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August 2011 Archive for Economic Sense

RSS By: Matt Bogard, AgWeb.com

Matt's primary interest is in the biotech industry and ag policy.

The Trickle Down Economics of Cap and Trade

Aug 30, 2011

By Matt Bogard
"The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design." - Frederick Hayek

What I used to think about climate economics:

What economists must do then is take consensus science into account, and approximate what the price of carbon should be to limit economic damages from CO2. This level will be achieved where the marginal cost of reducing carbon emissions is equal to the benefits of decreased damages from climate change in the future.  

What I used to believe to be the current state of the art of climate economics:

Nordhaus ( Using the DICE-2007 model, and based on the science of the IPCC Fourth Assessment Report) prices carbon at about $30/ ton, with the average person in the US generating about 5tons/yr, for a total of about $150/year, or .09 /gallon of gas and .01/kwh for electricity. However, the Stern Proposal(proposed by another economist in the U.K) estimates the damage from global warming to be closer to $300/ton carbon for the next two decades. In this case we are looking at increasing gas prices by about $1.20/gallon. (read more)

I used to ponder, who is right, and how can economics narrow the gap between these approaches. Now I question the idea of even 'pricing carbon' and the assumption that the impacts of climate change (manmade or not) are not captured in market interactions.

Carbon Taxes

The idea of pricing carbon is that given the assumption that CO2 production has a negative impact on climate change and so many goods and services are carbon intensive, if we can put a price on carbon (paid by corporations that trade carbon permits or a carbon tax)  to capture the value of the negative externality, this will 'trickle down' to the mirco level, such that when you buy an ice cream cone, gasoline, or a pencil, the impact of your choice on the climate will be captured in the price you pay for it.  This is the climate change knowledge problem. We have to get the initial price of CO2 correct so that the 'trickle down' economics works at the micro level and we ward off catastrophic climate change.

The correct price for carbon will balance the marginal cost of reducing carbon emissions with benefits of decreased damages from climate change in the future.  As Armstrong points out, there are few scientific forecasts related to these future damages. And technological change allows us to continually respond the volatile effects of climate change. Advances in biotechnology are allowing us to produce more climate resilient crops, all the while reducing our carbon footprint in agriculture.  How can we incorporate this knowledge into our calculus? When it comes to the costs of reducing carbon emissions, it isn’t any easier. What are the opportunity costs of resources invested in emissions mitigation (voluntarily vs. those mandated or incentivised by government administered prices for carbon)?   
Tradeable Permits
Some will argue that instead of a tax, you can get similar or superior results by defining property rights in the form of carbon credits or tradeable permits. Then markets can solve the information problem via the price mechanism that manifests in the trading of permits. The problem still stands. Someone has to initially assign some quantity of permits to 'polluters.' This quantity has to be based on some determination of an 'optimal' quantity of CO2 emissions. This also requires the information necessary for determining the marginal benefits and costs of each associated unit if CO2.  The knowledge problem has not been solved, just reformulated in a way that is equivalently intractable for planners to solve. Unless planners get this quantity right, the price that 'trickles down' at the micro level for all goods and services will be too high or too low, based on the artificial scarcity or excess created by the planners’ miscalculation. The classic example of the Coase Theorem solves the externality of pollution of common property like a lake by clearly assigning property rights. The optimal level or quantity of pollution is a separate problem solved by the price mechanism via subsequent exchanges of property rights or contracting. In the case of CO2, the assignment of property rights and the optimal quantity of pollution both have to simultaneously be determined. You have to determine some initial quantity of pollution in order to create the permits (which a are then traded to establish a price).

From the Capitalism Today Blog at Western Kentucky University there was recently a discussion regarding macroeconomic equilibrium and the difficulties of knowing the micro-level equilibrium for something (seemingly) as simple as ice cream:

"They act as if not only there is equilibrium, but that they know where it is.  If anyone knows exactly how many ice cream cones the US needs to produce tomorrow, please raise your hands.  What no hands?  No one can know the "appropriate" amount of ice cream cone production for today let alone for tomorrow.  The $15 trillion US economy makes a lot more than just ice cream cones."
I think this analogy may also apply to pricing carbon. Ice cream comes in lots of varieties and flavors, produced and marketed various ways (natural, conventional, biotech, hormone free, organic, home made, store bought, ice cream trucks, retail outlets). Ice cream is pretty differentiated when you think about it. What about carbon? Noone knows how to set a 'national' or even a 'local' price for pencils, or the correct quantity of pencils that our complex world requires.  Why do we expect carbon to be any different than ice cream or pencils? Even if economists like Nordhous and Stern were in agreement, their solutions would not sufficiently deal with climate change's knowledge problem.

Some will agree that planners are no match for markets in determining prices and quantities, but because we currently have no established property rights to the atmosphere there is no 'price' for carbon. As such, there are going to be consequences if we do nothing, and the next best solution is an attempt, even if not perfect, to price carbon because it is not considered in market transactions.

Is that really the next best solution and is it true that the price mechanism totally ignores CO2? 

What is carbon really? 'Carbon' in an economy manifests itself in how we heat and cool our homes, how we manufacture goods and services, how we respond to emergencies, how we travel and transport goods, how we store and retrieve information. Leonard E. Read's essay I, Pencil demonstrates  the complexity involved in an economy that thrives on disaggregated information and processes with numerous feedback loops and interactions.  In a complex society, carbon is no different, and while it may not be explicitly and directly priced, it is hard to believe that its role is not part of the pool of knowledge characterized by the partial bits of information held by all individuals in society.

