Challenges for the future: the role of the university

by Antonio Cabrales – Department of Economics – Universidad Carlos III de Madrid

Challenges for the future: The role of the university

Transcript of the inaugural lesson for the course 2021-22 at Universidad Carlos III de Madrid

Your Excellency, Your Excellency the President, Your Excellency the Rector, … (to fill in appropriately).

We have lived through a very intense year and a half. But we have learned many things. We have become aware that human beings can be more fragile than we thought, but also that societies and human groups can be more intelligent, more resilient and more adaptable than the mere sum of their parts. With the right conditions, we can triumph in the face of adversity, innovate, advance without anyone being left behind, and look to the future with optimism.

Human beings collaborate with their fellow human beings because in our evolutionary past cooperating in the face of adversity has proven to be a robust strategy in an often hostile environment. This characteristic of human nature has helped us to overcome the current challenge. We have been able to lock ourselves indoors and shut down our businesses for weeks or months, at great personal cost, to protect the most vulnerable. We have developed and administered a vaccine in a time that we were told was impossible. The European Union has mobilized unprecedented resources to accelerate recovery at the same time as we Europeans face other challenges ahead. This also seemed unfeasible a decade ago. We must draw on these lessons for the future, because the challenges ahead are also enormous.

The university has played an important role in solving this crisis. Several of the vaccines injected by the millions have been developed by university professors funded in large part by public funds. In addition to vaccines, epidemiological models have been researched to optimize virus containment strategies, and the impact of the crisis on the economy, ecology or mental health has been studied in depth. And we have done all this while continuing to teach online classes, maintain other lines of research, and care for children without schooling, or for the elderly who could not go to a health system collapsed by the emergency associated with Covid19.

This experience proves that the university can and should contribute as a priority to the solution of many other future challenges. I am going to focus in this speech on climate change because it is something that concerns our university, to the point of having started a strategic initiative on the problem, and because it is something I am working on recently and would like to share.

The blunt opening of the executive summary of the Stern Review, published in 2006, says: “The scientific evidence is already overwhelming: climate change presents very serious global risks and demands an urgent global response.” And yet, carbon emissions have not only not decreased, they have increased since 2006. The latest IPCC report states that unless drastic reductions in emissions are made now, the average temperature will rise by more than two degrees Celsius this century. The economic and social consequences of these climate changes would be very serious. We need novel approaches to achieve a global reduction in carbon emissions in the coming decades, and in my view those approaches should include harnessing the power of financial regulation.

My research starts from the observation that financial systems are increasingly interconnected. As a result, a sufficiently large disturbance in one part of the system can be communicated to the global economy. This became evident during the Great Recession of 2008. This crisis came as a big surprise to us, because we were coming from an earlier long period of reduced volatility, dubbed the “Great Moderation.” But what those of us who research financial contagion discovered is that Moderation and Recession are not independent. By increasing financial interconnectedness, the economy is assured of stability against small shocks, but in return we have more widespread crises when those shocks are larger. This increasing interconnectedness has led regulators to take more account of these interrelationships in their activities. That is, they intend to reduce risks to the entire financial system, what they call “systemic risks,” rather than simply reducing risks to individual institutions.

The first part of my work is to document that the financial consequences of climate change generate social welfare losses. The reason is that individuals and firms, when contracting with each other, do not take into account the external effect that a problem in their operation can generate to third parties. Just as bad mortgages in Louisiana in 2008 generated financial disasters in the Netherlands or Germany, via investment banks in New York, if global warming causes my company to go bankrupt, for example, by making my tourism business unviable, that bankruptcy will result in a chain of effects on suppliers, employees and other companies and people who in turn depend on them. We can prevent this, but this implies disinvesting in companies that generate CO2 and doing so in clean technologies. That way the “dirty” companies cannot operate, fewer greenhouse gases are produced, and climate disruption will be less And that is where regulators can act. They have the mandate, and they have the tools. Now it’s “just” a matter of using them.

So why aren’t we acting already? If Antonio Cabrales has figured this out, it should be clear to any minimally informed regulator as well. To understand this, we must first think about another characteristic of human beings: how they react to uncertainty.

There is no doubt that the planet will warm considerably in the next century, with or without mitigation efforts. However, the uncertainty surrounding the precise magnitudes of the process is also very large. Climate change is a problem that humanity has not faced before, and that complicates decision making. This suggests that we will not be able to use standard tools to decide on this problem. A reasonable alternative, and one that has been verified in other contexts of “fuzzy” uncertainty, is to use “pessimistic scenarios” about what might happen and act accordingly. But it is not obvious that this implies more mitigation: we can be pessimistic about the consequences of climate change, and this leads us to act more strongly, but we can also think that our mitigation efforts will not be effective, and this leads us to do nothing. This could be one cause of the current inaction. To investigate this issue we have conducted an experiment with a representative sample of the Spanish population to see how they react in a context of diffuse uncertainty. Preliminary results suggest that this may indeed be an important factor in the problem. This in turn implies that we need more research to make uncertainty more “precise.”

There is at least one other reason for the slowness of the regulatory response. The evolution of social norms about what is right or wrong to do is a slow process, and transmission between different social groups also takes time and is not straightforward. Citizens can agree that everyone, including regulators, must do something to deal with this emergency. But regulators have their own rules and may interpret their mandate as more limited. And that climate change is a matter for the finance ministry, which should tax carbon. Until now, the horizon for monetary policy was two or three years, and that of financial stability, although a little longer, rarely goes beyond a decade. If that is the status quo, it is difficult to expect regulators to start adopting a view that extends perhaps half a century or more, especially considering the ambiguity and lack of awareness of some of the risks I mentioned earlier.

This is why we are studying how the concern for this problem has evolved in natural science, economics, the European Parliament and the European Central Bank, and their interactions. To understand this we have downloaded the publications of these institutions and looked for mentions of climate change in them and how they relate. The results are striking. The natural sciences have been consistently concerned about climate change since the 1980s. The daily press makes very few mentions until 2004, when it begins to increase explosively, an increase that is moderated in the 2008 crisis but then gains strength again. The European Parliament addresses it in its documents almost a decade later. And the European Central Bank has only been concerned with the issue in the last five years. Academic economists, sadly, seem to think this is not a major problem, at least judging by what their top journals publish.

Can we “beat” climate change? No, it is too late for that. But we can make life less bad for ourselves and our descendants. The IPCC report makes it clear that we are going to hell. But Dante told us that even in hell there are nine circles, and we have some leeway about which one we place ourselves in. Social science, like natural science, engineering and the humanities, has much to contribute to mitigate this crisis. The university will do its part. And we truly believe that the rest of society can do its part: our evolutionary history gives us hope. Let’s get to work!