Meltdown economics

8th March, 2008

So much hot air has been spouted over climate change it is a wonder the ice caps haven’t melted already. At first the debate was whether climate change was happening, and if so whether it was humanity’s fault. Far too late for the tastes of most economists, the debate then started to encompass other important questions, such as whether the costs of responding to the threat outweighed the benefits.

Perhaps I should withdraw my jibe about hot air. This is such an uncertain business, and the stakes are so high, it is no surprise that the debate on both questions continues. Still, that should not distract us from asking a different kind of question: given that climate change is going to need a policy response, what kind of institutions are best suited to implement it?

Think of an unlikely parallel: control of inflation. Nobody disputes that inflation should be kept under control, but the idea that an independent central bank should do the job is a more recent development. Andrew Sentance, a member of the Bank of England’s monetary policy committee – and before that, chief economist at British Airways – has recently been suggesting that the parallels between monetary and climate change policy are worth exploring.

One of the reasons that independent central banks are good at fighting inflation is that people expect them to succeed. When expectations of inflation are low, inflation itself tends to stay low. Credibility is important.

Credibility is also important for climate change policy: our expectations of future government taxes, subsidies and regulations shape our actions today. For example, if US citizens expected that a $3 environmental tax on a gallon of gasoline would be introduced permanently in 2010, that would immediately make gas-guzzling pickup trucks look less attractive. Few people would want to drive them in 2010, and few of today’s car buyers would relish the thought of trying to get a good price on the second hand market when the new tax came in.

A similar calculation applies to fridges or to home improvements.

Probably more important, if corporations confidently expected environmental taxes or regulation in the future, their research and design efforts today would reflect that expectation. It takes time to develop new technology, or even to produce more environmentally friendly products with today’s technology. If climate change is a problem, the sooner we begin to respond, the better off we shall be.

The other side of the coin is that if climate-change policy lacks credibility, people may not respond to it even when it arrives. Drivers will be unlikely to abandon their SUVs in the face of a gasoline tax that might be temporary; research and development activity will be even more tentative. And if future climate-change policy is expected to embody warped priorities – concentrating on scapegoats, favouring pet technologies – then today’s investments will also embody those priorities. At the moment, concerned consumers seem to be leading the battle against climate change; many companies are focused on pacifying them rather than achieving anything more substantial.

So it is tempting to leap to the conclusion that the UK needs an independent environmental authority with sufficient credibility to fight climate change, just as we now have a central bank with the credibility to fight inflation.

There is something in that idea, but the MPC’s Dr Sentance is not so hasty, and rightly so. Climate change is a more complex, uncertain, and international problem than monetary policy; it will need a new kind of institution. Successful institutions do not spring up overnight. They evolve over time. Finding the right institution to fight climate change is going to be a matter of trial and error. It is time to start experimenting.

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