Skeptonomics

You just can’t keep a bad idea down. The New York Times, reporting on Europe’s economic angst here and here, wallows in money illusion. Let’s survey the scene of the crime and speculate on the motives.

The way I teach it in introductory macro, there are two types of money illusion. In Type I you are aware of wage increases but not price increases; you think you have more purchasing power than you really do. In Type II you are aware of price increases but not wage increases; you think that if only prices would stop going up you would have more purchasing power than you do. Both are fallacies, since wages are prices, or to put it differently, the money you spend for the things you buy all ends up as someone’s income. It is a logical impossibility for Europeans as a whole to suffer loss of real income as a result of inflation. (And, just to provide context, recall that the rate of price increases over there is in the 3-4% range, not good but certainly sub-ferocious.)

So what are the real problems? The biggest one is income distribution, which is becoming more unequal across the continent as moderating institutions are eroded under the pressure of global competitiveness. This has the most immediate effect on workers who produce goods and services for export or which compete with imports, and it spills over into other labor markets as the wages of the most vulnerable workers slip backward. Firms are also adjusting their organizational strategies to the new world of global competition, relying progressively less on long-term relationships with employees shielded from market forces.

Another possibility, hinted at in these articles, is an adverse shift in the terms of trade, as oil and gas imports become more expensive relative to manufactured exports. Food is less clear, however, since Europe exports vigorously (and controversially) in agricultural products, which leads one to wonder where are the farmers, and those who sell to them, in these tales of Euro-woe.

By blaming the deterioration in living standards on the wrong culprit, these stories detract attention from the true causes. The ECB can crank its rates as high as it wants in order to snuff out inflation, but this won’t restore real income to the average European—quite the contrary, actually, since high rates will produce more unemployment while further elevating the already too-high euro. Wrong diagnosis, wrong treatment.

The question that comes to my mind is why this nonsense about inflation lowering real incomes still has traction after all these years. The disproof is no more complex than the old, familiar circular flow diagram. My suspicion is that it can be attributed to the fundamental political economy fact about inflation: that unanticipated increases in inflation reduce the wealth of net creditors, who map more or less perfectly on the rich as a whole. There will always be a need to find a reason to make inflation the scapegoat for whatever ails the general public, and simple logical error will not constitute a disqualification.

I’ve started working on a project related to the Western Climate Initiative, a process underway between seven US states and two Canadian provinces to put this scenic portion of the planet on a carbon budget. Because of this, I’ll be posting more frequently on topics related to climate change and how to limit it. Right now, I’m thinking of the decision to commit the WCI as a whole to auctioning only a portion, between 25 and 75%, of the carbon permits they intend to issue, distributing the rest gratis. Isn’t it generous to be handing out free money to the most polluting businesses?

Of course, it’s difficult for the general public to see just what’s going on. To remedy this, I propose the following: auction all the permits. Then take some of the money, between 75 and 25%, and deliver it to the doorstep of firms that emitted the most carbon in the past, preferably in suitcases with unmarked bills.

Maybe if you put the whole operation on YouTube people would get the point.

You’ve heard this one: A terrorist is being held captive. He knows where a bomb is scheduled to explode in a few hours, one that would kill thousands of innocent victims. Is it OK to torture him to get the information in time to defuse the bomb? But I don’t want to argue about that one again. Try this:

You are being held captive by a foreign power. Although it is a mistake, your captors honestly believe that you are a terrorist and know where a bomb is scheduled to explode in a few hours. Is it OK for them to torture you? (Cap tip to John Rawls.)

Two trends have dominated financial markets in recent decades. First, there is an arms race going on in instruments and trading algorithms. Math jocks are going braino-a-braino to devise increasingly sophisticated strategies, to the point where even specialists are unsure how to value portfolios. At the same time, there has been an escalation of leverage; unregulated investment funds are lending to the tune of 30 or more times their equity base. Maybe these developments are related.

