Rising & falling stars: Economic imbalances & global environmental problems

Draft of a paper in preparation for presentation in China later this year. Comments welcome. The gist is that efficient global climate agreements won’t plausibly be implemented because of current global imbalances.   This means cooperative responses are more difficult and hinge on unilateral penalty devices such as border tax impositions.  Of course developed countries should take steps to reduce their indebtedness so that they can perform a more responsible role in managing the global commons.

The possibility that the developing regions of the world would achieve the economic living standards of developed countries was once disputed on the grounds that many of them were trapped in a ‘vicious cycle of poverty’.  The switch of most developing economies to market-based systems and their consequent strong economic success has shown that this earlier assessment is overly pessimistic.  For example the success of China in taking hundreds of millions of people out of extreme poverty in about forty years, using market reforms, is a momentous event in world history.  At the same time unbridled reliance on markets has damaged the economic prospects of countries that developed strongly in earlier years.  The case for limiting the extent of market liberalization – particularly in the financial sectors – in these economies is an urgent concern.

The criticality of this case for reregulating capitalism is compounded by environmental pressures.  The current developed countries achieved their industrialization on the basis of cheap water and energy supplies with much smaller aggregate demands for resources because of much lower populations. The world faces the prospect of 9.5 billion people in 2050 seeking to live at the living standards of these already wealthy countries creating major pressures on the natural resource base.  Malthusian resource constraints loom.  Neither water nor energy will now be cheap. Indeed pricing the cost of catastrophic climate change continent on the continued use of fossil fuels means that such fuel use is extremely expensive now if valued appropriately.

Both developed and developing countries are in the process of addressing many local or national environmental problems such as air and water pollution and such issues as congestion and excessive water use.    There are reasons for policy optimism with respect to these problems and a rational basis for this optimism given that the associated environmental costs are borne within the country where they are created.   This is much less true for regional and global environmental problems where there are significant negative spill-over effects of pollution and excessive depletion of renewable and exhaustible resources.  It is particularly untrue for the case of climate change that is induced by carbon and other emissions.  Dealing with climate change involves supplying a global public good for which there are well-known free-rider issues.  We consider this issue in relation to the US-Chinese strategic interactions on climate change – concerns that lie at the centre of attempts to negotiate a cohesive post-Kyoto global climate change agreement.

As mentioned the developed countries have achieved high living standards by drawing on cheap fossil fuel stocks and water.  Many emerging countries are now seeking to replicate these successful development outcomes.  Both groups of countries however are now facing a climate change constraint – human burning of carbon-based fuels and changed land use practices are adding to the stock of greenhouse gases thereby heating up the world’s atmosphere.  These heating effects will be costly for humanity and are potentially catastrophic.

From a global viewpoint the efficient pricing/transfer response to the climate change problem is straightforward.  Developed countries must reduce their current dependence on polluting, carbon-based fuels and utilise more sustainable land use policies.  These countries are wealthy with a high private willingness-to-pay for environmental quality and with relatively strong capacity to deal with moderate degrees of warming via adaptation policies.  Developing countries need to industrialise by drawing on non-polluting and non-carbon based energy sources as they expand their energy consumption.  As these countries are primarily agriculturally-based, land use problems and water supply vulnerabilities are of central concern. These countries have less wealth and lower private willingness-to-pay for the environment given the urgency of their development objectives and their markedly lower per capita energy consumptions and pervasive significant poverty issues.  However developing countries also have distinctly lower capacity to adapt to moderate levels of warming. All countries – developed and developing – face the prospect of potentially severe costs of dealing with catastrophically high levels of warming.

This policy task can be resolved globally with greatest efficiency by reducing the extent of carbon pollution where it is cheapest to do so given a uniform global carbon price and by paying for this investment in provision of this global public good on the basis of a benefits principle that reflects each nation’s marginal willingness-to-pay for climate control.  For these investments should occur in developing countries where low emission technologies need to be installed to add to deficient secondary energy generation capacity.  Here the key relevant costs are the incremental costs of installing low pollution technologies rather than those based on polluting fossil fuels. For developed countries, replacing existing energy production technologies means writing off currently productive assets and replacing them with new carbon-friendly technologies at least until these technologies reach the end of their economic lives.  Given the disparity in willingness-to-pay across developed and developing countries this effort should be funded by wealthier countries by transferring resources to less wealthy countries.

Global economic imbalances – specifically current account surpluses and high growth in some developing countries and deficits with poor growth prospects in richer countries – restrict the options for the wealthy countries of the world to facilitate the types of structural adjustments required to make their own adjustments and to fund the investments required to secure less resource-intensive patterns of exploitation in current emerging countries.  Indeed the supply of savings required to produce such global restructurings is currently heavily contingent on countries such as China continuing to save at high rates.

Were it not for these imbalances integrated, international markets could be relied on to resolve environmental problems.  Resources for restructuring would be supplied by developed countries and free trade in the scarce environmental resources with redistributive transfers to developing countries ensuring that global cost efficiency was achieved with distributive justice.

