Harvard Professor Jeffrey Frankel : Market Failure and Political Failure

Markets can fail. But, as has been demonstrated in areas like air pollution, traffic congestion, spectrum allocation, and tobacco consumption, market mechanisms are often the best way for governments to address such failures. So why are such mechanisms now in retreat?

Consider markets for emissions allowances, in which firms that can cheaply cut air pollution trade with those that cannot. A decade ago, the idea that such markets could achieve desired environmental goals at relatively low cost was widely recognized and implemented. Today, however, politics is killing “cap and trade.”

In the United States, the highly successful cap-and-trade system for sulfur-dioxide emissions has effectively vanished. In Europe, the Emissions Trading System (ETS), the world’s largest market for carbon allowances, has become increasingly irrelevant as well. On both sides of the Atlantic, market-oriented environmental regulation has in effect been superseded over the last five years by older “command-and-control” approaches, by which the government dictates who should use which technologies, in what amounts, to reduce which emissions.

Cap and trade was originally supposed to be a Republican idea in the US: its backers were those who considered themselves pro-market, not those who considered themselves pro-regulation. Most environmental organizations initially opposed it, with many believing it immoral for corporations to be able to pay for the right to pollute.

Indeed, it was Ronald Reagan’s administration that pioneered the use of cap and trade to phase out leaded gasoline in the 1980’s. George H. W. Bush’s administration used it to reduce SO2 emissions from power plants in the 1990’s, and his son’s administration sought to use it to reduce SO2 and other emissions further in the 2000’s.

The problem is not that cap and trade is an ivory-tower theory that cannot work in the real world; on the contrary, its performance surpassed expectations. In the 1980’s, it enabled lead to be phased out more rapidly than predicted and at an estimated annual savings of $250 million relative to the command-and-control approach. Similarly, emissions of SO2 were curbed at a much lower cost than even cap-and-trade proponents had predicted before 1995.

As recently as 2008, the Republican candidate for US president, Senator John McCain, had sponsored legislative proposals to use cap and trade to address emissions of carbon dioxide and other greenhouse gases.

But Republican politicians now seem to have forgotten that this approach was once their policy. In 2009, they worked to defeat climate-change legislation by relying on anti-regulation rhetoric that demonized their own creation. This left only less market-friendly alternatives – especially after court cases upheld the validity of the 1970 Clean Air Act. Though such alternatives are less efficient, they are again the operative regime.

Likewise, the European Union adopted the ETS in 2003 as a cost-effective way to achieve the commitments it had made under the 1997 Kyoto Protocol. The ETS rapidly became the world’s largest system for putting a market price on environmental damage. But now it has been pushed aside by other kinds of regulation.

European directives require that 20% of energy must come from renewables by 2020. But, while policymakers have helped drive down the price of emissions permits in the ETS by mandating and subsidizing renewable energy, the supply of permits has not been reduced. As a result, demand now falls short of any binding constraint. Indeed, the price of permits fell below three euros a ton in April 2013, rendering the emissions-trading market almost irrelevant.

This, in turn, has encouraged greater reliance on highly polluting coal – the worst energy source, from the standpoint of global warming. That would not have happened if the price mechanism still underpinned climate-change policy. Moreover, the EU’s renewables policy has also proved to be ruinously expensive. All of this should give pause to the European Council when it meets in March to consider how to extend the 2020 goals to 2030.

There is a fascinating parallel between the evolution of American political attitudes toward market mechanisms in environmental regulation and Republican hostility to “Obamacare” (the 2010 Affordable Care Act). The core of Obamacare is an attempt to ensure that all Americans have health insurance, via the individual mandate. But it is a market-oriented program insofar as health insurers and health-care providers remain private and compete against one other.

This was originally a conservative approach. The two major alternatives to it are much further removed from the marketplace: a “single payer” system, as in Canada (or America’s Medicare system for the elderly), with the government providing health insurance, or “socialized medicine, ” as in the United Kingdom (or the US Veterans Health Administration), with the government providing health care directly.

The approach taken by Obamacare was proposed in conservative think tanks such as the Heritage Foundation and enacted in Massachusetts by Republican Governor Mitt Romney. But, by the time Obama adopted it, it had become anathema to Republicans, forcing Romney, the party’s presidential candidate in 2012, to run against his own record.

The market failure in the case of air pollution is what economists call an “externality”: those who pollute do not bear the entire cost. The market failure in the case of health care is what economists call “adverse selection”: insurers may not provide insurance, especially to patients with pre-existing conditions, if they fear that healthy customers have already taken themselves out of the risk pool.

But, again, government attempts to address market failures can themselves fail. In the case of the environment, command-and-control regulation is inefficient, discourages innovation, and can have unintended consequences (like Europe’s growing reliance on coal). In the case of health care, a national monopoly can forestall innovation and provide inadequate care with long waits.

In general, the best government interventions target failures precisely – using cap and trade to put a price on air pollution, for example, or relying on the individual mandate to curtail adverse selection in health insurance – while letting market forces do the rest more efficiently than bureaucrats can.