Archive for September, 2008

A Note of Optimism

Published
by
Steve Darden
on 9/30/2008
in Economics
. 0 Comments

From a new blog by University of Chicago economist Casey Mulligan:

In order to find good predictors of non-financial sector performance, and GDP growth generally, we look to the non-financial sector itself. One of those predictors is the profitability of non-financial capital, or the “marginal product of capital” as we economists call it. The marginal product of capital after-tax is a measure of how much profit (revenue net of variable costs and taxes) that each unit of capital is producing during, say, the last year. When the marginal product of capital after-tax is above average, subsequent rates of economic growth (and subsequent marginal products of capital) also tend to be above average.

Since World War II, the marginal product of capital after-tax averaged between 7 and 8 percent per year. During 2007 and the first half of 2008 – exactly the time when financial markets had been spooked by oil price spikes and housing price crashes – the marginal product had been over 10 percent per year: far above the historical average. Compare this to the marginal product of capital in 1930-33 (the years of Depression-era bank panics): 0.5 percentage points per year less than the postwar years and significantly less than in 1929. The marginal product of capital was also below average prior to the 1982 recession (in this case, far below average) and prior to the 2001 recession. Thus, the surprise was not that GDP continued to grow 2007-8 despite the bleak outlook from Wall Street’s corner of the world, but that GDP growth failed to be significantly above the average. More important from today’s perspective is that much capital in America continues to be productive, and that this will likely permit Americans to advance their living standards as they have in years past. The non-financial sector today looks nothing like it did in 1930.

Furthermore, productivity growth has continued strong through Q1. The sky isn’t falling just yet. Thanks to Greg Mankiw for the link - Prof. Mulligan’s blog looks to be a useful resource.

The $700bn bail-out and the budget

Published
by
Steve Darden
on 9/30/2008
in Economics
. 0 Comments

This was published 28 Sept. in the Financial Times prior to the House defeat:


Congressional negotiators have now completed action on a $700bn authorisation for the bail-out of the financial sector. This step was as necessary as the need for it was regrettable. There are hugely important tactical issues regarding the deployment of these funds that the authorities will need to consider in the weeks and months ahead if the chance of containing the damage is to be maximised. I expect to return to these issues once the legislation is passed.

In the meantime, it is necessary to consider the impact of the bail-out and the conditions necessitating it on federal budget policy. The idea seems to have taken hold in recent days that because of the unfortunate need to bail out the financial sector, the nation will have to scale back its aspirations in other areas such as healthcare, energy, education and tax relief. This is more wrong than right. We have here the unusual case where economic analysis actually suggests that dismal conclusions are unwarranted and the events of the last weeks suggest that for the near term, government should do more, not less.

First, note that there is a major difference between a $700bn (€479bn, £380bn) programme to support the financial sector and $700bn in new outlays. No one is contemplating that the $700bn will simply be given away. All of its proposed uses involve either purchasing assets, buying equity in financial institutions or making loans that earn interest. Just as a family that goes on a $500,000 vacation is $500,000 poorer but a family that buys a $500,000 home is only poorer if it overpays, the impact of the $700bn programme on the fiscal position depends on how it is deployed and how the economy performs.

…Second, the usual concern about government budget deficits is that the need for government bonds to be held by investors will crowd out other, more productive, investments or force greater dependence on foreign suppliers of capital. To the extent that the government purchases assets such as mortgage-backed securities with increased issuance of government debt, there is no such effect.

Third, since Keynes we have recognised that it is appropriate to allow government deficits to rise as the economy turns down if there is also a commitment to reduce deficits in good times. After using the economic expansion of the 1990s to bring down government indebtedness, the US made a serious error in allowing deficits to rise over the last eight years. But it would be compounding this error to override what economists call “automatic stabilisers” by seeking to reduce deficits in the near term.

Indeed, in the current circumstances the case for fiscal stimulus – policy actions that increase short-term deficits – is stronger than at any time in my professional lifetime. Unemployment is now almost certain to increase – probably to the highest levels observed in a generation…

More from former Harvard president Larry Summers.

