Deepish Thought

I just watched Thomas Friedman, in a particularly insightful interview with Jim Lehrer, give an excellent explanation of why putting a price on carbon is important if the US is even remotely serious about addressing global warming. It went a little bit like this:

Imagine I came to you 25 years ago (before cell phones) and said, “I have this brilliant new product. For just a $1000 I’ll sell you a phone with no wires that is small enough to carry around in your pocket. It’ll change your life.” You might say something like, “Well a $1000 is a lot of money, but you know what, this will change my life – I’ll buy one”. I could then take your $1000, do some more research, and then come back a year later and say, “You know that phone I sold you, well now I have a smaller, better one – only $850” and so on. Pretty soon everyone would have a cell phone.

Now imagine I came to you and said, “You see these lights in the ceiling here. They cost you about $100 a year to run. Well I have a new, carbon free way to power those lights. It’ll only cost you $150 a year.” What would be your likely response?

Unlike for the cell phone, the low carbon power supply won’t improve your life in any obvious way (unless global warming is actually keeping you up at night), so there is very little incentive to pay extra for the low carbon alternative.

Now imagine that the cost of carbon externalities were being included in the price of energy and I come to you and say, “You see these lights that cost you $160 a year. Well I have a new, carbon free way to power those lights. It’ll only cost you $150 a year.” What would your response be now?

Of the two scenarios, which is more likely to result in a low carbon energy infrastructure in the US?

There are a couple of ways we might include the environmental costs of CO2 in the price of energy. A carbon tax or a system of tradable carbon credits.

A carbon tax is politically difficult for any politician to advocate because it would (obviously) raise the price of energy. However there is an approach that might make a carbon tax politically viable. Harvard economist Greg Mankiw has suggested that the US could replace FICA taxes (payroll taxes that fund Social Security and Medicare) with a carbon tax. This might work politically because the total tax burden wouldn’t increase. It is particularly attractive economically because it would shift the burden of taxes from an economically positive activity (work) to a negative externality (global warming).

The main problem with a carbon tax is that it falls evenly across all CO2 producing activities. The result of such a tax is likely to be a modest reduction in emissions, through higher prices reducing demand and motivating efficiency improvements, across the whole spectrum of CO2 generating activities. This is not an economically optimum result.

From an economic perspective we would like to maximize the economic value we get from utilizing the limited resource that is the environment’s ability to safely absorb CO2. In other words, we would like for whatever CO2 emissions we find acceptable to be associated with those high value activities where avoiding emissions is either difficult or prohibitively expensive.

In order to achieve this result we need a system for allocating our carbon emissions around the economy. This is the genius of tradable emissions credits. By creating a market for trading CO2 emissions we would also be creating a mechanism that allowsthe economy to reorganize itself in order to to achieve maximum output for the allowable level of CO2 emissions.

This is not simply pie in the sky economic theory. A cap and trade system has been used very successfully to control SO2 emissions in the US. Under this system the government allocated a fixed supply of pollution permits amoung SO2 emitters. Permit holders that managed to reduce their emissions at reasonable cost were then able to sell their excess credits to organizations that faced more expensive constraints. The system led to a rapid reduction in SO2 emissions in the US at very little overall cost to the economy.

Despite its success, the SO2 system is not without issues. Simply allocating emissions credits to existing polluters is a somewhat questionable approach. It distorts the market in favor of existing SO2 generating activities, which receive credits for free, over possibly higher value new activities, which would have to buy them. This wasn’t a big issue for SO2, which is created by a limited number of activities, but would be a significant problem if the same approach were applied to CO2. In addition, the system potentially created an incentive for companies to increase SO2 output prior to the start date so as to receive higher emission allocations when the system got under way.

Quite apart from these criticisms, an SO2 style cap and trade system for CO2 would not generate any new sources of government revenue, which would mean foregoing the non-environmental benefits of Mankiw’s tax approach.

Fortunately, there is a way of combining both approaches in order to achieve maximum economic benefit. Instead of simply allocating CO2 credits to existing polluters, the government could have an annual auction of credits for the coming year (the credits being subsequently tradable). The revenue from this auction could then be used, as carbon tax revenue would have been in Mankiw’s proposal, to replace FICA taxes.

In addition to being economically sound, this proposal combines six great political selling points, adding up to across the spectrum political appeal:

1. No net new taxes
2. Higher employment (through eliminating tax on employment)
3. Harnessing the power of the market
4. Rewarding innovation
5. Punishing polluters
6. Aggressively combating global warming

The question is whether there are any politicians out there, especially viable presidential candidates, who would be willing to champion such a radical approach?

Having wasted a good part of the morning watching CNBC, I now know that practically everyone involved with Wall Street wants, needs and expects the Fed to cut interest rates. What I don’t know is whether, objectively speaking, this is really a good idea.

From Wall Street’s perspective a rate cut is a no-brainer. If the Fed declines to act a great many investment bankers, hedge fund managers and other assorted masters of the universe will suffer from severely depressed annual bonuses, which could disastrously affect the sales of designer handbags and German sports cars.

