How would Hayek solve climate change?

Disclaimer: this post concerns two things about which I don’t know very much: economics and climate policy. If you’d rather read something I’m supremely qualified to talk about, try this post on rookie errors I’ve made in my machine learning career.

Jimmy Wales, the founder of Wikipedia, created the most valuable product of the 21st century and gave it away for free. I was therefore a little surprised to read that he’s a fan of Friedrich Hayek, the Austrian economist commonly associated with neoliberalism and the Chicago school of economics. In particular, a 1945 piece entitled The Use Of Knowledge in Society  reportedly provided the inspiration for Wikipedia’s “wisdom of the crowds” approach to curation. This short essay turned out to be the best thing I read in 2020.

Hayek claims that most economists consider the foundational problem of the field to be roughly  “how to best organize an economy where everybody has perfect information and behaves rationally”. There’s a rich tradition of behavioural economists and psychologists challenging the second assumption (rationality), but Hayek’s problem is with the first part (information). 

In reality, asserts Hayek, nobody actually has all the information that you’d need to work out the right way to run the economy. In fact, it’s worse than that – most of the information doesn’t even really exist in a “concentrated or integrated form” – it’s locked up in the habits and the reflexes of people doing their jobs.

We need to remember only how much we have to learn in any occupation after we have completed our theoretical training, how big a part of our working life we spend learning particular jobs, and how valuable an asset in all walks of life is knowledge of people, of local conditions, and special circumstances

Hayek, The Use of Knowledge in Society, 1945

So how do you co-ordinate the activities of everybody in an economy when nobody really knows what’s going on? 

You have two options. The first is to find a way to aggregate all of the knowledge in the economy into a centralized place and then give a well-resourced institution like the government the job of running things. This is a centrally planned economy, and I think it’s fair to say it’s not in fashion (see: Stalin, Mao).

The alternative is to find a way to provide individuals in the economy with enough contextual information to allow them to make good-ish decisions that are aligned with whats going on elsewhere, without requiring them to have a god-like knowledge of everything that’s happening.

As you’ve probably guessed, Hayek prefers the second option, which is the one adopted by the vast majority of successfully economies. In fact, says Hayek, the system we’ve come up with for communicating economic information is so mindblowingly good that if we realized how clever it was we’d never stop talking about how neat it was. That system is money.

Money gives us a way of condensing tons of information into a single number. Anything going on in the economy that’s relevant to a particular decision is distilled into the price of the different courses of action we’re considering. If the thing we want is hard to make or obtain, it’s expensive; if it’s abundant or easy to make, it’s cheap.

As Hayek puts it, prices give us a single scale to assess how “more or less difficult to procure” different goods have become. Thus the baker doesn’t need to know the price of the steel that went into the plough; the cost of feeding the horses to pull the plough; the cost of milling the wheat. All he has to worry about is the price of flour, and if it goes up then perhaps he’ll shift to baking more flourless chocolate cakes and fewer baguettes.

Or, as Hayek describes it, people who use tin can adjust their behaviour without ever knowing the details of some calamitous event at a far flung tin mine:

Through the constant churning of prices, information flows throughout the economy. As Hayek puts it rather beautifully:

The whole acts as one market, not because any of its members survey the whole field, but because their limited individual fields of vision sufficiently overlap so that through many intermediaries the relevant information is communicated to all

Hayek, The Use of Knowledge in Society, 1945

If you’re mathematically minded, this conjures up the image of a graph. The economy is a sparsely linked graph. Although each node has relatively few links to other nodes, they’re sufficiently interlinked that information can flow between any two nodes relatively swiftly. Changes in prices to goods swiftly flow to all relevant parts of the economy- and if they don’t, people make money arbitraging them, thus incentivizing rapid information flow. ¹

To take a highly simplified example, here’s a graph representing the production of forks. Gas and coal can both be used to make electricity. Coal can also be used to make steel, which is a key material for forks:

Let’s imagine that the price of gas skyrockets:

We now have a problem, because gas was one of the two ways we had to make electricity. As a result the price of coal, a substitute for gas in electricity production, increases in turn. This directly impacts the cost of steel, and ultimately forks. Even though in this example fork manufacturers have no direct dependence upon gas, the knowledge of the gas price increase has percolated through the economy and is now reflected in a slight increase in the price of forks.

If you knew anything about Hayek, you didn’t need to read this far to know the answer to the question posed in the title: he would suggest pricing carbon as a solution to climate change.

