The Reserve Bank of India, in its June State of the Economy report, cautioned that ongoing heatwaves would lead to a decline in India’s labour productivity. Moody’s, the leading credit rating agency, added water as a major risk for India’s growth prospects. These show how the world of macroeconomics is undergoing a major change. There was a time when macroeconomic models were limited to growth, inflation, unemployment, etc. Now these macro-models will directly or indirectly include climate variables such as heat and water too.
Economists have always tried to build models to understand everything else but an economy. In 1758, Francois Quesnay, leader of France’s Physiocrat school of economic thought, developed the first economic model called “Tableau économique”. The diagram showed economic relationship between the three main economic classes at the time: landowners, labourers, and merchants. The Physiocrat school had a deep influence on Adam Smith who expanded on the Quesnay highlighted relationships in his classic The Wealth of Nations. From Smith’s classical school to the Marxist school, class differences formed the bulk of economics models and thinking. In the late 19th century, Alfred Marshall’s Marginalist school reoriented economic thinking on the individual and its preferences.
The Great Depression turned all the above developments on their head. There was a strong belief that the markets will eventually enable recovery from the crisis, but that did not happen. The Depression became more severe over time. There was a need to revisit the principles of economics.
John Maynard Keynes gave a new paradigm during the Depression, arguing the need for government intervention to stabilise the economy. His approach divided economics into two separate fields of microeconomics and macroeconomics. The Second World War led to a demand for measuring the impact of war on the economy. This demand created the most important metric for measuring economies — gross domestic product or GDP, which was an old idea first thought by another Physiocrat William Petty. Gradually, economists started thinking and making other macroeconomic estimates: unemployment, inflation, deficits (budget and current account), etc.
Once macroeconomic theories met the macroeconomic data, it was natural that it led to macroeconomic/macroeconometric models. Jan Tinbergen and Lawrence Klein developed the early econometric models for which both were awarded the Nobel Prize in economics. The early macro-models were mainly Keynesian, which emphasised the role of the government in stabilising business cycles. The advent of the Phillips Curve in 1958 that showed the trade-off between inflation and unemployment further cemented the role of government policy.
In the 1970s, the trade-off went missing and economies faced both high inflation and high unemployment, also termed as stagflation. The limitations of Keynesian models led to building of rational expectation models that made forecasts of outcomes based on current information. These new macro-models ignore the role of the financial sector, a weakness which was exposed gravely during the 2008 global financial crisis. The macro-models post-2008 started including the financial sector.
The above historiography shows how macro-models have changed with a new macroeconomic crisis. The ongoing climate crisis in a similar vein poses wide risks, including to macroeconomics.
Climate crisis is not a new phenomenon. The concerns of planet earth not producing enough for the growing population was the core of Robert Malthus’ doomsday thesis of 1798. However, due to technological advances in agriculture we were able to overcome the looming disaster. In 1972, the Club of Rome in its Limits to Growth report showed that if we continued on our growth path, the resource capacity of the Earth would get exhausted in the next 100 years. In 2005, the the UK government announced a high-profile review of the economics of climate change chaired by Lord Nicholas Stern. The Stern review echoed the views of the Club of Rome that climate change would have serious economic consequences. As the action on climate change was picking pace, the 2008 crisis shifted attention to the world economy and financial markets.
As the crisis eased, then-governor of Bank of England Mark Carney brought climate back on the agenda for macroeconomic policymakers. In his 2015 speech, he highlighted that climate change was a tragedy on the horizon and it would have profound implications for financial stability. In 2018, the economics Nobel Prize was co-awarded to William Nordhaus “for integrating climate change into long-run macroeconomic analysis”.
Climate change has now became one of the major concerns for the economics community. Concerns like heat, water, and pollution are entering macroeconomic models. Macro-models are showing more interest in questions such as impact of carbon tax on growth, water scarcity on productivity, heat on agriculture yields, etc. Central banks are not just assessing the impact of climate shocks on macroeconomic and financial stability but also preparing their regulated entities to develop climate plans. One should not be surprised to read the Monetary Policy Committees (MPC) highlighting risks not just from inflation but also climate. In fact, the government should consider establishing water/climate policy committee on lines of the MPC for accurate analysis of various climate trends and risks.
The author teaches at Ahmedabad University.
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