Carbon Pricing (Cap and Trade/Carbon Tax) Is Just One Piece of the Puzzle: Towards a Comprehensive Climate and Energy Policy – Part 1

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by: Michael Hoexter

In 2006 in the Stern Review on the Economics of Climate Change, the economist Sir Nicholas Stern called climate change, “the greatest market failure the world has seen.” Throughout the almost 20 year history of climate policy, some economists and climate policy designers have attempted to remedy this failure by assigning a price to carbon emissions thereby bringing this negative externality (to the market) into the reckoning of market actors.

However I believe the primary focus on carbon pricing ignores certain fundamental realities of economies, of technological development and of physics which will lead to frustration as we try to reach some very ambitious climate and economic goals by 2020 and 2050.

Sir Nicholas Stern was commissioned by the British Government to assess the economic impacts of climate change and the costs associated with mitigating carbon emissions. The Stern Review remains the most comprehensive economic study of climate change.

As then President-elect Barack Obama said in a speech to the nation, our economy will not recover if we rely on “worn out dogmas of the past”. Despite the recent emergence of the first proposals for cap and trade systems in the US, a monocular focus on pricing carbon bears many traces of past economic orthodoxies, which are now under revision in light of very recent events. The resistance to carbon pricing on the part of the Bush administration and deniers of climate change has obscured the fact that this policy instrument hovers just a little bit above and to one side of some of the main economic and energy challenges facing us in the next decade. In other words, the enemy (cap and trade) of my enemy (deniers), from the point of view of climate activists, is not necessarily always a friend.

Much of the risk involved in designing a long-range policy that is intended to have a discrete physical impact on our atmosphere and climate has to do with lack of certainty within economic theories, particular as regards the benefits and limits of market mechanisms. We, and economists, can’t seem to be able to make up our minds about the appropriate types of interaction between public and private actors within a prosperous and, now a carbon-emission-reducing, economy.  While some see the range of choices as a sign of our freedom and part of the “fun” of disputes in economic and political discourse, if we are choosing among partial or even false ideas and if the conflict itself causes distortions in our understanding, we are in trouble. Do we need to choose between the “magic of the market” and beneficent government-sponsored programs? Or is the picture more complex, less packagable into sound-bites, but reality-based?

Crisis of the Self-Regulating Market Ideal

The bankruptcy of 150 year old investment bank Lehman Brothers in September 2008 shocked the financial world and has led to a dramatic restructuring of the financial industry both voluntarily and with government assistance.

In the last several months there has been a sudden and complete about-face in the direction of economic policy actions with regard to the rightness of government’s role in the economy. Conceptual development and informed deliberation about this sudden spate of impromptu regulations and huge expenditures has lagged far behind the actions themselves. Faced with the collapse of major banks and other financial institutions, the conservative Bush Administration and governments around the world suddenly intervened massively in areas of the economy in ways which months before were inconceivable. While perhaps the US President most ideologically committed to the notion that markets can regulate themselves, George Bush in his last few months in office oversaw the expenditure of hundreds of billions of taxpayer money to prop up the economy in moves that have socialized economic risk for many large corporations. These ill-coordinated moves may have nevertheless prevented or at least delayed a slide into pure economic chaos.

A sign of a sea change in economic thinking can be observed in the mild mea culpa’s of Alan Greenspan, the retired head of the US federal reserve bank who had been seen as one of the principle architects of a hands-off market policy by the US government with much influence abroad. While previously a believer in the stabilizing effect of financial derivatives and limiting government regulation of finance, Greenspan recently expressed surprise that lenders had not acted in their own best self-interest by refusing to issue or buy risky loans and loan packages. Dominant in economics and economic policy since the late 1970’s, Greenspan was only the latest dean of the so-called monetarist school which advocates maximal market self-regulation, a tradition that includes economists Milton Friedman and Friedrich von Hayek.  Another self-regulating market philosophy, called supply-side economics, also came to have a highly influential role in the United States and elsewhere, which emphasized that simply cutting business and upper-income taxes and decreasing government spending on social welfare would increase private investment and therefore the supply of desirable goods, spurring, in turn, economic growth.

