Tuesday, December 29, 2020

Unintended consequences

The Dec 14 Wall Street Journal amplifies my warnings on the movement to de-fund fossil fuels by financial regulation, citing "climate risks." 
"The Senate Democrats’ Special Committee on the Climate Crisis recently issued a report detailing how the Fed and eight other regulatory agencies should penalize investment in fossil fuels and promote green energy. They claim financial institutions are underpricing the risk that carbon-intensive assets will become “stranded.”
Mind you, their worry isn’t about how climate change per se would devalue investments, which financial institutions already account for. They want a warning about the costs of government climate policies. “Because Congress has not advanced any comprehensive climate policies in the last decade, the market has not priced in the possibility of significant federal action,” the report notes."

As reported this is at least a refreshing breath of honesty. In all I have read (not everything, it's a mountain) of the BoE, ECB, BIS, OECD, IMF treatment of "climate risk," there is a vague insinuation that climate itself poses a "risk," which is utter nonsense. Beyond nonsense, it is a directive for banks to make up numbers in order to justify de-funding politically unpopular fossil fuel projects. (In case that's not obvious, climate is not weather. The tails of the weather distribution and their minor effect on the profitability of large corporations are better known than just about any other risk, at horizons where bank supervision and risk management operate.) Here, it is at least clear that the relevant "risk" is the risk that Congress or the administrative state will shut down businesses. 

Actually, if taken seriously, honestly and generally, I might be all for it. Yes! Let our financial regulators require that firms and the banks who fund them disclose and account for all of the political risks that future government action might take to harm them -- law, regulation, administrative decisions, and prosecution. Indeed, state every possible nitwit regulation, idiotic tariff (Dec 29 WSJ is a masterpiece of how arbitrary  administrative decisions make or break companies), or ridiculous law or politicized prosecution might harm the company or investment.  Let's make this really tough -- criminal penalties for failing to disclose ahead of time that, say, the government might challenge a decade-old merger, or decide with a secret algorithm that it doesn't like the interest rates you charged or who you hired, or decide (Wal-Mart) to sue you for prescriptions you are legally required to fill. While we're disclosing financial risks, let's disclose the risk that a future Congress might remove the long list of subsidies and protections that your green projects live on. The long lists of well documented potential mischief would be edifying! 

OK, I'll stop dreaming. This isn't serious, it isn't about climate in any vaguely sensible cost-benefit way, it's about fossil fuels. It's about de-funding fossil fuels before alternatives are available at scale, by capturing the regulatory system because the people's elected legislators are not about to do it. (In the US.)

And it's really clever. Or sneaky. That the US Congress will take an action which strongly hurts the finances of fossil fuel companies is not a given. There are a few still who recognize, say, that fracking for natural gas has lowered US carbon emissions dramatically, and improved our economy and geopolitical situation. A ban on fracking, or on nuclear power (Germany) would be a clear disaster. Will Congress really do it? Will the Department of Energy or the EPA really go so far on their own? It's not likely, is it. 

Banks and bondholders have taken a sober look at just how much damage Congress is likely actually to impose. They don't think it's likely to happen. So the effort is clever: Try to get a financial run going ahead of time to avoid a risk that doesn't exist.

The unintended consequences   

The title of this post is "unintended consequences." Here is the real question: How is it that the government has the power to force the financial system de-fund politically unpopular industries, under the guise that they might be "risky?" Do we not have a nearly constitutional right to bet on an industry, be wrong, and lose a lot of money? When everyone else is shunning so-far legal fossil fuels fearing government action, do we not have a right to take the contrarian bet? 

Well, no. And here is the really interesting story of a dramatic expansion of administrative power in only 10 years, all unintended. But once the avalanche gets going it keeps going. 

It really goes back to 1933. After that bank run, the US chose not to follow the "Chicago plan," narrow deposit taking and equity-financed banking, and instead chose the path of deposit insurance, and bank asset risk regulation. With each crisis, we doubled down. 

2008 was the most recent immense crisis, and basically a run. Once again, we needed to fix one of two things: either financial institutions have to get their money by issuing equity and borrowing long-term in ways that cannot run, or an array of bureaucrats has to monitor how they invest their money, making sure they don't take too much "risk." Our government doubled down on the second option. (Newcomers: A more detailed version of this little old lady who swallowed a spider history is in "toward a run-free financial system" and "a blueprint for effective financial reform.") 

