Krugman on climate economics: uncertainty makes the case for action stronger

By Bryan Walker 10/04/2010

Lucidity in an economist is to be prized, and Nobel winner Paul Krugman writes with great clarity in a lengthy article this weekend in the New York Times Magazine headed Building a Green Economy. Is it possible, he asks, to make drastic cuts in greenhouse gases without destroying our economy? I’ll offer a summary of his reasoning here, but strongly recommend reading the whole article if you have the time. He clearly understands the import of climate science, and rightly lets that have full influence in his policy preferences. Economists who haven’t taken on board the seriousness of the prospect the science points to are hardly reliable guides.

’Negative externalities’, says Krugman, are the costs that economic activities impose on others without paying a price for their actions. The market economy does many things well, but left to its own devices it won’t face up to those externalities. The emission of greenhouse gases is a classic negative externality — the ’biggest market failure the world has ever seen,’ in the words of Nicholas Stern.

What should we do about it?

’Textbook economics and real-world experience tell us that we should have policies to discourage activities that generate negative externalities and that it is generally best to rely on a market-based approach.’

The three approaches Krugman discusses are regulation, pollution taxes and market based emission controls (cap and trade). Each has benefits. Krugman allows that there are times when regulation is a sensible path, but it does not leave the scope for flexibility and creativity provided by the other two. The very scale and complexity of the situation requires a market-based solution, whether cap and trade or an emissions tax.

’After all, greenhouse gases are a direct or indirect byproduct of almost everything produced in a modern economy, from the houses we live in to the cars we drive. Reducing emissions of those gases will require getting people to change their behavior in many different ways, some of them impossible to identify until we have a much better grasp of green technology. So can we really make meaningful progress by telling people specifically what will or will not be permitted? Econ 101 tells us – probably correctly – that the only way to get people to change their behavior appropriately is to put a price on emissions so this cost in turn gets incorporated into everything else in a way that reflects ultimate environmental impacts.

’…A market-based system would create decentralized incentives to do the right thing, and that’s the only way it can be done.’

However he is impressed enough by James Hansen’s arguments that we must stop burning coal to advocate supplementing market-based disincentives with direct controls on coal burning.

He favours cap and trade over emission taxes, pointing out how well the former worked to achieve a significant mitigation of acid rain in the US and at a much lower cost than even the optimists expected. He also considers it politically more feasible because in doling out licensing to industry it offers a way to partly compensate some of the groups whose interests will suffer if a serious climate-change policy is adopted. A tax, on the other hand, imposes costs on the private sector while generating revenue for the government. Which is not to say that there can’t be hybrid solutions.

Part way through his discussions Krugman pauses to make it clear that the science of climate change is for real. He makes three points. First, the planet is warming. Second, climate models predicted this well in advance. Third, models indicate that if we continue adding greenhouse gases to the atmosphere as we have we will eventually face drastic changes in the climate and massively disruptive events.  There is still tremendous uncertainty in long-term forecasts, but that makes the case for action stronger, not weaker.

Can we afford what needs to be done?

Economic modelers have reached a rough consensus that restricting emissions would slow economic growth — but not by much. The Congressional Budget Office, relying on a survey of models, concludes that strong climate-change policy would leave the American economy between 1.1 percent and 3.4 percent smaller in 2050 than it would be otherwise. On a global level the estimates are somewhat lower because of the efficiency gains in energy use possible to emerging economies — between 1 percent and 3 percent.

Krugman acknowledges that there are a number of ways in which the modeling could be wrong. Nobody really knows, for instance, what solar power will cost once it finally becomes a large-scale proposition. But while it’s unlikely that the models get everything right, it’s a good bet that they overstate rather than understate the economic costs of climate-change action. That was the experience with the acid rain scheme. He particularly notes that models do not and cannot take into account creativity.  Surely the private sector will come up with ways to limit emissions that are not yet in any model.

Yet conservative opponents of climate-change policy claim that any attempt to limit emissions would be economically devastating. What has happened to their belief in the dynamism of capitalism?  He thinks they are reacting against the idea of government intervention and indulging in political ploys rather than reasoned economic judgment. Hence their strong tendency to argue in bad faith, willfully misreading the figures.

’The truth is that there is no credible research suggesting that taking strong action on climate change is beyond the economy’s capacity.’

To the objection that the emerging economies won’t participate and therefore there’s no point in limiting emissions in the US, he argues for positive inducements and, if they fail, for carbon tariffs. He certainly doesn’t see the problem as intractable. If the US and Europe decide to move they almost certainly would be able to cajole and chivvy the rest of the world into joining the effort.

The costs of inaction are difficult to estimate. Krugman has a lively sense of the drastic changes which could accompany higher temperatures. We’re reaching levels of carbon dioxide in the atmosphere not seen in millions of years. Nobody really knows how much damage would result from the level of temperatures now considered likely. This uncertainty strengthens the case for action. He agrees with Martin Weitzman that if there is a chance of utter catastrophe, that chance should dominate cost-benefit calculations. Utter catastrophe does look like a realistic possibility. It would be irresponsible not to turn back from what may be the edge of a cliff.

There has been debate as to whether we act with some decisiveness now or build gradually over the century, the big bang or the ramp. Krugman leans toward the big-bang view, represented most notably by Nicholas Stern. Again, it’s the nonnegligible probability of utter disaster that argues for aggressive moves to curb emissions, soon.

On the US political front he’s not sanguine, but thinks there’s some chance that political support for action on climate change will revive.  If it does the economic analysis will be ready.

’We know how to limit greenhouse-gas emissions. We have a good sense of the costs — and they’re manageable. All we need now is the political will.’