The Federal Reserve was established in 1913 as the central bank of the United States. It acts as the “banker’s bank” and has the dual mission of smoothing out the ups and downs of the business cycle and of containing price inflation. The Fed ultimately controls the U.S. money supply through its regulation of commercial banks, which are required by law to “back up” a fraction of their customers’ checking account balances with either cash in their vaults or reserves that the commercial banks themselves hold on deposit with the Fed. If the Fed thinks that inflation is too high, it “tightens” by siphoning reserves from the system which has the effect of raising interest rates and shrinking the money supply. On the other hand, if the Fed thinks the economy needs a shot in the arm, it pumps extra reserves into the banking system which causes interest rates to fall and increases the supply of dollars.

Though the Fed is supposed to create stability in the financial system, over the last year analysts have increasingly blamed the Fed for creating some of the current financial uncertainty. Business leaders must guess about Fed Chairman Ben Bernanke’s next moves. Will the Fed save large banks? Will Bernanke allow them to fail? No one knows. This uncertainty makes it more difficult to take large risks or make billion-dollar bets if the Fed will change the rules of the game. Not only have Bernanke’s actions caused some instability, but many analysts think Alan Greenspan’s ultra-low interest rates in the mid-2000s contributed to the housing boom and subsequent bust. While the Fed may have been created with the best of intentions, in the real world the Fed is not a perfect institution and its large economic powers can create a new set of financial problems.

The Fed’s role in our financial woes should give us pause. However, there are some people who promote extending the idea of a Federal Reserve to the regulation of carbon dioxide and greenhouse gases. Like the regulation of the money supply, this will likely lead to many problems.

The fundamental causes of our current financial mess would be amplified if we establish a new market for carbon permits, especially if such a market were regulated by an overseeing “carbon Fed,” as many academics propose. Although analysts disagree about who is responsible, clearly what happened during the housing boom was that investors began trading mortgage-related assets at prices that were not supported by the market fundamentals. Yet in a cap and trade regime, where firms must buy and sell permits giving them legal permission to emit carbon dioxide, the “assets” will have values entirely determined by government fiat. A simple change in government policy, such as changing the size of emission allowances, could cause a boom or bust in the permit market. This new source of uncertainty will make markets even more volatile, and will make long-term investment in the US economy even riskier.

Former Resources for the Future (RFF) researcher Daniel Hall recently left the think tank to join the Obama Administration as a Climate Policy Analyst. In his final post at the RFF website, Hall summarizes the issues he believes need to be hashed out in the upcoming debate on cap and trade. But Hall’s discussion of “allowance banking” and the proposed “carbon Fed” shows the danger that cap and trade legislation poses to the American economy. A “carbon Fed” that will target a “carbon price” will cause even more distortions in the economy and politicize markets even more.

In his summary of the unsettled cap and trade issues, Hall devotes a section to “Cost Containment.” He writes:

Cost containment is the central issue, the fulcrum on which legislators hope to balance the ambition of an emissions reduction program with its economic impact. It therefore intersects with the emissions target, the revenues that will be raised, and the impacts on domestic industries and households. Cost containment itself, however, is not well defined. In practice, it conflates two different (though related) issues. The first is how to manage short-term volatility in the price of emissions allowances. The second is how—or whether—to manage the long-term trajectory of allowance prices. Several policy mechanisms, outlined below, have been proposed to accomplish one or both of these goals.

So far, it sounds reasonable enough. The policymakers are considering that their efforts to reduce carbon dioxide emissions would adversely affect the economy. It sounds as if Hall is arguing for government to do the sensible thing and balance environmental goals against economic hardships. But when Hall discusses the various proposals for how businesses would actually receive relief, he does not reassure the alarmed reader. Two of the mechanisms to reduce short-term volatility in allowance prices are “banking and borrowing”:

Banking and borrowing provide intertemporal flexibility and prevent allowance prices from being driven by year-to-year fluctuations in unrelated factors (such as weather and economic growth). Banking of allowances is uncontroversial and will certainly be included in legislation. Borrowing is likely to be allowed but limited in both volume and duration because of concerns about default by heavily indebted firms.

