Questions About This Book?
- The New copy of this book will include any supplemental materials advertised. Please check the title of the book to determine if it should include any CDs, lab manuals, study guides, etc.
- The Used copy of this book is not guaranteed to inclue any supplemental materials. Typically, only the book itself is included.
- The Rental copy of this book is not guaranteed to include any supplemental materials. You may receive a brand new copy, but typically, only the book itself.
Table of Contents
“Wagner’s wry, witty prose brings rationality to an emotionally charged subject and urges us to take personal responsibility for the planet by demanding an economically sound solution to guiding market forces in the right direction, making it in our best interests to do the right thing.” —Publishers Weekly
“If you want to understand how an economist thinks about the biggest challenge our planet has ever stumbled up against, this book is an awfully good place to start!” —Bill McKibben, author of Eaarth: Making a Life on a Tough New Planet
CUE THE ECONOMISTS
Ask around what caused the financial crisis, and the answer, absent expletives, will be some version of “wrong incentives.” The road signs guiding market forces pointed in the wrong direction. Wall Street wasn’t doing what was in everyone’s best interests. What’s good for Goldman Sachs turned out not to be all that good for America.
Shift your focus on what ails the planet, and the answer will be very much the same. “Wrong incentives” are as important here as they were in the financial crisis. Replace “Goldman” with “Exxon,” and you have everyone’s favorite environmental villain. They ravage the planet for their own gains, without regard for anyone else around them. Greedy bastards.
There is something to this idea, as knee-jerk as it might be. By now, “privatizing profits and socializing losses” has its ownWikipediapage. On Wall Street, that translates into “too big to fail.” If my bets pay off, I will get the fat year-end bonus. If they don’t, I will be on a one-way (business-class) flight back from the craps table in Vegas, and everyone else—you, government, society—is left with cleaning up the mess. Heads I win, tails you lose; or, the dirty underside of capitalism for the masses, and the gentle safety net of socialism for the corporate echelons.
The environment is in the same situation, caused by the same misguided incentives. Exxon, BP, and the like rake in record profits while enjoying dubious tax loopholes and special subsidies.1 When an oil platform in the Gulf explodes and entire fishing grounds go belly-up, everyone faces the consequences. And that says nothing about global warming, where literally everyone—all seven billion of us—is affected, the poor and disenfranchised most of all.
The risk calculus that capitalism was supposed to force risk takers to make, it turned out, was a hoax. It became instead a one-way street where those who controlled the wealth stood to make the gains, and those who carried the liability side of the planet’s balance sheet were expected to clean up after them.
Waiting in the hope that corporate executives will be shamed or enlightened into giving up loopholes, forgoing subsidies, and turning corporations into charities is a fool’s game. Greed—capitalism—is not the problem, and vilifying any company that turns a profit is ludicrous. That’s its appointed purpose, and, like it or not, it’s the single most effective organizing principle of modern society. I am not saying capitalists are doing God’s work; they just work to feed their families and bank accounts, like the rest of us.
You and I are rich and can enjoy the pleasures of reading and writing books because of it. If you read this in any kind of electronic form, or aren’t afraid of losing loved ones to typhoid, cholera, or the plague, or have ever sat in a car, train, or plane, you will certainly appreciate the fact that capitalism didn’t stop its ascendancy around the time Gutenberg printed his first Bibles. We don’t want to stop market forces, even if we could. We want to work with—not against—them.
The solution is clear:put the right incentives in place. Or, if you care for more sophisticated academic parlance:internalize the externalities.
Measure how much damage each and every action does, put a dollar value on it, and set the appropriate price. Don’t like trillions of dollars being sent around the globe every day at the stroke of a button? Introduce financial transaction taxes.2 Don’t like treating the atmosphere like a free sewer? Put a price on carbon.
That’s a wrap, people. Two problems solved at once. Future financial crises averted; environmental crises gone. I’ll save myself the trouble of writing the rest of the book, and you can get back to worrying about whatever occupied you before the recession and an increasingly unstable planet crowded those worries out. We even save a few trees or iPad charges in the process. Win-win-win.
If only it were that simple.
POLITICAL ECONOMICS 101
In 1990, Congress, in its finite wisdom, capped total economic damage payments for any one offshore oil spill at $75 million.3 This despite the fact that no one in either chamber apparently knew what it meant to link these kinds of limits to ever-rising prices—a.k.a. inflation—or that $75 million wasn’t all that much even then. Worse, perhaps they all did and still voted for the final bill 99–0 in the Senate and 360–0 in the House. Talk about a slam dunk. When it comes to contradicting Economics 101, bipartisanship, apparently, is all the rage.
It’s not hard to concoct conspiracy theories on how Big Oil controls the political machine. Yes, politicians do what voters want them to do. If not, they get voted out of office. That would be Democracy 101. But vested interests clearly have a stake in the status quo, and it doesn’t get much bigger than Big Oil, which comprises some of the most profitable companies in history.
Surprise, political “leaders” aren’t always driven by deeply held convictions. Reaching the masses requires having a megaphone, and megaphones cost money. Lots of it. By now, U.S. national and even some state-level elections run in the hundreds of millions of dollars. Little wonder politicians say what big donors want them to say. Money speaks and votes. Politics 101.
During the 2008–10 congressional fight to enact a comprehensive climate law, Big Oil, King Coal, and climate deniers of all stripes spent around $500 million against sensible climate action, outspending environmental campaigners, renewable-energy interests, and the like to the tune of ten to one. Never mind that there is some reason to believe that even the United States may have a “climate majority.”4 Careful polling unearths three-quarters of Americans who say that the climate is changing and that humans are the cause of it. Over 85 percent say they want limits on how much air pollution businesses are allowed to emit. Still, recent poll results show clear trends toward increased polarization and politicization of century-old scientific facts. When Al Gore says global warming is happening, you no longer care what basic physics and chemistry say. You care about whether or not you would vote for Gore for other reasons. One key factor in all of this is money. Those who have it can sway the malleable masses. Those who don’t can’t. By the time the Senate all but killed climate legislation in the summer of 2010, dirty money had prevailed.
