As we continue to face extreme volatility in financial markets, the dire economic prospects for the real economy are now also becoming increasingly apparent. Policymaking is rightly focusing on short-term measures to stabilize financial systems. But it is clear that financial stability alone will not be enough to avoid a dramatic global economic slowdown and recessions in many countries. The policy debate is focusing towards measures that can revive the real economy.
The immediate concern is to counter the short term downward movement in the domestic and global business cycle using counter cyclical Keynesian policies. There is an emerging consensus that strengthened public investment programmes will be needed to boost economic demand and employment as broadly and rapidly as possible.
Investments needed to mitigate climate change, including large and ambitious projects that include developing countries, may provide an opportunity to both boost demand in the short run as well as contribute to longer-term poverty reduction, inclusive economic growth and sustainable development. I see two clear ways forward.
Addressing the Economic Crisis while Not Giving Up on the Climate Agenda
First, we can help to counter the economic crisis while at the same time not giving up on the climate change agenda by directing public resources towards climate change mitigating infrastructure, technology, and activities. This would pay off in the short- run by giving a countercyclical demand impulse and also in helping with the transition towards low carbon economies.
Jump-starting global demand will require a combination of aggressive macroeconomic policies. We are already seeing this in the realm of monetary policy, with sharp and even globally coordinated easing – not only aimed at stabilizing financial markets, but also reviving the economy. These measures will, in all likelihood, need to be complemented by vigorous countercyclical fiscal policies. The room for maneuver varies across countries, but the goal would be to use significant fiscal expansions to boost demand and employment as broadly and rapidly as possible. Given the severity of the recession that is now predicted for many countries, especially in the developed world, the scale of these fiscal expansions will likely have to be large and widespread across many economies.
Allocating a significant portion of the public resources mobilized through fiscal expansions to climate change mitigating investments would both boost demand in the short-run and contribute to addressing climate change, a critical longer-term growth and development challenge.
Earlier this year, I wrote about the type of longer term growth benefits – in addition to avoiding the costs of climate change – that would likely come from investments in climate change mitigation when answering questions from readers of Daniel Altman’s blog at the International Herald Tribune. As has been argued by Thomas Friedman, and others, I am also of the view that a technological revolution triggered by the transition to a low carbon economy could set in place growth multiplying effects and knowledge breakthroughs that bring about additional economic and social benefits. We have experienced this in previous economic and technological revolutions.
Sustaining Financing and Incentives for Climate Change Mitigation
There is, however, a second dimension in this opportunity to green the global economy. Sustaining financing and incentives to reduce greenhouse gas emissions over the long run will require more than a counter-cyclical impulse to public investment. Continued public investment over many years will be critical, as well as channeling private resources to climate change mitigating infrastructure and activities. To achieve this, prices in our economies have to send the right signals to people, firms, and governments in guiding their consumption and investment spending decisions towards reducing the emissions of greenhouse gases. Prices will have to be aligned to reflect the full social costs of emitting greenhouse gases as well as the benefits of opting for carbon-free technology. Recently, as I described in more detail in the Ideas4Development blog, fossil fuel prices increased to levels that implicitly made carbon more expensive than what the most ambitious climate change mitigation policies would have prescribed having based on the price of oil at the beginning of this decade. As the price of oil increased up until the summer of this year, people adjusted by using less oil and lowering the consumption of gas guzzling automobiles. There was also a push for investments in alternative energy sources and in scaling-up of projects for expanding and developing new hybrid and fuel efficient cars.
However, the oil price collapsed in the last few weeks. Oil prices are hovering now, in late October, around 65 dollars a barrel, compared with the 147 dollars a barrel peak reached on July 11. This kind of volatility is unprecedented since the oil crises of the 1970s. Under this extreme volatility, investment priorities and behavioral changes towards less greenhouse gases emitting activities may be reversed – or not started at all. Recently, there have been press reports that a number of investments in alternative energy sources that seemed extremely attractive a few months ago no longer appear viable. There are also reports that people are driving more and going back to buying large cars.
As an illustration, we can look at what has happened to changes in miles driven in the US. Oil consumption is determined by a complex set of factors. Subsidies, elasticities of demand, income effects, and other factors all play a role, so the price is not the only determinant of the miles driven. Still, it is significant that as oil prices peaked this summer, the decline in miles driven was higher than during the first oil crisis in the early 1970s and close to the decline in the second oil shock in the late 1970s. This is illustrated by the graph below from a post in the calculated risk blog, which shows the annual change in the rolling 12 month average of miles driven in the US up to and including August 2008, based on data from the US Department of Transportation. The graph also suggests that behavior can be very volatile when prices are more volatile – as in the oil shocks of the 1970s.
Given this huge price volatility and the challenges that it poses (not just for climate policy but also for planning investments and setting budgets) I wonder whether there is merit in trying to think seriously about a variable carbon tax. Carbon taxes could be coordinated at least among the rich countries in the world so that they would be high when the oil prices are low and automatically lower when the price of oil rises. This could stabilize the user-cost of fossil fuels – put a floor below the user cost - and would guide consumers and investors in their behavior and resource allocation towards less greenhouse gases emitting activities. At the same time, the revenues generated could be channeled to public investments in climate change mitigation and development or used to lower taxes on low-income households. Of course, many questions remain. One important issue is the response by oil producers, especially relevant if the oil market is regarded as a real OPEC controlled monopoly. A few important suppliers acting in concert can influence oil supply and a perfect monopolist would adjust supply so that the pre-announced variable carbon tax would tend to zero. But OPEC is not a perfect monopolist and there is thus scope for a variable carbon tax. The appropriate timing for the introduction of such a variable carbon tax must also be put in a political context. The best time to pre-commit would have been when prices were sky-high in the summer of 2008 when the policy would have involved committing to a carbon tax if and when prices fell below a certain level. In the long run, a variable carbon tax could be both an instrument to increase the price of carbon and one to reduce volatility.
