Skeptonomics

There is a useful piece by Floyd Norris in this morning’s NY Times about the Fed’s response to the housing bubble. It echoes the larger debate, which has flared up again with his PR blitz, over whether Greenspan was fiddling while Roman property values went through the roof.

Let’s step back for a moment and consider the larger context. The US has been running a very large current account deficit. Here are the quarterly data since 1990 courtesy of the BEA:

US Current Account Balance as a Percent of GDP

If this were the total story, the US economy would have been moribund since the late 1990s when the deficit really took off. This fraction represents income that leaves the country rather than making purchases that would support domestic employment.

But this is only half the picture. The other half is the return of this money via the capital account, in the form of purchases of debt, like treasury bonds, and assets. This return flow not only finances the current account deficit, propping up the dollar, but also makes possible continued US economic growth. For instance, the willingness of foreign central banks to accumulate treasuries means that the Bush crowd can borrow freely to finance the federal government deficit without fear of pressure on interest rates. (This is not to say that the fiscal deficit is too high in any general sense, which it isn’t.) The infusion of foreign finance also sustains asset prices, like stock values, above what they would otherwise be. This generates capital gains for those who have positions in these markets and also encourages borrowing against paper wealth.

The housing bubble could be seen as a bit of both of these. Foreign purchases of mortgage-backed securities injected large amounts of money into the housing market, so that the demand for loans, no matter how outlandish, never exceeded the supply. This in turn fueled a bubble in the existing housing stock. Now that the bubble is bursting, there are fears of a general financial crunch.

Perhaps, but there is still one more river to cross. If the central banks and oil funds that currently finance the US external deficit continue their willingness to hold dollar assets, the money will simply have to go somewhere else. It can finance government and corporate debt, driving down interest rates. It can go into purchases of US companies, goosing the stock market. As long is it has to go somewhere it will.

The risk, of course, is that at some point the sovereign entities on the receiving end of the massive dollar flow will decide that enough is enough. Perhaps the extent of losses they will suffer due to the mortgage meltdown will force them to pull back. Maybe a private sector stampede, sparked by further bad news about defaults, will overwhelm the ability of CBs to stem the tide and sustain US financial markets.

The larger story, however, is that, as long as the US economy chugs along in a temporary equilibrium of massive external borrowing, bubbles of one sort or another are inevitable. That’s why it’s an equilibrium and also why it’s temporary.

The web is ablaze with talk about Iraq, oil and the latest passing comment from Alan Greenspan. Let’s be clear:

The Iraq war is not about controlling oil. There is a global market in the gunk, and if the US or anyone else has difficulty getting it from country A it can always turn to country B. Also, no otherwise poor country would ever, ever refuse to sell oil for any prolonged period of time. It’s the difference between being important and having some leverage, and being a nobody. Quite aside from whatever you think about Hugo Chavez’ policies, where would he be if he stopped pumping and selling oil? So, no, there is no threat that any oil producing country will cause chaos by dismantling its industry or even reshuffling its sales contracts.

It could be about setting OPEC quotas, maybe. The countries the US hates and tries to undermine tend to be OPEC hawks (Iran and Venezuela). But it is not clear that those who set US priorities are so in favor of cheap oil either. There are also less expensive ways to influence OPEC.

Then what’s it about? The oil money. It’s big, one of the primary forces in the global economy. If Everett Dirksen had been a sheik, he might have said, “a few hundred billion here, a few hundred billion there, and soon you’re talking about real money.” Who gets this moolah and what they do with it is what it’s all about.

Washington has two overriding imperatives. First, the money should not be used to fund political movements the US opposes. This includes Chavismo, Islamicism or any other attack on liberal capitalism from the left or right. Second, the money should be recycled to banks with the appropriate dollar and euro portfolios, lest financial imbalances lead to a run on the hegemonic currencies. (OK, maybe there is no alternative if you have to put an unimaginably large sum somewhere, but it remains an imperative.) The blog folk wisdom about “the war was because Saddam wanted to price oil in euros” is technically wrong but gropes after the right answer: those who are allowed to rake in the oil billions must be counted on to send them back to the proper address.

