today. There could be no "standard commodity," no numéraire. The question of the choice of numéraire would be moot because there are no candidates to choose from.

With perfect foresight, however, market actors would know whether or not compensation is/was/will be paid to the losers in a "potential" Pareto improvement. In other words, the addition of the word "potential" makes the phrase an oxymoron that violates the model's specifications.

No doubt Cost-Benefit Analysis gets around this dilemma by smuggling in a "common-sense" notion that money is nevertheless performing its magic in spite of the value theoretical "rigor" that has banished that supposedly illusory veil. With such a hybrid of theoretical abstraction and absent-minded distraction, neoclassical value theory gets to barter off its cake and eat it too.

Try not to think of an elephant. Money is essential to a market economy. "Market economies based on barter are inconceivable..." Andre Orlean argues in "Money: Instrument of Exchange or Social Institution of Value?" That "inconceivable" must be taken literally. The attempt to conceive of a market economy based on barter flounders on the shoals of cognitive dissonance. "Don't think of money," the theory commands. But you think of money. As Hyman Minsky wrote 30 years ago, "the Emperor of today's theory, the Arrow-Debreu version of Walrasian general equilibrium, has no clothes."

The Kaldor-Hicks compensation criterion proclaims that we can all get richer by laundering the Emperor's invisible new clothes.
*****
In 1952 the Bureau of the Budget, in a Budget Circular [A-47] that neither required nor invited formal review and approval by the Congress, nailed this emphasis into national policy, adopting it as the standard by which the Bureau would review agency projects to determine their standing in the President's program. And soon thereafter agency planning manuals were revised, where necessary, to reflect this Budget Circular. In this way benefits to all became virtually restricted to benefits that increase national product. The federal bureaucrats, it should be noted, were not acting in a vacuum; they were reflecting the doctrines of the new welfare economics which has focused entirely on economic efficiency.
***** 
When all is said and done, the New Welfare Economics has succeeded in replacing the utilitarian smoke-screen by a still thicker and more terrifying smoke-screen of its own.

Sunday, November 16, 2014

Climate Catastrophe, the Numéraire, and a Smokescreen of Technical Jargon

I invite the reader to connect the dots and be horrified. If I tried to explain my interpretation of the passages below and the documents they come from you might not believe me, you may not want to grasp what I am trying to tell you.

Mistakes have been made. A mistake. A monumental error. The error has been detected but the magnitude of its consequences is incomprehensible... inconceivable. Nothing will be done to correct the error because there is too much at stake in admitting that public goods are different than private goods -- that the sign (plus or minus) of the sum of net benefits from a mixture of private and public goods is not independent of the choice of numéraire. This was the intuition behind John Kenneth Galbraith's observation, more than half a century ago, that "in an atmosphere of private opulence and public squalor, the private goods have full sway."
"In all cases, therefore, where a certain policy leads to an increase in physical productivity, and thus of aggregate real income, the economist's case for the policy is quite unaffected by the question of the comparability of individual satisfactions; since in all such cases it is possible to make everybody better off than before, or at any rate to make some people better off without making anybody worse off." – Nicholas Kaldor, 1939.
 *****
"When all is said and done, the New Welfare Economics has succeeded in replacing the utilitarian smoke-screen [of technical jargon] by a still thicker and more terrifying smoke-screen of its own." – John Chipman and James Moore, 1978.
 *****
"The ethical appeal of this [compensation criterion] argument, however, is weak. If compensation is only hypothetical, it is irrelevant. If it is actual, it should be counted as part of the project… In the light of these flaws, it may be asked why the ABC [aggregate benefit] criterion is so widely used in practice. Several possible reasons come to mind. First, the practitioners may not appreciate these flaws. Second, they may be aware of them, but use the ABC criterion for convenience. Third, they may be reluctant to contemplate the value judgements involved in choosing distributional weights. Fourth, they may hold the normative view that marginal social utilities are equal in terms of their chosen numéraire. Fifth, they may simply be siding with the rich." -- Jean Drèze, 1998.
 *****
"Some people, on the one hand, want to make recommendations, and others  want to be told, without the responsibility of deciding for themselves, what is the best thing to do. If they are told without its becoming too obvious that they are being told, so much the better. It is, in fact, attractive to  some people to have a theory which tells them what is the best thing to do." – I.M.D. Little, 1949.
***** 
"...it has become the norm for BCA [benefit-cost analysis] 'to focus on efficiency' and to compare a dollar of costs with a dollar of gains at a one-to-one exchange rate—no matter who is gaining or losing—which in practice amounts to setting η equal to zero. 
Although distributional weights are seldom used in practice, there is one big exception, where distributional weights turn up under another name: discounting! By setting η higher than zero, distributional weights are in fact applied to future generations." – Thomas Sterner and U. Martin Persson, 2008.
*****
"The numéraire matters in cost-benefit analysis." Kjell Arne Brekke, Journal of Public Economics (1997) 64: pp.117–123.

