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Hurricanes and the social rate of discount

With first Houston, then several Caribbean islands and Florida suffering dreadful flooding and destruction from Hurricanes Harvey and Irma, many are questioning whether more should be spent on flood prevention and reducing greenhouse gas emissions. Economists would normally argue that such questions are answered by conducting a cost–benefit analysis.

However, even if the size of the costs and benefits of such policies could be measured, this would not be enough to give the answer. Whether such spending is justified would depend on the social rate of discount. But what the rate should be in cost-benefit analyses is a highly contested issue, especially when the benefits occur a long time in the future.

I you ask the question today, ‘should more have been spent on flood prevention in Houston and Miami?’, the answer would almost certainly be yes, even if the decision had to have been taken many years ago, given the time it takes to plan and construct such defences. But if you asked people, say, 15 years ago whether such expenditure should be undertaken, many would have said no, given that the protection would be provided quite a long time in the future. Also many people back then would doubt that the defences would be necessary and many would not be planning to live there indefinitely.

This is the familiar problem of people valuing costs and benefits in the future less than costs and benefits occurring today. To account for this, costs and benefits in the future are discounted by an annual rate to reduce them to a present value.

But with costs and benefits occurring a long time in the future, especially from measures to reduce carbon emissions, the present value is very sensitive to the rate of discount chosen. But choosing the rate of discount is fraught with difficulties.

Some argue that a social rate of discount should be similar to long-term market rates. But market rates reflect only the current generation’s private preferences. They do not reflect the costs and benefits to future generations. A social rate of discount that did take their interests into account would be much lower and could even be argued to be zero – or negative with a growing population.

Against this, however, has to be set the possibility that future generations will be richer than the current one and will therefore value a dollar (or any other currency) less than today’s generation.

However, it is also likely, if the trend of recent decades is to continue, that economic growth will be largely confined to the rich and that the poor will be little better off, if at all. And it is the poor who often suffer the most from natural disasters. Just look, for example, at the much higher personal devastation suffered from hurricane Irma by the poor on many Caribbean islands compared with those in comparatively wealthy Florida.

A low or zero discount rate would make many environmental projects socially profitable, even though they would not be with a higher rate. The choice of rate is thus crucial to the welfare of future generations who are likely to bear the brunt of climate change.

But just how should the social rate of discount be chosen? The following two articles explore the issue.

Articles
How Much Is the Future Worth? Slate, Will Oremus (1/9/17)
Climate changes the debate: The impact of demographics on long-term discount rates Vox, Eli P Fenichel, Matthew Kotchen and Ethan T Addicott (20/8/17)

Questions

  1. What is meant by the social rate of discount?
  2. Why does the choice of a lower rate of social discount imply a more aggressive climate policy?
  3. How is the distribution of the benefits and costs of measures to reduce carbon emissions between rich and poor relevant in choosing the social rate of discount of such measures?
  4. How is the distribution of the benefits of such measures between current and future generations relevant in choosing the rate?
  5. How is uncertainty about the magnitude of the costs and benefits relevant in choosing the rate?
  6. What is the difference between Stern’s and Nordhaus’ analyses of the choice of social discount rate?
  7. Explain and discuss the ‘mortality-based approach’ to estimating social discount rates.
  8. What are the arguments ‘for economists analysing climate change through the lens of minimising risk, rather than maximizing utility’?
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A broken economy

According to a new report, Time for Change published by the Institute for Public Policy Research (IPPR), ‘The British economic model needs fundamental reform.’

It is no longer generating rising earnings for a majority of the population, and young people today are set to be poorer than their parents. Beneath its headlines figures, the economy is suffering from deep and longstanding weaknesses, which make it unfit to face the challenges of the 2020s.

The report by the IPPR’s Commission on Economic Justice is an interim one, with the final report due in the latter part of next year. The commission was set up in 2016 and includes business leaders, such as the heads of John Lewis and Siemens, the TUC General Secretary, the Archbishop of Canterbury and other leading figures.

Commenting on the interim report, Justin Welby, the Archbishop of Canterbury said

Our economic model is broken. Britain stands at a watershed moment where we need to make fundamental choices about the sort of economy we need. We are failing those who will grow up into a world where the gap between the richest and poorest parts of the country is significant and destabilising

The report found that wages have stagnated for the majority of the population since the financial crisis of 2007/8. Wage income has fallen as a proportion of national income, while the proportions going to income from profits and property have risen. Young people are poorer than previous generations of young people.

Despite low unemployment, many people are on zero-hour contracts, part-time contracts or employed on a casual basis. For many, their jobs are insecure and they have no bargaining power.

