Bringing the Coase Theorem to Copenhagen

The climate change summit convening in Copenhagen this month is unlikely to produce a binding legal agreement on carbon emissions considering “it is a prisoner’s dilemma, a free-rider problem and the tragedy of the commons all rolled into one” according to The Economist special report on the subject.

An alternative characterization of the complexity of climatic cooperation is in the context of property rights.  In his fundamental paper, The Problem of Social Cost, R. H. Coase posits that bargaining between agents can achieve a socially optimal outcome with respect to external damages caused by economic activity as long as property rights are well defined, meaning the responsible party is clearly liable for the damages (1960).

Unlike localized “end-of-pipe” pollution (or in Coase’s illustrative example end-of-cow mastication), the damages from greenhouse gas accumulation in the atmosphere cannot be directly connected to individual sources within the same political jurisdiction.  Therefore, an optimal contract between those benefitting and suffering from such pollution remains a “pipe dream” until legal liability is distributed amongst the international community.

R. H. Coase.  The problem of social cost. The Journal of Law and Economics, Vol. III, 1960, pp. 1-44.

 

As safe as… houses?

The falling value of real estate appears a world-wide phenomenon—I heard that even China (Kroeber and Kelly 2009) has a real estate bubble!

Foreclosure: A sign of the times

Housing prices have yet to fall here in Australia, and whether Australian home prices are about to burst is a major talking point. Will prices fall? By how much? When?

Throughout much of the developed world, debate still rages about the role of cheap money, poor lending practices, consumer practices and so on.

The meltdown of the US sub-prime mortgage market precipitated the 2008 global financial crisis, although the subprime lending may have been a symptom rather than the cause (Coleman, et al. 2008). In the UK and Ireland, house price inflation may have led to a boom in debt-financed consumer credit (Hay 2009).

Yet there is evidence that house price movements also affect the unsecured indebtedness of households (Disney, et al. 2009). Consumer spending has reflected changes in house prices — but they could both be driven by something else, such as expected future earnings (Attanasio, et al. 2009). There is also evidence that economic downturns are worse when they coincide with credit tightening and falling house prices (Claessens, et al. 2009).

For all these reasons, some have argued (see, for instance, Davies 2009) that central banks need to monitor asset prices as they monitor indices of consumer and producer inflation. That sounds like a smart idea to me.

 

EU acknowledges the failure of traditional economics to predict so adopts agent based modelling

By HopeForTheDismalScience (William P Bell)

“This long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.”
— John Maynard Keynes
A Tract on Monetary Reform (1923), 80.

Traditional economics has failed to predict the knock on effects of the financial crisis says the EU. The Eurace project is designed to remedy this failure, which uses an agent based modelling methodology as an alternative to the rational representative agent model, a cornerstone of neoclassical economics. My earlier post discusses how the three basic axioms of neoclassical economics embodied in the rational representative agent are logically inconsistent, making the framework unsound and how agent based modelling offers the economics profession a scientific approach to modelling the economy as opposed to the mathematical axiom-proof-theory approach of neoclassical economics, which includes the CGE and DSGE models.

 

Price of Students’ Dreams

According to an article in the local Santa Barbara Independent, tuition fees for students attending the University of California (hereafter UC) will hike by 32% next fall. UC argue that they have no choice because their state allocations are decreasing by 20% during the current recession ($3.25 bn for the 2008-2009 school year to $2.6 bn for 2009-2010). Hundreds of students protested this increase. A picture in the New York Times showed a student holding a placard demanding: “STOP (upp)ing the price of our DREAM.”

 

In the face of such criticism, UC will expand financial support for its undergraduates, spending over a third of the money gathered by tuition increases on them. As a result, about one-third of all UC undergraduates will be covered by some financial support. However, several protestors were concerned how higher fees might affect illegal immigrant students (ineligible for financial aid) and minority students.

