Wednesday, November 3, 2010

Talking climate with Warwick McKibbin

I met RBA board member Professor Warwick McKibbin yesterday.  Alas, his reserved academic demeanour was a successful deterrent to a gruelling discussion on monetary policy and his thoughts on Australian housing.

I was, however, enlightened about his academic research and particular area of expertise – macro-economic modelling and climate change.

For such a diminutive guy he manages to raise a large public profile and promote intense debates on matters of macro-economic policy.  He was intensely critical of the government stimulus package, although many economists see it as very well implemented in hindsight.  

Some of the critics of the implementation of Australia's fiscal stimulus fail to see the broader political picture.  Professor Tony Makin, for example, argued that the fiscal stimulus was not necessary because adjustments in exchange rates and interest rates absorbed most of the impact of the crisis.  Yet he gives no credit to domestic impact of fiscal stimulus from abroad, particularly with our main trading partners.  His argument was that we should have been free riding on the stimulus of other nations.

The broader political picture reveals that there was an explicit agreement by G20 nations in November 2008 to take coordinate fiscal action to avoid this very issue.  In an international context our stimulus appears light on – maybe we still did partly free-ride.

But McKibbin is clearly most passionate about climate policy, driving hard his ideas for coordinated global action – The McKibbin-Wilcoxen Blueprint for climate policy.

Prior to Professor McKibbin's detailed overview of his economic modelling of climate change policy I had sat through a macro-economic modelling discussion which was a world apart from reality, an academic exercise, and I was ready to cast an intense critical eye over the next economic model to be presented. So I did.

His ambitious world economic model seemed to show that it was all too easy for most countries to meet their climate change targets, with many having very small (sub5%) impacts on GDP to their baseline forecast for 2020. Why was that?

I guess the principle reason I could see is that the displacement effect was not considered. This effect describes the "race to the bottom" whereby richer nations outsource their environmental harmful production functions to poorer nations with weaker environmental controls, resulting in net increases in global pollution.

But the displacement effect is really very subtle, and captures much of the sectoral change in the economy over time.  As such, estimates of substitution effects (elasticities) for the model where higher than I would expect.  They were estimated for energy prices from measurements of the US domestic economy from 1950-1980, a period where a dramatic shift in the composition of domestic production took place, yet composition of consumption remained more stable (Japanese manufacturing for example).

Given that this is the key model assumption I would hesitate at interpreting the outputs as a sign of the low cost of meeting targets, or cross-country indicator of comparable effort on climate change.  Obviously the global economy has no opportunity to displace production, yet the model inputs essentially assume we can.

The Professor did take on board this critique, and perhaps the next iterations of the model may show more severe changes to baseline estimates.  

Yet this type of problem exists with all macro-economic models, where data is usually sparse and unreliable, and you make do with the best you have at the time.  But interpreting the results knowing the shortcomings is especially troublesome.

Once again, I fear that questionable economic theory is crowding out common sense and political pragmatism, and I muse over how much this may occur at the board of our favourite central bank. 

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