The current argument is that over-the-top leveraging is the consequence of a regulatory breakdown, and there is certainly truth to the extent that the failure of oversight has enabled investment banks and hedge funds to do whatever they want — but why did they want to extend themselves so far?

Here is one possibility: the new math-intensive strategies are chasing tiny margins. The trading programs are designed to perceive opportunities for arbitrage a nanosecond before anyone else, taking advantage of the slightest misalignment of related prices. We have also witnessed ever more elaborate strategies involving complex tradeoffs between risk and return to create composite positions whose alpha is perceived to be a shade higher in relation to its beta.

The profit margins on these strategies are minuscule, but if everything goes as programmed, predictable. This means that they can be turned into respectable earnings only through intense leverage. By investing in positions at the rate of 3000% of capital, you turn 1% annualized margins (which correspond to much smaller margins on any given trade) into 30%. And the geniuses who devise these opaque instruments tell you that the risk is small relative to the return.

What the risk jockeys always seem to miss is that estimates of portfolio risk depend on covariances among the individual elements, and these in turn are determined by the structural properties of the system in question. And no one can know what they are, because the system is too complex, there are too few data points, and the structure keeps changing. So the models work, trade after trade, until there is an unforeseen systemic event, after which all hell breaks loose.

Then the high degree of leverage, which was necessary to make the strategy pay sufficient dividends, magnifies the risk instead of the return.

If this analysis is correct, it suggests that putting a ceiling on leverage may also slow down the drive toward unfathomable financial complexity. That would be a good thing, and not just for us dummies.

Readers of the latest missive from Brad Setser may not realize the full implications of his numbers, so we will do the math here. Brad crunches the latest Treasury International Capital (TIC) survey from our friends at the US Treasury Department, adds some other sources, and comes up with the estimate that central banks and sovereign funds pumped over $100B back into the US financial system during the month of January. He worries about the apparent shift away from agencies — our public creditors are reluctant to prop up our crumbling housing sector — but I worry about the implication for private capital flows.

The most recent estimate for last year’s current account deficit is around $740B. To make things simple, assume it remains the same this year. (Recession at home will push it down; recession abroad, if it begins to happen, and oil prices, if they remain higher, will push it up.) If the January rate of official finance continues, it would stand at more than $1200B for the year. The difference, $460B would represent net private capital outflows from the US. If this isn’t capital flight, it’s at least a pretty substantial exodus. My instincts tell me that a full-bore capital flight is the big risk lurking in the shadows. What is the cutoff point between where we are today and a dollar crisis? The answer is, a rate of private outflow that central banks are unable or unwilling to offset. And how much is that?

We are conducting a global experiment right now to find out.

Somehow I missed the news that Duane Chapman died last summer — he was only 66 years old. Duane taught environmental economics at Cornell and did pioneering work on several fronts. It was from him that I first learned, back in the mid-1980s, about the importance of the environment-trade nexus; he was years ahead of that curve. He produced a powerful critique of a different sort of curve, Environmental Kuznets, showing that it is an artifact of looking at production rather than consumption footprints. His textbook, Environmental Economics: Theory, Application and Policy, failed to find its audience, but it was sprinkled with analytical gems found nowhere else. While his style could sometimes be a bit gruff, he was never less than warm and supportive to me. I’m grateful I had the opportunity to get to know him.

Says Steven Weisman in today’s NYT: “The fear of some economists is that, as the dollar declines, there could be a panic sell-off. But most experts doubt such a panic would occur, because it would be in nobody’s interest, least of all investors who are holding dollar-based investments.” Someone should tell him that it is never in the interest of investors or depositors for there to be a run on a currency or a bank. But it is in their individual interest to get out ahead of everyone else. This is not to say that there will be a run on the dollar, but you might want to find a better reason than the notion that bad things cannot happen in capitalism because capitalists don’t want them to happen.

