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3 How Macroeconomic Policies Affect the Environment: What Do We Know?

Editor(s):
Ved Gandhi
Published Date:
June 1996
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Author(s)
Ved P. Gandhi and Ronald T. McMorran 

The International Monetary Fund is a monetary institution charged with the responsibility of promoting international financial and exchange stability through the adoption of sound macroeconomic policies in its member countries (see Annex 1, and IMF, 1993). It is not an environmental institution and is not concerned with the environment per se. Fund work on the environment is therefore related to its primary mandate of helping member countries achieve economic stability through reform of macroeconomic policies.

Interest of the Fund staff in the subject arose soon after the Executive Board’s discussion of the environment in late 1990 and early 1991 when the Board directed the staff to develop a better understanding of the interplay among macroeconomic policies, economic activity, and the environment.1 Toward developing this understanding of the possible impact of macroeconomic policies on the environment, the Fund staff has, over the last four years, done some work (see Annex 2) and has studied and reviewed the work done by academics and researchers at the World Bank, the OECD, and other specialized governmental and nongovernmental institutions. Although many of the conclusions reached by the Fund staff have been confirmed and reinforced by those reached by others, we continue our studies on how macroeconomic policies affect the environment and how the environmental conditions and policies affect the macroeconomic situation.

This paper describes the major conclusions that the Fund staff has reached on how macroeconomic policies and their reform affect the environment. It also identifies the reasons why the impact of macroeconomic policies on the environment remains a difficult area of study and research.

Conclusions

Drawing clear-cut conclusions about the direct impact of macroeconomic policies on the environment is not easy because environmental problems are generally sectoral and are often a result of microeconomic policies (pricing and institutional), while macroeconomic policies normally affect relative prices at the economy-wide level. Reaching conclusions on the subject is further hampered by the lack of a well-developed theoretical framework to explain the interrelationships between macroeconomic policies and the environment.2 Finally, the environment has not yet been fully integrated into computable general equilibrium models that alone can help generate meaningful empirical results and that are readily accepted.3

Nevertheless, four conclusions, which enjoy broad agreement, seem to have emerged from recent studies regarding the effect of macroeconomic policies on the environment.4

  • Macroeconomic stability is a minimum and necessary condition for preserving the environment.
  • Environmental degradation is caused primarily by market and policy failures at the sectoral level.
  • Macroeconomic policies can sometimes harm the environment but only indirectly and only when serious market and policy failures exist.
  • Macroeconomic policies are inefficient instruments for mitigating environmental degradation; appropriate environmental policies are more efficient and effective.

These conclusions are more fully described now.

Macroeconomic stability is a minimum and necessary condition for preserving the environment.

Macroeconomic instability is often characterized by high and variable inflation, serious balance of payments problems, large fiscal deficits, low or negative output growth, and high and growing unemployment. Together these have a serious impact on the environment through their influence on incentives to preserve environmental resources or to invest in environmental protection.

High rates of inflation, for example, frequently distort intertemporal choices concerning the use of forests, mines, and other natural resources, reducing the incentive to preserve resources as producers and consumers act as if they were facing high discount rates.5 To the extent that macroeconomic policies help control inflation, lower discount rates, and create stable macroeconomic conditions, they encourage “a longer term view on the part of decision-makers at all levels, and lower inflation rates lead to clearer pricing signals and better investment decisions by economic agents.”6

Sound macroeconomic management creates conditions for environmental protection in other ways as well:

  • Demand management (controlling aggregate demand to match aggregate supply) also means better management (or control) of demand for natural resources.
  • Exchange rate reform and trade liberalization raise the costs of environmentally damaging inputs and outputs (fertilizers, pesticides, insecticides, petroleum products) and improve the capacity of exporters to use environmental investments (in controlling soil erosion and other land improvements, if they are in farming, and in pollution-curbing technologies, if they are in manufacturing).7
  • Interest rate reforms reduce implicit subsidies to capital and encourage employment, thereby discouraging deforestation and other damage to the environment that would otherwise have been caused by the unemployed.
  • Reduction of fiscal deficits and improvements in revenue buoyancy enhance the capacity of the government to undertake and support environmental protection programs.
  • Sound macroeconomic policies encourage larger external capital flows and facilitate external debt rescheduling and relief, some of which may be specifically dedicated to improving environmental conditions.

