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.
" 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? 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."

Thursday, October 23, 2014

Been Discounted So Long It Seems Like Up To Me

The monks ascending the steps on the outside of the wall are growing the GDP, while the monks descending the steps on the inside are abating carbon dioxide emissions. Climate change mitigated -- emissions decoupling accomplished!

"Business profit," Schumpeter tells us, "is a prerequisite to the payment of interest on productive loans... The entrepreneur is the typical interest payer." There are three cost-reduction strategies that firms may pursue to maximize profits. The most opportunistic is cost-shifting, in which some third party, society or the environment gets stuck with the cost rather than the firm. The cost doesn't go away, it just becomes external to the accounting entity's balance sheet and thus is an "externality." Greenhouse gas emissions are such an externality. They are a cost-shifting success for the profit maximizing firm.

Carbon trading schemes and Pigouvian taxes are supposed to "internalize" those externalities so that the users of fossil fuels, for example, are made to pay the full cost -- or at least a larger proportion of the cost -- of their production processes or consumption preferences. Assessments of the costs and benefits of such policies typically discount the present value of future costs and benefits. The appropriate discount rate, it is often argued, should reflect market interest rates or else it may result in spending that is less efficient than would occur through the market. William Nordhaus in A Question of Balance:
The choice of an appropriate discount rate is particularly important for climate-change policies because most of the impacts are far in the future. The approach in the DICE model is to use the estimated market return on capital as the discount rate. The estimated discount rate in the model averages 4 percent per year over the next century. This means that $1,000 worth of climate damages in a century is valued at $20 today. Although $20 may seem like a very small amount, it reflects the observation that capital is productive [S'man: no, it reflects the assumption that capital is "productive"]. Put differently, the discount rate is high to reflect the fact that investments in reducing future climate damages to corn and trees should compete with investments in better seeds, improved equipment, and other high-yield investments. With a higher discount rate, future damages look smaller, and we do less emissions reduction today; with a lower discount rate, future damages look larger, and we do more emissions reduction today.  
Update:  But... if profitability is a function of cost shifting, the market interest rate a function of profit, the discount rate a function of the market interest rate and cost/benefit optimization of GHG abatement a function of the discount rate, doesn't said optimization embed a circular reference? No, this is both too simple and too forgiving an interpretation of the relationship between discounting and cost shifting. More on this soon...

Nordhaus, again:
In thinking of long-run discounting, it is always useful to remember that the funds used to purchase Manhattan Island for $24 in 1626, when invested at a 4 percent real interest rate, would bring you the entire immense value of land in Manhattan today. 
Professor Nordhaus here simply updates and tones down the hallucinations of Dr. Richard Price, who exclaimed in 1774:
One penny, put out at our Saviour's birth to 5 per cent compound interest, would, before this time, have increased to a greater sum, than would be contained in a hundred and fifty millions of earths, all solid gold. 
As Marx began the chapter in Capital in which he cited Price's dazzled fancy:
The relations of capital assume their most externalised and most fetish-like form in interest-bearing capital. We have here M — M', money creating more money, self-expanding value, without the process that effectuates these two extremes. 
In his discussion of discounting, Nordhaus doesn't distinguish between compound interest and the process that brings about the apparent productivity of capital that he extols. What makes this lack of distinction particularly telling is that he is supposedly discussing solutions to a problem that results from the very process that makes capital productive of profits sufficient to sustain interest payments on money capital. It is as if the greenhouse gases are unrelated to the industrial processes that emit them.

Compound interest does not emit greenhouse gases. What people do to make the profits to pay the compound interest does. Money capital does not compound itself. The discount rate is no more independent of the cost-shifting that engenders it than it is of the greenhouse gas emissions whose costs are being shifted. D.I.C.E. thrown will never annul chance.

Sunday, October 19, 2014

"From him exact usury whom it would not be a crime to kill."

The truth about usury lies somewhere beyond St. Ambrose's condemnation and Jeremy Bentham's cavalier apologetics. In a very brief but valuable essay, Francis Bacon counselled,
It is good to set before us the incommodities and commodities of usury, that the good may be either weighed out or culled out; and warily to provide, that while we make forth to that which is better, we meet not with that which is worse. 
Strictly speaking, compound interest is usury. Discounting is compound interest, ergo discounting is usury. Bentham, who upheld usury in a series of letters addressed to Adam Smith, also was a pioneering proponent of cost-benefit analysis for public investments. Considering that usury has both incommodities and commodities, a proper cost-benefit analysis would need to evaluate the costs as well as the benefits that arise from the discounting of future value.

The typical way of handling traditional objections to usury is to cite scripture and the interpretations of it offered by religious authorities. This was the method followed by Benjamin Nelson in The Idea of Usury, whose analysis was taken up by Lewis Hyde in The Gift and by David Graeber in Debt: the first 5000 years. But the biblical injunctions are laconic and subsequent interpretations may partake more of rationalization than motive. Bentham was right when he observed,
It is one thing, to find reasons why it is fit a law should have been made: it is another to find the reasons why it was made: in other words, it is one thing to justify a law: it is another thing to account for its existence. 
Bentham's defence of usury, though, was as verbose and meandering as the infamous passage from Deuteronomy about brethren and strangers was terse. His account of the grounds for the prejudice against usury was frivolous and dismissive. "To trace an error to its fountain head," Bentham cited Lord Coke, "is to refute it." What Bentham meant by "trace" was "assert." According to him, the prohibition of usury was motivated by the perverse asceticism of early Christians, foolish abstractions of Aristotle and ill-tempered envy toward the wealthy by the profligate debtors.

More concisely and substantively, Francis Bacon presented, in one paragraph, a catalogue of seven disadvantages arising from usury. A second paragraph elaborated on three advantages. Bacon's fourth criticism of usury is of particular interest:
…it bringeth the treasure of a realm or state into a few hands; for the usurer being at certainties, and others at uncertainties, at the end of the game most of the money will be in the box; and ever a state flourisheth when wealth is more equally spread…
In favour of usury, Bacon's second point is his most compelling:
…were it not for this easy borrowing upon interest, men's necessities would draw upon them a most sudden undoing, in that they would be forced to sell their means (be it lands or goods), far under foot; and so, whereas usury doth but gnaw upon them, bad markets would swallow them quite up.
In modern parlance, Bacon's most compelling arguments, both for and against usury, refer to what Marshall called the "external economies" -- or positive and negative externalities -- of the loan transactions. For better or worse then, compound interest is a vehicle for the shifting of costs and benefits. It is well to remember, in this connection, Joan Martinez-Alier's observation that "one can see externalities not as market failures but as cost-shifting successes."

One doesn't need to assume that cost shifting is necessarily a bad thing. Insurance, including social insurance, is a form of cost shifting. But when the project being evaluated in a cost-benefit analysis has the overt purpose of internalizing the cost of externalities -- such as in the analysis of abatement of greenhouse gas -- it is disingenuous to overlook the role of compound interest in enabling the social cost shifting in the first place and of perpetuating it over the period being analyzed. In other words, part of the value allegedly being "added" by capital in the analysis is not in fact being produced but is merely being appropriated by capital through social cost shifting.

(See also "Why Is the Discount Rate So Important?" page 9 in "More than Meets the Eye: The Social Cost of Carbon in U.S. Climate Policy, in Plain English.")