We know the weather reports are wrong

We have an innate desire to know what will happen. It can manifest itself in the form of very practical questions related to technology and applications of physics and biology, like "if I sharpen this stick, and throw it at one of those mammoths, can I feed my family with it?" Questions can be strategic in nature, like "if I invade Persia with my legions, will I win?" Big questions at the moment include "if we continue to pour carbon into the atmosphere at current rates, are we doomed?" and "if we increase our commitment of troops in Iraq, will we be reelected?" The path to answers has ranged from the scientific method to scapulimancy, computer simulation of prototype machinery, eminent study group reports, the I Ching, consultation of sacred texts or oracles, business forecasts, and climate change models. At one level, all of these represent a genuine effort, given beliefs and available technology, to discern the future. Depending on your cultural predispositions, some of these methods are preferred to others. For those that belong to the tribe of Aristotle and Bacon, the drive to understand has led us to a combination of formulating theories about cause and effect, and confronting them with experiment and mathematics.

In an uncertain world, what is the role of scenario or policy studies? I include here macroeconomic forecasts, as well as climate change models and the recent hybrid of the two -- studies of the economic consequences of climate change.

An important example now in play at the monent is the Stern Report. The report offers us a synthesis and interpretation of available climate and economic simulation modeling. There has been heated discussion in editorials and blogs (see the RealClimate blog) about the quality of these estimates. If the report is correct, then inaction in the face of rising levels of global warming and greenhouse gasses implies very high opportunity costs relative to the alternative path of corrective behavior. If it is wrong, corrective action can be a costly mistake.

What is the function of an inherently political report on economic and climate forecasts? For that matter, what is the function of the broader family of forecast and simulation-based policy studies? At one level, they are certainly meant to quantify the issues at hand. Viewed in this way, it really is important that the numbers be right. If we are going to make decisions, we want accurate forecasts. This seems to be the spirit behind much of the critical economic discussion (dissection?) of the Stern Report. Did we get interest rates (i.e. the discount rate for future costs and benefits) correct? (Jane Galt offers a good discussion of the discount rate issue). Are underlying assumptions about the trajectory of technical change correct? (See "Running the rule over Stern's numbers," BBC). Is opportunity cost calculated correctly?

This discussion and criticism is important, especially if the purpose of the forecasting study really is to accurately forecast. Indeed, from this starting point, the criticism of the Stern Report has been quite harsh. Richard Tol, from Carnegie Mellon University, is quoted by BBC4 saying "There is a whole range of very basic economics mistakes that somebody who claims to be a Professor of Economics simply should not make...Stern consistently picks the most pessimistic for every choice that one can make. He overestimates through cherry-picking, he double counts particularly the risks and he underestimates what development and adaptation will do to impacts." These criticims are from people who believe climate change is happening, and that something needs to be done. At one level, the criticims are valid. However, I think many of the critics have missed the point of the study. The purpose the study is not really to get an accurate prediction of exact economic costs 30 years from now. Rather, the purpose of the report is to serve as a focal point for discussion, and to provide a broad sense of alternative directions and magnitudes. It is a policy study, and hence by definition is something of a straw man. The discussion it fosters will most certainly discard many of the premises of the study, and will move in directions not covered in the original forecasts and estimates. This is ok. The role of policy studies (even when the economics are sloppy) is to serve as starting points for discussion by creating a structured, rational inventory of our uncertainties. The Stern Report creates a space for constructive argument. Arguably, reports by oracles and high priests have served a similar purpose in the past. In this sense, they are all important and useful, even if wrong.

To illustrate the point, I am going to quote Kenneth Arrow out of context. In a very personal, worldview discussion of uncertainty and the hopelessness of accurately modeling what will happen in the real world of markets, Arrow offers the following anecdote from World War II:

''Some of my colleagues had the responsibility of preparing long-range weather forecasts, i.e., for the following month. The statisticians among us subjected these forecasts to verificiation and found they differed in no way from chance. The forecasters themselves were convinced and requested that the forecasts be discontinued. The reply read approximately like this: ' The Commanding General is well aware that the forecasts are no good. However, he needs them for planning purposes.' '' ^[*]

Arrow's point is that, at one level, the weather reports really were useless because they were wrong. Yet he then goes on to say that "Accuracy of prediction is a desirable aim, but it is not the only aim of economic theory. As in meteorology, understanding is possible, desirable, and useful even when predictability is very limited." Like CGE studies of trade policy, finance ministry and Congressional Budget Office budget forecasts, and military plans, we know the precise estimates in the Stern Report will prove wrong. This does not preclude their usefulness for policy debate.

