The Pope & the Market

Pope Francis’s encyclical on the environment and capitalism, Laudato Si’, is an eloquent description of the natural world and its relationship to human societies.¹ An appreciation of its poetic and epic qualities is completely absent from secondhand accounts, most of which are devoted to explaining why the pope got it right (about climate science) or wrong (about climate science). In reading the encyclical, one senses the struggle of an ancient institution, immersed in its doctrine and history, slowly and incompletely adapting to modern science. Most commentaries have focused on the pope’s endorsement of climate science, but my focus here is primarily on the social sciences, particularly economics.

My major point is that the encyclical overlooks the central part that markets, particularly market-based environmental policies such as carbon pricing, must play if countries are to make substantial progress in slowing global warming.

Laudato Si’ is a document that draws on the traditions of the Catholic Church and Catholic doctrine. Its quotations and references are virtually entirely to pronouncements of earlier popes or others in the church hierarchy. There are a few references to secular environmental documents, such as the UN Framework Convention on Climate Change (1992), as well as to a handful of Catholic philosophers such as Teilhard de Chardin, but no references to any scientific studies. Similarly, there is much discussion about economics, finance, and inequality, but no citations of any data or sources.

I will not attempt to reconcile the economic doctrines in Laudato Si’ with earlier statements, such as in Compendium of the Social Doctrine of the Church (2004). Rather, I will focus primarily on the economic analysis, starting with its general position toward the goals and means of the globalized market economy, and then discussing the views on environmental economics and policy.

Laudato Si’ contains an extensive discussion of the features of markets and modern capitalism. It emphasizes certain dysfunctional tendencies and distortions. For example, there is criticism of excessive consumption:

Since the market tends to promote extreme consumerism in an effort to sell its products, people can easily get caught up in a whirlwind of needless buying and spending. Compulsive consumerism is one example of how the techno-economic paradigm affects individuals. [Paragraph 203]

And of the distorting effect of profits:

Once more, we need to reject a magical conception of the market, which would suggest that problems can be solved simply by an increase in the profits of companies or individuals. Is it realistic to hope that those who are obsessed with maximizing profits will stop to reflect on the environmental damage which they will leave behind for future generations? [Paragraph 190]

Another statement, which argues that profit-seeking is the source of environmental degradation, is this:

The principle of the maximization of profits, frequently isolated from other considerations, reflects a misunderstanding of the very concept of the economy. As long as production is increased, little concern is given to whether it is at the cost of future resources or the health of the environment; as long as the clearing of a forest increases production, no one calculates the losses entailed in the desertification of the land, the harm done to biodiversity or the increased pollution. In a word, businesses profit by calculating and paying only a fraction of the costs involved. [Paragraph 195]

The financiers of the world receive special disapproval:

In the meantime, economic powers continue to justify the current global system where priority tends to be given to speculation and the pursuit of financial gain, which fail to take the context into account, let alone the effects on human dignity and the natural environment…. [Paragraph 56]

This paradigm [consumerism] leads people to believe that they are free as long as they have the supposed freedom to consume. But those really free are the minority who wield economic and financial power. [Paragraph 203]

A mainstream economic account might share many of these views, but it would have a different starting point. Modern economics judges the performance of an economy according to its achievement of three general goals. Does the economy produce efficiently and expand the available quantity and quality of appropriately priced goods and services? Are the resources equitably distributed among different people? And does the economy perform without either high unemployment or ruinous inflation?

In considering the moral aspects of economic activity, the major questions involve the functioning of private market activities. Markets perform the function of coordinating individuals with differing goals and resources through a system of prices, wages, and profits. Compared to other systems, markets have proven a mighty engine of growth in living standards around the world. The chaos of daily life without smoothly functioning markets was vividly illustrated in July 2015 when Greece’s banking system was closed.

Mainstream economics contains one major and paradoxical insight about ethical behavior in a market economy. This insight (first described by Adam Smith in 1776 and later proved by Kenneth Arrow and others about a half-century ago) is that the efficient performance of a market economy does not depend upon the ethics of individual behavior. This is put eloquently in The Wealth of Nations:

It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.