Amazingly, that’s not always the case. The same Congress that voted 99–0 and 360–0 to cap damages for offshore oil spills also voted 89–10 and 401–25 to cap sulfur dioxide pollutants that cause acid rain. That’s small potatoes compared with capping carbon dioxide emissions, but it has shown how unusual coalitions between environmental activists and business interests can form to pass a strong market-based law. More recently, in 2010, venture capitalists and others with stakes in a greener future outspent and out-campaigned opponents of a comprehensive climate bill in California to the tune of three to one. Thirty million dollars for keeping a climate bill on the books; $10 million to suspend it.5 In the end proponents of the bill prevailed. It’s not the first time that Sacramento showed Washington the way on environmental issues. Perhaps there’s some hope after all.
There are other ways to change minds. How about a global campaign to right the wrongs? Let’s put “Internalize Externalities” on bumper stickers. Stage teach-ins at the local parish. Organize the Million Internalizers March on Washington. I can see Madonna lining up for the London concert and Nepalese Sherpas spelling out those two all-important words on the dwindling snows of the Himalayas, in biodegradable paint. Activism 101.
That’s clearly a crucial component: raise awareness, start a movement. Convince everyone around you to eat locally grown food—slowly—and quickly plant a million trees in the Sahel. Concerts help, too. Madonna even wrote a new song for Live Earth in 2007. And we have seen Sherpas in action as well. A group of them joined thousands of others in holding up “350” signs all over the world as part of a campaign to limit greenhouse gas concentrations to 350 parts per million in the atmosphere, what’s required to stabilize the climate and stop sea levels from rising too far. (We are now at above 390 and counting.)
Activism is important—I’m in one of those “350” pictures—and lots of crucial things are happening on the ground: from American teens being miles ahead of their parents in their awareness of how they are changing the planet, to a new generation of Indian youth leaders realizing that environment and development ought to go hand in hand. There’s hope, lots of it. Sadly, we don’t have another decade or two until those young leaders come of age. And even once they do, and this is the crucial point, the solution will be very much the same as what we have on deck.
That answer is clear: get comfortable with the idea that we ought to be using markets and market forces, and use the very people—you, me, all of us—whose greed and everyday behavior got us into the mess in the first place to get us out of it. It’s time to substitute the right incentives for the wrong ones and set a new default path for the planet.
Sadly, we have known about this fundamental problem of misguided incentives at least since Madonna was dancing circles around her fellow third graders—and the problem didn’t just appear in obscure academic writings. Robert F. Kennedy lamented on March 18, 1968, in the first major speech of his presidential campaign, that gross domestic product “measures everything … except that which makes life worthwhile.”6
Consider the Christmas tree.
When I put on my water-repellent Birkenstock hiking boots and trudge through the snow to a Christmas tree farm to get my Norway spruce for the most idyllic of family fests, I pay the farmer for his trouble of growing the tree with organic fertilizers, keeping it pest-free without pesticides, and packing it in a biodegradable mesh bag. Mainly, though, I pay for the tree itself, the wood. I don’t pay for the roots’ sophisticated water filtration services, nor for the needles’ equally sophisticated system for cleansing the air. No one does.
These essential arboreal functions and the cleaner water and air they provide are worth a big fat zero in our corporate and societal balance sheets. Most trees only become valuable once dead. A standing tree may be valued for its future timber but little else. Put that tree forever beyond the saw of man, and its effective value in our official statistics falls to zero.
GDP is our main economic yardstick of how well we are doing as a society.7 It determines the fortunes of entire peoples, not least those of the people in power at any given time. Two consecutive quarters of declining GDP, and the bean counters at the National Bureau of Economic Research, the official scorekeepers of such things for the United States, declare a recession. Have that announcement coincide with the election cycle, and the president can start packing. Ask Gerald Ford, Jimmy Carter, or George H. W. Bush. Or ask John McCain why he thinks he didn’t make it into the White House in 2008.8
Long-term trends are even more important. When Hong Kong, Singapore, South Korea, and Taiwan—the Asian Tigers—roared into the global consumerism super-league within a few decades, GDP was the scorecard that put them there. China is now following suit in the most far-reaching transition ever.
It would be comforting to say that more GDP is always a good thing, and to a point that’s clearly the case. Living on a dollar a day is miserable no matter how you look at it.
But RFK had it exactly right. GDP reflects a lot of destructive and nonproductive activity, and all but ignores everything other than material wealth, money. The work of leaves and tree roots is just one such contribution left to the wayside. Indonesia’s GDP growth figures throughout the 1970s and 1980s would have been cut in half had the official number crunchers bothered to consider that extracting a tree trunk or a barrel of oil from the ground today means it’s no longer there for the taking tomorrow.9 The same recalculation could be done the world over, for Madoff-style, fairy-tale accounting has been the norm for a long time. It’s like running a business and reporting only your revenue, not the costs of raw materials. Now those costs are galloping forward, and it’s time to audit the books honestly.
If the game is to maximize GDP as currently constructed, protecting the planet is not in the cards. Every ton of coal taken out of West Virginia mines adds over $30 to GDP, but no one accounts for the fact that the ton is no longer in the ground. Imposing that simple act of honest bookkeeping would decrease the value to half, around $15.10 And that still doesn’t account for the larger human and environmental costs: black-lung disease in miners, destruction of ecosystems from mountaintop removal, coal sludge runoffs polluting rivers near mines, or the impacts on public health and the world’s climate of burning the coal.
Oil is just like coal: everything gets added, nothing subtracted. Every barrel of oil pumped out of the ground, whether it ends up in your gas tank or on our shorelines, increases GDP. The barrel that gets burned in your car adds to GDP because you pay for it at the pump. The barrel that washes up onshore adds to GDP because someone pays for the cleanup costs.
What’s true for countries is also true for companies. They gladly add gains from selling oil to their corporate balance sheets. The ensuing pollution is someone else’s problem. And you can’t blame Exxon’s management for making sure this is the case. They have to. It’s not just the nature of the game; it’s the law. Managers have fiduciary responsibilities to the company’s shareholders to maximize profits. The current road signs, as it were, all point them in that one direction. And without that incentive, capitalism as we know it could not function. If managers don’t manage in the interest of a company’s owners, the model of corporations will fall apart. If depleting natural resources comes at zero charge and the planet doesn’t count, exploiting it isn’t just good business. It’s the only business.
There are plenty of case studies of companies that do well by doing good. But that’s the point. These are case studies. Many others are hunkering down in their respective industries and going about doing business as usual. BP might want to claim it’s moving “beyond petroleum,” but a million rebranding campaigns can’t hide the fact that its core business is oil. The economy as a whole isn’t changing gears voluntarily.
