A sobering aspect of the global financial crisis is comprehensive failure of officials and experts, first, to see the problem coming and, next, to appreciate its severity until full-blown calamity was at hand. Well into 2008, US officials were providing assurances that financial troubles could be confined to the mortgage industry. Then, one after another, venerable financial institutions run by the industry’s brightest minds began in various ways to topple, their previously hidden vulnerabilities suddenly on shocking display.
Among multiple shortcomings contributing to the fiasco is one that festered at the core of earlier, less-sweeping financial breakdowns. It’s the inability of modern, sophisticated risk management adequately to manage risk. The spectacular collapses of enterprises like Metalgesellschaft, Barings Bank, and Enron had in common the loss of control over risk amid aggressive trading of complex derivative instruments. This time, the failure didn’t confine itself to a single institution. It’s systemic. And it may yet undermine the global economy.
New market
Against this background, the US soon may create a massive derivatives market with no commercial foundation. The government will determine the underlying value of the traded instruments. Rules will be complex. Trading will be hard for anyone but traders to understand.
Current events provide no reason for confidence that the government can effectively administer a synthetic market such as this or that industry can manage risks within it. That such a monstrosity is even under discussion defies belief. But so does much that flows from popular anxiety over global warming.
Both presidential candidates propose “cap-and-trade” schemes to limit emissions of the gases thought to aggravate observed warming. The programs would set emission caps and provide for the trading of emission allowances, the supply of which the government would control. The main difference between the candidates’ proposals is the ultimate target. Sen. John McCain (R-Ariz.) wants emissions to be 60% below 1990 levels by 2050. Sen. Barack Obama (D-Ill.) wants the reduction over that period to be 80%.
Like anyone who has proposed a cap-and-trade response to climate change, the candidates promote their ideas as market-based strategies able to capitalize on technical ingenuity. Their programs are in fact highly prescriptive and very complex, enforcing staged reductions in emissions by phasing down over time the availability of emissions allowances. Two features are important: the creation of a market for emissions allowances, or “offsets,” and limits on emissions of greenhouse gases.
The prospective market’s size depends on the value of allowances, which depends greatly on regulatory details such as whether buyers can hold allowances for future use. An allowance value of $25/tonne of carbon dioxide-equivalent is a reasonable guess. At that value and at current emission levels, allowance trading could be worth a tantalizing $150 billion/year. It’s enough to inspire considerable risk-taking, corruption of regulators and lawmakers, and surely some measure of the type of accounting deception that camouflaged the housing-credit mess. And it all will serve an activity that produces nothing of genuine economic value.
House of horrors
Why would anyone propose to build another financial house of horrors?
The answer is simple and troubling: Cap-and-trade systems mask the inescapable and inescapably large costs of global-warming responses. However they’re achieved, emission cuts replace low-cost with high-cost energy. A market for allowances can in no way assuage the consequent economic harm and might, by diverting resources to the pursuit of trading profits unrelated to real goods and services, make things worse. Supporters of cap-and-trade schemes say new businesses related to nonfossil energy would offset the damage. Given the subsidies needed to bring alternatives to market, not to mention the effects on consumers forced to pay more for energy, that assertion is delusional.
In the perilous second half of 2008, a cap-and-trade remedy for global warming should be unthinkable. If there must be warming response, the people forced to pay the bill—that is, all who consume energy and pay taxes—deserve an honest view of the cost. In the perilous second half of 2008, new economic hazard is not something politicians should paper over with program tricks.