 

In line with Epple, Romano, and Sieg (2006), this expansion of financial support enhances price discrimination by income; as that means colleges will penalize higher income students and subsidize lower income ones. Their empirical results suggest price discrimination can be done only by colleges seen as possessing ‘high educational quality’ (dependent on per capita instructional expenditures and peer quality) because they have such strong market power. College with high educational quality can set tuition fees above effective marginal costs, and generate more revenue to enhance quality still further.

 

If UC were a college with low educational quality, the response to decreasing state funding would be simply a lowering of per capita instructional expenditure, not a tuition fees hike (and associated widening financial support). According to the Santa Barbara Independent, the tuition fees “can return to normal” in a few years once the budget gets balanced and the current recession ends, however, nobody really knows whether the tuition fees will really return to “normal”.

 

Dennis Epple, Richard Romano, and Holger Sieg

“Admission, Tuition, and Financial Aid Policies in the Market for Higher Education” Econometrica vol 74, 4 2006, pp885-928

 

 

How many parts pragmatism to meaning creation explain Christmas consumption?

Low interest rates and an impending VAT increase may be improving the Christmas shopping season for retailers in the United Kingdom.  According to a report from CNN, memories from “Christmas past” may be responsible for the lower stock levels held by retailers that could lead to a shortage of some items considering “Christmas present” is showing higher sales figures.  The 5.9% increase in electronics and other durables, such as refrigerators, could be due in part to the increase in VAT planned for January that will increase prices on larger purchases.

Some students of consumer behaviour explore non-fiscal motivations to explain the pattern of economic transactions during the holiday season.   Sally McKechnie and Caroline Tynan examine “how British consumers create social meaning through their consumption of the festival of Christmas” concluding that “social meanings are rich and complex in nature “ (p. 141).  Their approach serves as a reminder that just because a rational (economic) explanation for human behaviour in the market place exists, it may not be the dominant factor.

 

The global food crisis: A second serving?

Remember the global food crisis? There was a big jump in commodity prices in 2007 which caught everybody’s attention. The boom was part of the excitement over the commodity super-cycle but went bust with Wall Street in 2008.

Central market of Léo, Burkina Faso

Well, food prices are on the rise again — and it’s caught the attention of The Economist. Food prices have already risen 10% this year.

The main issue is staple foods — the foods that form the basis of diets, such as rice and wheat. The initial commodity price boom had major negative poverty effects in countries such as Mozambique (Arndt, et al. 2008), Pakistan (ul Huq, et al. 2008)  and Mexico (Valero-Gil and Valero 2008). The effects are usually worse in urban areas, possibly because subsistence farmers can feed themselves, but poverty effects vary greatly by commodity and by country (Ivanic and Martin 2008).

 

Reckless risks and bank bonuses

It is reported by the BBC that the UK government is considering restricting banks’ ability to pay bonuses to employees who take “reckless” risks.  This assumes that:

-Banks would otherwise want their employees to take reckless risks.
-There are good ways to determine ex-ante which risks are reckless.

Ignoring the first point, I have severe doubts about the ability of banks or regulators to adequately provide for the second point. Assuming there is some uncertainty in the markets, there will be times when it is impossible to determine whether a trader is earning outsized profits in the short term because he is taking on positions with significant tail risk or because he holds some advantage in strategy over his rivals. Moreover, we would expect that traders who find, through accident or device, a way of earning money through risk that is unrecognized by others will give the appearance of being good at their jobs and will multiply in number and in the size of the positions they are allowed to take.

According to Lord Myners the proposed policy would mean that:

“…contracts which guarantee bonuses for several years are no longer acceptable and, if those contracts are written, they will be voided under law.”

This is a curious policy from an economist’s perspective, as a “guaranteed bonus” is not really a bonus at all, but part of a base salary. The proposed regulation could be easily circumvented by banks simply relabelling them as such.

