Category: Essentials of Economics: 8e Ch 04


The Climate Change Pact agreed by leaders at the end of COP26 in Glasgow went further than many pessimists had forecast, but not far enough to meet the goal of keeping global warming to 1.5°C above pre-industrial levels. The Pact states that:

limiting global warming to 1.5°C requires rapid, deep and sustained reductions in global greenhouse gas emissions, including reducing global carbon dioxide emissions by 45 per cent by 2030 relative to the 2010 level and to net zero around mid-century, as well as deep reductions in other greenhouse gases.

So how far would the commitments made in Glasgow restrict global warming and what actions need to be put in place to meet these commitments?

Short-term commitments and long-term goals

According to Climate Action Tracker, the short-term commitments to action that countries set out would cause global warming of 2.4°C by the end of the century, the effects of which would be calamitous in terms of rising sea levels and extreme weather.

However, long-term commitments to goals, as opposed to specific actions, if turned into specific actions to meet the goals would restrict warming to around 1.8°C by the end of the century. These long-term goals include reaching net zero emissions by certain dates. For the majority of the 136 countries agreeing to reach net zero, the date they set was 2050, but for some developing countries, it was later. China, Brazil, Indonesia, Russia, Nigeria, Sri Lanka and Saudi Arabia, for example, set a date of 2060 and India of 2070. Some countries set an earlier target and others, such as Benin, Bhutan, Cambodia, Guyana, Liberia and Madagascar, claimed they had already reached zero net emissions.

Despite these target dates, Climate Action Tracker argues that only 6 per cent of countries pledging net zero have robust policies in place to meet the targets. The problem is that actions are required by firms and individuals. They must cut their direct emissions and reduce the consumption of products whose production involved emissions.

Governments can incentivise individuals and firms through emissions and product taxes, through carbon pricing, through cap-and-trade schemes, through subsidies on green investment, production and consumption, through legal limits on emissions, through trying to change behaviour by education campaigns, and so on. In each case, the extent to which individuals and firms will respond is hard to predict. People may want to reduce global warming and yet be reluctant to change their own behaviour, seeing themselves as too insignificant to make any difference and blaming big business, governments or rich individuals. It is important, therefore, for governments to get incentive mechanisms right to achieve the stated targets.

Let us turn to some specific targets specified in the Climate Change Pact.

Phasing out fossil fuel subsidies

Paragraph 20 of the Climate Change Pact

Calls upon Parties to accelerate … efforts towards the … phase-out of inefficient fossil fuel subsidies, while providing targeted support to the poorest and most vulnerable in line with national circumstances and recognizing the need for support towards a just transition.

Production subsidies include tax breaks or direct payments that reduce the cost of producing coal, oil or gas. Consumption subsidies cut fuel prices for the end user, such as by fixing the price at the petrol pump below the market rate. They are often justified as a way of making energy cheaper for poorer people. In fact, they provide a bigger benefit to wealthier people, who are larger users of energy. A more efficient way of helping the poor would be through benefits or general tax relief. Removing consumption subsidies in 32 countries alone would, according to International Institute for Sustainable Development, cut greenhouse gas emission by an average of 6 per cent by 2025.

The chart shows the 15 countries providing the largest amount of support to fossil fuel industries in 2020 (in 2021 prices). The bars are in billions of dollars and the percentage of GDP is also given for each country. Subsidies include both production and consumption subsidies. (Click here for a PowerPoint of the chart.) In addition to the direct subsidies shown in the chart, there are the indirect costs of subsidies, including pollution, environmental destruction and the impact on the climate. According to the IMF, these amounted to $5.4 trillion in 2020.

But getting countries to agree on a path to cutting subsidies, when conditions vary enormously from one country to another, proved very difficult.