And over the next 10 years the ambition of our regulators to regulate "risks" expanded dramatically. If they regulate only banks, financial activity moves outside the banking system, which it did. So now the government "monitors" and regulates "risks" throughout the "financial system." (Scare quotes indicate fuzzy words.) 

And  the early restriction that risk had somehow to be "systemic," threatening not an individual loss of money but a systemwide panic, faded away. "Systemic" now means "anywhere in the system," not "threatening a run to the entire system, not individual failures." At the cost of repetition, let me emphasize this point. As I travel around and read the output of central banks and other institutions, in 10 short years it is now universally understood that regulators job is to "monitor risks" everywhere in the financial system. not just those risks that might conceivably cause a run, panic, or crisis. 

For example, a company wishing to borrow to finance a (heavens) fracking project to bring low-carbon natural gas to market or a pipeline, to avoid shipping oil in rail tank cars, frozen out of banks, might simply sell corporate bonds. Those bonds would be bought by a mutual fund or exchange-traded fund. That poses zero risk of a run. But mutual funds too must disclose "risks," and can be effectively regulated. 

The ability of the Fed to tell banks what to do, to shun fossil fuels if the Fed so desires is essentially total and arbitrary. But the  danger is not just the Fed, which the WSJ article points to. As Norbert Michel writes in Forbes the larger target is the FSOC, 

Environmental activists are hopeful that Janet Yellen, Joe Biden’s pick for Treasury Secretary, will lead a major shift in public policy toward actively addressing climate change. ...activists are calling for her to use the Financial Stability Oversight Council (FSOC) in the “campaign against global warming.”...

What, exactly, is the FSOC?

Created by the 2010 Dodd-Frank Act, it is a council of all the major federal financial regulators. The Treasury Secretary serves as the council’s chair. Section 112 of Dodd-Frank defines the FSOC’s basic purposes, such as identifying risks to U.S. financial stability that come from “outside” the financial marketplace, and responding to “emerging threats” to financial stability.

However, the Dodd–Frank Act does not spell out how the council may respond to emerging threats to financial stability. In fact, it doesn’t even define emerging threats or, for that matter, financial stability. This sort of ill-defined government authority is dangerous in its own right.

Separately, section 120 of Dodd-Frank authorizes the council to recommend more stringent regulations for an “activity”— if the council determines that the “conduct, scope, nature, size, scale, concentration, or interconnectedness” of the activity could “increase the risk of significant liquidity, credit, or other problems spreading” through other companies or markets. ...

Thus a Biden administration would have the authority to restrict/redirect practically any climate-related economic activity based on nothing more than a belief that it might cause “problems” in the future.

If you are iffy on climate goals, social-justice goals are not far behind. Michael again

Congress should never have given such authority to unelected officials running regulatory agencies and, arguably, should not have such power to begin with.

Congress did have, I think, a fairly narrow concept in mind. Nobody really knew back then just how a "systemic run" evolves, so it hoped with vague language that the FSOC and subsidiary agencies would figure it out and define a limited scope. That is the vain hope. The institutions instead have interpreted their mandate for action ever more broadly. And here we are. 

Michel is thoughtfully even handed

Many climate activists will probably scoff at this objection, but the FSOC could just as easily make life miserable for the companies that they like. For instance, the FSOC could slap solar energy companies (or their investors) with stringent regulations and fees. In the last year, two major solar companies filed bankruptcy. These cases provide concrete examples of renewable energy companies posing a risk to “financial stability,” thus justifying (under Dodd-Frank) virtually any new regulation that the council comes up with.

It is common to both parties, but strikes me as especially common on the left to forget that someday you might lose an election and your opponents use the tools you just created against you. Filibuster anyone? 

But this is an important point. For my objection has nothing to do with climate policy, it is an objection to untrammeled power that can de-fund anyone's crusade. A new Republican administration might de-fund industries that trade with China, as both administrations have de-funded pot farmers, for-profit schools, payday lenders, and a range of other unpopular industries. Who is next? 



  1. "It really goes back to 1933. After that bank run, the US chose not to follow the Chicago plan, narrow deposit taking and equity-financed banking, and instead chose the path of deposit insurance, and bank asset risk regulation."