Common among advocates and theorists of self-regulating markets, a.k.a. monetarists and supply-siders, are assumptions that people are more rational and economic information is more accurate than they and it actually are. The recent housing bubble progressed and mushroomed to enormous size resting largely on these assumptions, as borrowers, lenders, securitizing firms, insurers and rating agencies created a self-reinforcing circle of denial of the downsides and risks involved. These views may have been held sincerely, even naively, by some or, for others. as part of a self-interested calculus in which it was OK to assume the best if one also quickly divested oneself of responsibility for or connection with the consequences of risky decisions.

While there is now a large experimental literature in the newer field of behavioral economics that has shown that people are not nearly as rational as self-regulating market theory assumes, the assumption that people are most often protective of their best interests is contained in the numerous policy recommendations and statements by politicians, from the Bush Administration but also Administrations past. The call that the best economic stimulus is always putting more money in private hands via tax cuts or tax rebates, rests on the assumption that these economic actors will always, in all contexts, alone and in aggregate, act in their best interest and in that of the entire economy.  In other words, the idea is that economic surpluses are always best left or rapidly returned to individual or corporate actors in markets rather than remain part of a government spending program, however efficient or well-regarded.

Friedrich von Hayek, a leader of the Austrian School of Economics, one of the prominent "free market" schools of economics, did not think of himself as a conservative but a "liberal" in the European sense; he saw as his main opponents Communism and Keynesian economics. His work was inspirational to Margaret Thatcher, one of the promoters of the new libertarian vogue in economics in the mid 1970’s.

In another, conflicting account of the financial collapse, true believers in a totally unregulated and unsubsidized private market, libertarians, contend that the current economic situation is in fact caused by too much regulation and the socialization of risk prior to the credit crunch. Criticizing both the Bush administration and its Democratic critics, these libertarians point out how various companies knew they were “too big to fail” and made risky financial bets on the assumption that they would be bailed out or could in the end rely on government to save them. The Bush administration may have flirted with this more radical policy orientation in allowing Lehman Brothers to fail in September only to become terrified of the resulting credit crunch.

Libertarian advocates of a “pure” market, claim that a consistent, hands-off approach would have better results, helping all corporations and individuals learn to become more responsible market actors. As we have had no governments that adhere to this vision in power in recent memory, it is difficult to say what the consequences would be but in all probability we would see, as happened in the latter half of the 19th Century when laissez faire policies were the norm, an even more extreme polarization of wealth, more pronounced boom and bust cycles, and more rampant environmental degradation without the intermediation of regulation and government programs. There is no room in the “pure” market view for pricing in market externalities, as market actors are thought to be in full command of all economically-relevant issues and information. For some reason, the military and military spending are exempted from this same scrutiny by these commentators, perhaps because there are no private market alternatives to these institutions.

Revived and Updated Keynesianism:  A Rush Delivery

John Maynard Keynes was the most influential economist of the mid-20th Century, credited with supplying the theory that helped explain how market economies emerged from the Great Depression. While dissatisfaction with Keynesianism peaked in the 1970’s and 1980’s in political circles, the Keynesian approach is credited with lengthening the periods of economic growth and shortening recessions in post-WWII economies.

The economic school which the latest crop of monetarists and other “free market” advocates reacted against was Keynesianism, which ruled Western economic discourse from the mid 1930’s to the 1970’s. Based on the work of the British economist John Maynard Keynes, the climate of opinion that is Keynesianism believes that government involvement in the economy and in particular government spending is necessary to balance the tendencies of the market towards boom and bust. Keynesians believe that regulation of market actors by government is in many cases warranted. Keynesians in general support some form of social welfare spending, with those to the political left supporting a comprehensive social safety net paid through tax revenue.

Inequality is not only a moral problem to Keynesians but also, in Keynes’s words, a “magneto” (kinetic-mechanical) economic problem leading to insufficient overall demand for goods in economic downturns, demand that needs to be stimulated by loosening monetary policy, direct government spending, including public works programs and unemployment insurance. People with relatively less means tend to spend more of their money as a percentage of their income than the rich, who by virtue of being rich, cannot or can choose not to spend so much and still survive. Keynes observed and theorized that people prefer to hold onto their liquid assets (to save) during economic downturns and the concomitant deflationary period, reducing overall economic activity and further exacerbating the recession. This is one aspect of what is called people’s “liquidity preference”.