In the age of Google, our main competition is with ourselves, or, more precisely, with those who share the same name. In that context, I find myself several rungs below the esteemed Peter Dorman, professor of things ancient and Egyptian at the University of Chicago. Now his fame is destined to spread further, as he accepts the presidency of the American University in Beirut. From what I can see from afar, AUB’s star will also rise from its association with this highly accomplished archaeologist. My hat (the one in the photo) is tipped to both of them.

All eyes are currently on US financial markets, where the Fed has offered to sink half its portfolio into mortgaged-based securities. And it is true that there is a risk that the spreading credit crunch could cause great economic trauma. But don’t forget about the dollar. It is now trading at over 1.55 to the Euro after another sharp bump, and no one thinks it has touched bottom. There is a second path to chaos: a potential run on the dollar. The two risks are related — the crunch could trigger a run — but not the same.

Update: Make that 1.56 to the Euro….and counting.

The nice thing about the Fed exchanging treasuries for MBS is that it is not expansionary monetary policy and need not be seen as inflationary. The not so nice thing is that $400B, the amount said to be in play, is tiny compared to the $10T or so in anticipated losses stemming from the collapse of the housing bubble. If fiddling with its portfolio is not enough and Plan B is for the Fed to flood the markets with money, expectations of inflation could be reignited, with further risks to the dollar.

So there are two abysses facing the US economy and not much policy space between them.

I’ve been reading Eric Janszen’s interesting piece in last month’s Harper’s, “The next Bubble: Priming the Markets for Tomorrow’s Big Crash.” He compares the dot.com and housing bubbles as part of a general theory of why the US economy is so bubble-prone. Reading it is like sitting next to a caustically witty financial analyst at a bar; he’s had one too many and is shredding his life’s work, and for you it’s prime entertainment.

So what’s his theory? In a nutshell, he says that the US is now in the hands of its FIRE brigade — finance, insurance and real estate. They own the politicians and control economic policy. Bubbles are their stock in trade. These guys get rich and leave the rest of us with the tab. To save our economy from certain ruin in the wake of one bubble, we have to pump up the next one. This is how the housing bubble inflated after tech bubble popped. And where do we turn after housing goes bust? Janszen predicts alternative energy (including nuclear) as the new new new thing.

I like anyone who builds a worldview around bubblesome finance. Nevertheless, putting on my skeptical academic hat, I think he has slipped into the dangerous waters of functionalism, believing that social or economic events happen because they are needed to happen. There is a longstanding critique of such reasoning, but I’ll spare you. The point is that functionalist explanations don’t really explain. For instance, Janszen’s article doesn’t explain why some economies are more bubble-prone than others, nor does it offer a reason why efforts of insiders to inflate a new sector will necessarily succeed.

As my loyal legions know, I think there is a structural factor behind US asset price inflations during the last 15 years or so, capital account recycling. I’m hoping to get a few hours in the coming weeks to put this into its proper algebraic form. This is how we become convincing in my business. As Groucho almost said, “Who are you going to believe, my model or your own eyes?”

Speaking of quotes, I like this one by Janszen: “Since the early 1980s, the free-market orthodoxy of the Chicago School has driven policy on the upward slope of an economic boom, but we’re all Keynesians on the way down: rate cuts by the Federal Reserve, tax cuts by Congress, deficit spending, and dollar depreciation are deployed in heroic proportions.” Amen brother.

Round 1 has seen the world’s central banks picking up the slack from private investors and keeping the dollar afloat in the face unrelenting US current account deficits. Now we are hearing the first murmurs of Round 2, a coordinated move by some or all these same players to backstop crumbling US credit markets.

In very broad outlines, here is how Round 1 looks: Over the course the 1990s the US began to run increasingly large current account deficits, which then further swelled during the Bush years, peaking at nearly 7% of GDP in 2006 before falling back a percent or so.

