Friday, August 7, 2009

"cap and cut"?

Today's Calgary Herald editorial calls for "cap and cut". Let's be clear here: "cap and cut" is not a policy, it's a tagline created by a politician. Saskatchewan Premier Brad Wall's new slogan makes little economic sense because if the government caps the emissions of two large emitters, say X and Y, and X could cut emissions at a cost of $10 per tonne and Y for no less than $20 per tonne, the government is making emissions abatement unnecessarily costly if Y cannot "trade" with X such that Y pays X $15 per tonne to reduce on Y's behalf. Y saves $5 per tonne in costs and X finds a new profit source in reducing emissions and selling the credits thereby earned.

The skeptics suspect that if a market for carbon emissions credits were actually set up, X would be an out-of-jurisdiction enterprise that would indeed find a new profit source in selling credits (to within-jurisdiction emitters) but without actually doing any real emissions reductions. I share this skepticism to sufficient extent that I am not a supporter of cap and trade relative to a carbon tax. But that's because the particular nature of the thing to be traded here. The Herald seems to object to the "trade" part of "cap and trade" on the general grounds that it would be, well, trade: to wit, "moving money around". As such, Calgary's paper of record feeds the presumption, perhaps unwittingly, that market systems in general just "move money around" and enrich financial sharks without creating any economic value.

In general, markets function well in setting the price signals that determine production. But the critical issue for markets is how to deal with information asymmetry.

A review of the financial crisis is instructive here. Although the flood of capital into the US (partly a consequence of the 1997 Asian crisis, in the wake of which many countries decided to protect against future runs on their currency by accumulating USD denominated assets) increased the risk that a sector of the US economy would have too much financing available to it, a bubble (which is a market failure, never mind the efforts of the EMH proponents to argue otherwise) was not strictly inevitable. The root of the 2008 financial crisis was rather a moral hazard: US mortgage originators were insulated from risk (or, more precisely, thought they were) because they spun the risk out to third parties via the financial system. Although financial markets perform a valuable function by redistributing risk, a tradeoff occurs (diminishing the social value of seeing the market trade occur) when the buyer of risk has less information than the seller. Had mortgage originators remained fully exposed to the risk of default by carrying the mortgages on their own books, they would have been fully incentivized to play a more active monitoring role with respect to their more doubtful clients. Although market discipline could have theoretically ensured that the originators remained vigilant, this discipline presumes that players all the way down the securitization chain could have been insightfully informed of the situation "on the ground". Maintaining this is increasingly difficult the more abstract the securitized products get. It is thus not just the quantity of information transmitted through layers of market players that matters but its complexity. More exacting disclosure regulations could not have helped avert the crisis when the problem was that it was too difficult to interpret the available information and when the people who could interpret the information had incentives to not share what insight they had. Finally, there was also an element of plain old dishonesty in that people filled out forms claiming that they had high incomes when in fact they didn't even have jobs. The bottom line is that the picture became too obscured for the pricing mechanism to ensure the efficient allocation of capital (although the US practice of allowing the tax deductibility of interest paid on residential mortgages was distortionary despite its transparency). Too few financial actors were engaged in the price discovery that sends signals to real production (they were instead creating and trading derivative products, which are effectively parasites on the price discovery process).

"Cap and trade" has problems of incentives and pricing complexity in spades. To take but a couple of examples, who is going to discipline the jurisdiction that sets easy caps on emitters in its territory in order to poach industry and keep employment up? Multilateral agreements could be made, but how is one going to detect and discipline cheaters? How economically useful is it going to be to stimulate the growth of a lobbying industry dedicated to convincing politicians to raise or lower the caps? An unworkable international emissions credits market (a purely local market defeating the whole point of a market) nonetheless does NOT mean that markets in general do not work. Economists are in almost universal agreement as to the value of free trade in goods and services. The consensus is also clear with respect to the free movement of capital provided it is genuine capital and not financial derivatives thereof which may or may not accurately represent changes in underlying capital. The problem with "cap and trade" comes down to the fact that the emission credits to be traded, which need to be fungible across jurisdictions, might not represent real emissions reductions. But that's a specific problem, not a general one.

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