The Stern Review on MER/PPP

One of the issues that’s been debated at length here is the choice of exchange rates to use in converting different currencies for projections of future economic growth and energy demand. The scenarios developed by the IPCC have used market exchange rates (MER) Ian Castles has argued, in very strong terms, that it’s crucial to use exchange rates adjusted so as to exhibit Purchasing Power Parity (PPP). In my submission, I made a couple of points. First, that there is no uniquely satisfactory method of obtaining PPP exchange rates. Second, and more importantly, the choice doesn’t make much difference to projections of energy use or CO2 emissions, as long as the same values are used consistently. A method like MER, which tends to overstate income differences between poor and rich countries relative to PPP will yield a lower income elasticity of demand for energy. And since MER data have been, until recently more readily available for more countries, there are some practical arguments in favour of using them.

That said, there are a couple of reasons to favour a move to PPP-based scenarios. First, since these are now becoming the norm, continued use of MER numbers is likely to cause confusion. Second, while the crucial numbers regarding emissions aren’t much affected (and any error may be either up or down) other variables, particularly those used in calculations of economic welfare, might be significantly affected.

In this context, it’s unfortunate that the debate has been seized upon by denialists as a basis for attacking the whole IPCC process. The energy that’s gone into pointless disputes could have better been used in a constructive attempt to improve things.

Where does the Stern report come out on all this? Pretty much right in my view. Key quote

efforts are under way to improve the provision of PPP data. The International Comparison Programme (ICP), launched by the World Bank when Nicholas Stern was Chief Economist, is the world’s largest statistical initiative, involving 107 countries and collaboration with the OECD, Eurostat and National Statistical Offices. It produces internationally comparable price levels, economic aggregates in real terms, and Purchasing Power Parity (PPP) estimates that inform users about the relative sizes of markets, the size and structure of economies, and the relative purchasing power of currencies.

In the IPCC SRES scenarios that use MER conversions, it is not clear that the use of MERs biases upwards the projected rates of emissions growth, as the SRES calibration of the past relationship between emissions per head and GDP per head also used GDPs converted at MERs as the metric for economic activity (Holtsmark and Alfsen (2003)). Hence the scenarios are based on a lower estimate of the elasticity of emissions growth per head with respect to (the incorrectly measured) GDP growth per head. As Nakicenovic et al (2003) have argued, the use of MERs in many of the IPCC SRES scenarios is unlikely to have distorted the emissions trajectories much.

I should point out that the World Bank ICP is a successor to the earlier ICP work of Heston and Summers who initiated the idea of systematic PPP comparisons and produced the well-known Penn World Tables. Still, as the quote makes clear, Stern can speak with authority on this topic.

34 thoughts on “The Stern Review on MER/PPP

  1. This sounds vastly familiar to any number of threads in which Ian Castles has participated.

    I can’t wait…

    So, until Mr Castles turns up, can I simplify/summarise the argument, to see if I’ve got it right? Here goes…
    Ian Castles has no comment about the physical processes of ACC, he accepts that there is an increased level of greenhouse gases and that these may or may not change the climate. However, modelling of future emissions relies on sophisticated guesses regarding what the global economy will do. As the global economy is merely a collection of a bunch of national economies, the way in which you treat them relatively is important. One common measure has been used by the IPCC, and Ian Castles thinks that’s the wrong measure. Using a different calculation may greatly change the predicted greenhouse gas outputs, so any predictions needed to be treated with scepticism.

    How did I go?

    If I am fundamentally on the right track, well in my naive view, that’s a really trivial, second order concern. Greenhouse gas concentrations are elevated, they’re going to become moreso, and that’s the main worry. Considering how inexact economic modelling is (never mind about climate models!), we don’t have that great a clue about future emissions anyway. So why worry, why say this is some massive point against the IPCC?

  2. John, Just a few points.

    First, the International Comparison Programme (ICP) isn’t the World Bank’s ; it is managed by a Global Office HOUSED at the Bank, which operates under the supervision of a Global Executive Board chaired by Dennis Trewin, the Australian Statistician.

    Secondly, the origins of the present round of the ICP are best explained by Jacob Ryten in “MERs, PPPs and IPCCs: Illusions and Reality�, Energy & Environment, 15: 3, 2004 (363-367), as follows:

    “My interest in the subject of this controversy stems from my involvement over many years with the International Comparison Programme (ICP) and the estimation of Purchasing Power Parity rates (PPP’s). In the 1980s and early 1990s I was responsible within Statistics Canada for Canadian economic statistics, including Canada’s participation in the OECD’s PPP programme, the results of which were (and are) used in the ICP. Later I undertook an extensive evaluation of the ICP for the United Nations Statistical Commission (Ryten, 1997) at the same time as Ian Castles conducted a similar exercise in relation to the OECD PPP program (Castles, 1997). Our reports were prepared independently but reached similar conclusions. Both reports were used to inform the processes that have led to the establishment of a revitalised ICP which is being managed by the World Bank. Today I am in charge of the Latin American ICP, in addition to being a member of the executive board for the global programme.

    “I hold no credentials in environmental economics, and make no comment on the parts of the argument of the SRES Teams that deal specifically with these matters. I do, however, claim expertise on the subject of economic statistics. From that perspective, I cannot help being shocked by the contrast between the Teams’ bold assertions and peremptory dismissal of the arguments advanced by Castles and Henderson, and their manifest ignorance of the conceptual and practical issues involved in developing and using intercountry measures of economic product.â€?

