Market Failure and Political Failure – Markets can fail. But, as has been demonstrated in areas like air pollution,
traffic congestion, spectrum allocation, and tobacco consumption, market mechanisms
are often the best way for governments to address such failures. So why are such
mechanisms now in retreat?

Consider markets for emissions allowances, in which firms that can cheaply cut air
pollution trade with those that cannot. A decade ago, the idea that such markets
could achieve desired environmental goals at relatively low cost was widely
recognized and implemented. Today, however, politics is killing “cap and trade.”

In the United States, the highly successful cap-and-trade system for sulfur-dioxide
emissions has effectively vanished. In Europe, the Emissions Trading System (ETS),
the world’s largest market for carbon allowances, has become increasingly irrelevant
as well. On both sides of the Atlantic, market-oriented environmental regulation has
in effect been superseded over the last five years by older “command-and-control”
approaches, by which the government dictates who should use which technologies, in
what amounts, to reduce which emissions.

Cap and trade was originally supposed to be a Republican idea in the US: its backers
were those who considered themselves pro-market, not those who considered themselves
pro-regulation. Most environmental organizations initially opposed it, with many
believing it immoral for corporations to be able to pay for the right to pollute.

Indeed, it was Ronald Reagan’s administration that pioneered the use of cap and
trade to phase out leaded gasoline in the 1980’s. George H. W. Bush’s administration
used it to reduce SO2 emissions from power plants in the 1990’s, and his son’s
administration sought to use it to reduce SO2 and other emissions further in the

The problem is not that cap and trade is an ivory-tower theory that cannot work in
the real world; on the contrary, its performance surpassed expectations. In the
1980’s, it enabled lead to be phased out more rapidly than predicted and at an
estimated annual savings of $250 million relative to the command-and-control
approach. Similarly, emissions of SO2 were curbed at a much lower cost than even
cap-and-trade proponents had predicted before 1995.

As recently as 2008, the Republican candidate for US president, Senator John McCain,
had sponsored legislative proposals to use cap and trade to address emissions of
carbon dioxide and other greenhouse gases.

But Republican politicians now seem to have forgotten that this approach was once
their policy. In 2009, they worked to defeat climate-change legislation by relying
on anti-regulation rhetoric that demonized their own creation. This left only less
market-friendly alternatives – especially after court cases upheld the validity of
the 1970 Clean Air Act. Though such alternatives are less efficient, they are again
the operative regime.

Likewise, the European Union adopted the ETS in 2003 as a cost-effective way to
achieve the commitments it had made under the 1997 Kyoto Protocol. The ETS rapidly
became the world’s largest system for putting a market price on environmental
damage. But now it has been pushed aside by other kinds of regulation.

European directives require that 20% of energy must come from renewables by 2020.
But, while policymakers have helped drive down the price of emissions permits in the
ETS by mandating and subsidizing renewable energy, the supply of permits has not
been reduced. As a result, demand now falls short of any binding constraint. Indeed,
the price of permits fell below three euros a ton in April 2013, rendering the
emissions-trading market almost irrelevant.

This, in turn, has encouraged greater reliance on highly polluting coal – the worst
energy source, from the standpoint of global warming. That would not have happened
if the price mechanism still underpinned climate-change policy. Moreover, the EU’s
renewables policy has also proved to be ruinously expensive. All of this should give
pause to the European Council when it meets in March to consider how to extend the
2020 goals to 2030.

There is a fascinating parallel between the evolution of American political
attitudes toward market mechanisms in environmental regulation and Republican
hostility to “Obamacare” (the 2010 Affordable Care Act). The core of Obamacare is an
attempt to ensure that all Americans have health insurance, via the individual
mandate. But it is a market-oriented program insofar as health insurers and
health-care providers remain private and compete against one other.

This was originally a conservative approach. The two major alternatives to it are
much further removed from the marketplace: a “single payer” system, as in Canada (or
America’s Medicare system for the elderly), with the government providing health
insurance, or “socialized medicine,” as in the United Kingdom (or the US Veterans
Health Administration), with the government providing health care directly.

The approach taken by Obamacare was proposed in conservative think tanks such as the
Heritage Foundation and enacted in Massachusetts by Republican Governor Mitt Romney.
But, by the time Obama adopted it, it had become anathema to Republicans, forcing
Romney, the party’s presidential candidate in 2012, to run against his own record.

The market failure in the case of air pollution is what economists call an
“externality”: those who pollute do not bear the entire cost. The market failure in
the case of health care is what economists call “adverse selection”: insurers may
not provide insurance, especially to patients with pre-existing conditions, if they
fear that healthy customers have already taken themselves out of the risk pool.

But, again, government attempts to address market failures can themselves fail. In
the case of the environment, command-and-control regulation is inefficient,
discourages innovation, and can have unintended consequences (like Europe’s growing
reliance on coal). In the case of health care, a national monopoly can forestall
innovation and provide inadequate care with long waits.

In general, the best government interventions target failures precisely – using cap
and trade to put a price on air pollution, for example, or relying on the individual
mandate to curtail adverse selection in health insurance – while letting market
forces do the rest more efficiently than bureaucrats can.

Jeffrey Frankel is Professor of Capital Formation and Growth at Harvard University.

Project Syndicate