Skeptonomics

Does anyone else see the irony in the ongoing panic in global asset markets? Last week we feared global imbalances; this week we fear they may dissipate.

Don’t get me wrong — the last thing I want to see is global rebalancing by way of a massive US recession. But why are investors from Hong Kong to Frankfurt getting spooked? They are signaling that they don’t think their economies are decoupled from ours, and that a US downturn means the global buyer of last resort is putting away his credit cards. The US will cease to be the bottomless export market, and sellers everywhere will stumble.

Maybe so, but drastically curtailing the US import habit is a necessary part of rebalancing; it is not possible for US exports alone to do the job. So the contagion we’re seeing demonstrates that the current imbalances have become addictive on all sides. (OK, rebalancing via recession lacks a terms of trade sweetener, but is that what the markets are freaking about?)

Econ bloggers have really missed the point about Landsburg’s free trade screed. The estimable Dani notwithstanding, the issue isn’t ultimately ethics or even procedural fairness. The problem is that doctrinaire economists understand less about trade than the average person with no academic training in the subject.

Ordinary people in many parts of the world, and not just in the US, worry about trade because they are afraid that jobs lost to imports will not be counterbalanced by jobs gained through exports. They worry that there will be fewer economic opportunities for them and their children. They worry that their wages or working conditions will be pushed downward through competition with even more vulnerable, desperate workers in other countries. They are right to worry about these things. Such miseries are not destined to happen, but they cannot be ruled out either.

Except in standard economic models which begin with the assumption that increases in imports automatically call forth equally valued increases in exports. If trade balances on the margin we live in the happy world of comparative advantage, and it is indeed true, as Landsburg says, that “when American jobs are outsourced, Americans as a group are net winners.” But the assumption that trade balances at the margin is simply a modeling convenience, something that enables Landsburg to regale his students with blackboards full of elegant diagrams and equations. It is not grounded in real experience, and especially not the experience of the US economy since the 1970s.

You have to be very well trained in economics and have high-level skills to make such a brain-dead assumption and not even know you’ve made it. Then you don’t have to give serious consideration to counterarguments because, hey, why pay any attention to the fallacies of economic illiterates and mathphobes?

But let’s get specific. Here’s how Landsburg illustrates his claim that international trade makes us better off: “I doubt there’s a human being on earth who hasn’t benefited from the opportunity to trade freely with his neighbors. Imagine what your life would be like if you had to grow your own food, make your own clothes and rely on your grandmother’s home remedies for health care.”

Notice a problem here? Landsburg assumes that there is no difference between trade within an economy and international trade. (To be more precise, the only difference is that governments interfere more often with trade across national borders.) Worse, he accuses anyone who recognizes the difference of woolly thinking, based of course on his assumption that there is no difference.

This is why the French students complained about autistic economics.

For what it’s worth, my view is that we as a society ought to provide opportunities for as many of us as possible to have a satisfying livelihood. If a community is down and out we should step in and do what we can whether or not trade played a role in creating the problem. We should create rules for international trade that minimize downward pressure on wage, environmental and social standards and that limit dangerous imbalances. These ideas are fairly widespread among the general population, and if economists think really creatively they might just be able to rise to the same level.

According to Leonhardt in yesterday’s New York Times, the fault line between Clinton and Obama runs through the rationality postulate. Hilary’s citizenry is rational and responds to precisely calibrated market incentives; Barack’s is guided by impulse and habit and can only be moved by big policy objects in bright colors with thick borders. Is this the revolution in economics we’ve been hearing about?

Leonhardt locates the Obama/Goolsbee strategy in the rise of behavioral economics, an approach that replaces robotic rationality with a psychologically realistic characterization of real-world decision-making. In particular, he is drawing on the field of behavioral law and economics, which emphasizes commonplace cognitive “biases” that prevent people from acting consistently in their own interests. Examples include “availability bias” (attributing greater-than-actual probability to outcomes that are vivid or widely publicized), “status quo bias” (resistance to switching from A to B, or if starting with B, from B to A) and the inability to cope with high levels of complexity (such as public benefits few apply for because the forms are too complicated).

