Sunday, June 29, 2008

Teaching the Worldview First

An op-ed in the NYT by two neuroscientists says:

Adding to this innate tendency to mold information we recall is the way our brains fit facts into established mental frameworks. We tend to remember news that accords with our worldview, and discount statements that contradict it.
This is hardly breaking news, but it strikes at the heart of my central criticism of the way economics is taught. In economics, the worldview is taught first. Professors teach students the basic neoclassical model first, with its assumptions of complete information, efficient financial intermediation, a full set of competitive markets for all goods and services, etc. As the economics courses get more advanced, the neoclassical model is augmented and expanded upon to more accurately represent the real world. The problem, as should be obvious, is that by the time students get to the more advanced courses—assuming they get to the advanced courses at all, which most students probably don't—they believe that the basic neoclassical model is a much more accurate representation of the real world than it actually is. (When I got to graduate school, I thought my economics education was pretty far advanced; as it turned out, I didn't know shit.) In other words, if a student who has just taken Econ 101 is presented with two pieces of evidence, one supporting and one contradicting the claim that more government regulation of the market for tomatoes would enhance efficiency, the student would be much more inclined to believe the evidence contradicting the claim that more government regulation of the tomato market would enhance efficiency. (Now, it's possible that the evidence against more government regulation of the tomato market is more likely to be true, but the point is that the Econ 101 student would assign a greater probability to the chances of that evidence being true than is warranted.) Teaching students first that markets are totally awesome and basically always efficient unduly slants their worldview toward believing that markets are infallible. Once that worldview is established, it becomes harder and harder to convince students that sometimes markets aren't totally awesome. This is why I've always said that the most dangerous employee is the economics minor. Avoid them at all costs.

Will we get a second fiscal stimulus package? The first stimulus package seems to have worked better than most experts anticipated, and with the economy still deteriorating, the idea of a second fiscal stimulus package seems to be gaining support. Robert Shiller called for a second stimulus package in today's NYT; Larry Summers does the same in his monthly FT op-ed tomorrow; and Robert Reich joins the chorus on his blog. And, of course, Barack Obama is now calling for a second stimulus package. I've seen this movie many times before, and I think the chances for a second stimulus package are now probably greater than 50-50.

Friday, June 27, 2008

Krugman The Open-Minded

Yesterday I criticized Paul Krugman for seemingly digging his heels in on the issue of speculation in the oil market, but it looks like I was too quick to criticize. In today's column, Krugman does, in fact, argue that speculation isn't the primary driver of high oil prices, but he displays a surprising openness to debate:

Is speculation playing a role in high oil prices? It’s not out of the question. Economists were right to scoff at Mr. Masters — buying a futures contract doesn’t directly reduce the supply of oil to consumers — but under some circumstances, speculation in the oil futures market can indirectly raise prices, encouraging producers and other players to hoard oil rather than making it available for use. Whether that’s happening now is a subject of highly technical dispute. ... Suffice it to say that some economists, myself included, make much of the fact that the usual telltale signs of a speculative price boom are missing. But other economists argue, in effect, that absence of evidence isn’t solid evidence of absence.
Krugman has been right far more often than any other commentator over the past 10-15 years, especially about economic issues. So whether you agree or disagree with him, his opinion deserves to carry some weight.

There's widespread concern that the credit crisis may be roaring back, with the equity markets plunging (all 3 major indexes lost about 3% today), oil topping $140, Citi in shambles, etc. The TED spread is over 100bp, which indicates that the credit markets may be seizing up again. But the previous waves of the credit crisis all saw a very sudden and sharp increase in the TED spread. There was no real lead-up to the jump in the TED spread. By contrast, the current rise in the TED spread seems to be much more gradual. Does that make a difference? I don't know—maybe, but probably not. We shall see in the next week or so. But when I looked at the 1-year TED spread chart, that was what immediately jumped out at me.

In the wake of the Heller case (which I think was decided correctly), I expect there will be a spate of op-eds and blog posts about gun control. Indeed, Megan McArdle has already plunged into the debate with this post on gun statistics. One of the main problems with gun control debates—which contributes to their food-fight-like nature—is that "gun control" is a hopelessly ambiguous phrase that means different things to different people. As a result, the two sides often end up talking past each other. McArdle's post mostly addresses the effects of allowing "normally law-abiding citizens" to carry handguns, but she wanders out of that sphere a few times (e.g., discussing "would-be homicides"), which muddles her argument. So I'm not entirely sure what she means by this:

It turns out that suicides and would-be homicides weren't paying much attention to the legality of their actions. It also turns out that having a gun in your hands does not seem to turn a previously law-abiding citizen into a spur-of-the-moment killer.
Lest this be construed as a broad claim that guns are benign, the following should be pointed out (over and over again): it also turns out that having a gun in your hands tends to turn previously non-lethal crimes (e.g., assaults, robberies) into spur-of-the-moment homicides. As for the arguments about gun ownership serving as a deterrent, I agree that we don't have sufficient data to definitively answer the question. But based on the limited data we do have, one side of the debate is clearly winning:
In the gun policy debate, a related claim about the benefit of widespread gun ownership is that it serves to deter burglars, and especially “hot” burglaries of occupied homes (Kleck, 1997; Kopel, 2001). This claim is based on little evidenc of any kind. The only systematic analysis of this point of which we are aware (Cook & Ludwig, 2003b) demonstrates by use of the geocoded National Crime Victimization Survey data that the individual likelihood of residential burglary or hot burglary is not reduced by living in a county with high gun prevalence. One reason may be that a high gun prevalence increases the profitability of burglary, because stolen guns are readily fenced and easier to carry than televisions and many other types of loot.
Broadly, I agree with McArdle that the available statistics on guns are pretty weak, although I'm probably more willing to draw conclusions based on the available evidence than she is. There has been statistical malpractice on both sides of the debate, to be sure (Michael Bellesiles comes to mind); but I can recognize statistical malpractice when I see it, so I'm not too worried about getting bamboozled. Speaking of statistical malpractice, what's John Lott up to these days?

I just finished reading the majority opinion in District of Columbia v. Heller, and I just wanted to mention that Eugene Volokh -- the proprietor of the Volokh Conspiracy blog and a UCLA law professor -- had three of his law review articles cited in the opinion. Two of the citations were very prominent: one on page 3, and the other on page 24. In both instances, Justice Scalia clearly relied on Professor Volokh's articles -- not for tangential issues, but for core aspects of Second Amendment interpretation. One dealt with the interplay of the prefatory and operative clauses of the Second Amendment, and the other dealt squarely with the meaning of the phrase, "Security of a Free State." Having the Supreme Court prominently cite your law review article, and rely on it for constitutional interpretation, is probably the highest honor a law professor can receive. Congratulations, Professor Volokh!

Unfortunately, it looks like Paul Krugman has dug his heels in on the issue of speculation in the oil market. He doesn't think the surge in speculation in the futures market is driving oil prices higher, and it'll take a veritable smoking gun to change his mind. Krugman's argument reminds me of the old joke about economists, where the senior economics professor says to the junior economics professor, "Your idea may work well in practice, but it will never work in theory." Essentially, Krugman says that speculation isn't the driving force behind the rising oil prices because inventories haven't risen (he has made other peripheral points, but this is the heart of his argument). He admits that keeping oil in the ground is the equivalent of building up physical inventories, but brushes that fact off. For example:

OK, you can offer excuses. Maybe the oil inventories are being held in the ground; but do we have any evidence that oil producing countries are withholding output?
Well, there's this:
King Abdullah, reported by the official news agency this month, said: "I keep no secret from you that when there were some new finds, I told them: 'No, leave it in the ground, with grace from God, our children need it'."
And this:
Some producers, such as the U.A.E., are easing back at times on the crucial industry practice of injecting natural gas into crude oil fields, which is done to boost reservoir pressure and increase crude recovery rates. Halting the injections ends up undercutting oil production, further reducing exports.
Finally, there's the fact that OPEC refused to boost production right in the middle of the run-up in oil prices. Yves Smith, for example, has generally taken the opposite view, arguing that speculation may indeed be driving up oil prices. As Smith notes, it's impossible to determine how much oil is being inventoried in the ground. Unfortunately, the debate between Krugman and thoughtful proponents of a speculation theory, such as Smith, has gone something like this: Krugman: "Inventories aren't rising, so speculation isn't important." Smith: "But oil inventories are more likely to be held in the ground." Krugman: "Show me the data on oil being kept in the ground." Smith: "That data doesn't exist." Krugman: "I win." Color me unconvinced—by either side.

