Randomness, risk and uncertainty: How do we know what we don’t know?

Being a habitual sceptic (and an economist), the insights offered by Nassim Nicholas Taleb in The Black Swan have struck a chord. I have never found a receptive audience in academia for my dislike of the assumptions of the characteristics of randomness that determine the probability density function (amongst other assumptions) in most statistical analysis – especially in social phenomenon. But finally I have a wing man.

The general attitude I face is that if we don’t make these (sometime radical) assumptions, we can’t do any analysis of the data, and draw any conclusions. My response is; what use are conclusions based on flawed assumptions?

The book poses the challenge to think rationally about probabilities, and the impact of improbable events. In particular, Taleb challenges us to acknowledge the limits of knowledge. Real risks and randomness come from the unknown unknowns.

He uses an example of casino to explain the difference between known risks that occur in a world he calls mediocrastan, and the wild unknowns and events from the world of extremistan. The mediocristan risks are those involving the gambling itself. Each individual bet has a risk that is essentially Gaussian, so with a large number of bets taking place, and limits on the size of each bet, these risks are eliminated.

Taleb suggests that most of our concerns about risk, and the high impacts of improbable events, are from the world of extremistan, where complex systems result in variations at all scales. The point is that in extremistan, large variations and extreme events WILL HAPPEN, and much more often than we think. Such large complex systems include financial markets, the global economy, and the climate.

While attending a statistical conference at a Las Vegas casino, Taleb discovered that the four largest losses incurred by the casino did not involve the gambling itself (whether cheating or otherwise). The first was when a tiger performing in a stage act maimed one of the performers. The next was when a disgruntled contractor who became injured on job threatened to blow up the casino with dynamite because he was insulted by the settlement offered. The third was when an employee failed to mail paperwork to the Internal Revenue Service for a number of years, which ended in a monstrous fine. And finally, the casino owner’s daughter was kidnapped and held ransom, which forced the owner to dip into casino funds.

These events are Black Swans. Unpredictable, outside the scope of expectations, and have massive consequences.

He makes a number of interesting points that I want to share. These are particularly relevant in current environmental debates. For example, where I work we try to estimate the environmental impacts from changes to stream flow in rivers. The number of assumptions in unbelievable, and any output from this type of modelling has to be taken with a grain of salt. It is merely some background information that either confirms or challenges the experiences on the ground. When I write about the economic impacts of changing water regimes I repeatedly make the point of acknowledging the unknowns and the limitations of my analysis. Can you imagine the complexity of climate models, and the staggering number of assumption built into them? One wonders whether climate scientists understand statistics at all.

The first point of interest may be familiar for those who are statistically inclined. It is the statistical regress argument and it is a cause for concern. It goes as follows:

Say you need past data to discover whether the probability distribution is Gaussian, fractal, or something else. You will need to establish whether you have enough data to back up your claim. How do we know when we have enough data? From the distribution – a distribution tells you whether you have enough data to “build confidence” about what you are inferring. If it is a Gaussian bell curve, then a few points will suffice. And how do you know if the distribution is Gaussian? Well, from the data. So we need the data to tells us what the probability distribution is, and a probability distribution to tell us how much data we need. This causes a severe regress argument.

Given that our data samples for global temperatures are extremely limited, climate scientists face this problem at the outset.

Another interesting point is how the nature of Black Swan events, and the resulting silent evidence distort our interpretation of history. Any act that aims to prevent a Black Swan event goes unnoticed because its success can never be observed. Imagine there is a bureaucrat who decides to implement aviation rules in August 2001 that would have prevented the September 11 events in New York. We could never judge the success of these measures in preventing terrorist attacks, and the bureaucrat would never gained any credit for the measures. Possibly, due to the complexity, cost and frustration of travellers, he would have had to overturn the rules in 2002. He would be labelled as someone whose best skill is to waste time and money. Learning from history is very, very distorted due to silent evidence. I can imagine in the not too distant future that the history book will explain how we should have seen an event like September 11 coming, due to such things as ‘rising tensions between terrorist groups and the US’, but they would simply be wrong. The crashing planes were the sign of rising tension!

Another great insight is the problem of induction. He uses an analogy of a melting ice cube. If we know the shape of the ice-cube, we can fairly well predict the size of the puddle of water when it melts. But, if we have the puddle of water as our source of information, there is not much we can say about the shape of the ice-cube. In economics we constantly go about measuring puddles of water, and through flawed statistics, try and make outrageous claims about the shape of the ice-cube. The herd mentality of the global economics profession and media seem to have induced that overzealous lending in a few sub-prime locations in the US has led the whole world into a massive recession. My question is, the given how many other more significant events were happening around the globe during this time, how can anyone be so sure of that the ice-cube was shaped like a few bad loans, and not like a oil shock? Or why was the cause not simply a unique combination of unforeseeable events? This same question can be applied to climate change. If we agree that the climate is changing (which itself is questionable due to the previous two reasons), how can we isolate a single cause in a complex system?

I will stop now because I don’t really think I can do justice to the ideas of Taleb and his philosophical predecessors here. I just want to reiterate that we know a lot less than we think we know.

My main concern is that for someone who preaches a precautionary approach to making claims of knowledge, Taleb is a devoutly religious man who has used arguments such as ‘religion has not killed so many people as the concept of the nation state’. So, if religion is the root cause of, say, 10 million premature deaths, while fighting for or defending a nation state (which coincidently have often been religious states) has killed, say, 20million people prematurely, does this mean that religion is good for society? Taking this argument elsewhere and we get such things as ‘murder kills 100 people annually, but motor vehicle accidents kill 300 people’. For a guy who we are meant to believe has a solid grasp of logic, reason, argument, and science, this seems a rather appalling justification for his beliefs. But of course, nobody is perfect, and we need to judge each argument on its merits.

Tagcrowd - heard of it?

I recently ran across a very interesting website called Tagcrowd. It counts word frequency in text and presents a neat cloud of words that provides a good visual summary. I did it with my whole blog and got the following result. Seems to sum it up nicely.

Can governments be more innovative than private enterprise?

I have had some interesting thoughts lately regarding the trends towards the privatisation of infrastructure and the user pays principle which underpins this trend. My theory suggests that private infrastructure based on user pays principles locks society into a particular path of development which becomes increasingly self-reinforcing, thus excluding innovative solutions to transport, communications, energy and water supply.

Let me explain in more detail.

Consider two countries, A and B. Previous governments of country A have spent the past century investing heavily in a rail network for both passengers and freight, while country B has spent the past century ignoring rail and building roads as the major land transport system.

Now imagine that a technology, X, is developed that can massively increase the efficiency of rail transport, but not road transport. Think along the lines of mag-lev trains or some such thing.

Now both country A and B believe that this technology is superior to their current land transport system and aim to develop a network based on private investment. Country A already has the land, the stations, and the infrastructure in place, while country B has none of it. One would expect that the compared with country B, country A is more likely to find potential private investment for such a project given the likely lower costs but equal benefits.

Thus due to historical capital investment, country A continues along a rail based path towards the most efficient outcome available with technology X, while country B continues along a road based path and will never reach technology X through private investment alone and will remain 'stuck' with a less efficient land transport network. This is the problem of path dependence, a situation encountered in both evolutionary theory and economics –“the cheapest manufacturing method may not be achievable by “evolutionary steps” but may require a complete change in method”.

The question then arises that if country B is ‘stuck’ on a more costly trajectory of land transport development, how does it become ‘unstuck’. This is where I believe governments can intervene to make the decision to become unstuck by directing investment into the superior new infrastructure. Rather than the user pays principle of privatisation, the government can justify funding such scheme due to benefits to the user, but also benefits to non-users in society.

For example, if a rail line is established along a popular road corridor, both the rail users and the road users benefit - the rail users from cheaper transportation, and the road users from less congestion. Unless a private enterprise can charge the road users for the rail line, a publicly funded outcome is far superior.

The inability for private infrastructure owners to capture external benefits limits their opportunity to innovate and provide broad social benefits.

Governments on the other hand can consider all external benefits and consciously ‘invest’ a region out of their current development trajectory on the basis of providing indirect social benefits.

The problem then is getting a government to even perceive these potential social benefits, let alone act on them.

The other problem is that if governments do ‘invest’ a region out a of a particular development path, they are now stuck in the new path, unless they invest heavily once again. For example, Brisbane ditched trams back in the 1960s, and successive governments ever since have been considering getting them back. But each change in trajectory is more expensive than the last.

So what then should a government do to maximise social welfare? Should they just stick to the path they are on and hope that future technologies are advantageous, or should they embrace innovation and change the development path?

On Andrew Bolt

I must say that until recently I have had little exposure to the writings of Andrew Bolt. A short snippet of him on telly once seemed to highlight for me that this guy was a headline grabbing voice of the extreme ‘right-wing’ (whatever that is anyway) political agenda. However in the past few days I have been reading his blog, and now finally have read his book Still not sorry. And I must say, although he can fall into the trap of making illogical assertions, just as can the left on many occasions, he writes quite a bit of commonsense that seems to raise much less publicity. His book provides snippets of his basic opinion on particular issues, so let me please take the time to highlight this commonsense on various issues.

