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  • The Fannie and Freddie Solution for Pollution

    Senators Kerry and Lieberman have introduced their “compromise” climate change legislation that relies largely on a “cap and trade” scheme to reduce carbon emissions.

    Even assuming there was a need for carbon limits, the Kerry-Lieberman bill gets the mechanism all wrong, apparently because the Senators either don’t understand or don’t trust markets.  Kerry and Lieberman propose that the government manage a carbon market because controlling pollution is really important.  This will work about as well as the government running grocery stores because everyone needs food.

    The insight underlying the use of market mechanisms to achieve public goods (such as reducing pollution) is the Coase Theorem , developed by Nobel Economics laureate Ronald Coase.  The theory holds that private actors will find optimal uses and costs so long as property rights are transferable and transaction costs are eliminated.

    In other words, to make it work, the government has to define property rights and then get out of the way and trust the market.

    Kerry and Lieberman begin by attempting to vest a sort of property right in existing energy-generating uses of carbon fuels, but then they do everything else wrong.  The bill does not make the rights freely transferable, but limits the market to existing utilities.  And rather than reducing transaction costs, the bill increases them by limiting trading to a government-managed exchange.

    Under the bill the Treasury Department will decide who gets to be a “market maker” on the exchange and how much they can charge.  “Market makers would be in this business not to make vast sums of money,” explained one Senate staffer.  Sorry to burst your bubble Anonymous Staffer, but market makers are in business to make money: vast sums if possible.  The way to limit those profits is not through limiting the market participation and prices controls but through vigorous competition.

    Come to think of it, we do have some recent experience with government-approved market makers.  Remember what a great job Fannie Mae and Freddie Mac did in the housing market?

    It is hard to predict whether a Treasury-managed carbon market would get the price too high (and thus kill trading) or too low (like Fannie and Freddie), but it is certain that they would get the price wrong.  In the real world, a license from the Treasury Department to extract fees from a captive trading pool is far more likely to result in excessive profits than it is to lower costs.  And, if you screw up, taxpayers will always be there to bail you out.  (Can anyone imagine the Treasury Department letting the government-mandated carbon market fail?)

    The magic of the market is that everyone who wants to play can participate on the terms they choose (assuming anyone else likes those terms).  The government can’t limit who gets to be in a market, how they can trade, and how much they can make and expect the market to work.

    Rather than encouraging the private sector to make optimal use of carbon the Kerry-Lieberman bill establishes a series of fees to pay and hoops to navigate. That’s why the bill is really a cap and tax scheme.

    There is one last irony.  There is actually an operating carbon exchange in Europe, with trading on the London Stock Exchange and a futures market managed by a US-based company.  There is even a US market ready to start trading.  If there really is a need for a carbon market, Congress just needs to define the property rights involved and get out of the way.  (And under the Coase Theorem, it doesn’t even need to get the property rights assigned perfectly.)  Trying to micromanage the market from Capitol Hill is a sure way to failure.

    Posted in Economics [slideshow_deploy]

    6 Responses to The Fannie and Freddie Solution for Pollution

    1. Pingback: Must Know Headlines 5.14.2010 — ExposeTheMedia.com

    2. Sue Fitchett says:

      'There is even a US market ready to start trading. If there really is a need for a carbon market, Congress just needs to define the property rights involved and get out of the way. ' … Catch that??? This has been a plan for a long, long time. They just needed the .Right Man/Woman in office, to make it happen. Don't tell me there are no Super Power People that 'We the People' don't know about. This is a game and the 'People' of the US are on the Losing end!'

    3. Janice - Mobile, AL says:

      In bygone years I used to joke that the government would some day tax the air we breathe. Learn to hold your breath! That some day is here. I feel confident that Big Brother will soon get around to issuing meters that each person will be required to wear (implants?) to measure the amount of air we breathe each day and tax us accordingly.

    4. Drew Page, IL says:

      Cap & Trade, regardless of what it is called, will do nothing to eliminate pollution. Polluters will be free to continue polluting as long as they PURCHASE carbon credits, from places like the Chicago Climate Exchange.

      The cost of the carbon credits will go into the price of goods and services produced by these so-called "polluters" and will be paid by all consumers. It will make energy more expensive, including the cost of gasoline, natural gas, home heating oil and electricity generated by the burning of fossile fuels like coal and oil. Oh, and it will put one hell of a lot of money in the pockets of those investing in these "Climate Exchanges".

      If Liberman and Kerry a so concerned about air quality, let's see them get behind more nuclear energy production.

    5. Macello Joe, Marin C says:

      It seems that this pollution issue is flawed as was the Global Warming issue. How is it that the public is not scientifically informed about pollution so that we can direct the politicians as to what the American people want and not the special interests. Our economy is a mess, with Health Care and now the pollution trade, we don't know what to make of it, perhaps it would be best to shut Congress down for six months out of the year so those farcical clowns can do less damage to us!

    6. Pingback: Current mortgage rate » Blog Archive » Mortgage-Bond Yields Guiding Loans Decline to Six-Month Low – BusinessWeek

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