* * *
Let’s look back to the financial sector for a particularly poignant example. In the lead-up to the latest economic crisis, everyone up and down the financial-sector food chain had been facing the wrong incentives, and in many instances they still are. Whether you are the poor mortgage broker reduced to cold-calling renters in graduate student housing (one tried to convince my wife and me in 2005 that we could afford to get a $400,000 interest-only mortgage: “You’re still in school now, but you are graduating soon, right?” “Well, yes, but she will be a medical resident, barely making enough to pay back her student loans.” “Oh, hmm, we can work something out”), whether you are a credit-rating agency hired by the issuer of an overly complicated financial instrument to rubber-stamp that it is indeed secure, or whether you are Chuck Prince, the CEO and chairman of what was once the world’s largest bank, in the end you are responding to the incentives presented to you. There were plenty of crooks and even more who checked their moral compasses at the door, but most were only following orders.
This is not the Nuremberg defense: I know my actions were illegal, but I was just following orders. Actually, it’s the opposite. The orders followed didn’t lead to illegal actions. Just as fiduciary responsibility compels Exxon managers to extract ever more oil, it also requires everyone in the finance sector to keep on dancing. Shortly before collecting his own $40 million golden parachute, Chuck Prince uttered his famous last words: “As long as the music is playing, you’ve got to get up and dance.” Emphasis on “you’ve got to.” And the fact that legislators had erased many of the existing checks and restrictions—those few road signs that had been pointing in different directions—only lit fire under Prince’s and other bankers’ feet.
Don’t vilify Prince. He had it right. Bankers ought to be dancing to the music. That’s what we are paying them for, and the task isn’t to stop them or to turn off the music entirely. Regulators need to make sure that everyone faces the full consequences of his or her actions. The goal may be to slow down the dance a bit, but mainly it’s to change the beat.
The same goes for environmental problems. No one wants entrepreneurs and businesses to stop dancing. Well, let me amend that. I’m sure there are some environmentalists who would rather have all business grind to a halt. That can’t be the goal, though. Explain to a poor Indian living on a dollar a day—who watches his infants die because of preventable diseases and poor sanitation—that now that we are rich and he is not, the world must stop all development for the sake of preserving unspoiled nature. Beyond being immoral, it is utopian to imagine it possible.
We know that there are strong forces compelling us to dance. But we also know that we can’t keep dancing the way we have been so far, not while the planet is burning. The big question is how to change the dance beat. Why now? And how quickly can we do it? Time to seek counsel from a higher power.
Sitting through one of Martin L. Weitzman’s lectures is a transformative experience. Not because he is the clearest and most organized lecturer. He isn’t, and he concedes as much. It’s because every once in a while Weitzman takes command of the blackboard and doesn’t stop writing for the next eighty minutes. A Wednesday in November 2005 was one of these days.
“Mathematically advanced.” Those are the first two words on the class syllabus. You bet. “I think he just derived a new theory,” said one puzzled student confiding his confusion to me. I know that spells trouble. As the teaching assistant, I had to take the math and translate it into (German-accented) English by the next day’s review class.
Weitzman is fond of saying that the best way to learn is a couple of No. 2 pencils, a blank notebook, and a few hours alone on a hard, wooden chair: “Make your own mistakes. It’s the only way you will learn.” The reason most students diligently come to the review even if they sometimes skip the actual lectures isn’t because they’ve taken him up on the suggestion. Most of the time they want translations, or better yet answers. That day they just wanted to understand what in the world had happened in class the day before.
Weitzman hadn’t derived a new theory. Not quite. He had presented results from his latest research, the culmination of several months of painstaking work, into a problem that has vexed economists for generations: Why don’t people invest more money in the stock market?
The answer, it turns out, has as much to do with stocks and the financial crisis that would haunt the world later that very decade as it does with the climate crisis facing our planet. The direct link between them: ten-foot women.
IT’S NOT OVER TILL THE FAT TAIL ZINGS
Weitzman showed impeccable timing in the lead-up to the financial crisis. While most everyone else was getting ready to ride the latest stock market bubble, he started worrying about a problem that has stumped economists for over two decades: the equity premium puzzle.
Equities, stocks in companies, seem to be paying premium returns to investors. If you invested $100 in stocks in an average year over the past several decades, you would, on average, have $107 a year later—a 7 percent return. Contrast that to the so-called risk-free rate of return of close to 1 percent. This is what investors get when they put their money in the investment equivalent of “under the mattress”: short-term Treasury bills backed by the U.S. government, (still) considered one of the safest investments in the world. The difference, the risk premium to make up for your sleepless nights fretting about the stock market, is 6 percent.
That’s reality. It also happens to be “real” in the economic sense of the word. That’s what’s left over after everything is said and done. Not a bad return on your money, if you can get it. It means your investments double once a decade.
Except economic theory doesn’t seem to agree. It says that under rather reasonable and widely used assumptions for U.S. economic growth (2 percent per year) and a somewhat opaque but well-established factor depicting the inclination of individuals to accept risk (commonly measured to equal 2 as well), the risk premium should be closer to 0.08 percent. If $100 invested the safest way imaginable gives you $101 next year, putting those $100 into stocks, says standard economics, should give you $101.08. That paltry 0.08 percent is almost a hundred times less than the 6 percent difference we see in the real world.
I would be lying if I said that I didn’t consider switching majors when I first heard about this “theoretical discrepancy” in college. Calling this failure of economic theory “embarrassing” is to put it mildly. I wasn’t expecting Newtonian physics–style accuracy, but this borders on the obscene. Economists nowadays use their craft to explain everything from cheating in sumo wrestling to primate mating patterns. What we do not seem to have a handle on is how the stock market works.
One interpretation of these results is that investors just don’t get it. They don’t put nearly enough money into stocks. Instead, they put their money under a mattress and lose out on reaping otherworldly returns in the stock market. Some kind of bias, myopia, or simple ignorance, the argument would run, is at work here. The former White House and World Bank chief economist Larry Summers, during his early days in academia, once began a draft paper with the line “There are idiots. Look around.”11
The solution? Let’s just tell the misguided masses about this finding. Or even better: keep it to yourself at first, and put all your money into stocks. Other people will realize the error of their ways soon enough. Investors will put more money into stocks, their risk premium will decline, and economic theory will turn out to be right after all. By then you will have made out like a bandit.