Financing the deficit was not difficult during the go-go years of the ‘90s bull market, as private investment poured in from around the world. In the wake of the dot.com collapse of 2000-01, however, it became increasingly difficult to recycle dollars through private channels. Central banks, and to a lesser extent sovereign wealth funds, stepped forward to do the job. These entities now finance essentially the entire payments gap, largely by using their dollar accumulations to purchase US treasury bills. Acquisition of other assets, as when China tries to acquire an oil company or Dubai goes in for a money center bank, attracts headlines but as yet account for a small fraction of this recycling.

The willingness of these public entities (it may be a stretch to call funds under the control of Gulf monarchies “public”, but economic language is not especially nuanced) to hold dollar assets prevents the dollar from falling even faster, and more broadly, than it has and serves to keep US interest rates far lower than they would be otherwise. The growth in foreign dollar reserves alone last year was approximately $900B, in excess of the entire US financing requirement. It would be going too far to claim that this extraordinary level of support is motivated by a desire to sustain the US economy; certainly other interests are at play, but the effect has been to enable US consumption to exceed production by a substantial margin, year after year. Given the scale of the enterprise, you might call this not a bailout but an international payments sump pump.

Now we face a new crisis: because of large developing writedowns in the housing market and the opacity of investment instruments that bundled low-value mortgages in ostensibly high-value securities, a credit crunch is enveloping US markets. Banks and equity funds, desperate to safeguard what remains of their capital base, are pulling out of markets for a variety of loans: for business investment, for certain forms of municipal investment finance, for college students borrowing to pay tuition. This credit retrenchment, according to Larry Summers, constitutes “the most serious….economic and financial stresses that the US has faced in at least a generation, and possibly much longer.” (Thanks to Brad Setser for this.)

The Federal Reserve has created a term auction facility (TAF) which will extend up to $200B to banks, while accepting mortgage-backed securities as collateral. Effectively, this represents an infusion of $200B in demand for the most troubled assets. Dean Baker thinks this simply socializes the losses of the rich after years in which their profits were hoarded by an elite few. Even so, the biggest fear has been that the Fed intervention will prove to be too small relative to the size of the markets to make a difference. This is precisely Paul Krugman’s point, seconded by Setser. So does this mean that there is no defense against a financial meltdown?

Think again about where the financial clout now lies. After years of accumulating treasuries, foreign central banks now have a far larger stash of securities than the Fed. (The Fed’s holdings of treasuries stand at about $800B, less than a year’s accumulation abroad.) The Fed can play with its portfolio, selling some treasuries and effectively buying mortgages, but between them the dollar-soaked central banks of China, Japan, the Gulf states, Brazil et al. have an even larger portfolio to deal from. Hence the potential for these entities to step into the market and buy assets at risk.

Will this be Round 2? If it is true that the Fed is no longer big enough for the job, it’s hard to see an alternative. The US, even in financial tatters, is too big to fail, and it is not difficult to imagine that rescue discussions are already under way. It’s not a sure thing, but a coordinated global move could restore enough demand to keep mortgage and other bubbly assets afloat yet a few more quarters or even years into the future. This would buy more time for the adjustments needed to address the true underlying problem, massive ongoing US current account deficits. I could even imagine a quid pro quo in which support for US markets is tied to a set of policies to rebalance the US position, although it would not likely take a public or transparent form. (Whether those policies would actually do the job is another matter, of course.)

We are in highly speculative territory here, and I could be way off the mark. But maybe not, and if the second phase of the global bailout begins to take form in the next few weeks, tell everyone you heard it here first.

Ben Stein, who writes a column on “economics” for the New York Times, also displays his credentials in “science” in the forthcoming film “Expelled”. Stein, we are told, interviews believers in “intelligent design” who say they have been denigrated by the scientific and educational establishment. We know that Stein has been the brunt of quite a bit of criticism, especially from Brad DeLong, but his grasp of economics is not inferior to his chops as an evolutionary biologist.

