A Good Ismaili is a Good Economist

So during the Golden Jubilee year (2007-2008), His Highness the Aga Khan was able to travel to see many Ismailies around the world. Now if you are unfamiliar with the term Ismaili, I suggest you click here.

During his travels, he had many messages to convey to Ismailis around the world and though many of them were timeless, I found only one to be extremely pertinent to 2007-2008. This message was that of frugality. December 2007 is the official month when the US recession started which has had several global effects, many OECD countries also fared pretty badly and most developing countries saw a slow-down in their growth.

Now back to the message of economic prudence, it was very simple: if you are a consumer then you should protect yourself from a future change in your income due to the economy. And if you are a producer, cut costs so you’ll be better positioned when the economic hardships start.

Well any forward looking consumer would have followed this advice without needing to be reminded. But not everyone is a homo economicus but instead we are homo sapiens, so it may be hard for many to have known the extent or magnitude of the recession and this sort of uncertainty may have delayed people’s consumption decisions. (And some of us wouldn’t have acted so even if we did know what the future held – its okay, self control and myopia are human problems).

Now here is some economics you should know: Marginal utility of consumption decreases as you consume more. Utility is a fancy name for satisfaction, and this first statement means that if you are really thirsty on a hot day and you consume two glasses of lemonade, the second glass won’t be as satisfying as the first glass. Consumers realize this, so they smooth their consumption over their lifetime. So instead of consuming all their income when they are earning the most in their 40’s (owning the fastest cars, living a lavish life) and then consuming nothing when they are retired, rational consumers spread out their consumption over their lifetime. So they’ll buy a Volvo instead of a BMW when they are rich, and be able to take trips to Florida instead of living on the street when they are poor.

Volvo's arent that bad actually

So a good Ismaili would have listened to this advice and acted like a good economist. They would have known that there is a good chance that their future income will decrease and so they would have known that their present value of lifetime resources (their net income over their life) will decrease. This in turn would cause them to decrease consumption slightly. So now lets say at the age of 30 a person was able to earn to $400,000 for the rest of their life and they intend to only live to be 70, so they would spend $400,000/40= $10,000 per year. But if they see that over the next two years their income decreases by $10,000 in each year, that doesn’t mean they decrease consumption by $10,000 each year. Instead their new smooth consumption would be 400K-20K/40 = 9.5K, so instead of decreasing their consumption by $10,000 for two years they decrease their consumption by $500 for the rest of their life.

Consumption Smoothing

So a Good Ismaili would listen to this sound economic advice to live frugally and reduce consumption; thus acting like a good economist. (In case you were wondering, the opposite does not hold, a good economist doesn’t make a good Ismaili).

Partial Equilibrium Persuasion

In one of my classes I had the opportunity to listen to a guest lecturer from someone who heads Stanford’s recycling department. She talked to us about recycling and why its important. And she came up with ‘Top Ten List’ for reasons to recycle (hopefully in a future post I’ll discuss why I dislike such lists). But the top two reasons on her list were: 1. Its good for the economy and 2. It creates jobs (a bit redundant I might say).

But her point was that when we recycle you employ someone to collect the waste, someone to receive it, someone to filter it, someone to process it, someone to sell it, and on on… she said around 10 jobs are created for each tonne of waste we recycle. Sounds like a good idea right? We recylce, and create jobs, a win-win for sure!

I hope my sarcasm was conveyed in that last sentence. This is too simplistic and a partial equilibrium analysis. Now I’m all for green-collar jobs and such, but lets say we didn’t have any extra unemployment (nothing above the rate of natural unemployment). Would this still be a good argument? If the economy is in a state of equilibrium such partial equilibrium analysis should only be taken with a grain of salt. If there is no involuntary unemployment, everyone has a job, so her second argument is total BS since a recycling program isn’t creating jobs but rather just reallocating labor from one job to the next. There is no net change in employment.

But her first point may be true, it could be good for the economy and society as a whole. That is only if people choose to actually gain employment in recycling professions. If people already have jobs, why would they move to a recycling-related job? For the vast majority of people a big incentive would be higher wages. And general production theory dictates that we pay wages that are equivalent to the marginal productivity of labor. So people will only earn higher wages if they their labor is more valuable and by the income approach we can see this reflected in a larger GDP.

The cobb-douglas production function for an entire economy is as following:

Where Y is GDP, K is capital, N is labor and A is any total factor productivity but most commonly referred to as technology. An increase in GDP due to recycling would be included in the A component since N has not changed but is more productive (lets assume that capital stays constant too or has negligible change due to recycling jobs).

But this is all contingent upon the premise that recycling related jobs are better paying than other jobs. But since there is such a variety of jobs that are related to recycling, its hard to say whether recycling will actually be better for the economy. For example, its easy to say that creating trash collector jobs isn’t going to be a great investment for our economy. But what if a bicycle-maker can produce more bicycle thanks to higher recycling of metal scraps, what if the firm is growing so rapidly it needs another high-paid manager. Such jobs will increase productivity of labor (assuming marginal productivity of labor is equal to wage) and help the economy. But its really hard to tell whether the sum of all jobs created by recycling is really better for the economy compared to the jobs people previously held. So until then I cannot give a definite answer.

In conclusion, yes recycling is good for the economy and in the current state with so much unemployment it could possibly create jobs. But the moral of the story is when people make such claims, do take them with a grain of salt because if the unemployment rate would not have been as high, this analysis may not hold.