Abstract: The choice of numéraire is shown to be important in cost-benefit analysis. When a public good is involved, individual consumers" marginal rates of substitution will generally differ. Thus, the less valuable the numéraire is to a person, the higher the number required to express his net benefit, and the more will his interest weigh in the total sum. The choice of money as numéraire is systematically favourable to those who value money the least, relative to alternative numéraires.

*****

"On a fallacy in the Kaldor–Hicks efficiency–equity analysis." David Ellerman, Constitutional Political Economy (2014) 25: pp. 125–136.

Abstract: This paper shows that implicit assumptions about the numéraire good in the Kaldor–Hicks efficiency–equity analysis involve a 'same-yardstick' fallacy (a fallacy pointed out by Paul Samuelson in another context). These results have negative implications for cost-benefit analysis, the wealth-maximization approach to law and economics, and other parts of applied welfare economics—as well as for the whole vision of economics based on the 'production and distribution of social wealth,'
*****
In 1952 the Bureau of the Budget, in a Budget Circular [A-47] that neither required nor invited formal review and approval by the Congress, nailed this emphasis into national policy, adopting it as the standard by which the Bureau would review agency projects to determine their standing in the President's program. And soon thereafter agency planning manuals were revised, where necessary, to reflect this Budget Circular. In this way benefits to all became virtually restricted to benefits that increase national product. The federal bureaucrats, it should be noted, were not acting in a vacuum; they were reflecting the doctrines of the new welfare economics which has focused entirely on economic efficiency." – Arthur Maass, 1966.

Saturday, November 8, 2014

Remedies Are Made of This... (cornmeal and potatoes edition)

"Mayor Wood of New York in 1857 suggested employing on public works everybody who would work, payment to be made one-quarter in cash and the balance in cornmeal and potatoes." -- Otto T. Mallery, "The Long Range Planning of Public Works," chapter XIV of Business Cycles and Unemployment, President's Conference on Unemployment, 1923.
Chapter XIX of John Maurice Clark's Studies in the Economics of Overhead Costs contains a section on "Remedies for the Business Cycle," in which Clark anticipated his later, much more extensive discussion in Planning for Public Works:
"For filling up the hollows [of the business cycle], the most positive and definite prescription is that government should plan an elastic schedule for public works of a postponable sort, and should save certain works to be prosecuted only in time of depression and unemployment, or prosecute the entire program more actively at such times."
Two years before Clark's book on overhead costs was published, President Warren G. Harding's Conference on Unemployment convened to consider how to relieve unemployment resulting from the 1921 depression. Commerce Secretary Herbert Hoover chaired the conference. Philadelphia playground pioneer Otto T. Mallery wrote the chapter on public works for the National Bureau of Economic Research's report to the conference.

After citing the opinion of the Minority Report of the 1909 Royal Commission on Poor Laws and Relief of Distress that "it is now administratively possible, if it is sincerely wished to do so, to remedy most of the evils of unemployment..." Mallery concluded his chapter with the observation that "flexible distribution of public works merits careful consideration as a factor in limiting the swing of the industrial pendulum and in lessening the shocks of unemployment." Thus was optimism kindled for combatting what John R Commons reckoned to be "the greatest defect of our capitalistic system, its inability to furnish security of the job."

Ninety-some odd years later and how are those "remedies for the business cycle" working out? This is not to suggest that the various remedies proposed in 1923 by the President's Conference -- unemployment insurance, counter-cyclical spending on public works, improved economic statistics, responsive monetary policy -- were inappropriate or ill-conceived. The conference report may even be viewed  as somewhat of a blueprint for the New Deal.