From a vocal fringe that has had inordinate influence on popular economic discourse for three decades, libertarians contend that Keynesianism has remained the philosophy of government economic policy even during the Bush Administration despite its talking up of the virtues of the market and private initiative. From this radical perspective, all who interfere with the market are Keynesians or “socialists”, therefore erasing the differences between the regulatory policies of the Bush Administration and what we imagine to the policies of the beginnings of the Obama Administration or the Roosevelt, Eisenhower, and Johnson Administrations of the past. This accusation also overlooks the fact that Keynesianism is itself an effort to preserve capitalism rather than supplant it with another economic system.

Important for this discussion is Keynesianism’s agnosticism towards some forms of economic planning especially as applied to areas of public investment like infrastructure. In the Cold War confrontation with the Soviet Union, planning was thought to be an attribute of Soviet style economies yet in the US, federal, state and local governments continued to plan to manage their own investments and budgets. With the rise of the libertarian ideal in the 1980s, planning was considered to be inefficient or a “taboo”, as the play of market forces was thought to be the optimal solution to all economic problems. If we re-emerge into an era where public funds are once again used to build infrastructure or invest in other public goods, the need for planning once again comes to the fore despite the ideological wars that have surrounded the term. As a sure sign that the rush away from planning has now “bottomed-out”, one hears lifelong capitalist and conservative T. Boone Pickens now publicly lamenting the lack of planning in the area of energy in the US over the past 40 years.

While before the collapse of 2008 and monetarism/supply-side’s precipitous fall from grace, public praise in recent decades for Keynes and Keynesianism was hard to find, we now find ourselves in an era when economists and the public are engaging in a crash study course of the works of Keynes and notable Keynesians like John Kenneth Galbraith. Most significantly, President Obama quoted Keynes almost exactly in his inaugural address by citing that our productive capacity remains underutilized in this financial downturn. Paul Krugman, the recent Nobelist in Economics, has become one of the most vocal advocates for a rediscovery of Keynes in the US, using his influential op-ed pieces and blog at the New York Times to revive interest in a positive relationship to targeted government involvement in the economy. One needn’t however look to a left-leaning economist like Krugman or political leaders to find voices that recommend that government needs to do more to regulate the extremes of the business cycle and business practice, as billionaires Warren Buffett and George Soros have for the last several years questioned the existing hands-off policy.

The Works Progress Administration or WPA was one of Roosevelt’s New Deal programs that functioned as a fiscal stimulus, training workers and putting them to work on public works projects. Conservatives argue that the WPA and other New Deal programs were ineffective and lengthened the Great Depression while liberal economists claim that they were insufficiently large and stimulative in comparison to the WWII mobilization which ultimately ended the Great Depression.

In current debates, the key arguments are around the role of so-called “fiscal stimulus” to the economy, as opposed to “monetary policy”, as well as the size and duration of that fiscal stimulus. Fiscal stimulus means the government spends money out of its budgets (fiscal) to stimulate economic demand and jumpstart the economy, rather than rely solely on adjusting interest rates. In the years in which Keynesianism was in the political and, to a lesser degree, academic doghouse, fiscal stimulus was considered to be taboo and dangerously inflationary. Using fiscal stimulus can lead to deficit spending, meaning governments running up their deficits and risking decreasing the value of the national currency. Opposition to the stimulus package proposed by President Obama will draw liberally from these criticisms and fears.  Economic blogs are rife now with discussions of the potential effects and risks associated with large stimulus programs.

“Monetary policy” usually involves the adjustment of interest rates by central banks, the instrument which has been periodically used throughout the period of monetarism’s dominance of economic discourse. With interest rates currently effectively at zero, monetary policy has no more stimulus to offer to the economy. While in this crisis most commentators on economic policy accept the need for fiscal stimulus of some kind, there are key arguments and decisions to be made about the duration of the fiscal stimulus or direct government involvement in the economy. Is this fiscal spending an emergency measure or part of a new economic common sense?