    Following on from the Ryten and Castles reports, and with the support of all of the major national statistical offices, the World Bank supported a revitalised ICP in a submission to the UN Statistical Commission in 1999 which included the following:

    “ICP is an integral part of SNA [the System of National Accounts], which lays a heavy emphasis on the importance of harmonization and comparability which are the primary concerns common to any international framework. The 1993 SNA, endorsed by all the major international agencies, including Eurostat, the International Monetary Fund (IMF), OECD, the United Nations and the World Bank, is part of a global effort to bring about consistency in the definition and classification of macroeconomic activity to enhance comparability between nations (Document E/CN.3/1999/8/Add. 1).�

    Regrettably (this gets me to my third point), the Bank’s support for this global effort waned after Nicholas Stern became Chief Economist in the following year. After I criticised Bank President James Wolfensohn’s misuse of statistics in an article published in the Australian Financial Review in 2001, Dr. Stern wrote to me to explain why he thought I was wrong.

    Unfortunately, the error was Dr. Stern’s. As I said in a letter to Dr. Rajendra Pachauri, Chairman of the IPCC, in August 2002:

    “The pernicious consequences of using this false method of measuring output [exchange rate conversions] are apparent in the analysis of greenhouse issues in the World Development Report 2003, released by the World Bank last week.

    “For example the Bank argues that ‘non-OECD countries use … 3.8 times as much energy per dollar of GDP [as OECD countries], and claims that ‘This disparity suggests looking for ways that developing and transition countries can increase efficiency and reduce fuel costs – with reduced GHG emissions as a welcome side benefit…’ The Bank goes on to wonder ‘why these apparent ‘win-win’ situations are so elusive’, and decides that the answer lies in two types of institutional failure – ‘distortions in energy policy [which] benefit special interests’, and the neglect by firms and households of profitable ways of saving energy ‘because it is simply too much trouble to pursue them’ (p. 177).

    “There is a simple answer to the question that the Bank poses. The assumption of a huge margin of difference in energy intensity between OECD and non-OECD countries which the Bank is seeking to explain is false. The ratio of use of energy per unit of GDP in non-OECD countries to that in OECD countries, calculated using PPPs rather than the spurious exchange rate conversion favoured by the Bank (and the IPCC) is not 3.8: 1 but 1.2: 1.�

    This was an astonishing error for the Bank to have made in its flagship publication, issued on the eve of the Johannesburg Summit on Sustainable Development. The correct data are now provided in the Stern Report, Table 7.1 (p. 178): that Table shows that in 2002 there was only a marginal difference between the energy intensity of OECD countries and “Non Annex I Parties�, and the report specifically notes that “at least in China and India, energy intensity is now below that of the United States.� So the analysis in the “World Development Report 2002.�

    I am surprised that you think that Sir Nicholas Stern can speak with authority on the subject of MER vs PPPs. In my view, the discussion in Box 7.2 of the Report is almost as confused as those in the IPCC Reports. For example, the Report says that PPP conversions “try to compare real incomes across countries by comparing the ability to purchase a standard basket of goods and services�. As David Henderson and I have repeatedly pointed out, this is not so:

    “It is sometimes said that PPP converters are measures of cross-border differences in the cost of buying ‘a standard basket of goods.’ This is not so. They are not defined with reference to a specific ‘basket’: their purpose is to measure cross-country differences in price levels; and in these comparisons, each economy has its own ‘basket’, which compares its own aggregate output of goods and services. In principle all goods and services are covered� (David Henderson, 2005, “SRES, IPCC and the Treatment of Economic Issues: What has emerged?�, “Energy & Environment�, vol. 16, nos. 3 & 4, pps. 556-557).

    The Stern Report goes on to argue that “Different baskets of products and PPP conversion rates are appropriate for comparing the incomes of old people across countries than for comparing the incomes of the young; similarly, different price indices need to be used for comparing industrial outputs.� As an argument for persisting in using MER conversions, this is ridiculous. It is no more sensible than arguing that one can’t measure a country’s GDP at constant prices because different price deflators are appropriate for the expenditure of the old versus the young. So the growth in GDP should be measured at current prices instead?

    Then the Report seriously argues, in favour of the use of MER conversions, that these measures “are available at high frequency�!

    The failure of the Sir Nicholas to cite the Ryten and Henderson papers cited above, or the Castles and Henderson paper “International Comparisons of GDP: Issues of Theory and Practice� (World Economics, Jan. Mar. 2005, pps. 55-84, also published by ANU ePrints), or to consult with any of hundreds of national accounts experts or index number theoreticians who could have advised on this issue, is a serious reflection on the Report. It reveals a fundamental lack of interest in the ‘global effort to bring about consistency in the definition and classification of macroeconomic activity to enhance comparability between nations’ to which the World Bank referred in its report to the UN Statistical Commission in 1999. The implications for policy are significant. There is of course no possibility of avoiding the continued use of MERs by those that find this convenient to the particular argument they wish to put.

  3. “It is sometimes said that PPP converters are measures of cross-border differences in the cost of buying ‘a standard basket of goods.’ This is not so. They are not defined with reference to a specific ‘basket’: their purpose is to measure cross-country differences in price levels; and in these comparisons, each economy has its own ‘basket’, which compares its own aggregate output of goods and services. In principle all goods and services are coveredâ€? (David Henderson, 2005, “SRES, IPCC and the Treatment of Economic Issues: What has emerged?â€?, “Energy & Environmentâ€?, vol. 16, nos. 3 & 4, pps. 556-557). …

    At least to the extent that the welfare theory underlying PPPs is valid, they do indeed compare the cost of buying a specific basket. Given the assumption of common (homothetic) preferences, needed for international (ratio) comparisons to be meaningful in terms of revealed preference, there is a unique (income-independent) optimal commodity bundle associated with the vector of international prices. If this assumption is not satisfied, there is no economically meaningful interpretation of “cross-country differences in price levels”.

  4. Please Dr Castles, can you answer one simple question: Does this matter? By which I mean in the broad thrust of ACC and the general conclusions of the Stern Report.

  5. PPP vs MER – for what it is worth:

    I believe there are two issues.
    a) coordination of actions among sovereign countries to reduce C02 emissions globally. This is necessary to avoid a prisoners’ dilemma outcome.
    b) coordination of actions of individual decision makers within a sovereign country such that they are at least (logically) consistent with the internationally agreed targets.