Macroeconomic stability is thus a prerequisite for the preservation of the environment.

Environmental degradation is caused primarily by market and policy failures at the sectoral level.

Economic theory suggests that environmental degradation is the consequence of economic agents—firms and households—not taking into account social costs associated with their consumption and production decisions. This may be because of market failures or of policy failures. Market failures can arise when no mechanism exists for making economic agents aware of the social costs of their actions or forcing them to internalize these costs into their private decision-making. It may also be the case that such mechanisms do exist but are simply inadequate or ineffective. Policy failures, on the other hand, exist when the government fails to charge adequately for the exploitation or use of mining, forestry, fishery, and other natural and environmental resources. They also exist if the government provides price subsidies to environmentally damaging inputs or outputs in the name of economic or social objectives. Environmental degradation, in fact, tends to be compounded when policy failures exist simultaneously with market failures.

Industrial and developing countries differ somewhat in respect of market failures but not necessarily in respect of policy failures. Industrial countries generally have relatively well-functioning markets, adequate environmental infrastructure and institutions, relatively well-defined and secure property rights over communal resources, and well-structured and enforced environmental standards and regulations. They even tend to have environmental taxes (though not always adequate) for internalizing environmental costs, and their public utility prices normally reflect long-term private (though not necessarily social) costs. Developing countries, on the other hand, have nonexistent, thin, or uncompetitive markets, inadequate environmental infrastructure and institutions, poorly defined and insecure property rights (with large open-access resources), poorly designed or enforced environmental standards and regulations, few (if any) environmental taxes, and prices for public utility services that do not reflect even the long-run private costs. In developing countries, therefore, prices of resource- and environment-intensive goods and services rarely reflect environmental costs.

Environmental degradation in both developed and developing countries, for the most part, is thus the result of market or policy failures at the sectoral level rather than of macroeconomic policies or their reforms.

Macroeconomic policies can sometimes harm the environment but only indirectly and only when serious market or policy failures exist.

In the first-best world, where environmental resources are priced to reflect social costs and private decisions are based on social costs, macroeconomic policymakers need to worry little about the environment, except to the extent macroeconomic policy changes may call for some adjustments in the levels of environmental taxes or subsidies to ensure their intended effect on the behavior of economic agents.

As noted above, however, in practice policymakers operate in a second-best world, where market or policy failures are present and even pervasive. This is especially so in developing countries, but developed countries are not immune to these failures either. Where such failures are present, macroeconomic policy reform can have an adverse impact on the environment, although this impact tends to be indirect. Besides, how adverse this impact will likely be is extremely difficult to determine without reference to the structure and effectiveness of environmental policies of the country and whether or not the adverse effects are partially or fully offset by some positive effects. A few examples in support of this conclusion will suffice.

Monetary stringency may form an important element of the macroeconomic reform package aimed at reducing domestic absorption. This may be implemented, in part, through tight credit policy that may curtail the availability of credit to farmers (much like other borrowers) and may reduce their capacity to purchase agricultural inputs or invest in land improvements. This, in turn, may encourage an environmentally undesirable shift by them to extensive farming in the presence of an open-access land policy. However, the same monetary stringency may have a positive impact on the environment if increases in real interest rates limit borrowings by farmers who might have had plans to invest in environmentally damaging crops or sectors of the economy. The net outcome may therefore be difficult to determine.

Reducing the fiscal deficit, as another example, may be a second major element of the demand restraint package to help reduce public sector absorption of output. Among other things, this may be accomplished through a reduction in public sector employment. Laid-off staff, who may be unable to find alternative employment in cities, may be compelled to move to the country and engage in clearing land, which might contribute to deforestation. This would occur provided marginal lands have open access. However, the same fiscal deficit reduction strategy may have a positive impact on the environment if price subsidies for fertilizers and petroleum products are sharply curtailed. Once again, the net impact would be hard to determine.

