Skeptonomics

Slopping thinking by the great mathematician has been enshrined for decades in the undergraduate economics and statistics curriculum. You know the story: the problem of whether to believe in the Christian god and follow church teachings can be formulated as one of expected value, the cost in pleasure of being religious times the likelihood that there is no such god compared with the cost in eternal damnation times the probability that the Bearded One actually exists. The small likelihood of divine existence is outweighed by the even greater imbalance in the value cofactor. Except that it’s all wrong.

There are different ways to approach the issue, but the simplest error is that of assuming only two possibilities, no god or the one particular god promulgated by Pascal’s church. Logically, the case for a Christian deity is no stronger than for many other pretenders. Pascal could follow all the church precepts, die and come face to face with a Hopi god, for example, or maybe a god no human group had latched onto. Perhaps the “godly” practices Pascal had adhered to would just annoy the true, ex post god. Or maybe, if there is a god, this omnipotent character has no self esteem problem to speak of and doesn’t care whether lowly mortals love, hate or ignore him/her/it. And I’m leaving out a wide swath of other possibilities, from multiple godheads to extra-dimensional beings we can’t begin to conceive of.

The point is that the expected value formula works only if you calculate over the full set of possible states or outcomes; the p’s have to add up to 1.

I’m reminded of this because of the column by Peter Bernstein in the Sunday NY Times, which repeats the Pascal chestnut even as it invokes the spirit (but not the name) of Nassim Nicholas Taleb to argue that we should anticipate the unexpected.

Oil prices are very high and moving higher. In Asia and Europe there have been large protest actions, while the popular response in the US is still at the grumbling stage. This is likely to be an important issue in the US elections, and progressive candidates need clear, non-wonkish ways to frame and deal with the problem.

The strategy of choice right now seems to be “blame the speculators”, and Obama has jumped on this bandwagon. Not a good idea, in my opinion, for two reasons. First, there’s not much evidence that speculators are the cause of this price runup. Second, high oil prices—in fact, much higher oil prices—are good. They will combat climate change, slow down the environmental destruction of sensitive drilling areas and conserve a nonrenewable resource for future generations.

So what’s the alternative? The problem is not that oil is expensive, since burning it is truly costly for the human race, whether we pay the monetary price or not. The problem is that the money ends up in the hands of governments and oil companies that get rich simply because they’ve captured the resource. In economic terms, it’s the problem of rents: vast sums of money are being transferred from us, the consumers, to those who control a commodity in high demand but limited supply. And the solution is to get the money back. This is another reason why we need a cap-and-rebate plan for carbon. Put a tight cap on carbon fuels. Auction all the permits. Give the money back to the people. By drastically lowering demand we also put a lid on the price of oil at the wellhead. In other words, rather than paying lots of money to Exxon and the Saudi royal family, we pay it back to ourselves. Either way, oil will be expensive, because it has to be. But the solution is to get the money back, so we can protect our standard of living in other ways that won’t imperil the planet.

It’s been two weeks since I put out a challenge to proponents and practitioners of computable general equilibrium (CGE) models. As you may recall (or if your short-term memory falters, reread), I pointed out that, in light of well-known issues in general equilibrium theory, and after 30 years of experience, the time had come for those who believe in CGE to step forward with performance data. Is there any evidence that predicted CGE results hold in the real world, or that CGE methods are seen as useful in the marketplace? Or is this simply a self-perpetuating enterprise, feeding off academic and government contracts in a world where results don’t matter?

In addition to its thunderous presence on EconoSpeak, my challenge was mirrored in several other venues. Thanks to the magic of Google, I was able to monitor the comments posted around the blogosphere, and here is what I got: nada. Oh, I read several lame arguments that it is in the nature or purpose of CGE that real-world performance data are impossible to come by or that they wouldn’t matter anyway, but no one had even a shred of evidence to offer.

So here we go again, and I will be more explicit. Unless anyone can demonstrate otherwise, I suggest that CGE is an academic bubble whose intellectual value is grossly inflated, and which will crash to earth once the idea dawns that conjectures are no substitute for results. Those who currently buy this sort of analysis, not to mention those who make the career decision to invest years in learning its technical arcana, are throwing away their time and money. There’s no there there. Show me why I’m wrong.

There is a lot I could jump on in Roger Lowenstein’s witless diatribe in today’s New York Times Sunday Magazine, but let’s keep it simple. Lowenstein, claiming to paraphrase Gary Hufbauer of the Peterson Institute (who should either sue for libelous misrepresentation or go into a different line of work), writes: “Thanks to the cheap dollar, U.S. exports are booming; trade is now the economy’s strong suit.” Now read that last clause again: “trade is now the economy’s strong suit.” Um, no. Have I mentioned that we have numbers on that?

It is a commonplace of international economics that virtually all economies obey the Marshall-Lerner conditions, which must be met if a change in the exchange rate is to have the “proper” effect on net exports. It’s just possible, however, that this no longer applies to the US. When the dollar falls, US exports rise and non-oil imports fall by enough to otherwise satisfy M-L. But much of the rise in oil prices, as experienced in the US, is also attributable to the decline of the dollar, and our demand for brown goo is (so far) highly inelastic. As reported in Brad Setser’s invaluable blog, this explains why the US trade deficit increased in April despite deteriorating domestic demand. So: has the US left the predictable world of M-L? It depends. How much of the price spike in petroleum is traceable to the fading dollar? How do we parcel out the role of declining domestic demand from that of dollar depreciation on the trade balance? I’m too involved in other things to figure this out, so I place it in your laps, estimable readers.