As time went by "various kinds of remedies" were replaced by aggregate demand management which was superseded by "real business cycle" focus on the supply side. Jean-Baptiste Say was rehabilitated. "If labour markets were allowed to function freely," the supply-side ideology claimed, "protracted unemployment would be cured automatically." In other words, the cure for unemployment is... unemployment.

Ninety-one years ago, Commons summed up the then prevailing interpretations of unemployment:
The older economists held that the elasticity of modern business was provided for in the rise and fall of prices through the law of supply and demand. But they assumed that everybody was employed all the time and that all commodities were on the markets and were being bought and sold all the time. If commodities in some directions were abundant then their prices would fall, which meant that the prices of other commodities would rise Then the disparity would equalize itself by capital and labor shifting from the low-priced and over-supplied industries to the high-priced and undersupplied industries. The rise and fall of prices through oscillations of demand and supply made the system elastic and harmonious. 
Seventy years ago Karl Marx came upon the scene with exactly the opposite interpretation. He rejected the law of demand and supply, with its oscillation of prices, and held that the elasticity of modem capitalism is found in the reserve army of the unemployed: Just as modern business must have a reserve fund in the banks and a reserve stock of goods on the shelves and in the warehouses, in order to provide for elasticity, so it must have a reserve army of that other commodity, labor, which it can draw upon in periods of prosperity and then throw upon its own resources in periods of adversity. 
It was seventy years ago, also, that modem trade-unionism started in England and America. It started on the same hypothesis of unemployment, but it retained the economist's doctrine of demand and supply. There is not enough work to go around [!], because the wage fund is limited, and therefore the workman must string out his job; must go slow; must restrict output; must limit apprenticeship, must shorten the hours, in order to take up the slack of the unemployed. 
This theory is not peculiar to labor unions. It is the common conviction of all wage-earners, burned into them by experience. Willing, ready and able to work, needing the work for themselves and families, there is no demand for their work. Trade unionists differ from unorganized labor in that they have power to put into effect what the others would do if they could. 
And who shall say that they are not right? Two years ago business men, newspapers, intellectuals, were calling upon the laborers to work harder; their efficiency had fallen off a third or a half; they were stringing out the jobs. Then suddenly several millions of them were laid off by the employers. They had produced too much. The employers now began to restrict output. Where labor restricted output in 1919 and 1920 in order to raise wages and prolong jobs, employers restrict output in 1921 in order to keep up prices and keep down wages.
The Marxian and trade-unionist critiques and prescriptions have been vanquished. Keynesian advocates of aggregate demand management are reduced to kibitzing from the sidelines. The "older economists" are back in the saddle. Everything old is new again. 

Or is it?
There's nothing you can do that can't be done
Nothing you can sing that can't be sung
Nothing you can say but you can learn how to play the game
It's easy
All you need is growth
All you need is growth
All you need is growth, growth
Growth is all you need
Is growth "all you need"? One hundred and five years ago, a Royal Commission minority surmised, "it is now administratively possible, if it is sincerely wished to do so, to remedy most of the evils of unemployment,.."

If it is sincerely wished to do so.

Those who insist there are no "limits to growth" seem to forget that the evils of unemployment have not been remedied -- even though it was believed by some, over a century ago, that it was administratively possible to do so. If, in more than one hundred years, unemployment could neither be remedied administratively nor "decoupled" from economic growth, what foundation does one have for faith that economic growth can be "decoupled" from carbon dioxide emissions or other natural resources and ecological impacts?

Or was that transition too sudden? What I am saying -- and have been saying all along -- is that there are not one but two couplings implicated in the environment/economy nexus. To say that GDP growth can be decoupled from natural resource consumption is to speculate about only one of those couplings. We have no data from the future that can confirm or deny such speculation.

We do, however, have data on the persistence of business cycle fluctuations that result in unemployment. Remedies for climate change face precisely the same political and ideological barriers as do remedies for the business cycle. There is no reason on earth that one would be given a free pass while the other is held hostage to rapacity.

