MILAN — The eighteenth-century British economist Adam Smith has long been revered as the founder of modern economics, a thinker who, in his great works “The Wealth of Nations” and “The Theory of Moral Sentiments”, discerned critical aspects of how market economies function. But the insights that earned Smith his exalted reputation are not nearly as unassailable as they once seemed.
Perhaps the best known of Smith’s insights is that, in the context of well-functioning and well-regulated markets, individuals acting according to their own self-interest produce a good overall result. “Good,” in this context, means what economists today call “Pareto-optimal”, a state of resource allocation in which no one can be made better off without making someone else worse off.
Smith’s proposition is problematic, because it relies on the untenable assumption that there are no significant market failures, no externalities (effects like, say, pollution that are not reflected in market prices), no major informational gaps or asymmetries and no actors with enough power to tilt outcomes in their favor. Moreover, it utterly disregards distributional outcomes, which Pareto efficiency does not cover.
Another of Smith’s key insights is that an increasing division of labour can enhance productivity and income growth, with each worker or company specialising in one isolated area of overall production. This is essentially the logic of globalisation: the expansion and integration of markets enables companies and countries to capitalise on comparative advantages and economies of scale, thereby dramatically increasing overall efficiency and productivity.
Again, however, Smith is touting a market economy’s capacity to create wealth, without regard for the distribution of that wealth. In fact, increased specialisation within larger markets has potentially major distributional effects, with some actors suffering huge losses. And the refrain that the gains are large enough to compensate the losers lacks credibility, because there is no practical way to make that happen.
Markets are mechanisms of social choice, in which dollars effectively equal votes; those with more purchasing power thus have more influence over market outcomes. Governments are also social choice mechanisms, but voting power is, or is supposed to be, distributed equally, regardless of wealth. Political equality should act as a counterweight to the weighted “voting” power in the market.
To this end, governments must perform at least three key functions. First, they must use regulation to mitigate market failures caused by externalities, information gaps or asymmetries, or monopolies. Second, they must invest in tangible and intangible assets, for which the private return falls short of the social benefit. And, third, they must counter unacceptable distributional outcomes.
But governments around the world are failing to fulfill these responsibilities, not least because, in some representative democracies, purchasing power has encroached on politics. The most striking example is the United States, where electability is strongly correlated with either prior wealth or fundraising ability. This creates a strong incentive for politicians to align their policies with the interests of those with market power.
To be sure, the Internet has gone some way towards countering this trend. Some politicians, including Democratic presidential candidates like Bernie Sanders and Elizabeth Warren, rely on small individual donations to avoid becoming beholden to large donors. But the interests of the economically powerful remain significantly overrepresented in US politics, and this has diminished government’s effectiveness in mitigating market outcomes. The resulting failures, including rising inequality, have fuelled popular frustration, causing many to reject establishment voices in favour of spoilers like President Donald Trump. The result is deepening political and social dysfunction.
One might argue that similar social and political trends can also be seen in developed countries, Italy and the United Kingdom for example, that have fairly stringent restrictions on the role of money in elections. But those rules do not stop powerful insiders from wielding disproportionate influence over political outcomes through their exclusive networks. Joining the “in” group requires connections, contributions, and loyalty. Once it is secured, however, the rewards can be substantial, as some members become political leaders, working in the interests of the rest.
Some believe that, in a representative democracy, certain groups will always end up with disproportionate influence. Others would argue that more direct democracy, with voters deciding on major policies through referenda, as they do in Switzerland, can go some way towards mitigating this dynamic. But while such an approach may be worthy of consideration, in many areas, such as competition policy, effective decision-making demands relevant expertise. And government would still be responsible for implementation.
These challenges have helped to spur interest in a very different model. In a “state capitalist” system like China’s, a relatively autocratic government acts as a robust counterweight to the market system.
In theory, such a system enables leaders, unencumbered by the demands of democratic elections, to advance the broad public interest. But with few checks on their activities, including from media, which the government tightly controls, there is no guarantee that they will. This lack of accountability can also lend itself to corruption, yet another mechanism for turning government away from the public interest.
China’s governance model is regarded as dangerous by much of the West, where the absence of public accountability is viewed as a fatal flaw. But many developing countries are considering it as an alternative to liberal democracy, which has plenty of flaws of its own.
For the world’s existing representative democracies, addressing those flaws must be a top priority, with countries limiting, to the maximal extent possible, the narrowing of the interests the government represents. This will not be easy. But at a time when market outcomes are increasingly failing to pass virtually any test of distributional equity, it is essential.
