Cut-Rate Carbon: Why We’ll Price Carbon Wrong

Cairo air pollutionTwo interesting articles appeared next to each other in the New York Times on Wednesday (print edition): One was about calculating the value of the future impact of carbon emitted today. The other was about economist Wynne Godley. Seemingly unrelated, they told an interesting story about the future of climate change policy in the United States and why, when we get around to pricing carbon, we’ll most likely get it wrong.

The first article contrasted approaches to putting a price on carbon. If a carbon tax were ever to come to pass, this is how it would be derived. This is done by estimating the future cost of the impact of our carbon emissions. This past spring, the Obama administration released revised, higher estimates of the “social cost of carbon,” a compendium of the cost of everything from floods to disease. Using one set of assumptions, the estimate was about $65 per ton of carbon or $ .56 per gallon of gas. Under another set of assumptions, the estimate was about $13.50 per ton, or around $ .12 per gallon of gas.

Why the difference? Not the estimates of damage, it turns out. Rather the differential arises from how much assumes today’s carbon users should pay for the damage that future generations will see.  The arguments are more nuanced than I am presenting here, Porter does a good job of laying them out in the Times, but environmental groups tend to favor the pay-more-now approach while business groups generally want to pay less.

And that’s where Godley comes in. Godley was one of the few economists to have a model that predicted the 2008 financial collapse. Although the “Times of London called him ‘the most insightful macroeconomic forecaster of his generation,’ he had long been out of the economics mainstream. His work is now gaining some posthumous acceptance.

Godley had the audacity to try to inject some reality into his economic models (pardon my sarcasm but I have an undergrad degree in Economics so I have seen how wedded economists can get to their models and the underlying assumptions):

Mainstream models assume that, as individuals maximize their self-interest, markets move the economy to equilibrium. Booms and busts come from outside forces, like erratic government spending or technological dynamism or stagnation. Banks are at best an afterthought.

The Godley models, by contrast, see banks as central, promoting growth but also posing threats. Households and firms take out loans to build homes or invest in production. But their expectations can go awry, they wind up with excessive debt, and they cut back. Markets themselves drive booms and busts.

What does all of this have to do with the cost of carbon? According to the Times, the business-friendly low estimate has gained traction in policy circles. After all, classical economics tells us that we are rational and optimize current spending against future needs:

In mainstream economic models, individuals are supposed to optimize the trade-off between consuming today versus saving for the future, among other things. To do so, they must live in a remarkably predictable world.

Mr. Godley did not see how such optimization is conceivable. There are simply too many unknowns, he theorized.

Godley’s models did not assume that the world all that predictable, certainly not by most of us, and that instead we use general “rules of thumb” to guide us to decisions. What we see in the cost-of-carbon debate are rosy estimates from businesses forces that really wish all of this would just go away and environmental groups that see the impending end of the world. Businesses tend to be relentlessly focused on the short term while environmentalists tend to discount some of the realities of the marketplace.

Putting a cost on carbon is critical. We have past the time that business can be allowed to ignore such externalities and policy makers should be trying to move us a situation where a tax (or cap-and-trade system or whatever) allocates costs as accurately and fairly as possible. Only then can the market work its magic. My question is this: what would Godley do?

My simple plea is this — and I think that Godley would agree — when confronted with a real challenge such as climate change and with an understanding of our own fallibility, start with two rules of thumb that have always served me well: Question the assumptions. Challenge the orthodoxies.  Shouldn’t we push hard to discern between what we know versus what we think before we set policy?  Shouldn’t we then start the discussion somewhere in between the best and worst case scenarios?  Let’s build a model based on $32 a ton and see where we go from there.

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