Follow the money.

The drumbeat for carbon taxes has begun in earnest, and if we don’t pay attention we may wake up one morning a year from now and find the issue has been settled and a rare opportunity has been lost.

Mankiw has a piece in today’s New York Times that says the intellectual battles are over, and now it’s time for a grand coalition to put a tax on carbon. He gives these arguments:

1. Carbon taxes use a tried-and-true method for curtailing something we don’t like, in this case pumping carbon into the atmosphere.

2. We can use the revenue to cut other taxes, like the income tax. The taxes we cut have harmful effects on the economy, so we reap a double bonus: less bad stuff (carbon emissions), more good stuff (economic growth).

3. The only alternative to taxes is cap-and-trade. This opens the door to giving away carbon permits (bad), and if we somehow manage to auction them the result is identical to a carbon tax.

4. Each nation can set its own carbon tax, so we don’t have to worry about coordination. A global permit system would enable polluters in the US to buy carbon offsets in China.

In each case Mankiw is wrong, in some a little, in others a lot. It all adds up to a questionable sell job.

1. Yes, putting taxes on things we want to discourage is an old, time-tested idea. (Incidentally, it long predates Pigou. Do you remember a harbor fracas just before the American Revolution?) But so is issuing permits. We have permits for hunting and fishing, also for marriage. (One to a customer.) Neither involves reinventing the wheel.

2. Mankiw makes this argument because he believes that income, corporate profit and other taxes prevent the economy from reaching the free-market bliss it could otherwise attain, He knows government has to raise money, but he thinks it causes wicked distortions when it siphons off some of the earnings stream. This is faith-based economics, however. There is no systematic evidence that the income tax leads people to work less, and even if it did, it may just be the case that many of us should work less. If Mankiw’s travels take him to Cornell, he should have a Frank discussion on this topic.

But relying on carbon taxes is also a terrible way to finance the government. We are talking about half a trillion dollars or so in revenue, so the percentage of financing would be quite large. Income fluctuates, and that is a problem, but the spending on a particular set of items, like fossil fuels, has the potential to fluctuate even more. Example: suppose we really are facing an oil production peak, and scarcity causes the price to spike? Every 10% rise in oil prices will tend to cause something like a 5% reduction in long run demand (I’m rounding here – and thanks to Gar Lipow for his valuable work in collating the evidence), but this also means less carbon tax revenue, potentially a lot less. This is a serious problem, one that the green taxers have not really confronted.

3. Cap-and-trade and cap-and-auction are two entirely different animals. The first gives away the permits to historic polluters, the second asserts the public’s ownership of the commons and charges a price for its use. It is true that the dominance of wealth over our political system often leads to giveaways like cap-and-trade, but that’s a fight we can’t avoid in any case.

The real wonder here is that Mankiw could make such an elementary economics error as to suggest that taxes and cap-and-auction are “effectively” the same. In an uncertain world this is false. From a conventional benefit-cost perspective, Weitzman showed long ago that there were important differences depending on the slope of the marginal benefit and cost functions. Translated into common English, if we are uncertain about the long run relationship between the price of carbon emissions and the amount of emission – and we very much are – and if the risk of allowing too much climate change is greater than the risk of economic indigestion from trying to be too green – which seems pretty clear to me – then permits are the right choice. By controlling the number of permits we control our most important impact on the earth’s carbon budget, but allow prices to wander. By setting a tax we control the price but allow the amount of pollution to wander. That’s a big difference: you might say, given the gravity of what is at stake, that it’s the difference between ecological responsibility and irresponsibility.

4. Both taxes and permits create the same problem. If one country takes stringent action of either sort and another doesn’t, producers in the less-green country get a competitive advantage. If you have a permit system, they don’t have to pay for the permits; if you have a tax system, they don’t have to pay the tax. What to do? There have been mumblings from Europe about a green tariff to offset these differences, which makes sense to me. This is a discussion we need to have no matter what system we put into place.