Not quite. This strategy of trying to game the market for your own benefit might work for an insignificant theoretic quirk here or there, but it will fail if the theory is supposed to describe most human investment behavior, about which we have data spanning decades and reflecting millions or billions of observations. There must be another reason why people don’t invest more in the stock market, something economic theory doesn’t quite capture, something every professor of financial economics and generations of graduate students have missed—the perfect setup for Weitzman.
Weitzman is known for his razor-sharp writing and his intellect, which towers above his students and many of his fellow economists, even at Harvard. In his first book,The Share Economy, written in 1984, he foreshadowed the rise in stock options and employee ownership models. He laid out how both could help fight stagflation, the dreaded combination of economic stagnation and high inflation, and break the link between employment and the business cycle. ANew York Timeseditorial hailed it as the “best idea since [John Maynard] Keynes.”12
Weitzman has never been one to shy away from controversial topics. He single-handedly developed an economic theory of biodiversity—which species to save when you can’t save them all, what he called the “Noah’s Ark Problem”—and worked on ways to measure sustainability and the relative worth of future generations. Now he had a different problem on his hands: fixing the way economists look at the stock market.
He had a hunch but not much more. Statisticians, investment analysts, economists, physicians, and many other members of the wonk set tend to look at the world and see “normal distributions.” Many everyday phenomena can be put neatly into this shape, not unlike a bell. Hence, the name “bell curve”: a fat body, and thin tails on either end.
Take height. The average American woman in her twenties is five feet four inches tall.13 Out of one hundred randomly chosen women, ninety will be between five feet and five feet eight inches, the large body of the bell. Really short or really tall women are rare. Only five of the hundred, on average, will be taller than five feet eight inches. Despite their preponderance on the runway, six-foot women are oddities, at least statistically. Only one woman in recorded medical history was taller than eight feet. Zeng Jinlian grew to 8 feet 1.75 inches before she died at the age of seventeen. No one, woman or man, ever grew to twice the average height.
Yet in other parts of life we do see ten-foot women. Stock market crashes are one example. On any given day, the stock market moves a couple of percentage points up or down. Sometimes it even jumps up 5 percent or down 5 percent. Large movements are rare, but unlike living, breathing ten-foot women, they are possible.
Such possibilities defy our powers of imagination, so, sadly, we tend to ignore them—as it turns out, at our peril. October 19, 1987, entered the history books as Black Monday when the Dow Jones Industrial Average crashed 22.6 percent in a single day. In the Black Week beginning with October 6, 2008, the Dow fell 18 percent—a weeklong runway of one unlikely creature after another. On May 6, 2010, the Dow lost almost a thousand points within minutes before it regained its footing and jumped back up.14 It shouldn’t happen. It must not happen. It does happen.
If, instead of women’s heights, we draw stock market movements on a piece of paper, the bodies of the bells become smaller. Their tails are thicker. Some of these tails are outright obese, “fat” in technical statistical jargon.15
Ten-foot women do not register on the radar of ordinary statistics and economics. They are anomalies, outliers, something to be ignored lest the analysis get too messy. “Statisticians have known about fat tails for a while,” Weitzman explains, “but we simply haven’t known how to deal with them. So we just assume them away.” That’s often an okay strategy. No model can explain reality fully. No map is a complete replica of the geographical area it tries to show. There are always some phenomena left unexplained. Trouble is, here the phenomena left out are crucial to the outcome. I can’t say I like the idea of ten-foot women. I am intimidated by them as much as the next guy, but we can’t just assume them away. As rare as they may be, ten-foot women rule the world.
So what’s a risk manager to do? Let’s imagine that he fully understands that he is ignoring ten-foot women at his peril. He has read Nassim Nicholas Taleb’sThe Black Swanand grasped its argument around surprises waiting at every turn, but even so he can’t just call all economic modelers ignorant dweebs. Taleb might get away with it, but the risk manager can’t. His boss demands advice based on real data, a model.
“You have to capture reality in a tractable model,” Weitzman likes to say. “Tractable” seems to be Weitzman’s favorite word. Too complicated, and the model won’t help anyone. Too simple, and you end up ignoring the details that really matter. Modeling is as much art as science, akin to mapmaking—and you always need to keep your audience in mind. A tourist in Paris needs a way to find the most direct path from the Louvre to the Arc de Triomphe with nods to Montmartre and Notre Dame, preferably with sights and street names in spellings he recognizes. The local plumber cares more about every side-street apartment address, and building maps with even more detail. Even the plumber’s map, though, requires abstractions. A city map capturingeverydetail would be an impressive feat. It would also be entirely useless.
Weitzman is a master modeler—part artist, part scientist—and is always looking for that sweet spot, the model in which theory no longer ignores reality and no one living in reality can afford to ignore the theory.
His next step was clear: move from reality back to theory and find a way to represent ten-foot women in an equation any risk manager can understand. Weitzman retreated to his seaside home and spent months poring over papers and textbooks—immersing himself in a parallel statistical universe, an alternative and underused way of looking at numbers: Bayesian statistics.
The Reverend Thomas Bayes first developed these ideas in eighteenth-century England, but others have managed to sideline them for the most part ever since. Ordinary statistics assumes that life operates like a card game. There are fifty-two cards in a deck. The only mystery is which of these cards you will draw next. Bayes figured life was more complicated. He argued that in addition to not knowing which card in the deck would come next, we didn’t know how many cards the deck had to begin with. That seems to be a fair assumption about life. There are “unknown unknowns,” as the former secretary of defense Donald Rumsfeld might say. Stuff happens.
Mainstream economics wanted little to do with Bayes for over two centuries. The formulas that arose from this kind of thinking weren’t nearly as elegant or easily taught as classical statistics. No kidding. Weitzman would emerge every once in a while to present some Bayesian insights at research seminars. When he did, the faces on most of the economists in those rooms looked as puzzled as his students’.
In the end, he wrote a paper that explained the full equity premium puzzle—and then some. It’s not that we can’t explain why stocks command a premium. Once we take these “unknown unknowns” seriously, “the puzzles even reverse.” As he tried to argue to the group of a dozen students attending his class with me, “It’s no longer a question of why people aren’t buying more stocks.” Now it’s a question of why, given the occasional ten-foot woman delivering a surprise, they are buying them at all. The models that economists have used for decades do not take into account the actual risks faced by consumers. They ignore ten-foot women. In Weitzman’s model, that’s no longer the case. Economic theory reflects these past crashes perfectly. Investors are now the ones who forget, as is indeed the case in reality. Consequently, the 6 percent risk premium may actually be too low given all the risks involved.
