Cap and Trade Would Sink the U.S. Economy

Oct.29.09 | About: iPath Global (GRN)

First and foremost, cap and trade is a carbon tax on capital, which really means a tax on economic growth. To get some understanding of the severe ramifications of Obama's proposed carbon tax we need to get a grip of basic capital theory. In everyday parlance capital has several meanings. It can be what an entrepreneur needs to start a business or what a business needs to expand output. It can also be an individual's assets: his house, savings, investments, etc. Using the term capital in this way is perfectly legitimate. However, in economics capital is something else altogether: it is the material means of production. It consists of those tools by which we eventually transform lower-valued resources into those higher-valued products we call consumer goods.

Unfortunately the vast majority economists tend to treat capital as a homogenous lump in which capital goods are perfect substitutes for each other. When challenged on this approach they readily admit that it is pure fiction. On the other hand, (there's that phrase again) they would argue that from a theoretical point of view it ultimately doesn't matter whether capital is treated as homogeneous or heterogeneous. This is a dreadful error that is preventing economists from grasping the enormity of Obama's insane energy policy.

Economic textbooks once contained diagrams illustrating the fact that production took place in stages and that these stages formed a capital structure consisting of heterogeneous producer goods, e.g., lathes, furnaces, trucks, drilling machines, etc. Goods moved down this structure until they reached the consumer. (Please understand that this is a highly simplified explanation). To keep on raising real wages and hence living standards for everyone the structure needs to be continuously extended. (What economists usually call raising the ratio of capital to labour). This is can only be done by using savings to add more and more complex stages to the structure that embody new technologies. It is this process that raises what economists call the value of labour's marginal product and therefore wage rates.

Regardless of what some economists teach, there is absolutely nothing automatic about this process of capital accumulation, which is what it is. No savings means no growth. Negative savings, meaning capital consumption, shortens the structure which in turn lowers real wage rates. In other words, any policy that causes the production structure to abandon the higher stages of production (reduce the capital-labour ration) will savage living standards. And this is exactly what the Waxman-Markey cap and trade policy that Obama loves so much will do to Americans — savage their living standards.

Not only does a production structure narrow as one moves up it but the higher stages become more and more energy and labour intensive per unit of output. A miner, for example, requires more capital to work with than someone who sells shirts. Production workers at the Caterpillar company require more energy and tools than someone making hamburgers.

These stages have a common feature: they are what we call time-consuming projects, unlike a McDonald's outlet they can take years to plan and set up. This makes them particularly sensitive to interest rate movements and energy costs. The higher the rate of interest the less capital intensive the project and therefore the less productive it will be.* This is where Obama's so-called energy policy comes in. It's aim — he freely admits — is to cause electricity prices to "skyrocket". (An interview with the San Francisco Chronicle, January 2008). Whether he realises it or not, this would cause firms in the higher stages to immediately close down or start consuming their capital. Either way, the result would be the same, an eventual fall in living standards.

The reason is straightforward, Obama is championing wind and solar as viable energy alternatives. Complete and utter balderdash. These so-called alternatives are grotesquely inefficient economically. This is because solar energy is not only erratic it is also highly dilute, which in turn creates massive diseconomies of scale that no amount of subsidies can possibly overcome. So even if they were 100 per cent efficient from a technical angle the economic consequences could still not be evaded. In plain English, you cannot get a gallon out of a pint pot.

Now the Heritage Foundation estimates that by 2035 — a mere 26 years from now — Obama's policy will have cut economic output by $9.4 trillion and destroyed 2.5 million net jobs. I have gone over this before. My critics argued that it's not that great a loss because an average growth rate of 3 per cent over 26 years will give the US a GDP of $30 trillion, turning the $9.4 trillion into a loss of less than $400 billion per annum which would be about 1.5 per cent of GDP in 2035. "No big deal". Apart from the fact that there is a huge difference between $30 trillion and $40 trillion this line of thinking is totally wrong. The actual cost would exceed $9.4 trillion by a vast amount.

Most people do not realise that GDP does not measure economic growth. Now it has three basic components: consumption, investment and government spending. Under no circumstances should consumption ever be confused with growth. As for government spending: it would take a statist fanatic to assert that every dollar of government spending expands the capital stock, particularly social spending. This leaves net investment which we define as that which adds to the capital structure. The following chart reveals the average growth rate for GDP during the last century to be about 3.2 per cent.

