How the climate crisis is slowing down the world economy

Paul Krugman, the economist, Nobel laureate and New York Times columnist, has picked up a new habit. He now keeps reiterating that uncertainty is hurting economies around the world. His core argument relates to trade disputes. As no one knows how things will evolve, investment activities are slowing down. Business leaders who depend on open borders are afraid that their business plans cannot work out, but the same is true of business leaders who would benefit from protectionism. He argued so here and again here.

Krugman’s argument is certainly valid. Other causes of uncertainty include the unresolved Brexit drama or the rise of artificial intelligence, as Krugman and other economists often point out. What they only rarely mention is the climate crisis. I am sure it plays a huge role.

We have been witnessing inadequate investments in the real economy for over a decade, starting with the financial crisis of 2008. Interest rates are low in all major economies because savings exceed the demand for loans. The background is that businesses usually need loans for investing. If they don’t invest, they don’t go into debt, and that means we get a savings glut with low interest rates.

The climate crisis is certainly one of the underlying reasons. Energy is essential for basically every industry. It is increasingly clear, however, that fossil fuels must be phased out. What will happen is most uncertain because policymakers so far have not taken the necessary decisions. The international community still pretends basically that business can and will go on as usual. Responsible business leaders who ponder long-term investments, however, know that the energy system is set to change at some point in the not-too-distant future. They also know that this will require determined political action, but they cannot tell what form it will take. Accordingly, they cannot be blamed for dithering.

As the climate crisis escalates, moreover, the uncertainties related to it increase too. This is something else smart investors are aware of. What does it mean for food production that pollinators are becoming ever rarer? How will wildfires affect real estate prices in California? What if China or some other large market suddenly bans cars powered by petrol or diesel?

Climate deniers cast doubt on science, but I am sure that many investors do not believe them. And the climate deniers are even wrong when they say that the studies they do not like are alarmist. Unfortunately, the opposite is true. Climate researchers are keen on building and protecting their academic reputations. Therefore they want to appear to be sober and rational. They definitely prefer making conservative forecasts to alarmist ones. The truth is that we are feeling the impacts of global heating earlier and with greater force than most climate scientists expected.

Economics is the field of science which is perhaps the least aware of climate challenges. Nicholas Stern of the London School of Economics and Naomi Oreskes of Harvard University spelled out why in New York Times.

Let me briefly summarise the main points:

• If economists take climate issues into account at all, they rely on the forecasts of climate scientists which, as just argued above, tend to be conservative.
• Economists need numbers they can use in their models. Climate science, however, often does not offer sufficiently precise figures. The result is that even environmentally-aware economists do not include the changing climate in their models. They are afraid that someone might accuse them of “making things up”. Rather than run that risk, they consciously construct models that leave out important, but not precisely quantifiable issues. The models are distorted, therefore, and support a wrong feeling of security.
• This tendency is becoming increasingly problematic. The more the environment changes, the more  distorted the models become. Things like rainfall, sunshine, wind et cetera. used to vary a bit from year to year, but basically stayed the same on average. That meant that economic models did not have to take account of them, because they were basically “stationary”, as the technical jargon has it. Stationarity, however, has already become a victim of the climate crisis.
• Compounding these problems, tipping points are likely to further accelerate global heating. Risks are set to cascade faster and faster. Obviously, that makes them even more difficult to model. At the same time, the impacts are likely to prove even more important. Economists’ models are becoming ever more inadequate.

Diminished faith in forecasts

Anyone who wants to make long-term investments in the real economy normally takes into account leading institutes’ economic forecasts. So you might now think that the climate crisis cannot be hurting investment much since the forecasts do not really take it into account. I am sure that this is not so. Let me explain:

• For one thing, trust in economic forecasts has decreased dramatically in the past decade. One reason is that so few economists predicted the financial crisis in 2008.
• For another, entrepreneurs, just like scientists and other human beings, are not entirely rational creatures. Their gut feelings matter very much, and some business media, including for example the Financial Times or The Economist, have never downplayed climate change. Smart observers have known for at least two decades that conventional economic forecasts are incomplete and that environmental change is a real threat.
• Moreover, debate on the validity of our understanding of growth has gained momentum in recent years. Natural disasters cause massive harm, but they also drive economic growth to the extent that they trigger additional spending. GDP statistics basically count monetary transactions, but the loss of buildings, infrastructure and natural resources do not figure. Clever investors are aware of these things and worry about them.

As a matter of fact, leading central bankers have been pointing out that the climate crisis is real for some time. Mark Carney, the governor of the Bank of England, is a prominent example. Private-sector managers tend to pay attention to people like him. Christine Lagarde, the new president of the European Central Bank and former managing director of the International Monetary Fund, similarly says that monetary policy must take climate issues into account. No, these things do not feature in the modeling yet, but yes, they matter very much.

I am therefore absolutely convinced that environmental uncertainty has been a drain on the global economy for at least a decade. The international community expected the climate summit in Copenhagen to conclude a global agreement in 2009, but the summit failed. Prudent investors must have taken note. No doubt, this kind of uncertainty has been driving the much bemoaned short-term thinking in the business community and a preference for financial-sector investments over real-economy investments.

This is a problem the private sector cannot sort out by itself. I plan to return to the topic soon.