    Item (b) allows for alternative institutional environments. The two limiting cases are: (i) total central control with administered prices; (ii) market prices for all marketable commodities and financial securities and legislated quantity controls on C02 emissions with tradeable pollution rights.

    For those involved in (ii) of (b) it is the actual market prices which count. That is, MER is relevant.
    I can’t see that questions arising from the foregoing are statistical in nature (other than classifying the institutional environments and counting the number of entries in each).

    “It reveals a fundamental lack of interest in the ‘global effort to bring about consistency in the definition and classification of macroeconomic activity to enhance comparability between nations’�

    I am about to put my neck out and attract a big ‘chopper’. But, the ‘chopper’ is only a word – an abstraction in this context – so nothing really bad can happen when I propose that ‘macroeconomic activity’ does not exist in reality.

    Having said that, the macroeconomic data collected since WWII was very useful for tracking the ‘recovery of European countries from WWII’. It worked quite well, but not surprisingly, because the number of comparable natural and produced commodities before WWII was ’similar’ enough among the OECD countries such that an increase in GDP was ‘meaningful’ to people in terms of their expectations and observables , etc. (In other words, Ricardo’s and subsequent international trade theory models weren’t totally disconnected with the ‘real world’ of interest) But these macroeconomic aggregates, no matter how consistent the definitions and classifications, are, IMPNSHO, quite meaningless if the list of marketable commodities in one country has say 5 trillion rows and that for another country has say 25 0000. I propose that one notion of reducing ‘uneven development’ – and I believe this is a policy concern for some countries – is to reduce the difference in the size of the commodity lists (this surely is a policy concern within large and unevenly developed countries – eg Telstra and the bush).

  6. “At least to the extent that the welfare theory underlying PPPs is valid, they do indeed compare the cost of buying a specific basket. ………If this assumption is not satisfied, there is no economically meaningful interpretation of “cross-country differences in price levelsâ€?. ”

    Exactly. (and the criticisms of the strong assumptions underlying revealed preferences doesn’t even have to be dealt with in this instance)

    (The subjective probability of a ‘chopper event’ has changed but it is not zero as yet)

    Dr Castle? .

  7. The failure of the Sir Nicholas to cite the Ryten and Henderson papers cited above, or the Castles and Henderson paper … is a serious reflection on the Report … The implications for policy are significant.”

    Ian, please tell us what these significant policy implications are. Assuming your critique to be valid and material, are you saying that (a) the costs of doing nothing about global warming are significantly less than Stern says, or that (b) the costs of reducing global warming are significantly greater than Stern says, or are you saying something else?

    John, who is an expert in these index number problems, says your critique is a second order issue with respect to (a) and (b). Presumably you disagree.But why?

  8. Ernestine, I agree that nothing bad can happen when you propose that ‘macroeconomic activity’ does not exist in reality. Nothing bad can happen if you propose that greenhouse emissions don’t exist in reality either. But when the World Bank tells the world’s leaders gathered in Johannesburg that the OECD countries generate over three times as much macroeconomic activity per unit of energy than do non-OECD countries, and explains that this difference is attributable to institutional failures in the non-OECD countries that they should attend to, I think something bad has happened. Your statement that “For those involved in (ii) of (b) it is the actual market prices which count. That is, MER is relevant” involves a complete non sequitur. To the best of my knowledge, no one has suggested that international comparisons of GDP can be made except by making comparisons of actual market prices. Your statements about commodity lists reveal some misunderstanding of the ICP process. As a first step, I suggest that you read the first section of the paper “Measuring Economic Progress”, which I presented to the Reserve Bank of Australia Annual Research Conference on “Productivity and Growth” in 1996, and also the comments on the paper by the invited lead discussant, John Quiggin.

    John, the comparisons of GDP produced by the ICP relate, for each country involved, to the aggregate of ‘C+I+G+X-M’, and your observations about consumer preferences can at best relate only to ‘C’.

    On the latter issue, you will know that Erwin Diewert, Professor of Economics at the University of British Columbia, sent to the Stern Review a comment on your submission to the review on this PPP/MER issue. It is available both on the Stern Review website and on Professor Diewert’s own website. Could I suggest that you re-read Professor Diewert’s views on your submission?

    On the specific issues of welfare theory that you raise above, you may find helpful the following comments made by Professor Diewert. I had sought his views on a statement by William Nordhaus, Professor of Economics at Yale University, in the paper that he (Nordhaus) presented to the IPCC Expert Meeting on Emissions Scenarios in Washington, DC, in January 2005:

    “There are other approaches to index number theory (the axiomatic or test approach, the stochastic approach and symmetric basket approaches) that do not rely on consumer (or producer) theory. For these alternative approaches, see the following chapters in the ILO Consumer Price Index Manual (which I wrote):

    “Basic Index Number Theory: Chapter 15 of Consumer Price Index Manual: Theory and Practice, International Labour Organization, Geneva, (2004), pp 263-288.

    “The Axiomatic and Stochastic Approaches to Index Number Theory: Chapter 16 of Consumer Price Index Manual: Theory and Practice, International Labour Organization, Geneva, (2004), pp. 289-311.

    “… Even using the economic approach to index number theory on the consumer or household side, there are approaches to index number theory that do not rely on homotheticity! For these alternative approaches, see the following chapters in the ILO Consumer Price Index Manual (which I also wrote):

    “The Economic Approach to Index Number Theory: The Single Household Case: Chapter 17 of Consumer Price Index Manual: Theory and Practice, International Labour Organization, Geneva, (2004), pp. 313-335.

    “The Economic Approach to Index Number Theory: The Many Household Case: Chapter 18 of Consumer Price Index Manual: Theory and Practice, International Labour Organization, Geneva, (2004), pp. 337-343.”