Saturday, November 1, 2014

Opportunity Costs and Secondary Benefits of Class Struggle

"Many difficult conceptual issues such as externalities, consumer surplus, opportunity costs, and secondary benefits that had troubled earlier practitioners were resolved and other unresolved issues, such as the discount rate, were at least clarified." -- Maynard M. Hufschmidt, "Benefit-Cost Analysis 1933-1985"
And they all lived happily ever after... (in the Cost-Benefit fairy tale, that is).

What are secondary benefits? What are opportunity costs? How did the difficult issues get resolved? And who cares?

What if I told you -- just for argument's sake, mind you -- that "secondary benefits" was a cipher for "wages of labor" and that "opportunity costs" was code for "return on investment"? What if I pointed out that the "difficult issues" were "resolved" by declaring that wages were of little concern to public policy making but that profits were paramount? Would you care about secondary benefits, opportunity costs and how those difficult issues were resolved?

Economists generally don't. At least not until now anyway.

The Sandwichman has scheduled an EconoSpeak blog post for Wednesday, November 5, titled "Unemployment, Interest and the Social Cost of Carbon" that doesn't quite go as far as the "what if" scenarios above [pssst: sneak preview at Ecological Headstand]. It explores highlights of the untold story of CBA from the New Deal to today's climate change policy "Integrated Assessment Models."

But keep those "what if" scenarios in mind. Cost-Benefit Analysis is about class struggle, the rules for conducting that struggle and which class makes the rules.

Thursday, October 30, 2014

Unemployment, Interest and the Social Cost of Carbon

I. Public Works and Economic Stabilization


This is where it all began. The National Resources Board's 1934 Report on National Planning and Public Works contained a radically different vision of the methods and purposes of conducting a cost benefit analysis than what has subsequently become the convention. This has profound conceptual (and possibly legal?) consequences for the supposed "economic optimization" of action to limit climate change.

John Maurice Clark was the NRB's economic consultant on the issue of "the use of public works as an economic stabilizing device." His findings provided the substantial basis for the report's Section II, Part 3 "Public Works and 'Economic Stabilization.'" A comprehensive report by Clark, Economics of Planning Public Works, was published in 1935 by the National Planning Board of the Federal Emergency Administration of Public\Works.

In Chapter Nine of his 1935 book, Clark introduced the (Kahn-) Keynesian multiplier into American economic discourse. This theoretical analysis provided a rationale for including the extended "secondary effects" of work relief in the calculation of project benefits. As the NRB report had noted: 
A second series of questions involves the relations of public works to economic stabilization and the emergency problem of work relief. What part can public works play in meeting the problem of business cycles and how far can these works be made an instrument for recovery?
This "second series of questions" was given a very high priority indeed by the Roosevelt administration in the context of the Great Depression. But for Clark the employment of labor that would otherwise have been idle was more than simply a secondary benefit of public works. It was the redress of a cost-shifting "externality" that resulted from the treatment of labor by employers as a variable cost that could be dispensed with during times of business slack. 

In his Studies in the Economics of Overhead Costs, Clark (1923) had argued that labor should be considered as an overhead cost of doing business rather than as a variable cost of the employing firm because the cost of maintaining the worker and his or her family "in good stead" has to be borne by someone whether or not that worker is employed:
If all industry were integrated and owned by workers, what would be the relation of constant to variable expense? ...it would be clear to worker-owners that the real cost of labor could not be materially reduced by unemployment.
One might argue that in a democracy, public works can be regarded as "integrated and owned by workers" and thus capable of restoring payment for the real cost of labor, if not by private employers then by the government -- which could then recover the outlay through taxation. Nor should it be assumed that Clark's attitude of reparation was not shared by the National Resources Board. The opening paragraphs of the report's foreword proclaimed in populist prose:
The natural resources of America are the heritage of the whole Nation and should be conserved and utilized for the benefit of all of our people. Our national democracy is built upon the principle that the gains of our civilization are essentially mass gains and should be administered for the benefit of the many rather than the few; our priceless resources of soil, water, minerals are for the service of the American people, for the promotion of the welfare and well-being of all citizens. The present study of our natural resources is carried through in this spirit and with a desire to make this principle a living fact in America. 
Unfortunately this principle bas not always been followed even when declared; on the contrary, there has been tragic waste and loss of resources and human labor, and widespread spoliation and misuse of the natural wealth of the many by the few. [emphasis added]
The conservation movement begun a quarter of a century ago marked the beginning of an organized national effort to protect and develop these assets; and this national policy was aided in many instances by the individual States. To some extent the shameful waste of timber, oil, soil, and minerals has been halted, although with terrible exceptions where ignorance, inattention, or greed has devastated our heritage almost beyond belief.
So this, then, is the founding rationale for cost-benefit analysis, as different from today's market-appeasing conventions as chalk from cheese. And -- oh, yes -- it is THE LAW:
"...if the benefits to whomsoever they may accrue are in excess of the estimated costs, and if the lives and social security of people are otherwise adversely affected." --  Title 33 U.S. Code § 701a - Declaration of policy of the Flood Control Act of 1936
Refugees from the "1000-year" flood of the Mississippi River in 1937.

