(June 29, 2011) The following is a response to Peter Foster’s article published in the Financial Post on June 29, 2011. To read The Demons in Krugmanomics, click here.

Mr. Foster,

In today’s article on Paul Krugman, you touch on an important trend in Economics that goes beyond Krugman.  In many ways, the “science” has gone out of the discipline.  Many, if not most, “leading” economists are now basing their policy advice on the output of models that still largely reflect the way income was generated, wealth was created and capital and goods moved between countries 40 years ago.  The result is economic models that could not be less relevant in today’s world…being used by a generation of economists who have their heads so deep in their models that they no longer recognize real life–or use real data–to form their opinions.  At one time an economic model was only one tool in the economist’s bag.  The art of Economics–as it once was and also is no longer in accounting–was what we once called “analysis of the variance”.

Good economists once knew how and which assumptions built into their modelling standardized real-life factors that are dynamic.  Building a model and producing modelled output were only steps one and two in sophisticated analysis.  Given the modelled output, the scientist then revisited these key assumptions, and worked hard to understand the extent to which those assumptions resulted in output that does not reflect real life.  It was, in my view, this exercise of analyzing the variances that spawned some great and important policy advice from leading economists from the late 1940s through about 1985.

But when access to massive and cheap computing power hit, most economists left real life and dedicated their skills almost exclusively to the modelling exercise–making little progress, however, in revising the hard-wired assumptions that result in output that is not reflective of real life.  They rarely analyze the variance anymore.  They just report modelled results.  That would not be so bad, if that is where they stopped and left it to social and political scientists to take up that very important next step in the policy-development process.  But now we live with a generation of economists who have slipped into the illusion that the results of their now relatively out-dates modelling hobbies directly translate into good policy positions, without the analysis of the variance.

For example, let’s look at the carbon tax.  Krugman joins a majority of “leading” economists that suggest it is/will be a “successful” mechanism for battling CO2 emissions.  But a dozen countries have had forms of carbon tax in place for 20 years, and demand for the carbon-taxed commodities has grown faster over these last 20 years than ever before. Every traditional economist who has “examined” the carbon tax that was introduced in British Columbia, Canada, 3 years ago has declared it a “success”.  But the carbon tax revenue forecast in B.C.’s provincial budget anticipates unprecedented increases in the consumption of the taxed commodities (and significant increases in taxes collected) over the next 3 years.

The data shows, clearly, that non-industrial energy consumption is a function of household income levels and population density.  Per capita gasoline demand in the US has been 10.8 barrels/person/year +/- 5% SINCE 1969.  Per capita transportation fuel and home heating/lighting energy demand in Europe has been equally constant for the last 40 years–notwithstanding policy differences.  There is no significant demonstrable short-, medium- or long-term correlation between changes energy tax levels and retail prices, or retail prices and energy demand, anywhere in the western world.  But the R2 for population density and income-weighted non-industrial energy demand is almost 0.9.

What does the data tell us?  Non-industrial energy demand is a function on income and population density.  This means that energy demand is income, not price elastic.  Traditional economic theory tells us that a tax in income–not price–elastic commodity is highly regressive.  It raises tax revenues and is not an efficient demand management measure.  And it shifts tax burden from the rich to the poor.

That is what the data says.  But you will never get Krugman or a swath of his colleagues to say that.  They will say that the carbon tax is “efficient” because they have concluded it is cheap to collect.  Implicit in their modelling and ideas–but not often publicly acknowledged in their public discourse, is the assumption that governments are efficient when it comes to spending the new revenues to achieve the stated social objective–in this case reducing carbon emissions.  That carbon taxes are efficient and effective measures is an assumption that is hard-wired into their modelling.  It is not a result that the models produce from actual data.

The same economists typically say that it is easy for governments to mitigate the carbon tax burden shift from rich to poor through tax rebates, credits, etc.  They never ask or answer the following question: how much does it cost to shift tax burden from the rich to the poor and then administer the increasing need to immediately return increasing shares of the taxes collected back to the poor, ideally in the same month/year the tax is collected.  When we collected $1 billion in tax revenues, most of it was available for government programmes and debt servicing/retirement.  When we give up $1 billion in income tax revenues and introduce $1 billion in carbon tax revenues, how much of the carbon tax revenues are then lost to the newly-required tax redistribution effort?  Because the carbon tax is both inefficient and regressive, we need to collect closer to $2 billion in carbon tax revenues to address $1 billion in foregone income tax revenues.  And that discussion does not even start to address the false assumption that government will prove capable at directing the spending of any net carbon tax revenues to reduce emissions.

This reality partially explains why no European nation has introduce a carbon tax since 1999, and most of the nations that introduced carbon taxes between 1990 and 1999 have since worked, aggressively, to re-shift their basis of taxation back from energy consumption to income.  This is a near-impossible challenge, and this pre-recession-established imbalance in their tax regimes has made it much more difficult for many EU nations to pull out of the recession.  Note that Germany does not and has never had a carbon tax.  Sweden’s carbon tax has always included an 100\% exemption from all energy taxes (not just the carbon tax) for all “energy intensive businesses” where “energy intensive” is a business for which energy costs account for 3% or more of production/cost of sales.  Note that for a typical hotel, energy accounts for 5% of cost of sales.  In other words, this exemption covers most commercial activity–services as well as goods producers.  Have you ever hear Krugman, Jaccard or the C.D. Howe Institute talk about these realities and their implications?

I have fought for effective and efficient policy to address climate change over the entire 20 years that the western world has experimented with carbon taxes.  They have not worked (nor has “cap and trade”, in any of its 44 forms that have been tried since 1977–notwithstanding its cheerleaders).   Whenever I say “look, the policies you are recommending have no history of success if you look at actual data — as pollution/emission mitigation measures…can’t we start by examining the successful strategies we implemented to remove the lead from gasoline, reduce sulphur in diesel, remove CFCs from the refrigerant chemical supply chain, etc., to see if anything in those models could be applied to the climate change challenge?”  Other economists (I am one) from Simon Fraser through the University of Calgary through McGill, Harvard, MIT, etc. respond “she’s a climate denier, she does not haver tenure, she has no status, she is an oil industry hack (I wish!!!)”.  We all know that the best defence is a good offence.  But name-calling from our leading tenured academics and bank economists?

What is going on here?  When is name-calling — as opposed to substantive dialogue — the best offence?  When there is not substantive defence.

While some (not many) in the business press — including you in today’s the Financial Post — occasionally report accurately on the academic community’s irresponsible default to name-calling, I have seen next to no reporting on the actual weakness of these modern-day economists’ policy recommendations, or why those weaknesses prevail.  The business press, in my opinion, has to go beyond the climate-denier conversation and ask: if, for just a minute, we assume that CO2 emissions are a problem, what is wrong with the recommendations coming out of this community of leading economists?

The answer is there is much wrong — at least from my perspective — and the important but unreported story of the day is why that is so.

Someone needs to ask: how are these economists’ defining success?  While the BC and European carbon taxes might prove to be significant new public revenue generators, after 20 years there is no fact set that justifies calling them efficient — let alone effective — CO2 emission mitigation measures.
I am not a climate denier.  I AM angry that we rarely reports that go beyond believer-denier name-calling.  Why does the MSM not take a look at the data and then call the economists’ bluff  on their baseless policy recommendations?  This is the same crowd that failed to anticipate the global recession — for, in my view, exactly the same reasons their public policy recommendations have become increasingly irrelevant over time.

Aldyen

Aldyen Donnelly, June 29, 2011