    I can find no reference in the Stern Report to your submission to the Review commenting on Castles and Henderson, or to Professor Diewert’s comments on your submission. Nor does Stern refer to Nordhaus’s paper, which is rather surprising given that the organisers of the IPCC Expert Meeting chose him as their keynote speaker.

  9. OT, I know, but I have to say it – I hate your font. The letters are too cramped. I P C C reads like I P O C in your post, for example – IPCC IPOC.

  10. Of course, Diewert is correct that the economic approach to index number theory is not the only one. Still, it seems unreasonable to criticise economists for making statements based on the economic approach.

    As I’ve said before, I have no problem with Diewert’s discussion of my submission, though I’d put more emphasis on some points and less on others, and I don’t agree with some of his parametric assumptions. Diewert concludes that even for poor countries “the market exchange rate is a reasonable approximation to the direct energy comparison gap.” (emphasis in original). His poor country example has a PPP income around 1/6 of the rich country level, which would appear to fit China and India pretty well. He gets the opposite result for countries with 1/50 of the rich world income level, but only a handful of African countries fit this category, and I don’t think they are likely to affect the projections significantly one way or the other.

    On citations, it appears from a quick reading that the Stern Report hasn’t cited submissions as would be the practice with, say, the Productivity Commission, but has sought whenever possible to cite previously published work.

  11. Ian,

    1. “Nothing bad can happen if you propose that greenhouse emissions don’t exist in reality either.�
    I did not propose that.

    2. �But when the World Bank tells the world’s leaders gathered in Johannesburg that the OECD countries generate over three times as much macroeconomic activity per unit of energy than do non-OECD countries, and explains that this difference is attributable to institutional failures in the non-OECD countries that they should attend to, I think something bad has happened� .

    I agree there is something very strange. In terms of my own theoretical model (general equilibrium) of a ‘competitive private ownership economy with partially segmented markets and multinational firms’ (no physical externalities) the local economies (‘countries’) can be parameterised by a technology coefficient to characterise uneven technological development. This structure can persist (or get worse) even though the institutional environment is ‘markets’. So, while I can see there is a problem, according to the information you have provided, I can’t see that this problem crucially depends on PPP vs MER. However, the notion of PPP does not obviously extent to the model of a ‘competitive private ownership world economy with partially segmented markets and multinational firms’, irrespective of the various ‘economic approaches to index theory’. (A short version of my model is in Gross, “One World One Market or Partially Segmented Markets, Conference proceedings of ANZIBA, 1998.).

    3. “[“For those involved in (ii) of (b) it is the actual market prices which count. That is, MER is relevant�] involves a complete non sequitur.�

    Really? What is the point of arguing PPP vs MER?

  12. Dump of Word file deleted. TimTam, don’t you have the slightest understanding of how blogs work? if you want to link to something at another blog, let alone an entire document, you don’t cut and paste the entire thing. You post a hyperlink, like this to Richard Tol. My comment in response (posted this morning) hasn’t gone up yet, but no doubt Roger Pielke will get around to it in due course.

  13. So the author of anti-Stern says society needs to be given time to adapt. The people of Towoomba have said they are not going to drink their own pee. To me that’s a strong hint.

  14. Ernestine, The current ICP round is the most ambitious programme of collection of actual market prices in history. This is because ALL national accounts statisticians and experts in productivity and price measurement, without exception so far as I know, believe it is the actual market prices which count: that is, only PPP conversions are relevant. I don’t understand why you think that price collection can somehow be avoided by dividing nominal GDP by some average of (so-called) market exchange rates in the period in question. Exchange rates, like interest rates, are sometimes loosely called the “price” of money, but they are not a price in any sense which is relevant to measuring the quantum or price of goods and service.

  15. JQ: apologies, but Tol’s paper deserves the widest possible audience. I await your response with interest, yet I doubt it will deal with another lacuna in Stern, his lack of econometric evidence to show why the amazing growth of global GDP while CO2 rose will turn to catastrophic losses in GDP if it keeps rising. Windmills will do no more for Stern and his political patrons than they did for Don Quixote.

  16. “why the amazing growth of global GDP while CO2 rose will turn to catastrophic losses in GDP if it keeps rising”

    Because the economic losses are caused by global warming, not CO2 as such.

  17. Why do you hate nucular power ToS? Why worship the black God oil? Coal and oil are cheap – what other things do you worship because they are cheap? Is cheap the main thing, or the only thing, or merely the sacred thing?

  18. krusty: I have written at length on this very site supporting nuclear as the only meaningful alternative to fossil fuels for base load power night and day.

  19. Ian,

    PPP is not an (empirical) market price and PPP is also not an (empirical) administered price at which trades occur. PPP is a calculated statistic. PPP is a meaningful calculated statistic, within the context of a theoretical framework, if the theoretical conditions, under which PPP measures have been derived, hold empirically (with a little room for judgment). See earlier post by John Quiggin.

    If you don’t believe me, try to buy a quantity of Euros with ‘PPP’. I say you can’t. You can buy a specified quantity of Euros with another specified quantity of say A$. The relationship between the two quantities is called ‘exchange rate’. This exchange rate, a ‘relative price’, may be an administered relative price or it may be a market determined relative price at any point in time. Some ‘administrators'(monetary authorities) may, from time to time, use PPP calculations to assist them in determining exchange rates at which they are prepared to buy or sell their currencies during periods of time. (I did allow for a wide range of institutional environments in my items (a) and (b) in my initial post. However, I have implicitly assumed that all institutional environments are ‘non-dictatorial’. This excludes, for example, the possibility that institutions are managed by post-modernist pubic relations experts who end up believing their own messages; it also excludes empirical cases where a physical strong man – or woman? – terrorises people into submission).

    Incidentally, an appropriate framework for conceptualising non-negligible physical externalities, such as C02 emissions, is, IMO, the theory of incomplete markets, developed during the 1980s (methodology like in general equilibrium models). The EU is currently acting in a manner that is at least logically consistent with this framework.