Michael Spence, a Nobel laureate in economics, is professor of Economics at New York University’s Stern School of Business and senior fellow at the Hoover Institution. He was the chairman of the independent Commission on Growth and Development, an international body that from 2006-2010 analysed opportunities for global economic growth, and is the author of “The Next Convergence – The Future of Economic Growth in a Multispeed World”. Project Syndicate, 2019.
AVIGNON – This January, 3,554 US economists – including 27 Nobel laureates, four former Chairs of the Federal Reserve, and two former Treasury Secretaries – proposed a previously heretical policy. The United States, they said, should combine a domestic carbon price with a “border carbon adjustment system.” By backing tariffs that would reflect the carbon intensity of key imports, they broke with the free-market orthodoxy that national environmental policies should not impede global trade liberalization.
They were right to do so. Absent carbon tariffs, concerns about industrial “competitiveness” will continue to constrain vital action to counter harmful climate change.
The fundamental obstacle to decarbonization is the apparent paradox that the costs are trivial at the final consumer level, but large for an individual company. As the Energy Transitions Commission’s recent Mission Possible report emphasizes, the technology to achieve total decarbonization of the global economy by around 2050-60, with very small effects on households’ living standards, already exists. If all steel used in car manufacturing were produced in a zero-carbon fashion, the price of a typical car would increase less than 1%. The total cost to decarbonize all the harder-to-abate sectors – heavy industries such as steel, cement and chemicals, and long-distance transport (trucking, aviation, and shipping) – would not exceed 0.5% of global GDP. Viewed from this perspective, there is no excuse for national policymakers failing to adopt policies that can drive progress to a zero-carbon economy.
But, viewed from the perspective of an individual company, the costs of decarbonization can be daunting. Producing zero-carbon steel could add 20% to total production costs, and producing zero-carbon cement might double cement prices. So any individual steel or cement company that committed to zero-carbon emissions, or was forced to do so by regulation or carbon pricing, could be driven out of business if its competitors did not face equivalent constraints.
This conundrum has so far stymied the effective use of explicit carbon prices to drive decarbonization. Almost all economists who accept climate science believe that carbon taxes, or prices set in an emission-trading scheme, must be part of any optimal policy response. But even in places where this theoretically desirable policy has been deployed – for example, within the European Emissions Trading System – carbon prices have played a less important role than either regulation or direct subsidization of renewable energy in driving decarbonization. The reason for this is either that carbon prices have been too low to make a major difference, or that the most energy-intensive heavy industries have been exempted. And those weak policies reflect the fear that higher carbon prices and more complete coverage will make domestic industry uncompetitive with imports from countries without such policies.
The obvious response is to impose carbon taxes in one country, or in a customs union of multiple countries, with an equivalent tariff per ton of carbon on carbon-intensive imports, combined with rebates of the tax for exporters. Ten years ago, when I was Chair of the UK Committee on Climate Change, we debated this possibility. But it was met by a wall of opposition. Such policies, it was said, violated WTO rules, were undesirable in principle, and would unleash tit-for-tat tariff increases justified by whatever environmental priority each country wished to pursue.
Since then, we have successfully used other policy levers to drive large-scale deployment of renewable electricity systems, with costs falling dramatically as a result. But in the industrial sectors, the multiplicity of alternative possible routes to decarbonization, and the fact that different routes will likely be optimal in different circumstances, makes it essential to use the price mechanism to unleash a market-driven search for least-cost solutions. And to do that, we need an answer to the competitiveness problem.
That’s why the ETC’s Mission Possible report argues for the inclusion of border carbon adjustments (carbon tariffs) in policymakers’ tool kit, and why so many leading US economists have reached the same conclusion. They now argue for a carbon price within the US, combined with border adjustments for the carbon content of both imports and exports. Such a scheme “would protect American competitiveness and punish free riding by other nations.”
But while the economists couch their argument in language designed to play well in the US, the policy could equally be applied by other countries to defend their industries against carbon-intensive imports from America, should the US choose to be a free rider in efforts to tackle global climate change.
Indeed, no country committed to addressing climate change should regard this policy proposal as a threat to its economy. If one country applies a tax of, say, $50 per ton of carbon dioxide emitted, with an equivalent border tax on imports and with a rebate for exporters, any other country doing the same will leave its industries in exactly the same relative competitive position as before either country introduced the policy. But companies in both countries would now face an effective carbon price.
Global political agreement on carbon pricing has proven to be elusive. A carbon tariff could unleash a sequence of independent national decisions that drive a beneficial “race to the top” in which roughly equal carbon prices spread around the world.
Sometimes, intellectual taboos should be dropped. Border carbon adjustment is an idea whose time has come. It could play a major role in driving progress toward the zero-carbon economy that is technologically and economically possible by mid-century.