Macroeconomic and Fiscal Implications of Climate Change Adaptation Policies

1. Comments on the papers by Forni, Lozej, Haughwout, and others Teresa Ter-Minassian Bank of Italy XXI Workshop on Public Finance March, 22, 2019

2. The paper by Catalano, Forni, and Pezzolla (I) • Main focus • Macroeconomic and fiscal implications of preventive and remedial policies for adaptation to climate change • Methodology of analysis • Develops, and calibrates to a representative less developed economy, an overlapping-generation model, to simulate the output and fiscal impact of policies to • Reduce the accelerated depreciation of physical capital brought about by gradual climate change; and • Remedy damages from extreme weather events

3. The paper by Catalano, Forni, and Pezzolla (II) • Main results • If no action is taken to adapt to its impact, climate change will substantially reduce GDP, widen fiscal deficits, and increase debt stocks • Enhancing resilience to climate change requires multifaceted, country-specific, strategies that include both preventive and remedial actions • However, limited fiscal space, and uncertainty about the timing and extent of extreme weather events, create incentives, particularly for small vulnerable countries, to avoid adequate preventive actions • The fact that international support is typically more forthcoming for remedial actions in the wake of weather-related disasters than for preventive policies aggravates the bias against the latter

4. The paper by Catalano, Forni, and Pezzolla (III) • Main comments • A very nice paper, including a comprehensive, well-focused review of the relevant literature, a state-of-the-arts analytical framework, and policy-relevant, plausible results • A few methodological quibbles • The assumption that interest rates do not react to deficit-financed adaptation policies • The assumption that in less developed economies the main constraint on growth is the scarcity of capital, and therefore the effects of climate change on human capital and total factor productivity can be safely ignored • The assumption that the output costs of extreme weather events vanish quickly (unlikely to be true in small island economies)

5. The paper by Catalano, Forni, and Pezzolla (IV) • Issues for further research • Simulating the effects of budget-neutral adaptation policies (financed with spending cuts and/or alternative tax reform packages) • The political economy of adaptation policies, and how to improve incentives for policy makers to take timely preventive measures, including through institutional reforms, such as legislation requiring • Periodic estimation of the impact of gradual climate change, and of the risks and potential costs of extreme weather events • Transparency and dissemination of the results of these estimations • Budgetary provision for the expected value of the cost of extreme weather events, or for their insurance in international capital markets • The role of regulatory policies in fostering adaptation by private agents • How bilateral and multilateral international partners can support timely preventive adaptation policies of less developed countries

6. The paper by Hickey, Lozej and Smyth (I) • Main focus • Macroeconomic and fiscal effects of a significant increase in government investment in Ireland, under different financing assumptions. • Methodology of analysis • Uses a variant of the global DSGE model of the Euro Area (EAGLE), calibrated on Irish data, to simulate the above-mentioned effects under different financing scenarios • Main results • The additional investments increase long term-output, through their positive effects on the public capital stock and on productivity, under any of the simulated scenarios • But, the size of the impact varies, being largest under a budget-neutral scenario, financed by a reduction in government consumption, and lowest under a scenario of debt financing • Effects on the trade balance also differ across the scenarios

7. The paper by Hickey, Lozej and Smyth (II) • Main comments • An interesting exercise with policy-relevant and plausible conclusions • Some key, but debatable, assumptions • The quality and productivity of public investments is not affected by the extent and speed of their increase • Under the non budget-neutral scenario, interest rates do not react to the increase in the public debt. This assumes away any crowding-out effects, and makes the debt dynamics look more benign • The debt-to-GDP ratio, under the same scenario, returns eventually to its long-term value reflecting revenue increases and “ the operation of the fiscal rule” • It is feasible to cut government consumption commensurately with the increase in investment • Possible extensions of the analysis • Explore modifying the assumption on interest rates • Explore the impact and feasibility of other financing options, including a reduction of transfers to households, or to enterprises, and a cut in tax expenditures

8. The paper by Haughwout and Inman (I) • Main focus • Whether and how balance sheet positions of US states affect their infrastructure investment decisions • Methodology of analysis • Construction of detailed balance sheets for US states, disaggregated into short-term, pensions-related, and other longer-term assets and liabilities components • OLS and IV regressions of changes in states’ real per capita infrastructure stock on changes in their net financial wealth (and other variables) • Main results • States’ investments in infrastructure is strongly pro-cyclical • They appear to be negatively related to changes in states’ net financial wealth (implying some substitutability between the two), but the relation is weak

9. The paper by Haughwout and Inman (II) • Main comments • The paper explores an important and so far under-researched question, but it is still work in progress • The careful compilation of a consistent database on states’ balance sheets is very useful, and an essential pre-condition for further analysis of the behavior of the major component of public infrastructure investments in the US • The results are somewhat puzzling, as they seem to contradict the prior that financial pressures have been an important determinant of states’ investment behavior in the last decade or so

10. The paper by Haughwout and Inman (III) • Possible explanations • State politicians are myopic, focusing on current flows (changes in income and revenues) rather than on stock positions. This tendency may be exacerbated by fiscal rules requiring balanced budgets • Longer term liabilities such as under-funded pension systems are not transparent, and do not promote timely policy responses (including cutbacks in public investments) • There are missing exogenous variables (e.g. cyclical developments in output, or political economy factors, such as the party affiliation of the state government) • There may be non-linearities, asymmetry of responses, and longer lags in the relation between changes in financial and non-financial wealth • In summary, there seems to be significant scope for further analysis of a topic that is highly relevant, given the predominant role of the states in public investment

11. Thank you!