    The economist Irving Fisher had this to say:

    "Fisher (1936) claimed four major advantages for this plan."

    1. First, preventing banks from creating their own funds during credit booms, and then destroying these funds during subsequent contractions, would allow for a much better control of credit cycles, which were perceived to be the major source of business cycle fluctuations.

    Response: Banks act in concert with private borrowers to create funds during credit booms. They don't create those funds willy nilly.

    2. Second, 100% reserve backing would completely eliminate bank runs.

    Response: NO IT WOULDN'T. It might alleviate a fear of loss among depositors, but if people want to withdraw their money from a bank all at the same time (for whatever reason), nothing about 100% reserve banking would prevent them from doing so.

    3. Third, allowing the government to issue money directly at zero interest, rather than borrowing that same money from banks at interest, would lead to a reduction in the interest burden on government finances and to a dramatic reduction of (net) government debt, given that irredeemable government-issued money represents equity in the commonwealth rather than debt.

    Response: NOPE. The presumption is that money should be a risk asset like any other form of equity. If the federal government sold equity that was separate and distinct from money, that would lead to a drastic reduction in the total government debt as well as stabilize the value of the currency.

    4. Fourth, given that money creation would no longer require the simultaneous creation of mostly private debts on bank balance sheets, the economy could see a dramatic reduction not only of government debt but also of private debt levels.

    And reducing private debt levels is a good thing because? As long as real GDP and incomes grow faster than the debt build up, why is constraining private credit growth necessarily the ultimate objective?

  2. When a government sells equity rather than dictates that it's currency is equity - you get risk taking by choice instead of risk taking by government mandate.

    See Milton and Rose Friedman - "Free to Choose"

  3. When words in a contract or in a piece of legislation are not specifically defined in the document, then words and phrases have their ordinary meaning. If there is ambiguity in a phrase or sentence in the document, then the court will determine its meaning in the context of the document.

    What could be more straight-forward? Thus, it is not necessary to define each and every word or phrase in a legal document.

  4. "This isn't serious, it isn't about climate in any vaguely sensible cost-benefit way, it's about fossil fuels. It's about de-funding fossil fuels before alternatives are available at scale, by capturing the regulatory system because the people's elected legislators are not about to do it."

    This reminds me of an idea Hayek presented in "The Road to Serfdom." He explained how centralizing decisions is bound to cause resistance because the implementation of a plan requires that it be specific, but support for a plan dwindles as details are determined. A lot of people are concerned about managing carbon emissions. Fewer are interested in using nuclear power as a means of achieving this goal. Fewer still would be happy with a nuclear power plant built in their backyards. Therefore, either you give up on your plan, or you must commit to its imposition by force.

    He also explained how this sort of necessity created a perverse dynamic where the absolute worst people are bound to rise to the top in a movement towards centralized planning, the very sort of people to whom you would never want to give any sort of power in the first place.

    Do you think that Democrats supporting Black Lives Matter has anything to do with a genuine concern for racism? I fail to see how activists burning down buildings in black communities or destroying public property is helpful to black people. Most of what I saw was another load of pasty white college educated upper middle class urbanites engaging in actions that destroyed the support their own movement had gained following the death of Floyd.

    I'm going to be far more cynical than you: The only reason they say Black Lives Matter is to be able to accuse any critique of believing blacks lives do not matter. Identity politics as a whole is just a rhetorical weapon intended to silence any critique by painting them as hate-mongering bigots. It's pretty clear: They paint individual, liberty and free markets as inherently prejudicial institutions.

  5. This comment has been removed by the author.

    1. The main impact of such an initiative, as with emissions-reduction policies in general, would be to accelerate China's move towards world dominance - a much bigger threat than any possible negatives from further warming (which if it occurs might prove net beneficial).

  6. What the Federal Government could actually do is eliminate the tax subsidies to the fossil fuel industry:


    or stop subsidizing the "free" (meaning not paying because you use them paying because you earn money) roads all over the country and inside de cities.

    Obviously, the US government is not alone in this schizophrenic hypocrisy. Even “climate virtue signaling” Europe opposes the closing of coal power plants.


    But what puzzles me the most is that:

    1.- there is a significant consensus among economist that Pigouvian carbon taxes (or the equivalent market for emission permits) are the most efficient way of internalizing this cost (and "significant consensus among economist" is something relevant taking into account the extreme difficulties of achieving such a rare state).

