Macroeconomics and physical consistency

In this article Etienne Lorang  and Reyer Gerlagh from Tilburg University explain how macroeconomic models, namely the “Computable General Equilibrium” (CGE) model are been deployed to understand better the circular economy possibilities. 

While the economy seems sometimes an abstract entity, it requires substantial material processing. Along with economic growth, their use is expected to double over the next 40 years. This goes in hand with pressing environmental issues: constrained material supply, pollution and social impacts from extraction, and materials also make an important contribution to climate change and waste accumulation. To alleviate those impacts, we need to break the linear economic model based on the extraction/consumption/disposal tryptic. In this context, the concept of Circular Economy (CE) has gained a considerable political momentum in recent years. As opposed to a unidirectional linear economy, it is part of a wide reflection with the objective of “closing material loops” (Kirchherr et al 2017).

After having highlighted the environmental potential of CE, countries and organization have started to include it in roadmaps and legislation, with for instance the EU Green Deal or the introduction of the Critical Raw Materials Act (March 2023). In order assess the major economic, social and environmental impacts that CE is expected to have and inform policymakers, researchers develop macroeconomic modelling tools. Such tools are already widely used to address topics such as climate change or innovation, with outputs that are used for instance by Working Group III of the Intergovernmental Panel on Climate Change (IPCC) (CITE IPCC WG3).

Models called “Computable General Equilibrium” (CGE) are widely used in the literature assessing the effect of (fiscal) environmental policies. Based on Léon Walras and later Kenneth Arrow and Gérard Debreu’ General Equilibrium theory, they aim at representing the economy with interrelationships between the different sectors and regions. With a detailed description of the system, including fiscal transfers and trade, they are very efficient at representing substitution between different industry sectors and distributional impacts of policies (Gerlagh and Kruik 2014, Böhringer et al 2021) with very detailed models and data already existing (e.g., GTAP).

However, these economic models often lack representation of CE elements. More generally, macroeconomics is often criticized for its lacking representation of material flows, or more broadly for its lack of physical consistency. Most of the models do not account for material balance, and when they do material flows are usually calculated afterwards, and not while running the models. Thus, these models need to be adapted to include a description of material flows during their lifecycle (“from cradle to waste”), including capital accumulation and durable goods; and, CE features such as material loops (“from cradle to cradle”, McDonough and Braungart 2002) and other R-strategies (Potting et al 2017, PBL –Netherlands Environmental Assessment Agency).

Within the wide variety of macroeconomic models, CGE models are good candidates for the addition of material balance and CE elements. The sectorial description of economic flows can be adapted to physical flows as they have a structure similar to what is used in industrial ecology, the study of material and energy flows in the industrial apparatus (Ayres and Ayres 2002). Social Accounting Matrices provide a data structure to CGE model that conforms to standardized national accounting. Building on existing approaches, CGEs can be extended to physical accounting, as used in Physical Input/Output Tables or Material Flows Analysis. Combining the two approaches, macroeconomics and industrial ecology, is essential for future environmental policy assessments, in order be able to draft sustainable economic paths within Earth environmental and physical boundaries.