II. The Fallacy of Maximizing Net Returns

In the early 1950s, the mandate for giving prominent consideration to secondary benefits was effectively expurgated from federal government cost-benefit guidelines. The purge was carried out through two documents: the "Green Book," Proposed Practices for Economic Analysis of River Basin Projects, published in May 1950 and Budget Circular A-47 issued on December 31, 1952. Maynard Hufschmidt's (2000) chronicle of "Benefit-Cost Analysis 1933 - 1985" provides a useful overview of the sequence of events. Hufschmidt worked for the National Resources Planning Board, the Bureau of the Budget, and the Department of the Interior between 1941 and 1954.

Hufschmidt recounted that the Green Book's "treatment of the thorny issue of secondary benefits was at odds with the  practice of the Bureau of Reclamation" and it recommended that benefits "should be measured from the strict national economic efficiency point of view" rather than from the perspective of local or regional benefits. This controversial recommendation was not implemented by the concerned agencies.

John Maurice Clark was called upon again, along with two other economists, to adjudicate the issues in dispute between water resources agencies and the interagency subcommittee on benefits and costs. According to Hufschmidt, the panel of economists "recommended a cautious approach to including secondary benefits," which included separate reporting of primary and secondary benefits but did not rule out their use. [I have requested the Report of Panel of Consultants on Secondary or Indirect Benefits of Water-Use Projects through interlibrary loan and hope to elaborate on its analysis when I have had a chance to study it.]

The economic consultants' report was submitted at the end of June, 1952. Six months later it became a moot point as the federal Bureau of the Budget issued Budget Circular A-47, severely restricting the use of secondary benefits. Hufschmidt described A-47 as a "conservative document" that was regarded as imposing "severe restraint" on water projects:
The subject matter coverage was much the same as the Green Book; basically, it was a conservative document, which placed primary emphasis on economic efficiency-oriented primary benefits for project justification. The use of secondary benefits was severely restricted, an opportunity-cost concept of interest or discount rate, tied to the interest rate of long-term government bonds, was adopted, and a 50-year time horizon was established.  
Budget Circular A-47 was widely regarded by the water resources agencies and by the many proponents of water resources projects in Congress as a severe restraint on water projects. It served this purpose during the eight years of a relatively conservative Republican administration under President Eisenhower from 1952 to 1960, and was finally rescinded in 1962 in the early days of President Kennedy’s administration.
It doesn't need to be assumed that skepticism or caution regarding the evaluation of secondary benefits was unwarranted. Richard Hammond (1966) observed that the practices of the Bureau of Reclamation "brought benefit-cost analysis into disrepute in many quarters, particularly when agencies continued, in times of wartime boom and post-war 'full employment,' practices generated by the depression." On the other hand, the remedy pursued by the Green Book had its own problems, characterized by Hammond as "The Fallacy of Maximizing Net Returns" which the Green Book pursued as an "incontrovertible proposition":
The most effective use of economic resources is made if they are utilized in such a way that the amount by which benefits exceed costs is at a maximum rather than in such a way as to produce a maximum benefit-cost ratio or on some other basis... This criterion of maximising net benefits is a fundamental requirement for economic justification of a project. [emphasis added by Hammond]
"What seems to have happened," Hammond observed of the foregoing paragraph,"is that a familiar abstract proposition of economic theory, that rational conduct consists in balancing marginal cost against marginal gain, has been mistaken for a prescriptive rule of behavior applicable in any and all circumstances without qualification." Furthermore, he eventually explained, the maximizing mania ultimately boils down to substituting guesswork about one set of "opportunity cost" intangibles for other intangibles called "secondary benefit" and diminishing some of the speculative figures to an infinitesimal amount by the application of an arbitrary discount rate.