    I don’t understand a few sentences in your post. You seem to have imputed ideas to me, which I don’t have.

  20. I am very interested in this topic, but feel like that I am lack of some background infomation/knowledge in this aspect. So can anyone here answer some of my very very basic question to help me understand the issues here to be discussed?

    Q1: From Ian Castles’ first post

    “There is a simple answer to the question that the Bank poses. The assumption of a huge margin of difference in energy intensity between OECD and non-OECD countries which the Bank is seeking to explain is false. The ratio of use of energy per unit of GDP in non-OECD countries to that in OECD countries, calculated using PPPs rather than the spurious exchange rate conversion favoured by the Bank (and the IPCC) is not 3.8: 1 but 1.2: 1.�

    As 3.8:1 (MER) > 1.2 :1(PPP), does it mean that when using PPP,the non-OECD can have lower energy intensity cost for converting energy into GDP? However,intuitively(have not checked the data), it looks like that the non-OCED countries has a worse environmental problem than the OECD countries, esp. ones with high GDP growth rate.

    From wikipedia: Energy intensity is a measure of the energy efficiency of a nation’s economy. It is calculated as units of energy per unit of GDP.

    * High energy intensities indicate a high price or cost of converting energy into GDP.
    * Low energy intensity indicates a lower price or cost of converting energy into GDP.
    Thus, a nation with mild and temperate weather, demographic patterns of work places close to home, and uses fuel efficient vehicles, supports carpools, mass transportation or walks or rides bicycles, will have a far lower energy intensity than a nation with extreme weather conditions requiring heating and cooling, long commutes, and extensive use of generally poor fuel economy vehicles.

    Q2: From John : “A method like MER, which tends to overstate income differences between poor and rich countries relative to PPP will yield a lower income elasticity of demand for energy.”

    Income is a measure from the consumer side.So if there is big difference in incomes, MER will yield a lower income elasticity. However, if look at the investment. For the same amount invesment to be expensed, will MER method yield a higher investment elasticity of demand for energy when compared to the case under the PPP method? And any adjustification to use PPP for investment evalution?

    Q3: Do GDP statistics include the domestic investor’s investment on the foreign countries?

    I do not know which method PPP or MER would help to control the pollution brought by the foreign investment. A lot of non-OCED countries try to attract as much as foreign direct investment as possible, but how to control the pollution impacts resulted?

    My naive guessing about MER method is that the lower the exchange rate set by some non-OCED countries, the higher the energy intensity ( If I understood the concept), the more warning-effective signals sent by the enronmental statistics to show the energy efficiency.

    A quite interesting effect here seems to be that the pollution burden created by foreign investment could be automaticaly involved into the foreign exchange policy. However, in this situation, will the goverment of the non-OCED countries be the only entity to bear the responsibilities? What can be done to ask some foreign investors also take the responsibility? Coz if they do not, the situation would be some investors of the OCED countries go to non-OCED countries to emit their CO2? As a matter of fact, this is happening.

  21. Presumably, Hermit the people of Toowomba prefer to drink the ‘natural’ multiply-urinated pee from all animal life in their watershed.

    More seriously, on my quick reading of the Stern Report reports I can find no attempts to quantify the benefits of Global Warming for some areas e.g. Russian, Chinese and Canadian agricultural production.

    Surely any economic analysis worth the name tries to put a figure on both costs and benefits?

    The report also seems to too narrowly frame the Adaptation/Ameliorisation options. Shouldn’t an economic analysis compare the nett costs and benefits at the margin of each possible temperature? Isn’t the right question to ask- given we can affect global climate and therefore must choose by our actions or inactions, what is the long run optimum climate for Humanity as a whole? What is so sacred about the status quo?

    I confess I don’t like the company I am keeping when I ask these sceptical questions, but I don’t much care for the emotionally manipulative ‘sky is falling ‘ tone of much environmentalist rhetoric either.

    This is the first decision humanity has ever been consciously required to take together. Lets try and get it right

  22. Thanks Ernestine. Of course I believe you when you say that PPP is not a market or administered price: I certainly didn’t intend to suggest that it was. For my answers to most of your queries, please refer to Ian Castles and David Henderson, “International Comparisons of GDP: Issues of Theory and Practice�, “World Economics�, vol. 6, no. 1, Jan.-Mar. 2005 (republished by ANU eprints at http://eprints.anu.edu.au/archive/00003050/ ).

    On p. 6 David and I discuss what the “System of National Accounts� (SNA) describes as the “economic-theoretic approach to index numbers� (see paras 16.21-30 of the SNA at http://unstats.un.org/unsd/sna1993/tocLev8.asp?L1=16&L2=3 ). I think this is the same concept as John Q’s “economic approach�, which leads him to the position that if the welfare theory underlying PPPs is not satisfied there is no economically meaningful interpretation of “cross-country differences in price levels� (or, presumably, of cross-country comparisons of output). David Henderson and I came to a different conclusion, which is simply that such differences represent the price and volume components of comparisons that have originally been made in value terms.

    Box 7.2 of the Stern Review says that different PPPs need to be used for comparing industrial outputs between countries. John, is it your position that such PPP-based intercountry comparisons have no economic meaning, or that there is a welfare theory which underlies them? If the latter, how is it determined whether or not the theory is fulfilled?

    In principle, the cross-country comparisons of output from the expenditure side which come from the ICP can be cross-checked by similar comparisons from the output side, of the kind produced by the Groningen Growth and Development Centre. In fact, Angus Maddison has recently proposed to do just this (Ruggles Lecture, IARIW Conference in Cork, August 2004, p. 6, available at http://www.ggdc.net/maddison/articles/ruggles.pdf ). The same questions arise.