It took another two years and several revisions for Weitzman’s paper to make its way through the labyrinth that is the academic peer-review process. The final paper, modestly and just a tad cryptically titled “Subjective Expectations and Asset-Return Puzzles,” appeared not a moment too soon. It was published in the summer of 2007, at the same time that Bear Stearns became the first victim of the mortgage meltdown and the financial crisis slowly started to take shape.
This tends to be the moment when even the most hermit-like academic steps out of theory land and goes to the airwaves, explaining how his insights could have saved the global financial system. Or at least he starts to rake in lucrative consulting and speaking fees for brief appearances in high-powered boardrooms and at corporate retreats. Four Seasons Jackson Hole, anyone? Successful consulting firms have been founded on much less of an insight.
Weitzman, however, was never one to preach to the masses or to rest on his intellectual laurels. He soon moved on to a much bigger target: the climate crisis.
A PLANETARY GAMBLE
Only it wasn’t much of a move. It doesn’t take much to shift gears from the financial to the climate crisis. It’s the same problem, and as it turns out, it has a similar solution. Protect yourself against ten-foot women. It’s the extreme events that define the outcome.
Weitzman owns a home barely above sea level near Gloucester, Massachusetts, a beautiful little fishing town just under an hour north of Boston. I might be a bit biased; I proposed to my wife there. The place is any nature lover’s dream. Weitzman certainly is one of them. He is also an avid gardener who apparently requires quite a bit of fertilizer. He landed a mention in a Jay Leno monologue after being charged with stealing a truckload of manure from a horse farmer near his home in 2005, on April 1, his birthday. Weitzman pleaded not guilty at the time and has since settled the case, although he maintains that he had permission to take the manure. Some of his friends and colleagues have had their fair share of fun with it. One colleague sent him an e-mail saying, “Congratulations. Most economists I know are net exporters of horse shit. And you are, it seems, a net importer.”
Global warming is not simply a topic of personal interest for Weitzman; it’s “one of the largest intellectual challenges” of his, and indeed our, lifetime. He certainly treats it as such. In classic Weitzman fashion, he spent months reading through stacks of scientific reports and dove into the atmospheric science and assorted other literature to reevaluate firsthand some of the conclusions found by the Intergovernmental Panel on Climate Change, the authoritative scientific body usually given the last word on all things climate.
The fun paid off. He has since written a handful of papers applying insights from his work on stock markets to climate change and draws the clearest parallel yet between the two.16 Once again, it’s the ten-foot women that matter most. It’s Bayes’s deck-of-cards problem—when you draw the next card, you don’t know how large the deck is. It’s Rumsfeld’s “unknown unknowns”—the unforeseen events that derailed the U.S.-led occupation of Iraq. It’s Nassim Nicholas Taleb’s “black swan”—unimaginable for someone who has only ever seen white ones. It’s a Frenchman’s “c’est la vie,” Forrest Gump’s box of chocolates. Put all of the above together in a way statisticians can understand and you get “fat tails.”
If nothing were done to limit greenhouse gas emissions into the atmosphere, expected average effects would be bad enough. The current IPCC consensus view says that global average temperatures would rise by another 3.5°F to 7°F by the end of the century, on top of the roughly 2-degree rise since we humans started to burn up fossil fuels at the beginning of the Industrial Revolution. (The IPCC, of course, speaks in centigrade. That makes 2°C to 4°C of warming on top of the 1°C since the Industrial Revolution.)
A rise of 3.5 to 7°F and the Greenland ice sheet would be in real danger; the West Antarctic ice sheet would begin to melt. The two combined hold enough water to raise global sea levels by forty feet. Of course, we don’t know exactly when they are going to melt. It may already be too late to save either. We may still have time to reverse course. We do know that they will melt, if we don’t change course. Moreover, that’s the average effect, and it does not yet include increased extreme weather events from droughts and famines on one end to more intense hurricanes, typhoons, and monsoons on the other, to say nothing of large-scale species extinction or the disappearance of coral reefs.
It’s impossible to emphasize this enough:not if, when. If we don’t change course, these things will happen, and some are already happening.
* * *
Still with me? If not, I’ll blame it on what psychologists gallantly describe as “cognitive dissonance.”17 It’s akin to shutting out bad news when that news doesn’t correspond to the accepted hypothesis in one’s brain. We are pumping billions of tons of greenhouse gas pollution into the atmosphere each year, and every scientist worth his or her Ph.D. tells us that these gases trap heat. But look, it’s snowing! How can the planet possibly be getting warmer? That click in your brain was your cognitive dissonance kicking in. (Never mind that, scientifically, more snow in winter is what we should see with a more unstable climate.)
There is a lot to this psychological phenomenon, but let’s first stick close to the underlying climate science and Weitzman’s take on it. There is more bad news: 3.5°F to 7°F is the average in two senses of the word. It’s the expected warming around the globe. Some parts of the planet will warm by less, and might even become cooler. Others will warm more. The poles with their surrounding ice sheets are particularly prone to greater-than-average warming—not a good sign for your beachfront property, or for much of human civilization, for that matter.
Worse, 3.5°F to 7°F is average in another sense: it’s the range of temperature increases across six different scenarios commissioned by the IPCC. Each of these scenarios comes with uncertainties. The range for the most optimistic scenario with the 3.5°F average is 2°F to 5.5°F. The range for the most pessimistic scenario is 3.5°F to 11°F. So really, we are in for “likely” warming somewhere between 2°F and 11°F. With 2°F, things may turn out to be fine after all; 11°F would be catastrophic. The British science writer and centigrade afficionado Mark Lynas’sSix Degreespainstakingly lists climate impacts degree centigrade by degree centigrade. He ends with 6°C (11°F). Any increase beyond that is an unknownnightmareland, and 11°F itself isn’t all that comforting. Lynas’s first citation in that chapter: Dante’sInfernoand the sixth circle of hell.
So far, recorded trends have not been very encouraging. The growth rate in emissions over the past two decades has been greater than the worst-case scenario modeled by the IPCC. That puts us a lot closer to 11°F than to 2°F. And none of what we have done so far takes into account the vaunted ten-foot women.