The UK for many years has had a lower rate of investment that other developed economies and productivity, in terms of output per hour, is the lowest of its major competitors. Productivity in Germany is 36% higher than in the UK; in France and the USA it is 29% higher. Although there are some internationally competitive UK firms with high productivity, the country has:

a longer ‘tail’ of low-productivity businesses, in which weak management and poor use of skills leads to ‘bad jobs’ and low wages.

There are many other challenges, including an ageing population, uncertainties from Brexit, a large current account deficit, increased competition from abroad and growth once more in private-sector debt, which means that consumption may cease to be the main driver of economic growth as people seek to curb their borrowing.

The report is also critical of fiscal policy, which with record low interest rates could have been used to finance infrastructure projects as well as supporting public services.

The report recommends three approaches:

The first is institutional reform to support investment.

The second is making the economy more competitive through a coherent industrial strategy, reform of the financial sector to support long-term investment, reform of corporate governance to promote business success and tackling the market dominance of companies such as Amazon and Google.

The third is to bring greater social justice and equality through encouraging more secure and better-paid jobs, strengthening trades unions and reforming the tax system to make it fairer and smarter.

Not surprisingly the government has defended its record of reducing debt, presiding over falling unemployment and reduced inequality as measured by a reduced Gini coefficient. However, there has only been a modest fall in the Gini coefficient, from 0.333 in 2009/10 to 0.315 in 2016/7, and this has largely been the result of the very rich seeing a decline in income from assets.

Articles
Britain’s economy is broken and failing to tackle inequality, says major new report Independent, Ben Chu (6/9/17)
UK’s economic model is broken, says Archbishop of Canterbury The Guardian, Phillip Inman (5/9/17)
Tax wealth or see the UK tear itself apart, Cable will warn Bloomberg, Alex Morales and Thomas Penny (6/9/17)
Archbishop of Canterbury calls for radical economic reform BBC News (5/9/17)
Archbishop warns economy is “broken” as report reveals longest period of wage stagnation for 150 years Huffington Post, Rachel Wearmouth (6/9/17)
Britain’s economy is broken. We desperately need new ideas The Guardian, Tom Kibasi (4/6/17)
Carney: Britain is in the ‘first lost decade since the 1860s’, Business Insider, Oscar Williams-Grut (6/12/16)
Our broken economy, in one simple chart New York Times, David Leonhardt (7/8/16)

Report
Time for Change: A new Vision for the British Economy IPPR Commission on Economic Justice (6/9/17)

Questions

  1. Why have wages for the majority of the UK population stagnated for the past 10 years?
  2. Why is productivity in the UK lower than in most other developed economies?
  3. Is it possible for poor people to become poorer and yet for the Gini coefficient to fall?
  4. What institutional reforms would you suggest to encourage greater investment?
  5. Explain the possible advantages and disadvantages of abandoning ‘austerity policy’ and adopting a more expansionist fiscal stance?
  6. Does it matter that Amazon and Google are dominant players in their respective markets? Explain.
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Oil prices – the ups and the downs

Oil prices are determined by demand and supply. Changes in oil prices are the result of shifts in demand and/or supply, with the size of the price change depending on the size of the shift and the price elasticity of demand and supply.

Some of the shifts are long term, with the price of oil varying from year to year or even moving in a particular direction for longer periods of time. Thus the opening up of new supplies, such as from fracking wells, can lead to a long-term fall in oil prices, while agreements by, say, OPEC to curb output can lead to a long-term rise in prices (see the blogs The oil see-saw, OPEC deal pushes up oil prices and An oil glut).

Medium and long-term price movements can also reflect medium and long-term changes in demand, such as a recession – oil prices fell dramatically as the world economy slid into recession in 2008/9 and then recovered as the global economy recovered.

Another long-term factor is the development of substitutes, such as renewable energy, which can reduce the demand for oil; another is developments that economise on power, such as more fuel-efficient vehicles and machines.

But oil prices do not just reflect these long-term movements in demand and supply. They also reflect daily and weekly movements as demand and supply respond to global and national events.

Two such events occurred at the end of August/beginning of September this year. The first was Hurricane Harvey. Even though it was downgraded to a tropical storm as it made landfall across the coast of the Gulf of Mexico, it dumped massive amounts of rain on southern Texas and Louisiana. This disrupted oil drilling and refining, shutting down a quarter of the entire US refining capacity. The initial effect was a surge in US oil prices in late August as oil production in much of Texas shut down and a rise in petrol prices as supplies from refineries fell.

