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Uncertainty is the Friend of Delay
Regarding global warming and what to do about it, Brad DeLong approvingly paraphrases Tyler, "uncertainty is not the friend of doing nothing." Bearing in mind the obvious dangers of contradicting both Brad and Tyler let me counter with "uncertainty is the friend of delay."
If you are faced with two environments one of which has outcomes somewhere between -10 to 10 and the other somewhere between -100 to 100 then I agree that the greater uncertainty of the latter provides no necessary reason for doing less relative to the former.
Suppose, however, that we are uncertain about which environment we are in but the uncertainty will resolve over time. In this case, there is a strong argument for delay. The argument comes from option pricing theory applied to real options. A potential decision is like an option, making the decision is like exercising the option. Uncertainty raises the value of any option which means that the more uncertainty the more we should hold on to the option, i.e. not exercise or delay our decision.
Imagine, for example, that there are 100 doors before us. We can enter any door but once we enter it will be costly to exit. If we don't decide then over time we learn a little bit about what is behind each door. If our uncertainty to begin with is small, we know that behind each door is more or less the same thing, then learning has little value and we should decide now (assuming some modest cost to waiting). But if our uncertainty is large then learning has a lot of value and we should delay our decision until some of our uncertainty has been resolved.
Applying the theory to global warming isn't easy because our decisions involve many options and exit costs but if we think that our knowledge of the extent, cost, cause and solutions to global warming are increasing at a faster rate than the danger of global warming then delay of any major decision is a rational policy at the present time.
Posted by Alex Tabarrok on January 1, 2007 at 07:21 AM in Economics | Permalink
Comments
I see the difference between us as such: you write: "making the decision is like exercising the option...". But many costly decisions *increase* option value. Such decisions include more R&D, more savings, a compensation fund, investment in greater economic flexibility and response capabilities, and so on. Anything we do counts as a "decision," so we cannot postpone decisions per se. We can and should postpone relatively irrevocable decisions, and under that heading "consumption" is a prime candidate. The correct implication of your argument is that when uncertainty increases, we should (under some specific conditions outlined in my post) consume less, which is close to my point of view.
Posted by: Tyler Cowen at Jan 1, 2007 8:30:15 AM
I'm not sure that this generalization holds. The result that options shouldn't be exercised early is for call options that are either held by risk neutral investors or (equivalently) can be hedged to eliminate risk. E.g., if you are a risk averse Google employee with $100MM in unhedgeable employee options but no other assets, it is optimal for you to exercise most of your options.
The economic difficulty of global warming is precisely that we are not risk neutral. Most people are highly risk averse, especially when considering uninsurable catastrophic losses. Thus, the risk neutral results may be misleading. And that's not to mention that some of the global warming policy options may have dividends and put-like features, which make exercise optimal even for a risk neutral investor.
Posted by: DK at Jan 1, 2007 8:33:40 AM
I agree on the difficulty in applying option theory to global warming policy. There’s a myriad options with varying cost/lead-time trade-offs. The uncertainties are considerable, have many dimensions, and the flow of information to resolve them is stochastic. But option theory doesn’t always argue for delay. If your doctor said there was a chance you had a flesh-eating bacterial infection that would take several days for the tests to resolve, would you delay or accept treatment? It’s a no-brainer if the treatment was just taking a bottle of antibiotics, but if your arm is turning red immediate hospitalization for intravenous antibiotics might be the optimum strategy. Acting now can preserve options going forward. At a simple level for communication, an insurance framing of the problem works better for me.
Posted by: Victor at Jan 1, 2007 8:45:33 AM
Tyler, saving and investing are as irrevocable decisions as consuming. My decision not to travel to Paris and instead save the money and the carbon emissions is irrevocable. Afterwards I cannot go back in time and change that decision. My forgone enjoyment of Paris is lost forever. Traveling to Paris some time later is not a perfect substitute - it can be better or it can be worse but it will certainly be different.
Labeling the decisions you disagree with as "relatively irrevocable" is just a device to scare your opponents.
Posted by: Bioopolitical at Jan 1, 2007 1:25:51 PM
I second the objection that what to do about global warming is not irrevocable. Your argument supports a 5 year plan with sunset clauses not choosing the option (doing nothing is taking an option here) of doing nothing for the next five years.
Posted by: logicnazi at Jan 1, 2007 1:37:11 PM
Victor's point is well-taken.
Alex's argument seems to ignore the fact that some of our "real options" expire while we wait for more information. Indeed, the information we get may well be, "Your option has just expired."
Another way of saying this is that delay in exercising an option may affect the environment we find ourselves in. The price of an underlying security is independent of whether we exercise our call. In the case of policy options this is not necessarily, or even probably, so.
Posted by: Bernard Yomtov at Jan 1, 2007 2:07:25 PM
I too agree with Victor. Part of what's uncertain concerns how much non-linearity there is in climate change. If there is a lot of positive feedback in the warming process, then the flesh-eating bacterium analogy fits really well.