More specifically, why has the percentage of voters by party affiliation been converging over the past 40+ years? Forgive me for asking such a stupid question. I must be having a serious brain freeze, because I feel like the answer should be obvious, especially for someone who has followed politics closely for so long. I'm sure the political scientists know the answer. Here's the chart that got me wondering about this:

(Source note: The chart is from the CQ Voting and Elections Collection, and is based on Gallup Poll data.) Remember, convergence implies increasing polarization, so up is down in this chart. Curiously, the highest spreads (and thus the least polarization) occurred in 1964—the year Lyndon Johnson signed the Civil Rights Act of 1964. Vietnam probably explains most of the exodus from the Democratic party from 1964 to 1974. But the long-term trend is clearly toward partisan parity. Why does our political system (or representative democracy in general) trend toward partisan parity? Is it self-reinforcing? Is partisan parity inevitable? I'm sure plenty of people would instinctively answer, "it's because Republicans have pursued a strategy of political polarization." But that's an extremely flimsy explanation for the long-term trend, and relies too much on evil intentions. It has to be something about our political system. I'm just blanking out on what, exactly. Please help me. Seriously, I feel like the answer is on the tip of my tongue and I just can't spit it out.

Kevin Hassett, an economist at AEI and an adviser to John McCain, is stepping into the debate over whether NBA referees are fixing games (via Marginal Revolution). Having an economist apply his statistical tools to sports data is a dicey proposition because even after applying his tools, the economist has to properly interpret the results. That generally entails exploring alternative explanations for the results, and economists as a group probably aren't well suited for this. A case-in-point is Hassett's piece on Bloomberg describing his findings:

A first look at the numbers is troubling. Basketball is the one sport that should have the smallest home-field advantage. Every court is the same. Yet in the 2008 playoffs, the home team won 64 of 86 games -- or 74 percent of the time. If we exclude the first round, where there are bound to be some blowouts, the home team won 34 out of 42, an 81 percent clip. ... Travel might explain a modest home-court advantage. It could also be that adrenaline is stoked by the fans, and the pattern is completely innocent. There may be another answer.
Obviously, you're not a golfer. Just because all the rims are 10 feet off the ground and all the free-throw lines stand at 15 feet doesn't mean that "[e]very court is the same." It's about knowing exactly where you are on the court at all times, without having to think about it. Players have to know, without looking at the basket, exactly how far they are from the basket. When a shooter is running off a double-screen, he has to have an innate feel for when he's behind the three-point line. These kinds of things are tremendously important, especially at the NBA level. Hassett also thinks he has stumbled upon something when he discovers that home-court advantage is more pronounced in the playoffs than in the regular season. He thinks this is important because playoff games should be no different from regular season games. But anyone who has played in a post-season game at any level knows that playoff games are completely different from regular season games. Everyone plays tighter, inexperienced shooters get a bit more hesitant, etc. Also, coaching strategy changes dramatically. I suspect that if you told an NBA fan that home-court advantage was more pronounced in the playoffs than in the regular season, the fan would say, "of course it is." To be fair to Hassett, he correctly identified one of the biggest (and most under-appreciated) reasons for a home-court advantage in basketball: the fans. But he definitely should have consulted a basketball analyst or an NBA player before interpreting the data.

Monday, June 23, 2008

The Arrogance of George Will

George Will's unbridled arrogance never ceases to amaze me:

Barack Obama is a "choice architect" aiming to implement "libertarian paternalism." He might not know that he is; he might embrace the practice without understanding the theory. It is adumbrated in the new book "Nudge" by two occasional and informal advisers to Obama, both of whom are former colleagues of his at the University of Chicago, Richard H. Thaler of the Graduate School of Business, and Cass R. Sunstein of the Law School.
Obama might not "understand[] the theory" of libertarian paternalism? I've read Nudge, and believe me, libertarian paternalism is not a difficult concept. The book is written at the level of a popular economics book. It's interesting and highly recommended, but the concepts aren't even remotely difficult to understand. This is a variation on one of Will's most common arguments: that Democrats vote the way they do because they just don't understand economics (a subject Will has no formal training in, by the way); in Will's mind, if Democrats did understand economics, they'd be libertarians or conservatives. To be sure, there are plenty of Democrats who don't understand economics (I'm looking at you, Sherrod Brown). But when the overwhelming majority of professional economists are Democrats, it's time to put the old "Democrats don't understand economics" argument out to pasture. Or better yet, put George Will out to pasture.

Saturday, June 21, 2008

Vice President T-Paw

This is an interesting post about Minnesota Gov. Tim Pawlenty (nicknamed T-Paw), the leading candidate to be McCain's VP, in that it reveals a couple of interesting character traits. First, Pawlenty is "an Eagle Scout on matters of ethics," which evidently explains why he doesn't have a large political operation. Scheiber concurs with this assessment, and notes that when he was writing a profile of Pawlenty, his office was adamant about separating official activity and political/personal activity. Granted, his office was just adhering to state ethics laws, but in today's world, that's impressive for a politician from either party. Second, we learn that Pawlenty is "something of a micro-manager" who hates to delegate authority. Why are those two character traits so interesting? Because they've been completely absent in George W. Bush's administration. Even if you agree with the Bush administration's ends, there's simply no denying that Bush, Cheney, Addington, Libby, Gonzalez et al., have shown an unprecedented disregard for ethical considerations. Also, one of the biggest criticisms of Bush has been his willingness (which some might describe as eagerness) to delegate decisions, particularly to Cheney. It's possible that Pawlenty could be trying to set himself up as the anti-Bush/Cheney selection. If so, McCain would be wise to put him on the ticket (and I think he definitely will).

An article on the possible evolutionary origins of the endowment effect in this week's Economist says near the end:

The [endowment] effect also complicates the negotiation of contracts, as people demand more to give up standard provisions than they would have been willing to pay had they bargained anew.
This is so true. When negotiating a contract for a client, a somewhat common strategy among transactional lawyers is to draft a contract heavily tilted towards your client to use as the template in the negotiations. That way, when the other party is attempting to strike or modify a provision that favors your client, he thinks he's securing a much more valuable concession than he really is. In other words, the endowment effect works the other way too: if the other party thinks a provision tilted towards your client is normally included in a standard-form contract, he'll pay more to modify the provision than he would have been willing to pay for the modified provision had the contract been negotiated from scratch. When I'm drafting a contract to use as a template in the negotiations, I always put the most important provisions that are tilted towards my client at the end (usually dealing with liability), and the least important provisions that are tilted towards my client at the beginning (usually dealing with the timing of payments). That way, when we're going through the contract in the initial negotiation, the other party gets to successfully strike or modify a bunch of provisions he thinks are unfair right at the beginning. Then by the time we get to the end of the contract (where the most important provisions tilted towards my client are), the other party thinks he's already secured a bunch of valuable concessions, and is much less aggressive about striking the important provisions. When the other party is the seller (which is usually the case in my practice), sometimes he's actually willing to drop the final sale price in exchange for striking or modifying one of the important provisions at the end of the contract. Of course, this only works when the other party doesn't have an experienced lawyer representing him. In that case, we usually spend a good bit of time arguing over whose draft contract we're going to use as the template. But if the other party is represented by a lawyer with little experience in the particular field, you'd be surprised how well this works.

Over at the Volokh Conspiracy, Jonathan Adler, parroting Karl Rove, manages to criticize both Obama and McCain for "economic nonsense" in a post that is, itself, economic nonsense. A impressive feat. Adler writes:

In today's WSJ, Karl Rove observes both John McCain and Barack Obama are proving "that in close elections during tough economic times, candidates for president can be economically illiterate and irresponsibly populist." He criticizes Obama for embracing a Carter-esque windfall profits tax, and McCain for seeking to direct how oil companies invest their own profits. ... Rove is not known for his mastery of energy policy or economic principles, but in this case he's right on target.
It should be painfully obvious that Adler isn't known for his mastery of economics either. Basic economic theory tells us that Obama and McCain are acting completely rationally by advocating these "economically illiterate" policies. They are both trying to win an election, and thus must maximize the number of votes they receive. Obama is advocating a windfall profits tax because gas prices are incredibly high, and voters are likely to be particularly responsive to a politician who promises to lower gas prices. The benefits (i.e., more votes) of advocating a windfall profits tax are thus very high. The costs are low because Obama won't ever have to actually follow through on his promise. Windfall profits taxes on oil companies are proposed every summer (when oil prices go up, usually due to the summer driving season). These bills are always drafted in such a way as to make it them ineffectual even if they were passed. Usually they include a clause stipulating that the tax only becomes effective if the President declares a "national gas crisis." That's how you know they're not serious. The costs of advocating a windfall profits tax are limited to losing the votes of people who oppose a windfall profits tax, i.e., hard-core pro-business Republicans and oil industry employees. The number of votes lost is not only numerically smaller than the number of voters potentially gained by proposing a windfall profits tax, but it also includes virtually none of the most valuable voters: independents. The same analysis applies to McCain. What's "economically illiterate" is the assertion that Obama and McCain's populist proposals "reveal a disturbing animus toward free markets and success."