With this view of human fallibility, it is not surprising that practitioners of this sort of economic thinking incline to paternalism. The non-biased minority with impeccable cognitive skills (you know who you are) must take it on themselves to guide their less capable brethren toward more rational choices. I exaggerate, but not too much, as those who have delved into this literature will recognize. Yes, there is elitism in the traditional incentive-based approach too, but it is at least honest and transparent in its methods. The flagship policy innovation of the behavior-wonks, making participation in private savings plans the default option, so that workers would have to choose to opt out (rather than making no savings the default and asking them to opt in), combines the we-know-what’s-best-for-you of the incentive school with a kind of tawdry manipulation. Of course, it may also work better.

But loyal readers of this blog should be aware that behavioral economics is much larger than its portrayal by Leonardt. For one thing, much research now focuses on the differences in behavioral patterns across the population. Rather than fixing on the central tendency, attention has shifted to the dispersion. What this will mean for policy is not clear at this point, but it has to lead to greater diversification and decentralization of the means and ends, don’t you think?

Another important departure concerns the emergence, reproduction and evolution of social norms governing economic (and other) behavior. Many, myself included, think this has enormous potential for changing how we think about politics and human well-being. It reintroduces cultural factors that have been banished from proper economics for generations, not least of which are the gender norms emphasized by feminist economists. And what about the effect that changes in governmental policies and business practices have on the norms governing income distribution? We have begun to see empirical work in this area and it is a safe prediction that we’ll see a lot more.

I hate writing these vague, sweeping posts, but it would take much more than a few paragraphs to properly document the upsurge in behavioral research. The point for now is: the policy space spanned by Clinton and Obama is minuscule compared to the opportunities for new thinking in economics that already exist.

The New York Times reports that Europe is gradually approaching the point of decision on whether to allow genetically modified corn. Because of WTO rules on such things, the EU is required to base its policy on “science” if it want to keep out mutant corn from the US. This reflects a deep, deep misunderstanding of what science can contribute to policy.

Let’s start with the basics. There are two sorts of error we can make in this uncertain world, Type I (the risk of believing something to be the case when it is not) and Type II (the risk of not believing something to be the case when it is). Science is, among other things, a human enterprise organized around the systematic minimization of Type I error. Experimental protocols are about this, and so are the conventions we follow in determining statistical significance. This obsession comes at the cost of permitting greater Type II error, but that’s OK. Science operates on the basis of a vast division of labor, where each scientist’s work depends on the reliability of the methods and results carried over from what others have done. One false conclusion, if not noticed in time, could invalidate the efforts of an entire research community. This is why a serious Type I error is a potential career ender, whereas an avoidable Type II glitch simply diminishes a researcher’s list of accomplishments.

This single-minded insistence on avoiding Type I error is the reason why science is the one truly progressive human activity. Today’s science is better than yesterday’s, and tomorrow’s will be better than today. You can’t say this about poetry or politics.

(It is also, in the end, why economics is not a “real” science: it is no big deal for an economist to claim something to be true and to later discover that it isn’t.)

Policy, on the other hand, has to take Type II error as seriously as Type I. Take the Bt corn case before the EU, for example. It is a problem if regulators falsely think Bt corn is dangerous and ban it, but it is also a problem if they falsely think it is not dangerous and allow it to be used. A reasonable first cut is the standard cost-benefit approach: value each sort of error in terms of its cost function. Thus the cost of banning Bt corn is the probability of Type I error (falsely believing it to be harmful) times the economic cost of not taking advantage of this technology, whereas the cost of not banning it is the probability of Type II error times the cost of the damage it would do in that case. You go for the lowest cost option.

(There is an even better approach, as I argued here, based on the fullest possible utilization of information.)

The difference should be obvious. Science is radically asymmetric in the way it treats uncertainty: avoiding a false positive is everything. Policy is more balanced: failure to see is potentially as harmful as seeing what isn’t there. If you happen to be the sort of person, as I am, who thinks environmental risks are particularly important to avoid, you might tilt the policy calculus on issues like Bt corn toward less Type II error, even at the expense of more Type I.

Science has one job to do. Policy has another. They follow different rules.

I’ve been asked to review an article using computable general equilibrium (CGE) methodology. I’m likely to decline, but before I do I want to ask the vast universe that follows this blog: is there any defense against the argument that CGE and its offspring (DSGE) are simply bad economics?

