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A Rejoinder: Why Cap and Trade Will Devastate the US Economy

My last article on Obama's energy policy (Cap and trade would sink the US economy and permanently change the political landscape) certainly provoked an angry response from the green energy brigade. Now experience has taught me the futility of trying to reason with those who dogmatically cling to ill-informed opinions. Nevertheless, considering the extreme importance of this issue it is pretty clear that the nonsense that is being dished up in defense of Obama's energy policy needs to be refuted. I don't imagine for one moment that my critics are open to a closely reasoned argument. Hence this response is for those who prefer facts and reason to green dogma.

The first thing I noted is that all of the criticism was completely void of economic reasoning. It seems that for these people economics really doesn't matter, particularly if its conclusions run counter to green dogma. Secondly, I was left wondering in some cases whether the critic had actually read the article. My third observation was the tendency of some critics to rely entirely on logical fallacies.

One line of attack is that mine is an old and tired argument that was discredited by the clean air acts. According to this line of thinking, as these acts did not hurt American industry then neither will Obama's energy policy. This is a non sequitur. It does not follow that because these acts allegedly had no detrimental effect on industry and therefore living standards Obama's energy policy will not damage the US economy. Moreover, it simply is not true that stringent environmental controls did not affect the economy. Like it or not, these regulations are not costless.

In 1979 the economist Murray Weidenbaum calculated that pollution controls were costing industry $100 billion per annum. (About $262 billion in today's money). This expenditure was at the expense of investment that would have raised the productivity of labour and hence real wages. Harvard economist Robert Leone showed that water pollution controls slashed the number of metal finishing factories from 70,000 to 5,000. Further investigations also showed that these regulations had the same effect on tissue-paper manufacturers. The results were predictable: large firms survived while their smaller competitors were bankrupted. Needless to say, these large concerns favoured the regulations1.

I find it very hard to believe that the pollution from metal finishing factories was so great that 93 per cent of them needed to be bankrupted. But this is simply the result of the "Pigouvian" policy of taxing negative externalities so as to bring private costs into line with social costs. Unfortunately Pigou's tax solution is deeply flawed. His erroneous view of the problem led the British economist Ronald. H. Coase to develop what became known as the Coase theorem, which basically argues that optimum outcomes are achieved if property owners are allowed to negotiate between themselves. (This is a highly stripped down description of the theorem). In other words, the problem here is not market failure but institutional failure.2

It is generally recognised among economists that the Coase approach is superior to the Pigouvian remedy, though I believe it does contain a serious flaw with respect to its particular use of prices. Now if the Coase approach had been applied to the water-pollution problem would 65,000 metal-finishing factories -- not to mention a large number of paper-tissue manufacturers -- have been forced to wall? I doubt it.

A Pigouvian policy results in a bureaucratic strait-jacket, a one-size fits all irrespective of individual circumstances. Moreover, it is open to corruption and political abuse. For instance, what is to stop green fanatics in the Environmental Protection Agency from using it to try and destroy an industry -- coal mining, perhaps -- that they don't like?

Pollution controls are not costless. This is not to imply that they are not necessary, only that we need to be made aware of the fact that there are always trade offs. I was raised in the Midlands, sometimes called the industrial heart of Britain, and I still vividly remember the unbelievable density of the smog -- which was also a killer -- and its frequent recurrences. Thanks to the clean air acts (there was no pollution tax) smog quickly disappeared from the British environment. But This only happened because economic growth had created the wealth and the means to eliminate smog with very little cost to the economy.

One critic declared that "connecting a cap and trade tax to capital was dishonest". This amounts to saying that a land tax would not affect the price of land, or that changes in demand cannot affect the prices of capital goods. In other words, only a complete economic illiterate could make such a ridiculous assertion. Fortunately there exists a recent example that neatly exemplifies my point. Australia's National Generators Forum estimated that the Rudd Government's carbon tax would impose $10 billion in capital losses on coal-fired power plants. (ETS 'may bankrupt power stations', Lenore Taylor, The Australian, 1 May 2009). So much for the air-headed notion that carbon taxes cannot affect the prices of capital goods and therefore the capital structure.