1. Australia is divided into the ‘elites’ who get much of the air time, and whose opinions are out of step with the average Aussie. The elites believe that people need such things as racial sensitivity training, and as a group give a disproportionately loud voice to left wing agendas. The majority of us think things are pretty good and we just like to get on with enjoying life.

I must say that the more exposure I’m having to many academic and intellectual types trying to make a difference to policy, the more I am beginning to see the total disconnection with reality of many of these said ‘intellectuals’.

2. Australia is a great country, and we shouldn’t sacrifice our fundamental freedoms and opportunities for fringe issues of minority interest groups.

Many of the problems we face in Australia today are, in comparison to the rest of the world and to recent history, very trivial. Economic research is a good guide. These days economists can theorise about happiness coefficients, gender implications of armed conflict. If there were real issues to tackle, economists would not get sidetracked like this. Compared to historical standards we are living in a utopia. The message from Andrew Bolt is that we should get some perspective and be thankful for the opportunities provided to us in our society.

3. Racism is not the issue it is made out to be, and we could do much better if we didn’t promote policy based on race, gender or any other ‘ist’ feature.

Along these lines, there has been further frustration for me this week. The Wild Rivers Act allows the government to protect the natural flow of waters courses if they meet certain criteria for being natural environments. No problems there, it is the type of policy I think delivers tangible benefits. But Indigenous leader Noel Pearson had now started complaining that the legislation will lock up land from development, taking away opportunities for local indigenous communities. But most indigenous groups surveyed by the department found widespread support. So what is the real opinion of indigenous people in the Cape?

I think our mistake here is to segregate people by race. Can’t they just be two opinions of groups in the Cape? Why should race imply a set opinion about a policy?

In France it has been illegal for quite some time to classify people by race. The government does not even collect statistics about racial identity (since gathering that data is illegal). This, I believe, should be the target for us. If we can’t classify people by race, we can’t write racist policies.

The French elite are typical targets of Bolts critique. They say such things as, ‘Every time we want to study the divisions of society we are accused of dividing society’. That is exactly the point.

Bolt also stole my idea about irrational women in positions of power – about 7 years before I had it! I have recently attended a workshop with Australian academics and experts on environmental economic assessment, and was shocked at the illogical and often conflicting theories that underpin sociology – a discipline, that from my experience, is populated with highly ‘educated’ middle aged women who believe in astrology and alternative medicine. Are these ‘elites’ the people we want advising our decision makers?

4. Help people help themselves.

Bolt also repeatedly claims that handouts are not long term solutions to poverty. There is nothing controversial here. While we as a society have decided that in times of need people who cannot support themselves will be supported by the rest of us, no one believes that this support CAUSES, or provides incentives to, those who are provided with it to begin to look after themselves again. Economists know that such support inadvertently provides incentives to not return to work. So why should we continue to throw good money after bad in supporting communities such as Palm Island?

Where Bolt gets himself into strife is when he allows himself to effortlessly drop his evidence-based critical line of argument and get down in the gutter, spruiking pro-Howard pro-liberal rhetoric, when there are obvious flaws in both Green and LIberal sides of the argument. He lets fly with ‘facts’ without citations, which actually quite bugs me, as it is easy enough to find ‘reliable’ evidence both ways in the world of grey that is politics.

What does it mean to 'save a life'?

I have been reading some great articles about poor science journalism, and gross misrepresentation of the facts. These articles got me thinking about what it actually means when a new drug, vaccine, surgery, or other medical intervention has the possibility of ‘saving thousands of lives’. What exactly does the phrase ‘save a life’ mean?

My starting point for this analysis is that everyone dies. Therefore, we cannot save someone from death; at best we can postpone death – from being the direct result of condition X, to being the result of some unknown future event.

The question is further complicated if we consider the flow on effects from death. For example, a child (A) may die from disease X, but the flow on effect from this one death is the birth of another child (B) by the couple, who would not have chosen not to have that child (B), had the first child (A) not died young.

So here we have a theoretical conundrum. In the previous case if child A had be ‘saved’ by a new drug or surgery, child B would never had been born. Imagine then comparing two hypothetical scenarios:

Scenario 1 -
Child A is ‘saved’ by a new drug or surgery.
Child B is never born
Child A lives until the age of 60.

Scenario 2 –
Child A is not saved and dies
Child B is born
Child B lives until the age of 90

If we consider a year of life to have an equal value amongst all individuals, we can say that Scenario 2 provides more life. The net effect of the drug/surgery is to postpone the death of Child A by, say 55 years, and eliminate the chance of Child B being born. Scenario 1 provides 35 years less combined life years than Scenario 2.

In a more general sense, do we need some death to create life?

Another hypothetical can let us examine this question. Imagine a new drug is invented that, for example, promotes tissue repair, and the life expectancy of the population rises dramatically over just a few years. Does this prolonged life of existing generations come at the expense of future generations? If the birth rate did not slow as a reaction to this, population growth would also see a dramatic spike in population growth.

We can think about the ambiguity of ‘save a life’ more when we consider treatments for the elderly. If a drug cures one life threatening disease in an 80 year old, and they die a year later from a different disease, did the drug still ‘save a life’? Again, I would say that we can just postpone death. In this case, the drug postponed death by one year.

But if the same drug could be used on a child, it may postpone death by quite a number of years. Does it then ‘save a life’?

Economists know that a very large chunk of government health expenditure goes to treatments in the last 30 days of someone’s life. All we can derive from this is that we are getting some very poor ‘life returns’ on our health investments. It is a much better investment in terms of ‘life returns’ to fund medical care for the young.

I guess my point is that if we don’t think about saving lives, but rather about postponing death, we get a much better perspective on the effectiveness, and usefulness of various medical claims. We also need to consider that postponing death is not inherently a good thing for society as a whole, although it often is for the individual person whose life is prolonged. I hope anti-abortion and anti-euthanasia activists can think deeply about these issues before launching their next hysterical propaganda campaign.

Sunburnt cows and daylight saving time

I am shocked. Really. The amount of time and energy devoted to ridiculous ‘social issues’ like daylight saving time could be devoted to so many other worthy causes.

The DS (or is the BS) debate has seen the light of day again this week (sorry about that) in WA, where farmers have cited an obscure 1996 study by Stanley Coren that shows an extra hour of daylight contributes to fatigue and therefore road accidents. Apparently the study found an 8% increase in road crashes the first Monday after the introduction of daylight savings time, compared to the previous Monday.

While it is quite obviously a scare campaign by the WA Farmers Federation (WAFF), their website appears not to be a spoof, and contains the following important questions for the concerned public to consider. I have reproduced them below with my personal response to each.

• Does it make it harder to put your children to bed, while it is still light outside?
Do you mean like when they have a daytime nap?

• Are people becoming more fatigued, as they are inclined to stay awake an hour later at night, and what safety concerns does this raise (i.e. accidents while driving)
Are they also inclined to stay up later because they can use lights? Why aren’t they inclined to sleep in longer?

• Does it make sense to be driving to work in the dark during the daylight saving period?
Like the rest of the year you mean?

• Does it put businesses out with their key trading partners in Asia, given that WA’s normal time zone is the most populist time zone in the world?
Get real. By this logic we should all have the same time zone. And while phone calls are instant (and business hours will still overlap for 7 hours a day) transportation of goods takes time – a lot longer than the one hour we are so concerned about. Oh, not mentioning that by changing time by and hour you get a whole lot of other regions in on the same time – you win some, you lose some.

• Are you concerned that children may be in the sun during the hotter and more dangerous part of the day during daylight saving?
They’ll be sleeping because they are fatigued from staying up late. Is that why it wouldn’t be safe? Wouldn’t want tired children playing.

• Are there animal welfare issues, from farmers being forced to work livestock during a hotter period of the day?
No one tells you how to run your business. You can do it at the same ‘sun time’ if you like.

• Is daylight saving convenient?
Depends who you are.

Apart from the fact that literally hundreds of millions of people across the world quite comfortably handle a change in timekeeping twice a year, there is further scientific evidence to show the fallacious nature of the WAFF claims.

Four months after the cited Coren study was published, a response citing a plethora of existing studies using much more detailed data was published that put the debate to rest. They find a reduction in the number of evening road accidents, but and increase dawn accidents, with a net effect 900 fewer fatal crashes based on data for Virginia. In fact they cite a rigorous natural experiment in the UK where daylight savings time was kept year round in a 3 year experiment, where a reduction road fatalities by 1100 a year was attributed to more evening hours of light.

Oh, and I forgot to mention that the favourite study of the WAFF also showed that there is an 8% decline in road accidents on the first Monday upon a return to non-daylight saving time, leaving the net effect on road accidents to be… zero, zip, none.

