Building a Green Economy  

Paul Krugman has a (long) article in the New York Times on the transition to a clean energy economy - Building a Green Economy.

If you listen to climate scientists — and despite the relentless campaign to discredit their work, you should — it is long past time to do something about emissions of carbon dioxide and other greenhouse gases. If we continue with business as usual, they say, we are facing a rise in global temperatures that will be little short of apocalyptic. And to avoid that apocalypse, we have to wean our economy from the use of fossil fuels, coal above all.

But is it possible to make drastic cuts in greenhouse-gas emissions without destroying our economy?

Like the debate over climate change itself, the debate over climate economics looks very different from the inside than it often does in popular media. The casual reader might have the impression that there are real doubts about whether emissions can be reduced without inflicting severe damage on the economy. In fact, once you filter out the noise generated by special-interest groups, you discover that there is widespread agreement among environmental economists that a market-based program to deal with the threat of climate change — one that limits carbon emissions by putting a price on them — can achieve large results at modest, though not trivial, cost. There is, however, much less agreement on how fast we should move, whether major conservation efforts should start almost immediately or be gradually increased over the course of many decades.

In what follows, I will offer a brief survey of the economics of climate change or, more precisely, the economics of lessening climate change. I’ll try to lay out the areas of broad agreement as well as those that remain in major dispute. First, though, a primer in the basic economics of environmental protection.

Environmental Econ 101

If there’s a single central insight in economics, it’s this: There are mutual gains from transactions between consenting adults. If the going price of widgets is $10 and I buy a widget, it must be because that widget is worth more than $10 to me. If you sell a widget at that price, it must be because it costs you less than $10 to make it. So buying and selling in the widget market works to the benefit of both buyers and sellers. More than that, some careful analysis shows that if there is effective competition in the widget market, so that the price ends up matching the number of widgets people want to buy to the number of widgets other people want to sell, the outcome is to maximize the total gains to producers and consumers. Free markets are “efficient” — which, in economics-speak as opposed to plain English, means that nobody can be made better off without making someone else worse off.

Now, efficiency isn’t everything. In particular, there is no reason to assume that free markets will deliver an outcome that we consider fair or just. So the case for market efficiency says nothing about whether we should have, say, some form of guaranteed health insurance, aid to the poor and so forth. But the logic of basic economics says that we should try to achieve social goals through “aftermarket” interventions. That is, we should let markets do their job, making efficient use of the nation’s resources, then utilize taxes and transfers to help those whom the market passes by.

But what if a deal between consenting adults imposes costs on people who are not part of the exchange? What if you manufacture a widget and I buy it, to our mutual benefit, but the process of producing that widget involves dumping toxic sludge into other people’s drinking water? When there are “negative externalities” — costs that economic actors impose on others without paying a price for their actions — any presumption that the market economy, left to its own devices, will do the right thing goes out the window. So what should we do? Environmental economics is all about answering that question.

One way to deal with negative externalities is to make rules that prohibit or at least limit behavior that imposes especially high costs on others. That’s what we did in the first major wave of environmental legislation in the early 1970s: cars were required to meet emission standards for the chemicals that cause smog, factories were required to limit the volume of effluent they dumped into waterways and so on. And this approach yielded results; America’s air and water became a lot cleaner in the decades that followed. ...

Many people, including me and, um, Al Gore, have recommended Paul Krugman's primer on climate economics. It's a top-notch introduction and a welcome antidote to the ignorance and hysteria that characterize most media coverage of climate policy. Read it!

In describing environmental economics, however, Krugman simply passes along many of its flaws. Economist James Barrett identified a few of them. I want to echo and reinforce one of the points he made.

"Not that bad" ain't good

The great sin of conventional economics is the assumption of rationality. According to rational choice theory, individuals act to maximize their self-interest; ergo, markets based on free exchange of goods and services will yield maximally efficient distribution of resources. A free market is, in German philosopher Gottfried Leibniz's terms, the best of all possible worlds. Most of what economists miss about energy can be traced to to the lingering effect of this assumption.

Now, every time I bring this up, people come out of the woodwork to tell me I'm constructing a caricature, and everybody knows about market failures. Which is ironic, since the people who bitch about rational choice theory more than anyone I know are economists. (Again: see James Barrett. Or anything Dean Baker's ever written. Or the entire field of behavioral economics.) What they tell me is that the most common macroeconomic models still rest on the assumption of rational choice; that the most influential names in the field still work with the assumption; that new approaches are still marginal and viewed with skepticism by modelers; and that laypeople's understanding of economics is heavily colored by it.

Anyway, the assumptions of rational choice theory are the only way to explain something like this -- and that's one of a dozen articles I could cite. They are the only way to explain the results of the economic models used by the CBO to score climate legislation. They're the only way to explain the conventional wisdom in D.C. that climate legislation is all about costs. After all, as Barrett says, "with everyone constantly and correctly optimizing their behavior, there is nothing the government can do to make us any better off."

Lamentably, Krugman's article reenforces that conventional wisdom. He concludes that pricing carbon is the Ultimate Climate Policy (maaaybe we can tack on a few performance standards for coal plants). According to mainstream economic modeling, a carbon price will inhibit GDP growth. Krugman's cri de couer is as follows: "Restricting emissions would slow economic growth -- but not by much." Freeeeeedooooom!

"Not as bad as you might have worried" may be a convincing argument to pointy-headed intellectuals, but it hasn't exactly gotten the public fired up. To boot, it's almost certainly incorrect. Krugman simply ignores the panoply of policies proven to boost economic productivity and reduce emissions.

They exist! Long ago, in the Dark Ages (1997), over 2,500 economists, including nine Nobel Laureates, endorsed "The Economists' Statement on Climate Change." The second of three propositions in that statement was:

2. Economic studies have found that there are many potential policies to reduce greenhouse-gas emissions for which the total benefits outweigh the total costs. For the United States in particular, sound economic analysis shows that there are policy options that would slow climate change without harming American living standards, and these measures may in fact improve U.S. productivity in the longer run. ...

But my objection to Krugman's take on climate economics is even more basic. To see what I mean, consider this passage:

If there's a single central insight in economics, it's this: There are mutual gains from transactions between consenting adults. ... Free markets are “efficient” -- which, in economics-speak as opposed to plain English, means that nobody can be made better off without making someone else worse off.

...

But what if a deal between consenting adults imposes costs on people who are not part of the exchange? What if you manufacture a widget and I buy it, to our mutual benefit, but the process of producing that widget involves dumping toxic sludge into other people's drinking water? When there are “negative externalities” -- costs that economic actors impose on others without paying a price for their actions -- any presumption that the market economy, left to its own devices, will do the right thing goes out the window. So what should we do? Environmental economics is all about answering that question.

Perhaps inadvertently, Krugman reveals how environmental economists seem to think of their work. Assume a free market filled with exchanges among "consenting adults." Then introduce a negative externality -- say, CO2 emissions. What's the proper response? Viewed in that light, obviously the right response is to put a price on the externality. Done! That's why the environmental economist's approach to climate policy always seems to be: price carbon and get out of the way.

But ... and this is a gargantuan but (quit snickering) ... why would you assume a free market? Are there free markets in energy anywhere in the world? If so I'm not familiar with them. Everyone involved in energy markets is always and already operating within a skein of existing market distortions. We live in a fallen world.