Cap & Trade Debate

Greg Mankiw, one of my favorite economists, writes in the New York Times that the cap-and-trade bill making its way through Congress represents a ``missed opportunity'' to collect nearly a trillion dollars in government revenue. How so? Because the bill will create permits to emit greenhouse gases and then, instead of selling them at auction, give them away to ``powerful special interests''.

But who are those so-called powerful special interests? They are firms in carbon-based industries---firms whose existing factories and machinery stand to lose a lot of value if they can't be operated without an expensive permit. In that light, it doesn't seem so unreasonable to ameliorate their losses by letting them have the permits at a deep discount.

There are good arguments in both directions here, but Professor Mankiw has failed to engage with any of them. Let me try to point out the issues that he and so many other economists have overlooked.

The primary goal of cap-and-trade is to make firms behave better in the future, and as Professor Mankiw points out, that goal is served equally well whether we give the permits out for free or require firms to buy them. But the latter option not only creates an incentive for good future behavior; it simultaneously punishes badpast behavior. The firm that recently invested in a million-dollar machine that now can't be operated without a half-million dollar permit is effectively paying a half-million dollar fine for behavior that was perfectly legal a year ago.

The larger question, then, is this: When people do things that are socially destructive but nevertheless perfectly legal (like, say, owning slaves in the 19th century or leaving an excessive carbon footprint in the 21st), ought they be punished ex post facto? The answer is far from obvious.

There are two competing principles here. The first principle is: Nor shall private property be taken for public use without just compensation, a principle enshrined in the Bill of Rights. Arguably, in the case of the million-dollar machine, the government has effectively taken half your machine from you for the public purpose of cleaning the air; therefore you should be entitled to just compensation. One form of compensation would be to give you your permit for free.

(Actually, a free permit amounts to overcompensation, because cap-and-trade will lead to higher prices for carbon-based products, which already partly compensates the affected firms. So maybe our principle dictates that permits should be cheap but not free.)

This is the principle that justifies job retraining programs for displaced workers. Like slaveholding and overpolluting, working in a tariff protected industry is socially undesirable even when it's perfectly legal: You really oughtn't be overcharging your neighbors for goods they could get cheaper from overseas. When we put an end to your bad behavior with a free trade agreement, we simultaneously punish you by devaluing your job skills. A lot of people think we should ameliorate that punishment by giving you some training. That's a lot like ameliorating the effects of cap-and-trade by giving out free (or cheap) permits.

But here's the countervailing principle: Bad behavior ---even legal bad behavior---should be punished eventually, because that precedent deters future bad behavior. If that principle were applied consistently and predictably, firms might not have overinvested in the wrong technologies to begin with. That's partly why we didn't compensate the slaveholders when we freed the slaves; we wanted to send the message that you really shouldn't have been holding slaves in the first place.

One problem with applying this principle is that a government with the power to punish bad behavior ex post facto is also a government with the power to punish good behavior ex post facto. If today they can retroactively punish overinvestment in bad technologies by making people buy cap-and-trade permits, then perhaps tomorrow they can retroactively punish saving by taxing our 401Ks. The fact that a principle is capable of being abused does not invalidate the principle, but it does suggest we might want to be cautious about invoking it.

In this case, I'm not sure which principle should prevail. I am, however, sure that these are the principles at stake, and any useful debate will have to address them.

That's why I'm so disappointed to see am economist as smart as Professor Mankiw arguing in essence that we should sell cap-and-trade permits just because it's a good way for the government to get its hands on a big pile of money. The fact is that the government does not lack for opportunities to get ahold of big piles of money. It could go ahead and tax those 401Ks, or confiscate them altogether. For that matter, it could confiscate all our houses and make us buy them back. That would raise plenty of revenue, but it's still a bad policy.

The real question on the table is: Do we want to empower our government to punish bad behavior that was perfectly legal when it occurred? If you answer one way, you'll favor compensation for slaveholders, retraining programs for displaced workers and free (or at least inexpensive) cap-and-trade permits for polluting firms. If you answer the other way, you'll reverse those judgments.

Let the debate begin.