Friedman and Hayek

Brad DeLong gets the distinction between Friedman and Hayek pretty much right in my view.

I think that there is an important difference between Friedman and Hayek. Hayek is an economic (classical) liberal but a social conservative: a believer in respect for throne and altar. Social conservative Hayek can see Pinochet as a good thing: far better to have an authoritarian state that maintains the conservative moral order, if it can be persuaded to adopt laissez-faire economics, than it is to have a democracy that regulates the economy. Friedman, by contrast, hates and fears a government that prohibits use of recreational drugs in your home almost as much as he hates and fears a government that won’t let you undersell your politically-powerful competitors. For Friedman, Pinochet is a bad–an aggressive, powerful military dictator–whose evil the Chicago Boys can curb by persuading him to adopt laissez-faire policies.

Roughly speaking, Friedman’s position was that even a dictatorship (such as Chile or China) would be better off with free-market economic policies. Hayek’s was to prefer a liberal dictator to a democratic government lacking liberalism.

Gaffes

In ordinary life, we know that the word “gaffe” means an inconvenient truth. If your SO asks “does this make me look fat” or “can I get away with a combover” the true answer is almost certainly a gaffe (if not, they wouldn’t have asked).

In politics, some avoidance of inconvenient truths is inevitable for much the same reasons. Ambitious upstarts have to say somethng along the lines of “I love and respect our leader” and patient leaders have to say “Colleague X is doing a great job” until the day the knife or axe is ready for use. In matters of this kind, no-one expects truthfulness.

But, as used by the MSM, the term “gaffe” means inconvenient speaking of the truth about policy questions. the latest instance is the statement by Queensland Liberal leader Bruce Flegg that recycled water is safe, and that, given the uncertainty of future rainfall, there is little choice but to go for recycling.

The first statement is supported by overwhelming evidence, and the second by any reasoned assessment of the situation. But because the Nationals are bidding for the support of the large segment of the public with irrational fears on the topic, and Labor is ducking the issue with proposals for a referendum, Flegg’s statment of the plain truth is a gaffe.

We’ll all be rooned

Today’s Courier-Mail has a report pushing the Beattie Government’s plans for new dams, and threatening financial ruin if they aren’t built. Crucial quote:

As its efforts to win approval for the controversial Traveston Crossing Dam in the Mary River Valley move into top gear, the Government has used a consultant’s report on possible economic losses to the region to push its case for the project.

The lack of new water sources could end up costing southeast Queensland at least $55 billion and perhaps as much as $110 billion by 2020, according to the consultants ACIL Tasman.

Even before this episode, the name ACIL Tasman wasn’t one that filled me with confidence. All consultants like to produce reports that support their client’s preferred position, and my experience of ACIL Tasman is that the approach to this outcome is “whatever it takes”.

I haven’t been able to find the report yet, but the numbers seem way off-beam to me. This report says that the total revenue for SEQ Water and sewerage businesses was about $1.4 billion in 2005/06, growing at about 6 per cent a year. ACIL Tasman wants us to believe that limits on additional supplies could cost between $5 billion and $10 billion a year.

I find this implausible, at least as an economically meaningful cost estimate. A doubling of water prices would be enough to reduce demand significantly over time (even allowing for underlying growth in population and income), and make all sorts of supply options, such as desalination, economically feasible, without any need for new dams. The welfare cost of this would be around 0.5 billion a year (I’ll do a proper check on this number later). So, I’d say ACIL Tasman is out by a factor of 10 to 20.

I haven’t seen enough information to determine whether the proposed dams pass the cost-benefit test. But this report makes me think the case must be pretty weak.

If you can’t beat them …

Back in August 2005, Anita Quigley had this to say about blogging:

“Why some pimply-faced geek, sicko or average Joe Blow thinks someone else wants to read every random thought that crosses their mind is beyond me. Alongside the belief that we all have a novel in us – we haven’t – blogging is the ultimate form of narcissism.�

Hmm

The Stern Review and the long tail

My first post on the Stern review started with the observation that

the apocalyptic numbers that have dominated early reporting represent the worst-case outcomes for 2100 under business-as-usual policies.