Hall is saying that under a cap and trade system, the government will issue a given number of allowances entitling the bearer to emit a specified amount of carbon dioxide each year. But businesses will not have to use their allowances in the year of issue. If it proves more profitable, a business will be allowed to “bank” its current allowances so that they can be used in the future. (Academics argue over the proper “interest rate” the government should pay on these allowance deposits.)

The economic rationale for allowing “banking” of carbon permits is cost containment. Even in the computer simulations that yield the most worrisome projections of future climate change, the policy goal is to reduce emissions in the long-run. The precise timing of the emissions isn’t nearly as significant as the total amount of emissions over, say, a ten-year period. But differences in timing can have a significant impact on how costly it is for businesses to comply with the regulations. This is why Hall argues that allowance banking is “uncontroversial” and will certainly be included in legislation.

However, Hall points out that policymakers should be much more skeptical of allowing companies to borrow against future allowances. In theory, borrowing provides cost containment just as much as banking. For example, a particular factory owner might decide that it makes sense to completely revamp his operations, so that (say) in five years his factory emissions are much lower. On the other hand, if carbon dioxide-capturing technologically existed on a commercial scale, at a reasonable price, a factory owner could go for a hypothetically cheaper, quicker fix by installing these hypothetical filters on his smokestacks. Without the possibility of borrowing future allowances, the factory owner might not be able to afford the first approach, even though it would mean lower long-run emissions.

If a company borrows against future carbon allowances and uses them in the present, it means total U.S. emissions are higher in the present year than the amount actually allowed by the legislated cap. But in terms of reducing carbon dioxide emissions this outcome is acceptable, so long as the company remains in business and then pays back its “loan” in a future year by buying excess permits off the carbon market and returning them to the government, unused. That loan payback will ensure that total U.S. emissions are lower that year, than the number of permits actually issued.

What if a company borrows against future carbon permits—so that today’s emissions are higher than the legislated cap— then the company goes bankrupt before it pays back the “loan”? The government would then be in a bind. If it simply forgives the loan, then long-run emissions will exceed their legislated trajectory, because the company’s over-emission during its period of borrowing will not be counterbalanced by under-emission when the company pays back permits from the market. On the other hand, the government could adhere to the legislated (long-run) emission cap by reducing the total number of permits issued by the amount of the company’s default. For example, if the now-bankrupt company had been obligated to buy and deliver 500 tons worth of unused carbon dioxide emission permits, the government could instead auction 500 fewer permits in the first place. Under this approach, ultimately the taxpayers would eat the loss of the company’s default, because the Treasury would effectively be auctioning the 500 permits to the bankrupt company for free, rather than charging the market price.

With all of the shenanigans surrounding the recent bailouts of financial institutions, we should be very alarmed by Hall’s casual discussion of carbon banking, and the potential for corruption that such schemes would entail. Yet Hall’s discussion of a “carbon Fed” is even more disturbing:

Independent oversight bodies have been proposed to oversee and intervene in allowance markets (modeled in some ways on the Federal Reserve for monetary policy). This proposal is not so much a mechanism as an institutional structure through which various policy mechanisms could be applied.

Just as the Federal Reserve is given a two-pronged task of fighting inflation while ensuring economic stability, so too the “carbon Fed” would have the dual mandate of fighting carbon dioxide emissions increases while ensuring economic growth. During hard times, the Federal Reserve allows the money supply to increase more rapidly, and is willing to tolerate higher inflation if it helps get the economy out of recession.