The first draft of the conference agreement called for countries to ‘to accelerate the phasing-out of coal and subsidies for fossil fuels’. But, after objections from major coal producing countries, such as China, India and Australia, this was weakened to calling on countries to accelerate the shift to clean energy systems ‘by scaling up the deployment of clean power generation and energy efficiency measures, including accelerating efforts towards the phasedown of unabated coal power and phase-out of inefficient fossil fuel subsidies’. (‘Unabated’ coal power refers to power generation with no carbon capture.) Changing ‘phasing-out’ to ‘the phasedown’ caused consternation among many delegates who saw this as a substantial weakening of the drive to end the use of coal.

Another problem is in defining ‘inefficient’ subsidies. Countries are likely to define them in a way that suits them.

The key question was the extent to which countries would actually adopt such measures and what the details would be. Would they be strong enough? This remained to be seen.

As an article in the journal, Nature, points out:

There are three main barriers to removing production subsidies … First, fossil-fuel companies are powerful political groups. Second, there are legitimate concerns about job losses in communities that have few alternative employment options. And third, people often worry that rising energy prices might depress economic growth or trigger inflation.

The other question with the phasing out of subsidies is how and how much would there be ‘targeted support to the poorest and most vulnerable in line with national circumstances’.

Financial support for developing countries

Transitioning to a low-carbon economy and investing in measures to protect people from rising sea levels, floods, droughts, fires, etc. costs money. With many developing countries facing serious financial problems, especially in the light of measures to support their economies and healthcare systems to mitigate the effects of COVID-19, support is needed from the developed world.

In the COP21 Paris Agreement in 2015, developed countries pledged $100 billion by 2020 to support mitigation of and adaptation to the effects of climate change by developing countries. But the target was not reached. The COP26 Pact urged ‘developed country Parties to fully deliver on the $100 billion goal urgently and through to 2025’. It also emphasised the importance of transparency in the implementation of their pledges. The proposal was also discussed to set up a trillion dollar per year fund from 2025, but no agreement was reached.

It remains to be seen just how much support will be given.

Then there was the question of compensating developing countries for the loss and damage which has already resulted from climate change. Large historical polluters, such as the USA, the UK and various EU countries, were unwilling to agree to a compensation mechanism, fearing that any recognition of culpability could make them open to lawsuits and demands for financial compensation.

Other decisions

  • More than 100 countries at the meeting agreed to cut global methane emissions by at least 30 per cent from 2020 levels by 2030. Methane is a more powerful but shorter-living greenhouse gas than carbon. It is responsible for about a third of all human-generated global warming. China, India and Russia, however, did not sign up.
  • Again, more than 100 countries agreed to stop deforestation by 2030. These countries include Indonesia and Brazil, which has been heavily criticised for allowing large parts of the Amazon rainforest to be cleared for farming, such that the Amazon region in recent years has been a net emitter of carbon from the felling and burning of trees. The pledge has been met with considerable cynicism, however, as it unclear how it will be policed. Much of the deforestation around the world is already illegal but goes ahead anyway.
  • A mechanism for trading carbon credits was agreed. This allows countries which plant forests or build wind farms to earn credits. However, it may simply provide a mechanism for rich countries and businesses to keep emitting as usual by buying credits.
  • Forty-five countries pledged to invest in green agricultural practices to make farming more sustainable.
  • Twenty-two countries signed a declaration to create zero-emission maritime shipping routes.
  • The USA and China signed a joint declaration promising to boost co-operation over the next decade on various climate actions, including reducing methane emissions, tackling deforestation and regulating decarbonisation.

Blah, blah, blah or real action?

Many of the decisions merely represent targets. What is essential is for countries clearly to spell out the mechanisms they will use for achieving them. So far there is too little detail. It was agreed, therefore, to reconvene in a year’s time at COP27 in Egypt. Countries will be expected to spell out in detail what actions they are taking to meet their emissions targets and other targets such as ending deforestation and reducing coal-fired generation.