I just got around to reading an important paper, “Current Account Patterns and National Real Estate Markets” by Joshua Aizenman and Yothin Jinjarak. Looking at a sample of developing and developed countries over the period 1990-2005, they find the current account deficits are the main explanatory factor for real estate appreciation. (It would be clumsier but more accurate to say real real estate appreciation, since prices are deflated by the GDP deflator.) Their work is careful, and their empirical model accounts for 70% of the variation they study. Running a current account deficit results in higher real estate values, especially in countries with more developed credit markets, but this effect is somewhat reduced where there is less country risk. The authors control for the appropriate confounders, such as interest rates. In fact, external balances play a bigger role than interest rates in real estate markets, a surprising result.

This is consistent with the position that I’ve taken on this blog, that the inflow of funds to finance our current account deficit renders the US susceptible to asset price bubbles, and that the runup in housing values was just one (but a very big) manifestation of this. If I’m right, and if the housing channel is being shut down, some other bubble is indicated.

Problem: McCain will define himself as tough and resolute in foreign policy, committed to defending us vulnerable Americans from the wolves near and far. Implicitly, and perhaps explicitly, this will paint Obama as weak, confused and incapable of assuring our safety. This is a matter of images, not reality, of course, but that’s how elections work.

Analysis: Obama’s counter-image is that he will restore America to respect around the world, rebuilding alliances and replacing bellicosity with diplomacy. Against this backdrop, McCain’s foreign policy would take on the hue of Bush, continued. One challenge Obama faces is how to convey this impression visually and viscerally. Fear and retaliation are easier to package than cooperation.

Solution: Obama should undertake a foreign campaign trip this summer, publicly appealing to American voters overseas, including both civilians and military expats. He could explain that America is itself now globalized, with its citizens scattered across the continents. His trip could then be portrayed as a campaign swing like any other. But holding enthusiastic mass rallies across Europe and Asia especially, Obama could deliver exactly the we-are-the-world images that would give emotional resonance to his political stance. Honestly, I don’t see what McCain could do to diminish the power of this strategy.

This report from the front shows how important it is to get the basics right in climate change policy. The more discretion the federal government has in how many permits to allocate to which industry, and how many should be given away and to whom, the more the whole program will be swallowed up in political gridlock and rent-seeking. There are five big principles to follow if we want to avoid this nightmare scenario:

1. Cap carbon as upstream as possible, at its source rather than its use. Any entity bringing coal into the economy, by mining or importing it, should have to have a permit. Don’t put the government into the position of deciding who should be given a special dispensation to burn it.

2. Auction all the permits. As soon as you accept the idea that some of them should be given away, you have to pick the lucky recipients. These permits will be worth real money, and so will political influence. (Corollary: recycle the revenue, so households are protected from price increases, and to lock in political support for serious emission limits.)

3. Don’t allow offsets. Measurement of how much carbon the offsets really offset will always be fuzzy, and wriggle room will be sold to the highest bidder.

4. Tax imports that aren’t produced under a carbon cap. If other countries delay in setting up their own policies, adopt a transparent tariff schedule based on embodied carbon content, ideally under the auspices of an international, disinterested body. This will address much of the competitiveness fear, while producers gear up for long-term advantage based on innovative responses to emissions caps that will eventually be adopted worldwide.

5. Adopt sector-specific technology subsidies and mandates. Don’t fall into the either/or trap: carbon capping provides the architecture, but there is still a need for policies that mobilize a coordinated response in dimensions like research, infrastructure and breaking down the institutional barriers to innovation. Fuel and appliance efficiency standards, large-scale public investments in new technology, installing a higher-tech electrical grid, mass transit—these are the kinds of measures that will make it possible for us to make a reasonable life for ourselves under an ever tightening carbon cap.

I’m currently working with Sightline Institute in Seattle, monitoring the economic analysis phase of the Western Climate Initiative. WCI, which consists of seven US states and three Canadian provinces, is cooking up a common carbon emissions plan, and a consulting firm has been brought onboard to help clarify the economic implications of different policy alternatives. There are many issues specific to this project I may return to later, but for now I’d like to put the spotlight on the methodology WCI will be relying on, CGE modeling. I think these models are so dubious theoretically and unreliable in practice that there is no case for using them. In particular, I am issuing a challenge to their defenders: if no one can answer it, the case is closed.

On a theoretical level, it is surprising that CGE modeling has become such a vibrant industry, since its underpinnings in general equilibrium theory have been systematically undermined over the past several decades. (1) CGE models use the technique of representative agents—vast numbers of households and firms are treated as if they were a single decision-making entity—when we now know that multiple agents cannot be modeled as if they were just one. (2) In particular, the Debreu-Sonnenschein-Mantel result demonstrates that full knowledge of all supply and demand relationships in an economy is not sufficient to predict the equilibrium the economy will arrive at when it is not there yet. (3) The behavioral assumptions of these models, typically resting on utility maximization or simple modifications of it, have been empirically falsified. (4) Production and utility functions are routinely chosen for their convexity properties, despite the widespread recognition that nonconvexities (that yield multiple equilibria) are rife. In short, if theory should inform practice, we shouldn’t be doing CGE.

Now for the challenge. As far as I know, there has never been a rigorous ex post evaluation of CGE models in practice, one that compares predicted to actual outcomes. Based on performance, is there any evidence that such models add value—that their predictions are any better than those derived from macro or sector-specific models, or even a random walk? Also, are CGE models employed by any private sector players who bet real money on the results, or is it only in academia and the public sector that CGE modeling is taken seriously?

My challenge is for those who think there is anything to CGE to come up with evidence that their forecasts add value—either careful retrospective analysis, market applications or both. If not, after more than three decades of experience to go on, why shouldn’t we draw the conclusion that this is a self-perpetuating enterprise promulgated by specialists who sell not an improved ability to make forecasts, but a patina of high-tech respectability for agencies with no stake in whether their policies will actually perform?