From Karl Case and John Quigley's new paper, How Housing Booms Unwind: Income Effects, Wealth Effects, and Feedbacks through Financial Markets:


The paper is required reading for anyone who wants to know the likely direction of the economy.

An op-ed in the LA Times by three law professors (via Mark Thoma) calls for the Justice Department to sue OPEC for violating U.S. antitrust laws. The op-ed is about as stupid as you'd think. But for a few sentences in the middle of the piece, the authors took brazen stupidity to a whole new level:

Imagine suing OPEC members for the amount they overcharged for petroleum products the U.S. government purchased. Then triple that amount -- for that is what can be awarded to consumers injured by cartel activity.
Please tell me how these law professors plan to figure out how much OPEC "overcharged for petroleum products." There's already a fierce debate over whether the current oil price is justified by the market, and you want a court to decree not only that the current oil price isn't justified by the market, but also how much the current oil price is above the market-clearing price? Please. Back to the professors:
Imagine the seizure of OPEC assets to pay this award, such as Venezuelan government-owned Citgo headquarters in Houston or Saudi Arabia's Aramco assets in New York. Imagine criminal charges filed against key cartel individuals when they come to the U.S.
Yes, and then imagine all 13 OPEC nations declaring war on the U.S. We could take them, of course, but that's not the point. I'm no international relations expert, but I'm pretty sure it's not in our long-term interests to start arresting heads of Middle East nations and seizing assets that are the lifeblood of their domestic economies. I think that would probably harm our standing in the Middle East. But that's just me.

A front-page story in today's New York Times is a perfect example of the harm caused by the rise of political journalists. The story is about the mass protests in South Korea. Look at the beginning of the story:

Critics of President Lee Myung-bak vowed Thursday to continue their protests despite his repeated apologies for a U.S. beef import deal that has paralyzed his four-month-old government. Reeling from the biggest anti-government demonstrations since the end of military dictatorship in the late 1980s, Mr. Lee promised to fire some of his aides and reshuffle his cabinet. But the damage inflicted by the beef protests and aggravated by soaring oil prices has curtailed his plan to stimulate the economy with pro-business legislation. The demonstrators have supplied political ammunition to the opposition which criticizes Mr. Lee’s hard line on North Korea and accuses him of moving too close to the United States. Mr. Lee angered South Koreans by agreeing in April to lift an import ban on U.S. beef that was imposed in 2003 after a case of mad cow disease was discovered in the United States. The beef protests quickly grew into broader demonstrations against Mr. Lee’s leadership style.
We don't even learn what the protests are about until the 5th graph! Instead of saying, "there are protests in South Korea; here's what the protests are about; here are the political ramifications," the story says, "there are protests in South Korea; here are the political ramifications; oh yeah, and here's what the protests are about." It's easy for journalists to think they're political experts, because political strategy isn't difficult to grasp conceptually. But that doesn't mean every journalist should emphasize the political aspect of their stories. (Nor does it mean that every journalist who covers politics has any idea what they're talking about when it comes to political strategy, but that's a topic for a different post.)

Via Mark Thoma, I see that Martin Feldstein has an op-ed in tomorrow's Washington Post in which he proposes a plan to limit the number of mortgage defaults. Here's the crux of Feldstein's proposal:

The federal government would offer all homeowners with mortgages the opportunity to replace one-fifth of their existing mortgage (up to some dollar limit) with a government loan. This loan would carry a substantially lower interest rate than the individual's mortgage (reflecting the government's cost of funds). It would be a full-recourse loan that would have to be repaid regardless of what happens to the borrower's mortgage or home. By law, it would take priority over all non-mortgage debt.
He then offers a hypothetical:
Consider how the program would work for someone who has a $360,000 mortgage on a home worth $400,000, a 90 percent loan-to-value ratio. A 15 percent drop in prices would push that homeowner into a negative equity position, because the house's value would be only $340,000. But if one-fifth of that $360,000 mortgage ($72,000) were converted to a loan from the government, the mortgage loan be $288,000. As a result, the 15 percent decline in housing prices would still leave the homeowner with $52,000 in positive equity -- the difference between the reduced house price of $340,000 and the new mortgage of $288,000. There would be a strong reason not to default.
This proposal would only work if Feldstein's hypothetical homeowner represented the typical homeowner in danger of defaulting. But it's highly unlikely that's the case. Feldstein seems to think that because experts are predicting a further 15% decline in aggregate housing prices, the typical house has just 15% further to fall. When experts say that housing prices will fall another 15%, they're talking about a 15% decline in the Case-Shiller indices or the OFHEO indices. These home price indices measure aggregate housing values in given metropolitan areas—they don't measure median home prices. The Case-Shiller national composite index measures housing values in all the MSAs (which is then converted into an index number with the same base value as the MSA-level indices). Saying that housing prices will fall another 15% on the Case-Shiller national composite index doesn't mean that the price of a typical house will fall another 15%. Let's say a majority of houses in a given MSA don't decline in price at all, but a small minority of houses in the MSA experience dramatic price declines (on the order of, say, 50%), which leads to a 15% decline in the Case-Shiller index for that MSA. Allowing the homeowners who experienced 50% price declines to replace one-fifth of their mortgages won't stop them from going into a negative equity position (assuming normal LTV ratios), and thus won't reduce the number of defaults. I'm sure there are some homeowners who are in the same situation as Feldstein's hypothetical homeowner, and Feldstein's proposal would undoubtedly help them. But given the huge number of additional foreclosures predicted, it's hard not to find proposal wanting.

From a paper on housing costs in California by Berkeley's John Quigley and Steven Raphael:



Quigley and Raphael add:

"These figures show a clear positive relationship between the average price of a constant quality unit of housing and the degree of anti-growth regulation. Housing price and rental rates are roughly 30 to 50 percent higher in the most regulated cities relative to the least regulated cities. Moreover, if we omit the one anomolous city with twelve growth restriction measures, housing costs—rents and house values—rise monotonically with the degree of regulation."

A falling dollar is supposed to stimulate U.S. exports, and if China and other developing countries allow their currencies to appreciate, consumers in those countries should be able to start buying stuff from the U.S. and other advanced countries. This morning I was trying to think about what U.S. industries are poised to benefit from this shift—that is, what do we make that Chinese consumers want? Chinese consumers are still, by Western standards, very poor. So the products they buy will primarily be low-cost products, such as clothing and food. Ironically, the abundance of cheap labor has attracted a lot of the garment industry to China, so we're out of luck there. Food, on the other hand, is something the U.S. still produces in large quantities. Demand for crops grown in the U.S., such as corn, wheat, and soybeans, should take off even more than it already has. It might be a good time to be a farmer. (I would include cars on this list, but let's be honest, the U.S. auto industry isn't going to win a lot of market share in China.) A rise in the RMB should also spur infrastructure investment in China. This, however, will undoubtedly be done through the Chinese government—they are, after all, still technically communist. Building highways, schools, and hospitals will require heavy construction equipment. So the Chinese government will probably need to buy fleets of bulldozers, excavators, and rollers. Luckily, the U.S. has the largest heavy equipment manufacturer in the world: Caterpillar. Just off the top of my head, it seems that farmers and heavy equipment manufacturers are in the best position to benefit from increased exports to China.