(Note that the decade 1930-39 shows a rate of 1 per cent. The problem here is that overall this decade was one of capital consumption. In other words, real growth was negative. Aging capital goods is one sign of capital consumption. After all, if there is no net addition to capital then it follows that machinery should be getting older. And this is precisely what we find: the amount of metal working machinery more than 10 years old rose from 48 per cent in 1930 to 70 per cent in 1940, an increase of 45.8 per cent. Obviously the average growth in GDP came from reductions in idle capacity, increased consumption paid out of capital, and government spending.)

It is my contention that if Obama's energy policy is implemented capital accumulation will cease. So-called green investments in the form of wind farms and solar plants are gigantic malinvestments: utterly wasted capital that can never be retrieved. These phony investments will not only divert huge amounts of savings from productive expenditure they will also — as Obama admitted — cause electricity prices to "skyrocket" — sending their operating costs through the roof. Under these circumstances there is no way America could maintain its capital structure let alone expand it. (All of this escaped the attention of the Heritage Foundation because it has no capital theory with which to work with).

But what about green jobs? Because the policy reduces the capital-labour ratio (makes the economy more labour intensive) these so-called green jobs will lower wage rates. This sort of thing can happen a lot fast than one imagines. A recent report by Senator Debbie Stabenow of Michigan and Representative Jay Inslee of Washington, both Democrats, revealed that green jobs pay below the "national average" for those employed in the production of durable goods. Clear evidence that these so-called green investments do not raise the productivity of labour. The classical economists understood that jobs relying directly on consumption or the wasteful use of capital do not raise real wages. This is why John Stuart Mill could write:

I apprehend, that if by demand for labour be meant the demand by which wages are raised... [the] demand for commodities [consumer goods] does not constitute demand for labour. I conceive that a person who buys commodities and consumes them himself, does no good to the labouring classes; and that it is only by what he abstains [saves and invests] from consuming... that he benefits the harbouring classes, or adds anything to the amount of their employment. (John Stuart Mill, Principles of Political Economy, University of Toronto Press, 1965 p. 80)

To further hammer home my point let us take the example of a stationary economy. This is one that is neither expanding nor shrinking and in which the size of the population remains constant. Let us also assume that this community's GDP is $12 trillion. One day its government decides that eventually all of its electricity needs must now be produced by wind power and solar plants. The appalling economic inefficiency of these plants is such that their costs amount to $4 trillion. (I am also assuming a very docile population). Being a stationary state it must now shorten its production structure until the economy comes to rest at an annual GDP of $8 trillion.

Critics will scream that the US economy is not stationary. So what? The principle remains unchanged. The colossal changes Obama and his economic vandals propose will have this effect because there is absolutely no way on this planet that the dreadful economic consequences of running an economy on these so-called alternative energy sources can be averted. (It would be very much like forcing the economy to rely on animal and water power and then claiming that it will have no affect on output). Therefore a so-called green economy can only be achieved through a massive consumption of capital accompanied by a collapse in living standards, a fact that the more intelligent greens fully grasp as revealed by the following statements:

Amory Lovins: "It would be little short of disastrous for us to discover a source of clean, cheap abundant energy".

Paul Ehrlich: "Giving society cheap abundant energy . . . would be the equivalent of giving an idiot a machine gun".

Ernest Callenbach, another green, made it clear in his book Ecotopia that alternative energy sources should be used precisely because they will raise energy prices and thus slash living standards.

However, I don't actually envision a collapse in US living standards because I don't believe Americans would tolerate it. Once they realise what is really afoot there will be a very nasty electoral backlash that could permanently change America's political landscape to the detriment of the Democrats, assuming they survived the political repercussions of their collective stupidity. At the moment it all depends on how many Congressional Democrats are prepared to support Obama's green lunacy

Economic impacts from the promotion of renewable energies: The German experience. This report was produced by the German think tank Rheinisch-Westfälisches Institut für Wirtschaftsforschung. It is devastating. Subsidies were up to 175,000 Euros about US $250,000 per worker! One can only imagine what would have happened to Germany if the economy had been forced to rely entirely on these phony energy sources. Incidentally, this study nails the Australian Centre for Independent Studies' ridiculous assertion that tax cuts can offset the destruction of capital. Senator Debbie Stabenow and Representative Jay Inslee's report does the same thing.

Study of the effects on employment of public aid to renewable energy sources was study directed by Dr Gabriel Calzada Álvarez at the Universidad Rey Juan Carlos in Spain. It's results mirrored the German report.

Unfortunately Australia also has its share of stupid politicians: The government's green Renewable Energy Target legislation is economic lunacy

*This doesn't mean that every time-consuming process is more productive than shorter processes, only that those genuinely more productive would be adopted.

Gerard Jackson is Brookesnews' economics editor