Posted by: Bill Gardner at Jan 1, 2007 6:00:07 PM
Tabarrok makes an excellent point. It is not really true that our options “expire”. They only become slightly more expensive, but certainly worth the wait since the probability that the global warming scare is exaggerated is large.
What people seem to miss is that the interesting debate is not about the cause of global warming, but the effects. Even the most pessimistic the UN climate panel envisioned are manageable, if costly. The most likely scenarios are barely even costly (nett).
After all, 1 foot of ocean rising over 100 years and slightly more variable weather will not end human civilization, whatever Al Gore thinks.
For example, the most common “worst case” scenario, that the Gulf Stream would weaken (the basis of the movie “Day After Tomorrow”) has recently lost probability.
http://www.sciencemag.org/cgi/content/full/314/5802/1064a
Waiting and learning is valuable, when you don’t exactly know what you are dealing with. The answer to Knightian uncertainly is not assuming extremes, but search for information.
Posted by: Tino at Jan 2, 2007 2:59:19 AM
Even greater than the uncertainty of the global warming threat is the uncertainty in the threat posed by a potentially quite corrupt international bureaucracy with the power to regulate our most basic industries into obliviion.
As uncertain as our global warming science may be, an even more important learning task is reducing our genuinely vast uncertainty -- political ideologues of any stripe with their pat solutions notwithstanding -- of how to solve it without creating problems far worse still.
Posted by: nick at Jan 2, 2007 3:26:58 AM
This thread cuts right to the heart of risk managment. How do you respond to a grave but unlikely risk?
One of the more interesting ideas I've ever run across results from your response to this question: What odds do you need to risk your entire net worth on a coin flip? That is, what payout will compell you to risk your net worth on a 50-50 chance? For most people the payout required to bet their entire net worth is quite high, and at somepoint for every person, no payout will sway them to bet everything they own. For Bill Gates, there are no odds that would sway him to risk his fortune on a coin flip.
The reason I bring this up is the risk from global warming relates to the risk of ruin. If you haven't traded or gambled professionally, you may not know this concept. What is your risk of going broke if you continue to use your current betting strategy, given your trading environment? This is not the same as traditional decision making strategy, because the outcome is 100% negative and must be avoided at a high degree of certainty. Ask John Henry about this concept, he has mastered it. "Risk not thy whole wad" is poster worthy pithyness, but in regards to this problem, it is very relevant.
If you are not familar with the term "expectancy", you should look it up. If you don't know what the "kelly criterion" is you should look it up. These concepts are far more useful than outright maximization of returns, which appears to be for most people the only way to evaluate a range of outcomes. When traders bet with the idea of return maximization, rather than the avoidance of going bust, they go bust. Most libertiarians use return maximization as the only criteria for evaluation of an economic "strategy".
If we are wrong about global warming, we end modern civilization within my childrens lifetime. This is the risk of ruin. Many people will not risk their entire net worth on a coin flip for even 20 to 1 payout.
We are short options in the usual sense of option, not long them. We don't have the right of exercize, we will be obligated to be exercized against our will. We are collecting small amounts of current benefits against the massive in consequence but small in probability of being wrong, much like a short put strategy on the S&P 500.
When you factor in that most remediation strategies for global warming will provide increases in the quality of life for many people around the planet, it becomes pretty clear that we should be taking action now.
Posted by: mickslam at Jan 2, 2007 10:44:21 AM
It is not really true that our options “expire”. They only become slightly more expensive, but certainly worth the wait since the probability that the global warming scare is exaggerated is large.
Once something irreversible happens, our option to take steps to prevent it has indeed expired.
Even if the strike price of our options merely increase, there is no basis for assuming that the increase will be slight.
Your analysis hinges on your belief that the scare is likely exaggerated. But this is more or less irrelevant to the point. The question is what to do in the face of uncertainty. If you know what the stock price is going to be it's not hard to figure out what to do with an option.
Posted by: Bernard Yomtov at Jan 2, 2007 8:03:54 PM
Mickslam - perfectly said.
Since the global consesus with the Scientific community is not "if" it is occuring but rather the "rate" in which it is occuring. Taking action now is ultimately cheaper sooner than later (refer to the value of fiat currency in history).
But then again... maybe a clean slate is needed ;)
Posted by: feareddevil at Jan 3, 2007 7:13:50 AM
Mickslam you said
"If we are wrong about global warming, we end modern civilization within my childrens lifetime." -
Where did you get that idea from? Using the Stern report's numbers, which presumably are the latest view, the expected reduction in global GDP is 5% in the business as usual case, i.e. if we do nothing. They mention a downside case which (in my view) takes in some dodgy arguments on the value of social disruptions. Bit let's use their numbers, I quote below:
"Putting these three additional factors together would increase the total cost of BAU climate change to the equivalent of around a 20% reduction in current per-capita consumption, now and forever. Distributional judgements, a concern with living standards beyond those elements reflected in GDP,and modern approaches to uncertainty all suggest that the appropriate estimate of damages may well lie in the upper part of the range 5 – 20%."
