When Economics Gets Ugly

Google relies heavily on McKinsey’s US Low Carbon Economics Tool to write this optimistic report.  It boils down to the claim that enacting carbon pricing will trigger a “free lunch” for our economy and the environment.   I wish this could be true but is it true?

While the McKinsey team have all attended Ivy League schools, they are not Ivy League profs and there is a difference!  They are a for profit business selling advice and information rather than merely being “truth seekers” (again there is a difference). 

Without charge, McKinsey offers this overview of their vaunted software.   As shown in exhibit 1, they have built an applied general equilibrium model. To make a long story short, there are dozens of behavioral elasticities (such as if the price of electricity goes up, how much will demand decline by) for which these guys must make up estimates to feed into their model.    In the 50 page report, I can find no discussion of how they calibrate their model or whether their optimistic estimates are sensitive to which behavioral elasticities they choose.   This is not science. This is wishful thinking.   While I would love to see carbon pricing, this is economics at its worst as these “economists” make tight predictions without providing any true details about how they generated their predictions. 

Author: Matthew E. Kahn

Professor of Economics at UCLA.

18 thoughts on “When Economics Gets Ugly”

  1. While the McKinsey team have all attended Ivy League schools, they are not Ivy League profs and there is a difference! They are a for profit business selling advice and information rather than merely being “truth seekers” (again there is a difference).

    You mean like the ivy league profs advising on the privatization schemes in eastern europe following the end of the cold war? Or the ivy league profs who assured people that deregulation of finance would lead to great economic and social benefits? Or the ivy league profs who poopoohed any possibility that what was happening in the housing market was a bubble (I except Shiller and Krugman here)? From which ivy league profs do those on the McKinsey team differ, and in what ways?

  2. To answer Marcel’s question:
    There is a difference between your profs and McKinsey. It is the same as the difference between a ho and a freak. The Ivy League profs were mostly freaks, with a few exceptions. They actually believed in the destructive nonsense they were propounding. McKinsey is only in it for the money. Maintaining their reputation despite this obvious fact requires very bright people, perhaps brighter than Ivy profs.

  3. Ebenezer: what about Andrei Schleifer in Russia, e.g.? Seems to me that he played a role similar to Rep. Cantor’s today, helping determine policy on the debt ceiling while simultaneously invested in a mutual fund that is shorting US Debt (cannot find a link just now, but Josh Marshall reported this in the last 2-4 days)?

  4. “This is not science. This is wishful thinking.”
    Unlike the claim that cities will thrive in the face of global warming — that’s pure science, baby.

  5. Adding on – like the professors in almost the entire elite of the ecnonomics professoriate, Matt? Like the Chicago Boyz who are still yelling ‘Fire!’ in Noah’s flood?

  6. Barry: I’m a chicago alum, and I think people on both sides of the divide would agree that it is important to distinguish between chicago and the ivies. They tend to be snooty and arrogant about different things; pure unadulterated intellect on the one side vs. a mix of intellect, practical wisdom and social standing/status on the other. So let’s keep em straight.

  7. “Pure unadulterated intellect…”? Maybe if you mean unadulterated by common sense and acquaintance with reality.

    Either way, I don’t give a toss for snooty people, especially ones that claim to be wise. Those two things don’t go together. We need to stop giving economists so much power in our discourse. They do not deserve it. It’s not a science anyway.

    Scrooge: love your ho/freak construct. I am glad it is now non-gendered, so I can use it more often.

  8. I love that everyone in the comments take you to the woodshed, which you rightly deserved for making such stupid comments. How do you devalue the ivies with this blog post?

  9. Benny: ditto. No one in or from a UC needs to feel inferior, imho.

    And as for professors, at any school: Ph.Ds aren’t as impressive as they used to be. After the last 20 years, in fact, the whole “best and brightest” thing is pretty much over.

  10. Ivy League economists as truth seekers. Oww! Expelling beer though one’s nostrils is not pleasant.

  11. I thought the Google white paper, The Impact of Clean Energy Innovation, was quite good, and probably useful.

    Far from being Pollyanna-from-Chicago, they drew attention to just how far short even aggressive, optimistic innovation will leave us:

    “We set very optimistic rates of innovation, pushing technologies hard on cost and performance. Even with aggressive breakthroughs, by 2050 we achieved only a 49% reduction in GHG emissions vs. 2005 emissions in the All Tech Breakthrough scenario, well short of the standard, IPCC-inspired reduction targets of 80% by 2050.”

    Their central argument is not that innovation is a “free lunch”, but, rather, that a policy, such as carbon-pricing, can have a synergistic effect with clean-energy innovation:

    “Breakthroughs in clean energy technology can reduce the cost associated with implementing policies such as Clean Energy Standards or carbon prices — growing the economy while de-carbonizing our energy use. Policies can also amplify the economic, security, and pollution benefits of breakthroughs by creating markets, dis-incentivizing the highest-emitting technologies, and leveling the playing field for clean energy, leading to increased adoption.”