In defence of Clark's earlier formulations regarding secondary benefits, he was almost exasperating in his insistent qualification of cost and benefit estimates as judgemental and tentative. This contrasts with the maximalist language of pseudo-scientific precision exemplified by the Green Book's use of "words like measure, ascertain, and evaluate in contexts where estimate, expect, and guess would be more appropriate."

III. Kapp and Trade

In 2010 the U.S government's Interagency Working Group on Social Cost of Carbon (IAWG) presented its estimate of the social cost of carbon "to allow agencies to incorporate the social benefits of reducing carbon dioxide (CO2) emissions into cost-benefit analyses of regulatory actions that have small, or 'marginal,' impacts on cumulative global emissions." The IAWG's central estimate for the social cost of CO2 in 2010 was $21 in 2007 dollars, based on a 3% discount rate. One of the damages associated with an increased increment of carbon emissions in a given year is specified as "property damages from increased flood risk." Would the Flood Control Act of 1936 have any pertinence to their cost benefit analysis?

The Kaldor-Hicks compensation test constitutes a guiding principle for the selection of a discount rate for cost-benefit analysis, the IAWG report explains:
One theoretical foundation for the cost-benefit analyses in which the social cost of carbon will be used— the Kaldor-Hicks potential-compensation test—also suggests that market rates should be used to discount future benefits and costs, because it is the market interest rate that would govern the returns potentially set aside today to compensate future individuals for climate damages that they bear.
The Kaldor-Hicks test presumably allows the analyst to set equity considerations aside while evaluating the economic efficiency. Does it?

David Ellerman argues that the efficiency/equity distinction is simply an artifact of the choice of numeraire. In other words, the supposed efficiency of a policy outcome measured in dollars is an illusion created by the fact that efficiency is being measured with the "same yardstick" that was used to assign "value" to incommensurable things like human life, output of goods and services and damage to the environment. If one reverses the process and establishes human life or environmental damage as the unit of measurement, then the results of the analysis are also reversed.

Although simple, this is not an intuitively obvious argument, so Ellerman illustrates it with a very simple example in which John values apples at one dollar each, while Mary values them at 50 cents. Social wealth would be improved if Mary sells an apple to John for 75 cents. Under the Kaldor-Hicks criterion, social wealth would also be improved if Mary lost her apple and John found it, even though Mary receives no compensation. Kaldor-Hicks would deem this an efficiency gain because John could potentially compensate Mary by paying her 75 cents for the lost apple. Measured in apples, though, there has been no change in total wealth because Mary's lost apple exactly balances John found one..

But using apples as the unit of measurement changes everything. Since John values one apple at one dollar, he also values one dollar at one apple. Mary values a dollar at two apples.Measured in apples, social wealth would be improved if John lost a dollar -- worth only one apple to him -- and Mary, who values the dollar at two apples, found it. John's cost is smaller -- in apples -- than Mary's benefit. But since a dollar is a dollar, if the unit of measurement was dollars, the cost and the benefit would exactly balance leaving no net gain.

Ellerman's illustration may seem trivial but the "same yardstick" argument comes from Paul Samuelson who pointed out that, measured in money, the marginal utility of income is constant at unity. Bill Gates would value an extra $20 a week of income as much as a Walmart clerk would -- $20 dollars worth! It's a tautology.

Of course that's not the only problem with the IAWG's cost of carbon estimate. Moyer, Woolley, Glotter and Weisbach argued that the social cost of carbon estimates in the IAWG models are constrained by shared assumptions of persistent economic growth. Even a modest negative impact on productivity, they find, would increase social cost of carbon estimates by several orders of magnitude above the IAWG estimates.

Johnson and Hope found that assigning equity weights to damages in regions with lower incomes or using different discount rates generates social cost of carbon estimates two and a half to twelve times those of IAWG. Foley, Rezai and Taylor argued that the social cost of carbon and the relevant social discount rate are conditional on a specific policy scenario "the details of which must be made explicit for the estimate to be meaningful." There is also Martin Weitzman's analysis that the uncertainty about the prospect of catastrophic climate outcomes renders traditional cost-benefit analysis irrelevant.