The best and worst case scenarios

Published
by
Steve Darden
on 9/30/2008
in Economics
. 0 Comments

Tyler Cowen:

The best case scenario: The bad banks continue to be bought up, there is no run on hedge funds next Tuesday, only mid-sized European banks fail, money market funds keep on buying commercial paper, and the Fed and Treasury continue to operate on a case-by-case basis. Since Congress doesn’t have to vote for something called “a bailout,” it can give Paulson and Bernanke more operational freedom than they would have otherwise had. The American economy is in recession for two years and unemployment does not rise above eight or nine percent.

The worst case scenario: Credit markets freeze up within the next week and many businesses cannot meet their payrolls. Margin calls cannot be met and the NYSE shuts down for a week. Hardly anyone can get a mortgage so most home prices end up undefined rather than low. There is an emergency de facto nationalization of banks to keep the payments system moving. The Paulson plan is seen as a lost paradise. There is no one to buy up the busted hedge funds, so government and the taxpayer end up holding the bag. The quasi-nationalized banks are asked to serve political ends and it proves hard to recapitalize them in private hands. In the very worst case scenario, the Chinese bubble bursts too.

I still think some version of the best case scenario is more plausible, but I wish I could tell you I am sure.

Why revenue-neutral carbon taxes are superior to “cap and trade” schemes

Published
by
Steve Darden
on 9/28/2008
in Energy Policy
. 3 Comments

[This is a revised version of an earlier post - Ed.]

To stabilize carbon emissions we need to choose effective policies that incentive investors and consumers to make low-carbon choices immediately — not twenty years in the future. The most critical investment decisions are those of the power generation utilities — who are rapidly constructing inexpensive coal-fired plants around the world. To stop that impending train wreck the electric utility boards of directors need certainty of the future costs of carbon emissions. I.e., we need to establish a “price on carbon” that produces immediate results.

Fortunately, the requirements for efficient taxation and regulatory policies have been thoroughly studied — we do not need to create new “Bi-partisan Commissions” to recommend structural options. The following summarizes some of the relevant research demonstrating that a revenue-neutral carbon tax scheme is far superior to the politically popular “cap and trade” schemes such as Kyoto or the European “Emissions Trading Scheme” (ETS).

A revenue-neutral carbon tax scheme can be implemented with nearly zero administrative cost — existing tax collection and auditing channels are almost all that is required to implement a new tax schedule. The price mechanism allows each investor to confidently plan for her future cost of emissions. The carbon tax option gives us certainty of future costs, transparency, and low transaction costs associated with the carbon pricing.

The opposite of certain is what we get with the quantity mechanism of cap-and-trade. The investor faces a volatile, uncertain profile of future emissions costs. The ETS experience has demonstrated great volatility. Volatility is the enemy of what we urgently need — that is fast decisions to stop building dirty coal power generation, substituting the larger capital investments required for low- or zero- carbon plants.

The cap and trade scheme creates a new administrative monster that will be impossible to kill off once it gets going. Envision an apparatus ten times bigger than the Dept of Agriculture. Do not forget that cap and trade requires measuring and auditing reported quantities of emissions. Cap and trade will create a rich growth medium for rent seeking — which leads inevitably to corruption.

In “Bootleggers, Baptists, and Global Warming” Bruce Yandle looks at the post-Kyoto negotiations in the light of the “bootleggers and Baptists” theory of regulation. Yandle points out that in the South, Sunday closing laws make it illegal to sell alcohol on Sunday. These laws are maintained by an inadvertent coalition of bootleggers and Baptists. The Baptists (and other religious denominations) provide the public outcry against liquor on Sunday, while the bootleggers (who actually sell liquor on Sunday) quietly persuade legislatures and town councils to maintain the closing laws. In this paper, Yandle explains that something similar is happening with the treaty negotiations over climate change. Baptists are the environmental groups, and bootleggers are the companies, trade associations, and nations that are seeking favors through the global warming negotiations.

