Nature’s constraints need not limit innovation and growth – Part 1: William Nordhaus

The story of how two economists integrated innovation and climate with long term economic growth and won a Nobel prize.

With the fetish for obsessing over the latest quarterly GDP figures or daily stock movements, it was a welcome departure that the 2018 economics Nobel prize focussed on something more important – continued long term growth in human welfare.

How society accounts for economic growth and the environment has been a topic that has puzzled economists for centuries.  The debate rages on today – but it is much more informed due the contribution of the 2018 Nobel prize winner William Nordhaus.  In a brilliantly conceived double act, the Swedish Academy of Sciences co-awarded the coveted prize to Paul Romer – who helped better account for the way ideas contribute to growth.

While questions of natural resource allocation have always dominated economics, the sub-discipline of ‘environment economics’ did not gain popularity until the 1960s as issues like climate change gained prominence.

The economics discipline of the time was also undergoing a transition from a social science to a hard science like physics.  Subsequently, mainstream economists became slaves to macroeconomic models of the economy known as General Equilibrium (an attempt to create conditions similar to a science lab for conducting tests on the economy).

These models were tools to understand how individual markets work in aggregate and provided guidance on the impact of certain interventions over the long run.  In hindsight, the religious devotion to these models have had tragic consequences, none more so than the Global Financial Crisis – for more on that topic check out another Nobel economist, Robert Solow, telling Congress why these models “don’t pass the smell test”.

One area where the long run models came up short was dealing with climate change – more specifically accounting for the economic cost of curtailing greenhouse gas emissions.  The lack of tools to measure the cost meant that it was impossible to do credible cost-benefit analysis on climate policy, which consequently led to inaction.

Step forward William Nordhaus – who in the 1970s introduced a Dynamic Integrated Climate-Economy (DICE) model.  Nordhaus was both able to calculate a social cost of carbon and integrate it into existing macroeconomic models of the economy.

The DICE analysis concluded that the social cost of carbon was low enough for economies to adapt without requiring unacceptable trade-offs with human welfare.  Nordhaus suggested a simple carbon tax of around 40 USD/tonne could strike the right balance – a relatively modest impost that could be offset with a commensurate reduction in other taxes on the productive economy.

Such an elegant approach stands in contrast to the prevailing smorgasbord of subsidies, tariffs, grants, levies, taxes, RETs, synthetic markets, development restrictions and regulations that form the world’s response to climate change.

The DICE model is still used today to show efficient pathways to dealing with climate change.  The chart below uses the model to showcase the impact of four of proposed pathways.

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While progress on climate policy has been anything but rational, thanks to Nordhaus that is now more a political challenge more than an economic one.

Nordhaus on the returns of innovation

Nordhaus was far more than a climate economist though, with formidable insights into calculations of productivity and innovation – both essential ingredients to dealing with climate change and maximising human flourishing.

One illustration to demonstrate the remarkable progress of humans was his work on the cost of lighting over 4000 years.

Many economists such as Nordhaus had become frustrated that official measures of inflation and growth in the economy were not telling the real story of progress. 

To demonstrate his argument, Nordhaus conducted a series of experiments on the price of light over centuries.  He found that 4000 years ago light was incredibly expensive - a day’s wages could purchase around 10 minutes of light.  For the next few thousand years this literally dark human existence did not change.

Fast forward to the 1800s, with the breakthrough technology of kerosene, a day’s work could now purchase five hours of light – 30 times more purchasing power than the Babylonians. 

And this is before the really big one – electricity and light bulbs.

As the average person toils away at work today, they will earn enough to purchase around 20,000 hours of light.  Nordhaus showed that the price of light today is less than 0.1% of its price 200 years ago. As Tim Harford says “A thing that was once too precious to use is now too cheap to notice.”

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It wasn’t just innovation in light that interested Nordhaus, he wanted to know how the benefits of innovation were shared between entrepreneurs and society.  His findings here were just as remarkable as his previous work.

Nordhaus’ 2004 paper on the topic found that “only a minuscule fraction of the social returns from technological advances over the 1948-2001 period was captured by producers, indicating that most of the benefits of technological change are passed on to consumers rather than captured by producers.”

In other words, the gains for every $100 of innovation were distributed as: $2.20 to entrepreneurs and businesses that produced it; and $97.80 to the general public. 

Not a bad deal!

The work of Nordhaus is important because it helps us to better understand the present-day world that we live in and how we can make it better in the future.  Political debate today has become more emotive and less factual; the calm methodical work of the latest Nobel laurates provides an antidote.

In Part 2 of this blog, we will look at the work of Paul Romer who proved how important ideas are to economic growth.