My favorite howler from this article was the following Stein quote: “there’s just a lot of people who don’t believe that big science and Darwinism should have a stranglehold on academic life….” Yes, big science is the problem. We need small, innovative start-up sciences that aren’t tied down by, you know, peer-reviewed journals and experimental protocols. Biology, geology, they’re just cruising on their legacy market share. With a good business plan and access to the right angels, a neo-biblical venture could be really competitive.

Stephen Roach is almost right. No doubt an avid reader of EconoSpeak, he has come to see that the US has slid into the condition of a bubble economy, and that the post-bubble landscape has the potential to be chronically depressive. His article is constructed around a comparison between the US today and Japan in the wake of its own debubblization. The big difference, of course, is that Japan was and remains a major creditor nation, while the US is storming new depths in external debt.

This matters a lot. Leaving Japan aside for another day, we should note that the broad relationship between US bubbles – stocks, mortgages, creative credit packages, and the currency itself – are ultimately derived from the recycling of dollars exiting the country through the current account deficit. These returning capital inflows purchase assets that support, directly or indirectly, the ability of US consumers to enjoy consumption in excess of production. The moral of the story: the US economy, steadily drawing down its privileges from decades of producing the world’s key currency, is able to maintain otherwise impossible external deficits, and these in turn impose low or even negative savings rates. (For details, read this.)

So Roach has it backwards when he says

Like their counterparts in Japan in the 1990s, American authorities may be deluding themselves into believing they can forestall the endgame of post-bubble adjustments. Government aid is being aimed, mistakenly, at maintaining unsustainably high rates of personal consumption. Yet that’s precisely what got the United States into this mess in the first place — pushing down the savings rate, fostering a huge trade deficit and stretching consumers to take on an untenable amount of debt.

Trying to solve the underlying cause of the current account/bubble dependency problem by allowing consumption to collapse is killing the patient to cure the disease. He then partially contradicts himself and gets it right when he immediately adds

A more effective strategy would be to try to tilt the economy away from consumption and toward exports and long-needed investments in infrastructure.

Investments in infrastructure, need we point out, also support consumption, especially if they are financed by an enlargement of public debt, but they do it the right way.

His other suggestion, a weaker dollar, is reasonable as far as it goes, but it would be an exaggeration to call it a policy. There is no magic wand anyone in the US can wave to make the dollar go down: it requires accommodation from those whose currencies have to rise. Moreover, the problem at the moment is that exchange rate flexibility is grossly uneven and doesn’t correspond to trade flows. Nearly all the burden of adjustment is being placed on the dollar-euro exchange rate. This is a big problem for Europe, particularly since the RMB is tied to the dollar. So the EU racks up an ever-bigger deficit with China: how does this help the US? A dollar initiative has to be multilateral, like the Plaza Accord of old. Failing that, or as an inducement to cooperation, the US can begin to explore unilateral options to manage its current and capital accounts.

Sectoral strategies can also play a big role. Emergency action to reduce oil consumption, and therefore imports, should be high on the agenda. We can dust off perfectly reasonable ideas that were shelved at the end of the 1970’s, beginning of course with much more aggressive fuel economy standards and support for residential insulation. For more particulars see organizations like ACEEE. The general point is that expenditure-switching is ultimately an investment program.

Incidentally, one of the paradoxes of this election season is the vast gulf that separates the economic pronouncements of the candidates from the actual condition of the country. No one is talking in a coherent way at the moment about the toxic stew of external deficits, bubble finance, and sputtering demand. Creative strategies that could link economic solutions to progress on climate change and other social goals are completely out of the picture. Do we expect sensible policies to just descend on us, like spores from outer space, in 2009?

Maybe this is important, maybe not. But what do I know? I’m holed up here in my rainforest hovel, where the Long Damp has finally returned. I am ignorant of most accounting matters, but I suspect that the current credit crunch is, to misquote John Sayles via Burt Reynolds in “Breaking In”, “a big event in the world of asset pricing.”