Then prices fell back again in early September as production and refining resumed and as it became apparent that there had been less damage to oil infrastructure than initially feared. Also the USA tapped into some of its strategic oil reserves to make up for the shortfall in supply.

Then in early September, the North Koreans tested a hydrogen bomb – much larger than the previous atom bombs it had tested. This prompted fears of US retaliation and heightened tensions in the region. As the Reuters article states:

That put downward pressure on crude as traders moved money out of oil – seen as high-risk markets – into gold futures, traditionally viewed as a safe haven for investors. Spot gold prices rose for a third day, gaining 0.9 per cent on Monday

Quite large daily movements in oil prices are not uncommon as traders respond to such events. A major determinant of short-term demand is expectations, and nervousness about events can put substantial downward pressure on oil prices if it is felt that there could be a downward effect on the global economy – or substantial upward pressure if it is felt that supplies might be disrupted. Often markets over-correct, with prices moving back again as the situation becomes clearer and as nervousness subsides.

Articles
U.S. crude edges higher, gasoline tumbles after Harvey Reuters, Libby George (4/9/17)
Global oil prices fall after North Korea nuclear weapon test Independent, Henning Gloystein (4/9/17)
Brent crude oil falls after North Korea nuclear test The Indian Express (4/9/17)
Oil prices remain volatile AzerNews, Sara Israfilbayova (4/7/17)

Questions

  1. What are the determinants of the price elasticity of demand for oil?
  2. Search news articles to find some other examples of short-term movements in oil prices as markets responded to some political or natural event.
  3. Why do markets often over-correct?
  4. Explain the long-term oil price movements over the past 10 years.
  5. Why is gold seen as a ‘safe haven’?
  6. If refineries buy oil from oil producers, what would determine the net effect on oil prices of a decline in oil production and a decline in demand for oil by the refineries?
  7. What role does speculation play in determining oil prices? Explain how such speculation could (a) reduce price volatility; (b) increase price volatility. Under what circumstances is (b) more likely than (a)?
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Collusion between German car makers

The car industry has featured heavily in the news in recent weeks with the announcement of plans to ban the sale of new petrol and diesel cars in the UK from 2040. Around the same time, news broke that the European Commission had commenced an investigation into potential collusive behaviour between German car makers.

Since the investigation is ongoing, it is not yet clear exactly what the firms are accused of. However, allegations first published in German magazine Der Spiegel claim that since at least the mid 1990s Volkswagen (and subsidiaries Porsche and Audi), Daimler (owner of Mercedes-Benz) and BMW met several times a year. Furthermore, it is alleged the meetings aimed to give the firms an advantage over overseas rivals by:

co-ordinating the development of their vehicles, costs, suppliers and markets for many years, at least since the Nineties, to the present day.

In particular, Der Spiegel claims that the cartel limited the size of the tanks that manufacturers install in cars to hold chemicals that reduce diesel emissions. Smaller tanks then left more room for the car’s sound system.

Limiting the size of these tanks should be seen in the context of the 2015 emissions scandal where it became clear that Volkswagen had programmed its cars to limit the use of these chemicals and cheated in emissions tests. This meant that 11 million cars worldwide produced excess emissions. Whilst other manufacturers have suggested that the cars they produced may also produce excess emissions, Volkswagen has so far been the only firm to admit to breaking the rules so explicitly. However, if the allegations in Der Spiegel turn out to be true, there will be clear evidence that the harm caused was widespread and that illegal communication between firms played a key role in facilitating this. If found guilty, substantial fines will be imposed by the European Commission and several of the firms have already announced plans to put in place measures to reduce emissions.

It is not clear how the competition authorities discovered the cartel. However, it has been suggested that incriminating documents were uncovered during a raid of Volkswagen’s offices as part of an investigation into a separate steel cartel. It seems that Volkswagen and Daimler are now cooperating with the investigation, presumably hoping to reduce the penalties they could face. It has also been reported that Daimler’s role in the investigation will have serious implications for future cooperation with BMW, including a project to develop charging sites for electric cars. It will be extremely interesting to see what the investigation uncovers and what the future ramifications for the car industry are.

Articles
European officials probe claims of huge German car cartel CNN Money, Mark Thompson (23/7/17)
Automotive corruption: German manufacturer collusion could spell bankruptcy Shout out UK, Christopher Sharp (4/8/17)
Germany’s auto industry is built on collusion Bloomberg, Leonid Bershidsky (31/7/17)
BMW reassured top staff about cartel allegations: sources Reuters, Edward Taylor (4/8/17)

Questions

  1. What are the consequences of the coordination between German car makers likely to have been for consumers? What about for rival car manufacturers?
  2. Are there circumstances in which coordination between car makers might be beneficial for society?
  3. How do you think the German car industry will be affected by these allegations going forward?
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Ten years on

Ten years ago (on 9 August 2007), the French bank BNP Paribas sparked international concern when it admitted that it didn’t know what many of its investments in the US sub-prime property market were worth and froze three of its hedge funds. This kicked off the financial crisis and the beginning of the credit crunch.