There are two arguments actually:

1. CGE is an attempt to implement empirically a model that has been blown away theoretically. For 30 years we have known in precise terms why representative agent GE models are hogwash. We also know that the conditions for unique solutions are impossibly restrictive. Finally, while we have models that can translate modern, post-utility understanding of economic behavior into functional form, to do this throughout an economy, in every nook and sector, would be a gargantuan, and probably pointless, project. To put it bluntly, CGE modelers take as their starting point refuted theory.

2. CGE is false empiricism. It claims to generate results based on real-world data, but testing is nil, and I mean nil. Is there any literature out there I have missed in which past models are examined retrospectively against actual economic outcomes? If not, where is the falsifiability?

I will wait to send my rejection email. Maybe one of you can convince me that it is worth a few hours of my time to promote “better” CGE work.

In recent election cycles the term “populist” has been applied to such varied figures as John Edwards, Mike Huckabee, Patrick Buchanan, and Ross Perot, arguably sharing a sort of economic nationalism for the poor. Originating in anti-aristocratic agrarian movements in Europe, especially the Russian Narodniki of the late 1800s, the movement in the US attempted to encompass the urban working class as well, as symbolized by the rural Scarecrow marching along with the urban Tin Woodman on the Yellow Brick Road to defeat the Wicked Witch of the East, with populist heroine Dorothy and the Cowardly Lion stand-in for fundamentalist and anti-imperialist populist William Jennings Bryan, he of the “Cross of Gold” speech, in Baum’s populist fantasy novel. The movement would be partly absorbed by the later Progressive and New Deal movements.

The movement has always had a deep divide, with race the central issue. So, on the one hand we have the progressive wing, symbolized by the remnant Democratic-Farmer-Labor Party of Minnesota and the presidential candidacy in 1948 of FDR’s former Ag Secretary, Henry Wallace for the Progressive Party. On the other, in the Deep South, we got “Pitchfork” Ben Tillman in South Carolina, whose follower, Strom Thurmond, would run as the “Dixiecrat” in the 1948 presidential campaign. Today, this divide most clearly shows up in the struggle over immigration.

Credit markets are all a-jitter again. No one knows how many assets will be nonperforming, which ones they will be, how much total value is at stake. We also know that there has a been a sudden stop, a complete cessation of net long-term private capital inflows to the US; nearly all of the financing burden of the US current account deficit has to be shouldered by central banks and sovereign wealth funds. These two events are related.

It is US debt, mortgage items but perhaps not only, whose quality is in doubt. This is why there is little appetite for such goodies among private investors. But if enough liquidity is pumped in to dissuade investors from wholesale dumping, and if the CB’s continue to do what it takes to keep the dollar afloat, we may continue to muddle through.

The risk is that the two dangers will interact. The Fed and its partners can support asset values by buying into these markets, as they have indicated they will. But if for any reason this effort falls short, it is possible that default risk and currency risk could spiral upward in tandem. Fear of default could push private capital flows into the red; this would ramp up the pressure on the dollar, increasing currency risk, and so on. It is not beyond the realm of the possible that this nasty synergy could erupt within the time frame of a few hours or even minutes. It would be sudden and unexpected: one morning you could go online to scan the headlines and find out we were already in the thick of it.

I’m not saying that a crisis is inevitable, but I’m not saying it can’t happen either.

The eco-elite have descended on Bali to devise a successor regime to the Kyoto Protocol. I think most of them are asking the wrong questions and are likely to come up with the wrong answers.

To begin with, we should be clear on what the limitations of Kyoto are. They are not primarily the weak targets that were set for carbon reduction, nor were they the forbearance shown to developing countries. Why not?

The targets proved not to matter because they have not been met. In fact, there is no way at present to force a country to act decisively on curbing greenhouse gases, so discussion of specific targets is a sideshow. In any case, no country should pull back from taking aggressive action because an international treaty sets the bar several notches lower.

For the same reason, it was never a problem that Kyoto exempted low income countries from the expectations put on the industrialized world. Aside from the question of equity – climate change is driven by accumulated emissions, most of which came from us and not them – there is no way to force a country like China or India to make its development conditional on reaching carbon goals.