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Questions

  1. What were the main achievements of COP26?
  2. What were the main failings of COP26?
  3. How can people be incentivised to reduce their direct and indirect greenhouse gas emissions?
  4. How is game theory relevant to understanding the difficulties in achieving global net zero emissions?
  5. Should developing countries be required to give up coal power?
  6. If the world is to achieve net zero greenhouse gas emissions, should all countries achieve net zero or should some countries achieve net negative emissions to allow others to continue with net positive emissions (albeit at a lower level)?

The development of open-source software and blockchain technology has enabled people to ‘hack’ capitalism – to present and provide alternatives to traditional modes of production, consumption and exchange. This has enabled more effective markets in second-hand products, new environmentally-friendly technologies and by-products that otherwise would have been negative externalities. Cryptocurrencies are increasingly providing the medium of exchange in such markets.

In a BBC podcast, Hacking Capitalism, Leo Johnson, head of PwC’s Disruption Practice and younger brother of Boris Johnson, argues that various changes to the way capitalism operates can make it much more effective in improving the lives of everyone, including those left behind in the current world. The changes can help address the failings of capitalism, such as climate change, environmental destruction, poverty and inequality, corruption, a reinforcement of economic and political power and the lack of general access to capital. And these changes are already taking place around the world and could lead to a new ‘golden age’ for capitalism.

The changes are built on new attitudes and new technologies. New attitudes include regarding nature and the land as living resources that need respect. This would involve moving away from monocultures and deforestation and, with appropriate technologies (old and new), could lead to greater output, greater equality within agriculture and increased carbon absorption. The podcast gives examples from the developing and developed world of successful moves towards smaller-scale and more diversified agriculture that are much more sustainable. The rise in farmers’ markets provides an important mechanism to drive both demand and supply.

In the current model of capitalism there are many barriers to prevent the poor from benefiting from the system. As the podcast states, there are some 2 billion people across the world with no access to finance, 2.6 billion without access to sanitation, 1.2 billion without access to power – a set of barriers that stops capitalism from unlocking the skills and productivity of the many.

These problems were made worse by the response to the financial crisis of 2007–8, when governments chose to save the existing model of capitalism by propping up financial markets through quantitative easing, which massively inflated asset prices and aggravated the problem of inequality. They missed the opportunity of creating money to invest in alternative technologies and infrastructure.

New technology is the key to developing this new fairer, more sustainable model of capitalism. Such technologies could be developed (and are being in many cases) by co-operative, open-source methods. Many people, through these methods, could contribute to the development of products and their adaptation to meet different needs. The barriers of intellectual property rights are by-passed.

New technologies that allow easy rental or sharing of equipment (such as tractors) by poor farmers can transform lives and massively increase productivity. So too can the development of cryptocurrencies to allow access to finance for small farmers and businesses. This is particularly important in countries where access to traditional finance is restricted and/or where the currency is not stable with high inflation rates.

Blockchain technology can also help to drive second-hand markets by providing greater transparency and thereby cut waste. Manufacturers could take a stake in such markets through a process of certification or transfer.

A final hack is one that can directly tackle the problem of externalities – one of the greatest weaknesses of conventional capitalism. New technologies can support ways of rewarding people for reducing external costs, such as paying indigenous people for protecting the land or forests. Carbon markets have been developed in recent years. Perhaps the best example is the European Emissions Trading Scheme (EMS). But so far they have been developed in isolation. If the revenues generated could go directly to those involved in environmental protection, this would help further to internalise the externalities. The podcasts gives an example of a technology used in the Amazon to identify the environmental benefits of protecting rain forests that can then be used to allow reliable payments to the indigenous people though blockchain currencies.

Podcast

Questions

  1. What are the main reasons why capitalism has led to such great inequality?
  2. What do you understand by ‘hacking’ capitalism?
  3. How is open-source software relevant to the development of technology that can have broad benefits across society?
  4. Does the current model of capitalism encourage a self-centred approach to life?
  5. How might blockchain technology help in the development of a more inclusive and fairer form of capitalism?
  6. How might farmers’ co-operatives encourage rural development?
  7. What are the political obstacles to the developments considered in the podcast?

