Black Swan’s, Weitzman’s Dismal Theorem and Climate Economics

Nassim Taleb has become an international celebrity following his book on Black Swan “theory” (see a shorter essay explaining his points here, and an interesting portrait of him by Malcolm Gladwell here). A black swan is, roughly, an event with extremely large consequences that was highly unexpected – and Taleb frequently criticizes financial analysts for fitting empirical data to normal distributions and using these for forecasts, arguing that distributions actually have fatter tails (extreme outcomes are more likely than they would be under a normal distribution), and that this approach seriously underestimates the risks.

A similar but more extreme argument has been made in climate economics recently by Martin Weitzman, under the name of “the dismal theorem” (see, for instance, here). This argument has now even made its way out of the ranks of economists. For instance, it was the subject of a long post recently in the climate blog Climate Progress.  Weitzman argues that the kind of uncertainty we face on the climate issue invalidates cost-benefit analysis and makes discussions of appropriate discount rates of little interest. As discussed in a recent paper by William Nordhaus, the key assumptions are that the marginal utility of consumption goes towards infinity as consumption goes towards zero, and that the probability of more and more extreme outcomes (i.e. larger and larger reductions in consumption) falls more slowly than the marginal utility increases. When this happens, the expected loss is infinite/extremely large.

Nordhaus is skeptical of the claims Weitzman has made for his theorem and makes critical points, both regarding Weitzman’s theoretical assumptions, his use of climate model results and the practical applicability of his theorem.

Nordhaus argues against the practical applicability by stating that this would require a combination of many neccessary factors:

• That we don’t understand the dangers of our emissions OR fail to institute good policies
• That our emissions have large climate effects
• That the damage function (how bad higher temperatures are for humanity) has sharp threshold effects (increases very rapidly after some value)

He then argues that climate change is gradual, so that we would learn over time if emissions have larger climate effect than expected, and that this would make us aware of the dangers of our emissions and cause us to institute good policies. He also questions whether the damage function has sharp threshold effects, and (using simulation models) tries to show that none of these factors are sufficient to cause the problem Weitzman has identified – all three are required.

While Nordhaus writes well and argues clearly, I felt unsatisfied by his attempt to calm the reader. Without having thought very deeply about this, my initial (and perhaps misleading) counterthoughts were as follows: I believe Nordhaus

• Ignores the potential for climate runaway effects – assuming throughout a simple “multiplier” that translates emissions into temperature changes. If there are threshold effects in the climate system (methane release from the tundra, collapse of the rainforest in south-america with resultant release of the carbon stored in the vegetation there, etc. – see an overview of some possible threshold effects or tipping points here)
• Overestimates the “rationality” of the human race –assuming that “everyone” would agree on the causes of climate change if they became dramatic and that putting the necessary policies in place would be simple at that point
• Discusses what “zero consumption” means (e.g., many people with really bad lives, fewer and fewer people with good lives, or people with good lives but then no more people) – but discusses “catastrophe” only as fall in aggregate consumption. I would think there are some outcomes that cannot easily be traded off by high consumption elsewhere – if many millions die in a huge natural catastrophe, for instance, or if a whole region is destabilized and thrown into chaos and anarchy over a fight for fresh-water. I would think that the “willingness to pay” to avoide such outcomes would be higher than the resultant decrese in total global production.