Trade and exchange tend to benefit both parties. Therefore, most economic activities in a well-regulated market are ethically neutral or positive because they do not harm and may improve the welfare of others. Moreover, from an ethical vantage point, it does not matter whether I buy my meat or beer or bread in a charitable or a foul mood because my actions are transmitted through the impersonal market forces of prices and quantities. What is needed for ethical behavior is to behave as responsible members of the market community: to earn and to pay, but not to steal or to cheat.

The idealized world of Adam Smith ignores two major shortcomings of a realistic market economy. The first is the presence of market failures, such as monopoly or unregulated pollution, that distort market decisions and outcomes, and the second is inequality of opportunities and income.

In his magnificent book on the tradeoff between equality and efficiency, Arthur Okun wrote that he would award two cheers for the market but not three. He referred to the fact, often overlooked by market zealots, that markets contain no automatic mechanisms to guarantee that market outcomes lead to an equitable distribution of income and wealth:

Given the chance, [the market] would sweep away all other values, and establish a vending-machine society. The rights and powers that money should not buy must be protected with detailed regulations and sanctions, and with countervailing aids to those with low incomes. Once those rights are protected and economic deprivation is ended, I believe that our society would be more willing to let the competitive market have its place.²

Pope Francis is clearly deeply concerned about global poverty and the inequalities generated by markets. He argues that resource abuse and exploitation are major contributors to global poverty. Much has been written about rising inequality, particularly in important recent books on the subject by Anthony Atkinson, Thomas Piketty, and Joseph Stiglitz. However, it would be inaccurate to point to degradation of resources or pollution as major causes of rising poverty. In accounting for the causes of inequality, careful studies of the US by scholars such as David Autor, Claudia Goldin, and Lawrence Katz point, as important causes, to forces such as the labor-saving nature of technological change, rising imports from low- and middle-income countries, and the distortions of the financial system.³

Moreover, while inequality in both income and wealth in the US has risen sharply over the last half-century, trends for the world as a whole have moved in the other direction. Because of rapid growth in low- and middle-income countries, global inequality has been stable or declined slightly in recent years.⁴

Most contemporary economists would argue that Okun gave one cheer too many to the market. They point out that markets can distort incentives and produce inefficient and potentially dangerous “free-market” outcomes. So far as the environment is concerned, the most important market failure is called an externality. This is the term for byproducts of economic activity—such as pollution—that cause damages to innocent bystanders. These externalities occur because those who pollute do not pay for that privilege, and those who are harmed are not compensated.

Laudato Si’ has an eloquent discussion of many local, national, and global environmental problems. The discussion of biodiversity is particularly insightful. It points to the fact that many popular analyses incorrectly look primarily to the market value of lost species (such as the stock market value of some potential miracle drug lurking on a tropical tree) and ignore their intrinsic value (Paragraphs 32–42). But the discussion of solutions in Laudato Si’ provides little guidance on effective policies. The encyclical points out the need to replace fossil fuels with renewable energy and conservation. It also acknowledges that this will be expensive. But who will develop the new energy technologies that will replace fossil fuels? And, more important, why would people use more expensive fuels when cheap fossil fuels are available?

The encyclical states that the advances in slowing climate change have been regrettably few. There is a lack of “honesty, courage and responsibility.” Progress has been slow because countries have shown “failure of conscience and responsibility” (Paragraph 169).

But the growing peril of climate change and many other environmental problems arises primarily not from unethical individual behavior such as consumerism or cowardice, bad conscience or excessive profiteering. Rather, environmental degradation is the result of distorted market signals that put too low a price on harmful environmental effects.

Putting a low price on valuable environmental resources is a phenomenon that pervades modern society. Agricultural water is not scarce in California; it is underpriced. Flights are stacked up on runways because takeoffs and landings are underpriced. People wait for hours in traffic jams because road use is unpriced. People die premature deaths from small sulfur particles in the air because air pollution is underpriced. And the most perilous of all environmental problems, climate change, is taking place because virtually every country puts a price of zero on carbon dioxide emissions.

To understand environmental problems today—whether local ones like congestion or national ones like air pollution or global ones like global warming—requires understanding markets. Markets can work miracles when they work properly, but that power can be subverted and do the economic equivalent of the devil’s work when price signals are distorted. For climate change, the major need is to raise the price of CO2 emissions sufficiently high that they are reduced sharply. This can be done either by taxing emissions or by a system of cap-and-trade.