Looking from outside the hot house of Wall Street the case for a cut looks somewhat more ambiguous. On one hand there is obviously a danger that the problems in the credit markets will spill over into the real economy. On the other the Fed risks creating significant ‘moral hazard’ problems if it starts stepping in to prop up the markets every time investors get into trouble after making questionable decisions. In addition, a rate cut could cause a slide in the value of the dollar, which in turn could re-ignite inflation. Perhaps even more important, a significant rate cut could diminish Wall Street’s incentive to sort out the significant problems in the mortgage backed securities market.

While I would hate to see the economy tip into recession, I would also hate to see the clearly dysfunctional mortgage industry avoid a much needed shake out.

It recently came to light that everybody’s least favorite Attorney General, Alberto Gonzales, has acquired new powers to “fast track” death penalty cases in federal courts. While the headline may play well with the Republican base, which remains infatuated with the death penalty, the measure itself is extremely limited and probably won’t make all that much difference to the rate at which death row inmates meet their ends.

The death penalty itself remains intensely controversial and thus politically useful. Support for the death penalty is the tough, god fearing, law upholding, capital “C” conservative candidate’s favorite way of distinguishing himself from all those namby-pamby, soft on crime Democrats who like nothing more than pandering to criminals and recklessly compromising the safety of honest Americans.

Not being particularly enamored with the culture wars, I would like to propose a solidly conservative argument for dispensing with the death penalty and it’s accompanying political, legal and media circus. My hypothetical pragmatic Republican candidate might make an argument something like this:

“I have not one single shred of sympathy for the inmates on death row. They are undoubtedly the vilest of criminals and thoroughly deserve to be put to death.

Nevertheless I oppose the death penalty, not because it is cruel, but because it is far too kind.

Consider what happens when a convict is placed on death row. For a start he is handled with extraordinary care by his jailers least some incident provide grounds for appeal, or the psychological stress of his situation render him medically unfit to be executed.

Once comfortably installed on death row the convict is practically overrun with sympathetic media types and bleeding-heart liberal lawyers, who explain to the convict, in the most understanding tones, how he is really the victim.

This wouldn’t be so bad were it not for the glacial pace of the legal system. Our laudable desire to ensure that no innocent citizen is ever put to death has resulted in a near endless menu of legal avenues by which liberal lawyers can seek to delay or subvert the course of justice.

On being convicted of a capital crime the criminal knows two things. He will enjoy at least 15 years (probably many more) of the most comfortable accommodation the prison system can provide while the appeals process plays out. He will also receive attention, understanding and sympathy that he absolutely doesn’t deserve and may even achieve a measure of celebrity. What is absolutely not certain is whether he will ever be executed.

Is it any wonder that the death penalty isn’t much of a deterrent?

The people who really suffer in a capital case are the victims. Ignored in the outpouring of concern for the criminal, the victims are deprived of any sense of finality or justice. Through the years, as appeal follows appeal, the victims can be called back any number of times to reiterate their testimony, always knowing that one slip in testimony or error in memory may be enough to allow their attackers to escape punishment.

For the sake of justice, for the sake of the victims, I call on all true conservatives everywhere to write to the president and ask that he commute the sentences of every death row inmate to life with hard labor and no possibility of parole. We may not be able to make the death penalty work, but we can sure as heck make our worst offenders wish they were dead.”

Some interesting insights into inequality and unhappiness. Particularly interesting given that inequality will likely be a big issue in the democratic primary and possibly in the 2008 election.

This week the New Zealand stock exchange ‘shockingly’ came out in favor of looser monetary policy. The main reason the NZX is pushing this ‘bold’ reform appears to be that interest rates are inconveniently high.

The NZX50 has essentially doubled since 2003 despite New Zealand consistently having some of the highest interest rates in the OECD. Unsatisfied with this very solid performance the NZX has apparently been watching the low interest rate fueled Dow over the past couple of years and come to the conclusion that things could be even more fun if only those killjoy central bankers weren’t so fixated on controlling inflation.

Of course Wall Street hasn’t looked so hot over the past couple of weeks. The resulting panic has also knocked around the NZX, which suggests a second reason that NZX management may be interested in monetary policy reform. They may be trying to create a kiwi version of the ‘Greenspan Put’. Essentially a Reserve Bank that takes a ‘balanced view’ would chop interest rates whenever the markets take a tumble, helping to mitigate losses. Such a policy reduces the risk inherent in the share market and thus tends to increase valuations, which wouldn’t upset the NZX in the slightest.

While a ‘balanced’ monetary policy may well be in the best interests of the NZX, a come what may attitude to inflation has some serious downsides. Contrary to some reports inflation is very far from dead. In fact it is likely to be back about thirty seconds after we conclude it doesn’t matter anymore. To paraphrase a famous quote, ‘The price of stable money is eternal vigilance’.