Unfortunately, a lot of responses to the review have been characterized by a failure to understand this point correctly. On the one hand, quite a lot of the popular response has reflected an assumption that these worst-case outcomes are certain (at least in the absence of radical changes in lifestyles and the economy) and that they are going to happen Real Soon Now. On the other hand, quite a few critics of the Review have argued that, since these are low-probability worst cases, we should ignore them.*

But with nonlinear (more precisely strongly convex) damage functions, low-probability events can make a big difference to benefit-cost calculation. Suppose as an illustration that, under BAU there is a 5 per cent probability of outcomes with damage equal to 20 per cent of GDP or more, and that with stabilisation of CO2 emissions this probability falls to zero. Then this component of the probability distribution gives a lower bound for the benefits of stabilisation of at least 1 per cent of GDP (more when risk aversion is taken into account). That exceeds Stern’s cost estimates, without even looking at the other 95 per cent of the distribution.

An important implication is that any reasoning based on picking a most likely projection and ignoring uncertainty around that prediction is likely to be badly wrong, and to understate the likely costs of climate change. Since the distributions are intractable the best approach, adopted by the Stern review, is to take an average over a large number of randomly generated draws from the distribution (this is called the Monte Carlo approach).

To sum up, the suggestion that because bad outcomes are improbable, we should ignore them is wrong. If it were right, insurance companies would be out of business (not coincidentally, insurance companies were the first sector of big business to get behind Kyoto and other climate change initiatives)
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Milton Friedman: a brief appreciation

Milton Friedman has died at the age of 94. He made some huge contributions to macroeconomics, notably including his permanent income theory of consumption, which paved the way for the modern life cycle theory and his work on expectations and the Phillips curve.

He was also the most effective advocate for free-market policies since Adam Smith. As has been said several times over at Crooked Timber recently, everyone, and particularly everyone with a leftwing view of the world, should read Capitalism and Freedom at least once. As Mill said, beliefs you hold merely because you haven’t been exposed to the strongest possible critique of those views, aren’t really well-founded. Certainly, my own views were changed in some respects by exposure to Friedman, and where they were not, I was forced to reconsider the basis for my positions.

Friedman was effective in part because he was obviously a person of goodwill. I never had the feeling with him, as with many writers in the free-market line, that he was promoting cynical selfishness, or pushing the interests of business. He genuinely believed that economics was about making people’s lives better and that disagreements among economists were about means rather than ends and could ultimately be resolved by careful attention to the evidence.

Stern on the costs of climate change, Part 1

The standard (expected utility) approach to assessing the cost of climate change is to
(i) derive a probability distribution for possible rates of climate change under some given projections,
(ii) attach a cost (or benefit) number to each possible outcome, expressed in utility terms,
(iii) calculate the expected utility gain (or loss)
(iv) express the calculated number as a percentage change in some income aggregate (usually GDP)

In this post, I’m going to look at step (ii). In most respects, the Stern review has adopted assumptions that favour strong action to mitigate climate change – relatively optimistic regarding the costs of stabilising CO2 levels, and relatively pessimistic regarding projections of changes in climate. But the cost calculations are conservative, probably because the previously published estimates of Mendelsohn, Nordhaus and Tol have been way too low.
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Stern on discounting and risk

One of the crucial issues in any assessment of climate change policy is how to handle discounting and risk. The Stern review (Ch 2) goes back to first principles and gets the main issues exactly right. The reason for both discounting and risk premiums, in economic analysis, is that the marginal value of a dollar of income is lower when we are rich than when we are poor. Hence, we’re prepared to pay for insurance when we are well off in order that it will pay out when we are badly off. Similarly, if we expect income to rise over time, a dollar of income now is worth more, at the margin, than a dollar in the future. The same points are relevant in considering income distribution but this isn’t covered in the parts of the report I’ve read so far.

In addition, there’s a justification for “inherent discounting”, reflecting the fact that some future event (most probably bad, but perhaps good) may mean that “all bets are off” in relation to future consumption levels. Individuals should have reasonably high inherent discount rates, since we may not be around next year, but the appopriate rate for a community is much lower, being confined to the risk of catastrophes like nuclear war.

The Stern review also has a good discussion of probabilities, including the recent literature on problems where there do not exist well-defined probabilities.

The quality of the economics here is very high, and sets a new bar for discussion of these issues.

There’s more on Stern from James Wimberley