The one thing Kyoto did that “worked” shouldn’t have, carbon offsets. The evidence shows that much of the offsets actually offset nothing at all: they are fictitious carbon reductions. And others take money to mitigate one environmental hazard by creating another, like tree plantations that replace living forests.

So the first thing an enlightened eco-diplomat in Bali should understand is that Kyoto should not be fixed; it should be scrapped. I appreciate its symbolic value, but surely the time for symbolism is past.

What to do then? The starting point for reasonable negotiation is the awareness that the majority of the world’s people will be direct financial beneficiaries of controlling climate change, if the job is done properly. Any country that sets up a system of carbon permits, auctions them off and rebates the money to its citizens on a per capita basis will find that most will come out ahead. This is because climate-bashing consumption is disproportionately done by the rich. Make them pay for it, and distribute the proceeds equally; the lower- and middle-consumption majority will get back more than they pay in. To put it another way, societies have been giving away their crucial environmental resources, like the atmosphere in its role as a waste sink, for free to anyone who wants to take them. Charging a price puts money in the pockets of the owners – us.

Implication: we don’t need a global treaty for countries to set up serious carbon emission controls. That’s not what Bali should be about.

What it can do are two things. First, by far the most efficient point at which to control carbon is where it enters the economy, as oil, coal or gas at the mine or wellhead. This is far less complicated than trying to track it down in its myriad uses, and it leaves the fewest loopholes. For any individual country this will mean requiring permits to bring fossil fuels across the border. Negotiators of a new international framework can work to standardize these permits, so that their markets can be international. This would minimize disruption to cross-border economic life. (I’m a rootless cosmopolitan and favor this sort of thing.)

The most important topic to discuss, however, is how to insulate national economies from the possibility that carbon control could raise domestic costs of production, hurting domestic producers in international markets. (Yes, I know the argument from trade theory that says this is not a problem, and no, I don’t believe it.) It is becoming clear that this will have to take the form of carbon adjustment tariffs (CAT’s), something I weighed in on a few posts back. I think there is a real risk that lobbyists would swarm all over the process of deciding how large a tariff is needed to offset carbon cost differences, and that an internationally negotiated schedule would have more integrity. That, more than anything else, is what Bali should be about, setting up a framework for negotiating such tariff schedules, so that each country can decide for itself how aggressive to be in carbon policy without worrying about getting too far out front.

What Bali should not do is convey to anyone anywhere that local or national action has to wait until a worldwide consensus has been reached.

This is serious:

The blue stuff is private sector financing of the US current account deficit; the red stuff is life support from foreign central banks and SIV’s (sovereign investment funds). Brad Setser points out, as he has from the beginning of his blog, that official flows (red) are greatly underestimated; by arithmetic logic they have to make up the difference between private flows and the current account.

But the point is clear: if the US were any other country (i.e. too big to fail), we would be in the grips of an economic crisis at this very moment. Foreign exchange would freeze up, essential goods would be unavailable, mass layoffs would ripple across the land, while the dollar would sink like a stone. This would be Mexico 1994, Argentina 2001.

But it’s not, at least not right now. By the grace of central bankers and oil fund managers we in the US get to sip our latte (or in my case Darjeeling) and muse on this question in tranquility. But the dollar keeps going down, and the governments that prop us up are taking really big losses. The talk now is of Wiley E. Coyote and Hyman Minsky.

OK, this is scary, but those of us who have followed the situation have been scared for years, and yet the crisis still hasn’t come. Maybe this is another false alarm. We have been in bailout mode for a long, long time.

Still, the risk of a rupture is real. My advice: progressive people need to start thinking systematically about the political environment we are likely to find ourselves in if all hell breaks loose. What narratives, based in reality or fantasy, will make sense of this catastrophe for the general public? Who will step forward to manage the crisis? How can we minimize the risk of an authoritarian surge?

And you think you’re paranoid?

One of fundamentals of contemporary economic wisdom is that short run fluctuations only affect short run output; in the long run it’s all about growth. Textbooks have dropped their chapters on business cycles and replaced them with fancy growth models. The short run is for speculators; the long run is for serious policy analysts. But what if it’s all wrong?