Exchange rate reform can be taken as yet another and final example. It may encourage the rate of depletion of nonrenewable natural resources, as their value grows with devaluation and their exports are encouraged. The extent to which this will occur will depend upon the existence of user charges, royalties, and the like. While exchange rate reform in this way may be seen as having an adverse impact on the sustainability of certain natural resources, it may, at the same time, raise the domestic prices of certain environmentally damaging imports, such as fertilizers and pesticides, and curtail their use, which would help protect the environment. Thus, the net impact of this macroeconomic reform also is not that clear cut.8

Only a computable general equilibrium model of an economy, which incorporates macroeconomic variables as well as environmental variables and policies, can help determine the net impacts of macroeconomic policies on the environment.

Macroeconomic policies are inefficient instruments for mitigating environmental degradation; appropriate environmental policies are more efficient and effective.

Given the lack of clear and direct links between macroeconomic policies and the environment, as noted above, the role of macroeconomic policies as instruments of solving environmental problems cannot but be limited; in any case they cannot be efficient. Furthermore, given that market policy failures are the primary causes of environmental degradation everywhere, the most efficient and effective instruments simply have to be the environmental policies of the country.

Macroeconomic policies are inadequate and inefficient instruments of environmental protection because they change the relative prices of broad categories of goods and services and not the prices of specific environmental goods and services whose underpricing or easy access may have been the major cause of environmental degradation to begin with. Protecting the environment would, therefore, require the adoption of appropriate environmental policy instruments.

A number of environmental policy instruments can be employed: Pigouvian taxes, indirect environment taxes, land (property tax) reform, pricing reform for products linked to environmental damage, pollution standards and other regulatory policies, and tradable permits. An efficient environmental policy for a given environmental problem would encourage socially optimal behavior at least social cost.

Much in the literature suggests that one of the most efficient environment policies is the Pigouvian tax, a specific rate tax on units of emissions or damage.9 Two distinctive features of Pigouvian taxes make them attractive as efficient environmental policy. First, the costs of achieving a given environmental objective may be lower with taxes because they rely on the price system in contrast to the administrative costs of command and control policies. Second, Pigouvian taxes reduce pollution in the least-cost manner by encouraging the greatest pollution abatement by firms able to adjust at lowest cost and least cost abatement by each firm.

As regards other environmental policies, they, unlike Pigouvian taxes, may not encourage abatement of environmental damage along all possible abatement margins at the least social cost unless there is an identifiable functional relationship between the policy instrument and the environmental damage. Because identifiable functional relationships are rare, these other environment policy instruments may end up imposing greater costs than a Pigouvian tax in efficiently mitigating environmental damage.

Environmental policies, if efficiently designed and effectively implemented, can help not only to achieve environmental objectives, but also to address one or more macroeconomic imbalances. As an example, eliminating subsidies on environmentally damaging products and imposing environmental user charges and fees can bring about proper pricing of environmental resources and thus help mitigate environmental degradation. In addition, these policies can help raise revenue for investing in environmental protection and at the same time reduce overall fiscal imbalance. Such policies can be considered win-win policies for macroeconomic improvement as well as environmental protection.

Before closing this lengthy section on major conclusions, it is worth repeating that these conclusions are in the nature of broad generalizations and only a general equilibrium approach can help us understand how macroeconomic policies of a country interact with its environment. To integrate environmental objectives of a country into macroeconomic policy calls for the development and adoption of a new analytical framework.10 How easy or difficult that task may be at this stage is described in the next section.

Integrating Environment into Macroeconomic Policy

The growing body of literature referred to earlier has greatly improved our understanding of the links between macroeconomic policies and the environment. A common feature of these studies, however, has been the assessment of the environmental impact of macroeconomic policies undertaken in a second-best world where substantial market or policy failures are prevalent. As a result, definitive conclusions concerning the environmental impact of macroeconomic policies have proven difficult to draw and, more often than not, the researchers have tended to attribute environmental degradation to macroeconomic policies, although it should properly have been attributed to a failure of environmental policies or institutions.

In our opinion, the analytics of integrating the environment into a macroeconomic policy framework still remains to be developed, and this work continues to be hindered by three factors.

First, integrated environmental and economic accounts are presently lacking in most countries. While considerable effort has gone into developing a methodology for taking into account the environment in national accounts,11 environmentally adjusted national accounts have been developed only for a few countries and often only in an exploratory and experimental way.12 To date, few governments have actively pursued the development of or produced environmentally adjusted national accounts.