So the question I have is this. Why are the members of the WAFF so upset about daylight savings time as to spend $10,000 and plenty of their own time and effort on a scare campaign? Further, in the US, farmers are having much the same issue, and citing the same study by Coren to ditch daylight savings time. In fact most web sites against DS time cite this research.

I wonder if we did the reverse, and called DS time standard time, and called standard time daylight wasting (DW) time, would we have the same anti-DS campaigners join the anti-DW brigade? Don’t waste our winter daylight because it causes traffic accidents.

What if we flipped it around and had DS time in winter in QLD? We could then have the same summer evenings (sunset around 6:45pm), and longer winter evenings, with the latest sunrise in winter being 7:39am, but the earliest sunset delayed from 5pm to 6pm (with twilight for half and hour before sunrise and after sunset).

Personally I prefer winter DS time. But daylight savings or not I’ll be fine. Can we just stick to our decisions and stop filling the airwaves with nonsensical rubbish that confuses and intentionally deceives people for narrow-minded agendas?

I’ll leave you all with a quote:

Of course, anyone who really doesn’t like daylight saving could leave their watch unchanged, stick to their old schedules as far as possible, and just bear in mind that everyone else is using a different time. The reverse is true in the present situation if you really like daylight saving.

Oh, yes I get the irony about the waste of time and effort on DS debate, and the effort I spent writing this blog. That’s just how frustrated I am with intentional deception by farmer lobby groups.

The construction of value

My title is yet another rip off. This time from Dan Ariely et al.’s 2006 paper Tom Sawyer and the construction of value. In my opinion, this paper lifts the lid on economics. Let me explain.

The majority of economists (there are exceptions) take the preferences of individuals as a given. I prefer watermelons to rockmelons if I am willing to pay more for watermelons. The study of economics can then be seen to answer the following question – given a group of individuals with given preferences, how are resources allocated?

Determining how these preferences are formed in the first place, and how they can be manipulated is an entirely different question, and one economists are only now beginning to grapple with. Psychologists and marketing departments have known for a long time how to influence peoples preferences, but economists have thus far remained quite ignorant.

Personally, I see a serious issues with overlooking the formation of individual preferences by economists. Ignoring the ability to manipulate preferences ignores an important feedback loop when attempting to explain inequalities of wealth. Not only does wealth provide the ability to accumulate more wealth, it provides the ability to manipulate the preferences of others in society. In fact, it is quite interesting to theorise about the impacts of a tradable commodity called a 'preference manipulation service' in a market economy. How would such a theoretical economy compare to one in which all preferences are fixed through time?

But getting back to the main point, that our preferences are revealed by our decisions, how then would we quantify preferences for non-market goods? Non-market goods are those which we cannot directly buy and sell such as air quality, clean oceans and other such things. This is a real dilemma for environmental policy makers.

The problem with surveying peoples’ willingness to pay is that they don’t actually have to pay, and can respond consistently with social expectations. For example a recent ABS survey found that "around one-third of households who were aware of GreenPower were willing to pay extra for electricity generated from renewable sources, but not all of them were using it, with around 10% of households paying for GreenPower electricity". Maybe if we use a conversion factor for such surveys, such as one third or one quarter, we might be close to the truth (if there is a truth).

There is a clear link between Dan Arierly's paper and the methods for surveying peoples preferences. For example, there are substantial priming effects. As a general rule, the more information supplied to the survey participant, the more they are willing to pay for anything! Tell them all the intricate details about the plight of penguins and we will admit that they are more valuable to us. A one liner that penguins are in danger and we won't take too much notice.

The economists dilemma then is whether or not we even have a preference unless we are forced into making the decision. Are preferences up for grabs until the last moment when we commit ourselves to a purchase? Are preferences the quantum mechanics of economics - not really there until observed?

Then again, maybe we shouldn't delve to deeply into this or we might find out just how easily we can all be manipulated and how little we know about ourselves.

Happiness, facebook style

Although spiritual leaders would suggest that happiness comes from within, recent research is suggesting it may also come from without.

You know the feeling, when someone laughs uncontrollably, you just start laughing as well for no reason – simply because they are laughing. Well this type of reaction is known as ‘emotional contagion’ and may describe why some groups of people always seem to throw a great party while others seem to be able to spoil the mood every time. A group of dominant and happy people can actually make others in the room happier.

Thinking of friends of mine I know there are some who are constantly happy, and probably part of bond between us is the mutual benefits of happy emotional contagion. And of course, this is likely to result in a feedback loop where one happy person makes others happy, and others who are now happy make the original superstar even happier.

Just throwing it out there, it probably happens in reverse as well. Unhappiness rubs off too. Maybe try whistling in the streets and see if you can rub off some happiness.

Hedonic price indexes - not only in America

If you recall a previous blog which linked to a crash course in global economics, you would remember a part about hedonic price adjustments when measuring the Consumer Price Index (CPI). Unfortunately, these methods are being adopted in Australia. For personal computers a hedonic price index was introduced into the Producer Price Indexes in 2003 and into the Consumer Price Index and the National Accounts in 2005.

That means that although prices for computer may be steady, they are falling in ‘real terms’ according to the ABS, thus we are all experiencing cheaper computing. The following graph shows that computers declined in price by 30% from July 2007-08. The same models only dropped in price 15%. So the question is: do we include the extra 15% decline in our price index?

I would suggest that the methods used by the ABS misinterpret the term hedonic. Hedonic psychology is concerned with the attributes of good or service from which we derive pleasure. By breaking down a single product into hedonic attributes we can determine the willingness to pay for component parts.

Hedonic analysis has been happening in property valuation since it first began. To compare heterogeneous goods we break them down into characteristics such as location, views, noise, number of bedrooms, and so on. We can then estimate how much a person may be willing to pay for an identical apartment in a different area, or with different views.

In terms of the computer price index, they have taken factors such as CPU speed, RAM, memory, as the characteristics from which we derive value. But clearly this is not the case. Many people have no idea of these specifics. They just care what it can do – save music, photos, word processing, internet etc. If I write this blog on an old computer, and I getting less satisfaction than writing it on a new computer? Unlikely.

A good that seems to me to be more suitable for hedonic pricing is housing. While house prices have dramatically increased, so have their quality. The renovation boom of the past decade has turned many suburbs into backyardless air-conditioned wonderlands. We can use hedonic methods to easily determine the potential price or rent of a house of apartment based on its features (this is how real estate agents do it in their heads). Now unlike computers, these features closely relate to the benefits we actually derive from the home. An extra bedroom of a given size has a number of possible uses from which we derive benefits. Adjusting for an extra room is prefereable, adjusting for the type of materials on the wall is probably not as good. Just because a more modern material is used (read faster processor, or bigger hardrive) doesn’t mean I can actually use the room (computer) for more purposes than I previously could.

Since housing is a large part of household expenditure (20%+) this type of adjustment might provide interesting results.

Anyway, it’s a slippery slope of political misdirection from here with hedonics. Let’s hope that PCs are just a pet project for now (they are not - one of the desired outcomes of the review of the desktop computer price index is the development of techniques to be applied to hedonic price indexes for other consumer durables), until their methods align a little better with the theory. This may involved surveys of consumers see which attributes provide them with benefits.

Why are the poor, poor?

Economists have tried to determine the reason some countries are wealthy while, relatively speaking, others are poor. They have eliminated a number of reasons that at first seem very logical.

1. Endowment of natural resources.
2. Quality of government and rule of law

However one major flaw is that studies comparing the endowment of natural resources compare current day reserves of resources currently in demand. If they had instead compared endowment of natural resources of use during the rise of agriculture some thousands of years ago, the answer may have been quite different.

I would propose that the reason some countries are poor, despite their current resource endowment, is that they were too slow to take advantage of those resources.

Consider the colonial powers of Europe during the 1600 and 1700s, namely the Dutch, German, English, the Spanish earlier on, the Italians a thousand year earlier, and the Greeks before that. The wealth of these nations grew from their own natural resources AND the quality of their government and rule of law. If there are rival tribes within a State, so many resources are devoted to war, that the accumulation of capital in the form of buildings, ship and machines is impossible.

Given time, any part of Africa could have achieved this type of emergence of civilization and wealth by developing cooperative States. In fact any less developed, or less wealthy, society could have followed this path. But there is a key reason why this did not occur.

The already wealthy European nations began trading, mostly through coercive force, with these less developed countries. Now trade itself is fine if we all start from equal positions and enter into it voluntarily, but history has shown that such ‘perfect markets’ are rare. Often one side has a clear advantage. And so it was with European traders.

If you have zoned out from reading, now is the time to pay attention. The reason trade between the already wealthy nation and the poor nation was not going to improve the situation of each player equally is because the wealthy nations brought with them capital. That is, they had tools, ships, weapons, and all manner of goods (and the knowledge of how to build them) that could be brought to the party, whereas the poor nation merely had labour and natural resources.

