Friday, June 26, 2009

Cap & Trade: The Next Gov't Failure

There is a lot uncertainty about the future effects of the proposed Waxman-Markey climate-change bill. As the Wall Street Journal points out, the bill is full of exceptions and concessions. It will establish a system that looks nothing like the cap-and-trade model I teach to my econ students. According to the Journal:

The leadership's solution to this problem [of placating various Democrats] is to simply claim the bill defies the laws of economics.

The bill is terrible. I'm almost certain the costs of the bill will far exceed the benefits - a classic case of government failure. Once again, according to the Journal:

Americans should know that those Members who vote for this climate bill are voting for what is likely to be the biggest tax in American history.

The Congressional Budget Office (CBO) provided an optimistic appraisal of the bill, but:

A closer look at the CBO analysis finds that it contains so many caveats as to render it useless.

I'm not in favor maintaining the status quo. Global warming is a serious problem that needs to be dealt with soon. (I'm currently writing an article about climate-change cost-benefit analysis.) But I'm beginning to think that cap-and-trade won't work on this scale, given our political system's proclivity for satisfying special interests' rent-seeking requests.

Why can't Congress implement a carbon tax with zero exceptions? Administrative costs would be much lower. The tax revenue could be used to solve other environmental problems. Polluters would directly bear the costs of their action. We wouldn't need additional regulations for vehicle emissions, since drivers would already pay a higher price for low mpg vehicles. Sure a Pigovian tax wouldn't spur the innovation that advocates of cap-and-trade envision, but at least the rules of the game would be set beforehand and the system would be much less amenable to corruption.

Fractional Reserve Banking

I don’t understand how any libertarian can oppose fractional reserve banking (and very few do). With fractional reserve banking, two parties voluntarily enter into a contract that results in both parties becoming better off. The bank provides a free service and thus acquires cheap funds it can lend to others. The depositor gets someone to hold her money so that the money can be conveniently used when she makes a purchase. There is no deceit since depositors know that their money will be lent out. Sure the bank profits off the depositors’ money, but that’s how capitalism works - as long as no coercion is involved.

To say that fractional reserve banking is immoral is like saying, as Marx did, that capitalism is immoral because capitalists profit at the expense of their workers. What Marx didn’t really understand, however, is that the workers are made better off because of the opportunity to work. If depositors would be better without fractional reserve banking, banks would form that would promise not to lend people’s money. Of course, banking services would no longer be free, and I doubt the bank would find many customers.

Gold Standard

In most countries central banks control the supply of money. In the United States the Fed increases the supply of money by buying treasury bills on the open market or by buying bonds issued directly by the U.S. Treasury. The Treasury Secretary (currently Geithner) is a cabinet member in the presidential administration and can thus be pressured to sell bonds to allow the federal government to increase spending. If the Fed submits to the will of the Treasury by buying bonds whenever the federal government wants to spend money, there is a significant danger of inflation. Marriner S. Eccles was important in American history because he was a strong advocate of Fed independence. There is an inverse correlation between central bank independence and inflation.

Many people have argued that a gold standard is one way to ensure that federal government lives within its means. A gold standard, in theory, could prevent central banks from printing too much money and thereby causing rampant inflation.

One problem with a gold-backed currency (or a silver-backed currency, or any other –backed currency) is that the government determines the value of the currency. It mandates that, say, $20 is equal to an ounce of gold. If the government sets the gold/dollar exchange rate (as it did throughout the 1800s), the government can modify the exchange rate to reduce debt through inflation. The U.S. federal government did exactly this prior to World War II.

According Milton Friedman: “I think those people who say they believe in a gold standard are fundamentally being very anti-libertarian because what they mean by a gold standard is a governmentally fixed price for gold.” Of course, a gold standard where the dollar/gold exchange rate is determined by the market would not have the same “immoral” problem, but that’s not what most people argue for when they say we should return to the gold standard.