Tuesday, June 17, 2008

The Economics of Campaign Proposals

Paul Krugman, in his latest column, writes:

The surprise about the Obama plan is how much in the way of tax breaks it contains, and how much that cuts into the revenue available for other things, especially health care.
What's surprising isn't Obama's tax proposal, but that a great economist like Paul Krugman would be so blind to the economics behind campaign proposals. Voters want two things when it comes to tax policy: lower taxes and a balanced budget. Thus, a vote-maximizing politician will want a campaign proposal that promises voters both. This is why the Laffer curve was such an effective lie political tool. Both campaigns are emphasizing their tax cuts, so that takes care of promising lower taxes. How do the candidates promise to balance the budget? Balancing a budget in deficit requires either (1) a small tax hike on a large group of people, (2) a large tax hike on a small group of people, or (3) spending cuts (or some combination thereof). A vote-maximizing politician will want to choose the option with the lowest political cost—that is, the option that will negatively affect the least voters. McCain has chosen option (3): he's promising to balance the budget by cutting "wasteful spending." To minimize the political cost of option (3), he isn't specifying which government programs will have their spending cut, so he won't lose the voters who use those government programs. Everyone thinks a different government program (which they presumably don't use) constitutes "wasteful spending," so McCain is allowing people to project their concepts of "wasteful spending" onto his proposal. That way, McCain is able to promise voters a balanced budget without explicitly losing any votes. Obama has chosen option (2): he's proposing to balance the budget by raising taxes a lot, but only on a small group of voters (i.e., the uber-wealthy). To minimize the political cost of option (2), Obama is proposing to raise taxes on the uber-wealthy enough that his tax proposal is portrayed in the media as more fiscally responsible than McCain's proposal. Obama doesn't care that his tax proposal won't balance the budget (given the spending he's promising)—Obama only wants his proposal to increase the deficit less than McCain's. That way, the media will label him as the candidate of fiscal responsibility. Which campaign chose the better strategy for maximizing votes? It's too early to say. But the Obama campaign got exactly what it wanted when Krugman wrote in his column:
Barack Obama’s tax plan is more responsible than Mr. McCain’s: relative to current policy, the Tax Policy Center estimates, the Obama plan would raise revenue by $700 billion over the next decade, compared with a $600 billion loss for Mr. McCain.
Check-mate, professor.

This CNN.com article on the decline of the suburbs and the rise of "walkable urbanism" (a.k.a. New Urbanism), relies too much on Arthur C. Nelson:

As the market catches up to the demand for more mixed use communities, the United States could see a notable structural transformation in the way its population lives. ... [Arthur C. Nelson, director of Virginia Tech's Metropolitan Institute,] estimates that in 2025 there will be a surplus of 22 million large-lot homes that will not be left vacant in a suburban wasteland but instead occupied by lower classes who have been driven out of their once affordable inner-city apartments and houses. The so-called McMansion, he said, will become the new multi-family home for the poor. "What is going to happen is lower and lower-middle income families squeezed out of downtown and glamorous suburban locations are going to be pushed economically into these McMansions at the suburban fringe," said Nelson. "There will probably be 10 people living in one house."
Nelson is a prolific and long-time scholar in urban policy, but he's boldly predicted about 13 of the last 0 dramatic transformations in the urban landscape. First of all, I don't grant the article's premise that New Urbanism will become the new American Dream, replacing suburban life. New Urbanists have been claiming that the era of New Urbanism is right around the corner(!) for about 15 years now. They've convinced journalists write breathless articles about the coming of New Urbanism so many times I've lost count. The article notes that more and more young people want to live in walkable urban areas. Yes, they do. But then they get married and have kids, and move to where there's less crime—suburban areas (yes, crime rates in urban areas have decreased significantly, but they're still higher than in suburban areas). Preferences change over time. Just because young people want to live in walkable urban areas today doesn't mean that they'll always want to live in walkable urban areas. Second, there won't be a wholesale exile of low-income families to the suburbs. The low-paying jobs are concentrated in the urban areas, and low-income families can't afford the already high—and rising—transportation costs of commuting to work in the urban core from the suburbs. Affluent people relocating to walkable urban areas will displace some low-income families, but those low-income families will just move to other poor neighborhoods in the urban core. Poverty won't be dispersed, it will become more concentrated. If affluent people flock back to the urban areas, it will be because of high gas prices. High transportation costs won't shift the different income groups around the traditional city-suburb model. Rather, high transportation costs will compress the traditional city-suburb model. Affluent people will still live on the fringes of the metropolitan area and poor people will still live in the center, it's just that the metropolitan area will be geographically smaller.

Trade with China decreases U.S. producer prices in trade-affected sectors, but the decreases are due primarily to increases in total factor productivity (TFP), not lower wages. Dani Rodrik (via Mark Thoma) wonders why the increased competition from China increases TFP:

Perhaps what is happening is a kind of industry rationalization--exit of the least efficient firms--in which case we should see this restructuring and the associated layoffs in the data as well. Moreover, labor does not exactly come out unharmed in this case either. It is after all job loss, and the threat thereof, that workers complain about.
Dani: look to the immigration literature. The effect of immigration of unskilled workers should be to lower wages for unskilled native workers, right? But it does so only marginally. Instead, the increased competition for low-skilled jobs often forces unskilled native workers to move to other cities and other industries—in effect, it causes a restructuring of the labor market. This National Academy of Sciences report on the effects of immigration puts it best:
[Studies of a particular industry in a particular city] typically trace the employment patterns in an industry as it is penetrated by immigrants. Often, they find substantial "displacement"—in the sense that native workers leave the industry as the immigrants enter it. ... However, such studies are not inconsistent with our overall conclusion that immigrants have no large negative impact on wages. ... [T]hese case studies are asking a question different from ours: employment displacement may well be very large without any noticeable wage adjustment if the displaced workers find employment often in other industries or in other areas of the country. ... [T]he evidence that the wages and employment of natives are not substantially lower in areas with large numbers of immigrants suggests that, if substantial displacement occurs, displaced workers must either find other jobs with similar pay or move to other areas.
Assuming that trade with China has more or less the same effect as the immigration of unskilled workers, then trade with China would also induce a restructuring of the labor market. Dani Rodrik is right. He, unlike Naomi Klein, is smart.

Megan McArdle makes a key point about asset bubbles (a point that seems to elude 99% of journalists):

It is not enough to think that prices are going to rise; you have to think that they will rise more than everyone else thinks they will. Otherwise, the future appreciation should already be fully priced into the current asset. Failure to understand this--the belief that you can actually make a profit based on a certain rise--is the root of all bubbles.
This is why I find it so hard to believe that the dramatic run-up in oil prices over the past 17 months can be explained solely—or even mostly—by rising demand from developing countries, particularly China and India.

Rising demand from developing countries can explain high oil prices, but not rising oil prices. If the current high price of oil ($140/barrel) can be explained solely by increased demand for oil from developing countries, then the futures markets should have priced in the increased demand a long time ago—we've known for quite a while that developing countries would increase their demand for oil as they grew. The price of oil was around $60/barrel in January 2007. What do we know about the rising demand for oil from developing countries now that we didn't know in January 2007 (or for that matter, January 2005)? Virtually nothing—except that both China and India's growth has actually slowed a bit. But look what the price of oil has done:



To find out what's behind the run-up in oil prices, you have to figure out why the futures market has underestimated the spot price of oil over and over again for the past 17 months. There hasn't been any important new information about rising demand from developing countries for futures traders to price in. So something else has been driving oil prices up. The question is, what?

Here's where speculators could play a role. As the housing bubble has wreaked havoc on the financial markets, investors seeking higher returns have flocked to commodities—particularly oil. The vast majority of these investors are brand new to commodities. They're just looking for high returns, and oil futures have been providing high returns ever since the investors started to flee the mortgage market (and all other investments tinged by mortgages). This is a possible explanation for the rising oil prices because the subprime crisis unfolded slowly, and thus new investors have been constantly moving into oil.

Each successive wave of investors flooding into oil futures would have very little specialized knowledge of the oil market. Moreover, the reason these investors were buying oil futures was the belief that oil prices were rising. So the vast majority of these investors would have been long oil, thus driving oil prices ever higher.

Now, I don't think this is the whole story by any means. I just think it's a conceivable explanation for rising oil prices over the past 17 months—it's a more believable explanation that just "rising demand from China and India," at least.

