Skeptonomics

It’s good to see that Paul Krugman is channeling Marty Weitzman on the urgency of preventing catastrophic climate change. Here is what the Weitzman analysis means for economists.

Weitzman argues forcefully that in the face of extreme risk and great uncertainty, the quest for “optimal” policies is futile. The point is simply to insure against the worst, and that will mean very aggressive programs to stabilize greenhouse gases at a tolerable level. (Bill McKibben wants us to memorize 350 ppm.) It turns out that stopping runaway climate change is at heart an ecological problem, not an economic one.

Meanwhile, a whole industry of economists, financed by clueless foundations, are barking up the wrong tree. They assemble and run dubious CGE models estimating marginal costs and benefits, as if anyone in a position to make decisions really cared. In fact, not only is there no reason to believe this line of research has anything to offer, there is no evidence that the advice of economists, even heavy hitters like Nordhaus, have or will have any effect on the main policy parameters, like carbon targets and timetables.

So what should we do with all the economists freed from the quest for the true dollar value of a ton of carbon? Put them to work anticipating the impact of an impending carbon cap and coming up with measures to adapt as painlessly as possible. What regions and industries will be most affected? What policies can smooth their transitions? How much of the capital stock will be written off before amortization and with what affect on employment and the financial system? What are the most cost-effective ways to increase the elasticity of demand for carbon-intensive goods? That is, how can we foster substitutes, fast?

Why are hundreds of economists laboring night and day to answer questions no one with any sense asks any more, while the critical issues of economic adaptation are almost completely ignored? Why are we about to walk blindly into a carbon-constrained world?

That’s the economic wisdom behind an op-ed piece in today’s NYT by Victor Davis Hanson, a former classics professor and current columnist for the National Review (where he extolled the “humane treatment” of Guantanamo inmates in a recent offering). Far be it from me to defend the current level and especially pattern of subsidies, which go largely to the wrong people for growing the wrong things in the wrong way, but I’d love to see the economic model that shows how agricultural subsidies lower food output in a hungry world.

Due to the advertising you see on the left, EconoSpeak has a karmic debt to repay concerning the Peterson Institute. In that light, please deplore with me the free pass given to Peterson’s fear mongering in today’s NY Times. All the usual obfuscations were served up: bogus projections of Social Security, the lumping together of Social Security and Medicare, the specter of a supposedly-unprecedented increase in the percentage of retirees in the population. The headline reflects the tone of the article: swallow the gunk without asking any questions.

As for the present, a fiscal deficit of 4% of GDP (first quarter 2008) is entirely reasonable for an economy sinking into a recession. (Spending priorities are bonkers, but that’s another matter.) Long term, Social Security doesn’t need to be fixed; health care does, but this is not primarily a fiscal issue. And the real monster in the closet is the current account deficit, which goes completely unmentioned by either Peterson or his interviewer.

A billion dollar PR budget can’t turn this sludge into syrup.

The headline in the NY Times says the improvement is the result of a weak dollar, but, as usual, we learn more from folks like Brad Setser and Menzie Chinn, along with a quick perusal of weekly petroleum delivery data from our hardworking friends at the US Energy Information Agency.

For once, oil imports are down, even on a value basis. A 10% physical decline in imports is consistent with a 6% decline in total physical consumption. A rough cut at the EIA delivery data, however, shows a decline of only about 1% from April to May. The interesting information is not the total, though, but the composition. Motor vehicle and aircraft fuel were up, but were more than offset by large declines in heating fuels. There is no evidence of seasonality in these series, so we can’t jump to conclusions, but it may not be unreasonable to suppose that this boost to the US trade position is less sustainable than a similar reduction in travel might be. Those who follow these fuel data more closely than I do should feel free to chime in.

Meanwhile, if Chinn is right and contemporaneous measures may be overstating GDP, some to all (or even more than all) of the trade improvement could be attributable to a US slowdown. This is entirely in line with economic theory, but it is not such good news: if the US has to bring down its trade deficit substantially on the back of its economic growth, we are in for one long, miserable ride.

Actually, it’s worse than that, since, in the context of existing financial fragility, a slump in the real economy portends disorder in financial markets. One reason among many: the longer and deeper the incipient recession, the further and faster housing prices will fall, and the greater will be the default risk so liberally distributed across a range of credit instruments. And to return to my repeating nightmare, it is near certain that any serious implosion of US financial markets will morph almost immediately into a dollar crisis. If I were Ben Bernanke I’d be laying in a supply of my favorite hard stuff.