Since investment in capital generates a return, the wealthy country could maintain returns on the poor country’s endowment of natural resources. If they were wise (and most were very savvy) they would reinvest in the land itself. Thus the wealthy country would continue to preserve its wealth through the ownership of land and capital of other countries.

In absolute terms, the poor country would probably become ‘less poor’, but in relative terms, the gap in wealth between the rich and poor countries would in fact grow, not diminish. This is capitalism.

However, that is not to say that such a situation is inevitable. With an improved knowledge of the nature of capitalism, the Asian Tigers have been able to adopt the same strategies as the British colonial capitalists once did. By smartly investing in capital, both domestic and abroad, they have broken this historical trend.

Even as I type, China is making moves to acquire Australia’s mineral reserves. They are seeking to begin owning the capital, the physical means of production, by acquiring large shares of mining companies. Thus, they will generate a profit stream back to China from the use of Australia’s natural endowment of resources.

The same thing happens on a domestic level. Those who inherit wealth have a distinct advantage as they preserve their wealth in capital which can generate future returns, thus reinforcing the cycle. But that is not to say that those who start life relatively poor can never prosper. If they follow the simple rule of saving their earnings on labour and investing in capital, they too can prosper.

If economists could take a history lesson and broaden their perspectives a little they would see the simple explanation for the observed divergence in wealth. Given a stable political environment, rules could be attached to foreign aid that might require a proportion of domestic reinvestment in capital works. Poor nations, desperate for foreign capital, might want to rethink the advantages of allowing foreign investment in their natural resources, and instead promote the extraction and use by government owned companies that can keep profits within the country for further reinvestment.

What happened to whistling?

I see in so many black and white films young working class men strolling (perhaps even skipping) to and from work while whistling a merry tune. Why is it that in my hours spent cruising the streets of Brisbane I hear no whistling? Come to think of it, I may the only whistler remaining in Brisbane.

What happened?

Here are my suggestions:
1. People have headphones on playing music for them
2. People don’t know what good music is anymore
3. People have less skill (I remember learning to whistle when I was 7 – it took a while to get proficient)
4. People are afraid of bringing attention to themselves (although they are happy to wear whatever ridiculous fashion is trendy at the time)
5. People are to busy thinking of other things to think about a song
6. People aren’t very good at remembering portions of a song long enough for it to be interesting
7. People have lost imagination and really shy away from trying such a crazy thing as whistling their own melody

I propose – bring back whistling. And my reason is this. When I watch the crazy chimney sweep (thinking of Mary Poppins here) whistling his way to work, it makes me quite cheerful about life. There is a positive externality from whistling.

Maybe it is good government policy to slip some whistling in their next propaganda campaign. If you taught it at school it would lose its appeal. People have to think that they thought of it themselves.

Voting revisited

In keeping with the theme of my last post I will examine elections in more detail.

There are two issues that I want to raise;
1. strategic voting, and
2. the need for electoral districts

Strategic voting is where a person chooses not to vote according to their preferences because the probability of achieving them is very low. They may instead choose to vote for a second choice candidate in the hope of getting a higher probability second choice outcome.

For example, in the recent Queensland election I may have wanted to ditch the current Labor government for the Greens. Knowing that the Greens were unlikely to win a seat, I may vote instead for the LNP who were my second preference, but would have a much higher chance of winning.

The question remains, how many people vote for the major two parties but would really prefer a minor party or independent?

This brings me to my second point. Why do we need electoral districts? Given that each level of government should be concerned about issues covered by its laws irrespective of their location, why do we a need a local person to represent people at a State level? Shouldn’t the concerns of people anywhere in the State be equally as important? Why then the need to differentiate communities by their elected representative?

My solution is simple. Remove electoral districts. Have a parliament made up of representatives from each party in proportion to their vote. If 30% of votes go to a party, they get 30% of the seats to allocate to their best people. People would then have a clear incentive to vote for their preferred party/candidate. In this scenario independents could be elected by anyone in the State – it might be a large ballot paper.

The only problem that remains is getting anything done. If the parliament is made up of ten minority parties with 10% of the seats each, there is a strong incentive to do nothing and blame everyone else for delaying your proposals.

Of course, there is no perfect system. You get better incentives for people to vote for their preferences, you get less done and even more political finger-pointing.

Rewarding bad behaviour

One of the main functions of government is the redistribution of wealth. However, governments also have the luxury of promoting social goals through the incentives offered to both the contributors, and the beneficiaries of this redistribution.

However, the unfortunate problem is that much government intervention rewards 'bad' behaviour.

Let me explain.

A progressive tax system conveys the principle of vertical equity; that those with a greater ability to pay should pay more. However, if you look at this from a slightly different perspective, you are simply punishing the good behaviour of highly productive people. The reverse of this is rewarding people for not working through unemployment benefits.

Don't get me wrong, I believe that these two problems are minor in comparison to the benefits such a welfare structure brings to society. But what about other more controversial ways to use taxes and subsidies?

In the water industry there have been plenty of subsidies lately in both and urban and rural context. In the city, households are given free water tanks and free toilet and shower fittings to promote more efficient use of water. In the country, there is a rural water use efficiency program that essentially subsidises farmers to invest in more efficient irrigation methods.

If you think critically about this you see the perverse incentives. Those households who are already efficient, who already have efficient fittings, get nothing. Those wasteful households who have done nothing to conserve water now get a whole bunch of free stuff. The same applies in the country. Those irrigators who already use more efficient techniques get nothing while those who have caused the water problems by using outdated irrigation methods get subsidised sprinklers.

Rewarding bad behaviour has been happening with the subsidisation of energy efficient lightbulbs, solar hot water, and other 'energy saving' gadgets. Those people who have already spent their own hard earned cash on such things get nothing, while the slackers get some them all for free.

It is equally as bad with the advent of proposed trading schemes for both water and emissions. Those companies and individuals who already use the most water or energy efficient technology have little scope to adapt. Those who use outdated and inefficient technology now get incentives for them to invest in new technology. They also get rewarded with more permits due to their higher historical emissions or water use.

The question that remains is how to overcome these incentives. Well I for one have a view that the water and energy efficiency subsidies are ineffective anyway, so the easiest thing to do is scrap them. For the cap and trade systems, which I believe are currently the best way to deal with finite renewable resources (and for sustainable levels of emissions/pollution), it is a more difficult question. You could, for example, gift permits at the beginning of the scheme inversely related to previous use. The more they have used, the fewer permits they get. But determining an actual measure for this over a vast array of businesses of different scales and different industries seems close to impossible.

I am open for suggestions on how to overcome these issue, and for any other examples of well intentioned policies rewarding bad behaviour.

Another reason for small government

As a new public servant I have discovered what I would call the ‘baseline’ person. They don’t seek to challenge the status quo, they all seem to desire the ‘normal’ life – a house, two cars a pool out on the city fringe. If you tell them you did anything out of the ordinary is immediately received with absolute shock. Mountain biking – shock. “Isn’t that dangerous?” You have longish curly hair – shock. You eat rice that comes wrapped in a leaf – shock. (insert anything that hasn’t recently been on Today Tonight here) – shock.

I am going somewhere with this. Public servants seem to be, either by selection or through indoctrination, reluctant to challenge anything. Also, given the ‘worker’ mentality and fairly widespread unionism, I would suggest that most would be Labor voters.

This leads me to two interesting conclusions.
1. The reluctance to challenge things make them highly likely to vote for the sitting political party, and
2. if that political party is Labor, then the this likelihood is greatly increased.

Therefore, there is a self-fulfilling process happening. Labor governments by their nature prefer more government intervention, thus need a larger government. The more people they employ, the more voters they get indoctrinated, thereby reinforcing their position.

When a challenging party that believes in small government comes along, there is a massive pool of workers who, now indoctrinated, also feel like there job is threatened if the government is going to downsize.

Maybe this goes some way to explaining the Labor dominance in the States. Maybe it helps to explain the failure to get widespread support to dispose of States altogether. There are 1.3million State employees in the country, but only 400,000 employees in the federal and local governments combined.

Then again, maybe I have just seen a representative sample of a much broader population. Given that I have spent the past 10 years on the fringes, rather than in ‘mainstream’ society, this might just be my first real introduction to the silent majority, the baseline person.

Tuscany v Tassie

For those who don’t know, I am planning a trip to Europe in June. The attraction of Europe for me, a simple Aussie, is the history of human society that is embedded in the environment there. The rivers, still often beautiful, have been subjected to thousands of years of human tinkering. No one would even know the original path of some developed rivers. Even the countryside is not ‘natural’, but the product of thousands of years of agriculture in various forms. The cities obviously are the product of man, but still capture humanities path through history to the present. This humanised environment is beautiful and enticing to me.

Then I consider the wild areas of Tasmania and New Zealand. My Dad is a fan of this environment, hiking the tracks in the fresh mountain air, with none of the bustle of city living. But even in this environment, humanisation (for want of a better term) is occurring. Huts are built. Tracks are formed on the side of steep ravines, and fallen trees are transformed in to nifty seating for a weary wanderer.