How will the spike in oil and food prices affect the global economy? Mohamed El-Erian of Pimco, writing in the FT, makes a number of predictions I'm inclined to agree with. As to the first-round effects, El-Erian predicts:

The price shock will serve to undermine real incomes in the US and lower imports. On the policy front, it will accentuate the tug of war that the Federal Reserve faces on account of its now conflicting inflation and employment objectives. Emerging economies face greater inflation in the context of their buoyant liquidity conditions. Several will see their real effective exchange rates appreciate, by means including measures to allow the nominal exchange rate to appreciate markedly against the dollar. In Europe, growing demands for wage increases may force companies to step up structural reforms and will cause the European Central Bank to increase its hawkish rhetoric.
And the second-round effects:
In the US, look for renewed pressure for further fiscal stimulus and a monetary policy that, while appropriate for the US, is too inflationary for the rest of the world. In Asia and the Middle East, the spike in inflationary pressures may inadvertently slow the move towards more efficient tools of indirect economic management. In Europe, expect attempts to bypass fiscal responsibility guidelines in order to mute political protest.
I'm about two-thirds of the way through El-Erian's new book, When Markets Collide, and it's fantastic so far. It gives a great big-picture view of the global economy, and makes persuasive case for reforming the international institutional set-up.

Sunday, June 15, 2008

Ideology is Relative

Paul Krugman on Obama:

Obama supporters...are suddenly starting to have the queasy feeling that their hero might be a bit of a …. centrist.
David Brooks on Obama:
[W]hen you look into [Obama's] actual policies, you often find a list of orthodox liberal programs that no centrist or moderate conservative would have any reason to support.
The lesson: where a politician stands on the ideological spectrum depends on where you stand on the ideological spectrum.

Fisking a Naomi Klein column is like shooting fish in a barrel, so I won't get into all the idiotic statements in her latest logically-challenged article. But it's truly baffling how Klein, and critics like her, willfully blind themselves to the data:

Now is the time to worry about Obama's Chicago Boys and their commitment to fending off serious attempts at regulation. It was in the two and a half months between winning the 1992 election and being sworn into office that Bill Clinton did a U-turn on the economy. He had campaigned promising to revise NAFTA, adding labor and environmental provisions and to invest in social programs. But two weeks before his inauguration, he met with then-Goldman Sachs chief Robert Rubin, who convinced him of the urgency of embracing austerity and more liberalization. Rubin told PBS, "President Clinton actually made the decision before he stepped into the Oval Office, during the transition, on what was a dramatic change in economic policy."
And boy was Clinton's economic policy an unmitigated disaster for the working poor! Oh wait. The Clinton era was the veritable golden era for the working poor:




Wouldn't it be awful—just awful!—if Obama followed in Clinton's footsteps? Apparently to Naomi Klein, it would be awful. She wants Obama to fire Jason Furman for the grave sin of wanting to implement economic policies that have a proven record of raising the living standards of the working poor. Makes sense.

Naomi Klein is not smart. There's just no way around that.

1. The lure of ideology. Why are Chicago-school economists proud of being part of a tradition that has an explicit ideology? Is considering empirical evidence without ideological predilections out of style? I don't get it. 2. No oil bubble? This seems like fairly strong evidence against an oil bubble:

"Refiners are paying record premiums for the high-quality crude oil they use to produce diesel and petrol, a sign of strong demand in the physical oil market. ... The fact that refiners are willing to pay a higher price for physical supplies than the futures benchmark lends weight to the argument that speculators are not the cause of record oil prices."
3. When pigs fly. Joseph Stiglitz calls for all capital gains to be taxed at the same level ("at least") as ordinary income. That's about as likely as a constitutional amendment repealing the Second Amendment. 4. Universal Healthcare Vouchers. This is an innovative healthcare proposal. I'm not so big on the "independent Institute for Technology and Outcomes Assessment" it proposes, but reining in medical costs would do wonders for both the budget deficit and the economy as a whole, so maybe such a drastic action is the best course.

Saturday, June 14, 2008

Bob Herbert Doesn't Understand Sampling

With the media's obsession over campaign polls, you'd think that a political commentator like Bob Herbert would have a basic understanding of sampling. But he does not. Sen. Bernie Sanders (I-VT) showed Herbert a batch of heartbreaking letters from constituents describing the harsh economic realities of being middle-class in a bum economy. So Herbert spent his entire column today describing the letters and lamenting the disconnect between the "polling data and alleged trends," and "ordinary Americans." But are the letters really from "ordinary Americans"—that is, do they accurately represent the economic circumstances of the typical middle-class citizen? No. As Herbert notes:

Senator Sanders asked his constituents to write to him about their experiences in a difficult economy.
So Sen. Sanders only solicited letters from constituents who are having a difficult time in a worsening economy? What a surprise that the overwhelming majority of the letters were from people who are struggling! Herbert, though, doesn't consider that the letters might be skewed (can't let those pompous statistics get in the way of a good story!):
The letters to Senator Sanders offer a glimpse into the real lives of ordinary people in an economic environment that was sculpted to favor the very rich.
Reporting anecdotal evidence can be very useful—it's important to recognize the realities underlying macroeconomic statistics. And Herbert is absolutely right that the middle-class is—and has been—under incredible economic strain. But reporting anecdotal evidence from a highly skewed sample is misleading. I'd say that Herbert knows better, but I really don't think he does.

Richard Green, an urban economist who specializes in real estate economics, makes an interesting estimation:

Over the past six years, the price of gasoline has risen about $2 per gallon. What does this mean for relative urban land prices? Let's say the average household makes five one-way trips per day--for work, shopping, entertainment, etc. Let's also say that the average car gets 20 mpg in city driving. Each mile of distance to work, shopping, etc. is therefore now 50 cents per day per household more expensive than before. A household living immediately adjascent to work and shopping should then be willing to pay $5 per day more in rent than a household 10 miles away compared with six years ago, all else being equal. This becomes $150 per month, or $1800 per year. Assuming a five percent cap rate for owner occupied housing, this translates to $36,000 in relative change in value. Given that the median house price in the US is about $220k, this is kind of a big deal.
Professor Green acknowledges that his assumptions are "pretty crude," but his assumptions seem pretty reasonable to me at first glance. And given the magnitude of his estimation ($36,000), even significantly more dynamic assumptions would produce startlingly high results.

Winterspeak links to a graph of income growth at the top end of the income spectrum from the Wall Street Journal. The graph itself just presents Emmanuel Saez and Thomas Piketty's research, which is well known. In short, Saez and Piketty have shown that only incomes in the top 10% rose in real terms from 2000-2006, and only incomes in the top 1% saw any significant income growth. But the graph reminds me of one of the most grating conservative arguments against raising taxes on the wealthy. The conservative argument generally goes something like this: "Yes, middle-class incomes have stagnated, but incomes in the top 10% haven't been growing much either, so it's unfair to raise taxes on the top 1%." The fallacy is obvious to anyone who thinks about it for measurable time (unlike, say, journalists). On the issue of whether to raise taxes on the top 1%, real income growth in the top 10%, as a group, is irrelevant. What's relevant (if you consider income growth relevant to such a discussion at all) is income growth in the top 1%. Comparatively small increases in real incomes in the top 10%-2% could be—and as Saez and Piketty have shown, is—masking substantial increases in real incomes in the top 1%. Real incomes in the top 1% have increased at an 11% annual rate in the Bush era; real incomes in the top 0.01% have increased at a whopping 22.2% annual rate in the Bush era. The fact that real incomes in the top 5%-1% have increased at an annual rate of only 1% in Bush era doesn't matter, because both candidates want to extend the Bush tax cuts for people in the top 5%-1%. Obama is only proposing raising taxes on incomes in the top 1%. If you want to argue against Obama's plan on fairness or efficiency grounds, then by all means, go ahead. There are certainly arguments to be made. But please, please don't use statistics on all incomes in the top 10%, or the top 5%.

Paul Krugman thinks that "2008 was definitely the year in which the progressive movement lost a lot of its innocence." I beg to differ. There's always a "progressive movement," even though it's not always called that. And young people are always at the core of the progressive movement. Young people are almost always overly-idealistic about politics—an obvious consequence of their inexperience with politics. Every 4 years, the young people at the core of the progressive movement set out to Change the World, and get heavily invested in the presidential election. Then the dark side of politics rears its ugly head. And the young people at the core of the progressive movement lose their innocence. Repeat as needed. DISCLAIMER: In no way am I trying to mock the progressive movement. I'm just saying that the majority of the young people at the core of the progressive movement are extremely naïve about politics—a claim Krugman would no doubt agree with (see also here). I also don't think that's really an insult: the idealistic portrayal of politics that kids are taught in school has to meet reality at some point, and a presidential election is usually where the rubber meets the road.