In fact, while politicians and special interests argue over the politically optimal arrangement of regulatory protections and subsidies to 'combat climate change' markets have responded in much more meaningful ways without any bureaucratically administered price of carbon or cap on CO2.

As Dr. Don Boudreaux of George Mason University points out in a recent piece in the Wall Street Journal, in response to climate alarmists’ connecting violent storms and climate change (and obviously calling for centralized solutons to combat it): (read more)

 "...because of modern industrial and technological advances—radar, stronger yet lighter building materials, more reliable electronic warning devices, and longer-lasting packaged foods—we are better protected from nature's fury today than at any other time in human history."

Perhaps the innovations in green technologies in agriculture provide the greatest example of mitigating climate change:

Total decreases in carbon dioxide as a result of using biotech crops was equivalent to removing 6 million cars from the road in 2007. The carbon footprint for a gallon of milk produced in 2007 was only 37 percent of that produced in 1944. For every 1 million cows, the reduction in global warming potential from rBST supplemented cows is equivalent to removing 400K cars from the roadways or planting 300 million trees. The use of grain and pharmaceutical technology in beef production has resulted in a nearly 40 percent reduction in greenhouse gases (GHGs) per pound of beef compared to grass feeding. Intensive agriculture has actually has a mitigating effect on climate change with a reduction of 68 kgC (249 kgCO2e) emissions relative to 1961 technology. (read more)


We are not really sure how to price carbon, and what we observe in all of these instances is that despite the absence of a centrally planned price or quantity of carbon, people are making choices that optimize its use or production. Because we don't have the knowledge to price carbon, we don't know that the resources expended in 1) lobbying lawmakers to tweak the proposed rules and regulations 2) mitigating the costs of a centrally planned price or quantity, would not have higher valued uses mitigating climate change in other ways (like investment in green technologies like biotech). The best approach for dealing with climate change or any environmental problem is to develop resilient market based economies that are able to invest in the technology necessary to adapt to ever changing resource constraints.

The S&P Credit Downgrade

Aug 13, 2011


"the downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned when we assigned a negative outlook to the rating on April 18, 2011"
One of the main reasons that the ‘multiplier’ effects of the stimulus have not taken hold, and the reason that the economy is recovering so sluggishly is the uncertainty in the regulatory environment. Last fall, NCBA president Steve Fogelsong put this quite well in an interview on Agritalk where he discusses the regulatory zeal including cap and trade, the takeover of the financial and auto industry, the student loan industry, dust regulation, inheritance taxes, failure of pending free trade agreements, as well as livestock marketing regulations to name a few (at 9:23 on the clip you can find here
A very similar argument  is also well put in a post on the economics blog Café Hayek:
"But if the decline in GDP growth and in the rate of employment are caused, not by a taste-driven increase in the demand for money but, instead, by a large enough disruption in what Arnold Kling calls "patterns of sustainable specialization and trade," then kicking up aggregate demand won't solve the problem. Neither kicking it up, or trying to, through monetary policy or through fiscal policy will work. The problem is not originally one of widespread inadequate demand…. it is clearly the result of distorting government policies, regulatory and monetary, leading up to 2008 as well as of the symptom-treating policies since then that only worsen matters. (And not to mention yet other actual and threatened policies)"
The issue of regulatory uncertainty is not unique to our current economic challenges, we had a very similar situation following the Great Depression, which lasted for over a decade. According to Robert Higgs, this was largely the result of New Deal Policies that created regulatory uncertainty prolonging the depression. You can find his paper here. You can also find a good discussion of this work on the EconTalk podcast here.
I’ve shared a lot of the following research in the past discussing the prediction that the stimulus probably would not work, but given the recent downgrade in the U.S. credit rating, it seems like it is worth a review:
"The Keynesians had it all wrong. In the Great Depression, employment was not low because investment was low. Employment and investment were low because labor market institutions and industrial policies changed in a way that lowered normal employment." --Edward C. Prescott Federal Reserve Bank of Minneapolis Quarterly Review Winter 1999, vol. 23, no. 1, pp. 25–31
"We find that New Deal cartelization policies are an important factor in accounting for the failure of the economy to recover back to trend." -Journal of Political Economy, 2004, vol. 112, no. 4 New Deal Policies and the Persistance of the Great Depression : A General Equilibrium Analysis. Harold L. Cole and Lee E. Ohanion.
"We conclude that a new shock is needed to account for the Depression’s weak recovery. A likely culprit is New Deal policies toward monopoly and the distribution of income." ---The Great Depression in the United States From A Neoclassical Perspective Federal Reserve Bank of Minneapolis Quarterly Review Winter 1999, vol. 23, no. 1, pp. 2–24
"Businessmen came to ask themseleves whether Roosevelt really understood a system where the hope of profit sparks expansion and investment. Or did he believe simply in centralizing decision and authority in boards and "planners" along the Patomac?" ---The Enterprising Americans: A Business History of the United States BY JOHN CHAMBERLAIN INSTITUTE FOR CHRISTIAN ECONOMICS TYLER, TEXAS 
Until we can start thinking outside the box of Keynesian economic policies as well as get a handle on the uncertain regulatory environment, we won’t likely see a strong recovery. That means higher budget deficits and downward pressure on future credit ratings.
For a more entertaining look at policy alternatives, I highly recommend the following youtube videos:
Fight of the Century


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