When I go camping, it is partly to get closer to nature, but in doing so I change it. I instinctively humanise the landscape as I go - remove fallen branches to make some nice open space, forge a track through to the beach, and make a fire place. I want to go out to nature, but then subconsciously change it as soon as I get there. The result then, for me at least, must be better than the landscape in its original form.

At this moment I believe there must be an instinctive desire to humanise our environment, whether we value natural environments or not. But how does this impact our lives in contemporary urban society?

One important thing that springs to mind is that this humanising desire explains why people apparently ‘over value’ design. I live on the darkside with a Mac laptop. Yes, in my opinion it is more functional, but I must admit, in the beginning, the design really appealed. When the initial decision was made, I simply paid for looks. It was humanised.

More specifically, does this kind of desire explain the premium people are willing to pay to own their own home? Yes, home ownership is more secure, but does security explain the massive premium people are willing to pay? Or does the ability to customise, to humanise, to personalise our space contribute to this willingness to pay? I don’t know; it is just a suggestion.

To put the whole thing in reverse, would there be outrage at the suggestion that you couldn’t personalise your office space at work? Would a premium be paid for home ownership if regulations forbade different colour paint, renovations or extensions, and no changes to the garden?

Then again, maybe I’ve picked up on something that is explained by deeper causes and possibly has an evolutionary explanation.

It takes a global financial crisis (GFC) to...

1. Make government function efficiently. In our department budgets have been slashed, people are not being hired, travel expenses are coming down, but the same work is being done. What a way to improve the productivity of government.
2. Send very large but inefficient companies bust. They had so much power to keep doing what they were doing, holding back innovation, adopting new business practices last, but now they're broke, and the efficient guys remain. There will be plenty of slack to be taken up by young innovative companies. Also, rumour has it that Pacific Brands has wanted to cut back their workforce for a while now, but needed the GFC as an excuse.
3. Teach generation Y about the budget constraint. When I was teaching economics to first years they had trouble comprehending that individuals have limited budgets and must choose between various consumption options. A common response was that I just spend what I need, when I need. Maybe now their family funded credit cards are being reined in, and students will start get better results in first year economics.
4. Shelve poor infrastructure investments – I’m thinking of the Northern bypass tunnel here. No one has the money to build this kind of rubbish.
5. Make us all expert economists. The amount of rubbish in the media lately, and the number of unqualified and irrelevant experts is astounding.
6. Actually make people worried enough to pay off their credit card. Hundreds of dollars in interest payments and fees weren’t enough incentive – thanks GFC.
7. Reduce global emissions
8. Prevent new mining operations on environmentally sensitive sites.
9. Decrease politicians pay (US only)
10. Decrease outrageous CEO pay (US only)
11. Give us the cooking practice we used to pay for – for free in our own homes every night!

Can you think of anything else?

Updates

Well, it appears I was ahead of the crowd on at least some of the issues I've been discussing in this blog.

For starters, a previous blog that was critical of the research paper proposing to fix the floor in the emissions trading scheme pre-empted the current debate, which threatens to postpone any emissions reductions measures. You can read about the political debacle it created here.

Another point getting more publicity is the proposal that governments make no new policies in response to the GFC (that's Global Financial Crisis for those out of the loop). My stimulating paradox blog came to the same conclusion as Dan Denning. But hey, who trusts what they read on the internet.

A final update regards the announced (finally) Queensland elections. Given the GFC, the basic lack of innovation over the past decade, the threat to the Great Barrier Reef from climate change, the massive social disruptions likely to be caused from mining operations closing down, I am surprised there is even an opposition wishing to get elected! My bet is that whoever has the catchiest slogan will win - yes, it is a fickle business. But really,there may be plenty of fodder for bloggers in the next month.

Sorry for the cop-out blog, but there will be some detailed analysis next time.

Homogenous Humanity

I want to take a bit of a break from the financial crisis to talk about humanity, and more specifically, racial identity. The growing number of interracial and relationships I have witnessed, including my own, has led me along a line of enquiry that has some interesting implications.

To summarise, the question bugging me is whether the increased interracial breeding, especially in Australia, and probably much more so around the world, will cause distinct racial identities fade away? More importantly, will we end up with a ‘standardised’ race of humans? Or, will other environmental factors contribute to changing the nature of humans? Could we develop new races?

Overall, what will this impact have on our society?

The issue has bugged me since I learnt that there are in fact different races. At primary school I was completely ignorant of race. I had friends back then who I only now realise are Aboriginal, Indian, and Chinese. Further confusion was raised when I discovered that there are many policies that specifically determine outcomes based on race – with various Aboriginal assistance programs. There is an obvious justification for singling out the Aboriginal people for assistance given Australia’s history, but what about the half Aboriginal guy? Should he get half the assistance? Should half of him assist the other half of him? Why does he identify as Aboriginal and not Irish anyway? What about the quarter Aboriginal Chinese Indian African guy? Or is he something else altogether?

This brings me to the important social implications of such racial change. With which groups will the mixed race generations identify. Am I Indian or Chinese? And what if India was at war with China (heaven forbid); with which powerhouse will I side? My point is that the destruction of racial identity might have a beneficial effect of decreasing animosity amongst nations. In Australia especially it would be difficult to conjure domestic support for wars with nations whose racial heritage runs through the blood of many of our citizens.

Will religiousness fade away as racial ties fade? What religion would the son of a Buddhist and a Catholic be?

Would we try and preserve ‘pure’ races? Will some become extinct through breeding alone?

Maybe I should have at least proposed some hypothetical answers to these questions before I started writing. Please, I am interested to know your thoughts. Having a half Anglo-Saxon (what am I anyway?), half Chinese son myself I expect that many more questions will be raised. Will this generation of interracial children have trouble fitting in at school, being neither in the Chinese nor Aussie crowd? Who knows.

Challenging the time value of money

Why is it that we expect our savings to ‘grow’ all by themselves? What would happen if our savings diminished over time instead?

Let’s first have a look at the historical coincidences that led to the absolute acceptance that the future should be discounted. Before any banking system existed, to save you must store your valuables, whether it be precious metals, grains or other food, somewhere where they can be preserved. To save them for the future, you must invest MORE in the present, in the form of preserving food, building defensible stores, and if there was enough gold in there, possibly paying for protection, to have LESS in the future. Thus prior to banking , the future was valued MORE than the present.

The logic behind this is simple. The future is risky, and to maintain your wealth for future times of uncertainty, you must invest in the present to protect it.

So where did the idea of earning a return on savings originate?

It must have been some time ago when the idea of lending money with interest first came into being – it even gets a mention in religious texts. I imagine that the ancient Greeks and Romans were the first to consider the problem I am considering today.

I guess there were two interrelated issues that led to money lending at interest – the advent of central banking in the form of paying goldsmiths to store and protect your gold, and the advent of international ‘trade’. I use the term trade loosely because much of the trade was involuntary in ancient times – by that I mean that that trade was achieved by waging war. But the point is that through trade increased wealth could be achieved easily, which could then be used to pay interest.

To get back to the questions I raised at the beginning of the blog, I would suggest that the reason we expect our savings to grow is because that is how it has been for a long time. Most of the time we can generate a small positive return on savings if there is a little growth in production.

But what if we have reached some resource limits, and growth is now a little more difficult to achieve. How can we lend money with interest in an environment of negative growth? On a national scale, how can we generate the wealth necessary to pay the interest? In short, we can't.

Maybe some readers have already noticed a major problem with negative interest rates (or a deteriorating money supply, or a reversal of the principle of the time value of money). Those who hold wealth will have a much more difficult time preserving its value. Challenging this one basic principle raises questions of the validity of land ownership and rents, and how it may be possible to own any income producing asset, let alone value it? Imagine capitalising an asset at 0.00001% - any income producing asset would be almost infinitely valuable. Where would be the motivation to invest in any capital equipment?

Where does this leave us? To be honest, the more I think about it, the more I see the importance of maintaining economic growth. A sustained period of negative growth would destroy the system – the money supply, capital values, rents – but what would it be replaced with? I am yet to think of a reasonable alternative, but I am sure there must be one.

Stimulating paradox

I read an intriguing article yesterday about the fundamental paradox that underlies the global phenomenon that is currently known as an ‘economic stimulus package’. The basic gist is that to justify spending billions of dollars the government has to scare the crap out of everyone to justify it. In doing so, they radically increase the chances that people will want to save instead of spend. They could have alternatively just said everything was fine, downplayed the situation as a media beat-up, and done nothing. At the moment, doing nothing is exactly what I think is the best thing for governments.

But let’s take a moment to look at the theoretical arguments surrounding the stimulus. I am going to raise quite a few economic theories that have been subject to debate a long time, so please do a little research if anything interests you.