Tuck away this latest post by Menzie Chinn, who has illuminating things to say about the reliability of GDP and CPI estimates.

I could blog every day on the harebrained schemes being cooked up to deal with rising oil prices, but in the interest of efficiency I’ll focus only on the worst. Certainly holding its own among the goop at the bottom of the $136 barrel is this suggestion from Harry Reid, according to today’s New York Times:

He [Reid] also hinted at a potential element of compromise legislation: that any oil produced from wider access to federal lands off shore be reserved for domestic use and barred from export.

How patriotic this sounds, until you realize that the US exports virtually no oil, consuming all it produces and then another 150%. But even if we did export some of the off shore supply, so what? Suppose we export 100,000 barrels we would have consumed and then import an extra 100,000 barrels to make up for it, how would this affect energy prices, the current account, global warming or Reid’s majority in the 111th congress?

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?

If there were any doubt that old fashioned Tory moralism is alive and well in (temporarily) Labor England, this crazy idea should dispel it. It plays on the “personal responsibility” trope at the expense of any hope of getting the job done fairly and efficiently. To wit:

1. If you have a national cap, you have a national cap. Enforce it and people’s carbon emissions have to fall in line according the laws of arithmetic.

2. How on earth are you going to put carbon prices on each and every personal decision, especially if you take life-cycle and indirect effects into account? After all those years of Maggie channeling Hayek you’d think the basic lessons of the socialist calculation debate would have rubbed off.

3. The more upstream the cap, the more flexible and efficient the system will be. Capping each individual’s consumption is as downstream as you can go. Upstream capping means that the advantages of shifting the economy across sectors, technologies and the like would be transparent and seamless: if the higher cost of carbon results in an investment in rail transport being more productive than one in highways, you can transfer the resources and adjust in a lower-cost way to the cap. If you have separate caps for separate activities this visibility and flexibility is lost.

4. And the whole scheme is based on the misperception that an economy-wide carbon tax—or even better, an economy-wide cap—bleeds households. Yes, of course, taking money from households would do this, and the tax/cap would function much like a regressive sales tax. But wait: the money has to go somewhere. The simple solution is to give it back on an equal per capita basis. This reimburses the public and turns a regressive transfer into a highly progressive one. Much more sensible, I would say, than moralism run amok.

Why am I not surprised that the newly announced Milton Friedman Institute will be located in the former Chicago Theological Seminary?

Or so the sign says in Uncle Sam’s Petroleum Saloon, a.k.a. the US Energy Information Agency. Take a look at the monthly forecasts from February to May—the price of oil is always supposed to go down, wherever it is. I’d love to look at the model that generates this serial silliness.

(Thanks to Kevin Drum.)

McCain gave a major policy speech on climate change yesterday. Politically, we might consider this a lower bound on potential federal action next year, so here is a rough assessment of its hits and misses.

1. Sizing up the problem: McCain is forthright on much of the science of climate change. He recognizes it is happening now and is likely to intensify, that human alterations of the carbon cycle are responsible, and that it is imperative to reverse this trend. To put it mildly, this constitutes a big shift away from the doctrine that currently rules Washington. He can be faulted, however, for failing to draw attention to the very real threat of catastrophic climate change Weitzman, among others, has been calling attention to.

2. Mitigation: Many of the consequences of climate change, like sea level rise and disruptive changes in precipitation patterns, are already in the pipeline. McCain recognizes this and accepts a federal role for helping communities defend and cope. I give him credit for this.

3. Instituting a carbon cap: McCain, as he has for several years, endorses a nationwide carbon cap. He is a bit vague on how far upstream he would impose it. This is a rather wonkish topic for a campaign speech, but it has a lot of practical importance: the further upstream the cap, the less scope there is for playing politics with coverage.

4. Emissions target: McCain wants a 60% reduction by 2050. Mainstream opinion, reflected in the Clinton and Obama proposals, targets an 80% reduction, and even this may not be enough in light of the evolving understanding of positive feedback mechanisms in global carbon cycling. In my opinion, however, this is the least significant shortcoming of McCain, since the cap mechanism would readily enable progressive tightening as the political will materializes.