By the same token, then, the carbon Fed would adjust its various rules—such as the total size of the cap, the interest rate charged on loans or earned by deposits of allowances, and the “credit limit” granted to various businesses—in order to ease the pain of carbon dioxide mitigation during recessions. On the other hand, if the economy is healthy and climate scientists bring alarming new projections to the attention of the carbon Fed governors, then they might decide to “raise the price of carbon dioxide emissions” the same way that today’s Fed raises the federal funds rate when it wants to tighten the money supply.

The scope for unintended consequences—as well as simple corruption—involved with the proposal for a carbon Fed is breathtaking. It would introduce yet another huge source of uncertainty for businesses. In addition to trying to anticipate their customers’ tastes, new regulatory and tax burdens, and the Fed’s stance on interest rates, businesses will also have to make forecasts about how loose or tight “carbon dioxide policy” will be. This extra uncertainty in the U.S. economy will cause investors to shift some of their funds to other countries.

As with any major new institution, a carbon Fed would almost certainly make enormous mistakes as it interacts with the economy and environment. Remember, the Federal Reserve was established in 1913 ostensibly to prevent the volatile financial panics that had periodically gripped the country, such as the then-most recent 1907 panic. And yet, fifteen years after the Federal Reserve banks opened their doors for business, the U.S. suffered the worst stock market crash in history, followed by the worst decade in U.S. economic history. (Clearly the Federal Reserve had a long learning curve when it came to its mission of ensuring stability.) In our own times, more and more analysts are blaming the housing boom and our current financial mess at least partly on Alan Greenspan’s ultra-low interest rates following the dot-com crash and 9/11 attacks.

Beyond the honest mistakes that will inevitably accompany any major new enterprise, we must also beware of the huge scope for corruption afforded by these proposals. The danger here is a quantum leap from the permit banking programs established by the Clean Air Act for air pollutants, because the market for carbon dioxide emissions will be much larger and will affect more businesses. For example, an incumbent president could put pressure on the carbon Fed to keeps carbon prices low going into an election year. Or, the government might allow large companies experiencing hard times to receive very generous carbon dioxide credits because they are “too big to fail.”

This new form of corporate welfare would be particularly insidious, because the “debt” wouldn’t involve future taxpayers. Currently, if the government wants to bail out a politically-favored company, it ultimately puts the taxpayers on the hook, either through higher deficits or more inflation. But once a carbon Fed is up and running, corporate bailouts can occur through printing up new carbon dioxide emission permits “out of thin air” on the carbon Fed’s balance sheet—just as Bernanke currently grants new reserves to banks out of thin air, by simply increasing their account balances with the Federal Reserve.

However, the political incentives against “loose” carbon dioxide policy would only come from environmental groups. These groups would be the only ones concerned when the carbon Fed grants new allowances to businesses. Unlike inflation or deficits, which are very tangible indicators of irresponsibility to taxpayers, average citizens won’t be up in arms over a “low carbon price” that gives them cheaper electricity. Given the lopsided incentives, we would expect the carbon Fed to very soon hold a high proportion of “non-performing” loans of allowances. There would be direct and immediate benefits from granting allowance relief to politically connected companies , while the (alleged) harms of such loans would only even be realized years later, if and when the company didn’t pay back the carbon permits.

Because of real-world politics, even those who believe in catastrophic predictions of climate change should think twice before running to the U.S. federal government as a savior. Whether it is the Federal Reserve, Social Security, the Securities and Exchange Commission, or even the FBI and CIA for that matter, the government has a poor track record in creating institutions that actually live up to their founding purpose.

If policymakers implement an economy-wide cap and trade program as President Obama proposes, the special interests who cheerlead the move will eventually see the worst of both worlds: The government will pose as savior of the planet, and point to the stringent carbon dioxide emission trajectories contained in the initial legislation. But in practice, connected companies will receive special treatment, and new bodies such as the “carbon Fed” would allow certain businesses to circumvent the statutory caps. The U.S. economy would suffer needless hardship and inefficiency, while total emissions may not even be reduced from the status quo baseline.

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