After reviewing the Financial Times op-ed written by Nobel Prize winning economist Joseph Stiglitz and the LSE's Lord Stern entitled  "Obama's Chance to Lead the Green Recovery" and then hearing Federal Reserve Chairman Ben Bernanke recent testimony on his concerns for the economy going forward, it occurred to me that Stiglitz and Stern have at least a partial cure for what ails Bernanke about the US economy going forward. Stiglitz and Stern understand that the financial crisis and the climate crisis can be addressed together in a way that can lead to a more resilient, sustainable economic recovery. President Obama also understands this point and has tasked Congress with the job of structuring a cap and trade policy this year that would make the United States a world leader not only in addressing climate change but also in driving investment into low carbon energy technologies that can help create the jobs and the new industries needed to re-power the economy in a way that will put Chairman Bernanke at ease. Let me explain.

Federal Reserve Chairman Ben Bernanke’s recent testimony before Congress highlights two major concerns with respect to the economic crisis from a policy perspective. The first is that without transparency at the banks, it is impossible to predict when the credit markets will return to normal. The second is that while the economic stimulus package is expected to provide a meaningful capital injection into the credit markets, there is a risk that the economy may slip back into recession if the economic stimulus incentives for investment are eliminated too soon.

Chairman Bernanke's point about the banking system and transparency are fundamental to understanding how the credit markets work. Without transparency, the banks are forced to hoard cash and focus only on the very short term in order to remain solvent. Loan commitments are quickly reined in, reducing the amount of credit available in the marketplace and ultimately forcing companies to cut jobs and reduce investment in order to keep enough cash on hand to pay their bills. This creates a vicious cycle of de-leveraging in the economy that can make an economic stimulus package far less effective in driving long-lived private investments. As was seen time and again in Japan during its decade long recession, the money from Japan’s numerous stimulus package was not used to grow the jobs and industries needed to return the economy to trend growth, rather it was used to meet short term needs which provided little lasting benefit to the economy. Without transparency, the banking system is unlikely to be able to provide the additional private capital needed to leverage the stimulus money in a way that will enable us to grow our way out of the current economic crisis and as a result further capital injections into the banks may be needed.      

The Fed Chairman’s second concern about how coming off an economic stimulus plan would likely result in a drag on the recovery is probably a bit less straightforward and worthy of a broader discussion. Chairman Bernanke notes: "Congress will need to weigh the costs of running large budget deficits for a time against the possibility of a premature removal of fiscal stimulus that could blunt the recovery”. In other words, once the stimulus dollars have been spent in late 2010, the economy may find it difficult to transition back to relying on a still fragile banking system for their capital needs. As a result, Congress is likely to face a decision to either keep the country on public life support to better help the economy transition toward a sustainable recovery or pull the plug on public support for the economy and hope the private sector is able to carry the economic torch on its own. Given that neither decision is guaranteed to work, Congress needs to start thinking about ways to insulate the recovery from what will effectively be a withdrawal of $800bln of liquidity from the system.

Fortunately, Congress can provide the additional stimulus needed to ensure that the recovery remains on track well beyond 2010 and do it in a way that doesn't increase the deficit. By accepting President Obama’s challenge and passing a cap and trade bill this year, some of the revenue from future carbon auctions could be brought forward to incentivize a portfolio of investments in low carbon technologies starting today. The use of carbon allowances as a form of bankable collateral, would give the still fragile banking system the confidence to provide additional private capital to fund these investments and would ultimately help drive down the cost of compliance once carbon trading is officially launched in 2012.

The question of how to best structure a cap and trade bill has been thoughtfully reviewed by my colleague Dan Lashof in a recent blog post “Cap and… Invest or Dividend?”. The argument that some of the revenue from carbon emission allowances should be used to invest in low carbon technologies under a “cap and invest” plan before dividending the majority of these funds back to consumers over time seems compelling given what is going on with the credit markets today. I would only add that by bringing carbon allowance revenues forward, effectively turning a "cap and invest" plan into a "cap and invest now" plan, this investment cycle could be accelerated. Indeed it could be accelerated in such a way as to provide economic stimulus for investment that could carry the economy beyond the expiry of the stimulus package in late 2010 without causing the economy to stall out.

By bringing a portion of the revenues from the first 5 years of carbon emission auction forward as a form of bankable collateral for investment in low carbon energy technologies including; 1) scaled energy efficiency programs in commercial and residential buildings, 2) carbon capture and storage demonstration and deployment, 3) next generation wind and solar, and 4) incentive programs to reduce the amount of heat wasted in industrial processes using combined heat and power (CHP) ahead of the actual cap, Congress would not only help improve our countries energy productivity, saving the consumers and businesses billions of dollars, but also greatly enhance our climate and energy security as well.

The idea behind “cap and invest now” is simply to bring forward incentives to help reduce our energy bills before the cap and trade program is actually launched in 2012, improving our energy productivity so that the net costs of putting a price on carbon emissions will be smoothed out over time (see chart below):

In sum, Congress has an opportunity to pass climate legislation that would not only serve as an insurance policy against the harmful effects of climate change, but provide an additional form of  stimulus that would not only pay for itself but would help un-lock the credit markets and encourage private investment in Americas new energy economy. Investment that would create new industries and provide Americans with the good paying jobs needed to ensure a sustainable recovery. One that will let Chairman Bernanke finally sleep at night.