The responses to our economic crisis that President Obama has announced so far come largely from the Keynesian playbook even though he has not surrounded himself with economic advisors that historically have advocated nor are known for their emphasis on government investment and regulation. From outside Obama’s inner circle, Krugman, former Secretary of Labor Robert Reich, and economic commentator Bob Kuttner have praised the direction of policy but criticized the amount of fiscal stimulus that Obama has proposed, saying that the stimulus amounts will not cover the shortfall in economic activity expected to be caused by the downturn. The calculation of exactly how much stimulus is needed and for how long is a crucial affair, depending largely on one’s theory of how government should act in the economy in a downturn and, just as importantly, during normal economic times.

The role of tax breaks within President Obama’s proposed stimulus is hotly disputed among politicians and within the economic profession and is an area of compromise with the monetarist camp. Monetarists believe that private economic actors, individuals and businesses, will know best what to do with tax monies, and believe that money in their individual pockets will be most effective in stimulating the economy. Keynesians are more conscious of the liquidity trap, where economic uncertainty to the downside leads people to save and not spend. Data collected about the tax rebate of 2008 indicate that the Keynesians in this matter may be right: people tended to pay existing bills or saved the rebate rather than spend it on new purchases. This data point may not be enough to persuade believers in monetarist or supply-side ideals that government can spend social surpluses wisely and effectively outside of the areas of which monetarists approve: defense spending and administering the legal system.

It is not yet clear whether President Obama and for that matter other world leaders are “re-embracing” the notion that government has a rightful place in both good times and bad times in delivering services directly to citizens, building infrastructure, and creating new markets deemed socially useful. It is safe to say that at least some forms of regulation and government oversight are now considered to be desirable on an ongoing basis, so there is a partial move towards the Keynesian playbook worldwide.

Comparing the Monetarist/Supply-Side and the Keynesian Worldviews

Brownian motion is the random movement in all directions of particles and molecules in a stationary fluid, the result of their random collisions. In a more general philosophical sense, the monetarist/neoclassical model of economies sees economies as composites of independently moving economic actors that respond to forces like supply and demand (price). For these economists, government interventions would constrain or direct these economic actors interfering with their, in the free market view, optimal, natural distribution through their interactions.

These crucial decisions about the economy are based on conflicts in worldviews that underlie the choice of a “free market” vs. a Keynesian approach to economic problems. The various flavors of monetarist and supply-side worldview see economic reality as a composite of “particulate” atoms; actors that act independently and uniformly in their own self interest, more often than not competing with each other. The expansion of the role of markets implies that competition between economic actors is not only the “state of nature” but is universal, necessary and salutary; cooperation is achieved on a case-by-case contractual basis. “Free market” economics which had its heyday among the monied classes prior to the 1929 stock market crash, became in the 1980’s, a populist view, as the notion that people “know what to do with their money” rather than surrender some in taxes flattered people, both the rich and the aspiring-to-be-rich, that they knew better than the government. To maintain the political appeal of freeing the market from regulation, there was an ongoing campaign to downgrade and some would say malign the competency of government to handle money and deliver services. In this worldview, the government is characterized as a covert profit-seeking and overt and covert power-mad entity that wishes to expand itself and enrich itself through intervening in the economy.

The Keynesian world view is more of a climate of opinion than an organized theory and is therefore more difficult to characterize and condense. Keynesianism sees that economic actors come in a number of types, public and private. Also in Keynesianism, there is a legitimate place for the roles of regulator and not-profit-seeking entities like the government to play in the economy; in this view of the world, there is the potential for multiple complementary or cooperative roles rather than the competition of all actors with each other. Because of this complementarity, it is possible to imagine that new systems like infrastructure can be built within the economy with the sponsorship or leadership of government. It is more likely to speak of “systems” and to take a systemic view of the economy or sectors within the economy from a Keynesian point of view.

