Wednesday, December 21, 2016

Global Warming Boom

 I think that Trump's election has greatly improved the prospects for real economic growth by reducing the prospect of stringent controls on greenhouse gases.   I think it likely that the resulting increase in the production of greenhouse gases will add to global warming, so this is the "global warming boom."

The alarmist rhetoric that mainstream Democrats have adopted regarding global warming would suggest the necessity of highly restrictive regulation of the production of carbon dioxide.   Cold-turkey pollution control is (or should be) a textbook example of a supply-side recession.    If there really were a prospect of planet Earth turning into Venus, a Great Depression scale contraction of real output and real income would be possible and justified.

Of course, few elected officials would support such a policy    Much more likely would be a gradual tightening of regulations so that real output grows more slowly.   Over time, the growth path of real output and real income would be substantially lowered, but at least in terms of design, there would be no periods where regulation would cause it to actually drop.   There would be no supply-side recession, but just simply slower growth.   Given the very slow increase in per-capita real income at best, the result could easily be stagnation in material standards of living.

If the pollution in question were noxious gases emitted into the atmosphere or poisons disposed into rivers, lakes, or oceans, the benefits of a  cleaner environment would be plain.   It is possible that the sacrifice of material goods and services would be worth it--even a rapid Great-Depression scale contraction of real output.  It  seems likely to me that a supply-side recession would be efficient at least in parts of China.  That measures like GDP fail to fully capture changes in human welfare should not be a major concern.   This is just one of many circumstances where the rough rule of thumb that higher and more rapid growth in per capita real GDP improves human welfare fails.

That reduced emission of greenhouse gases into the atmosphere provides a less immediate and obvious benefit does not necessarily mean that it does not increase human welfare on net, but the sacrifice of material goods and services still remains as a cost.   How much benefit from less future climate change will appear in the present?

For all of the apocalyptic rhetoric, there hasn't really been all that much regulation as of yet.   And so, the current economic impact was about expectations of future regulations and somewhat less global warming.   The surprise election of Trump has now caused any increased regulation to recede into the more distant future while the global warming is more likely to be slightly worse.

Anticipated regulations that will reduce real income from what otherwise would be will tend to increase saving.   Current consumption is reduced to cushion the blow to future consumption due to lower future incomes.   However, expectations of global warming should also increase saving.   Consumption is reduced now so that future consumption is protected perhaps from the impact of lower income but also from the need to use future resources to mitigate against problems caused by climate change.    While this implies an ambiguous result for saving, the more immediate and certain cost of the future regulation versus the more distant and speculative effect of global warming suggests more saving now on net.

The impact on investment is more important.   The likely introduction of strict regulation of carbon dioxide in the near future would immediately depress investment in durable capital equipment that generates substantial carbon dioxide.   This would be especially true for efficient regulations that penalize existing capital goods, such as a carbon tax.   Command and control regulation that applies solely to new investment would not have such an effect.   Quite the contrary, there should be a rush to invest before the regulation is applied.   Cap and trade could have a similar effect if the caps reward those firms that currently emit the most carbon dioxide.

While the prospect of regulation of carbon would make investment in capital equipment that emits relatively little carbon dioxide more profitable, there seems little reason to purchase any of it until just before the new regulations will begin to bite.   It would seem that the most sensible strategy would be to refrain from new investment, including regular replacement of existing equipment, accumulate short term financial assets, and then purchase "environmentally-friendly" capital equipment right before the new regulations are implemented.

What kind of investment would be encouraged by some decrease in the intensity of global warming in the future?   More building in coastal areas?    Agricultural buildings?     Planting fruit trees?

It seems to me that the most likely effect of the prospect of intense regulation of greenhouse gases would be an increase in the saving supply and decrease in investment demand.   This results in a lower natural interest rate.

This would be somewhat temporary.  After the regulations are implemented, the supply of saving would decrease in an effort to maintain consumption.

The demand for investment is ambiguous.   The opportunity to replace capital goods that generate substantial regulatory costs with new capital goods that emit less carbon dioxide and other greenhouse gases would increase investment demand.    However, these techniques would have already been more profitable if they were more effective in producing output.   This suggests that the reduction in investment demand must be at least partially permanent.

