What Do Climate Economics Models Teach Us About The Future?
The Lucas Critique Always Lurks!
On Monday, the NBER will publish a new Working Paper titled; “The Macroeconomic Impact of Climate Change: Global vs. Local Temperature”. that will attract wide attention. Here is the current version. The paper is written by two young star economists and it is well written and the paper features no obvious logical errors. I expect that it will be published in a great journal and I expect that the New York Times and other thought leaders will embrace the paper’s key prediction that climate change will be incredibly costly for the world’s economy.
Take a look at this Conclusion of the paper where the authors discuss the implications of their work and you will see why I want to discuss it.
The authors take their model very seriously and conclude that global increases in temperature will have an enormous negative impact on the world economy over the next decades.
My Thinking?
This type of econometric analysis and stationary mathematical modeling tells us what losses we may suffer in the future if we fail to adapt. Under “business as usual”, I believe the authors that the suffering could be large in terms of lost productivity and damage to the capital stock. BUT, this is exactly why I am confident that they are vastly over-estimating what the costs of climate change will be!
Joe Biden’s policy team will read their piece and say “AHA, this scientific work PROVES that we need more green subsidies for the green economy so that the costs these guys predict never manifest themselves”.
Despite the costly efforts by the Biden Administration, I believe that global GHG emissions will just keep rising because of rising energy demand in the developing world. As a globe, we are running this climate change experiment. Read our 2022 paper.
The real question is how we adapt to this challenge. ADAPTATION is missing from any of the climate change mathematical models written down by the Grand-daddy William Nordhaus or any of his intellectual offspring. I discuss this point in detail in this blog post.
In my October 2023 talk at Hoover, I expand on my points regarding endogenous innovation.
Here is the paper I presented and here are my slides from my talk.
What is missing from the modern climate change mathematical modeling literature is the simple idea that as an aggregate societal problem grows worse that entrepreneurs devote more effort to innovating. Think of cures for male baldness. Think of the rise of Zoom. Entrepreneurs work on those problems that they believe that people are willing to pay to solve. As many entrepreneurs compete, many fail but some succeed. These winners grow rich and in the process their new products allow us to solve the challenges we face such as extreme heat. As heat grows worse, we will see better indoor air conditioning and improved worker protective cooling suits. There are zillions of other examples. This Messy Hayek process is missing from the mechanical Nordhaus Mathematical models. Here are some papers for you to read and consider.
Acemoglu, Daron, and Joshua Linn. "Market size in innovation: theory and evidence from the pharmaceutical industry." The Quarterly journal of economics 119, no. 3 (2004): 1049-1090.
Barreca, Alan, Karen Clay, Olivier Deschenes, Michael Greenstone, and Joseph S. Shapiro. "Adapting to climate change: The remarkable decline in the US temperature-mortality relationship over the twentieth century." Journal of Political Economy 124, no. 1 (2016): 105-159.
The Lucas Critique and Yale Economics
Back in the 1970s, Robert Lucas had a very interesting intellectual debate with Yale Macroeconomists. They wrote down mechanical models of Keynesian business cycles featuring a mechanical consumption function with a fixed marginal propensity to consume. The Lucas Critique argues that as the economy’s “rules of the game” change that rational people reoptimize. This means that past empirical regularities do not have to continue in the future.
In the case of climate change, the change in the “rules of the game” is due to Mother Nature changing the weather distribution over time. If we were blissfully unaware of this dynamic, then we can’t adapt but the whole agenda of the climate science industry and the media who amplify their daily findings is that the weather distribution is changing. This is common knowledge and thus we adapt. My critics counter that we are behavioral and ignore these shifts. Please read my 2015 reply to these “Thalers”.
The Lucas Critique is applicable today to the new Yale/Princeton Macro climate models. The new models violate the Lucas Critique as the core production functions of their economies feature no endogenous adaptation. The agents in these models are “passive victims” who have no strategies to protect themselves.
But look at our world. Bezos and Musk are developing space ships to leave earth. This is one extreme example of endogenous innovation.
I encourage readers to study the Boskin Report here. As endogenous adaptation innovation takes place, we will have a larger menu of homes that don’t catch on fire, infrastructure that is more resilient, and structures that can take the heat. Due to specialization and learning by doing and competition, these products will become cheaper over time. Think of your cell phone. JFK didn’t have a cell phone but now the urban poor all have one. As prices decline, more and more people will have a wider menu of adaptation options and this means that the predicted losses discussed in this new academic paper do not materialize.
So, I congratulate the authors for playing the role of “Paul Revere” but I would be happy to bet with them that they are wrong about their medium term forecast. Julian Simon versus Paul Ehrlich redux!!
To wrap up, read this.
I speak with so many earnest young economists who believe that their research documenting the costs of climate change helps to cause the world’s nations to overcome the free rider problem and to decarbonize. They under-estimate the free rider problem.
I’d like to hear what you think of the distributional skew of damages and adaptation. My intuition is that the globally wealthy will do mostly okay under the current trends but that net damages will skew to the poor.
If the costs are estimated without taking account of adaption, it is incorrect. [Also it is not clear if the estimates are for cost that result from further increases in CO2 that w can do something about, or of future AND past emissions.] Nevertheless, for purposes of knowing how much cost to incur now to to reduce future CO2 and Methane emissions, the cost of adaptation are part the benefits of avoiding future emissions.
The paper was probably written and will be lauded out of the largely mistaken idea that people in general do not think climate change is harmful. I think people DO believe the climate change's harmful but too many believe it is not harmful e enough for them soon enough to bear the costs beig bandied about (even "degrowth") of avoiding it. This misperception arises both from over-estimating the size of the problem (which overestimate is fed by exaggerated "warnings") AND overestimating the comparatively low deadweight losses of least cost cost ways of reducing emissions, a tax on net emissions of CO2, an excise on first sale on fossil fuels in proportion to their carbon content.