Bubbles

Speculation in markets can lead to wild swings in prices as exuberance drives up prices and
pessimism leads to price crashes. When the rise in price exceeds underlying fundamentals, such as profit, the result is a bubble. And bubbles burst.

There have been many examples of bubbles throughout history. One of the most famous is that of tulips in the 17th century. As Box 2.4 in Essential Economics for Business (6th edition) explains:

Between November 1636 and February 1637, there was a 20-fold increase in the price of tulip bulbs, such that a skilled worker’s annual salary would not even cover the price of one bulb. Some were even worth more than a luxury home! But, only three months later, their price had fallen by 99 per cent. Some traders refused to pay the high price and others began to sell their tulips. Prices began falling. This dampened demand (as tulips were seen to be a poor investment) and encouraged more people to sell their tulips. Soon the price was in freefall, with everyone selling. The bubble had burst .

Another example was the South Sea Bubble of 1720. Here, shares in the South Sea Company, given a monopoly by the British government to trade with South America, increased by 900% before collapsing through a lack of trade.

Another, more recent, example is that of Poseidon. This was an Australian nickel mining company which announced in September 1969 that it had discovered a large seam of nickel at Mount Windarra, WA. What followed was a bubble. The share price rose from $0.80 in mid-1969 to a peak of $280 in February 1970 and then crashed to just a few dollars.

Other examples are the Dotcom bubble of the 1990s, the US housing bubble of the mid-2000s and BitCoin, which has seen more than one bubble.

Bubbles always burst eventually. If you buy at a low price and sell at the peak, you can make a lot of money. But many will get their fingers burnt. Those who come late into the market may pay a high price and, if they are slow to sell, can then make a large loss.

GameStop shares – an unlikely candidate for a bubble

The most recent example of a bubble is GameStop. This is a chain of shops in the USA selling games, consoles and other electronic items. During the pandemic it has struggled, as games consumers have turned to online sellers of consoles and online games. It has been forced to close a number of stores. In July 2020, its share price was around $4. With the general recovery in stock markets, this drifted upwards to just under $20 by 12 January 2021.

Then the bubble began.

Hedge fund shorting

Believing that the GameStop shares were now overvalued and likely to fall, many hedge funds started shorting the shares. Shorting (or ‘short selling’) is where investors borrow shares for a fee and immediately sell them on at the current price, agreeing to return them to the lender on a specified day in the near future (the ‘expiration date’). But as the investors have sold the shares they borrowed, they must now buy them at the current price on or before the expiration date so they can return them to the lenders. If the price falls between the two dates, the investors will gain. For example, if you borrow shares and immediately sell them at a current price of £5 and then by the expiration date the price has fallen to $2 and you buy them back at that price to return them to the lender, you make a £3 profit.

But this is a risky strategy. If the price rises between the two dates, investors will lose – as events were to prove.

The swarm of small investors

Enter the ‘armchair investor’. During lockdown, small-scale amateur investing in shares has become a popular activity, with people seeking to make easy gains from the comfort of their own homes. This has been facilitated by online trading platforms such as Robinhood and Trading212. These are easy and cheap, or even free, to use.

What is more, many users of these sites were also collaborating on social media platforms, such as Reddit. They were encouraging each other to buy shares in GameStop and some other companies. In fact, many of these small investors were seeing it as a battle with large-scale institutional investors, such as hedge funds – a David vs. Goliath battle.

With swarms of small investors buying GameStop, its share price surged. From $20 on 12 January, it doubled in price within two days and had reached $77 by 25 January. The frenzy on Reddit then really gathered pace. The share price peaked at $468 early on 28 January. It then fell to $126 less than two hours later, only to rise again to $354 at the beginning of the next day.