We stress accuracy and statistical robustness when we teach econometrics and modeling. We also get bogged down in debate on the merits of observation vs. simulation. Maybe, in paying attention to the accuracy of the art, we sometimes lose sight of its purpose. Accuracy is not the only important function of forecasting and numerical modeling. It may also be to create space for constructive argument. We need policy studies for planning purposes.

Further reading:

1. The Stern Report.
2. The BBC4 report, "Running the rule over Stern's numbers".
3. "BBC Finds Stern Report Wanting", (The Volokh Conspiracy)
4. Robert Mendelsohn's "A Critique of the Stern Report"
5. The RealClimate blog.
6. Jane Galt's discussion on the discount rate issue.

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^[*] K. Arrow (1992), "I Know a Hawk From a Handsaw," in M. Szenberg, editor, Emminent Economists: Their Life Philosophies, Cambridge University Press.

ECON 101 -- Opportunity Costs (a transatlantic tale of guns and butter)

In introductory economics classes, one of the first basic concepts we cover is opportunity cost. Wikipedia defines opportunity cost as "the cost of something in terms of an opportunity forgone (and the benefits that could be received from that opportunity), or the most valuable forgone alternative (or highest-valued option forgone), i.e. the second best alternative." This definition is ok as far as it goes. The challenge in the classroom is to find examples that students can easily grasp. In older U.S. textbooks, the long shadow of the Vietnam War meant that the example was typically guns and butter. Another classic student examples is "pizza and beer." To update these examples, I offer here both a European and U.S. spin on the concept, based on things the typical undergraduate has probably heard about through the European and North American news services. My modest hope is that, with examples like this, students might better understand the opportunity costs of public policy and expenditures.

A U.S. example -- The Iraq War

The New York Times and International Herald Tribune recently published estimates that place the cost to the U.S. of the War in Iraq at approximately $1.2 trillion dollars. This offers, of course, a classic chance to ask "what if..." along the lines of the old Vietnam War era examples. I have done some price checking on a list of items -- NASA's manned Mars proposal, the price of Hummers, and the total value of income by U.S. State. Based on these, we can scale the $1.2 trillion spent as follows:

We could fund the proposed NASA manned and unmanned Mars program ($120 billion), and have enough money left over for 9 International Space Stations (with full funding of operating costs -- $120 billion each).

We could permanently colonize the moon ($50 billion) and Mars ($1 trillion.).

We could buy 44 million brand new H3 hummers. This is enough for 7 out of every 10 married couples in the United States. It is also enough for every adult in California, New York, and Texas.

We could buy everything, goods and services (i.e. state GSP), produced by the U.S. plains states (Iowa, Kansas, Minnesota, Missouri, Nebraska, North Dakota, South Dakota) and the New England states (Connecticut, Maine, Massachusetts, New Hampshire, Rhode Island, Vermont) for an entire year -- and throw it away.

We could by all the U.S. manufacturing output in all 50 states (cars, trucks, laptops, jetskis, microwave ovens, 747s, again based on state GSP) manufactured in the United States for an entire year -- and throw it away.

A European example -- The Common Agricultural Policy:

A more peaceful example of costs involves the EU's Common Agricultural Policy (the CAP). The European Commission spends roughly $65 billion (€50 billion) a year on subsidies to farmers. This has, naturally, been a highly controversial subject in European politics. Over a ten year horizon, the annual costs work out to only $650 billion. This is only half the projected cost of the Iraq War. Working within this budget, Europe could have done the following instead:

Colonize the moon ($50 billion) and split the cost with the U.S. to colonize Mars ($500 billion for half).

Buy the entire output of Denmark, Ireland, and Finland for one year (goods and services).

Buy all the outstanding shares in IBM ($120 billion), Boeing ($70 billion), Daimler-Chrylser ($63 billion), and General Electric ($392 billion), based on market valuation on 19 January 2007 (according to Forbes).

Increase gross domestic expenditure on R&D by 25% a year. This assumes EU27 GDP is $13.4 trillion, the CAP costs $65 billion a year. It also uses the official Eurostat estimate that total R&D spending in Europe is 1.84% of EU27 GDP.

Public policy involves tradeoffs, and this implies that to do some things, we use resources that might have been used to do something else. This holds as much for governments and countries (and humanity) as it does for individuals and households. This is an important lesson to keep in mind.

