COP26 and the Paradox of Thrift

The climate crisis is irrefutable, and action must be taken to stop the planet from hurtling towards disaster. But, at the same time, it is crucial for governments, central banks and financial markets to recognise the inevitable short term negative externalities arising from the fight against rising temperatures.

De-carbonisation means under-consumption. With under-consumption comes the paradox of thrift. The rise of global savings and the paradox of thrift will be most acutely felt amongst the so-called mercantilists, but economic growth will also be constrained in the rest of the world, with consequent impact on domestic politics, geopolitics and income distribution.

The COP26 Climate Conference is important because of the participating nation's commitments under the 2015 Paris Climate Agreement; they agreed to strengthen their climate commitments every five years. However, these promises are non-binding "National Determined Commitments". When you add up all of these national commitments, they do not promise sufficient emissions reductions to meet the Paris aspiration of holding global heating to 1.5 degrees above pre-industrial temperatures.

There are no cheap ways of saving the world, but developed governments are seeking to minimise these costs. Unfortunately, low carbon energy will cost more, and the only way to transition to a more expensive low or zero-carbon future is to make carbon more expensive. 

Carbon border taxes are the most controversial, but according to a 2018 report by economic and environmental consultancies KGM&Associates Pty Ltd and Global Efficiency Intelligence LLC, a quarter of the world's greenhouse gases are produced by goods that cross borders. The World Trade Organisation allows border adjustments that impose the same costs on domestic and foreign producers but repeatedly declare environmental policies illegal. Disputes are likely to intensify as carbon border taxes become commonplace.

The impact of carbon taxes and border tariffs will be the same as any rise in taxes and comes at the same time as the major developed economies are raising taxes to pay for ageing societies. Higher climate costs, whether in the form of taxes or border tariffs, depress activity by draining money from consumers' disposable income, reducing their consumption. The reduced consumption results in lower demand for imports, which in turn reflects adversely on the trade balances of the surplus nations.

Carbon taxes are likely to be global because it is a global problem, but 60% of global greenhouse emissions are the result of consumption, according to a 2016 study by the Norwegian University of Science and Technology, which suggests that global GDP will be adversely affected.

Discussions of under-consumption are currently incongruous as the world, particularly the developed economies, are going through a period of revenge spending driven by elevated pandemic savings rates. At the same time, there is evidence that the demand for services and, in particular, "experiences" are recovering from their lockdown/social distancing lows, which on the face of it suggests that the global economy and hence financial markets have little to be concerned about in the short term. 

However, even as this surge in demand has exceeded supply, leading to stressed supply-chains, there is evidence that goods spending has peaked. Thus, while supply chain disruptions and consequent cost-push price pressures will continue as companies correct deficient inventory levels, the supply and demand for goods is likely to rebalance over the next twelve months. Revenge spending is by its very nature temporary. Indeed, the history of pandemics shows that the devastating viruses are followed by rising savings, which in turn leads to a decline in the natural rate of interest (by contrast, wars are followed by a decline in savings and an increase in the natural rate of interest). We do not expect this time to be different. 

The pandemic was the catalyst for the second major economic contraction in twelve years. In the aftermath of the Great Financial Crisis, there was a short bout of revenge spending followed by a rise in savings rates. Revenge spending lasted six months, the rise in savings lasted four years and was compounded by tighter fiscal policy amongst the major developed economies (and tighter monetary policy in the case of the European Central Bank). As economies return to normal, revenge spending is likely to shift towards making up for forgone experiences, but in the post-recession recalibration of expenditure, I do not expect experience-led spending to return to its pre-pandemic levels. 

As George Santayana might have pointed out, politicians, now chastened by the spike in inflation, have forgotten the dual sin of tighter fiscal and monetary policy and seem doomed to repeat the mistakes of the past. Whether higher general taxation or environmental taxes, such as carbon pricing of flights, fiscal policy will be tighter at the same time as monetary policy moves off its emergency setting. The net result will be lower real disposable income and weaker expenditure. 

While the more extreme demands of climate activists are unlikely to be realised, but the media's censorious views on consumption, flight shaming and young activists "pester power" are likely to result in slower consumption at the margin. The latest example of this is the fashion industry's commitment at COP26 (which is renowned for its long and complex supply chains) to half their carbon emissions.

A side-effect of these higher environmental tariffs and charges, shorter supply chains and reduced carbon emissions are likely to be additional cost-push inflation. As a result, I expect average inflation in the developed economies to rise modestly to 2.0% from 1.5% in the post-GFC decade. 

The current boom will fade over the next twelve months and be replaced by weak growth. The rise in savings will be partly offset by increased environmental investment, but this is not likely to be sufficient. I expect real growth of 1% amongst the major industrialised economies and 2% amongst the developing economies. US nominal growth of 3% has traditionally been the trigger for the Federal Reserve to ease monetary policy; the period of tightening could be very short-lived.

3% nominal GDP growth does not leave much headroom for shocks, and I expect the Fed to be forced to move to negative rates by the middle of the decade. Negative rates in America will be a shock, but negative rates in China will be an even greater shock. 

Stuart Thomson is an independent economist and portfolio strategist. His writings reflect his personal views and are intended for the reader's entertainment and to elicit debate. They are not intended to constitute investment advice.