Climate Change, Fiscal Change, and Risk

By Kevin D. Williamson

Wednesday, January 30, 2019

Bob Litterman, who is the chairman of the risk committee of Kepos Capital and the former head of risk management at Goldman Sachs, has an interesting column in the New York Times on his specialty: risk.

Litterman is interested in the question of risk particularly as it applies to climate change and its financial effects, in this case its role in the bankruptcy of PG&E. (Many readers will be skeptical of his specific claims about climate change; he acknowledges that it is “not easy to attribute any particular event to climate change,” and you don’t have to buy his climate-change policy preferences to appreciate the more general point of the column.) Risk, as a concern in and of itself, is something that does not get the attention it deserves in our political debates.

In the classical-liberal model of government intervention in economic affairs, the state overrules the market in a couple of general circumstances: One is in order to secure the provision of public goods, which range from public-health programs to missile-defense systems; public goods are defined as those that are non-excludable in consumption (you cannot design a missile-defense system that protects a paying customer on First Street while leaving out his non-paying neighbors on Second Street) and non-rivalrous in consumption (Smith’s enjoyment of a city free of cholera epidemics does not diminish Jones’s ability to enjoy the same thing, whereas every apple Smith eats leaves one less apple for Jones). The second is to prevent, mitigate, or correct “externalities,” meaning the negative effects of a business relationship between A and B on C, who is not a party to the trade. For example, if you build a sports stadium that you expect to draw 50,000 visitors on any given Sunday, you are creating traffic and parking demand that may be in excess of the existing capacity. Government may respond to that with regulation — a requirement that you build a certain amount of parking — or by using taxes to fund mitigatory measures of its own.

Risk can be understood as an externality. (You’d think that that 2008–09 housing crisis would have made that clear enough.) It is also a liability that can be priced. That is part of what underwriting is supposed to do in the world of credit: assess the risks involved in the loan or other transaction. One of the neat tricks of government accounting is that it can price risk at zero for budgetary purposes and therefore make a program seem to be a better deal than it is. The bailouts following the financial crisis were sometimes “profitable” on paper — because the government made financing available to institutions at rates that priced risk well below what the market would have. The government took on the risk without charging an appropriate price for doing so (that’s what a bailout is, really), which is as much a subsidy as it would have been to just send those institutions bags full of cash. Similarly, the government bears the risk for some $1.5 trillion in student-loan debt, most of which has been subjected to no analysis of creditworthiness at all. There’s a great deal of risk in that, too, but charging borrowers an interest rate appropriate to their creditworthiness would defeat the purpose of the federal student-loan program, which is to shunt enormous sums of money into the pockets of a favored political interest group without putting a corresponding tax line on the budget.

Risk-mitigation is a useful way to think about climate change and climate-change policy. There is good reason to be skeptical of the alarmist view of climate change and the maximalist approach to climate-change policy; the case for assessing the risks associated with climate change at zero — and pricing them at $0.00 — is considerably more difficult to make.

Litterman is an advocate of the Baker-Shultz carbon-dividend proposal. He writes: “Economists generally agree that rather than regulate behavior, it is more effective to allow individuals to choose their actions, as long as the prices appropriately reflect the costs, including the risks posed by climate change. To date prices of energy have not reflected the risk of future climate damages.”

(And what do those risks look like? The editor in me can’t help himself when Litterman writes: “The thousand-year flood is now a regular event.” It already was: Something that happens every 1,000 years is regular, i.e. happening once every thousand years.)

The Baker-Schultz model appeals to some progressives because the dividend would be redistributive. (In theory.) My own view is that a more straightforward emissions tax (and why only on carbon dioxide to the exclusion of other greenhouse gasses?) would be more appropriate. (In theory.) If indeed we are assuming that the federal government is taking on a great deal of risk as the presumed lead actor in response to climate change, then it is going to need revenue.

And it needs revenue, anyway. Yes, yes, I think the federal government should spend a lot less than it does and would be happy to take a meat ax to much of the federal budget. But we live in a different political reality, and even we libertarians have to nod in the general direction of reality from time to time. And here is one aspect of that reality: When the federal government is collecting 19 percent or 20 percent of GDP in taxes, we balance the budget or run a small surplus. When the federal government is collecting 16 percent or 17 percent of GDP in tax revenue, we run a substantial deficit. For the next several years, spending is expected to be just over 20 percent of GDP, and taxes are expected to be less than 17 percent of GDP. My English-major math calculates that this will produce a deficit running somewhere between 3 percent and 4 percent of GDP. There are substantial risks involved in that, too. If interest rates on federal debt should return to their historical average, things are going to get very ugly very quickly.

If we had a politics less interested in tribal drum-beating (“Derka derka, you’re a racist!” vs. “Derka derka, you’re a Marxist!”) and more interested in the difficult and boring and thankless business of responsible government, some compromises would look pretty obvious, at least to me. A modest carbon tax in exchange for meaningful entitlement reform and broader rationalization of the tax regime — a compromise whose components would together do a great deal to put the country on more-stable long-term fiscal footing? That looks to me like the beginning of a pretty good deal.

I’m generally skeptical of grand bargains and have a strong preference for piecemeal reform with modest ambitions. But where there are opportunities for intelligent compromise — reducing meaningful risk in two different categories — then the responsible thing is to at least explore the possibilities.

There’s risk in cleaving to the status quo, too.