Climate science is a messy business. In the end, we care about temperature changes, sea-level rise, and the many other direct and indirect effects. Consequences like sea-level rise are a function of temperature. Temperature changes, in turn, are a function of the concentration of greenhouse gases in the atmosphere. Concentrations are a function of emissions. Every one of these steps has uncertainties surrounding it. Things vary, sometimes a lot.
We are reasonably sure about the connection between emissions and concentrations, although even there we can only talk about ranges, not exact links. (One big unknown is sinks, the amount of carbon that gets sucked out of the air through natural sources like forests and uptake by oceans.)
A much larger uncertainty surrounds “climate sensitivity,” the step between concentrations and temperatures. It’s the crucial link between tiny amounts of carbon dioxide—an odorless, colorless gas humans can’t detect—and what we read off a thermometer every day, what we can all feel: temperatures.
Carbon dioxide is measured in ppm, short for “parts per million.” One ppm is about the equivalent of one drop of water in a thirteen-gallon tank. Before 1750, the concentration of carbon dioxide in the atmosphere was 280 such drops in the tank, or 280 ppm. By now we are at 390, and things are pointing up to 450, 550, and beyond. Climate sensitivity is shorthand for what happens to temperatures when concentrations double.
The range of possibilities is disconcerting. The IPCC’s latest comprehensive review, itsFourth Assessment Report, lists twenty-two recent attempts to measure climate sensitivity. Taken together, these studies say that a grand planetary experiment of doubling carbon dioxide concentrations could yield higher temperatures anywhere between 3.5°F and 8°F with a best guess of about 5.5°F. That’s what the IPCC calls the “likely” range for climate sensitivity, what would happen roughly two-thirds of the time.
If we had a hundred planets at our disposal and could run this experiment of doubling carbon dioxide concentrations on each of them, sixty-seven would have temperature increases of between 3.5°F and 8°F. What happens on the other thirty-three, on the tails of this bell curve? That’s where we are back in the wondrous and disconcerting world of fat tails, black swans, ten-foot women, and other scary creatures.
Weitzman has calculated the chance of extreme climate sensitivity, the thickness of these tails, and has come up with disturbing results: the IPCC’s tails, much like the financial-sector models that got us into so much trouble, are too thin.
The IPCC’s own interpretation of the numbers says that there is a 5 percent chance of a doubling of carbon dioxide concentrations leading to temperature changes of greater than 12.5°F and a 1 percent chance of climate sensitivity greater than 18°F—the difference between a balmy 72°F spring day and a 90°F scorcher.
Weitzman looks at the same data and concludes that the IPCC cut off its tails too quickly: “I did my own calculations. I ran it by at least fifteen geophysicists—from the poor assistant professor at Harvard, who I cornered, to world-class scientists.” If you consider all uncertainties and don’t disregard extreme events, the results are more like a 5 percent chance of warming greater than 18°F and a 1 percent chance of warming greater than 36°F. Five out of a hundred planets would see temperatures rise 18°F by the end of the century at the rate we are spewing out pollution right now. Life as we know it would already be very different with warming of 2°F, 3°F, or 5°F. With 10°F or 18°F, we might want to pack up now and look for another planet.
We might as well do that before it’s too late. Weitzman’s latest draft paper focuses on 21.5°F (or 12°C, if you are keeping score in centigrade):
For me, [21.5°F] is iconic because of a recent study, which estimated that global average temperature increases of [around 20–21.5°F] would cause conditions under which more than half of today’s human population would be living in places where, at least once a year, there would be periods when death from heat stress would likely ensue after about six hours of exposure.
Full disclosure: my name is in the acknowledgments of Weitzman’s latest paper, but I had nothing to do with that passage, except for pointing out that his first draft included it twice. That may not have been such a bad thing. The authors of the original study add a dry warning: “This likely overestimates what could practically be tolerated: Our limit applies to a person out of the sun, in gale-force winds, doused with water, wearing no clothing, and not working.”18
Six hours on a planet like that would lead to death, if you are wet, naked, out of the sun, being buffeted by “gale-force winds,” resting, and presumably otherwise healthy. If not, you might die sooner. That paper is brought to you by the throwaway rumor rag commonly found in every supermarket checkout lane: theProceedings of the National Academy of Sciences. Per Weitzman, following his analysis of IPCC data, there is almost a 5 percent chance that we will be on a planet like this. Welcome to the planetary edition of Russian roulette.
* * *
We don’t have to wait until this nightmare scenario before we see the life-changing effects of an unstable and increasingly warming climate. Some of the earliest studies of climate change and agriculture have concluded that warmer climates may actually be beneficial. But don’t give out that sigh of relief quite yet: beneficial up to a point, and not for long at that. Again, theProceedings of the National Academy of Sciences:
We find that yields increase with temperature up to [84°F] for corn, [86°F] for soybeans, and [89.5°F] for cotton but that temperatures above these thresholds are very harmful … Holding current growing regions fixed, area-weighted average yields are predicted to decrease by 30–46% before the end of the century under the slowest (B1) warming scenario and decrease by 63–82% under the most rapid warming scenario (A1FI) under the Hadley III model.19
Translated into English, entirely without exclamation marks and other emphases added: holy cannoli.
The production of some of our most fundamental agricultural staples—corn, soy, and cotton—will decrease by between a third and a half by the end of this century per this analysis, and that’s under the best possible scenario, which no one believes any longer will, in fact, happen. The most rapid warming scenarios, which by now are already conservative, show decreased production by two-thirds or more.
Full effects go much beyond food production alone. Our society is well-adjusted to current climates. Increase temperatures and tempers flare. Drivers honk more on hotter days. In general, productivity goes down as heat goes up, and the overall effect may be even larger for those in office buildings than for growing food outdoors. The latest study looking at effects in the Caribbean finds that as temperatures rise, productivity drops more than twenty times faster off the farm than on it.20
Remember my quick reference to “cognitive dissonance,” which allows us to forget all of this at the sight of the first snowfall? I wish I could taste some of that right about now. This is the world we are heading toward at full speed.
* * *
It comes down to a simple insurance question. There’s a small chance that everything will be fine and that Weitzman, the IPCC, Al Gore, insert-your-climate-change-Cassandra-here, and I are wasting your time. But, sadly, there’s a much better chance that things will not be all that pleasant—the wide body of the bell curve. And on the opposite end of the curve, there’s a chance that even nude, in the shade, stationary, and whipped by gale-force winds, we won’t make it.