Keynesian theory suggests that recession is caused by a wave of pessimism that flows through society, impacting on business decisions. It has some merit. One business sees another buckling down for tough times ahead, so they do the same, and so on until everyone has reduced production, but no one knows why. Real herd mentality in action. The economists’ prescription for getting out of a Keynesian style recession (Yes that there are different types of recession that require different policy responses. For example one caused by a ‘supply shock’ to a key resource.) is for government to intervene in markets to maintain demand and employment, in addition to ‘talking up’ the economy to raise business confidence. It seems that the current policy response forgot to mention that things will be fine, and went for the big spend – the exact problem raised in the paradox article.

But there is more. The opposition raised a very interesting point about the merit of giving people cash to spend, when the principle economic theories of consumption suggest that only a very small proportion will be spent. Milton Friedman’s Permanent Income Hypothesis (PIH) explains how people choose how much to spend based on their long-term expectations of income. Thus it would be expected that a one off payment will be diluted amongst household spending over a long period.

The opposition has a few more economic theories up their sleeve as well. One of the main maco-economic models, the IS LM BP model, that links together interest rates and output of the economy taking into account international trade and foreign exchange, makes clear that in a country with a floating exchange rate, fiscal policy (government spending) will be rendered completely ineffective.

Further, the Barro-Ricardian equivalence hypothesis (which doesn’t gain much acceptance anymore, but makes a very good point) also suggests that fiscal stimulus will be ineffective, whether financed through debt or taxes. Since any money the government has is raised through taxes, and any debt they incur must be paid by future taxes along with interest, people will realise that this round of debt funded spending is actually equivalent to RAISING TAXES. And what kind of stimulus would that be.

My final point is about the continual decline in interest rate, and the possibility of a liquidity trap. In short, a liquidity trap occurs when lowering interest rates does not increase the supply of money. Banks are already reluctant to lend, and since their real returns are minimal once the nominal interest rate approaches the inflation rate, they fail to approve more loans even though the interest rate is lower. I would suggest that there may be a little of this occurring, especially if the current interest rates drops are perceived as temporary measures.

In any case, we will never know if the fiscal (and the Reserve Bank's monetary) stimulus did anyone any good, because we have no basis from which to measure the success of failure of the policy. Maybe we could have given the money to just half the states and done a bit of a real life experiment. The political claims will be obvious - Rudd Bank will claim success no matter what the outcome, because 'it saved us from the worst of it', while the opposition will blame the stimulus for any further deterioration of economic output. Neither of them are right. We are subject to the whims of international markets, and no policy of ours have a noticeable impact.

Before I go I just want to let you know that I am more of a subsriber to the theory of creative destruction. This theory suggests that recessions are a necessary part of development. A recession is simply a process of 'destroying' outdated and outmoded production systems to enable the 'creation' of production chains for new goods and services. Followers of this theory would see a recession as a sign of development, and not something to be avoided.

Unfortunately governments have a hard time persuading people that some short term pain is worth the long term gain.

That’s all for now folks.

A monetary system for a sustainable society – the BIG question.

I spent a couple of hours this evening watching Chris Martenson’s Crash Course. For those interested in financial or environmental matters, and believe there is any connection between the recent ‘financial crisis’ and the peak of oil production it is very interesting. For others, it is probably still quite interesting.

I won’t give it all away, but the lecture series gives a thorough overview of money supply, speculative bubbles (a must see section), debt, growth and all things financial. It concludes that we are in for some tough times due to the coincidence of peak oil, retiring baby-boomers, and the collapse of a speculative bubble in housing.

These intriguing lectures got me thinking about another issue. Why is it that concerned individuals spend so much time looking at the problem, and telling others about the problem, but are rarely discussing potential solutions. And I mean real solutions – the mechanics of it all – not just ‘be nicer’, ‘do your part’. What is nice anyway? And what is the part I should do, and will it work? These are the questions that need answers if change is to happen.

I know I may have fallen into this trap a little in some of my blogs. But I’m in good company. Al Gore’s Inconvenient Truth spent hours on environmental problems, but only flashed up a few dot points on what we as individuals could do, and given my recent research, most of them are a waste of time.

All of this must be leading somewhere. It is. Given the intrinsic relationship between economic growth and environmental decay, and consumption of natural resources, we must reject growth as a long-term proposition. However, if we accept that society will be forced to exist within limits, and that any growth period will be counteracted with periods of degrowth or ungrowth, how will the financial system operate?

By the time you have watched the Crash Course, you will know that for money to stay in existence growth is an absolute necessity. So how can we have a currency that performs the basic functions of money – a store of value, a medium of exchange, and a unit of account – when the quantity of goods produced in the economy may fall for long periods of time? How can interest be charged on loans if there is no extra increase in production with which to pay the interest?

This question has perplexed me for a long time. We need a monetary system that has the flexibility to adjust the quantity of money when the quantity of goods produced changes, but one that will not be prone to periodic episodes of high or negative inflation. If we have a fixed amount of currency, maybe used gold for example, when output increases prices would decline, and then rise again when output decreases. How can money act as a store of value in this case? If you lent money in period of price deflation, no one would be able pay the interest, as the loan would be continuously getting larger in real terms. This is one of the main concerns about the current financial crisis. If deflation sets in, it will become self-reinforcing, and lending will cease altogether, stifling investment of all forms.

Anyway, for now I hope this has raised your interest in the matter of money, and I will endeavour to examine some options in the next blog.

Down the rabbit hole

I thought it might be nice to put up on the front page a recent comment by Chris. He states:

I can't quite get my intuition around this counter-intuitive concept. I'd like to try to develop some points that still bamboozle me:

1. Equating dollars to energy: For the purposes of example let's make up an economy, let's call it Moldova, which is powered 100% by coal-fired power plants. Say Moldova is a pretty dodgy place and the coal-fired power plants are running break even: so it costs the same amount of Mol-dollars to produce the energy as what they sell it for. Intuitively we would expect that this system could work; that the Moldovians, however poor they may be, would have electricity. However if we substitute the words coal-fired power plant with solar panels it becomes impossible. In both examples the cost of production equals the price of their product. It's easy to understand that if in the process of creating the solar panel we require the same amount of electricity than it produces over it's lifetime we gain nothing since we can easily equate apples with apples. However when we equate dollars with energy, one dollar spent on buying a solar panel (e.g. $1 = 1Wh) only produces 1Wh back again we gain nothing from the process. Thinking this way, equating $ with Wh, how can our poor Moldovians still use their electric milking machines?

2. I'm trying hard not to believe that we gain nothing from buying solar panels. Assuming they cost (like in Moldova) the same as the value of the energy they produce. We spend a dollar on a solar panel: this dollar in infinitely divided as it swims upstream through peoples wallets, and through this process looses it's identity as my 'green' dollar and comes out representing the total resource inputs of our economy, probably more a brownish sludgy colour now. So it doesn't matter if I temporarily green wash my dollar or spend it to create a burning petrol feature-fountain in my front yard: it's all the same. However I reckon by buying a solar panel I change the resource inputs of our economy: so my dollar swims up a slightly altered stream, it still arrives a brownish sludgy dollar, but a slightly greener one.
However after my solar panel is online, the total resource pool of the economy increases, energy becomes cheaper and consumption increases to fill in the space my green dollar bought: so total polluting is not reduced. Arrghh! I thought I was arguing for solar panels!! damn. BUT.. if the federal government wants to stimulate the economy they should spend it on solar panels? Since they would be growing the economy without increasing pollution. I've lost my point. Anyway what do you think?

Cheers
Chris.

My response:

Chris. You have some very neat logical arguments here. And there is no real answer to the first one. I have been pondering this problem for about a year. I get the feeling we are getting very close to the bottom of the rabbit hole, with only one remaining theoretical explanation. Chaos! (complex adaptive systems to be more precise)

While I have given the impression that tracing resource inputs to the economy up the tree can be envisaged much like a never ending family tree, there are interactions along the way that make it a complex system, and the capacity to learn and change also makes it adaptive. There are two major problems with such systems; (1) an action cannot be isolated from the rest of the system (thus one product cannot be isolated as good or bad), and (2) the way to change the whole system is uncertain, given the complexity of actions in response to change within the system.

Further, there are major problems in my theoretical argument against solar panels due to time and technology. For starters, the energy we used to construct the power plant was from half a century ago, which came from power plants and oil wells built a century ago, which were constructed from… well you get the picture (maybe read my Hunger, humans or happiness blog). Without this previous energy use, we would not have current energy production. Thus we could arguably trace back infinitely through time the energy requirements of producing a given product, which may be a sum total of all energy use in history!

In light of these and other issues that arose in lunchroom economics discussions, I developed a ‘Theory of Private Property’, which suggests that somehow economic growth (but not human welfare) is fundamentally linked to the creation of private property. How to develop this into a comprehensive and useful theory presently escapes me, but I am yet to find contrary evidence to dispute the relationship. The point of such a theory would be to suggest that solar power cannot contribute to growth because it doesn’t involve the use of land (whereas fossil fuelled energy can due to the continued consumption of land in the form of coal or oil). If we could attach a right to the sunshine, it may help. The solar energy producers would pay rents on the rights to the sunshine.