Deficits redux

A short follow-up on my earlier posting,Deficits and ... more deficits. The "reserved central bankers" in the U.S. are now using words like "frightening" and "crisis." What they said this week:

We now have Janet Yellen, the San Franciso Fed President, on the record saying the long-term budget picture ''frightens me... We'll be looking at budget deficits that will make us wish for the level that we have now...''

Federal Reserve Chairman Ben S. Bernanke said the U.S. government may face a ''fiscal crisis'' in the coming decades.

from Reuter's,''Federal Reserve Chairman Ben Bernanke on Thursday told U.S. lawmakers that a review of U.S. tax code would be a good idea. 'I think the conventional wisdom among economists is that tax cuts don't necessarily pay for themselves,' Bernanke told the Senate Budget Committee."

On top of this, it seems that U.S. investors may be catching on, and shifting their portfolios abroad. ''U.S. investors send their cash packing.''

Time for crazy ideas: part 1

Albert Einstein defined insanity as "doing the same thing over and over again and expecting different results." One gets the feeling, looking at the progress of multilateral trade negotiations in Geneva, that we are borderline crazy. There are two issues where this seems to be the case -- repeated negotiations circling around the same intractable issues. One set of intractrables involves the importance of agriculture to the overall success of the negotiations, and the other is the role of OECD tariff reductions in determining likely benefits to developing countries from the current set of negotiations at the World Trade Organization (WTO). In both areas, we keep repeating ourselves and expecting a different outcome. Maybe it is time for a change, or at least time to step back from these issues. I will focus on agriculture here, and on OECD tariff concessions in a later posting.

Agriculture has been a thorn in the side of the modern trading system since its inception. Following pressure from the United States in the 1950s, agriculture was largely cut out of the system of rules and disciplines defined by the predecessor to the WTO -- the GATT (General Agreement on Tariffs and Trade). Indeed, until the creation of the WTO at the conclusion of the Uruguay Round of trade negotiations, agriculture remained outside the system. Ironically, it was the EU that exploited these exclusions most, and the U.S. that later regretted their introduction. This exclusion was largely an intra-OECD issue, with high profile disputes between the U.S. and Europe ranging from broiler chickens in the 1960s to soybeans in the 1970s and 1980s. The developing countries did not participate actively in the GATT, and so until the Uruguay Round, launched in the 1980s, this remained largely a source of intra-OECD conflict.

The effort to bring agriculture into the GATT/WTO system almost caused the collapse of the Uruguay Round, as the French threatened to bring the whole temple down around them if the European system of agricultural protection and subsidies (the Common Agricultural Policy or CAP) was compromised by the negotiations. The solution, in the end, involved lying and obfuscation. Commitments were made that were not really commitments, and liberalization was implemented that was not really liberalization. Everyone declared victory and went home. The basic process involved converting non-tariff barriers (licenses, quotas, inspection delays, import bans...) into tariffs that were supposed to reflect the then current level of protection. In reality, in politically sensitive areas the rates set were far above the rates needed, and the process became known as "dirty tariffication." (A good place to start reading on dirty tariffication is here: "WTO: Uruguay Round Agreement on Agriculture".) Indeed, there were worries that the "liberalization" undertaken as part of the Uruguay Round Agreement on Agriculture (known in the land of trade-related acronyms as the URAA) would lead to less trade.

At the time, estimates of the benefits of the Uruguay Round were dominated by agricultural liberalization. I was at the GATT at the time, and agriculture was indeed a large part of our initial assessment of the projected benefits of a successful conclusion to the global trade round. In the end though, as we learned more and more about actual commitments in agriculture (agriculture negotiations had been somewhat secretive even with respect to the rest of the GATT negotiating bodies at the time), our estimates linked to agriculture were dramatically reduced and eventually dropped from the calculus, and in the end trade ministries were reduced to statements like: "we have set the groundwork for future liberalization in agriculture."

In the end, the Uruguay Round did have important implications for agricultural liberalization and developing countries. However, the mechanism was not what was anticipated. In recent years, the new dispute settlement body (the DSB) (the legal underpinnings of the WTO) has led to successful cases against the U.S. and EU (led by Brazil) on cotton and sugar. At the same time, under different dispute mechanisms in the WTO, developing Latin American countries recently won a high-profile case against the EU on bananas. The most difficult issues are being handled through the legal machinery in Geneva, and developing countries are even winning. As it turned out, none of this really hinged on the agriculture negotiations themselves. (A good place to read up on the state of play at the WTO in Geneva on development issues is the Bridges Weekly Digest.)