The always-astute Yves Smith notes that it will be difficult to wean the financial sector off the Fed's emergency life-support, but then fails to mention Tim Geithner's ominous suggestion in his recent op-ed that the Fed is actually considering making some of the emergency measures permanent. First, here's Smith:

We wondered ever since the Fed established and then repeatedly increased the size of its Term Auction Facility, which now provides $150 billion of support to the US banking system, how the central bank would ever be able to wind down this program. It certainly can't do it when the financial system is fragile, and banks will argue that the withdrawal will hurt their operations even when the economy is in better shape.
Smith then links to an article in the FT by Gillian Tett that makes essentially the same point, but wildly misinterprets Geithner:
[A]s any addict knows, addiction rarely disappears by itself. On the contrary, procrastination tends to make the problem worse, as habits become deeply ingrained—be that in Japan, or anywhere else. The US Federal Reserve, for its part, appears to be keenly aware of this problem. And Timothy Geithner, New York Fed president (and himself an expert on Japan), has signalled his desire to avoid any Tokyo-style policy fudge by calling for a broader rethink of the regulatory structure.
Really? Here's what Geither wrote in the FT just 5 days ago:
The Fed has put in place a number of innovative new facilities that have helped ease liquidity strains. We plan to leave these in place until conditions in money and credit markets have improved substantially. We are examining what framework of facilities will be appropriate in the future, with what conditions for access and what oversight requirements to mitigate moral hazard risk. Some of these could become a permanent part of our instruments. Some might be best reserved for the type of acute market illiquidity experienced in this crisis.
Explicitly stating that the Fed is considering making some of the emergency facilities permanent is an awfully strange way of signalling a "desire to avoid any Tokyo-style policy fudge."

Wednesday, June 11, 2008

Limit the First Amendment's Scope?

The front page of nytimes.com summarizes an article on the First Amendment in tomorrow's NYT thusly:

As more countries move to ban or restrict hate speech, some legal scholars say the U.S. should reconsider the broad scope of First Amendment protection.
The article repeats the claim, stating that "[s]ome prominent legal scholars say the United States should reconsider its position on hate speech." Reading the article, though, I see only one legal scholar—NYU law professor Jeremy Waldron—who argues that the U.S. should reconsider the First Amendment's scope. The article does note that Anthony Lewis has argued that the Supreme Court should drop the "imminence" requirement from the incitement exception to the First Amendment. But that's a specific disagreement with one hurdle to one First Amendment exception—hardly a call for a reconsideration of the scope of the First Amendment. Among U.S. legal scholars, the broad protections of the First Amendment are almost universally celebrated. I would be very surprised if there was any real debate in the legal academy. The article is otherwise quite good. It shows how the First Amendment is truly unique internationally, as it grants constitutional protection to speech that most other developed nations consider illegal hate speech.

This story about Judge Alex Kozinski is unfortunate, if a bit strange. Judge Kozinski is without a doubt a brilliant jurist, and is immensely respected by the bar. I appeared as co-counsel in front of Judge Kozinski once a few years ago; I found him to be a lively and engaging questioner, and his intellect was obvious. I don't always agree with him (though I do more often than not), but he's one of the best federal circuit judges in the country.

Tuesday, June 10, 2008

The Electoral Map

Everyone is trying to get a sense of where the electoral map stands before the general election really starts. I spent a lot of time with pollsters when I worked in D.C. (most of them are good people, contrary to popular belief), so I know roughly how this game is played. Here's how I'm breaking down the electoral map right now. I'm not a huge fan of RealClearPolitics (could there be a stupider strategy than averaging polls?), but their broad electoral map is decent at this stage. The RCP map shows Obama with 228 electoral votes, McCain with 190, and 120 electoral votes up for grabs:

Which way are the swing states likely to go? For that, we have to look at the polls. Now, one of the most annoying thing campaigns do is cherry-pick polls. So to avoid cherry-picking polls, we should pick one polling outfit—presumably the best. SurveyUSA has been far and away the most accurate polling company this election season, so it's probably best to use SurveyUSA's polls. It's also important to limit ourselves to polls conducted relatively recently (say, in the past month) to make sure they reflect up-to-date public opinion. So applying the SurveyUSA polls conducted in the swing states in the past month, here's what we get: Virginia (13 EV) - Obama +7% Missouri (11 EV) - Obama +2% Wisconsin (10 EV) - Obama +6% Ohio (20 EV) - Obama + 9 Michigan (17 EV) - McCain + 4% North Carolina (15 EV) - McCain + 8% New Mexico (5 EV) - Tie Unfortunately, SurveyUSA hasn't conducted McCain vs. Obama polls in the other swing states in the past month. But even this limited snapshot is revealing. Obama needs 42 of the 120 "toss-up" electoral votes to get to 270. The SurveyUSA results indicate that 54 of the 120 toss-up electoral votes are leaning Obama. The bottom line: This is Obama's race to lose.

Update (2/5/09): Since Geithner's new role as Treasury Secretary has increased the public's interest in him, I should note that with the benefit of hindsight, it's clear now that Geithner was right, and I was wrong. The breadth and severity of the financial crisis, which are now apparent but weren't necessarily obvious when I originally wrote this post, absolutely justify extending the lending facilities like the TAF and the TSLF. Geithner was clearly ahead of the curve in terms of recognizing the magnitude of the problems in the financial sector. Tim Geithner has an op-ed in tomorrow's Financial Times. Geithner, as President of the New York Fed, is probably the most important financial regulator in the country, so anything he says should be taken seriously. He is the Fed's point-man on Wall Street. He also knows a great deal more about the financial markets than almost anyone, so I'm comfortable deferring to him on most financial matters. But I can't get on board with this:

The Fed has put in place a number of innovative new facilities that have helped ease liquidity strains. We plan to leave these in place until conditions in money and credit markets have improved substantially. We are examining what framework of facilities will be appropriate in the future, with what conditions for access and what oversight requirements to mitigate moral hazard risk. Some of these could become a permanent part of our instruments. Some might be best reserved for the type of acute market illiquidity experienced in this crisis.
Geithner is presumably talking about new facilities like the Term Auction Facility (TAF) and the Term Securities Lending Facility (TSLF). The TAF and the TSLF were indeed innovative, and could well have helped the Fed stave off a complete meltdown of the financial system. I don't question their utility in this financial crisis. But making them "a permanent part of out instruments"? That sounds an awful lot like making the bailout permanent. Geithner does say that the Fed is examining the conditions for access to these facilities. But the Fed would have to increase the strictness of the collateral requirements significantly to even begin to mitigate the moral hazard risk. I didn't believe the story when it came out, but maybe it's true: maybe Geithner has, in fact, been captured by Wall Street.

Thursday, June 5, 2008

More on a Potential Oil Bubble

In a Financial Times op-ed, Meghnad Desai aruges that there is, in fact, a speculative oil bubble:

The point is that this paper market is not driven by the pressures on demand and supply but entirely by price expectations. An underlying situation – which may well indicate a medium-run rise in oil price – is being exacerbated by the bolstering of expectations that prices will rise even faster. It is this extra layer of price rise that is driving money into even the farther future contracts. There are futures contracts being bought and sold for 2016 at $138 – only astrologers pretend that they can forecast that far ahead.
To pop the bubble, Lord Desai proposes charging "purely financial traders" a higher margin than "regular traders," by increasing (significantly) the margin required to trade as open interest. I'm still of the opinion that speculation is playing a role in oil prices, though no more of a role than the increasing demand from China/India and the stagnant supply of oil. I keep wondering whether the reason arbitrage hasn't forced futures prices back down yet is that a lot of arbitrageurs think the futures price will go even higher before peaking, and are therefore waiting until they can reap the most profits from arbitrage. If enough traders who would be going short are sitting out with the expectation that futures prices will be even higher later, then the number of purely financial traders would quickly overwhelm the regular commodities traders, pushing the price higher still. That could be a stupid thought, though.