Anyway, while that was not a short answer, it does begin to raise some important points that one might consider before proclaiming a specific behaviour as good or bad.

Banking is a Ponzi scheme

I mentioned in my last blog that I would comment on the similarities between Bernard Madoff's Ponzi scheme and the tradition of fractional reserve banking. However, many other, and probably more eloquent, writers have had similar thoughts and done the hard work for me. In a break from tradition, this blog simply directs you elsewhere to pursue this astounding, and concerning idea.

The Wall Street Ponzi Scheme called Fractional Reserve Banking: Borrowing from Peter to Pay Paul, by Ellen Brown

Ponzi Schemes in Russia, Colombia and the US: from Mavrodi to Murcia to Madoff (MMM), by Kaufmann

The bright side - a simple solution.

Many of my blogs have been perceived as a little pessimistic. This final blog of the year is intended to provide some optimism.

The positive message is this - Humans are infinitely adaptable, and can change very quickly when required.

Often I see graphs of exponentially growing resource consumption and environmental destruction, accompanied by the saying – this can’t go on. And that is absolutely right. It can’t go on forever. No matter what happens, we will adjust. We can’t defy physical limits. In times of crisis it amazes me how people can quickly make tough decisions, and devote their energies to the greater good. It appears that for most people then, there is no environmental crisis just yet, but I am certain when reality bites, actions will follow.

Now to the more specific task of reducing carbon emissions. I have made the point many times that we need to take a supply side approach, which means focussing on the actual source of pollution. Therefore pollution/emission limits are the only way to go. More importantly, this limit must consider all parties involved. For carbon emissions, we require global cooperation. Otherwise, there will always be incentive for those exempt from the limit to take advantage of the situation.

To explain why this is the case, consider the classic common pool resource problem (aka the tragedy of the commons). A common pool resource is non-excludable (you can’t stop anyone using it) and rivalrous (when someone uses it, others cannot). A park bench exhibits these features. Anyone can use it, but when someone is, others cannot. The atmosphere has similar characteristics. If one party uses the atmosphere to dispose of carbon, others cannot use it for providing a steady climate. The incentive in this situation is for the polluter to use as much of the resource as possible, as they receive all the benefits, while everyone else shares the costs. Water resources have, until recently, been much the same.

This issue has been historically solved by rituals, traditions, religion, and other enforceable means the limit use. The classic example is the summer meadows in alpine areas. Anyone can graze their farm animals there, but when there are too many other animals, there will not be enough grass for yours. To solve this problems of competing demands, one must enforce grazing limits (or some kind of rationing system) on all people involved. It is not enough that one person decide to do their bit and limit their herd, as it allows others to increase the size of their herd. Even if all but one farmer exercises self-control and limits their herd, the last farmer will take advantage of this and graze all remaining fodder.

In climate change lingo, the slack taken up by other countries is known as the displacement hypothesis. Tight pollution controls in developed countries stimulate the relocation of polluting industries to countries without environmental controls. This is the reason some countries appear to have been successfully reducing their carbon emissions.

Clearly then, we need enforceable limits on pollution at the relevant scale. For carbon emissions, this means global cooperation (this appears to be getting closer each day). For water management, whole catchment areas must be involved. It is a simple recipe for halting environmental degradation. As we have seen recently with the Murray-Darling Basin Authority, when we reach the point of ‘crisis’ effective actions follow swiftly.

Finally, to keep you give you a taste of what is in store for next year, some topics that are swirling around in my mind right now include:
- the similarity between Bernard Madoff’s pyramid scheme and the banking system
- the welfare benefits of piracy
- and the parallels between cap and trade regulations and land conservation.
- problems and solutions to degrowth

Merry Christmas.

Carbon tax V Cap and trade

This blog is to help those interested in understanding why there is a debate between these two alternative policy options for reducing greenhouse gas emissions. While at first a cap and trade scheme and a carbon tax appear to be different versions of the same thing, there are important differences. These differences explain the push from big business for a carbon tax.

First, we must recognise that a tax is simply a reallocation of funds between economic agents – from individuals and companies, to the government. Thus a carbon tax, a cigarette tax, an alcohol tax and a GST all generate government revenue. We know from my previous blogs that all consumption is equal (in resource terms). If governments do not spend this extra tax revenue, they will reduce other taxes, but the total economic production will be the same afterwards, as will the total consumption by all economic agents. Therefore a carbon tax will not reduce carbon emissions.

One quite interesting discussion I had earlier this year with ECOS magazine editor James Porteous led me to a paper by Barney Foran, entitled Powerful choices: Options for Australia’s transition to a low-carbon economy. Foran suggests that revenues raised from a carbon tax can be allocated to a future fund, which is basically an offshore investment vehicle. I think he fails to understand that this investment itself has serious carbon implications (This translates as “let’s stop climate change by taxing Aussies and investing in Chinese production”).

A cap and trade scheme on the other hand is actually a restriction on the amount of emissions – a ban on emissions once they hit a given level. This will guarantee emissions reductions (at least within Australia). Unfortunately, we know that to be effective, environmental policy must come at an economic cost – and this scheme will limit Australia’s total production, and limit its international competitiveness.

Without getting too political, the 5% target recently announced for the cap and trade scheme to be adopted in Australia in 2010 is infinitely greater than any carbon tax that could have been proposed to seek wide public approval. Intriguingly, I would suggest that the current governments popularity with green groups would increase with the proposal of a "large" carbon tax, even though it would be less effective at reducing emissions.

Some clarification on the solar riddle

My last blog was too brief, I suspect, for the challenging idea it presented. So I will elaborate a little further.

The key point I want to make is that a dollars worth of any consumption good or service, due to the infinite interdependency of economic production, requires an equal amount of resources for its production. A dollar spent on a pair of shoes requires an equal amount of coal, oil, minerals and other natural resource inputs, as a dollar spent on an apple, a hybrid car, a haircut, electricity, motor fuel, a solar panel, and every other good currently being produced. A dollar spent on any good also stakes a claim on an equal amount of pollution.

How can all goods be equal? Surely spending a dollar on a massage is better for the environment than a dollar on fuel or electricity?

But let us run through the flow on interactions in each of these cases. You buy a massage. You mistakenly believe that the environmental cost is negligible because there are no material inputs. What happens to the money then? The masseur then spends that money on whatever they choose – food, fuel, furniture, and any other items. Then what happens at each of these purchases/transactions? The dollar divides further to pay for the labour costs, and the upstream material inputs and so on ad infinitum.

The dollar spent on electricity can be traced in a similar way. The wholesale costs as well as the labour and rents of the electricity retailer are paid for. Then these upstream intermediate industries use this revenue to pay for all of their inputs. Any profits made along they way get spent on other consumption items. This single dollar continues to divide and change hands until it is diluted amongst all natural resources that supply our modern economy.

If a dollar represents a claim on a proportion of the resource inputs into the economy, this paints a different picture for environmentalists. There are no ‘green’ alternatives. Which brings me to the solar panels.

A $20,000 solar panel will generate less than $20,000 worth of electricity over its lifetime. If all consumption requires an equal amount of resources, then it takes more coal to make the solar panel than is required to generate the electricity it is intended to replace. In energy terms then, the solar panel is also likely not to produce more energy than is required to manufacture it in the first place.

But then again there is no harm in going solar – you will just have less money to spend on other things (oh, and they aren’t much good for the environment either).

Solve the solar riddle

My recent blog on the Ehrlich-Simon wager aimed to raise 'the principle of the indivisibility of economic productivity'. Briefly, this means that when you improve the efficiency use (aka productivity) of one resource through improved technology, you actually improve the productivity of other resources. So for example improved energy efficiency, will also improve the efficiency of use of other resources - minerals for example (due to reduced extraction costs).

The point of this blog is to take an extra step. I may have previously raised the possibility that all consumption is equally environmentally degrading. Spent a dollar on an apple, and that has equal environmental footprint to a dollar spent of motor fuel - somewhat of a shocking thought. But since the economy is infinitely interdependent this is the case. Costanza raised this issue back in 1980. He found that a dollars worth of any commodity has almost equal energy intensity.

Now to the solar riddle. If a dollars worth of any commodity has equal energy intensity, then a dollars worth of a solar panel will require an equal amount of energy to produce as a dollars worth of electricity. If this is the case, a solar panel that costs more than buying the electricity it produces  from another source, than it cannot be said to produce more energy than is required to produce it in the first place. Since the coal fired electricity that it replaces is cheaper over the panel lifetime, traditional grid sourced electricity must be the less energy intensive alternative, taking all the economic interdependencies into consideration.

In the end, although it is a difficult concept for many to accept, your income is the sole determinent of your environmental footprint. You can't just choose to spend that income in a particular way or another. But by reducing your income, and hence reducing your contribution to economic production and its associated externalities, you can make a difference.