Mankiw doesn’t seem to have paid attention to the global debate about climate equity. In the long run, there is no defensible argument against allotting each of the planet’s residents the same carbon “space”. In the short run, the rich countries start out with more because they can’t cut back to the sustainable level immediately without causing themselves and everyone else grave harm. But they also have an obligation to take action first and more aggressively since it is the accumulation of carbon in the atmosphere that causes the problem, and us industrialized types have been adding to this accumulation for a hundred years or more. Kyoto was a bumbling attempt to implement this ethical framework; hopefully we will do it better in the future.

The reason we need global action is that it is a global problem. Countries that fail to act free ride off of those that do. This points to the need for a stronger climate treaty, but no such treaty would try to tell countries what methods they should use, only what results they should be held to. So Mankiw’s discussion of taxes vs permits in the global context is confused and, in the end, irrelevant.

Bottom lines: (1) Although we still have (soon to be extinct) dinosaurs blocking the path, there is now a general consensus behind aggressive action to forestall the most extreme climate change. If Mankiw had published this article five years ago I would have welcomed it. Today, however, the question is what to do about the problem, and I would strongly encourage those who put ecological responsibility and social justice first to stick to their guns. We should have permits because they put the planet first, and we should auction them and distribute the revenues on a per capita basis because it is fair and economically sound. (2) It is a mistake to get drawn into a debate over how high to set carbon taxes. No one wants to pay taxes. The result will be a half-hearted effort riddled with safety-valves and loopholes. Perhaps this is why the big money is behind a tax approach: they know they will be let off the hook. When we talk about how many permits to issue, on the other hand, the debate is over how much carbon accumulation, and therefore how large a risk of catastrophic climate change, we are willing to accept. That’s the conversation we need to have.

The New York Times has a story today about John Dingell’s change of heart on climate policy. The auto industry’s point man in Congress now favors a stiff tax on carbon emissions. There has been an undercurrent of suspicion that he has rallied to the least popular approach to the problem in order to discredit it. The Times’ Leonhardt gives Dingell the benefit of the doubt.

What I didn’t like were Leonhardt’s claims that a carbon tax “is the climate solution that economists and environmentalists have long dreamed of” and that the only alternative is cap-and-trade, giving away emission permits to longstanding polluters. The third approach, and by far the best, is setting up a permit system and auctioning off each one of them.

There are two reasons why permits rule. (1) There is great uncertainty about the future relationship between carbon prices and pollution levels (long run elasticity of demand for fossil fuels). Taxes place the burden of this uncertainty on the environment (the amount of pollution); saleable permits place it on costs faced by energy users (fossil fuel prices). (2) Politically, if we go the tax route, we end up in a discussion about taxes. That’s why skeptics thought Dingell might be boring from within. If we center the policy on permits the debate is over how much greenhouse gas emissions we are willing to tolerate. That’s the discourse we need.

Folks, this is a very important issue at a very important time. In the next year the contours of the national debate over climate change policy will be set. Huge ecological consequences – and gobs of cash – are on the line. It is essential to start off in the right direction. I’d like to see enough clarity and truculence in the activist community that journalists are forced to take notice.

A recent discussion of industrial policy on Dani Rodrik’s blog got me thinking. When the phrase “industrial policy” comes up (as I’m sure it often does at the wild parties our readers get soused at), we think of government commissions that “pick the winners”, funneling credits and subsidies to the embryonic Industries of the Future, while showing the door to the enfeebled Industries of the Past.

My experience in Germany, however, showed me another model. A society can favor the development of certain types of industries via a mosaic of education and training institutions, stakeholder-oriented financial institutions, vibrant local and regional economic development initiatives and the like. In other words, IP can be bottom-up rather than top down. When Germans think IP they think France, where all decisions are made in Paris, but a foreigner can see that Germany has its own form of IP, one that probably works better and is more participatory.

