Essay - Carbon on Credit: Global Warming and the Derivatives Markets

Essay

Carbon on Credit: Global Warming and the Derivatives Markets

The environmental community may be missing the forest for the trees. Environmentally conscious consumers know that every purchase counts, and that taken together all our choices make up a "forest" of environmentally crucial decisions. But are we missing an even bigger forest, one that has an important connection to climate change?

I think we are, although it can only be found, with a little digging, in the back pages of the financial press. But while some, or even many, environmentalists may read a bit about carbon-trading programs or solar energy tax credits, how often do they read about the money supply, the yen carry trade, and credit instruments? Rarely, I suspect. We live a world apart from the Wall Street financial wizards.

But it may be that this world is where a really giant forest lies-a forest of credit options. And this forest "emits" carbon, rather than sequestering it.

Here's what I mean: Many places with large consumer classes, especially (though not exclusively) the United States, are heavily credit-based societies. If some law required pay-as-you-go purchasing, could the average American really afford to own a gas-guzzler, to buy a house that is half again as large as he or she really needs, and install cabinets made of wood imported from some distant rain forest? Probably not. Of course, there is no such law: consumers borrow the money with abandon at a historically low interest rate, as often as not using the equity in an over-priced home. Where does this equity come from? Where do the low-interest car loans come from? Why is there so much credit available to us?

And at a broader, more systemic level: Is there a relationship between the accelerating consumption of carbon resources and the accelerating "velocity" of the credit markets?

The path to understanding this relationship requires learning about a concept called the derivatives market, which most economists view as a positive innovation that emerged over the past 30 years or so to become a predominant factor in the global financial markets. Derivatives markets have triggered important changes in the credit environment.

Thirty years ago, if you wanted to borrow money to buy a car or build a factory, you most likely borrowed from a local banker. That banker carefully assessed your ability to repay the loan, and then held the loan to maturity. The bank made its money by collecting interest from you, always being careful to keep its default rate low enough to remain profitable and to keep on the right side of the bank examiners.

Those days are over. The bank now holds your loan for a few days or weeks, and then sells it into a global secondary market. The bank makes its money by charging loan fees, and moving the money in and out the door as quickly as it can in order to generate more fees. This practice increases the velocity of money creation, because the bank's reserves are used to back up an increasingly large volume of loans.

But this is only the beginning. Once the loans are sold, they are sliced and diced by unregulated-and very profitable-financial entities. These entities make all sorts of private deals based on the value of the income stream from the loans. These deals are collectively known as the credit derivatives market, since the contracts are derived from underlying assets. Credit derivatives markets are unregulated, primarily because they did not exist during the 1930s, when the U.S. Securities and Exchange Commission was created to protect the integrity of the financial markets.

Today, the global credit derivatives market is over five times larger than the value of all the goods and services produced in the world. And the high level of profitability in these markets has only exacerbated the gap between the super-rich traders of finan­cial electronic assets and the rest of us who make a living producing things and providing services that ordinary people need.

The conventional wisdom on Wall Street is that the widespread use of credit derivatives has distributed risk throughout the world's financial system in a way that increases its stability. But there is a credible minority of economists who think that the contrary is true: that this perception of stability has encouraged greater risk-taking than has traditionally been seen to be prudent. As a consequence of this perception, the premium for making risky loans and investments (read: interest rate) is lower than it should be.

They argue that the mathematical models for predicting risk do not take sufficient account of unexpected events. In fact, back in 1998, the entire global financial system narrowly avoided a meltdown when the "sophisticated" predictive models developed by two Nobel laureates failed to work as planned, and precipitated a financial crisis involving dozens of institutions around the world.

Environmentalists are primed to understand the risks involved in the global monoculture of money. Like any monoculture, it works fine for a while-until it doesn't. Then the whole system crashes. We understand intuitively that localized money systems would be less susceptible to global financial crises.

Our counterparts in the financial world (who include U.S. über-investor Warren Buffet) are worried about another global credit crisis that will prove impossible to contain. They question whether all these derivative contracts could be honored if there was a sudden shift in interest rates, currency values, or stock prices. There are tens of thousands of these highly leveraged "counterparties"-and nobody is making sure that their schemes will work in a major crisis.

Many major banks have bet more than their entire equity  on these less-than-transparent financial arrangements, and they would become insolvent overnight if something went awry. These are the same banks that safeguard the savings of ordinary working people.

But we have something more than our bank accounts to worry about: the environmental consequences of all the credit sloshing around the globe at the speed of light. If we were to live by more traditional rules of credit allocation guided by community bankers, I suspect that we would consume far fewer resources, including the fossil-based energy resources that are driving climate change.

We need to do a better job of informing ourselves about the financial markets. A good place to start is by picking up a Financial Times, Wall Street Journal, or New York Times, and begin to follow the debate brewing about the "excess liquidity" and "hot money" flowing around the world. It's not gripping reading, I admit, and it's not for everybody. But it grows on you.

Browse these newspapers for awhile and you'll discover that there are a few, very prominent voices calling for better oversight and more transparency in the credit markets. The environmental community needs to stand shoulder to shoulder with them.

 

Jim Cochran is the founder of Swanton Berry Farm near San Francisco, California. He received a Stratospheric Ozone Protection Award from the U.S. Environmental Protection Agency in 2002 for his work in proving the economic viability of growing strawberries without the use of the ozone-depleting fumigant methyl bromide.