Whenever there are opportunities to falsely upgrade values during a boom or falsely prevent them from dropping during a bust, I say keep an eye on the accountants.

The zombie that Keynes couldn’t kill still stalks the landscape. In a New York Times op-ed today, Conley tells us that the reason we are sliding into a recession is that we save too little, and that only more savings can pull us out.

A few remarks, with Conley in italics:

The recent slowdown in gross domestic product growth is only a symptom of recession, not the cause. While there are many things to blame for the current crisis — most notably the subprime mortgage mess — one factor that has received little attention is America’s low savings rate.

Um, what is the transmission mechanism here? Weren’t people buying subprimes saving too much or in the wrong way relative to their income? This seems to be an argument based on moralism, not economics: we have been bad these past years, spending beyond our means, and now the recession will be our punishment. In the middle ages our sins were punished by earthquakes and plagues, now it’s recessions. At least it’s an ordered universe.

The simplest approach would be to seed universal mutual fund accounts for low-income Americans. The best way to do this would be through a so-called refundable tax credit deposited directly into a special investment account for each taxpayer. In future years, the government could contribute an additional 50 cents for every dollar the taxpayer deposited into this account. Think of it as a universal 401(k), but one that could be used not only for retirement but also for things like a down payment on a house, college expenses or unexpected health costs.

Well this is dandy: in a time of recession we should create new incentives for individuals to salt away more money. Less consumer demand, that’s the ticket. And behind this proposal is the error of thinking that savings creates investment. If the economy is in a nosedive, and businesses are going bust everywhere, who will want to invest?

As I’ve written in this august blog before, our savings shortfall is the consequence of the massive and ongoing trade deficit: we have to borrow to make up the difference between what we earn and what we spend. The problem with the stimulus package, at least one of them, is that it does nothing for expenditure switching.

Don’t jump to conclusions. Children who work for pay usually make less than adults, but they are usually less productive too. It is far from obvious whether their employers take in more profits, or whether child labor undercuts jobs and wages for adults. You can speculate on this all you want, but now, for the first time, there is empirical evidence.

My study, “Child Labor Wages and Productivity” has just been published by the International Labor Organization (ILO). Working with teams in four countries, we surveyed children and their employers in two sectors per country, gathering data on the division of labor between adults and children, relative wages and productivity, firm-level factors, employer motivation, and the social context. You can read about children who fish off the coast of Ghana, repair cars and motor scooters in India and fold fireworks in the Philippines. The analysis is not particularly high-tech, but you can find basic wage regressions and estimates of production functions with child and adult labor inputs. There is also a ton of descriptive material.

The bottom line is, sometimes, under some conditions. When normal people talk about child labor they often assume that children are a gold mine for unscrupulous employers. This can be true, but it’s not the whole story. Meanwhile, when economists study child labor they usually assume the opposite, that the law of one price equalizes unit labor costs across all age levels. This is even less likely to be the case. If you care about child labor and want evidence instead of arbitrary assumptions, I think you’ll find the study up your alley.

It’s a free download at http://www.ilo.org/ipecinfo/product/viewProduct.do?productId=7065.

Out running today, I had occasion to think about the difficulties involved in sharing the planet with geese. These hefty birds would be a plus in every respect were it not for their shortcomings in the domain of personal hygiene. While picking my way gingerly along the route, I focused on possible solutions.

First, we need to direct environmental budgets to serious problems, like goose poop. If people were pooping in public to anywhere near the same extent, stopping it would be viewed as a top priority.

Now on to specifics. As we know, geese are subject to imprinting. We should pay people to become surrogate goose-parents and to lead them (as pictured in the linked photo) to an appropriate bathroom or outhouse so that they can see what proper pooping looks like. But this will create a further complication: geese, alighting from their migrations, will be knocking on doors everywhere, asking to use the facilities. To forestall this, I recommend building banks of public toilets along known flyways. This might seem extravagant, but the size of these goose-a-potties can be small, holding down costs.

