Today's date:
Fall 2006

On Global Warming and Financial Imbalances

Following are excepts of the annual Nobel Laureates roundtable hosted by the Milken Institute. The session was chaired by financier Michael Milken. Participants, all recipients of the Nobel Prize for economics, included Gary Becker, Myron Scholes and Daniel Kahneman.

On Global Warming

Gary Becker | It is difficult to make forecasts. Everyone remembers Paul Ehrlich’s famous projection of a population bomb that never exploded.

Although it is still not clearly proven, there does in this case seem some truth to climate change. The evidence is strong enough that we have to contemplate what kind of actions to take, even given the uncertainty.

Myron Scholes | Even if we have statistical times series for the last 300 years, is that sufficient data to be able to predict the future? That is one problem. Also, our own actions are part of what is going on. We affect the nature of the phenomenon. It is not exogenous. So, things we do will change the phenomenon as we go along. Price increases because of oil scarcity, for example, will affect any projections made about the future based on past behavior.

Daniel Kahneman | To psychologists, global warming looks like a very bad problem to solve. The outcome of any policy dealing with it is not immediate. It is completely abstract so far as the population is concerned. Nobody is feeling a thing. To mobilize public opinion, to get anything done, is extremely difficult.

It is one of those situations where one has to question whether the social arrangements we live by are adequate to the threat that we might face. Political leaders who are extremely sensitive to short-term concerns, to the poll results, may not be the best equipped to take a very long-range view.

If there were scientific consensus about something that could be done that would have its effect 100 years from now, it would take extraordinarily inspired leadership in order to get the population behind such a solution.

You would get a lot of what we psychologists call motivated doubters. There are a lot of people who will say that nothing has happened yet and the scientists have been wrong before and we don’t need to trust them.

Becker | I agree with Danny to a large extent. The Kyoto Agreement is a case in point of the problem. The United States didn’t sign that treaty to reduce global warming, although most other Western countries did, and Russia as well.

It is a very flawed agreement, an aspect of the fact that governments have trouble thinking far ahead. One hundred and forty countries are excluded from it, China and India in particular. These are fast-growing countries with growing use of CO2.

The result of this exclusion of almost all the developing world from the treaty sets out a strange incentive structure, namely for the advanced countries to shift CO2-causing production activities into the developing world where they are not covered by the treaty. That will mean per dollar of production in the developing world will be more polluting than per dollar of production in the advanced countries.

Is that good? No, that is bad. What are the solutions? The Kyoto Agreement, in effect, taxes CO2 pollution. Maybe the US should do that on its own?

The other potential solution is technological advance. Many scientists think there is a technological fix. Climate change is not irreversible if you can devise methods to draw CO2 out of the atmosphere. That is the real challenge. Profit-motivated businesses are working on that.

Let’s just don’t forget that, historically, major problems like running out of wood for fuel or not having enough food for a growing population found technological solutions.

Michael Milken | Without the US, India or China, it is very hard to be effective on climate change through the Kyoto Agreement. But we have seen some incentives created financially through sulfur indexing—in effect trading the CO2 you produce for the credits of those who produce less CO2. Selling pollution rights in other words.

Will we see the development of markets around the world that help reduce CO2 through this market mechanism?

Scholes | If we restrict emissions and allow people trading rights, yes, those that have the highest use would be willing to pay for that practice by buying credits from those who pollute less. As we reduce the overall amount that can be emitted in this way, that it is a financial incentive that can actually change the production facilities over time.

The worst thing would be to introduce governmental uncertainty into the process by changing the rules in midstream to just restrict CO2 emissions.

You have to have a system that allows for the fact that we have had old investments that were made under one set of rules that allowed more pollution, and we don’t want to preclude new investments because of the fear of arbitrary rules. So the process must be an evolutionary, grandfathering process to reduce the emissions by saying, “Let’s cap them for the future” and then allow selling the “property rights.” That is a sound financial way to go from the old regime to a new cleaner one.

Milken | If we try to estimate the true cost of a barrel of oil, it is very difficult to do because we have to factor in the cost of the US military protecting the shipping lanes with its presence in the Middle East and around the world.

If the cost of a barrel of oil is truly substantially above what we are selling it for today, do you believe it is realistic that we can bring these two in line, which, presumably, would create behaviors and incentives to look at other sources of energy?

Becker | The principle is right. There are these externalities, such as military expenditures, that should be priced into a variety of energy uses. Now, are we doing it the right way? We might well be under-pricing the tax rate on gasoline in this regard.

There are other ways the US could be conserving oil use—nuclear energy, for example. France gets 75 percent of its electric power from nuclear compared to about 20 percent in the US. Japan and China are building more plants. China has something like 30 more nuclear plants under construction at the moment. India also has a sizable number going up.

We are blocking off a sector that could be very important, particularly in electric power, and maybe we are under-taxing so much for gasoline use, which is a big user for the oil.

We take with one hand, and we give back with the other hand. A consistent energy policy has not yet emerged in the US.

On Global Financial Imbalances

Milken | A number of countries around the world—the United Arab Emirates, Singapore, Norway, Taiwan—have built up tremendous reserves relative to the size of their country. Most of them have not made the mistake of Japan, where deploying that surplus within the country through, for example superfluous road or bridge construction, caused massive increases in prices in the 1980s.

All in all, there is at least $25 trillion worth of surpluses in the world today that is invested short-term. It is pretty hard to find anything to put a trillion dollars into except US government and private bonds or mortgage-backed securities.

Where do you see this capital being deployed? Do you see it just compounding away, or do you see them following the model of Singapore where the government is creating its own industrial companies?

Scholes | When countries have surpluses, basically that could be thought of as a deficit of consumption. China, these other countries and Japan that have a trillion dollars’ worth of surpluses will be spending these surpluses over time through consumption.

For the short term, they might park it in US Treasury Bonds, but either they must ultimately spend it in consumption or put it to work in investments. It is unlikely that this shift will take place quickly, though.

So gradually over time you will see a change in the reserve mix as we have seen historically over the years. Japan is aging. If they don’t start spending their excess reserves on consumption, the last one left in Japan is going to be spending a tremendous amount of money!

Becker | If you factor the US into this picture, we see an international specialization developing. Some of these countries, like Norway, are piling up surpluses because of the high price of oil. China’s surplus is partly, but only partly, due to its exchange rate. The US is saving only a little and borrowing from those with surpluses at relatively low interest rates, though rising.

People lament what the US is doing. But if you look at total interest payments on US debt to foreigners, the total payments relative to the debt have gone down rather than gone up. So, the lament is misplaced.

The average country is saving a lot. If you have a well-functioning international system, then those who save less can borrow that money. That seems like an efficient arrangement all around. And that is what we have today.

All in all, the US has really done pretty well by engaging in a policy of importing capital, having a trade deficit as a result and running some deficit on our budget. It works.