In our previous post Life After Kyoto: Alternative Approaches to Global Warming Policies I reviewed the 2005 Nordhaus study of the same name — which I think very compactly demonstrates the real-world advantages of harmonized carbon taxes vs. cap-and-trade.

Non-economists will probably always be uncomfortable with using indirect instruments like prices, just as patients may wonder how little yellow pills can cure their disease. Nonetheless, the fact that prices are more indirect than quantity restraints should not prevent us from recognizing their superior power as a coordinator and motivator for global warming.

For an in-depth exposition of the superiority of the carbon tax strategy, see The Challenge of Global Warming- Economic Models and Environmental Policy by Yale’s William Nordhaus. You can read a clear discussion of the above issues by searching the PDF for this section The Many Advantages of Carbon Taxes [A. Prices versus Quantities for Global Public Goods].

Nordhaus has probably done the best work demonstrating the many efficiencies of price schemes over quantity schemes. As just one example, a key requirement of any scheme is that it be adaptive. In Nature, 8 May 2008: among the 4 letters responding to the Nature PWG commentary is this letter from Richels, Tol and Yohe, which makes the point on the adaptive requirement better than I have [emphasis mine]:

In their Commentary ‘Dangerous assumptions’ (Nature 452, 531-531; 2008), Pielke et al. show that the 2000 Special Report on Emissions Scenarios (SRES) reflects unrealistic progress on both the supply and demand sides of the energy sector. These unduly optimistic baselines cause serious underestimation of the costs of policy-induced mitigation required to achieve a given stabilization level.

This is well known among experts but perhaps not to the public, which may explain why some politicians overstate the impact of their (plans for) climate policy, and why others argue incorrectly that ‘available’ off-the-shelf technologies can reduce emissions at very little or no cost.

The numbers presented by Pielke et al. are revealing, but they divert attention from a more serious problem underlying the SRES approach to calculating mitigation costs: a failure to incorporate the dynamic nature of the decision problem into climate-policy analysis. Until we can keep adjusting the analysis by continually incorporating uncertainty, correction and learning, we shall continue to offer policy-makers an incomplete guide to decision-making.

The focus of policy analysis should not be on what to do over the next 100 years, but on what to do today in the face of many important long-term uncertainties. The minute details of any particular scenario for 2100 are then not that important. This can be achieved through an iterative risk management approach in which uncertain long-term goals are used to develop short-term emission targets. As new information arises, emission scenarios, long-term goals and short-term targets are adjusted as necessary. Analyses would be conducted periodically (every 5-10 years), making it easier to distinguish autonomous trends from policy-induced developments — a major concern of Pielke and colleagues. If actual emissions are carefully monitored and analysed, the true efficacy and costs of past policies would be revealed and estimates of the impact of future policy interventions would be less uncertain.

Such an approach would incorporate recent actions by developed and developing countries. In an ‘act then learn’ framework, climate policy is altered in response to how businesses change their behavior in reaction to existing climate policies and in anticipation of future ones. This differs from SRES-like analyses, which ignore the dynamic nature of the decision process and opportunities for mid-course corrections as they compare scenarios without policy with global, century-long plans.

For a recent study of the costly, messy world of trading permits and offsets see the April 2008 working paper [PDF] by reliable sources Michael Wara and David Victor. Excerpt:

This article reviews the actual experience in the world’s largest offset market–the Kyoto Protocol Clean Development Mechanism (CDM)–and finds an urgent need for reform. Well- designed offsets markets can play a role in engaging developing countries and encouraging sound investment in low-cost strategies for controlling emissions. However, in practice, much of the current CDM market does not reflect actual reductions in emissions, and that trend is poised to get worse. Nor are CDM-like offsets likely to be effective cost control mechanisms.

This is excellent work — and compelling results. I hope that all the politicians pushing “son of Kyoto” deals will read it and think carefully about what they are proposing.