5. Offsets: This is a big problem. McCain headlines his enthusiasm for offsets, suggesting that 40% of the emissions target can be reached simply by trading off for carbon sequestration in domestic farmland. Despite his assurances, it is highly unlikely that offsets will achieve true additionality, not to mention the still uncertain state of our understanding of long run carbon cycling in forests, farms and soils. In my opinion, one should deduct the amount of offsetting allowed to estimate the true cap. If McCain will accept offsets up to, say, 50% of his cap, he is guaranteeing a reduction of no more than 30% by 2050. Obama and Clinton, by contrast, eschew offsets. And offsetting is a political nightmare, dangling billions of dollars in manufactured profits in front of business interests and creating the biggest rent-seeking operation in human history.

6. Allocation: This is another big problem. McCain will simply give away all the permits at the beginning, and in his speech he offers only the vaguest of promises that some portion will be auctioned in the future. Every citizen should know that a cap will causes consumer prices to rise for carbon-intensive products, and if producers get the permits for free they keep the difference. Giving out permits is giving out profits. Every permit should be auctioned from the get-go, and Clinton and Obama are both in accord with this principle.

7. Recycling: If some of the permits are eventually auctioned, McCain would have the government keep the revenue and use it to make infrastructure and other investments. It is easy to see the rationale for this approach, but it is nevertheless a mistake. As much of the revenue as possible should be recycled to households. There are three reasons for this. First, the price increases resulting from the cap will take the form of a highly regressive sales tax, hitting low-income families the hardest. This effect needs to be countered by progressive recycling. Second, the price increase, like any tax, will have a depressive effect on the economy. In theory, if the government could spend the money as fast as it takes it in there would be no problem, but experience shows this is difficult to achieve. It is better to reinject it back into households. Finally, we are talking about a concentrated effort that will have to continue for over 40 years—at least two generations, without so much as a pause. To make the political support for a rigorous climate policy bulletproof, household incomes have to be protected. The climate plan of the future has to be like Social Security, so financially beneficial for so many people that its most rabid ideological opponents will not be able to dent it.

8. Border adjustment: McCain explicitly supports a carbon adjustment tax to prevent leakage via international trade. This is a necessary and important feature.

9. Nuclear energy: A lot of environmentalists are going to focus their ire specifically on McCain’s enthusiastic support for the nuclear option. At the risk of alienating all of my green friends, and the green half of my own brain, in light of the extraordinary risks of catastrophic climate change I think nuclear power has to be given an unbiased look. On the other hand, if it is to have a future, it must be one that does not depend on artificial subsidies, such as the Price-Anderson cap on liability and the failure to safely close the fuel cycle.

10. Regulation and public investment. McCain talks as though, once we’ve set the right price signals via a carbon cap, the magic of the marketplace will take care of the rest. Would that it were so. For better or worse, however, a nationwide cap will require complementary policies at all levels to make adjustment smoother and more manageable. Fuel, appliance, and construction standards will all have to be raised. Government will have to make large investments in research and development. Above all, we need a crash program in new, energy-saving infrastructure in our electrical grid and especially mass transit. These policies are not alternatives to a cap: they make it possible to meet the goals of the cap without bringing the economy to a standstill. Because the investment portion of this program will not begin to pay off for several years after it begins, there is a strong case for starting it before the cap goes live.

So here is my overall assessment: McCain’s approach represents a real improvement in some respects, but it falls far short in others. I’m not worried about the weak target; we can fix that as the need becomes clearer. The permit giveaway and the offsets are much worse, because they will create powerful constituencies determined to keep the spigot open and flowing. Failure to recycle will poison the political climate, creating the impression that to be for a responsible climate policy is to be against the living standards of working class America. And we can’t afford further delay on the wide range of regulations and investments we need to make a carbon cap succeed.

Since the commentary is continuing on the apparent political damage that the Wright affair has had on the Obama campaign, let me add my own view. Obama’s appeal to whites is based on his presentation as completely “safe” and unaggressive, the opposite of the feared “black militant” that still haunts white America’s imagination. He overflows with nice in order to neutralize racial paranoia. And this is why his association with Rev. Wright has been so costly: it reignites subterranean white fears that Obama’s political style takes such great pains to allay. Context is everything. (And the lack of a corresponding context is what makes McCain’s association with frothing right wing ministers politically irrelevant.)

This has nothing to do with what you may think about the good reverend’s jeremiads, some of which I think are right on target and others bizarre. It’s about a battle of racial subtexts.

It also poses another problem for Obama down the road. Quite a few voters think he’s a Muslim, and the web rumor mill will crank this up to a fever pitch as the election approaches. The simplest rebuttal would be to emphasize his church-going, but this will remind people once more of Wright. Forget about the flag pin; Obama needs to wear a giant neon cross.