What’s Missing in Paul Krugman’s Climate Economics Primer

from Peter Dorman

But let’s start by accenting the positive.  Krugman’s explanation of mainstream environmental economics is clear and powerful.  He recognizes that there really are a lot of free energy lunches lying around uneaten, in the form of potential efficiency improvements.  He knows that predictions of economic disaster due to carbon policy are without foundation and fail to take into account the potential for innovation.  Above all, he understands that investments in minimizing climate change offer valuable insurance against potentially catastrophic outcomes—the ice-sheet meltoffs and methane megabelches that we have little ability to predict and from which we would have little chance to recover.

Why ask for more?  Because three enormous concepts are completely missing. 

1. Equity.  How the burdens of climate policy, bearable as they may be, are distributed is a very big deal.  First, vast sums of money—hundreds of billions of dollars—are at stake.  Note that these do not reflect costs as economists understand the term.  We are not talking about overall loss of income and output, but transfers, money that will find its way from some folks’ pockets to others.  If carbon is priced, for example, then we will be paying this price, and someone else will be on the receiving end of those payments.  Who that is matters, big time.  Economists are not experts in climate science, but they have useful tools for analyzing and anticipating who will win or lose from a policy.  They have a large contribution to make in helping us design fair and equitable systems for controlling carbon, and this deserved some real estate in Krugman’s article.

But that may not even be the most important reason to support equity.  The bigger problem is that actual climate policy is lagging ever farther behind what is needed.  We still don’t have a policy framework at all in the US.  The European Union’s trading system has Europe on track to fail to meet its targets (unless the economic situation continues to deteriorate).  There are paltry carbon taxes here and there, too modest in size and coverage to make a difference.  There are many reasons for weak policy, but perhaps the most important is the fear of politicians everywhere that really cranking up the price of carbon will make voters furious once they get hit by rising energy costs.  An essential part of the solution, then, is a commitment, built into any legislation that has a whisper of a chance to be enacted, to return all or nearly all the proceeds from higher energy prices back to the public.  Just rebate it to them, and make the process completely transparent.  For every painful moment of facing a higher energy bill there needs to be a pleasant moment of getting a fat rebate check.  Can we break the political logjam otherwise?

Equity and political feasibility go hand in hand.

2. The pollution model.  It doesn’t work here.  The greenhouse gas problem is not a pollution problem, and if you apply pollution thinking you will come up with bad policies.

This is a problem for economists, since they have all been trained to see environmental problems in terms of pollution.  You will see in Krugman’s article, for instance, a comparison between the climate crisis and the problem of acid rain.  Acid rain was due to, among other causes, sulfur emissions from industrial smokestacks.  A cap and trade system was set up to limit the amount of these emissions, and the acid rain problem has been ameliorated.  Drawing on this experience, Krugman advocates cap and trade for carbon.  If carbon were a pollution problem he would be right, but it’s not.

Without going into detail, recall that there is a massive, planetwide carbon cycle, with huge quantities of carbon continually flowing between the atmosphere, the oceans and terrestrial ecosystems.  The flow of carbon from land and sea back up to the atmosphere is not the problem; it is part of the cycle.  The problem is that humans are burrowing into the earth to dig up carbon sources like coal, oil and gas that have been sequestered for hundreds of millions of years.  We are adding them to the carbon cycle, so that there will be more carbon everywhere, up in the sky and down on the earth’s surface.

What this means is that it is an error to try to mitigate climate change by controlling the “emissions” of carbon from human actions.  If the carbon has been dug up and added to the carbon cycle, it will find its way into the atmosphere no matter what we do.  And the carbon we emit that came to us from the atmosphere and will simply return there is not the problem.  This is a highly simplified version of the science behind climate change, and a longer account would explore the eddies and unevenness of carbon cycling, but it’s the right starting point.

Once you see that the pollution paradigm is wrong, two conclusions follow immediately.  First, what needs to be priced is not the carbon we emit, but the carbon that enters the cycle by being extracted from the earth.  That doesn’t invalidate Krugman’s broad generalizations, but it does suggest important dos and don’ts about carbon policy.  Don’t try to regulate the burning or other use of carbon on an industry-by-industry basis.  Don’t try to micromanage personal behavior or industrial processes.  Do keep carbon fuels in the ground, either by slapping high prices on their extraction, or directly restricting the amount that can be taken out.

The second point is that the offset business, by which permits to extract fossil fuels can be set aside in return for promises to plant trees or improve industrial processes in other countries, is a ruse.  It promises to make a lot of money for those in the right places, but it is antithetical to sound policy.  Period.

3. Economic interactions.  The market is a two-by-two mechanism.  It essentially sums up agreements between two parties, a buyer and a seller, altering prices according to the total buying and selling pressure at any point in time.  A fundamental limitation to markets emerges in situations characterized by interactions between many individuals and institutions, so that two-by-two adding up is ineffective.  An example is the role of cars versus trains in local transportation systems.  Markets can do a reasonable job of adjusting the number and quality of cars to the preferences of buyers and the costs of producers, but they cannot coordinate a system-shift from mostly-cars to mostly-trains, since there are so many interactions that are at stake, like urban density, the locations of jobs and residential areas, etc.  Markets tell us what people want, two at a time, based on what everyone else is doing, but they don’t coordinate shifts that make sense only if many do them at once.

This is important, since the shift to a low-carbon economy will be one of the largest system-level shifts in human history.  Much of it can be efficiently managed through markets, but only if the broad parameters are determined in a coordinated—that is, political—manner.  So far we are still in Krugman-land, in that he is advocating a mix of political (carbon pricing) and market mechanisms.  But there is a further wrinkle.  If we rely on the price of carbon to guide us from one economic configuration to another, we will almost certainly overshoot radically.  We will have to raise the price of carbon to a very high level so that, in this economy, with all its inherited biases toward energy profligacy, people will begin to cut back to the extent necessary.  Then, as the rest of the economy adjusts, this price will be seen to be much too high.  Of course, since the process will take place over many years, a too-high price translates into a too-drastic energy squeeze during the transitional phase.  By contrast, relying on quantities—limiting the amount of fossil fuels that can be extracted and letting the price rise as it will—does not overshoot in the same way.  There will still be a big price spike that can be alleviated over time as we build a low-carbon infrastructure, but the amount of energy made available will not be over-squeezed, since it will be directly controlled.  In simple language: economic theory tells us that, to achieve a system-shift in a densely interconnected economy, it is more efficient to control quantities than prices.  A carbon tax is inferior to a permit system in which the number of permits is fixed.

So this is my appendix to the Krugman primer.  He did a fine job with what he set out to do, but he left out important pieces that the public should be aware of, and that economics has the ability to provide.