Jeffrey Sachs talk at Stanford – on Sustainable Development

Fortunately for me I’ve had the opportunity to hear my two favorite Harvard-educated famous white males this year. One being Bill Gates and the other being Jeffrey Sachs. I used to worship Jeffrey Sachs back in high-school when I first read “The End of Poverty” (not so much now) but I was still elated to hear him at Stanford and luckily enough my roommate and I were able to find front row seats at his talk. I took some vigorous notes about his talk and which I’ve copied below, hope you enjoy!

Picture from the front row, unfortunately my iPhone isnt the greatest for pictures.

Designing a Path to Sustainable Development – by Jeffrey Sachs

Jeffrey Sachs, a prominent development economist, came to speak at Stanford last Thursday (a long time ago). His talk centered around the path to sustainable development, which he described as “the most complicated problem on the planet” and “the defining challenge of our time”. He defined sustainable development as the process through which we continue material progress (especially for the poorest of the poor) without hindering our world’s healthy ecosystem functions.

Sustainable development, he said, is a very complicated problem. It is often the root of many other global issues such as terrorism and it cannot simply be solved by market forces. To better understand sustainable development, Sachs listed 6 key features of the problem:

  1. It is a global issue: climate change is one of the many global problems, and that it doesn’t matter where the emissions come from because it impacts all of us. Sachs also commented on how our national institutions aren’t adequately prepared to address such global issues.
  2. It is an inter-temporal problem: we see the effects of sustainable development over a long period of time. Often it is due to a stock effect and not due to a flow effect, for example the accumulated stock of carbon emissions matters, not the amount that is emitted in a given year.  The problem with stock effects is that we may be crossing certain thresholds or tipping points in our environment and these problems may be irreversible.
  3. The involvement of ecosystems: many of our natural ecosystems are under stress right now because one action has several indirect effects on other parts of the ecosystem. Our markets don’t the hold the interests of our ecosystems at heart and hence allow us to get  away with many environmental crimes.
  4. There is profound uncertainty: There are a lot of things we don’t know about our ecosystems and how we interact with our environment. For example, it was out of pure luck that humans were able to detect the hole in the o-zone layer when we did. Right now we may be on the brink of several environmental catastrophes without even knowing it.
  5. There are several ramifications of population growth: Stanford’s Paul Ehrlich was very right when he said our world cant sustain as large a population as we have. Sachs said that all the problems we are going to face would be infinitely easier if we have a much small population.
  6. The solutions to these problems involved large scale technological transformation: markets aren’t all they are cut out to be and we will require technological transformation that goes beyond what markets may provide us with.

Sachs argued that right now we are far from the path of sustainable development. He talked about a 10,000 mile stretch of drylands from Africa to the Middle East to Central Asia that was degrading rapidly from our current practices. This area of environmental degradation is also an area that houses much political and civil instability. Sachs claimed that we have misdiagnosed the problems of these areas to be rooted religious ideologies while they are at root problems of water scarcity and hunger. This misdiagnosis is a common hindrance to sustainable development.

Sachs plead for action and described 2 risks for our inaction:

  1. Depletion of vital resources
  2. Pervasive environmental degradation

He stated that the path towards sustainable development doesn’t involve just maintaining our fossil fuels or minerals, but rather maintaining the capacity of our global ecosystem to keep us alive.

Sachs believes that the problems that we face are solvable at a modest cost. The real problem lies in the coordination of these solutions through institutions at the national and global level.

Interestingly enough, Sachs remarked on how Malthus was right all those years ago. Our population has grown above capacity and hence billions of people around the world are not meeting their basic food needs. He quoted that 1 billion people are starting, 1.5 billion more have micronutrient deficiency and that another 1 billion people are malnourished.

With reference to global warming, Sachs declared agriculture as the largest contributor to greenhouse gasses. Following agriculture, energy and then industrial toxics were the next biggest contributors. The problems we face are bounded and do have definable solutions, for example we can shift to a sustainable food and energy based economy. But there are certain steps we need to take in order to make this shift.

One of the steps is to stabilize population growth. If we assumed that all families would return to a replacement level of 2 children per family, then the disproportionate number of young people would cause the population to further grow to 8 billion people. The largest population growth is within the poorest populations and that we need to help these populations stabilize their growth by providing them with family planning and education. If Africa continues to grow its population at its current rate, then its population will increase by 1 billion people by 2050. The per capita income cannot grow if the population is growing that fast. Other steps towards a path of sustainable development include moving towards sustainable agriculture, behavior change towards better practices and switching towards cleaner energy.

Dr. Sachs made a very compelling argument for the feasibility of these solutions. He stated hat a comprehensive list of changes to get us on the path towards sustainable development would cost us almost 1% of the US GNP. Weighted against the long-term health of the planet, this is a very small cost to pay. He compared this to the amount of military spending in the US, where each soldier abroad costs the US $1 Million.

The Copenhagen summit was also highly criticized. He mocked the fact that after two years, only 4 pages were written on how to bring our world on a path of sustainable development. But this underlined the institutional problems that our world faces. As part of this discussion, Sachs also criticized President Obama for not campaigning for certain environmental policies.

One way in which Sachs believes that we can begin global dialogue on these matters is by identifying common human values. To create change at a global level we need to combine the environment, economics and ethics. Sachs emphasize that the capacity of our institutions to implement such change is limited and made a request to the university to see itself as a global problem solver. Universities worldwide need to take the initiative to implement such change. As his lecture came to a close, Sachs did assign the audience with a peace of homework, and that was to read or listen to John F. Kennedy’s commencement address at the American University – I have read it and I encourage you all to do so.