Equality in Health Spending

Published
by
Steve Darden
on 9/27/2008
in Economics and Healthcare
. 0 Comments

Via Greg Mankiw came this useful Robert Samuelson article, including some recent research that surprise me:

It is widely assumed that health care, like most aspects of American life, shamefully shortchanges the poor. This is less true than it seems. Economist Gary Burtless of the Brookings Institution recently discovered this astonishing data: on average, annual health spending per person — from all private and government sources — is equal for the poorest and the richest Americans. In 2003, it was $4,477 for the poorest fifth and $4,451 for the richest. Probably in no other area, notes Burtless, is spending so equal – not in housing, clothes, transportation or anything. Why? One reason: government already insures more than a quarter of the population, including many poor.

Tax and Charade

Published
by
Steve Darden
on 9/27/2008
in Climate Change and Energy Policy
. 0 Comments
It is high time we started calling cap and trade what it really is — tax and charade.

Roger Pielke examines the upcoming emissions permits auction for the Regional Greenhouse Gas Initiative (RGGI) of 10 northeastern U.S. states participating in this new cap and trade program.

…The evolving performance of RGGI should add weight to the argument that cap and trade is simply not up to the challenge of reducing greenhouse gas emissions.

Bueno de Mesquita on Iran and Threats to U.S. Security

Published
by
Steve Darden
on 9/27/2008
in Iran and Middle East
. 0 Comments

The Aug 11, 2008 Russ Roberts Econtalk interview with Bruce Bueno de Mesquita was fascinating. You can directly download the MP3 audio of the interview here. Better, subscribe to the Econtalk series at iTunes.

Russ has a short and very terse set of notes from the interview, including a couple of paragraphs on the threat profile of Iran, and of particular interest, how important is Pres. Ahmadinejad in the Iranian hierarchy? We knew he was effectively a figurehead or “front man” for the Supreme Council. But, typically, de Mesquita’s research puts Ahmadinejad at 18th in the ranking:

Intro. Danger, threats to the United States. Are Iran Ahmadinejad a threat to the U.S.? Threat to our friends. No missiles with sufficient range to reach the U.S. Can it smuggle a bomb into the U.S.? That’s more a matter of movies. Ahmadinejad is the President of Iran, but virtually all power there is held by the Supreme Council. Has veto power, can remove people from office; all people elected including Ahmadinejad serve at the pleasure of the Supreme Council. Interviews, Ahmadinejad ranked 18th in terms of power. At odds with most people’s public perception. Maybe he’s 17th or 19th; but he’s not 3rd or 4th. He is a very outspoken man, says many outrageous things, so he gets a lot of news coverage. Came to power by election from being mayor of Teheran by carving out a constituency of not-very-well educated who saw in him someone who would advance Iranian nationalist sentiment. His power has faded and his party keeps losing by elections. Media attention also because American media has poor or no access to Ali Khamenei, head of the Supreme Council, most powerful person in Iran. Putin had audience with Khamenei; Western leaders only get to see Ahmadinejad. Why would Khamenei want Ahmadinejad in power? Good for floating trial balloons, has a salutary effect in terms of foreign policy; has convinced some people that the Iranian leadership is irrational, and in doing so have attained a certain amount of deterrent clout. Very Schellingesque (Thomas Schelling, Nobel Prize winner), soft application of game theory to national security problems, brinksmanship. Strategy that if you convince the other guy that you’ll drive off the cliff, the other guy gets pretty nervous about it.

At 7:43 in the audio:

Do the 17 people ranked in front of Ahmadinejad have similar views? Do they want to build a nuclear weapon? Ahmadinejad would like to. Ali Khamenei would probably like the capacity to make weapons’ grade fuel, bargaining chip, but a weapon itself could lead to a pre-emptive attack by the Israelis. Others in power much more pragmatic, likely to advocate no more than a fuel cycle at the research level, not to produce enough actually to make a bomb. As a social scientist it makes sense to treat these people as if they are rational. Track record of predictions, last 24 years: 1984 predicted in print who would succeed Ayatollah Khomeini, designed someone; predicted instead shared leadership between Ali Khamenei and Rafsanjani. Khomeini died 5 years later. Based prediction on rationality assumption. Rationality doesn’t mean doing good things. It means doing things based on their own best interest. Logic of Political Survival, previous podcast, leaders want to keep their jobs. Data are consistent with Ali Khamenei’s wanting to stay in power. What would their motivations be to building a nuclear bomb? If they could get far enough without Israel’s attacking, they have a deterrent. India and Pakistan: since they both detonated nuclear weapons they have made an effort to get along. Argument is that deterrence claim is false because Israelis will move beforehand. Iran, Shiite force, is in competition with Al Qaeda, Sunni force to be the dominant leader in the Islamic world. They hate each other. Bomb would be a way of achieving nationalist pride, which keeps the party in power while the economy goes to hell. Rational reasons for wanting to build a nuclear weapon. They say want to develop nuclear power for peaceful energy uses, which is their right.

From other reading we have learned that de Mesquita has done repeated consulting assignments for the CIA. In this interview he said his work on Iran was for “confidential sources”.

Readers not familiar with de Mesquita’s work may conclude from this interview that he is an “Iran expert”. In fact the “Iran experts” called him a quack when in 1984, in “Forecasting Policy Decisions: An Expected Utility Approach to Post-Khomeini Iran,” Political Science (Spring, 1984), pp. 226-236, five years before the eventual succession, he correctly predicted that the successors to Khomeni would be the unknown clerics Rafsanjani and Khameini. His forecasting record has been built entirely upon the application of game theory to the politicians’ incentives — in the setting of their political structure.

Highly recommended.

Seeking an Israel Palestine solution via rational-choice theory

Published
by
Steve Darden
on 9/27/2008
in Economics , Israel and Palestine
. 0 Comments

Triggered by the desire to calibrate the value of the game theory research of Bruce Bueno De Mesquita (BDM) I found a useful review of his work by Michael Lerner. Following is a sample from the article — of BDM’s thoughts on more effective approaches to the Middle East conflict:

Recently, he’s applied his science to come up with some novel ideas on how to resolve the Israeli-Palestinian conflict. “In my view, it is a mistake to look for strategies that build mutual trust because it ain’t going to happen. Neither side has any reason to trust the other, for good reason,” he says. “Land for peace is an inherently flawed concept because it has a fundamental commitment problem. If I give you land on your promise of peace in the future, after you have the land, as the Israelis well know, it is very costly to take it back if you renege. You have an incentive to say, ‘You made a good step, it’s a gesture in the right direction, but I thought you were giving me more than this. I can’t give you peace just for this, it’s not enough.’ Conversely, if we have peace for land—you disarm, put down your weapons, and get rid of the threats to me and I will then give you the land—the reverse is true: I have no commitment to follow through. Once you’ve laid down your weapons, you have no threat.”

Bueno de Mesquita’s answer to this dilemma, which he discussed with the former Israeli prime minister and recently elected Labor leader Ehud Barak, is a formula that guarantees mutual incentives to cooperate. “In a peaceful world, what do the Palestinians anticipate will be their main source of economic viability? Tourism. This is what their own documents say. And, of course, the Israelis make a lot of money from tourism, and that revenue is very easy to track. As a starting point requiring no trust, no mutual cooperation, I would suggest that all tourist revenue be [divided by] a fixed formula based on the current population of the region, which is roughly 40 percent Palestinian, 60 percent Israeli. The money would go automatically to each side. Now, when there is violence, tourists don’t come. So the tourist revenue is automatically responsive to the level of violence on either side for both sides. You have an accounting firm that both sides agree to, you let the U.N. do it, whatever. It’s completely self-enforcing, it requires no cooperation except the initial agreement by the Israelis that they are going to turn this part of the revenue over, on a fixed formula based on population, to some international agency, and that’s that.”

As we have learned, “incentives matter”, in foreign policy just as in economics. Surely BDM’s proposal would at least improve the possibility of future cooperation. Will it take two generations of such policies to wash away enough of the Palestinian indoctrination of their young?