    And 2.- The Sovereign rejects (time and again) the imposition of a Pigouvian carbon tax:
    - The French government was forced to back track on the introduction of such a tax ("put your tail between your legs", was precisely invented to describe what Macron had to do on this topic)
    - The Washington Sovereign rejected twice the introduction of a carbon tax



    So, if the Sovereign rejects the most efficient way of dealing with the "carbon emission" externality, how on Earth, does the government agents think they have a mandate to tackle this problem in a way less efficient and convoluted way?

    And if they think they have a mandate to regulate the fossil fuel industry out of existence, why not doing so directly, instead of thru the regulation of the financial system that supplies funds to the industry?

    Are they, once again, showing off "the ingenuity and determination that political elites display in rendering their positions impregnable to evidence" (Tetlock)

    1. Excellent point. The key to running a government is to simultaneously subsidize and regulate all goods. All must then come asking for favors.

    2. El Emperador,

      "1.- there is a significant consensus among economist that Pigouvian carbon taxes (or the equivalent market for emission permits) are the most efficient way of internalizing this cost."

      See: https://theconversation.com/us-military-is-a-bigger-polluter-than-as-many-as-140-countries-shrinking-this-war-machine-is-a-must-119269

      How exactly does having the federal government collect carbon taxes and then using those taxes to fund a large greenhouse gas emitter (like the U. S. military) accomplish anything?

      I presume that the federal government is the issuer of carbon permits and does not need to purchase permits of their own?

      Perhaps the consensus needs to rethink things a bit?

    3. The carbon tax as a mechanism to internalize the cost of emission should be revenue neutral (if otherwise it would also be a tool to increase tax revenue).

      And if a big chunk of the emissions is left out of the mechanism it would not be optimal but still would be far better than a government industrial planning effort “design by a special Congress Commission”.

      I don't see how the fact that the government is a big polluter affects the consensus.

      But I agree with you: you cannot trust the government in the administration of such a scheme. It would be inviting lobbying efforts for exceptions and free rights (like the ones allocated to big consumers in Europe). And the lobbyist will be successful, the political will in climate change would be put to the test and would fail, when the economic impact in entire sectors of the economy reach the media.

      What the government need is a solution that can be sold to the public as a double win: tackling the climate change by shutting down the “carbon economy” while fostering growth thru investments in the green economy by developing a plan of capital allocation designed by Congress and implemented by Bureaucreats.

      This “alternative plan” has the same conceptual basis than the Great Leap Forward and the “Zafra de los 10 millones” in Cuba.

    4. One delightful example of John’s point is the European 750 billion recovery plan, "Next Generation EU", approved this summer to "support investment in the digital and green transitions".

      On October 14th, 8 different European countries announced the introduction of a Digital Services Tax and 3 others will be implementing it soon.

      I just hope Arthur Pigou is not watching.

    5. "The carbon tax as a mechanism to internalize the cost of emission should be revenue neutral (if otherwise it would also be a tool to increase tax revenue)."

      If the whole point of a carbon tax is to dissuade greenhouse gas emissions, how would it ever be revenue neutral?

      Carbon tax is introduced in year one collecting X dollars of revenue.
      Emissions fall by half (as a result of the tax) and as such revenue falls by half.

      If a carbon tax is successful at reducing greenhouse gas emissions, tax revenue should fall as a consequence. Ronald Coase argues that any Pigouvian tax should NOT be revenue neutral, but instead fixed below:

      See https://en.wikipedia.org/wiki/Pigovian_tax

      "Ronald Coase argues that the tax placed on an industry creating a negative externality should not be changed after it is implemented. The crux of his argument is that all social costs are reciprocal in nature. Coase argues that a factory emitting smoke is not entirely responsible for the social harm of smoky air. If the factory were not there, no one would suffer from smoky air, and if the people were not there, no one would suffer from smoky air. Because of this reciprocity of harm, Coase argues that neither party bears sole responsibility for the social harm, so neither party should pay the full cost."

    6. Arthur Pigou himself has said: "It must be confessed, however, that we seldom know enough to decide in what fields and to what extent the State, on account of [the gaps between private and public costs] could interfere with individual choice."