Many large investors who had shorted GameStop shares made big losses. Analytics firm Ortex estimated that hedge funds lost a total of $12.5 billion in January. Many small investors, however, who bought early and sold at the peak made huge gains. Other small investors who got the timing wrong made large losses.

And it was not just GameStop. Social media were buzzing with suggestions about buying shares in other poorly performing companies that large-scale institutional investors were shorting. Another target was silver and silver mines. At one point, silver prices rose by more than 10% on 1 February. However, money invested in silver is huge relative to GameStop and hence small investors were unlikely to shift prices by anything like as much as GameStop shares.

Amidst this turmoil, the US Securities and Exchange Commission (SEC) issued a statement on 29 January. It warned that it was working closely with other regulators and the US stock exchange ‘to ensure that regulated entities uphold their obligations to protect investors and to identify and pursue potential wrongdoing’. It remains to be seen, however, what it can do to curb the concerted activities of small investors. Perhaps, only the experience of bubbles bursting and the severe losses that can result will make small investors think twice about backing failing companies. Some Davids may beat Goliath; others will be defeated.

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Questions

  1. Distinguish between stabilising and destabilising speculation.
  2. Use a demand and supply diagram to illustrate destabilising speculation.
  3. Explain how short selling contributed to the financial crisis of 2007/8 (see Box 2.7 in Economics (10th edition) or Box 3.4 in Essentials of Economics (8th edition)).
  4. Why won’t shares such as GameStop go on rising rapidly in price for ever? What limits the rise?
  5. Find out some other shares that have been trending among small investors. Why were these specific shares targeted?
  6. How has quantitative easing impacted on stock markets? What might be the effect of a winding down of QE or even the use of quantitative tightening?

On 15 March 2019, the ‘Organ Donation (Deemed Consent) Bill’ was passed into law. (See the blog, Organ donations – Changing the default option vs active choice.) The government has just announced that this will come into force on 20 May this year. Under the scheme, ‘adults in England will be considered potential donors unless they chose to opt out or are excluded. The act is known as Max and Keira’s law in honour of a boy who received a heart transplant and the girl who donated it.’

This change from an ‘opt-in’ to an ‘opt-out’ system follows a similar a move in Wales in 2015. Since then, Wales has seen a significant increase in potential donors, with the consent rate rising from 58% to 77%. A similar move in Scotland will come into force in the autumn of this year. The government expects there to be an additional 700 transplant operations per year available for transplant by 2023.

These moves from an opt-in to an opt-out system are consistent with ‘nudge theory’. This maintains that positive reinforcement or making a decision easy for people can persuade them to make a particular choice. They are ‘nudged’ into so doing.

Opting out and nudge theory

In the case of having to opt in to a scheme such as organ donation, people have to make the decision to take part. Many, as a result, do not, partly because they never seem to find the time to do so, even though they might quite like to. With the busy lives people lead, it’s too easy to think, ‘Yes, I’ll do that some time’, but never actually get round to doing it: i.e. they have present bias and hence behave in a time-inconsistent manner.

With an opt-out system, people are automatically signed up to the scheme, but can freely choose to opt out. In the case of the new organ donor schemes in the UK, it is/will be assumed that organs from people killed in an accident who had not opted out could be used for transplants. If you do not want your organs to be used, you have to notify that you are opting out.

It could be the same with charitable giving. Some firms add a small charitable contribution to the price of their products (e.g. airline tickets or utility bills), unless people opt out.

Similarly, under UK pension arrangements introduced from 2012, firms automatically deduct pension contributions from employees’ wages unless they opt out of the scheme. Opt-out pension schemes like this retain between 90 and 95 per cent of employees. Opt-in pension schemes, by contrast, have much lower participation rates of around 60 per cent, even though they are otherwise identical.

This type of ‘nudging’ can improve the welfare of those who make systematic mistakes (i.e. operate in a time-inconsistent manner), while imposing very limited harm on those who act in a time-consistent manner. If it is in the interests of someone to opt out of the scheme, they can easily do so. Policies such as these are an example of what behavioural economists call ‘soft paternalism’.

