This is a guest post by Daniela Gabor, professor of economics and macrofinance at UWE Bristol, and Isabella Weber, an assistant professor of economics at the University of Massachusetts Amherst and the author of How China Escaped Shock Therapy, in which they argue a markets-based approach to reducing carbon emissions could sow more instability than it is worth.
If COP26 is to make any meaningful progress, the common wisdom goes, it has to be around carbon prices. Big finance would like a global $50 per tonne carbon price to be set at the meeting, which ends this week. Big business is finally on board too. Corporate lobby groups recently argued that a global price on carbon would encourage energy producers, industry, consumers and financial markets to switch to low-carbon technologies and activities. Global coordination at COP26 should enlist reluctant countries (notably the US, China and India) to ensure everyone faces the disciplining hand of the market. COP26 is the last collective chance to trust the power of price signals.
Those of us who lived through the transition from centrally planned economies have another name for the mantra of ‘get prices right and the market will deliver’. We know it as shock therapy. In the 1990s, shock therapists told governments in Eastern Europe and the former Soviet Union that their economies needed rapid structural change.
State-owned companies had to make way for a large private sector. Shock therapy would subject them to market discipline by liberalising prices of producer goods previously controlled by the state and by ending cheap credit, subsidies and tax concessions. Indeed, shock therapists insisted that only a strong dose of fiscal and monetary austerity would finally eliminate the ‘soft budget constraint’, that peculiar socialist affliction that kept deadbeat state firms alive, tying resources in the wrong sectors. The goal was to shrink heavy industry.
The real test for governments hiking prices, shock therapists warned, was not just to remain firm when real wages fell, but to stick to policies of tight credit even as bankruptcies in state sectors increased unemployment. This was an austerity test even committed governments would fail when the market delivered, rather predictably, social and economic upheaval. But shock therapists had a formidable institutional apparatus to condition reluctant governments: the IMF and the World Bank. Formerly planned economies depended for crisis support on the Bretton Woods institutions, both firm believers in the power of price signals reinforced by macro austerity. Conservative economists in local central banks were successfully rallied to their cause.
Look closer behind the rhetoric at COP26, and you can see the carbon shock therapists coming. The price narrative sounds eerily familiar: carbon price hikes will allocate resources, real and financial, towards the right sectors. Macro austerity may not be in the speech but it is on the menu: after nearly two years of pandemic-related monetary and fiscal expansion, we are back to calls for shrinking the public purse.
The fiscal discipline fetishists are (still) in charge, and they dislike the alternative to carbon shock therapy – massive green public investment under the Keynesian motto ‘anything we can actually do we can afford’. Just like with the old shock therapists, their rejection is a political choice: state-led decarbonisation would require central banks and Ministries of Finance and Industry to work close together again after nearly 40 years of separation. It would involve central banks actively redirecting private capital flows from investment in dirty to low-carbon activities. It would mean developing public institutional capacity to rapidly steer the private sector towards low-carbon activities, and to respond dynamically to obstacles and unintended consequences of higher carbon prices.
This is a bit like how China escaped shock-therapy: central planning institutions maintained control over strategic aspects of the economic system, while creating new market dynamics in an experimental and gradualist fashion. China used market signals but did not allow them to dictate the pace and direction of transition.
Carbon shock therapy will not be applied everywhere. While the global momentum is ostensibly about high-income countries, the historical polluters, the institutional apparatus of carbon shock therapy is rapidly shaping to target middle-income and poor countries. Yet again, the countries most vulnerable to climate events and least responsible for the climate crisis will be the laboratory. Saddled with high external debt in the wake of the pandemic and limited access to vaccines, they will have to turn to the IMF and the World Bank for financial support.
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The IMF has been an early advocate of global carbon pricing. Its new Climate Change Dashboard approaches the transition in terms of lost tax revenue and pricing emissions from fossil fuels at ‘socially efficient’ level that would reduce both pollution and increase consumption tax revenue. It does not, however, compute the damage to local companies from higher carbon prices or the implications for employment and growth. The IMF’s new Climate Strategy, published in July 2021, presents carbon pricing as the only viable strategy for transition. In 42 pages, it mentions carbon pricing 23 times, green industrial policy once, and green public investments never. The turn to carbon shock therapy is spelled out in its plans to ‘green’ conditionality lending: IMF loans to countries in need will scale up experiments with (fuel and energy) subsidy cuts, carbon pricing, and financial resilience building.
The emphasis on carbon pricing further sets up the central bank as a key local ally, recreating the institutional politics of shock therapy. Like its precursor, carbon shock therapy is inherently inflationary. Then, countries were promised that freely floating exchange rates would reinforce price signals, but what they got instead was higher inflation from weaker currencies, pushing central banks further into monetary austerity. Now, even if central banks refuse to selectively increase the cost of dirty credit (to high carbon industries), monetary austerity may be necessary to fight inflation from carbon pricing.
Carbon shock therapists may not support green public investments, but they have a reassuring climate finance message. Countries can mobilise the trillions of dollars that global institutional investors like BlackRock are keen to pour into the low-carbon transition. These investors haven’t shown up at significant scale because climate investments in poor countries are too risky relative to returns. Besides regulatory reforms, the key to unlocking private finance is fiscal derisking: countries are expected to find fiscal resources to guarantee returns for private investors, including from official development aid.
The IMF’s new Resilience and Sustainability Trust may also be enlisted to reallocate the newly created Special Drawing Rights from high income countries to global institutional investors, all in the name of derisking green private investments. The only sector that will be shielded from carbon shock therapy is private finance. Despite its devastating contribution to the climate crisis, via credit to polluters and greenwashing, is well known.
It is tempting to dismiss the growing calls for carbon pricing as empty posturing from entrenched interests that bet on the continuous absence of political will. But poor and middle-income countries look set to be forced, yet again, into subjecting their economies to chaotic structural transformation. What they really need are carefully designed macrofinancial policies to adjust their productive structures.
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