Tuesday, June 10, 2014

Economic Growth is Good

I've been quite ill the past couple of days, and the fever I've been wrestling with has given me some troubling thoughts. Thoughts of depreciation.

Please indulge me a bit of preface. Since economics and accounting share some vernacular, it is wise to clarify some important differences. First, consider "capital". To the economist, capital is a durable asset. Unless otherwise modified by words like "social" or "human", capital is stuff like machines, roads, engines, or houses. The chief contrast is between durable capital goods and disposable consumer goods. Let me outsource this one to Stephen Moore, writing in the Concise Encyclopedia of Economics (Liberty Fund, ed. David Henderson).
The term "capital" refers to produced goods used to produce future goods. Even a corner lemonade stand could not exist without capital; the lemons and the stand are the essential capital that makes the enterprise operate.
Under this definition, houses don't precisely make the cut, unless you consider that a happy home bustling with the giggles of children and the wagging of joyous canine tails to be "future goods". The definition isn't all that sharp on every margin. Still, I think you can get the gist. This is a lot different than the way B-School folk talk about capital. To most other disciplines, capital can include paper assets, stocks, bonds, and all the derived claims on actual physical capital assets. The term "capital gains" is coined in this latter sense. For this post, I want to stick with the first sense, mostly because I'd like to discuss depreciation.

"Depreciation" is closer in meaning between accounting and economics than "capital". Depreciation marks the decay of capital. Machines wear down, buildings collapse, bridges buckle. The difference between the accountants and the economists is a matter of estimation. Accountants are beholden to their principals, which means they are obliged to select from a pre-defined (by GAAP) menu of depreciation calculation options and apply the one that is in the best interests of the firm. This is typically done to minimize the firm's tax burden. Economists are generally under no such contractual obligations, and are therefore at greater liberty to select the method they think best approximates the actual degradation of productive physical assets. Which approach is superior, I honestly and without regret cannot say. I'm using the economist's version here, which is basically straight-line depreciation with no salvage value.

The thing that has been bothering me in these few lucid moments I've had the last few days is this. Much of the naive discussion I hear of the effects of distant disruptions (usually, but not strictly limited to anthropogenic climate change) either tacitly or explicitly ignores depreciation. Think of how often you hear claims that whole cities will be swallowed by rising sea levels or entire communities displaced by sweltering summers. The bowtied economist in me insists on asking "compared to what?" If you compare the world of a century hence with today, the idea that a billion people living in coastal flats will have to flat abandon their homes as the tides swell is pretty dang disturbing. But no city on earth is the same as it was 100 years ago, so we've got no good reason to assume it'll be the same 100 years hence.

These fever dreams encouraged me to run a quick back-of-the-envelope sketch looking at how much of today's capital will be under threat a century from now. Alert investors can take sensible precautions against rising ocean levels when repairing or replacing capital, so it's really only the particularly durable at-risk capital stock that would end up being a total write-off if it ends up under the unforgiving waves. Nota bene, I assume that all of the other feefaw about refugees and whatnot is subject to the Second Law of Public Finance (all policy is discretionary over a long enough time horizon) so worries about mass migration is a tempest in a teapot.

Well then, a century from now, how much of today's capital will remain? The answer: it depends. Here's a summary of the quick peek I took in Excel.

In a century, with modest 3% growth and at least a little depreciation, less than 5% of today's existing capital stock will be under threat. It's that series in yellow there at the bottom that most closely represent developed economies. Miami can creep northward (or if we had any sense, we'd just abandon the place wholesale), New Orleans can shimmy up the banks, Angelinos can settle higher up in the hills. Etc etc. But the blue series up top is the worrying one, and it probably reflects the most distressed economies. It may be that capital in developing economies depreciates faster (especially in the tropics, where humidity has a funny way of making fools of us all), but the effect of shifting between series is a lot stronger than the effect of moving along a series. Economic growth pummels today's capital into irrelevance more soundly than the wind and the waves.

There is one important exception to this sliver of sketchy analysis. If folks continue to build neighborhoods, factories, schools, and the like in at-risk areas up until the floodwaters rise, then it won't just be today's capital that's at-risk, it'll be a portion of future capital that's at risk, too. There are some plausible reasons why this might happen: truculence, lock-in, short-term bias, whatever. Even still, this is all the more reason to carefully present plausible, convincing forecasts of likely scenarios to the folks who make big investment (and public expenditure) decisions.

Euvoluntary exchange means allowing folks to find the best way to cooperate peacefully. There ain't much euvoluntary about climate catastrophe. To best mitigate its effects, consider peace, easy taxes, and a tolerable administration of justice: all the rest being brought about by the natural course of things.

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Do you have suggestions on where we could find more examples of this phenomenon?