Carbon on credit: global warming and the derivatives markets.

• Author: Cochran, Jim

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...