Now given that average world GDP growth is around 3% (although recently it has been higher than that) we are talking about a worst case loss of 6 or 7 years world growth, bad but not disastrous. Remember that those future people experience this loss are going to be a lot richer than us anyway. In other words the worst case is that your great-grandchildren instead of being 19.2 times richer than you in 100 years will only be 16 times richer - not really a big problem I would guess.
I would think that, given the limited downside, the benefits of waiting to see if it is a real problem are very strong.
Posted by: ChrisA at Jan 3, 2007 8:52:11 AM
ChrisA,
The analysis you provide is exactly the style of analysis that is not relevant to the issues of global warming and environemental changes. Planning for the most likely scenario isn't relavant simply because the worst case scenario is so bad, much like losing all of you money is extremely bad for traders. Note this part of the statement statement:
"a concern with living standards beyond those elements reflected in GDP,and modern approaches to uncertainty all suggest that the appropriate estimate of damages may well lie in the upper part of the range 5 – 20%."
Additionally, several times in the report is states the impacts may be larger than 20%, and says the estimates provided are simply the most likely.
I don't know what you think a 20-30% reduction in the world GDP means to you, but this is a decade of completely flat growth across the entire planet. Additionally, it would probably dislocate many 10s of millions, turning them into refugees. This closely resembles conditions that would spawn a truly global war.
Posted by: mickslam at Jan 3, 2007 10:30:03 AM
"this is a decade of completely flat growth across the entire planet"
Japan had a decade of flat growth and made it OK...
Perhaps if the poor countries of the world just economically liberated themselves, they could grow to a point where they could handle global warming.
Since these countries can't even seem to manage the political will to do this, how are they going to get the political will to limit CO2 and methane emissions?
Posted by: Mr. Econotarian at Jan 3, 2007 12:13:11 PM
Mickslam
You state that my analysis is not relevant - can you say why? I was trying to deal directly with your point about not betting more than we can afford. The analysis good enough for the British Government in the Stern report. On the report, it seemed from my reading that they were actually using a 5% reduction as their estimate this is the quote -
"Using an Integrated Assessment Model, and with due caution about the ability to model, we
estimate the total cost of BAU climate change over the next two centuries to equate to an
average reduction in global per-capita consumption of 5%, at a minimum, now and forever."
A 20% reduction in global GDP was the extreme suggested by Stern (and I quote from your own post) - "appropriate estimate of damages may well lie in the upper part of the range 5 – 20%". That 20% has been arrived at by including "non-market" effects, and increasing (a bit arbitarily) the amount by 25% because the impact is primarily on poor countries. So most of the 20% would not show up in official records of GDP.
You ask what would a decade of flat growth mean (actually, assuming a 3% GDP growth factor, 20% is only 6 years of lost growth not 10 and 3% is conservative, world growth is currently around 4 to 5%). Likely the effects would be manifest over many decades, so the world will actually experience this as a 2.8% versus 3% growth factor. And if there is a really strong link between slow global growth and wars (doubtful), then we had better hurry up and enact global free trade leglislation. There the science is settled, see China if you doubt this.
Posted by: ChrisA at Jan 3, 2007 12:50:31 PM
"Japan had a decade of flat growth and made it OK..." With the rest of the world operating normally.
ChrisA,
I answered why your analysis is not relevant in my first post. Risk of ruin based analysis, not most likely scenario or best outcome style analysis, is the correct method by which to evaluate this particular situation. Note that our most successful traders (Warren Buffet, John Henry, George Soros), essentially our most successful capitalists, have used this style of analysis to generate massive long term profits. It is a superior style of analysis for situations where there is the chance of catastrophic loss.
If you are buying a car, use best outcome or most likely scenario analysis. If you are wrong, bad outcomes will only set you back a little. If you are betting your childrens life, use risk of ruin style. If you are betting your net worth, use risk of ruin style analysis.
I've seen few situations where the acutal worst case scenario that actually happens is that imagined by economists. Usually, they are wildly off and what happens has little relationship to what was predicted. For example, what happened in Russia after the fall was far worse than predicted. Today, it is a country run by mobsters who kill people they don't like and imprision enemies and take their assets. Mobsters weren't part of the economic prediction - the free markets were supposed to sort all of that out. This was a smooth transition, almost bloodless, but the life expectancy of Russians went down by about roughly years.
Posted by: mickslam at Jan 3, 2007 1:49:34 PM
Mickslam
I understood your argument to use the Value At Risk (VAR) approach to global warming and was trying to give you what I thought the Stern's report view on the worst case downside was (20%).
Your original post suggested that the worst case was the end of civilisation, a 20% or even 30% reduction in future global GDP at least one order of magnatude higher than the current one is not the same as the end of civilisation.
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