In September 2007 there was a run on the Northern Rock bank in the UK, forcing the Bank of England to provide emergency funding. Northern Rock was eventually nationalised in February 2008. In July 2008, the US financial authorities had to provide emergency assistance to America’s two largest mortgage lenders, Fannie Mae and Freddie Mac.

Then in September 2008, the financial crisis really took hold. The US bank, Lehman Brothers, filed for bankruptcy, sending shock waves around the global economy. In the UK, Lloyds TSB announced that it was taking over the UK’s largest mortgage lender, Halifax Bank Of Scotland (HBOS), after a run on HBOS shares.

Later in the month, Fortis, the huge Belgian banking, finance and insurance company, was partly nationalised to prevent its bankruptcy. Also the UK government was forced to take control of mortgage-lender, Bradford & Bingley’s, mortgages and loans, with the rest of the business sold to Santander.

Early in October 2008, trading was suspended in the main Icelandic banks. Later in the month, the UK government announced a £37 billion rescue package for Royal Bank of Scotland (RBS), Lloyds TSB and HBOS. Then in November it partially nationalised RBS by taking a 58% share in the bank. Meanwhile various other rescue packages and emergency loans to the banking sector were taking place in other parts of the world. See here for a timeline of the financial crisis.

So, ten years on from the start of the crisis, have the lessons of the crisis been learnt. Could a similar crisis occur again?

The following articles look at this question and the answers are mixed.

On the positive side, banks are much more highly capitalised than they were ten years ago. Moves by the Basel Committee on Banking Supervision in its Basel III regulatory framework have ensured that banks are much more highly capitalised and operate with higher levels of liquidity. What is more, banks are generally more cautious about investing in highly complex and risky collateralised assets.

On the negative side, increased flexibility in labour markets, although helping to keep unemployment down, has allowed a huge squeeze on real wages as austerity measures have dampened the economy. What is more, household debt is rising to possibly unsustainable levels. Over the past year, unsecured debt (e.g. personal loans and credit card debt) have risen by 10% and yet (nominal) household incomes have risen by only 1.5%. While record low interest rates make such loans relatively affordable, when interest rates do eventually start to rise, this could put a huge strain on household finances. But if households start to rein in their borrowing, this would put downward pressure on aggregate demand and jeopardise economic growth.

Articles
The crisis: 10 years in three chart BBC News, Simon Jack (9/8/17)
Darling: ‘Alarm bells ringing’ for UK economy BBC News (9/8/17)
Alistair Darling warns against ‘complacency’ 10 years on from financial crisis The Telegraph (9/8/17)
A decade after the financial crisis consumers are still worried Independent, Kate Hughes (9/8/17)
Bankers still do not understand complex reasons behind financial crash, senior politician warns Independent, Ashley Cowburn (9/8/17)
We let the 2007 financial crisis go to waste The Guardian, Torsten Bell (9/8/17)
Bank of England warns of complacency over big rise in personal debt The Guardian, Larry Elliott (24/7/17)
On the 10th anniversary of the global financial meltdown, here’s what’s changed USA Today, Kim Hjelmgaard (8/8/17)
Financial crisis: Ten years ago today the tremors started Irish Times (9/8/17)
If We Are Racing to the Pre-Crisis Bubble, Here Are 12 Charts To Watch Bloomberg, Sid Verma (9/8/17)

Videos
The financial crisis ten years ago to the day Euronews (9/8/17)
Ten years later: What really sparked the financial crisis Sky News, Adam Parsons (9/8/17)
Bank of England warns on household debt Channel 4 News, Siobhan Kennedy (25/7/17)

Questions

  1. Explain what are meant by ‘collateralised debt obligations (CDOs)’.
  2. What part did CDOs play in the financial crisis of 2007–8?
  3. In what ways is the current financial situation similar to that in 2007–8?
  4. In what ways is it different?
  5. Explain the Basel III banking regulations.
  6. To what extent has the Bank of England exceeded the minimum Basel III requirements?
  7. Explain what is meant by ‘stress testing’ the banks? Does this ensure that there can never be a repeat of the financial crisis?
  8. Why is it desirable for central banks eventually to raise interest rates to a level of around 2–3%? Why might it be difficult for central banks to do that?
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