And then we humans can run along rivers and bays without staring at our feet all the time.

Barack Obama has been driving Paul Krugman and others crazy with his call for a warm, fuzzy hands-across-America style of politics. Where does this come from? Here’s one answer….

Cass Sunstein. Sunstein has been cited as an advisor to Obama, and he has written extensively on the dangers of a world in which people only communicate with those they already agree with. If the right listens only to Limbaugh and Hannity, and the left logs on only to Huffington and Kos, each side will shift further away from the other, until there is no middle ground left. All will be blinkered extremism. For details, consult his book Republic.com or his continuing stream of papers like this one. (Question: how does he write this stuff faster than I can read it?)

I have mixed feelings about this view of our political condition. On the one hand, as a partial follower of John Dewey, and as someone who teaches at an institution that embraces “learning across significant differences”, I know how important it is to listen with an open mind to those whose point of view challenges your own. You do yourself and the quality of your thinking no favor when you live and converse in an echo chamber.

But there are two problems with the let’s-all-get-along school. First, there is the issue of power. There are wealthy, well-entrenched interests that don’t want an open-minded, cooperative approach to political questions. They are in charge and want to keep it that way. Opposing views will be censored, defunded, misrepresented and, if they arise in distant oil-bearing regions, incarcerated and waterboarded. It is necessary to struggle against these interests if we want to create a world in which thoughtfulness and generosity rule.

Second, what counts as moderation in America is often hopelessly skewed to the right, even by the standards of other capitalist countries. I generally distrust corner solutions—all this or all that—and look for blending and balancing, but if John Edwards is too far to the left to be taken seriously, I’m a speck on the thin edge of the political distribution, several sigmas out. In this respect, the Sunstein/Obama analysis is correct, but radically incomplete. We need to really extend the conversation to the vast regions beyond the pale of approved discourse. The resulting zone of consensus will be moderate by the standards of intelligent human thought but extreme with respect the political constraints we live under today.

I am at the Bainbridge Graduate Institute, where last night I heard a presentation on the carbon offset market. Someone from the audience asked if this is really just a modern version of purchasing indulgences, salving the conscience of the sinner so he can go on sinning. This is a fair question, but it doesn’t dispel the confusion that now surrounds offsetting.

First point: it is an obvious fact that many if not most of the offsetting crowd in the US, the ones who seek to neutralize their carbon footprint, take a moralistic approach. In the end, purchasing offsets is about them and how they feel about themselves. I wouldn’t condemn this, since good intentions are, well, good (most of the time). But from time to time we should ask ourselves, what is the net effect of this business on actual carbon in the atmosphere?

This leads to the second point: carbon offsets mean entirely different things now and under a future regime of carbon permits. Today, if you buy a carbon offset, there is no particular social cost and probably some potential social gain. The offset doesn’t make you drive or burn fuel oil; you buy the offset because you do these things in the first place. Meanwhile, if the offset causes any improvement in the carbon situation somewhere else, even just a little, it is a plus. True, some offsets also make things worse because they take a tunnel vision to the problem and ignore other environmental and social effects, but these can be avoided with a little research.

Now think about the future. Suppose we institute a system of carbon permits, ratcheting them down each year to meet our long term carbon goals. In this hopefully not too hypothetical world carbon offsets become a threat. An offset represents the cancellation of some part of the permit framework: you get to emit more carbon because you bought an offset. In this case there is a clear and substantial social cost, measured against the same iffy social gain. The net effect is that carbon emissions are likely to go up.

Moral of the story: transcend moralism. Put some of your spare cash into carbon offsets, but do some digging into the practices of the offset providers. Support a national system of carbon emission controls that makes no room for offsets.