Still, there is good reason to believe that the natural interest rate would temporarily decrease before the regulations are implemented and then at least partially recover after carbon emissions are more strictly regulated.     If the prospect for regulation recedes, then the result should be a decrease in saving supply and increase in investment demand and so a higher natural interest rate.

The impact of an increase in saving supply and decrease in investment demand on the allocation of resources between the production of consumer and capital goods depends on which changes more and the interest elasticity of saving supply and investment demand.     At first pass, there is no effect at all--while both changes reduce the natural interest rates, they have opposite impacts on the allocation of resources.    While I would usually think the interest elasticity of investment demand is much greater than for saving supply/consumption demand, in this situation I would anticipate that the effort to save for the future would fail and firms would still postpone investment in capital equipment.  In other words, assuming the interest rate coordinates properly, the result would be increased production of consumer goods and services and fewer carbon-dioxide emitting capital goods.

More troubling is the possibility that the market rate fails to match the decrease in the natural interest rate so that at least part of the reduced investment demand and increased saving supply simply results in idle resources.     Further, the fear of these costly regulations, by deterring investment now one way or another, will begin to adversely impact growth of labor productivity.

Removing the threat of these regulations, then, would have the opposite effects.   The increase in investment demand will quite plausibly generate a substantial increase in  investment and the addition to the capital stock will enhance labor productivity.

That the Fed prefers to target short and safe interest rates has resulted in almost a decade of poor policy because short and safe interest rates are so low.   If firms begin to spend off their large holdings of short and safe securities and instead purchase capital goods, this problem will be greatly relieved.   The "Taylor rule" should begin to work somewhat better.

Finally, if we had the sort of massive contraction of real output that appears justified by the alarmist rhetoric of the Obama administration, the consequences for employment would very much depend on the monetary regime.    The direct and immediate effect of these stringent regulations would be to make the production of goods and services more difficult.   The reduction in supplies would tend to increase the prices of products.   A policy of strict inflation targeting would require that this be offset by reduced demand.   Equilibrium would require a substantial decrease in nominal and real wages.   It is difficult to see how anyone could pay off existing debts in such an evironment, and so widespread bankruptcy and financial reorganization would be necessary.    In other words, inflation targeting implies that a supply-side recession has an impact qualitatively similar to a demand side recession.

With nominal GPD targeting, the decreases in the supplies of various goods and services that require the emission of carbon would result in increases in their prices and so a transitionally higher inflation rate.   Real wages and real debts would be decreased.    With such a wrenching change in real production conditions, there would be substantial structural unemployment and business failures.  However, the collateral damage due to unnecessary bankruptcies and unrealistically high real wages would be greatly mitigated.

The implication of inflation targeting in the more realistic scenario where the regulations are implemented gradually so as to solely limit growth would have similar effects, but much less severe.   Spending growth must slow to prevent the slower growth in productivity/supplies from creating inflation and nominal and real wages must grow more slowly as well.   Stagnation in real wages is a real possibility given how slowly they grow anyway.  

When it is simply a matter of the prospect of more stringent regulations in the future, there is no immediate tendency for supply to be depressed other than the gradual impact of reduced investment on the capital stock and labor productivity.   If the market rate has failed to fall with the natural interest rate, inflation might well remain low.   Even so, nominal wages would need to grow more slowly in order for employment to be maintained.

Nominal GDP targeting would allow result in in modestly higher inflation when real output growth is slowed due to the gradual tightening of regulation.   Since nominal wage growth appears to have substantial momentum, the higher inflation will slow the growth of real wages and so tend to reduce any unnecessary reductions in employment.   The inflation will also modestly reduce real interest rates, and so help avoid the scenario where the market rate fails to decrease with the natural interest.

And if the threat of these regulations recedes into the distant future?    The need for  a lower real market interest rate and slower growth in nominal and real wages disappears.

The global warming boom--more investment, more productivity, more rapid growth in real and nominal wages, and more employment.   And a somewhat greater threat of harm from global warming.

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