Current circumstances where much of the developed world, and the US/Europe in particular, is heavily indebted, experiencing low economic growth and, in many cases, apparently holding delusional beliefs over the seriousness of emerging climate problems, makes such a pricing and transfer solution seem impractical.  It is difficult to believe that countries such as the US will heavily subsidise the creation of low polluting carbon facilities in the developing world when parts of the developing world are experiencing very high economic growth and enjoying hefty current account surpluses at the same time that developed countries are experiencing economic stagnation.   The falling stars will be reluctant to compensate the falling stars. There should be some transfers and technical assistance but this will be insufficient to address the overall climate change concerns of developing countries. Specific macroeconomic reform proposals to, for example, revalue China’s RMB, will increase international interest rates and exacerbate the borrowing problems faced by heavily indebted developed countries.  Longer-term demographic shifts and tightening labour markets in developing countries such as China will have some effect in providing this outcome in any event but this, alone, will occur too slowly to force countries such as the US to the climate change policy starting post.  Massive debt levels will need to be reduced and this will take decades. Longer-term too countries such as China will gradually realise their economic development objectives and operate on the falling portion of their environmental Kuznets curve but this will occur far too slowly.

Short-term the issue of how adjustments to climate change are to be made given constraints on the availability of substantial multi-lateral transfers imposed by the current macroeconomic imbalances.  A direct approach would be to reduce the indebtedness of developed countries, such as the US, by raising taxes, by cutting public spending on non-climate change control issues and by restoring a sense of purpose and balance in public policy formulation. In particular, the need for increased financial and environmental regulation in the global economic environment needs to be understood pragmatically and non-ideologically.

Macroeconomic and financial reforms need to be targeted at promoting more sustainable societies that can better address longer-term global financial and environmental concerns.  Before such efforts bear fruit climate policies, given the imbalance constraints on transfers, will most plausibly take the form of specific national carbon tax and direct interventions policies without a global carbon market. For indebted developed countries carbon tax measures can be used to help reduce pressure on public sector budgets and to facilitate debt reduction.  Such national policies sacrifice cost efficiency and distributive justice for developed country political feasibility.  They imply that greater reliance will need to be placed on US emissions reductions, not because this is efficient, but simply because it is expedient given the existing imbalances. While these policies will reflect respective national priorities they will still display strategic interdependence.

Formally, the analysis of the global climate policy resolves into the study of a Prisoner’s Dilemma issues where compensatory side payments cannot be made.  In a static setting the strategic problem is how such a game can be transformed to a more tractable strategic Assurance Game – a game where if one country mitigates satisfactorily the other will mitigate also. In some cases this can be achieved using unilateral penalties such as border taxes that are designed to offset negative spill-over effects of unilateral mitigation actions.  In this case it is then helpful if the US Senate passes the Kerry-Boxer Bill currently before it which seeks a 20 per cent reduction of carbon emissions by 2020 over 2005 levels.  Regrettably this seems increasingly unlikely. China and other countries can then be plausibly expected to scale up their own national mitigation efforts.

In the past the US resisted ratifying the Kyoto Protocol because non-Annex 1 countries were not bound to mitigate their emissions under it.  In fact China has embarked on a comprehensive energy research program, renewable energy program and industry rationalisation program – on a scale that dwarfs efforts by the US. China will however still add greatly to global climate emissions in the future – in the next few years even with the emissions targets in place it will add 500,000 MW of coal-generated electricity which is about equal to the total use of coal-fired power in the US.  China has rejected undertaking additional mitigation measures until the US itself takes action on the basis that the cumulative emissions stock is primarily a developed country responsibility.  There are questionable historical factual issues with respect to this claim.

With the possibility of an economically catastrophic global collapse as a result of unmitigated climate change this strategic situation can also be formalised as a Game of Chicken where countries seek to push costs of addressing climate change onto the other party but where all countries prefer an outcome where each mitigates top one where neither does.

In a dynamic setting the China-US strategic concerns can be formulated as an Ultimatum Game. The aggregate gains are the environmental benefits the countries of the world gain from effective mitigation less costs of action.  The US is currently doing little nationally to address climate change leaving many of the costs of addressing climate change problems to China. The implied US threat is that if China does not take developmentally expensive carbon mitigation options it will suffer more severe problems from climate change than will the US itself.  The China’s response is to insist that largely unilateral actions on its part leave too large a share of the gains from effectively dealing with climate change to the US. The implication is that China will not to commit to further emission cuts even if this results in severe damages to itself in the future.  This outcome is not sub-game perfect but does have an intuitively plausible rational on moral justice grounds. If the US does not satisfactorily deal with emissions issues and China limits its future mitigation actions then China faces the prospect of large to catastrophic climate induced damage while the US faces the prospects of lower average damages but analogous significant prospects of catastrophic risk.  

Strategically this issue does not need to be resolved immediately however the global costs of addressing climate change increase as policy effort is delayed. In addition the negative impacts of actual climate on productivity and economic growth will almost certainly become more pronounced further reducing the economic capacity to address the problem.  For the same reason while global imbalances can be expected to resolve longer term, thereby opening up the prospects for an more efficient pricing/transfer reform, this delay also raises the prospect of increased mitigation costs.