    Ernestine, I think that your point that one can’t buy Euros with PPPs is essentially the same as that made by Professor Lord Desai in the House of Lords on 21 April 2004. David Henderson and I discussed this in our paper (p. 15), and Angus Maddison also refers to it: Ruggles Lecture, n. 3, p. 32. Note also Angus’s reference to “ignorance of the pitfalls of exchange rate conversion� and his urging on statistical offices the desirability of being “more vigorous in explaining the merits of PPP adjustment.�

    I know at first hand just how hard national statisticians have tried. I am in regular email contact with many of them and talked with scores of these experts at the International Statistical Institute meeting in Sydney last year. So far as I know, no national accounts statistician or index number specialist has ever been invited to an IPCC meeting or selected for an IPCC writing team (despite my informing Dr. Pachauri of the names of several leading statisticians who had told me of their willingness to assist the Panel). The Australian Government also urged the involvement of national statistical offices and of the UN Statistical Commission in its submission on the scoping of the Fourth Assessment Report (March 2003), but these suggestions were also disregarded.

    The IPCC’s intransigence on this matter has done serious collateral damage to the United Nations Framework Convention on Climate Change (UNFCCC). The reporting of GDP and emissions intensity levels in the Expert Reviews of the National Communications of Annex I countries is farcical. The review for Germany reported the country’s GDP and emissions intensity in MER and claimed in the text that Germany was the third largest economy in the world (i.e., after the US and Japan: the Chinese economy is smaller than Germany, according to the UNFCCC experts!). The review for the UK reported the same aggregates in PPP, but Ireland reported in MER. France reported in MER, Italy in PPP. Belgium reported in MER, the Netherlands in PPP. Spain reported in MER, Portugal in PPP. Finland reported in MER, Sweden in PPP. Norway reported in MER, Denmark and Iceland in PPP. The European Union, which was the subject of a separate review, reported the aggregates for the total of all member countries in PPP. Switzerland reported in MER, Austria in PPP. Russia reported in MER, the Czech and Slovak Republics in PPP. Japan reported in MER, Australia in PPP. Canada’s aggregates were reported in its own currency, as were those of the US (which are by definition the same in MER and PPP).

    One would like to think that the authors of the reports for the countries that reported in MER were simply incompetent, but there is every reason to believe that many of these countries did so deliberately to make the emissions intensities “look better.� A particularly unfortunate feature is that these reports are prepared by teams of officials from around the world – e.g. Germany’s was prepared by a group which included representatives from Malaysia, Uganda, Armenia and Belgium; Switzerland’s review representatives came from Kenya, Lesotho, the Czech Republlc and Austria; Belgium’s from Burundi, Indonesia and Ireland, and so on. The effect of this is that the representatives of developing countries learn at first hand how rich countries fiddle the figures.

    Finally, John, you said it seemed unreasonable for me to criticise “economists” (presumably meaning Stern and co.) for making statements based on the economic approach, when the only criticism I made was in the form of a direct quotation of the opposite view from David Henderson, who in former existences has been Head of the Economics and Statistics Division of the OECD, Professor of Economics at University College London, Director of the Economics Department at the World Bank, Fellow of Lincoln College Oxford and Visiting Professor or Fellow at institutions in Britain, France, Belgium, Australia and New Zealand. I still believe that the statement in the Stern report is incorrect and misleading, and in any case there seems to be no sign in the Stern Report of any consultation with the Office of National Statistics (I am subject to correction). Might not such consultation have been desirable, in relation to the discussion of a technical statistical matter?

  23. Ian, thanks for your reply. I didn’t have questions that are addressed in the first reference you gave – but its a nice document anyway. It details why there is no totally satisfactory solution to the index problem and, IMO and from my perspective, it is the statisticians that are the best people to excercise informed judgement on which method is least unsuitable for the purpose at hand. The second and third reference are interesting, thank you, and so are your comments. They are interesting to me for questions related to ‘uneven development’ and the model I referred to earlier. I think these questions go a bit beyond the topic of this thread. It seems to me, and I’d appreciate your comment on this, the issue of PPP versus MER affects my item (a), namely the coordination of governmental policies, while MER is the relevant relative price once a decision on (a) has been reached (my item b). Of course there is a distinction between converting all country transactions data into a foreign currency versus converting only those which actually take place. Parenthetically, the welfare theory foundation for PPP does not hold anyway for the theory of incomplete markets, which, I would suggest is the relevant framework given the scientific data on CO2 feedback on the physical environment.

  24. “John, is it your position that such PPP-based intercountry comparisons have no economic meaning, or that there is a welfare theory which underlies them? If the latter, how is it determined whether or not the theory is fulfilled?”

    The standard approach is to test whether the data set is consistent with (various versions of) the revealed preference axiom. If it is not, for example if the average French person can afford the German average bundle, and vice versa, then no meaningful welfare comparison is possible. My papers with Steve Dowrick in the American Economic Review illustrate the approach, though of course the fundamental work was done by Afriat, Diewert and Varian. Broadly speaking the ICP data set is consistent with revealed preference, but the standard Geary-Khamis PPP measures do a bad job of representing the necessary homotheticity properties.

    To restate, if the relevant conditions are fulfilled, the PPP index measures the cost of purchasing a particular consumption bundle, namely the bundle preferred for the implied common preferences at international prices (and at the given income level). This is consistent with the statement in the Stern report. It’s surprising that someone with Henderson’s impressive qualifications would get this wrong, but the economic theory of index numbers is a rather specialised field and not one in which he has worked as far as I know. As you suggest, statisticians such as yourself tend to prefer axiomatic approaches rather than those based on welfare theory. That’s fair enough, and there are some good arguments for the statistical approach. But as far as economics is concerned, Stern is right here and the statement in Castles and Henderson is wrong.

    Note that standard demand theory can, in principle, be used to predict demand for energy, CO2 emissions and so on, whether or not there exists a meaningful internationally comparable income measure. This is another illustration of the point I made in my paper that the two are really separate questions.

