Hansen vs. Krugman: Second (Third and Fourth Order Effect)s Out!

Yesterday’s NYT includes a right royal spat. Well, online it does, at least. In a piece titled Cap and Fade, James Hansen argues that carbon taxes would be more effective than cap and trade. Paul Krugman responds under the heading Unhelpful Hansen, by first telling Hansen to stay off his turf. Climate scientists shouldn’t dabble in economics, apparently. Tosh. Ideas have to stand on their own merits.

Having highlighted the intellectual ring-fencing which is at the root of many of the world’s problems, Krugman proceeds to un-blot his copy-book. He points out very convincingly that, from an individual consumer’s point of view, it matters not a jot whether gasoline is more expensive because of a tax or because of a cap and trade mechanism.

Krugman is right as far as it goes. But both Hansen and Krugman fail to mention the second, third and fourth order effects of pricing carbon emissions. And it is the second, third and fourth order effects that will determine the effectiveness of policy.

Let’s start at the end, because it’s more fun. The fourth order effect of pricing carbon will simply be a redistribution of spending power in the economy. I’m sure I’ve said it before, but I’ll say it again: money is just a means of distributing resources. The economic system will adjust so that the available resources are used.

Perhaps I should try to explain a little further. Money circulates. There is not a fixed quantity. Let’s imagine we put an astronomical tax on carbon. The money raised by that tax must be spent. Let’s say we decide to spend it on more doctors. Suddenly there will be more doctors to fly off to junkets round the world. Or maybe they’ll spend their money on art (or more expensive houses, or televised sport…). In which case the previous owners of the art (or houses, or sportsmen, their agents and other freeloaders) will be able to afford to fly more…

But before we even get to this unhappy state, we should consider, first, a second order effect of pricing carbon. Pricing carbon will tend to reduce the price of fossil-fuels. All that might happen is that the price of petrol at the pump remains the same, but less of the motorist’s money ends up going to the oil-producer and more goes to the government. Maybe a good thing in itself, but we’re trying to stop global warming here, not change the shares of unearned spoils divided with the Saudis. Sure, depressing the global oil price might have the desirable third order effect of reducing investment in the most expensive fossil-fuels for a while (until the lack of supply pushes prices up again), but we need to reduce consumption of fossil-fuels that cost virtually nothing: coal, in particular.

And unfortunately the second order effect of carbon pricing on the oil price is dwarfed by the third order effects of another second order effect. The second order effect (I’m trying to be rigorous, here!) is that taxes raise money. So does carbon trading. We need to consider the effects of how that money is spent.

Hansen argues that the money should be distributed to the population. This will, at least in the short-term, increase equality. And, unfortunately, when you’re trying to reduce consumption of mass-market products, equality is not your friend. Money will be taken from those whose consumption is not constrained by their financial situation and given to those who would like to spend more. Likely on heating, driving, flying and so on. Oh dear!

But there are problems with carbon trading, too. The precise outcome will depend on how carbon permits are distributed. If they’re given away to power companies, then any excess permits will accrue to these companies’ shareholders in the first instance. (Over time, these profits will encourage new market entrants, although this may not happen if only incumbents are able to access the permits). If permits are auctioned, though, then we reach a situation similar to the carbon tax. The outcome depends on what the government does with the revenue. Simply distributing it to the population would fall foul of the same equality problem as for the tax. Direct or indirect subsidies for renewable energy production would clearly be by far the best policy choice, in the hope that, once renewable energy has a huge cost advantage over fossil-fuels, everyone will switch to clean energy. Maybe.

In perverse support for Krugman’s argument that taxes and cap and trade are equivalent, government could spend tax revenues in the same way as those from auctioning permits. Very similar to Hansen’s position is the idea of tradeable personal carbon allowances. These would have the effect of transferring wealth from the rich to the poor. And remember, equality is not our friend…

Let’s make some tentative conclusions and observations:
1. The indirect ramifications of carbon pricing policies are more important than their immediate effects.
2. Carbon trading is philosophically preferable to carbon taxes, because it at least imposes a limit on total consumption. The problems arise from leakage (the concept is explained in a previous post). Unfortunately, these are very big problems – probably deserving a post of their own.
3. If there is a limit on the carbon price in a carbon trading system, then it becomes almost equivalent to a tax. However carbon is priced, governments must be prepared to push the price up indefinitely. Otherwise, I suggest, the economy will simply adjust to the price.
4. Carbon trading is a superior policy if you’re really serious about reducing fossil-fuel emissions, because government doesn’t have to set a tax at an eye-watering level. It can simply say: “this is all the fossil-fuel we can afford to burn, it’s supply and demand in the market-place which has pushed the price up.”

Unfortunately, I don’t see too many governments around the world that are about to bite the bullet and set an effective carbon price.