The Period of Crisis Between Climate Change and the Economic Paradigm-Shift

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Sep 2, 2017 — Neil Boyle

The Multinational Development Banks (MDBs) of the 21st century including especially the Asian Development Bank are entering a period of crises given the twin challenges of climate change and the paradigm change of a brand new economics called Transaction Cost Economics that is currently being rolled out. I am knowledgeable in TCE and also of the way MDBs work having the founder of TCE as my advisor and worked in the first MDB the World Bank for 20 years, 10 years in USAID and the US State Department, and 20 years on my own, all dealing with MDBs in the context of economic and institutional development. The crisis comes about because it contends with two unforgiving global issues that occur simultaneously. The two are codependent–the economic vetting of trillions of dollars of infrastructure investments (mostly to mitigate climate change damages like hurricane Harvey) by using the new economic paradigm. Thomas Kuhn defined a paradigm as a scientific framework that interprets evidence. Science, therefore, deals not just with evidence, but also with its interpretation. (Kuhn, 1962)

This economic paradigm-shift encourages major rethinking: what was once a single economic theory for production, namely price theory, now is comprised of two subsystems, one for production, i.e., price theory, and the second for the way production is organized, namely contract theory. The two are vastly different and contract theory is the game changer. Price theory is dominated by inanimate (lifeless) objects where mathematical modelling is convenient because human randomness is a non-issue. Contract theory, on the other hand, is dominated by animate (living) objects where human randomness is alive and well; after all, what does organization consist of but people. The economic system is now a combination of two subsystems that are interactive meaning they are co-dependent in accord with some computation. What that computation is, is not yet known, but mutual dependence is certain.

That there are two sides to the economic system has been known since Adam Smith researched the pin industry in Scotland in 1776. We recall from his study discovery of the division of labor, specialization, economies of scale, assembly line production, and self-interest rather than the interest of the monarch, all of which established how the cost of producing a pin depended on how that production was organized. One may ask, why didn’t Adam Smith solve the conundrum of human randomness? One can only surmise that sufficient economic knowledge, particularly of the organization kind, was not yet developed. It took almost two hundred and fifty years to get to the point of convergence between production and its organization that we are beginning to embark on at the present time. Because of climate change, we can’t move fast enough.  We can thank Ronald Coase (1910-2013) for starting the ball rolling by publication of his two articles “The Nature of the Firm” in 1937 and in 1960 “The Problem of Social Cost” for which he won the Nobel Prize in 1991. And, we can thank Oliver Williamson for his brilliant paradigm-shifting and operational insights for putting this very complex puzzle together in the 1970s up to and beyond his winning the Nobel Award in 2009.

Yes, the mechanisms of adaptation, private ordering, ex-post governance, renegotiation and credible commitment, and more, figure prominently into the mitigation of climate change. A good part of this rethinking and emerging new knowledge will come from the experiences of ADB that it shares with other MDBs. ADB is special because it likely is to be the first among the MDBs to adopt TCE because it serves the most dynamic market among the other MDBs, including the World Bank. ADB has more to lose. Among the difficulties ADB is likely to encounter in the absence of TCE is the allocation of scarce resources and poor implementation performance of its vast sums of lending. Difficulties will be biased by the orthodoxy of emphasis on economic production and its financial counterpart of financial impact analysis. This bias could translate into large project delays and cost overruns over an enormous number of investments. According to McKinsey Global Institute (MGI, 2016), the incidents and magnitudes of project delays and cost overruns are worse today than they were two decades ago for large infrastructure. And for externalities and the pricing of carbon, the relationship between TCE and the mitigation of climate change damages couldn’t be more profound due to the changes economic theory is currently undergoing.

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