Depression analysis also applies to climate change

Last updated 16:26 19/05/2009

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The distinguished American jurist and scholar, Richard Posner, has just published A Failure of Capitalism. It is a commendably crisp and measured account of the depression into which we are descending (yes, he uses the "D" word without apology).

OPINION: Blame is apportioned. The risks we run in trying to dig our way out of the hole are elaborated.

Posner's root causes are relatively uncontroversial: cheap money and deregulation combined to permit a massive mispricing of risk. Most of the book is dedicated to examining how it was that warning signs - and one or two prescient doomsayers - were ignored.

At one level Posner's diagnosis is that for a time it became accepted wisdom that the world had changed - that the mismatch between asset values and economic fundamentals wasn't a mismatch because technology or some other factor had changed the rules of the game. A sort of "end of history" thesis for financial markets. And the people who should have been worried - macro-economists - had convinced themselves that the business of depression prevention had been solved, decades ago.

A common thread - familiar to Posner followers - is that there is no need to resort to theories of irrational greed or exuberance. The bubble in asset values was itself, he says, a rational response to the uncertainty about the possible effects of major innovations - just as it was in the 1920s.

And so was the unwillingness to accept that the world hadn't changed after all. Here are some of his reasons:

* Faced with uncertainty it is rational to fall back on preconceptions. They represent past knowledge which may be as good a guide as we have.

* Trying to get new information is costly and even if you do, why would you trust it if you can't test it empirically?

* "In the absence of empirical testing," says Posner, "preconceptions shaped by ideology will exert a mesmerising influence".

* "If you can't rely on information you have to make a 'shot in the dark' in which case the psychological traits of the decision-maker become important. Traders are risk takers and less risk-averse than most of us.

* "It is rational to ignore the indirect (and uncertain) consequences of one's business and consumption behaviour.

* "Denial is a familiar and psychologically appealing way of avoiding having to confront large difficulties.

* "Investors, advisers and (inside firms) employees are constrained by the conflict of pronouncing adversely on those who pay them."

The remarkable thing is the extent to which this analysis applies to another area of even greater uncertainty - climate change. Go back through the list. When it comes to preconceptions we haven't even got prior knowledge to base anything on. Nothing like this has happened before, so why should it now?

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As for information, we know far more about financial flows than atmospheric circulation so producing a robust cost benefit analysis of climate change poses an even more difficult challenge. True, we have the IPCC (Intergovernmental panel on climate change) - an attempt to gather and sift that information. But the cynicism with which sceptics greet the inevitable uncertainties suggests that Posner's stress on the role of ideology is alive and well here too.

Suspicion of taxpayer-funded science, the UN and the role of governments as regulators is rife in certain quarters. These are comforting prejudices to fall back on.

As for conflicts of interest, they couldn't be more obvious. Who is going to promote measures that will reduce the rents they can claim from fossil fuels or constrain their access to the atmosphere?

Addressing climate change should, as Sir Nicholas Stern, Ross Garnaut and others have tried to explain, be about taking out insurance against a potentially catastrophic risk. Time will tell whether we have monumentally mispriced this risk. By the time we know for sure it will be too late - and unlike financial depressions may be much harder to reverse.

Posner devotes a whole chapter to possible silver linings in the encroaching depression. Some of them apply to climate change too. He explicitly mentions reduced emissions and the retreat from conspicuous consumption. Of the recovery options being touted he seems favourably disposed to public works. In that case, some of the investment proposed for new energy technologies and energy efficiency make sense.

Remarkable similarities exist between the language of those who ponder how the unthinkable could have happened to the global economy and those who ponder how we may avert the unthinkable consequences of serious climatic disruption. An unwillingness to contemplate events of low probability but potentially catastrophic cost that are outside our experience pervades both fields.

As the Financial Times editorialised recently, "It does not help that our economic theories were constructed for a different world. Most models depict economies kept close to equilibrium by smooth adjustments. But we face a very real danger of large, abrupt changes." Change a very few words and you have the climate problem in spades.

- The Dominion Post

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