A recent paper by Cerra and Saxena, two economists at the Bank for International Settlements, argues that the economic costs of recessions and more serious crises tend to be permanent. According to their analysis, post-recession recovery does not generally return an economy to its pre-recession growth trend, but shifts the trend line down a notch. That is, periods of negative growth are not usually followed by periods of above-trend growth. Poor countries may be poor not because their growth rates during healthy periods are lower, but because they have more and deeper disruptions.

I am not in position to adjudicate, except to notice (1) most economists simply assume that recovery returns an economy to trend, (2) the issue is of enormous importance, and (3) if Cerra and Saxena are right, we need to rewrite the macro textbooks (again).

UPDATE: DeLong endorses the view that short run effects don’t last:

Which side am I on? I tell my undergraduates:

At a time horizon of 0-3 years, be a Keynesian: the most important things are the fluctuations in unemployment, in real demand, and in capacity utilization.

At a time horizon of 3-8 years, be a demand-side monetarist: you can assume (provisionally) that fluctuations in employment, real demand, and capacity utilization die out; the most important things are the fluctuations in the composition of real demand (investment vs. consumption vs. government vs. net exports) and in inflation- and deflation-causing nominal demand assuming (provisionally) stable growth of the economy’s productive capacity.

At a time horizon of 8 years or greater, be a sane supply-sider: the most important things are the processes of investment in physical, human, and organizational capital that raise the economy’s productive capacity

Menzie Chinn has done us all a service with his review of recent exchange rate theory, which I also skimmed in this. I was particularly intrigued by his reference to Frydman and Goldberg’s “Imperfect Knowledge Economics” approach. I read their article but not their book, and at the risk of thereby embarrassing myself offer these thoughts.

1. F&G are certainly right that a single model should not be expected to explain xrate movements over long periods of time because the market determinants are changing. This fits to a Kuhnian view: there are periods of “normal” trading, where movements respond predictably to economic news, and paradigm shifts—discontinuities in trading behavior.

2. PPP is a weak attractor at best. This is because the vast majority of transactions in international markets concern stocks, not flows. Forex markets are more like stamp or coin markets than markets in toothpaste, but PPP is based on the toothpaste template. Self-fulfilling prophecies can persist until the effects of currency misalignment are so disruptive that macro events force a correction; arbitrage doesn’t regulate. Any intermediate xrate would appear to be a statistical attractor due to mean reversion; is there any evidence that PPP outperforms other values in that respect?

3. F&G frame their argument in terms of forecasting, which on a practical level is certainly the test. The larger question, however, is whether their approach, or any of the alternatives, is consistent with the role assigned to xrates in micro models of international trade. This was the issue I raised in Challenge. The general answer, I still think, is that they don’t. F&G in particular present a view that, in theory, cannot be reconciled with strict comparative advantage. If a shifting bundle of macro fundamentals determine xrates, and if their weights change from one period to the next, how then can international prices be relied on to settle at levels that balance trade at the margin?

F&G end with the habitual sop toward trade orthodoxy, continuing the Hayekian tradition of deep insight into the process of markets combined with an inability or unwillingness to see that the normative view of markets has been eviscerated.

On November 1, Strike-Bike was locked out. The Nordhausen factory had been occupied by its workers since July 10, producing over 1800 bicycles. (You could order them in any color you want as long as it was red.) Now the court has taken over and the future of the operation is in doubt.

It’s always good when workers take an initiative, but the long term prospects were hardly rosy. This is one more instance in which a worker takeover occurred in response to the failure of capitalist owners, “lemon self-management” so to speak. There was self-exploitation as well: workers paid themselves just 10 euros an hour in their last-ditch attempt to keep the business going.

For a real test of self-organized production there has to be a level playing field: profits to be had by both owners and workers. And the goal would not be (only) to stave off insolvency, but to transform products and production methods for a better world.

*That’s Carbon Adjustment Tariff to you. It’s coming, probably, and here are some ideas for what form it should take.

The basic idea is simple: any country that gets serious about controlling carbon emissions will raise the price of the stuff, directly or indirectly. Because carbon inputs are important in many other goods and services, they will raise those prices too. If some countries take action on climate change and others don’t this will lead to distortions in global markets. Otherwise well-meaning governments might refrain from action, fearing the competitive effects. If the elasticities are particularly unfavorable, it is even possible that stringent regulation in one country could lead to an exodus of industry to places where carbon burns freely, resulting in an overall increase in global emissions.