Second, we still know very little about the functional relationships between macroeconomic policies and the environment. As Warford has pointed out, “Long-term impacts are difficult to predict in the best of circumstances, and in the environmental area there are special problems: behavioral and physical linkages are poorly understood, [and] many of the effects are long-term....”13 While environmentally adjusted national accounts can provide a basis for determining the level of economic activity, quantitative models would be needed for estimating and explaining changes in environmentally adjusted economic activity as a result of changes in macroeconomic and, for that matter, any other economic policies. Environment economics being a relatively new discipline, few quantitative models are presently available.

Third, as the environment is a multifaceted subject and many macroeconomic policies may be simultaneously affecting the net outcome (sometimes positive impacts may cancel out or outweigh the negative impacts while other times they may be reinforced by other positive impacts), a computable general equilibrium model of the economy is necessary to assess the impact of the macroeconomic policies of the government on the country’s environment. Unfortunately, not many countries at present have such models that can be considered reliable. Even where they exist (in some industrial countries they do), the models do not always incorporate environmental variables.

For the time being, therefore, it appears that we will have to be satisfied with the broad generalizations noted above, however inadequate or partial they might be. Nevertheless, the work on developing environmentally adjusted national accounts, as well as other elements of the analytics for integrating the environment into macroeconomic policy framework, must continue and even accelerate.

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Annex 1 Purposes of the Fund from Article I of Its Articles of Agreement
  • (1) To promote international monetary cooperation through a permanent institution which provides machinery for consultation and collaboration on international monetary problems.
  • (2) To facilitate the expansion and balanced growth of international trade, and to contribute thereby to the promotion and maintenance of high levels of employment and real income and to the development of the production resources of all members as primary objectives of economic policy.
  • (3) To promote exchange stability, to maintain orderly exchange arrangements among members, and to avoid competitive exchange depreciation.
  • (4) To assist in the establishment of a multilateral system of payments in respect of current transactions between members and in the elimination of foreign exchange restrictions which hamper growth of world trade.
  • (5) To give confidence to members by making the general resources of the Fund temporarily available to them under adequate safeguards, thus providing them with opportunity to correct maladjustments in their balance of payments without resorting to measures destructive of national or international prosperity.
  • (6) In accordance with the above, to shorten the duration and lessen the degree of disequilibrium in the international balances of payments of members.

The Fund shall be guided in all its policies and decisions by the purposes set forth in this Article.

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Note: The authors are Assistant Director and Economist, respectively, in the Fiscal Affairs Department. The opinions expressed in this paper are those of the authors and not necessarily those of the International Monetary Fund. They would like to thank David Nellor and Dale Chua for their helpful comments on an earlier draft.
2A recent paper by Girma, 1992, is a worthy attempt in this regard.
5See Nellor, 1993, p. 12, and the World Bank, 1994, p. 33.
7As noted in IMF, 1995, p. 13, the large majority of the population and the poor in many sub-Saharan African countries live in rural areas and their incomes depend on exports while their expenditures are largely made on domestic goods. In these circumstances, a more realistic exchange rate, accompanied by sound macroeconomic policies, helps improve real output, employment, and incomes in rural areas, laying the basis of poverty alleviation and environmental preservation.
8In fact, three country studies, sponsored by the World Wide Fund for Nature, provide adequate evidence that the environmental impact of an exchange rate devaluation is inconclusive. In the case of Thailand and Côte d’Ivoire, an exchange rate devaluation was found to have a negligible or benign impact on the environment while in the case of Mexico, it proved to be somewhat harmful to the environment as it encouraged firms to establish in a region with weak enforcement of environmental laws (see Reed, 1992).
10The framework underlying the Fund macroeconomic advice is described in IMF, 1987 and 1992.
11See, for example, United Nations, 1993a, p. 508, and United Nations, 1993b.
12See, for example, Repetto and others, 1989, for Indonesia; Solorzano and others, 1991, for Costa Rica; van Tongeren and others, 1993, for Mexico; Bartelmus and others, 1993, for Papua New Guinea; and Giannone and Carlucci, 1993, for Italy.

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