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Official Information

Questions

  1. Why do opt-out schemes have a higher take up than opt-in ones? Would this apply if people behaved in a time-consistent manner?
  2. What is present bias? How does it differ from simple impatience? Explain how present bias might help to explain the impact of changing the default option.
  3. What are the arguments for and against nudging people to make decisions that benefit them or are in the social interest?
  4. Give some example of nudges that are used in public policy or would be a good idea to use. Consider how effective they are likely to be. (You might refer to the work of the Behavioural Insights Team.)
  5. What are the possible drawbacks of presumed consent in organ donation?
  6. What are the arguments for and against paying live people to donate organs, such as a kidney?
  7. How might people be encouraged to behave in the right way during an epidemic, such as corona virus?
  8. To what extent was nudge theory used during the Brexit referendum campaign and in the two subsequent general elections?

How to get the most from your money? This is the question posed by the linked article below. It’s a topic we’ve looked at in previous posts, such as Studies show that money can buy happiness (but only if you spend on experiences), Happiness economics and Peak stuff. This article takes the arguments further.

It suggests that, up to a certain level of income, there is a roughly linear relationship between money and life satisfaction. As poor people have more to spend, so they can begin to escape poverty and the negative features of financial insecurity and a lack of basic necessities, such as food and shelter. They also gain a greater freedom to choose what and when to buy. Beyond a certain level, however, the rate of increase in life satisfaction tends to decline, as does the specific pleasure from additional individual purchases. In economists’ language, the marginal utility of income diminishes.

But the article goes further than this. It suggests that satisfaction or happiness is of two broad types. The first is the general sense of well-being that people get from their life. This tends to be relatively stable for any given person, but will tend to increase as people have more money to spend or have more fulfilling jobs. Of course, there may well be a trade-off between income and job satisfaction. Some people may prefer to take a cut in pay for a more fulfilling job.

The second is the satisfaction or happiness you get from specific experiences. This tends to fluctuate on a day-to-day basis, depending on what you are doing. Here, what you purchase and the use you make of the purchases is a key component.

So what lessons are there for earning and spending money wisely? To start with, it is important to get a good work-life balance. It may be worth trading income for job satisfaction. Here the focus should be on long-term fulfilment, rather than on the short-term happiness from more ‘stuff’. Then it is important to spend money wisely. Here the author identifies three lessons:

The first is to consider buying time. Time-saving purchases, such as dishwashers can help. So too can ‘outsourcing’ activities, such as cleaning, laundry, cooking, DIY or child care, if they give you more time to do other more fulfilling things (but not if you love doing them!).

The second is to spend more money on experiences (as we saw in the post Studies show that money can buy happiness (but only if you spend on experiences). A better TV or car may seem like a wiser investment than more dinners out, holidays or going to concerts. But we quickly adapt to new upgraded ‘stuff’, thereby eliminating any additional satisfaction. Experiences, however, tend to linger in the memory. As Tom Gilovich, a psychology professor at Cornell University, is quoted by the article as saying:

Even though, in a material sense, they [experiences] come and go, they live on in the stories we tell, the relationships we cement, and ultimately in the sense of who we are.

Choosing a more fulfilling but less well-paid job is a form of spending money on experiences.

The third is to give some of your money away, whether to charity or to helping friends or relatives. As Gilovich says:

It’s hard to find a more charming finding than that by giving away money, you not only make someone else happier, you make yourself happier.

Article

Questions

  1. What is meant by ‘diminishing marginal utility of income’? Is the concept consistent with the arguments in the article?
  2. In what sense may it be rational to choose a lower-paid job?
  3. Is ‘happiness’ the same as ‘utility’ as the concept is used by economists?
  4. Does the concept of ‘peak stuff’ apply to all physical products? Explain your answer.
  5. If giving money away makes a person happy, is it truly altruistic for that person to do so? Explain.