  25. John, I’ve got no idea where you got the notion that statisticians “tend to prefer axiomatic approaches rather than those based on welfare theory”, but your statement that I suggested this is simply wrong. This is from my first major paper with David Henderson:

    “… our arguments for PPP-based comparisons and aggregates are in line with those of other professionals who are working on issues and problems relating to the process of economic growth. Thus the editors of a recent volume entitled ‘International and Interarea Comparisons of Income, Output and Prices’ note that the UN International Comparisons Programme (ICP), which is the prime source of PPP estimates, has now been running for over 30 years; that ‘measures derived from it are increasingly used in economic research in place of the distorted values derived from exchange rates’; and that ‘Almost the entire recent literature on the determinants of economic growth that covers large numbers of countries is dependent on these [PPP-based] data” (Ian Castles and David Henderson, “Economics, Emissions Scenarios and the IPCC”, “Energy & Environment”, vol. 14, nos. 2 & 3, p. 419).

    The volume that we cited, which was published in 1998, includes many illuminating papers, but I’ll mention just two:

    * “The World Distribution of Well-Being Dissected�, by two professors of economics and the University of Pennsylvania, Robert Summers and Alan Heston. The first sub-heading of the paper is “What Should Enter an Empirical Social Welfare Function?�, so these two eminent economists apparently believe that the extensive empirical data that they present in the paper (all of which is based on the Penn World Tables) have some grounding in welfare theory.�

    * “Axiomatic and Economic Approaches to International Comparisonsâ€? by Erwin Diewert, Professor of Economics at the University of British Columbia. The citation for a recent prestigious award to Professor Diewert states that has “developed, and adapted for implementation, … theoretically improved measurement methods in direct support of statistical agencies in the United States, Canada, Australia, the United Kingdom, France, Germany, Sweden and New Zealand.â€? Why do you suppose that all of these national statistics agencies are seeking Erwin’s expertise, if they “tend to prefer axiomatic approaches rather than those based on welfare theoryâ€??

    You say that “It’s surprising that someone with Henderson’s impressive qualifications would get this wrong, but the economic theory of index numbers is a rather specialised field and not one in which he has worked as far as I know.” I really find it rather a stretch to believe that the Head of the Economics and Statistics Division of the OECD during a period of rapid development of the PPP programme is not reasonably well acquainted with the economic theory of index numbers. But in any case, before concluding that the statement that I cited is wrong, I think that I should let you know that Professor Henderson sent the paper in which the statement was made to Erwin Diewert for his comment. Erwin thought the paper was excellent, and said that he had no suggestions to make.

    Could I suggest, if you believe that David Henderson’s statement is wrong, that you set down your reasons for this view and submit your comment to the Editor of the journal in which it appeared, Dr. Sonja Boehmer-Christiansen? That is the normal academic practice and, if your paper is accepted, there would be yet another Australian or part-Australian contribution to the MER vs. PPP debate in the pages of “Energy & Environment”. In addition to several by Castles and/or Henderson, this journal has published papers by Warwick McKibbin of ANU, David Pearce and Alison Stegman (now at Macquarie); and Peter Dixon and Maureen Rimmer of Monash.

  26. Ernestine, I apologise for not responding to your interesting post. I will do so as soon as I can, but felt an obligation to reply without delay to John’s claim that David Henderson was in error.

  27. “Could I suggest, if you believe that David Henderson’s statement is wrong, that you set down your reasons for this view and submit your comment to the Editor of the journal in which it appeared, Dr. Sonja Boehmer-Christiansen? That is the normal academic practice”

    A brief response on this. Comments on passing remarks like the one you quoted are not normally considered for publication. The normal practice when a minor error is pointed out is for the author(s) to submit a correction. As I’ve point out, in the welfare-theoretic interpretation of index numbers, the PPP measure is the cost of buying a standard bundle. So, in the interests of correctness, you and David Henderson might want to write and clarify that you should have said “this is not the only interpretation” or something similar. But I’ll leave this up to you.

  28. Ernestine, Yes, I agree with the arguments in David Henderson’s article: I was the co-author of several of the papers in which most of them were initially advanced. And I certainly agree with David’s view that the UK Government’s response to the House of Lords Committee Report on The Economics of Climate Change reflects little credit on the responsible Department (the Department of the Environment, Food and Rural Affairs: Defra).

    Let me give an example. Following the publication of the Report, I wrote to Henry Derwent, the senior Defra officer who had given evidence to the Committee, to complain about what I considered to be the misrepresentation of the Castles and Henderson position in Defra’s Memorandum to the Committee. In that letter I reminded Mr. Derwent that David Henderson had said in his first letter to the IPCC Chairman, Dr. Pachauri (28 October 2002), that “Ian Castles has suggested that in the next IPCC Assessment national and international statistical agencies should be brought in and represented�, and that he (David) agreed with my view; and that in my letter of 17 December 2002 to Dr. Pachauri I had said that I believed that the National Statistician of the United Kingdom, Mr Len Cook, would be very willing to assist the IPCC in the AR4, and that Mr Cook had subsequently written to me to confirm that this was indeed the case. Here is an extract from the reply I subsequently received from Defra:

    “… You state that national statistical offices and the International Statistical Institute should be involved in the emissions scenario work. I would comment that if they produce any papers for peer review then their views should be considered by the IPCC. Similarly governments can elect individuals from the statistical sources you mention to serve on the IPCC Bureaux if their credentials justify it. The requirement for peer reviewed articles (and the credentials these provide) may be more conducive to academics contributing to the IPCC process but they also provide a quality control that is important in order to maintain credibility in the findings.â€?

    Len Cook was appointed UK National Statistician and Director of Office for National Statistics in 2000 following an open competition, and served in those offices until 2005. He had been Government Statistician of New Zealand from 1992 to 2000, and had been elected a Chartered Statistician of the Royal Statistical Society in 1973. He is currently serving as one of the three Vice Presidents of the International Statistical Institute, and is a Companion of the Royal Society of New Zealand.