Amazingly, we’ve been here before. One recent headline: “Death Toll Exceeded 70,000 in Europe During the Summer of 2003.”21 Slowly, the lines between supermarket-checkout-lane publication and scientific journal begin to blur. The tally of dead Europeans, sadly, comes from the latter.
Acting now to prevent an even greater death toll is the prudent thing to do. It’s the rational thing to do. In many ways, it’s the only option we’ve got. The gods were even kind enough to give us a parallel lesson in our failure to deal with risk during the latest financial crisis and ensuing multitrillion-dollar morass: Don’t be in denial about your fat tails. Put them on a diet. Stop feeding the beast.
The solution is still the same—right the wrong incentives, internalize externalities, privatize the socialized costs—and the case now is stronger than ever. We better nudge ourselves in the right direction, or await the nudging—more like a beating—from the ten-foot women.
I encouraged Weitzman to make the case in his paper a bit stronger. Academic clarity isn’t enough here. We need a cri de coeur, a clarion call, and it would be good if it came from someone like him. His response: “I am reluctant to pound home the message even harder. I’ve learned the hard way over many years that if you have a good case, it speaks best for itself.”22
Sadly, a good case all too often doesn’t speak for itself. We wouldn’t be where we are today if it weren’t for the fact that we, as a society, have systematically chosen not to listen to the best science and to take appropriate action. We can always wait for more scientific results to come in. We can always hope that Weitzman, the authors of the “heat stress” study, the ones looking at crop failures, the ones reviewing the 2003 European heat wave, and lots and lots of others are proven wrong. Perhaps there’s a first-grade math error somewhere, and one of these studies is overstating things by a factor of a thousand. It happens to the best. One or the other individual study may well be proven wrong in subsequent research. But wishing all are simply wrong, or wishing all of them away, is not a strategy.
TOLD YOU SO
Weitzman was not the first to point out the importance of fat tails and extreme events—far from it.23 To get to the bottom of this question, we need to take the ten-minute walk from Littauer 313 to Littauer 312. One is in the Littauer Center, which houses the economics department; the other is in the eponymous building at the Harvard Kennedy School of Government. Same Littauer, entirely different vibe.
Littauer 312 has been Richard J. Zeckhauser’s office for as long as anyone at the Kennedy School can remember. He used to have a joint appointment in the economics department, but he is not one smitten by extraneous titles (nor the extra teaching and advising requirements): “It got to be a real pain to handle the logistics of it and the paperwork.” That’s just as well. He clearly fits in better at a place that teaches and values practical thinking over mathematical prowess.
Practical does not mean nonrigorous, and he has elevated logical reasoning to an art form. Zeckhauser won the mixed-pairs contest at the 2007 North American Bridge Championships forty-one years after winning the U.S. pairs title. In between he wrote some 250 economics papers, with no sign of slowing down. He collaborates on most of his papers and is not shy to admit that he defers to his coauthors for formalizing equations as well as mundane number crunching. Zeckhauser provides the ideas.
One idea that has been a constant throughout his research is that uncertainty matters. Zeckhauser goes one step further and talks about risk, uncertainty, and ignorance. Risk is the deck of fifty-two cards. Uncertainty is not knowing the number of cards or how many decks are in play. That’s Bayesian statistical land, which Weitzman has mastered to the joy of mathematically minded economists everywhere. Ignorance is when all math goes out the window. No one knows the possible outcomes or how likely they would be.
Nassim Nicholas Taleb obsesses about these types of situations inBlack Swan. He accuses anyone conflating real-world situations with games of chance of committing a “ludic fallacy,” from Latinludus, “play.” Case in point: the highest-impact losses faced by casinos do not occur on the card tables à laBringing Down the House. They occur much closer toOcean’s Elevenfashion: when an angry contractor tries to blow up the building, when the owner’s daughter gets kidnapped, or when the star performer Roy Horn of Siegfried & Roy gets maimed by one of the team’s signature white tigers. That last tragedy cost the Mirage $100 million, more than any legitimate gambler had ever cost the casino or likely ever will.
Zeckhauser disagrees with Taleb about the value of games. Real-world contract bridge, by Zeckhauser’s reasoning, is somewhere between uncertainty and ignorance. There are fifty-two cards, and “it is a game with clearly laid-out rules. But there are also four players and too many possible scenarios for anyone to compute sensibly in an actual game situation.” That’s particularly true at 2:00 a.m. after dozens of rounds spent trying to interpret your own and your partner’s hands, those of your opponents, all of their faces, body cues, and everything else that might give a clue as to what is going on. Smarts help. So does the ability to make decisions in the face of unknown and unknowable situations. No wonder Bill Gates and Warren Buffett excel at bridge, or at least enjoy playing it.
Zeckhauser, in turn, is eager to dole out advice to would-be investors and practices what he preaches. He doesn’t shy from talking about his investments. His own, apparently wildly successful real estate investment venture has been returning 23 percent on its—his—money per year. “During the height of the crisis, it only returned 14 percent.” Not bad for a year when virtually everyone else lost money.
His article “Investing in the Unknown and Unknowable” stands out for both its timeliness and its timelessness: it’s the uncertainty, stupid. There is little to be gained through mathematical sophistry—“when your math whiz finance Ph.D. tells you that he and his peers have been hired to work in the XYZ field, the spectacular returns in XYZ field have probably vanished forever”—and much more by analyzing politics, balancing inherently uncertain outcomes, looking for the right partners, and constantly being on the lookout for new opportunities. That’s where the big bucks are, in the realm of the “triple U”: unknown, unknowable, and unique.
Some forms of insurance look like the U trifecta. Zeckhauser tells the tale of the California Earthquake Authority trying to buy reinsurance for catastrophic losses back in 1996. The Authority provides insurance to Californians. That may well be a fool’s game: the bigger the earthquake, the more needed the insurance; but a really big earthquake may bankrupt the insurance itself. The obvious solution is to spread the risk even more widely. Not many earthquakes affect both California and New York simultaneously, and if they did, we’d have bigger problems anyway. So the California Earthquake Authority decided to reinsure the insurance it provides.
Reinsurance is a big business. Munich Re and Swiss Re are among the largest insurance companies in the world. In this case, though, neither of them bit. And some of the most sophisticated financiers—loaded with finance Ph.D.’s and heavy on risk-modeling wizardry—took a pass as well.