In order to deal with the remaining criticism I must once again return to capital theory. For the sake of simplicity I shall use the orthodox approach and assume capital is homogeneous, with the proviso that capital goods are also discrete. This means that we can now measure the actual amount of capital. Let us number the capital stock at 100. Of this amount 10 units are used to provide electricity for the whole economy. We also assume that all the firms have factor combinations that minimise their average costs of production.

Everything is going swimmingly until a group persuade the government that unless the current method of using centralised generating plants to produce electricity is abandoned in favour of wind and solar power there will be a colossal environmental disaster. The government now mandates that the plants must be phased out and alternative energy used instead.

But because energy density for solar and wind is pathetically weak and hellishly unreliable they will require vastly more capital and labour to produce the same amount of electricity as a centralised generating plant3. Now let us say it has been estimated that alternative energy production is three times more expensive then the usual method. Does this mean that the economy would now need 30 units of capital to produce its electricity? Bad as this would be, the actual situation would be far worse.

As centralised power plants are closed down more and more labour, land and capital is directed to the production of the same unit of electricity. In plain English, productivity will dive and prices will "skyrocket", a fact that Obama admitted and which his supporters ignore. The price of electricity rises, not because it costs more (prices determine costs, that's why imputation exists) but because there is less of it. Because electricity prices are rising firms now find that their factor combinations no longer minimise their average costs of production. These combinations will start to disintegrate as firms move to more labour intensive techniques that employ less energy and capital goods will be abandoned4. Productivity falls, forcing down real wage rates and hence living standards. If this process continued uninterrupted the economy would come to rest at a point where living standards and the consumption of electricity have reached an abject level.

Critics could once again scream that this approach is too simplistic to apply to the US economy. On the contrary. In the real world capital goods are heterogeneous: this is a fancy way of saying that they are not perfect substitutes for each other. In such a world there is a great deal of specificity, meaning that changes in costs and demand can completely destroy the value of specific capital goods. This is one of the reason's Obama's energy policy would be particularly devastating.

Two further points: I thought it was clear from my last article that the idea that revenue from a carbon tax could offset its destructive effects was ludicrous5. Judging from some of the emails I got I was wrong. However, it should now be abundantly clear why it is impossible for tax cuts to offset the income effects of a carbon tax let alone stabilise energy prices and stimulate the economy.

This now brings us Co2 and the Orwellian dishonesty of the greens and their media allies. Co2 is not a pollutant: it is a nutrient and the building block of life. Secondly, it is not true that human activity correlates with the amount of Co2. The green argument that human activity correlates with global temperatures is another lie. (The Carbon Sense Coalition).

A final note: Not a single critic commented on the quotes from leading greens in which they admitted that alternative energy sources are to be promoted because they are expensive. Now why was that, I wonder?

1. The role that the big meat packers played in regulating their industry during the Teddy Roosevelt administration was detailed by Gabriel Kolko. (The Triumph of Conservatism, Free Press, 1977. pp. 98-108).

2. With respect to market failure, one obviously exasperated critic wrote, "OK smarty pants, whats your brilliant theory to explain the financial and banking crisis?" What is it with these people? I have written numerous articles on the causes of the trade cycle and the financial crisis and this bloke wants to know what my theory is. It is not my theory, it is the Austrian school theory, the roots of which can be traced back to some of the early classical economists. Seeing as this character is too lazy to do a Google search I'll give him a hand. Try Prime Minister Rudd's misbegotten assault on the market goes unchallenged.

3. In my last article I emphasised the fact that even if these alternatives were 100 per cent efficient technically they would still be horribly inefficient economically and that there is absolutely nothing that can be done about this situation. This why I said you cannot get a gallon out of a pint pot. Nevertheless, critics still mindlessly asserted that all we needed is "greater efficiency". Imagine that two techniques, A and B, produce p. A requires one unit of labour and nine units of capital while B requires one unit of labour but only 3 units of capital. It is obvious that B is the more efficient technique. However, in the greens' world we would be forced to adopt A. And this is eactly what is happening with respect to energy.

4. Some could argue that because the capital goods are perfect substitutes they would simply be recombined with labour and land but with a lower level of productivity. My argument is that capital goods are by definition complementary. This means that because of the supply of electricity had been drastically curtailed there would not be enough energy to now employ the entire capital stock.

5. The Sydney-based Centre for Independent Studies has also been promoting this rubbish.


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