So put a tariff on goods to offset price differences attributable to different carbon regimes. There isn’t an accepted name for the idea yet, so let’s call it a carbon adjustment tariff. The idea can be found in Warner-Lieberman and has been broached by heads of state in Paris and Berlin. It is difficult to see how individual countries can take the lead without it.

Good ideas can have bad consequences unless they are thought through, however. Here are three principles that ought to govern a CAT you could love.

1. A tariff schedule should be insulated as far as possible from self-interested manipulation. In a better world it would be the product of a representative and accountable global agency. In the shabby one we live in it should at least be the joint product of a subset of countries, rich and developing, that are willing to take some initiative.

2. All the money collected under such a tariff—repeat, all the money—should be returned in some fashion to the countries of origin, to finance green investment. Yes, I know a lot of this cash will be misspent, but it would be misspent in the collecting country too. The CAT must not become another means to suck scarce resources from South to North.

3. Some or all of the revenues should be held in escrow, pending the agreement of the trading partner to enter a “contract and converge” system under which it will approach a common per capita carbon emissions target. This money can sweeten a deal that should be made on its own merits.

It bears repeating: policies to forestall global warming are not only environmental policies. If they take their job seriously, they will have profound effects on national and global economies. They should be designed to be economically progressive and sustainable.

It appears that the conduit consortium is simply an extra layer of securitization. It reminds me of the way the lender of last resort function was implemented, sort of, with several noticeable failures, in the era preceding the creation of the Fed. It has the potential to further concentrate risk, like an Army Corps flood control project that can withstand a category 3 but not 4 storm—if there are any buyers.

From an equity standpoint, I think James Hamilton has it right:

In my opinion, part of what created the current problem was the perception that participants were too big and too many to fail. If the government won’t let Citigroup fail, could it allow a superconduit to go down?

I am skeptical of any claims for a feel-good, this-will-solve-all-the-problems fix. The reality is that someone must absorb a huge capital loss. The question we should be asking from the point of view of public policy is, Who should that someone be?

My answer is: the shareholders of Citigroup.

You write stuff and hope people read it. Clearly the recent discussion on this blog and elsewhere of whether there is a savings glut over there or a savings shortage over here ignores completely the argument I made this year in Challenge. Was my case really that weak?

2008 will be the year America debates climate change policy, hopefully without descending completely into election-year inanity. 2009 will be the year we get a policy. For an issue of this magnitude, that’s a fairly short time frame, so every turn of events counts.

Today Barack Obama has gone on record with his own approach. By my reckoning he got almost everything right, but there’s one huge missing piece. He is right on:

• setting a serious target: an 80% reduction in emissions by 2050 is the minimum we should aim for, if we take the scientific evidence seriously. We can get there only by starting soon and staying on course.

• capping carbon emissions: a cap is necessary if we are going to try to live within ecological limits, and it is far preferable to a carbon tax, as I’ve argued earlier on this august site.

• auctioning the permits: as Obama said, letting the cows out of the Barnes, “Businesses don’t own the sky, the public does…”

• rejecting offsets: he doesn’t even mention them.

• investing in a non-carbon future: we need basic R&D, infrastructure and other initiatives to turn our economy around.

The only element that’s lacking is a commitment to rebating most of the auction revenues back to the people on a per capita basis. Economically, this is necessary to protect real incomes and avoid a dangerous contraction of consumer demand. (The higher energy prices we will be paying under any reasonable cap will be in the hundreds of billions of dollars.) Politically, it is necessary to win support for tough limits on carbon emissions. After all, if it is true that we own the sky, we should share in the income it generates. Finally, a per capita rebate would constitute the most progressive income redistribution program since the New Deal, a big consideration at a time of spiraling inequality.

So how do you finance those green investments if you give the money back? Answer: by ending pork barrel subsidies to the nuclear and fossil fuel mafias ($24B give or take a few) and rethinking national security, for starters. NB: if rebating the auction proceeds on an equal share basis is highly progressive, withholding a big chunk of it for other uses is highly regressive. Finance public investment out of taxes.

Let me see if I understand this. When someone in Iraq or some other such country hires a private army, we call it a militia. When someone in the US hires a private army and sells it to the highest bidder, we call it a security firm. And the reason is?

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.