***

Reinventing compensation – Robin Buchanan,  Business Strategy Review

 

Too late to be young

Eternal youth now may not be a dream. According to the BBC, researchers at Leeds University are now developing a way to replace old body parts with new, own-grown ones that will be less likely to be rejected. People can already get replacement hips, knees, and heart valves but eventually scientists hope to make most of the body parts that people might ever need. The researchers’ aim is “50 active years after 50″.

This seems to be good news, especially for a person in need of a transplant. However, it’s probably too late for most current adults. One material scientist said “To replace all donor tissue using this technology will take 30 to 50 years. Each single product will need to be designed and tested individually.”

Pension reforms might be less painful, especially for current adults, if we all live longer. Miles and Iben show (in their simulation based on demographics in UK and Germany) that in the case of a transition from PAYG to funded pension systems that there must be a cohort who will simultaneously have to fund both themselves and pay for those who are already retired (and who hadn’t properly financed themselves). The wealth loss for these current workers would be substantial.

If the “spare parts” projects succeed, these current workers could have longer to pay for their own and others’ retirement pensions, as pension eligibility ages can be gradually raised because people can stay healthy (and work) for longer.

Reference

“Science to ’stop age clock at 50′”  at BBC site

David Miles & Andreas Iben, The Reform of Pension Systems: Winners and Losers Across Generations in the United Kingdom and Germany, Economica Vol 67, Issue 266, Pages 203 - 228

 

 

Will the global citizen ever see free market capitalism as a means to a just market society?

The dominant global opinion is that free market capitalism “has problems that can be addressed through regulation and reform” according to a recent survey by the BBC (see Free market flawed, says survey by James Robbins).  The second most popular assessment is that capitalism is “fatally flawed and a different economic system is needed” with “works well and increased regulation will make it less efficient” ranked second in only Germany and the USA.  The variation of responses across countries (27 were surveyed by the BBC) can almost certainly be explained by the unique interaction of the historical, political, and cultural context that lends itself to strengthening certain branches of a capitalist economic system in a given country.

Michael Thomas suggests that understanding capitalism as three separate concepts can help us use it to form a just society.  Financial capitalism refers to interconnected global financial markets “which swirl around in pursuit of share-holder value” requiring a world financial authority, stronger currency blocks such as the Euro, and punitive taxes on short-term speculative capital movement to maintain long-term global investments. Thomas describes Knowledge capitalism, the employment of scientific research to develop new products and services, as “the most powerful creative force yet developed to make people better off”.   Social capitalism reflects that economic activity, particularly creativity, benefits when people can trust one another, because it reduces risk and increases investment.  The regulation and reform demanded by the majority of the global community, according to Thomas, should seek to build a just society by combining these three types of capital “in a virtuous circle of innovation, growth and social progress” (p. 10-11).  However, increasing the missing ingredients for his recipe: “belonging, trust, respect and cohesion” at even the national level seems daunting and best.

 

… and after Copenhagen?

The Copenhagen climate change conference will convene in December to discuss the future of the planet and all that. At the centre of the table will be those messy issues that economists prefer to avoid — things resembling market failure, ethics and so on.

Moellendorf  (2009) has argued, like many others, that the industrialized developed countries — read rich people — need to take the pain. If there’s no agreement at Copenhagen, then the worst effects of climate change will fall on the poorest people. Moellendorf reckons the poor countries will endure the worst effects of climate change.

And there’s the catch — rich people need to take the pain which would otherwise fall on the poor as climate change gets worse. Sounds like an unlikely scenario, unfortunately. The governments of the world may fail to reach a genuine climate change agreement at Copenhagen.

Yet there may still be options if there’s no genuine agreement. If government can’t regulate, maybe shareholders can influence the way our economies responds to climate change? According to Reid and Michael (2009), “shareholder actions and regulatory threats are likely to prime firms to adopt practices consistent with the aims of a broader social movement.” There’s a serious argument hidden behind the managerial clichés. Companies need to develop strategies which fit with either new government regulations or their green-minded shareholders. In other words, if government failure results in no new climate change rules, maybe the market will.

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