      "Some Aspects of the Welfare State" - AC Pigou, 1954

      In other words, the economist's blackboard model assumes knowledge they don't possess – it's a model with assumed givens which are in fact not given to anyone."

      If Pigovian taxes are indeed little more than a blackboard exercise, then perhaps the "consensus" should step away from their blackboards and take a look outside the window.

    7. You're confusing issues. The "consensus" is about the most efficient way of internalising a known external cost. Pigou's claim is about the difficulty of identifying where these costs exist ex ante. In the case of carbon emissions, that problem's been "solved", so the quote is irrelevant.

    8. "The consensus is about the most efficient way of internalising a known external cost."

      The cost of greenhouse gas emissions is known and quantifiable? Really? How much GDP was lost last year because of greenhouse gas emissions? How many deaths were directly contributed to greenhouse gas emissions?

  7. "financial institutions have to get their money by issuing equity and borrowing long-term in ways that cannot run" is correct.

    The present problem with long term borrowing is it is done in multiple tranches of different terms which are not fungible. Demand deposits are fungible through the payments system so a deposit at one bank can be exchanged $ for $ to another bank. This is major advantage (until there is a run) of this form of issuance and makes it "money" rather than just an investment. Most major investors in Money Market Funds also require par value.

    Long term debts can however now be made fungible if they are issued as truly floating rate so that their FMV remains at par. Traditional FRNs are not true floating rate as they reset too infrequently and have fixed margins over a benchmark like Libor (also dodgy).

    A fungible true floating rate CD requires a perpetual CD (with a option to convert to traditional term CD if the market fails) whose rate is set continuously over the web by competing bids from investors. This is quite different to Auction Rate Securities where market makers falsely claimed to maintain a market but then reneged.

    The technology now exists. This is a practical way for banks to match fund their assets and banish runs.

  8. All of this micro regulation is nothing short of creeping nationalization of the banks. Here in Australia it has got to the stage that the regulator APRA has even demanded a seat on the Board of Directors to oversee the "culture". When working for one of the Australian banks the first question about any new deal was "What will APRA" think about it".

  9. Misguided risk concerns also have the unintended consequence of forestalling new investment. In 2010 we had pledges of $100,000,000 for a hedge fund start up. When The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 was passed, our compliance officer asked counsel for legal opinion as to how the act affected hedge funds. Alas, it was determined the D-F was so ambiguous, contradictory and arbitrary we decided not to move forward because we were uncertain, Knightian uncertain, we could generate risk adjusted market returns. How many other start ups will never be born because of this nonsense?

  10. Using govt to discourage the investment in fossil fuels and other activities that threaten the viability of - our coastal cities, the state of Florida, and lake-adjacent cities - makes total sense. How would you expect the moronic free market to figure it out and make the best decisions for the long run interests of our nation and the world. (Only if it impacts next quarter earnings I guess.)

    1. Except "Global Warming" is by definition a global phenomenon and there is no global government (or taxing authority for that matter). How do you expect the moronic elected government officials of the world to make the best decisions for the world. (Only if it impacts their prospects for reelection I guess).

  11. This slipped into fantasy:

    "Try to get a financial run going ahead of time to avoid a risk that doesn't exist."

    I think the point is simply to tax fossil fuels by raising oil company's borrowing costs. It's a very indirect way of going about it, but clever, as you say.

  12. One has to appreciate a blogger that pokes fun at a term widely recognized as refering to the various risks associated with climate change, only months after being engulfed by smoke, and watching their local utility file for bankruptcy due to factors directly related to climate change.

    It was unfortunate to read the claim that, "There are a few still who recognize, say, that fracking for natural gas has lowered US carbon emissions dramatically"

    On the contrary, "a recent study by the Environmental Defense Fund found that 3.7% of natural gas produced in the Permian Basin leaked into the atmosphere. That’s enough to erase the greenhouse gas benefits of quitting coal for gas in the near term." (https://www.scientificamerican.com/article/methane-leaks-erase-some-of-the-climate-benefits-of-natural-gas/)

    Going back to the main thesis, and the final paragraph - how is the power of the government 'untrammeled' in a democracy in which politicians are held accountable for their policy decisions, as we are seeing in this very moment in time?


Comments are welcome. Keep it short, polite, and on topic.

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