Remember how we got to this analytical impasse, though? Clark's analysis of planning for public works and the National Resources Board report were concerned with the environment to be sure. But their sense of urgency was more particularly focused on the unemployment crisis. Controlling floods, reclaiming eroded agricultural land and replanting forests were viewed as ways to productively employ workers who would otherwise have to be given welfare or work at "leaf raking" make-work jobs. Public works were being considered as a way to smooth out the fluctuations of the business cycle and ameliorate the effects of cost-shifting due to employers accounting for workers as a variable, rather than a fixed overhead cost.

In February 2010, the U.S. official unemployment rate was 9.8%. The word "unemployment" doesn't appear in the 50-page IAWG report on the social cost of carbon. Nor do the words "recession," "jobs," "poverty" or "inequality" The word "labor" occurs several times but only in the context of an arcane footnote about "a method of estimating η using data on labor supply behavior." The "lives and social security of people" is given short shrift. "Growth," however, appears 34 times, about two-thirds of which refer to economic growth. In the IAWG report, one may conclude, economic growth is unrelated to employment of labor but closely correlated with "interest rate," which appears 20 times, roughly the same frequency as "growth" in the economic context..

That's the problem right there.

In 1950, the same year the Green Book was curbing the use of secondary benefits in cost benefit analysis, Karl William Kapp's book The Social Cost of Private Enterprise was published, inspired by and elaborating on J. M. Clark's analysis of cost shifting. "As Kapp implied," remarked Joan Martinez-Alier, "from a business point of view, externalities are not so much market failures as cost-shifting successes." From that perspective, the IAWG's $21 a ton estimate of the social cost of carbon dioxide also may be better understood as a success rather than a failure.

Eighty years ago, it may still have been possible to believe that those cost-shifting successes of business could be remedied through planning and public works conducted by a democratically-responsive government. Today, the role of government and the intention of cost benefit analysis is very different from what was professed in the foreword to the National Resources Board's 1934 report.

Friday, October 24, 2014

Optimization and Its Discounts

Trying to reconcile cost shifting with the discounting of future climate change costs and benefits has taken me on some unexpected detours. I was initially thinking about bills of exchange and their role in the early modern era of concealing church-outlawed "usury" in the guise of a more palatable commercial transaction. Discounting was an arithmetical accounting exercise that arose out of the discounting of bills of exchange.

Both compound interest and discounting partake of the same exponential function -- from different ends of the calculation -- so it is easy (and misleading) to think of the discounting of a bill of exchange as a kind of loan. Discounting a bill of exchange is a sales transaction. The credit involved is commercial credit extended from a supplier to a purchaser. The bank then buys the bill of exchange from the supplier at a discount from its face value.

If one insists on seeing a loan from the banker in the transaction, it would only be an indirect loan to the purchaser of the goods, not to the supplier who sold the bill of exchange to the bank. But that loan would be secured by the goods that were the original object of the transaction that originated the bill of exchange... (Unless, that is, the bill of exchange was only speculative, a circumstance that Marx labeled a swindle.)

The important point is that bills of exchange originated in real transactions of goods, not in purely financial transactions. This has serious implications for the use of "discounting" in cost benefit analysis of public investments.

If the discount rate is meant as a metaphor it is a peculiarly bad one. The goods in question -- costs and benefits of climate change mitigation, for example -- have both negative and positive values but more importantly they have not been contracted for by the interested parties -- there is no "bill of exchange" to be discounted. Furthermore, the beneficiary of the discounted price is not society but the polluting firm who has shifted part of its costs to society and the environment. This perverse distribution of costs and benefits (and incentives) is concealed by the aggregate generality of the climate economy models that construe everything as one big happy economy.

Put it this way: discounting the future costs and benefits of greenhouse gas emissions provides a subsidy to the most prolific emitters of greenhouse gases that they can then reinvest at compound interest. This is hardly a matter of being "neutral" on questions of distribution. Nor is it a question of generational equity. This is simply taking the bankers' perspective on financial accumulation and proclaiming it "socially optimal."