So where are we now? Not surprisingly, we are now, again, at an impasse. If one looks ahead though, it is not clear to me that we should be stuck here, or that this is even the right road to be on anyway. Maybe it is time to change tack completely. (Warning: for those vested in the last several years of policy negotiations and the supporting policy research industry, the next line may be disturbing.) Maybe we should ignore agriculture for now, drop it as a negotiating issue, and move on to other things in a more streamlined Doha Round. How can I say this? I offer three reasons.

The first reason relates to medium-term policy sustainability in the OECD. The current set of agricultural policies in the U.S. and EU is not sustainable. In the case of the EU, the combination of (i) aging populations and (ii) an Eastern Enlargement that has taken in poor, agricultural economies means that the CAP as we know it is doomed. The European Commission knows this, and EU Members have already launched on a policy reform process that recognizes that future agricultural policy will have to be very different (and much cheaper) if it is to survive the budget constraints brought on by aging populations, and the demands for structural funds from new members. The EU has made a commitment to reform (necessary regardless of how events unfold in Geneva), and we can expect the process to continue. So, why not just wait? We can probably get the same results we would from active negotiation. In the case of the U.S., the budget hole is now so deep, and the looming costs for Medicaid and Medicare with retiring baby boomers is so large, that large farm outlays are likely to be a victim of the storm of budget rationalization that will arrive with the next White House team. So again, why not just wait? We will get rationalization anyway, regardless of whether or not we push this through Geneva.

The second reason also relates to medium-term changes, only in the middle-income and rapidly developing low-income countries. India and China (aka 2.2 BILLION consumers) represent economies growing at 8% to 10% per year. At these rates, changes in consumer demand for foodstuffs will move rapidly toward more expensive (and more grain and soybean intensive) meats and processed food products. This will put rising pressure on food prices. Recent baseline projections from the OECD and FAO build in assumptions about ongoing technical change sufficient to neutralize these demand-side pressures on agricultural prices. Reading between the lines, these technical changes are needed to avoid projections of substantial food price increases. Technical change notwithstanding, it is hard to believe that prices will not rise. Rising prices will make it easier for the U.S. and EU to back off of price and income support programs for farmers, and indeed will change the South-South policy calculus as a wedge is driven between food importers and food exporters.

The third reason involves the toxic soup of oil -- economics, politics, terrorism, and security. A surprise victim of events has been agricultural commodity prices. For reasons that will not go away, the U.S. and EU are both pushing their respective biofuel industries. (The EU just announced a target to replace 10% of vehicle fossil fuel use with biofuels.) This follows Brazil, which has been relying for years on its sugar industry for the same reason. The result has been a surge in prices. In mid-December, the European food industry press was noting that prices had reached highs not seen for ten years. ("Cereal Prices at Highest Levels for a Decade") . The President of Mexico is now making promises to keep tortilla prices low, after price hikes for corn driven by U.S. biofuel demands. And in scenario analysis, the International Food Policy Institute (IFPRI) has projected that an “aggressive biofuel growth scenario shows dramatic increases in world prices for feedstock crops." In addition, "the strong price increases for root crops like cassava in the first aggressive scenario suggest that without the necessary productivity improvements, aggressive growth in biofuels could have adverse effects on well-being in regions like Sub-Saharan Africa, where a large proportion of cassava consumption is for food..." ("Bioenergy and Agriculture: Promises and Challenges"). If global security trends continue, and if the U.S. and EU are on a permanent bent to achieve energy security through renewable energy, then the rules of the game have been rewritten substantially. The poor should probably start worrying about rising food prices, rather than demanding them.

On net, it looks to me like agricultural prices will be rising anyway, and U.S. and EU agricultural support programs will be contracting anyway, whether or not we make a big push on these issues is Geneva. The real problem areas for the poorest producers (sugar, bananas, cotton) are being managed through the international court system. As for the rest, we are doing the same thing, and getting the same results. Maybe it is time to try something else.

Further reading:

A student blog spin on the Doha Round and Africa.

Kymberly Anne Alliot at the Center for Global Development on "Delivering on Doha: Why Agriculture Matters."

Another post, from Biopact, asserting that "Biofuels boom may make WTO accord possible, cut US farming subsidies". This link was supplied by an anonymous post -- thanks.

Arvind Panagariya "The tide of free trade will not float all boats."

My own quantitative paper arguing that South-South liberalization is key to the "development" component of the Doha Round."Trade liberalization in the Doha Development Round."