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The High Cost of Distorted Economic Modeling—Viewpoints | EPI

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The High Cost of Distorted Economic Modeling

By James P. Barrett

In 1978, when Ohio, the home of Procter & Gamble, was on the verge of becoming the last state to ban polluting phosphates from detergents, a “detergent specialist” from the company pleaded to the media that reformulating laundry cleansers would cause washing machines to break down and people’s clothes to scratch them. Economic arguments by industry against environmental protection have come a long way since then. No more scary appeals to housewives. Nowadays we have complicated computer models purporting to show widespread economic devastation. But the level of believability hasn’t changed — it’s just been obscured.

One of the most egregious examples of this occurs in the debate over global warming. In December 1997, most of the world’s nations met in Kyoto, Japan, and agreed on a protocol to begin slowing the human contribution to the accumulation of gases – generated primarily through the burning of fossil fuels – that a consensus of reputable scientists believe is raising the Earth’s temperature. A series of efforts to use computer models to predict the impacts of this agreement on the U.S. economy soon followed. One, by Wharton Econometrics Forecasting Associates, WEFA, has the distinction of projecting some of the highest costs of complying with the Kyoto Protocol. The WEFA study predicted a 3.2% decline in gross domestic product with a corresponding loss of 2.4 million jobs by 2010. Unfortunately, although the study has been widely cited in the media and the halls of Congress, those costs present a totally unreliable estimate of the economic effects of meeting the goals set in Kyoto.

In order to generate its dire forecasts, Wharton Econometrics first completed a baseline run of their model to see what the economy would look like in the absence of any policies to reduce carbon dioxide and equivalent forms of global warming pollution (usually referred to simply as “carbon”). Then the firm ran the model with compliance policies plugged in, to show predicted impacts. The results of the second simulation, which appeared to foretell economic hardship, relied on three critical assumptions, each of which is extremely dubious.

The first assumption concerns renewable energy. As fossil fuel prices rise, renewable sources will play an increasingly important role in generating electricity. The rate at which this response happens will affect how much electricity the economy can consume while still meeting carbon-reduction goals. WEFA’s model assumes a response rate 27% lower than actual historical experience, shown during energy price increases from 1973 to 1985.

The next factor models how fast energy efficiency would improve in response to increasing fossil-fuel prices. As energy becomes more expensive, industry and consumers find ways to, in effect, go farther on the same tank of gas. But for Wharton Econometrics’ gloomy economic scenario to hold true, this “delivered energy efficiency” would have to respond 43% slower than it did between 1973 and 1985. This appears even more dubious when one realizes the nation has almost a decade to prepare for the final goals of the Kyoto Protocol, instead of being surprised by an OPEC-generated oil price shock.

Finally, the WEFA model assumes that virtually no sensible policies will be used to implement the Kyoto Protocol. This is actually a series of assumptions, whereby the model leaves out the beneficial effects of international trading of carbon permits, joint ventures with developing countries and the fostering of carbon “sinks” such as forests. Naturally, this puts the economic model in a roadblock, cutting off viable avenues that would significantly lower the costs of reducing carbon emissions.

Replacing WEFA’s assumptions with conservative but more reasonable estimates can reduce the projected loss of GDP to almost zero for the target year of 2010. Certainly, any macroeconomic policy change will cause disruption in specific sectors, even if the overall effect is positive. Such problems must receive individual attention but are insufficient reasons for rejecting sound initiatives, or else we would still be driving buggies instead of cars.

Americans stand to gain much from enhanced energy efficiency and increased supply of non-polluting, renewable energy sources. Such developments will cut global warming pollution, reduce dependency on imported oil and improve our balance of trade, and will likely create little negative – or perhaps even a positive – impact on the economy. Unfortunately, the WEFA study and others like it only serve to cloud the debate over a crucial issue. If we fail to solve the problem of global warming because of misplaced economic concerns, we may find ourselves paying a much higher price later on.


James Barrett is an economist at the Economic Policy Institute. He specializes in environmental issues.