On Financial Markets and Environmental Regulation

Posted on January 14, 2009 by Kevin Finto

I save the instructions for an item so I can try to figure out what is wrong when it breaks. Given the state of our financial markets, I went looking for the instructions. I couldn’t find a copy of Adam Smith’s nine hundred page, two volume set The Wealth of Nations, first published in 1776. I did; however, find the next best thing: P.J. O’Rourke’s On the Wealth of Nations, (Atlantic Monthly Press 2007), a concise 250 page explanation that is both informative and entertaining. In reading through O’Rourke’s summary, I noted that Smiths three principles that determine market behavior (i.e, pursuit of self interest, division of labor and freedom of trade) explain a lot about why the markets currently are frozen up. We have had perhaps too much of all three, and too much of a good thing rarely turns out well.  Being an environmental lawyer, it also struck me that unintended consequences of current environmental regulations might be at least in part responsible for our current financial situation.  Finally, given the change in administrations, it occurred to me that the interplay between the market economy and environmental regulation and policy will continue, so we need to be smart about it.  


Adam Smith identified three critical aspects of proper market function that have been called his “invisible hand.” The first is that people act in their own self interest. This is the basic motivation for capital investment, risk taking and human labor. The second is that we get more productivity and higher quality of life if there is a division of labor such that the people who are good at things do them and those that are not pay the people who are good to do them for them. Third, and the one most important to our discussion, is that the less regulation on trade among the people doing these specialized tasks, the better. Smith was, of course, most concerned about tariffs and their effect on international trade, but certainly any regulation imposes some friction on the markets.

This brings us to the question of how environmental regulation may have caused, at least in part, the current financial crisis. To make this point it is helpful to think of financial markets, which we want to be “fluid,” like a system of tanks and pipes in a waterworks.  Water is analogous to money in this example.  Adam Smith’s first principle, self interest, is a motivating force, like a pump in our system. The second principle, division of labor, is a set of pipes which are sized according to the amount of economic activity they carry (Wal-Mart is a bigger diameter pipe than say your local shoe repair shop). Regulations are analogous to valves that restrict flow in the system. 


Both water in a pipe and money in our financial markets follow the path of least resistance. Putting aside questions about excessive self interest (read greed) and excessive division of labor (read opaqueness or lack of accountability) which may have contributed to the financial meltdown, regulations played a role as well.   Just as valves can direct the flow of water in a system, regulations direct the flow of money in our economy. Traditional, capital intensive, economic multiplying investment opportunities, say in energy infrastructure or manufacturing facilities, have faced stringent regulation which imposed significant resistance to that investment opportunity -- small pipes with lots of valves. On the other hand, many financial investment vehicles offered little or no resistance; they were big pipes with no valves. Guess where the money flowed? 


            So what implications does this have for future environmental policy or regulation. With a change in parties in the adminstration, the old debate between those favoring market based regulation and those favoring command and control is rekindled. As the new administration considers economic stimulus packages and regulations on environmental impacts, it will be well served to understand that it is not only the absolute amount of regulation, but also the relative amount of regulation, on economic options can have a significant impact on the markets as well as unintended consequences. Moreover, while terms like “free market” and “markets forces” may be derogatory in some circles, the reality is that market-based environmental programs have worked so well. No one can seriously debate the success of the acid rain program far more productive than command and control regulations would have been in that situation.  The reason is that market-based programs rely on the same human nature that Adam Smith recognized in his first principle and that gets our entrepreneurial and creative juices flowing.  That is what is needed to solve economic and environmental problems.  Ignoring market concepts in environmental regulation only leads to unintended consequences, conflict and gridlock, which the markets and we can no longer afford.

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