The Economist thinks so:

[T]o make the bill more palatable to China-bashing politicians, its authors have strengthened provisions that would impose tariffs on energy-intensive imports from countries that are not taking “comparable action” against climate change, meaning all developing countries. That is a recipe for a trade war, which would only compound the economic pain of global warming. Just when a deal is possible, the stage is being set for a tragedy of Wagnerian dimensions.
This is not at all accurate. What the bill actually says is:
The term "comparable action" means any greenhouse gas regulatory programs, requirements, and other measures adopted by a foreign country that, in combination, are comparable in effect to actions carried out by the United States to limit greenhouse gas emissions pursuant to this Act, as determined by the President, taking into consideration the level of economic development of the foreign country.
The Kyoto Protocol would certainly qualify as a "greenhouse gas regulatory program[] . . . comparable in effect to" the Lieberman-Warner cap-and-trade (Kyoto was no doubt what the authors of the bill had in mind when they were defining "comparable action"). And since almost every developing country has signed the Kyoto Protocol -- including China, India, and Brazil -- they would all be deemed to have taken "comparable action" against climate change. Moreover, the bill also contains an escape hatch of sorts: it explicitly requires "the level of economic development" to be taken into consideration in determining whether a foreign country has taken comparable action against climate change. So even if Kyoto expires and there is no successor agreement, developing countries are unlikely to be hit with import tariffs. I agree that the "comparable action" provision was added to pacify China-bashers (and, no doubt, some hard-core environmentalists too). Pacifying opponents of a bill by using a tough-sounding phrase and then defining away its effect is a common trick in the legislative process. It appears The Economist was fooled as well.

Now that it's officially McCain vs. Obama in the general election, the race is on to compare and contrast the candidates' policy positions. One difference I expect the media to feature prominently is how the candidates would allocate emissions permits under their respective cap-and-trade proposals. McCain wants to initially allocate most of the permits for free based on past emissions; Obama wants to allocate the permits through an auction. It's important to remember that handing out emissions permits free of charge does NOT mean that the companies receiving them bear no cost. An emissions permit received free of charge still entails an opportunity cost. The opportunity cost of a permit handed out for free is the price for which the company can sell the permit. Once emissions permits are handed out free of charge, then every company can either keep its allotment of permits or sell them to another company. Assume that Company X receives 10 emissions permits, but it only needs 7. Assume further that Company Y is willing to buy permits for $1,000 each. If Company X decides to keep all 10 permits, then the opportunity cost of keeping the 3 permits it doesn't need is price for which Company X could have sold those permits to Company Y -- in this case, $3,000. Similarly, if Company X only values the remaining 7 permits it needs at $500 each, then the opportunity cost of not selling those 7 permits to Company Y is $3,500 ($500 × 7). I think Obama's proposal to auction off the emissions permits is superior, especially given our current budget deficit. But McCain's proposal to allocate most of the permits for free based on past emissions is not necessarily a hand-out to big corporations less efficient [ed: poor word choice originally on my part]. I hope the difference is portrayed accurately in the media. Wishful thinking, I know.

Wednesday, June 4, 2008

Real Wage Growth vs. Embedded Inflation

Over at Mark Thoma's site, Fed watcher Tim Duy argues that policies aimed at accelerating real wages are likely to embed inflation:

Funny thing is it appears if we want to pursue Krugman’s policy of real wage acceleration, we will have to push up wages to compensate for the recent acceleration in wages, which sounds an awful lot like embedding higher inflation expectations into wage expectations. I imagine it would be something of a delicate task to shift compensation power to labor while convincing firms not to respond to that shift by hiking prices. The risk is that guaranteeing against a 1970’s repeat requires accepting a lower standard of living for the many Americans who have already seen virtually no gains since 2000, and this will become increasingly politically unpalatable in the months ahead. I am at a loss to see the expenditure switching policies that smoothly redistribute income (profits to wages) with out boosting aggregate demand in an environment that is already potentially inflationary. Suggestions?
A sharp decrease in gas prices is the only thing I can think of that would allow real wage acceleration without running an unacceptably high risk of embedding inflation. The key is managing inflation expectations -- if workers and businesses think the Fed will quickly tame inflation, then workers can make wage demands based on real wage acceleration rather than inflation. As this chart shows, inflation expectations are volatile, so a sharp decrease isn't out of the question:
A sharp decrease in gas prices is the best way to quickly temper inflation expectations. Gas is still a relatively large share of household consumption, and the price of gas is by far the most noticeable price of any consumer good (what with gas prices being posted on every street corner and all). If gas prices dropped, people would be much less worried about inflation. I don't think there's actually a policy we could implement that would sharply lower gas prices on demand. We need to get lucky. Of course, lowering inflation expectations to the point where workers demand only moderately higher wages will only accomplish real wage acceleration if the Fed actually delivers the goods. If we convince workers that the Fed will tame inflation so that they won't base their wage demands on inflation, then the Fed actually has to tame inflation, or real wages won't accelerate at all. This is a complicated scenario, and I'll be the first to admit that it's not likely to happen. But it's at least conceivable.

In 1999, Paul Krugman wrote a pretty negative review of Thomas Friedman's The Lexus and the Olive Tree. At the end of the review, Krugman wondered aloud what the fashionable global vision would be in 2009:

Maybe I have just been in this business too long, and have seen too many global visions come and go. In 1979 everyone knew that it was a Malthusian world, that the energy crisis was just the beginning of a global struggle for ever-scarcer resources. In 1989 everyone knew that the big story was the struggle for the key manufacturing sectors, and that the winners would be those countries with coherent top-down industrial policies, whose companies weren't subject to the short-term pressures of financial markets. And in 1999 everybody knows that it's a global knowledge economy, where only those countries that tear down their walls, and open themselves to the winds of electronic commerce, will succeed. I wonder what everybody will know in 2009?
Since we're only about 7 months away from 2009, I started thinking about what the new fashionable global vision is. It was actually harder than I thought, and I'm still not sure I came up with the right answer. But here goes. In 2009, everyone knows that oil, coal, and other dirty sources of energy are the root of all the world's problems, and that the key to prosperity for every country is to win the race to develop new, clean, and viable "alternative energy" sources. Ironically, Thomas Friedman has also bought this story hook, line, and sinker.

This country badly needs a liquid, nation-wide derivatives market for residential real estate. I mean badly needs it. The potential social benefits of a well-designed, comprehensive, and liquid derivatives market for residential real estate are enormous. Let me explain why I feel so strongly about this. A house is both a consumer good and an investment. As a consumer good, a house must provide adequate shelter, be in good condition, have enough rooms if there's a family living in it, etc. As an investment, a house must remain attractive on the resale market. For the vast majority of homeowners in the U.S., their house is the single largest asset they own. A large percentage of homeowners also borrow heavily against their houses, so they have a very strong contemporaneous interest in the market value of their house, even if they're not going to sell their house. As a consequence, homeowners try to control as many of the factors affecting the market value of their house as they can. Some of the most important factors are events and conditions that occur beyond the physical boundaries of the property: the aesthetics of the neighborhood, the crime rate, the quality of government services (especially the quality of the local school) that the community's tax base will support, etc. How do homeowners exert control over these factors? Primarily through land use regulations -- exclusionary zoning regulations, in particular. Homeowners will use land use regulations to prevent almost any development they think will lower the market value of their house. And given homeowners' outsized influence on local governments, they're usually successful. So how does all this relate to derivatives markets for residential real estate? A derivatives market could allow homeowners to separate some of the investment components of housing -- particularly the ones that lead homeowners to adopt exclusionary zoning regulations -- from the consumption component. If homeowners were less concerned with the investment component of housing -- that is, protecting their house against a decline in market value -- then they would have less of an incentive to use land use regulations to prevent any nearby development they think might lower housing values. A derivatives market for housing is not necessarily a new idea, but there are two new and interesting proposals for such derivatives markets that I want to highlight: Chicago law professor Lee Anne Fennell's "Homeownership 2.0," and Ralph Liu's SwapRent (which I discussed previously in the context of the foreclosure crisis). 1. Homeownership 2.0 In a forthcoming law review article, professor Fennell proposes a derivatives market that would allow homeowners to reduce their exposure to fluctuations in the housing market that are attributable to "offsite factors":

