I was born with a can do attitude. I believe that hard work brings results. I believe that human being is amazingly creative creature. There are two good reasons to be optimistic. First, as shown in recent NYT article, optimists are less likely to suffer a heart attack. Second, reason is oil saga. As you may have heard Russia halted its oil exports flowing via the gaint Druzhba pipeline. In Russian, druzhba means friendship. It is friendly indeed to shut off oil supply in an exceptionally warm winter, they could have done it when the winter was really cold. Here comes the optimism part of the story. Europe now faces an enormous threat that Russia will use its oil weapon, and that in the future oil will be flowing to China (and demand will be there, no question) rather than to Europe. Some recent estimates also show that lack of investments in oil industry in Russia will drastically reduce oil exports (with growing domestic needs) anyway.
What is Europe best response? Strategists will say DIVERSIFY supply. Digg deeper (my web 2.0 habbits are so strong that I forgot spelling of the word, is it dig or digg), find new fields etc. My response would be INNOVATE. Instead of spending billions of euros on expensive oil supply diversification (and on subsidizing EU farming) spend money on research to find alternative to oil. Here comes the optimism part. It will be found if you make it TOP PRIORITY. I know that recent Rand report predicts that oil alternative can be a distant future, but with right motivation things can happen a lot faster.
I am not the only optimist among central bankers. Recent meeting of G10 bankers in Basle resulted in broad agreement that global growth in 2007 looks to be similar to that seen in 2006, as pointed by Times article. There are risks to this outlook, which are not Gaussian, they are long-tail risks. Can’t follow my statistics slang? Long-tail risk means that something is very unlikely to happen, but often when it does happen it brings enormous costs, think about LTCM crisis for instance. I begin to think that long-tail risks related to oil and to global growth are closely related.
To avoid these long-tail risks I would proceed in three steps (joint action of G7/EU):
- Establish Global Alternative Fuel Award (GAFA) of USD 1 bn and EUR 1 bn.
- Establish criteria, award will be given to a team of scientists who develop ready-to-use alternative to oil-based fuel (gasoline, heating) prior to set deadline
- Establish ambitious deadline (3 years)
What is the expected payoff of this strategy. Lets assume the probability of this innovation happening within given time frame is only 1 percent, and the probability of failure is 99%. The equations is:
1% * lifetime innovation benefits – 99% * costs of forgone opportunity = ?
First approximation of the costs (the funds could have been used elsewhere) is probably 3 years times risk free rate (assume 5% to be very conservative) times 2 bn allocated equals roughly 300 mln to be realized with 99% probability. Benefits are more difficult to estimate (will it be cheaper, by how much, will it reduce carbon dioxide emissions, how to price increased energy security etc.) But gains could be enormous, over lifetime counted in trillions rather than billions. My point is that expected global payoff of the proposed strategy is very high.
I was trained in economics such that I believe in the power of proper incentives, set them right and things begin to happen (I practice it with my kids every day, and believe me it works, I strongly recommend using house point system). Next IMF/WB summit should focus on global threats and on setting right global incentives to avoid these threats.