    They make a number of useful points. Just a couple of examples:

    1.) “Coal is Very Hard to Displace on Economics Alone: Coal power is abundant and cheap, especially from older and fully depreciated plants.”

    2.) “Cheap natural gas could reduce GHG emissions in the short term but also slow the deployment of clean energy sources in the long term. Initially, the improved economics of natural gas in our hypothetical $3/MMBTU price environment led to coal-to-gas switching and made coal plant retirements more economical. In the long term, when prices were held low, gas out-competed carbon-free energy.”

    Not exactly earth-shaking insight, I’ll grant you, but it is useful to get these things into some kind quantitative and time-specific perspective. And, their scenario-driven approach is pretty good at that. Some energy technologies are pretty close to displacing some high-carbon-generation applications; others are much further away.

    The idea that economic innovation depends, in part, on technical economies that arise from experience, scale, and networks, means that being able to find applications for these technologies depends on the price of the alternatives. Clean energy policies that change those relative prices can affect how soon the development of those technologies begin to realize a positive feedback loop from increasing returns. If the economics profession did not twist itself into knots, trying to limit its thinking to the small beer of purely allocative efficiency, they might have something more useful to contribute, than apologies for rapacious billionaires.

  12. Bruce: lovely post. I tend to agree that we need to take a variety of approaches, and we need to start them now. Put money into clean energy, maybe get people to buy smaller cars, take the bus sometimes, etc. Saving our little planet is one time when we shouldn’t maybe worry *too* much about precision? Let’s oversave it. Heaven knows we waste a whole lot on useless cr*p. It’s undeniable.

    And just to clarify- I don’t think we should defer to “experts” on big policy questions, in the sense that we shouldn’t worship people just because they have degrees, but I still believe in the creativity of the individual, and of groups, and of inventors. That’s going to be a big part of what gets us out of this mess.

  13. I’m merely a plant guy and come from an ecological perspective, having spent time listening to some economists in class. We think about stocks and flows and energy movement. If carbon pricing stays low, it will be used as energy and that is bad. Cheap energy will not drive innovation. We need something, quickly, else our population will suffer. I am not convinced that easing future suffering is a policy.

  14. I thought their report on Obamacare demonstrated pretty definitely that McKinsey is on the “ho” end of the scale. They’ll moan yes yess YESSS! for whoever comes up with the money.

  15. Actually, if these people are any good (and some of McKinsey’s people are, just not the ones who were stupid enough to release an internal marketing study as a predictive report) they won’t have made single estimates for any of the variables Kahn cites; they will have made multiple estimates, probably relying on the rather large body of published work already out there, and done either formal or informal sensitivity analysis to get a sense of where the numbers most likely are. I wouldn’t expect that level of detail in a white paper.

    But what I really object to is Kahn’s use of the term “carbon pricing” here, is if it’s a new thing. We’ve already got carbon pricing. It’s just that the pricing regime is thoroughly inconsistent across carbon sources and fails to internalize many costs, thus driving some really stupid consumption and arbitrage patterns. Imagine a real estate market where not only did the price of your house not take into account the debt that the local jurisdiction took on to build all the roads, sewer lines, storm drains etc, but where the tax-deductibility of your mortgage depended on the color you painted your basement. Oh, and the flood maps were dated from before the local reservoir was built. Wht we’re talking about is rationalizing carbon pricing, not introducing it.

  16. One glaring error — or at least an economist might argue, with some cause, that it is an error — is contained in the phrase I quoted, “Coal power is . . . cheap, especially from older and fully depreciated plants”

    A sound doctrine of economics insists that sunk-costs, being sunk, don’t rightly figure in marginal cost. Therefore, a business is deceiving itself, if it insists that “depreciation” is a component of marginal cost.

    Businessmen and business consultants are seldom all that circumspect on this logical point, and commonly adapt a way of writing and speaking, which seems to take too much account of what ought to be disregarded as sunk-costs. Personally, I’m not so fussy, about the often fuzzy logic of business strategy; I see great, offsetting advantages in the fuzzy logic approach, but ymmv.

    I hope Professor Kahn returns to the topic of his objection to the thesis that a carbon-pricing scheme will aid innovation, which may increase the total factor productivity of “clean energy” technologies.

    As for Professor Kahn’s objection to what he presumes are dubious estimates of elasticities, I’m not sure that his objections are well-grounded. From my admittedly superficial read, in the main, McKinsey’s argument rests on guesses about switching points in substitution elasticities. One can be pretty sure that there are switching points, and that people will switch, when one alternative becomes cheaper than the other. The point of the argument is to highlight the policy implications of the prospective existence of switching points, for policy strategies that aim at producing or exploiting such switching points.

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