The next step was to think again about John Dewey and his ideas for the extension of democracy (his strong democracy, not our current weak one) into the economy. Open up a system like Germany’s to even more participation and you would have something like what Dewey had in mind. (The old guy called it “socialism” but admitted it didn’t look much like what the rest of the world called socialism.) But Dewey’s concern was not only political but (ahem) pragmatic. It was essential that the system should really work and not just be politically agreeable. Most of his analytical juices went into that part of the problem, and I think much of his insight could be translated into IP-ish terms. He was also off base on some matters (such as an overly optimistic conception of the role of science), and we can learn from that too.

Kevin Q. can probably spin rings around this post – I’d be happy if he would.

Hmmmm. I guess I should say a word about myself, so as not to be too different from everyone else? (Q: What are you going to do when you grow up? A: Find some people, dress like them and follow them around. –Firesign Theater)

I am Peter Dorman, an economist and long-time political obsessive, not affiliated with any school, camp or fire ring. I teach at the Evergreen State College, known for its extraordinarily demanding brand of wanton indulgence. I do a little of this and that academically, never wanting to specialize to the point of accomplishment boredom. Some topics over the years: occupational safety and health, benefit-cost analysis, trade theory, international political economy, child labor, unemployment insurance, climate change, the precautionary principle.

Bloggers seem to be pronouncing themselves on free trade and liberty, so for my part I will say I have theoretical and political issues with the justification for unregulated trade, and I would like to reduce the role that hierarchy and authority (institutional not moral) plays in our world. What really irritates me is nationalism, the utopia of ages past that has now attained a gruesome hegemony.

I will mostly post on economics-related matters, since I figure the web is overrun with everything else, and because I think there is mostly a big hole where serious economic thinking ought to be in the discourse of the left.

Before the Crandall Canyon disaster recedes into media oblivion, it’s worth spending a moment to think about what economics does and doesn’t have to say about this grisly series of events.

The standard theory, which can be found in any labor economics textbook and even some principles texts, is that dangerous work is essentially a non-problem. Workers will only take a dangerous job if they get extra pay to compensate. This gives employers an incentive to make jobs safer up to the point when the cost of more safety exceeds the added wages they would have to pay. The result: the level of safety is efficient (marginal benefit of safety improvements equals marginal cost), workers with a taste for risk are efficiently matched with employers whose technologies make risk harder to reduce, and workers in dangerous jobs are no worse off than those in safe ones, since they have bigger bank accounts to keep them happy. There are two big regulatory implications: interference, like enforcing safety rules, is against the interest of both workers and employers, and the wage-safety tradeoff can be used to calculate a “value of statistical life”, which comes in handy whenever cost-benefit analyses need to be performed.

I kid you not.

The “consensus” view in the profession is that a wealth of empirical data validates this theory. The Environmental Protection Agency holds earnest discussions on whether the value of a life should be raised or lowered a bit, or perhaps set at a higher level for some groups (like the rich) compared to others.

There’s no point getting into a full-scale disquisition on this topic; my book from 11 years ago says it all. (Except for everything I’ve been saying since then….) One pertinent question we might ask, however, is this: what, if anything, does conventional economic theory tell us about a disaster like Crandall Canyon? Is this a theory for large data sets only, or can it be applied to a particular incident? My view: if it doesn’t make sense in any particular case, it doesn’t make sense in 60,000 cases.

So what do we have?

1. Efficiency: no, with the practice of retreat mining.

2. Risk-loving workers: we don’t know the psychological profile of the miners, but it would be outrageous to claim that the courageous rescuers, three of whom died on the job, simply had a higher tolerance for risk. Not knowing the difference between getting a kick out of risk and putting it on the line for others is typical of utility theory.

3. Fair distribution of risk: dubious. The tipoff is that three of the six miners now buried in the mountain were Mexican nationals; my guess is that they were not being offered whatever plum jobs were available in rural Utah.

Would it be too much to ask for an economics that, instead of spinning fantasies, asked practical questions like, what kind of labor market structures lead to this devaluing of human life? How can competition be prevented from leading to a race to the bottom (OK, not the best metaphor for coal mining) in safety practices? What forms of regulation can most effectively achieve the essential goals of public health and social justice?