Unfortunately, Laudato Si’ does not recognize the fact that environmental problems are caused by market distortions rather than by markets per se. This is seen in the condemnation of “carbon credits”:

The strategy of buying and selling “carbon credits” can lead to a new form of speculation which would not help reduce the emission of polluting gases worldwide. This system seems to provide a quick and easy solution under the guise of a certain commitment to the environment, but in no way does it allow for the radical change which present circumstances require. Rather, it may simply become a ploy which permits maintaining the excessive consumption of some countries and sectors. [Paragraph 171]

The target of the pope’s criticism is unclear. The term “carbon credits” is not a term of art in environmental policy. The Spanish version (from which the criticism may originate) refers to “bonos de carbono,” which are certified emissions reductions under the Kyoto Protocol.⁵ Many commentators have interpreted this passage as a condemnation of cap-and-trade, the most widely used system of limiting market-based emissions today. Whatever the specific target, this part of the encyclical is clearly a critique of market-based environmental approaches.

Because market-based environmental policies are so central, it will be useful to describe how they work. As with other environmental externalities, appropriate pricing is a central mechanism for reducing carbon dioxide emissions and slowing climate change. There are two market mechanisms by which countries can raise the price of emissions in order to reduce them: cap-and-trade and carbon taxes. I will focus on cap-and-trade because that is a system of buying and selling of credits that the encyclical criticizes.

How does cap-and-trade work and why is it effective? Cap-and-trade begins with actions by which a country, through its government, caps or limits its carbon dioxide emissions. The country then auctions or issues a limited number of “emissions permits.” These convey the right to emit a given quantity of emissions. Firms that own the permits can use them or sell them on carbon markets, while firms who need them can purchase permits. The advantage of establishing a market in permits is that it ensures that emissions are used in the most productive manner.

Here is a hypothetical example. Suppose that there are two types of firms, power plants and biotech companies. Both would be profitable in a world with no emissions limits, and each sector would emit one million tons of carbon dioxide. Next assume that the country decides to limit the total emissions of all these companies to one million tons, and it auctions the permits on a special environmental market.

The biotech companies, we can assume, have much higher economic value per unit of emissions, so they outbid the power plants. The auction price might be $25 per ton of carbon, which would be the market price of carbon and indicates the cost of reducing emissions by one ton. At that price, the power plants would find it unprofitable to continue using fossil fuels, while the biotech companies would emit one million tons and still earn a neat profit. The power plants would use nonfossil fuels or shut down, and total emissions would then be limited to one million tons.

So the high carbon price serves two functions. It serves as an economic incentive to stop emissions and at the limiting price will accomplish the desired reductions of emissions. But just as important is that it ensures that the scarce and valuable emissions permits are used by firms who can squeeze out the highest economic value per ton of emissions.

Additionally, the carbon price is an indicator of how much emissions should be reduced. A high price signals large required reductions, a low price requires smaller reductions, and a zero price (as in most countries today) signals that there need be no reductions. Ensuring a high price on carbon emissions is the single most important tool for slowing emissions.

Cap-and-trade has in fact been successfully used, for example to phase out lead from gasoline, to limit sulfur dioxide emissions in the United States by more than half, and to limit carbon dioxide emissions both in the European Union and more recently in major Chinese municipalities. The alternative to cap-and-trade is carbon taxation, which raises carbon prices by taxing carbon emissions. Such a tax is simpler and avoids any of the potential corruption, market volatility, and distributional issues that might arise with cap-and-trade systems.

Given the successes of cap-and-trade and other market mechanisms to improve the environment, it is unfortunate that they are the target of Pope Francis’s criticism. Permits for emissions are traded like other financial assets, and indeed they are often highly volatile; but there is no evidence that they are the favored instrument of financial speculators. Rather, they are volatile because future economic conditions (such as electricity demand or natural gas prices) are uncertain.

Perhaps no one will attend to Pope Francis’s attack on trade in permits and implicitly on carbon pricing. Perhaps his endorsement of climate science and the reality of warming and environmental damage will be effective in turning the tide toward strong actions.

But he has missed a unique opportunity to endorse one of the two crucial elements of an effective strategy for slowing climate change. He does indeed acknowledge the soundness of the science and the reality of global warming. It is unfortunate that he does not endorse a market-based solution, particularly carbon pricing, as the only practical policy tool we have to bend down the dangerous curves of climate change and the damages they cause.