Central to my approach is a distinction between parcel-specific influences on home values, which the homeowner is in a good position to personally control or insure against ("onsite factors"), and influences on home values that emanate from beyond the four corners of the parcel, such as neighborhood changes and larger housing market trends ("offsite factors"). I argue that only those value changes relating to onsite factors are essential to the homeownership bundle as it exists today.
Under Homeownership 2.0, homeowners could protect against a decline in the market value of their house by paying an investor to take on the downside risks attributable to offsite factors. As always, Fennell has a great diagram of Homeownership 2.0:
What distinguishes this from other home equity insurance proposals is that Homeownership 2.0 would allow homeowners to insure against only declines in housing values that are attributable to offsite factors, while retaining the downside risk for onsite factors. In other words, homeowners would only be buying a limited form of home equity insurance. This allays some of the moral hazard fears, because homeowners would still be on the hook for any price depreciation they cause themselves (i.e., the onsite factors). One big problem I see with Fennell's proposal is that homeowners will view the responsibility of maintaining margin accounts as unduly burdensome. Even if they have the cash to meet margin calls (many homeowners won't), they won't want to deal with frequent margin calls. The only way to sidestep this problem would be to have homeowners post high margins at the outset. I have a hard time believing that homeowners would be willing to post such high initial margins. A smaller problem I see could be worked out by contract. Homeowners would retain legal ownership of their houses, and thus would retain the ability to influence the local government, as well as the standing to challenge zoning decisions. Would homeowners be required to lobby the local government to deny a rezoning that would decrease the value of their house? Would homeowners be allowed to lobby for the rezoning? Would homeowners be required to challenge the rezoning in court? 2. SwapRent Ralph Liu is proposing a derivatives market in which investors would trade SwapRent contracts. There are many different kinds of SwapRent contracts, but the one I want to focus on is the DP (Depreciation Protection) SwapRent contract. In a DP contract, a homeowner would pay an investor a monthly premium, and in exchange the investor would be responsible for an agreed-upon percentage of the decline in the house's value. The amount of the monthly premium would depend on the percentage of the depreciation the investor is responsible for. A homeowner would have to pay higher premiums for the investor to bear responsibility for a higher percentage of the depreciation. Homeowners would still retain legal ownership of the house, and housing values would be based on a price index, such as the MSA level of the OFHEO index, or the Case-Shiller index. What I like about SwapRent is that homeowners can choose the duration of the SwapRent contract. A homeowner can protect against a decline in his house's value just for the next 3 years if he wants to. If the value of the house has declined when the contract expires, Liu explains how the contract is settled:
In the DP SwapRent (SM) contract, the investor will be responsible to the bank/homeowner for the previously agreed upon percentage of the loss in the value of the property at the time of sale, or refinancing.
Ironically, the only problem I see (from a policy perspective) also stems from the fact that homeowners can dictate the duration of the SwapRent contract. This is the problem of inside information. Say a homeowner has inside knowledge that the local government is about to approve the construction of a big, ugly, low-income apartment building in his neighborhood (he might be on the zoning board, or know someone on the zoning board), but he won't be able to move until he buys a new house, which will take about a year. In that case, the homeowner would want to buy a one-year depreciation protection contract. An investor who entered into the one-year depreciation protection contract would lose money (because he wouldn't demand a high enough premium, not knowing about the zoning decision), and would refuse to pay for failure to disclose. The availability of short-term depreciation protection contracts would encourage homeowners to use inside information in this way. Of course, this problem could be solved simply by requiring homeowners to disclose all relevant non-public information. But if the loss to the investors is high enough, you run the risk of investors deciding that it's in their interests to refuse to pay and claim failure to disclose, rather than simply accepting the loss (similar to what health insurers do). If this happens often enough, it could erode homeowners' confidence in SwapRent contracts in general; the derivatives market then might not be able to attract enough liquidity to remain viable. Technical quibbles aside, I think both Homeownership 2.0 and SwapRent are very good ideas. Land use regulations have been so fully "captured" by homeowners that no procedural safeguard will solve the problem. Decoupling some of the investment components of housing from the consumption components is the best way to roll back some of the truly pernicious land use regulations that have appeared in the last 25 years (or at least discourage their use). And a derivatives market for housing is the best way to accomplish that decoupling.

Jim Lindgren over at the Volokh Conspiracy embarrasses himself by trying to decipher the market's response to Obama clinching the nomination:

At 1:23pm ET, an AP story was released, reporting that Hillary Clinton would concede tonight because Barack Obama has clinched the nomination. The Dow Jones Industrial Average, which was at 12,493 and had been marking time for hours, immediately started dropping. In 9 minutes (1:32), it had dropped 72 points to 12,421. After another 23 minutes (1:55), it had fallen another 53 points, resulting in a 125 point drop in 32 minutes. It then stabilized, indeed rebounding a bit. This is not a particularly large drop (it's less than 1%), but the probable trigger was much clearer this time than for market responses to other primary wins and losses.
I'll let Barry Ritholtz explain why this is so bonecrushingly stupid:
Ever since the Primary on Tuesday, the market's have aggressively sold off. This clearly indicates the equity market's fear of a McCain presidency. ... And, the stock market has sold off, therefore proving that McCain must be bad for stocks and for the economy. ... Of course, I don't believe a word of that. But you would be surprised as to how many otherwise intelligent people spew variations of this sort of nonsense everyday. I will unequivocally state that anytime you hear this sort of nonsense, you can rest assured that the speaker is a) an unabashed partisan; 2) relatively clueless about how market's operate; iii) never worked on a trading desk. Markets operate not as forecastors, but as discounting mechanisms. Consider what has to be discounted to credibly say this: First, we would need to know who is likely to win the next election, 8 months in the future. ... The next president gets sworn in on January 20, 2009. They have to put together a series of legislative proposals, then get them passed by Congress, then fund them. Then, they have to begin implementing them. The impact of these would likely be felt sometime around 2010. Hence, the utter absurdity of the short term market twitches somehow reflecting unknown possible events, and their likely macro impact, several years hence. Ridiculous. Consider these questions as the more likely stimuli this bloody market is actually responding to -- the nearer term events that are still unfolding today: -Are we in a recession or not? -Is the credit problem fixed yet? -How much worse will housing get? -Will earnings rebound in the second half of 2008? -Will the US dollar ever stop falling? -Are US deficits going to continue to skyrocket? -How much more will consumers pull back on their spending? -(Did I mention the housing picture is a disaster?) -The war in Iraq is God-awful expensive, is there any relief in sight? -Is Oil going to go to $150? -Can the wobbly banks regain their footing? -And how much more will inflation heat up? The markets have enough data to digest before they even remotely begin to consider who might be president in 2009, and what they might do.
Could it be that instead of reacting to an AP story about whether Hillary will concede the nomination that everyone in the world knows she's already lost, the equity market was reacting to Ben Bernanke's surprising statements about the dollar, inflation, and weak growth? Nah. Better stick with the "stock market hates Obama" story.

A couple weeks ago I noted that all the cool kids were writing about inflation. At that time, pretty much everyone agreed that inflation was bad; the only disagreement was over exactly how bad it was. Now that Paul Krugman has weighed in on inflation -- taking the "don't worry, be happy" approach -- inflation is the hot topic again. Krugman argues that we shouldn't worry about inflation unless it leads to a wage-price spiral, à la the 1970s. Because there's no evidence of a wage-price spiral right now, Krugman believes the Fed should continue to focus on avoiding a financial meltdown. It's true that once inflation becomes embedded via a wage-price spiral, it will be difficult to contain without inducing a deep recession. It's also true that embedded inflation is the most severe threat inflation poses. But does that mean we should ignore inflation up until the point where we see evidence of an actual wage-price spiral? I have to believe the answer is "no." Surely there are indicators that we can look at to determine whether inflation is in danger of becoming embedded. Surely a wage-price spiral doesn't come out of nowhere. It seems to me that one of the most important indicators is consumer expectations of inflation. Consumers have to expect a certain level of inflation to start demanding significantly higher wages to compensate for inflation. And, as Tum Duy notes on Mark Thoma's site, major price increases by big companies such as Dow Chemical should also signal that the conditions necessary for a wage-price spiral are taking shape. On the other hand, Krugman rightly notes that whereas unions played a major role in the wage-price spiral of the '70s, there are comparatively few unions today. Can a wage-price spiral take hold in the U.S. with so few unions to demand huge wage increases? We don't know. Ultimately, I'm probably leaning more towards Krugman's position. Embedded inflation and a financial meltdown are among the most severe threats to an economy. We know how to deal with embedded inflation, because we did it in the '70s. We don't know how to deal with a full-scale financial meltdown. The last time we saw a financial meltdown (in 1929), the economy looked absolutely nothing like our current economy. That means we have virtually no precedent in dealing with a financial meltdown. For that reason, I'd rather risk embedded inflation than a financial meltdown.