BDM founded Decision Insights Incorporated in 1981 and the New York consulting firm Mesquita & Roundell in 2003, but has been consulting independently for years for clients in the private sector and for a long list of governments:

…As one of the foremost scholars of game theory—or “rational choice,” as its political-science practitioners prefer to call it—Bueno de Mesquita is at the center of a raging hullabaloo that has taken over some of the most prestigious halls of learning in this country. Exclusive, highly complex mathematically, and messianic in its certainty of universal truths, rational-choice theory is not only changing the way political science is taught, but the way it’s defined.

To verify the accuracy of his model, the CIA set up a kind of forecasting face-off that pit predictions from his model against those of Langley’s more traditional in-house intelligence analysts and area specialists. “We tested Bueno de Mesquita’s model on scores of issues that were conducted in real time—that is, the forecasts were made before the events actually happened,” says Stanley Feder, a former high-level CIA analyst. “We found the model to be accurate 90 percent of the time,” he wrote. Another study evaluating Bueno de Mesquita’s real-time forecasts of 21 policy decisions in the European community concluded that “the probability that the predicted outcome was what indeed occurred was an astounding 97 percent.” What’s more, Bueno de Mesquita’s forecasts were much more detailed than those of the more traditional analysts. “The real issue is the specificity of the accuracy,” says Feder. “We found that DI (Directorate of National Intelligence) analyses, even when they were right, were vague compared to the model’s forecasts. To use an archery metaphor, if you hit the target, that’s great. But if you hit the bull’s eye—that’s amazing.”

Lerner closes with “A sample of Bruce Bueno de Mesquita’s wilder—and most accurate—predictions”

Forecasted the second Intifada and the death of the Mideast peace process, two years before it happened.

Defied Russia specialists by predicting who would succeed Brezhnev. “The model identified Andropov, who nobody at the time even considered a possibility,” he says.

Predicted that Daniel Ortega and the Sandanistas would be voted out of office in Nicaragua, two years before it happened.

Four months before Tiananmen Square, said China’s hardliners would crack down harshly on dissidents.

Predicted France’s hair’s-breadth passage of the European Union’s Maastricht Treaty.

Predicted the exact implementation of the 1998 Good Friday Agreement between Britain and the IRA.

Predicted China’s reclaiming of Hong Kong and the exact manner the handover would take place, 12 years before it happened.

For readers interested in a deeper assessment of Bueno de Mesquita’s work, see his 17-page CV at NYU [PDF].

What really caused the financial crisis?

Published
by
Steve Darden
on 9/26/2008
in Economics and Financial Crisis
. 0 Comments

Kashyap, Rajan, and Stein have lots of explanation but here is the initial bottom line:

The proximate cause of the credit crisis (as distinct from the housing crisis) was the interplay between two choices made by banks. First, substantial amounts of mortgage-backed securities with exposure to subprime risk were kept on bank balance sheets even though the “originate and distribute” model of securitization that many banks ostensibly followed was supposed to transfer risk to those institutions better able to bear it, such as unleveraged pension funds. Second, across the board, banks financed these and other risky assets with short-term market borrowing.

In other words, one problem was not enough (!) securitization. They also call for counter-cyclical capital requirements. They like mandatory capital insurance — with payments triggered by capital disasters — even better. My main worry, of course, is how we should regulate (or not) the entities which offer this insurance. Will they too engage in liquidity transformation and if so who ensures them?

And, going back to banks, part of the governance problem was this:

…it is very hard, especially in the case of new products, to tell whether a financial manager is generating true excess returns adjusting for risk, or whether the current returns are simply compensation for a risk that has not yet shown itself but that will eventually materialize.

Their phrase “recapitalization as a public good” should not soon be forgotten. And it is leverage which is dangerous, a lesson becoming clearer every day.

More from Tyler Cowen

TED Spread widened suddenly last week on 16th, 17th

Published
by
Steve Darden
on 9/26/2008
in Economics
. 0 Comments

200809260507

The TED Spread went critical for the first time last August. The big jump in fear in the banking system surrounding the Paulson Plan is similarly shocking. Banks are still fearful of lending overnight to other banks.

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