Carbon markets do exist, and are implemented either as a carbon tax or a cap-and-trade system. A carbon tax – such as Canada’s, newly slated to rise $170/ton in 2030 –  imposes a simple price per ton of CO₂ emitted, giving everyone in the system an incentive to reduce their emissions. Cap-and-trade system – like the EU’s Emissions Trading System – in which permits for a fixed number of tons of CO₂ are issued and then traded between market participants, such that over-polluters buy permits from under-polluters. Generally, economists favour the former and politicians favour the latter. Either mechanism makes highly carbon intensive goods and services more expensive. 

Hayek gives us a lens to understand why this is such a good idea. Carbon pricing solves a big problem that consumers currently face: understanding the ecological impact of their purchases. As public awareness of the issue grows, more organizations are obliged to quantify and disclose the emissions-related impact of the products and services they provide. A number of companies have sprung up aiming to help companies (Watershed, Patch,  Emitwise) or individuals (Wren, Joro, Nori) figure out their carbon footprint (see this post), and it’s really complicated to do well.

Unpicking the web of materials and services which together constitute your carbon footprint is exactly the kind of economic needlework that pricing so brilliantly alleviates. A carbon tax on the handful of major root sources of emissions removes all of this heavy lifting, and allows market participants to behave in just the same way as they were before: adjust their decisions according to price fluctuations.²

Carbon footprinting relies upon analyzing the same kind of complex graph as our fork pricing example. To work out the embedded CO₂ in our fork, we can try to sum the emissions associated with the materials and activities (transport, manufacturing, packaging) involved in its sale. But this process is expensive, complex, and difficult, because the data we need is usually stale, if it’s available at all. But you know what’s always up to date and available? Prices.

Carbon emissions are dominated by a few sectors like energy production, heating, and heavy industry³. If we do a good job estimating the emissions from these few key activities, we can rely upon the magic of prices to carry those signals throughout the economy. This seems far preferable to a multitude of costly footprinting exercises and confronting consumers at every point in the system with a hard to parse, difficult to standardize, and frequently outdated impact assessment.

It shouldn’t be so surprising that Jimmy Wales is a fan of Hayek. The Use of Knowledge in Society makes clear that rather than representing an ideology, the free market might be more usefully seen as an algorithm for spreading accurate information in a complex system.

Just like building a global encyclopedia, mapping the economy’s carbon content is a monumental challenge. It’s hard because it requires the collation, co-ordination, and frequent updating of a large number of pieces of information for every good in the economy. Hayek’s answer: just put a price tag on it.

Thanks to Stephanie Willis for lots of the key ideas in this piece, and for helping me to draw an admittedly still poor picture of a tin mine.

1. If you’re really into maths, or at least have a vague and spurious grasp of lots of bits of maths (me), then you might draw some other speculative comparisons:

   • Dynamic programming allow us to solve big problems by solving lots of small problems and then adding up the solutions. A correctly functioning price system does the same thing: the price of a good represents the sum of the all the problems that had to be solved to make that good. The consumer of the good doesn’t need to worry about all of those subproblems and their solutions: the sum of the prices perfectly captures that information.
   • Neural networks are also non-fully-connected graphs. Just like actors in the economy, they have relatively few direct inputs. They get feedback signals only via these inputs (back propagation). And yet those signals – which are really just up/down for each connection- provide enough information for coherent organization of the network as a whole to improve over time.
   • There’s a rich and fascinating literature on the occurrence of different forms of networks in the real world. A surprising number of them end up conforming to a power law (so called scale-free networks), which means that there are a few nodes with tons of connections and lots of nodes with not very many at all. Social networks, airline routes, and the internet all follow this pattern. One beautiful property of such networks is that the average distance between two nodes in the network grows very slowly as nodes are added. This means that information travel remains very rapid. I suspect, completely without evidence, that the economy is similarly organized, with the “highly connected” nodes (hubs) being commodities like cement, steel, flour etc.

2. This is only strictly true if the designated carbon price matches your subjective value of carbon (you do know your subjective value of carbon, don’t you?). If you think that carbon has been dramatically mispriced, you would still want to do your homework on the environmental impact of the purchases you were making, and you might therefore still be tempted to choose the more expensive but greener option – because the dirtiness of the alterantives hadn’t been adequately priced in.
3. If you’ve been reading the footnotes, you might observe that this is exactly the kind of property you’d expect if the economy was a scale-free network