04 August, 2011

Ideas have consequences

Especially economic ideas. For example, what we assume about discounting the future--whatever we assume--likely leads to error. It does, however, clothe our assumptions in the image of "science."

Mark Buchanan - Bloomberg:
Pretend, for example, that we want to see if it is worth creating a costly marine sanctuary that could take many years to establish and even longer to effectively protect a population of endangered salmon or cod. The costs of the sanctuary come mainly in the first years -- the expense of setting it up and policing it, as well as perhaps millions of dollars a year in lost fishing revenue. The most important benefits, on the other hand, may come in the distant future. Even if the fish population might increase 100-fold, creating a sustainable fishing industry 500 years from now that is far more valuable than today’s, economists would discount the advantages coming in those distant years almost to nothing.

[But]...Geanakoplos and Farmer find that the correct formulas for discounting over long periods don’t follow the textbook exponential form. The math is tricky (I’ve put some discussion of the technical stuff on my blog. But the consequences are not. Using a standard model from finance for interest rate movements (with an average rate of 4 percent), the authors show that, for the first 100 years or so, their correct form of discounting gives results that are similar to those that come from traditional calculations. But at 500 years the standard exponential discounts the future not just a little too strongly, but a million times too strongly. And it gets worse after that.
Going back to the example of the marine sanctuary, and using the Geanakoplos-Farmer formula, you find that the present value of benefits 500 years from now gets multiplied millions of times compared with the standard analysis. A thriving marine ecosystem in the future, linked with a much larger fishing industry, might well be worth investing in today.
In effect, today’s standard economic methods make the distant future count for almost nothing. And those who always thought this seemed hopelessly na├»ve turn out to be right.

We really need new ways to think about economics.   Several people are trying to create them, but these people not only have serious methodological problems to overcome--there are entrenched interests  that profit from keeping our indicators and analysis techniques as they are.

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