    Defra submitted a detailed review of the Castles and Henderson critique to the House of Lords Committee, included an Appendix entitled “Empirical Studies relating to Henderson and Castle (sic) Critiqueâ€?. But they apparently couldn’t see the need to consult Castles or Henderson on the subject, or Cook or his colleagues at the Office of National Statistics. Given the information I’ve just provided about Len, and your agreement that “it is the statisticians that are the best people to exercise informed judgement on which method is least unsuitable for the purpose at hand”, I think that you should also agree that Defra should have cleared a government response on a technical statistical matter with the national statistics agency.

    John, if “the PPP measure IS the cost of buying a standard bundle of goods and servicesâ€?, the statement in your original post that “Heston and Summers … initiated the idea of systematic PPP comparisonsâ€? is even more in error than I originally thought. I’d wondered why you left out the systematic PPP comparisons under the ICP rubric by Kravis et al in the 1970s, and those under the OECD rubric by Gilbert and Kravis in the 1950s, and those done single-handedly by Colin Clark when he was Government Statistician of Queensland in the 1940s. But if systematic comparisons of the cost of buying a STANDARD BUNDLE of goods and services in different cities and countries qualify as PPP comparisons, you’d have to include studies by the League of Nations and the ILO in the inter-war period and studies by the UK Board of Trade before World War I.

  29. Ian, I should certainly have mentioned Kravis as well as his co-authors Heston and Summers. As to whether you would call the earlier efforts “systematic”, I don’t have a strong view. The purpose of the remark was not to give a detailed history of the concept but to correct any possible impression that the ICP had been started by the World Bank, a point you have stressed yourself.

    None of this affects the point that the claim quoted from your article with Henderson is incorrect. As I say, it’s a minor point and does not justify a comment, but given your concern with accuracy in these matters, a correction would be in order.

  30. The claim I quoted is not from my article with Henderson, John: it’s from a sole-authored paper by Henderson, and it’s right. I don’t understand how you can assert that “the PPP measure IS the cost of buying a standard bundle of goods and services”, and then question whether the inter-war studies by the Geneva-based organisations were “systematic”: these were the only studies, of all of those that I cited, that attempted to calculate the cost of buying a standard bundle of goods and services in different countries. The ICP doesn’t do this. As you didn’t comment on my earlier point that your argument could at best only relate to the private consumption component of PPPs derived from the expenditure side, let me quote again from the advice I received from Erwin Diewert:

    ‘… when we are doing international comparisons of GDP, it is obvious that consumer theory cannot be the “right” economic approach to use, since I+G+X-M are not directly determined by consumer preferences. The axiomatic or test approach, the stochastic approach or the symmetric basket approaches can be used in this GDP context but the domain of definition for the admissible transactions that go into the aggregate are of course much bigger than just the C transactions! For these alternative approaches to index numbers for GDP, see the IMF Producer Price Manual and the following chapters {three chapters by Diewert cited].’

  31. Ian,

    I assume you haven’t had time to reply to what you called my ‘interesting response’. For house-keeping purposes I call this my question #1.

    I then asked a question regarding the article http://www.staff.livjm.ac.uk/spsbpeis/RES-Henderson.htm (my question #2). I understand from your reply that you agree with the argument in this reference. I don’t agree because, as far as I am concerned, the argument in this article is an argument for procrastination on controlling CO2 emissions:

    “Rather than pursuing as a matter of urgency ambitious targets for curbing emissions, governments should take steps, the sooner the better, to ensure that they are more fully and more objectively informed and advised in matters relating to climate change. This requires action on two fronts: first, to improve the IPCC process by making it more professionally watertight; and second, to bring to an end the IPCC’s monopoly status by providing for other sources of information and ideas.”
    Source: http://www.staff.livjm.ac.uk/spsbpeis/RES-Henderson.htm

    In the context of my question #2, you quote my comment “it is the statisticians that are the best people to exercise informed judgement on which method is least unsuitable for the purpose at handâ€?. But my comment is irrelevant in the context of my question #2 because my comment relates to the first reference you gave in one of your earlier posts. This reference consists of a document on the index number problems in statistics.

    Negative feedback effects of C02 emissions on the natural environment are, IMHO, not an index number problem in statistics, but an important problem in Economics.

  32. Ernestine, I confirm that I haven’t had time to answer your question (i). I apologise for having misunderstood your point about the relevance of statistics. If there was an implication in my comments that your later point was not in line with what you’d said earlier, I withdraw it. But I’d adhere to the position that the projection of future levels of emissions is not for scientists but for economists (including, of course, index number theorists) and demographers.

    I also confirm my agreement with David Henderson’s position as quoted in the article you quoted. Last week David took the chair at a talk given in London by Dr. Dieter Helm of New College Oxford in the Beesley Lectures series on problems of regulation. The procedure for these Lectures provides for a personal contribution by the chairman, to be made after the talk and before the discussion is thrown open. The text that formed the basis for David’s remarks on that occasion included the following:

    “Let me however mention that a group of us, comprising both scientists and economists, hope to publish before long an assessment [of the Stern Review] which will be as extensive as we can make it. What we have in mind is two linked review articles, one focusing on scientific and the other on economic aspects. Though authorship would be largely or wholly separate, the two articles are being prepared in conjunction: they will be cross-referenced and mutually supporting. These twin contributions are scheduled to appear in a coming issue of the journal World Economics, which has already carried, in its summer issue, some exchanges between Sir Nicholas and the nine economists who are members of the group.�

    I am one of the co-authors of the economic review article that is in course of preparation, and this paper must now make the priority claim on my time. I must therefore ask you to excuse me for not having the time to continue our discussion. I hope that the article will provide answers, or at least explanations, for my position on some of the points that have been raised on this thread and in earlier discussions on John’s blog.

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