Keynesianism also offers a larger set of strategy alternatives within macroeconomics (the management of national and global economies) and therefore for political leaders and regulators; this set includes the regulation of the money supply, the monetarists’ main concern and policy tool but goes beyond monetary policy. In the Keynesian view, it is conceivable to imagine that government officials and politicians as well as other economic and political actors could be motivated by impulses other than profit-seeking or narrow self-interest. Therefore in this view, government officials might actually be both motivated to do good and to create value in the economy. To free market advocates, this is all merely a façade covering to them the “real” intentions of government described above, i.e. the acquisition of more power and money.

This French national health ID card entitles the insured to reimbursement for 70% of medical services, with many very expensive life saving procedures covered 100%. Through a process of negotiation, the French have worked out a system of universal health insurance regulated by but not administered by the French government, which effectively defines a wide set of medical procedures and services as "needs" or entitlements rather than "wants". Universal publicly-financed primary and secondary education in the US in effect defines education up to the 12th grade as an entitlement.

There is also a crucial difference in how each camp classifies human desires, which is not simply a matter of academic or philosophical interest for economists and for policy makers. Monetarists and laissez-faire oriented political actors are inclined to lump all desires into the category of “wants” as does conventional neoclassical economics. A theoretical entirely unregulated market system would tend to treat all desires as optional and discretionary. The health care proposals put forward, for instance, by the McCain campaign last year, suggested that people could treat health care expenditure as part of each person’s or family’s individual discretionary budget and would compete with other wants and spending. In Keynesianism, though also an heir to the neoclassical tradition, it is possible for government to except certain activities from being treated simply as another “want” in the marketplace by mandating programs that for instance guarantee pensions, health care, etc. In this way, there is a recognition of “needs” or as they are sometimes called “entitlements” rather than simply a category which mixes all “wants” together. Free market advocates recognize that entitlement programs exist but view them as sub-optimal departures from a philosophy that views all desires as optional.

The two worldviews also diverge in the valuation placed on human knowledge, science and forethought. Monetarists and other free-market advocates tend to see human knowledge as fatally flawed when extended beyond a personal or local orbit and requiring the turn of events or experience to validate the rightness of any bit of knowledge or understanding. Even then that knowledge is thought to be mostly of temporary or local value. Keynesians may share some of this utilitarian view but additionally are more likely to view science and accumulated human knowledge as having some validity through time and space and therefore potentially the basis for action for the common good now or in the future. These fundamental differences in philosophy lead to radically different valuations of natural science and the ability for us to plan aspects of our future based on current knowledge and projections into the future.

The “mixedness” and diversity of the Keynesian playbook and worldview, which might be a strength in giving governments a greater range of policy choices, has also been a political liability for it in comparison to the relatively simple message of monetarists and supply-siders, as broadcast by Ronald Reagan, Margaret Thatcher and their successors. In the Keynesian world there is not such a stark division between economic good and evil, while in monetarist and supply-side views, the bad government folk are almost always the economic enemy. Keynesians, who range from just right of center to left-liberal and social democratic, have not developed the compact political message that their monetarist critics have been able to project.

The Obama Administration has shown signs that it is aware of the challenges of re-creating a positive role for government in the economy after three decades, in which many elected officials heaped negatives onto the government that they were supposedly leading. The creation of a Chief Performance Officer position to which President Obama has appointed Nancy Killefer, indicates that Obama wants government institutions to become more economically efficient. Contained within at least its conceptualization is the belief in a positive good to be delivered by government which can and should be delivered better. Under a number of previous Administrations, we might imagine that someone in this position would be focused only on cutting budgets and, with that, services. We are hoping that this new Administration can deliver on the promise of better, not necessarily less, government services delivered more cost-effectively, perhaps developing a self-disciplined Keynesian approach to government’s role.

The qualitative characterizations of these two worldviews are not simply “hand-waving” arguments but form the basis for concrete policies that involve investments of billions of dollars on a regular basis as well as quite different legal frameworks that govern economic activity. How people believe people and social and economic institutions behave and select the essential truths of and goods in social and economic life turns out to be more than simply a philosophical argument.

Part II will continue by describing the economic assumptions and designs of proposed carbon pricing systems.

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