In fact that was not the end. Because if you weren't heading off to work each day to earn a crust, someone else might be able to expand their work instead. So there can be no blaming or finger-pointing in the environmental game. We live in a complex system, of which component parts are inseparable. Maybe we should instead attack externalities at their source by enacting effective regulations to prevent them.

A comment on Fixing the Floor in the ETS

Dr Richard Denniss recently published a research paper for The Australia Institute. Despite its promising title, there is no solution for fixing the ‘floor’ in the ETS to be found in this document. In fact, it takes tentative steps towards teasing out the mechanisms through which the economy and environment interact, but in the face of reality, jumps back on the feel good, greenwash, drive a hybrid, hold hands and be nice to each other bandwagon.

Let me explain.

The story woven by Denniss is that energy and emissions conservation efforts by households will be rendered ineffective due to the proposed emissions trading scheme (ETS). For example, if households reduce their electricity demand through efforts to conserve, the electricity producer now needs to produce less electricity, and can then sell some of their emissions permits to other polluters. Hence the ETS provides a floor on emissions that cannot be passed, as permits can always be traded to other potential polluters.

However, the fundamental assumption in the paper is that households can reduce their greenhouse gas emissions by simply changing their purchasing behaviour and embracing energy efficiency. If you have read my previous blogs you would know that this is an ineffective strategy.

While the paper provides an interesting insight for many, the major flaw is that Denniss acknowledges the flow-on effects from the ‘after ETS’ scenario, without any reference to flow-on effects in the ‘before ETS’ scenario. As an Associate Professor in economics, Denniss should know that these type of flow-on effects would appear without the ETS due the price mechanism. Taking the above example in the 'before ETS' scenario, a reduction in electricity demand should reduce the price of electricity, and subsequently increase electricity demand by others (because of the Law of Demand - lower the price, the more we buy). Therefore, the actions that are supposed to be rendered ineffective by the ETS are already ineffective.

Blake Alcott has a very interesting paper that debunks conservation as an effective way to reduce energy consumption and subsequent greenhouse gas emissions.

In short, as I have mentioned many times in this blog, to truly reduce resource consumption you must restrict the supply. In the case of greenhouse gas emissions, the ETS does exactly that. Individuals actions mentioned in the paper are presently ineffective, and will remain so under the ETS. However, there will now be the opportunity to buy emissions permits, restricting their supply to polluters if you wish to invest in behaviour that reduces emissions.

If the only pressure on emissions production is upwards, then the existence of a floor is clearly not an issue, as long as it also acts as a ceiling. If you think about is, most restrictive regulations that provide limits also act as floors with little criticism. Safety standards, town planning restrictions, and many other regulations provide no incentive to ‘outperform’. That is not their purpose.

It is time to stop the feel good ramblings and the government blame game and accept reality for a change.

Explaining the Ehrlich-Simon wager

In 1980, prominent environmentalist, and author of the book The Population Bomb, Paul Ehrlich, entered into a wager with the late cornucopian economist Julian Simon. Ehrlich saw resource scarcity as a major problem, and that with time, resource prices would begin to rise as a reflection of physical limits. On the other hand, Simon predicted that with increased human population and ingenuity, the prices of resources would continue to decline indefinitely. Based on this logic, he challenge Ehrlich with “a public offer to stake US$10,000… on my belief that the cost of non-government controlled raw materials (including grain and oil) will not rise in the long run.” They designated September 29th 1990 as the cut off date for the wager, and bet on five metals – chromium, copper, nickel, tin and tungsten. The result was that the price of all five metals dropped in inflation adjusted terms, and Ehrlich sent Simon a cheque in October 1990.

So why did Ehrlich lose the bet, when we know for a fact that there are long run physical limits to natural resources? The first reason raised by many environmentalists is that his timing was a little off. Maybe he was a few decades early in his prediction. I believe this explanation is entirely incorrect.

The second reason is Ehrlich ignored economic principles. The price of a good at any point in time only reflects its relative scarcity compared to the availability of other goods – not the absolute scarcity. If the rate of supply (aka the rate of extraction) of these metals was high, the price will be low, even if this rate could only be sustained for a few years before the total physical supply was exhausted. Ehrlich made the fundamental mistake of ignoring the rate of production. But the environmental debate of that decade did raise what has become a pressing issue in ecological economics of getting the absolute scarcity of natural resources reflected in the price.

What we know more clearly now is that the rate of extraction of most minerals and fossil fuels follows a Hubbert curve, where the rate climbs before at some point peaking, the beginning a long decline. While many suggest that the peak generally occurs when 50% of the absolute physical quantity of the resource has been extracted, this peak in the rate of supply still does not mean there will be a peak, or explosion in the price at this point.

First, consider what happens when there is a small increase in the price of copper. This makes the use of copper in production less attractive than alternatives such as fibre optics. So demand will drop as well, stopping the price from spiking. The prices cannot get too ‘out of whack’ before other adjustments take place.

Consider then if Ehrlich had wagered on the price of oil, and that the bet began in 2000, with the cut off date 2010. A year ago one would have been inclined to think that Ehrlich was a genius for predicting the price spike. But in the last few months, Simon would have got the upper hand, and Ehrlich would be on the back foot making excuses about the so called ‘credit crunch’. But what really happened?

First, the oil price spike was the result of a decrease in the rate of supply of oil compared with the rate of supply of other natural resources. But more than that, it was the expectation of a continued increase in demand in the face of decreasing supply. If you take a look at the metals, their price also spiked on the expectation of future demand and low future supply.

But the catch was what happens when the economy adjusts. These ‘out of whack’ prices cannot be sustained. They flow on to the real economy. In this case, the high cost of oil and metals made it difficult to increase production as there were few susbsitutes, so economic output slowed. Suddenly, the expectation of high future demand was replaced with the expectation of recession, and prices or natural resources (oil and metals) fell accordingly.

That’s the thing with supply constraints and physical resource limits. The general rule of thumb is that relative prices between goods are caused by available technologies. When one input is constrained, it doesn’t change the relative prices so much in the long-run, rather it changes the output level - especially if there are very few or no substitute resources.

This net result of an output reduction is due the infinite complexity of the modern economy. Estimating the embodied resources in goods has been a pursuit of the past decade, but recently it is coming to light that due to this infinite complexity, all goods have equal embodiments of all resources. A dollars worth of petrol requires an equal amount of oil to produce as a dollars worth of a massage. Thus a constraint of a single natural resource flows through to have an impact on the price of every good in the economy.

So when I previously wrote that supply side restrictions are the only way to go for improving environmental quality, it implies that economic output will be reduced. If Ehrlich knew then what ecological economists now know, he would have had a much different wager. In fact he did propose a second wager. He wanted to bet that the quality of the environment would deteriorate over the 1990s by referring to 15 different environmental quality measures. Simon declined because he believed that measuring such things did not reflect well-being. Although he did lose a wager about the price of timber in Canada, but blamed new government policies.

Is public transport for the public?

On a leisurely Saturday afternoon, I ventured down to the ferry with fiancé, child, friend and dog in tow, to take a trip across the river to enjoy a BBQ in the park with friends. I was initially impressed by the frequency of ferries – every 15 minutes on Saturday is pretty good I thought. I was not impressed by being refused entry because of the dog, nor was I impressed with the cost. $3.60 for a one zone return ticket per adult. That was even a discount from the regular cost of $4.80 on a weekday. Remember, these are the cheapest adult fares for a return ticket. For the three of us (luckily infants are free and two of us were full-time students) the cost was $7.20. For three adult fares it would have been $10.80, and if it were a weekday and three adults where headed to the park, it would cost $14.40. Does that seem a little much to anyone else?

We realised that it was cheaper to drive together in one car. Cheaper by a country mile in fact. Even with the fuel price around $1.20, the same round trip would cost less than $2 between us (and we could take the dog). It would still probably have been cheaper to take a car each!

With my economic hat on I saw the reason that the situation exists where private vehicle transport is now cheaper than public transport. Governments have spent decades (centuries?) subsidising private transport, rather than investing in public transport. You could logically argue that private cars are a form of publicly provided transport, since tax revenues are the dominant funding source for road building.

Governments must believe that public transport is not an appropriate or beneficial urban transport alternative. For if that was the case, less money would be spent on roads, and more on public transport, so that the incentives shift towards using public transport. You can’t build more roads and more public transport, and expect there to be a shift towards public transport use. By investing in both alternatives you have not changed the incentive structure – yes it is now cheaper to catch the bus/train/ferry, but it is also cheaper to drive! Public and private transport are substitutes. The more expensive one is, the increase in quantity demanded of the other. Therefore traffic jams, no parking, high registration costs, difficult licensing tests, high fuel costs, and strict vehicle emissions standards all provide incentives to use public transport (but sound like a list of things to promise if you are a government intending to lose the next election). On the other hand, new roads, improved traffic management, more parking, cheaper fuel and registration are good measures for reducing public transport patronage.