Anticipating the Irrational

I have always argued with the neoclassical economists over the power of 'rational expectations', mainly because I don't think most human beings act according to rational impulses most of the time. For those who are not well versed in economics jargon, rational expectations theory suggests that many players in the economy - employees, employers, politicians, consumers, and so on - are making informed guesses about what will happen in the future and base their current behaviour on this.

An example might be somebody deciding not to put their house on the market because they think prices are likely to rise next year. Or employees demanding wage rises because they expect prices to rise, or accepting lower wages because they expect prices to fall. Clearly, there is a lot of politics at play here, since a media which manipulates public opinion may - if the rational choice theorists are correct - influence their demands in the free-for-all that is the capitalist conflict over economic value.

But what I notice at present is how those in the private and public sectors are behaving quite differently in an economic crisis. Now that unpleasant material is flying in all directions from the metaphorical fan, the private sector players - who are there because they are comfortable with risk - are exercising the utmost political pressure to gain advantage for themselves, primarily by refusing to play the game of fair shares (continuing to claim their bonuses) and scaring and bullying the government into subsidising this.

Meanwhile, those in the public sector - who are there because they are risk-averse - are anticipating cuts and radically reducing costs in preparation for cuts that haven't arrived yet. Thus in my university we are preparing to cut expenditure by 15% over the next three years, although no figures are available for investment in universities for next year. In other words our apparently 'rational' behaviour is itself causing a significant shrinkage of the economy, and guaranteeing an extension of the Recession, making it likely it will turn into a self-reinforcing negative spiral.

Perhaps this is unsurprising. Those who came with the theories about rational expectations were themselves academics. They live in a world of brainy, cautious, forward-looking types and they have simply modelled the world they know. It now becomes clear what deeply irrational behaviour this can generate.

Rational expectations grew from one basic assumption: people behave selfishly. This assumption is in itself self-reinforcing, since is is hard to behave with generosity and grace when everybody else is scrabbling for the fastest buck, and harder still when the prevailing ideology tells you that this is irrational behaviour.

University planners may feel more comfortable that we public-sector employees cut our own throats before politicians do it for us. But by causing such a massive shrinkage of the public sector - which should actually expand during a recession - they are guaranteeing that the Recession will be longer, deeper, more costly and more painful. Having worked in a university for seven years I would not have expected rational behaviour from the bureaucrats who dominate the higher education sector, but to see such short-sighted and self-destructive reactions is depressing indeed. Tweet

Discounting the Future

'Discounting’ is a clever wheeze that conventional economics uses to balance utility (its measure of what we want to gain through our economic activity) achieved in different time periods, based on the assumption that we would always rather have a bird in the hand than in the bush. This is in itself questionable, of course, but conventional economics is unable to take account of delayed gratification, not to mention concern for our fellow species.

The consequences of many environmental losses and impacts are likely to be felt many years into the future. In the case of climate change we may be talking about 2050 to 2100; in the case of nuclear pollution we are talking about hundreds of thousands of years. Discounting is the method economists use to compare these impacts as though they were all happening in the now.

When working out the costs and benefits of any economic policy or production process over time the outcome depends entirely on the discount rate that is applied. The higher the discount rate, the lower the future costs of current actions. The discounting formula has the effect of diminishing the impact of environmental destruction caused in this present time-period and making our current actions appear less costly to future generations.

The discount rate is made up of pure time preference and wealth components. The ‘pure time preference’ component is a source of much debate since logically it should be zero, jam today and jam tomorrow having equivalent utility value, in the economic jargon. However, experiments and everyday experience suggest that in reality people are impatient and prefer to have things now rather than later, suggesting that they have a positive time preference. Somewhat ironically, the suggestion that we ourselves are undermining the possibility of future life for human on earth may actually greater increase our time preference for present consumption.

The wealth component is based on the assumption that incomes will rise, so that future generations will be richer than the present one. So if we are concerned with equity we do less to protect future generations who we assume will be richer than we are. Again, there is an obvious problem with this line of reasoning, since the idea of ever-increasing consumption is itself based on the economic growth that may be destroying the potential for future generations to enjoy their comfortable lives. In this sense we might reasonable suggest a negative wealth component to the discount rate.

Estimates from the World Bank for discount rates for different countries indicate that for poorer countries the discount rates are negative, meaning that future consumption there should be valued more than present consumption and these countries should have very protective attitudes towards the environment. This is not found in reality – just another proof of the flawed thinking that underlies the concept of a discount rate. The rates for developed countries are high, which, if they were applied to environmental problems, would mean that we would make little effort to protect the environment since the discount rate would suggest that, not so far into the future, the impact of our present behaviour would have been greatly diminished.

While this may seem an arcane and technical discussion, it is one which has an enormous impact on our chances of protecting our environment, which is why I have weighed down my blog with it this unseasonably chilly morning. These discounts rates are applied when future impacts of current policies are calculated, and if the equations are in error then we risk huge future damage to our environment. This is why, following the publication of the Stern Review of the Economics of Climate Change, orthodox economists engaged in their usual trick of missing the wood for trees and focused their discussion almost entirely on the discount rate Stern had chosen.

Stern’s conclusion that we need to act rapidly to tackle climate change resulted from his setting what was, for orthodox economics, a very low discount rate. Conventional economists were shocked by the consequences for the economy and challenged this on the basis that it had exaggerated the effects of climate change in the distant future. Stern was basing all his conclusions on statistical models about the probability of events occurring. The possibility that the planet might cease to exist would clearly have a major impact on people’s ‘time preference’, i.e. their preference for consuming now rather than in a (possibly non-existent) tomorrow. Even an economist can grasp that.

As green economists we would argue that the only legitimate discount rate is zero, since all generations’ preferences should be treated equally and the time at which somebody lives should not affect their right to be part of our beautiful and unspoiled planet. Tweet