When the music stops

The Environment and the Economy

There are parallels between the Global Financial Crisis and the problem of dealing with climate change.

There is now a broad consensus that the GFC was precipitated by the sub prime loans crisis which was a direct result of financial deregulation.  In the US this led to the extension of financial leverage by the banks (lending more and more money on a smaller and smaller equity base) into predatory lending (lending money to people who it was obvious would not be able to pay the interest on the loan let alone the principle). The people who made these loans didn’t care.

Financial deregulation allowed the bank lending to be transformed from ‘originate loans and hold’ – which imposed a natural restrain on predatory lending – into  ‘originate and distribute’ to other financial institutions, semi-government authorities and superannuation funds around the world. Rating agencies were paid by the originators of these ‘sub-prime’ loans to give these mortgages in bundled form high credit ratings, which were taken at face value by the unsuspecting recipients around the world, such as superannuation funds and local governments.

The ‘sub prime’ lending encouraged the originators to undertake excessive risk because the risk could be passed on. It was no different in principle to parlour games such ‘pass the parcel’, where the holder of the parcel when the music stops is eliminated. The originators of the sub-prime securities knew what they were doing. As one participant said after the GFC broke, ‘you’ve gotta dance while the music plays’.

The climate change parallel is – if the cost of pollution can be passed on to future generations it encourages polluters to keep going, hoping that the music won’t stop until after they are long gone. To change individual behaviour so that it is consistent with the long term survival of the planet, we need either direct regulation or to ensure that the cost of polluting is paid up front by those who pollute or benefit  from polluting.

In neoclassical economic theory the failure to incorporate the full cost of production into the final market cost of products and processes is known as market failure. The concept was developed early last century by Arthur Pigou who distinguished between private and social returns. Where these returns diverged there was a case for a tax where the private returns exceeded the social returns and a subsidy where the social returns exceeded the private returns. Neoclassical theory provides the theoretical framework for a serious attack on global warming.

Cap and trade is the preferred system of closing the gap. The amount of pollution allowable is set by the number of permits issued by government free or sold at auction.. The alternative is a carbon tax. Experience shows that ‘cap and trade’ is diabolically complex and therefore easily rorted, as has occurred in Europe. In Australia, the rorts have been embedded in the architecture of the CPRS before even one tonne of CO2 has been traded. It is designed to generate a financial bonanza for the financiers who will trade in the new class of derivatives, provide subsidies for the biggest polluters and slow down structural change and the creation of new industries necessary for the development of a green economy.

A carbon tax is cheap to administer, simple and easy to understand and therefore
harder to get around.. Because it is applied to consumption rather than production, it does not undermine the international competitiveness of Australia’s biggest polluters (it applies to coal exports when the coal is burnt in China, not when it is produced for export in Australia). The Scandinavian countries plus the Netherlands and Italy employ a carbon tax to reduce their carbon footprint. The French  conservative President, Nicholas Sarkozy has threatened to introduce a carbon tax in France because, like the VAT, it can be set at a different rate to that of trading partners without undermining export competitiveness. The carbon tax works – unlike ‘cap and trade’ which has failed to reduce CO2 emissions in the countries where it has been applied.

Sustainability and growth

Since the industrial revolution, economic growth has been characterised by a constant decline in the raw material intensity of economic growth. We now  consume less oil., less steel and other materials and less energy per unit of GDP than we did 10, 20 or 200 years ago. This process has been accelerated by relative
price changes, such as the two OPEC induced ‘oil shocks’ in 1973 and 1979 which resulted in a five fold increase in oil prices. Global GDP growth is compatible with a decline in man’s carbon footprint. Economic growth is not simply more and more smoke stack industries. Economic growth can also mean investment in clean energy generation, retrofitting homes and buildings for energy efficiency, expanding public transport and investing in services and human capital.

The real problem is global population growth-from about 1.5 billion at the beginning of the 20th century to 6.9 billion now and forecast to peak at about 9 billion by the middle of this century-which has overwhelmed the decline in the raw material intensity of economic growth. The 19th century classical economist, Thomas Malthus pointed to the tendency of population to grow geometrically (exponentially) if unchecked, whereas the food and other resources necessary to sustain the rising population tend to grow arithmetically (linearly).

The history of economic growth shows that rising standards of living are associated with an initial fall in infant mortality, leading to an upsurge in population growth, followed by a fall in the birth rate to about or below the replacement rate. Higher living standards lead to the development of the welfare state where children become a net economic burden and cease to be an insurance against decrepitude in old age. If the developing countries are able to develop in a way which avoids the energy and material intensive processes which characterised the early development of presently advanced countries, there is a good chance that global population growth will peak in about 2050 and the human carbon footprint will reduce.

But this scenario is only possible if rich countries – whose per capita greenhouse emissions are up to seven times higher than developing countries – reduce their greenhouse emissions, to accommodate the increasing emissions from developing countries until they can stabilise their populations.

There is scope for the highest emitters such as the US, Canada and Australia to reduce emissions relatively easily. Their per capita emissions are more than twice the level of other developed countries such as Germany, the United Kingdom and Japan. They have highly sophisticated industries with similar real living standards to Australia and North America. Arguably, in the future there may be an inverse relationship between per capita emissions in developed countries and their level of industrial sophistication.

Looking at the posturing of the political leadership from developed countries in the
lead up to the climate Conference at Copenhagen later this year, a policy which ‘makes way’ for developing countries looks like an impossible task. In practice, such a policy would require massive aid as well as opening up developed markets to developing countries. It would require imagination, intelligent self-interest and a moral transformation on the part of Western Europe and the US that dwarfs the sensibility which led the US to set up the Marshall Plan that financed the post WW2 reconstruction of Europe.

Bluntly ‘cap and trade’ is being set up to fail. A carbon tax, used to finance a massive increase in spending on infrastructure would be better.

In the preface to an influential series of essays on climate change by Ted Nordhaus and Michael Shellenberger, Ross Gelbspan points out that climate change is a far bigger challenge than WW2:. “Cap and trade has come to reflect an institutionalised failure of moral courage…proponents of an international ‘cap and trade’ regime argue that a directly financed transition to clean energy would be far too expensive.
History belies that argument. During WW2 for instance, government defence spending under President Franklin Roosevelt reached 30 per cent of GDP compared to 6 per cent now. At the most immediate level, that investment enabled us to emerge victorious from the war. But from a longer perspective that government outlay – which initially went in battleships, warplanes and tanks – provided the basis for one of the longest peacetime expansions in history. What we need, in short is a global public works program to rewire the world with clean energy. And we need it yesterday”.

The world has the capability and the technical knowledge to set the appropriate
investment priorities. Like WW2, properly managed, such a program would be likely to promote growth and employment. The difference is the threat in WW2 was immediate. The threat today is still perceived as years away. By the time the music stops it may be too late. By the time the threat is apparent and politicians can win votes by doing the right thing, the tipping point into irreversible catastrophic climate change may have been reached. The central message of James Lovelock’s Gaya thesis is that man is a parasite on the surface of the earth and he has the capacity to destroy the habitat of the host body. But man also has the capacity to understand this and also the means to control his appetites so that the surface of the host body remains habitable.