None other than the bridge enthusiast Warren Buffett jumped in and bought the entire lot. He took the opportunity to justify his decision to go into the reinsurance business in the 1996 Berkshire Hathaway annual report: “We don’t know—nor do we think computer models will help us, since we believe the precision they project is a chimera. In fact, such models can lull decision-makers into a false sense of security and thereby increase their chances of making a really huge mistake.”24
Buffett goes a step further than most would dare to go in their annual reports: “We’ve already seen such debacles in both insurance and investments. Witness ‘portfolio insurance,’ whose destructive effects in the 1987 market crash led one wag to observe that it was the computers that should have been jumping out of windows.”
It didn’t take long for Buffett’s warning to come true once again. The year 1998 saw the spectacular implosion of Long-Term Capital Management, which lost billions over the course of a few months and required a government-engineered $3.6 billion bailout to avoid taking down the wider financial system.25
Remember when $3.6 billion was a big number?
More important, remember what happened after? Neither do I. That’s because nothing much happened. We all went back to business, and then some. The LTCM bailout might have required emergency meetings of top bankers and some arm-twisting by the New York Fed. The damage was contained, LTCM died, a few were left with scars, and the wild-and-crazy overleveraged, underregulated ride continued and picked up significant speed. We spent the following decade building many more potential LTCMs. Regulators missed the boat completely.
In 1999, the Federal Reserve chairman, Alan Greenspan, warned that large financial institutions created the potential for “unusually large systemic risks”—code for taking down the entire financial system. Greenspan ten years later: “Regrettably, we did little to address the problem.” Regrettable, indeed. In the latest crisis, $3.6 billion is a rounding error. Global bailouts and government guarantees from 2007 through 2009 add up to between $3 trillion and $13 trillion, depending on who’s counting what.26 Europe added another $1 trillion in 2010, when everyone already thought the storm had passed.
Never mind the sums, these kinds of financial bailouts are at least possible. We might be throwing good money after bad, but it’s all money. Bailing out the planet is in a different league altogether. For starters, bankruptcy—declaring it quits and beginning from scratch—is not an option.
* * *
I attended M. Scott Taylor’s keynote address at the annual meeting of the European Association of Environmental and Resource Economists in Amsterdam. Taylor is a star theoretical economist, with the uncanny Weitzman-like ability of turning simple English statements into math. As far as these conferences go, the title was as sexy as can be: “Environmental Crises: Past, Present, and Future.” Taylor began with the demise of Easter Island, made famous by the Pulitzer winner Jared Diamond in his bestsellingCollapse. Easter Island is home to hundreds of giant stone figures,moai. It’s no longer home to many trees. Destruction of the local environment led to dramatic climate changes and several near-total collapses of Easter Island’s population.
The most vexing question of this story has always been, who cut down the last tree? Somebody must have seen how devastating that would be. Where were Easter Island’s tree huggers chaining themselves to the last tree, the last five, or fifty?
Diamond shows in English, and Taylor in math, that by the time the last tree was standing, the island’s ecology had been pushed well beyond its tipping point of certain demise. Little could have been done once the forces leading to the eventual collapse had been set in motion. No human would have had to cut down the last remaining trees. By that point nature was capable of felling them all by itself.
The problem with tipping points is that they come unannounced. And on Easter Island, once that point was reached, there was no time or reason to found the Easter Island Conservationist Society. By then it was too late.
It doesn’t take much to connect the dots to climate. There are three ingredients: tipping points, strong feedback, and weak governance. Climate change, Taylor argued in carefully couched academic language, had all three. Plus there’s the “potential precipitating event” of rapidly rising greenhouse gas pollution. Does he think a climate crisis is “likely”? “No, I don’t. But then again, no crisis ever is.” Cold comfort. It isn’t “likely” that your house is going to burn down next year or that you will get into a car crash. Still, most home owners insure themselves against fires, and law often mandates car insurance. Weitzman’s one-in-twenty chance of certain death isn’t exactly “likely,” either, that’s true. His own home is on the seashore. But it’s hard to conclude it’s a planetary game of chance worth playing.
I sat next to Michael Toman during Taylor’s talk. Little of what Taylor had to say was news to him. He manages the World Bank’s energy and environment team in its Development Research Group and spends his professional life worrying about an unstable climate. He spent a good part of the speech hunched over his laptop, finishing up some last edits on a paper he had been co-authoring with Zeckhauser. The title makes clear where they stand: “Responding to Threats of Climate Change Mega-catastrophes.” Plural. Not “if,” but “when” and “how.”
In the broadest sense, most think of two types of responses to catastrophic climate change: mitigation, climatespeak for reducing pollution that is causing the problem in the first place; and adaptation, rolling with the punches and adjusting to live with rising temperatures, rising sea levels, and extreme events.
This paper added a third: geoengineering, messing with the planet’s thermostat in ways other than addressing the direct cause.27 That’s how far we have come. Some of the same scientists who first warned about global warming twenty or more years ago are now cooking up schemes to hack the planet: mimic volcanoes and pump dust into the upper atmosphere, create artificial clouds, or deliberately change the environment in other ways to counteract the havoc that burning fossil fuels has been and still is creating. David Keith, a respected climate scientist, colleague of Taylor’s at the University of Calgary, and one of the leading geoengineers, calls it “chemotherapy” for the planet. “You are repulsed? Good. No one should like it. It’s a terrible option.” Another similarly fitting term would be “planetary tracheostomy.” Sadly, if we can’t get our obscene levels of pollution under control soon, it may still be better than letting the planet fry by itself.
I would add a fourth category: suffering. The rich will adapt. The poor will suffer. The ultimate policy question is which combination of the four we will choose, or, more likely, which combination will be forced on us given our reluctance to act on mitigating the problem to begin with.
Before you try to digest all of this and wish you could simply dismiss it instead, remind yourself once again of our very natural human tendency to do just that. You don’t even have to be thinking about snowfall to want to disavow any knowledge of an increasingly warming planet. Almost anything sounds better than thinking about a planetary-scale catastrophe—and the thought of ten-foot women marching through your dreams doesn’t help.
Call it “cognitive dissonance,” “cognitive dismissal,” call it what you will. By far the most simple, economically rational, laboratory-tested psychological response is to just do nothing. Time to stare nothing in the face.
Copyright © 2011 by Gernot Wagner