Go hike the Appalachian trail!

First CBS News, taking its cues from the Competitive Enterprise Institute (known for its "CO2: They call it pollution, we call it life!" ads), alerts the public to the EPA's suppression of an internal document calling global warming into question. The people at RealClimate look at the document in question and fall on the floor laughing:

So in summary, what we have is a ragbag collection of un-peer reviewed web pages, an unhealthy dose of sunstroke, a dash of astrology and more cherries than you can poke a cocktail stick at. Seriously, if that’s the best they can do, the EPA’s ruling is on pretty safe ground.

If I were the authors, I’d suppress this myself, and then go for a long hike on the Appalachian Trail…

Three or four mistakes?

Brad DeLong discusses whether the Fed erred in the early 2000s by keeping interest rates too low, thus creating the housing bubble and the catastrophe we are currently experiencing. He concludes that it did not - that interest rates in the early 2000s were in fact higher than the natural rate and low interest rates were therefore justified to keep the economy from experiencing a devastating deflation.

As it happens, Bob Barbera and I have written a few papers on just this question. We criticize the standard practice of measuring the gap between the actual rate and the natural rate of interest by comparing the real federal funds rate or the real interest rate on say 10 year treasuries to long-run averages of those quantities. The interest rates that matter for the economy are risky rates such as the yield on Baa corporate bonds. Monetary policy should be measured according to where something like the Baa bond is relative to its long-run average.

The graph below shows how policymakers might be misled by looking at the real fed funds or Treasury rate rather than the Baa bond rate. In the graph, the blue line is the real federal funds rate (fed funds rate minus previous 12 months PCE inflation) relative to its average over 1970-2009; the red line is the analogous figure for the 10-year Treasury rate; and the green line is the analogous figure for the Baa bond yield.

As the economy slipped into recession in 2001, the Fed reduced the federal funds rate dramatically. By early 2003 the real federal funds rate was more than three percentage points below its normal value (which you could take as a very crude estimate of the "natural" fed funds rate). The real Treasury rate was also more than a percentage point below its "natural" rate. By either of these measures policy was very stimulative, so why was growth so sluggish? The answer is that the real Baa rate was still close to its normal (neutral, natural) level; policy was not in fact very stimulative, once you took account of the risk premium on corporate bonds. (The risk premium was high during this period because of the fallout from the Enron and related scandals, 9/11, the wars in Iraq and Afghanistan, and the recession.) The correct policy response was to lower interest rates further, but the Fed's ability to do this was limited by the fact that it was already very close to the zero bound on the nominal federal funds rate.

Recovery began in late 2003 when the real Baa rate fell into expansionary territory. By 2004 it was clear by all measures that policy was very stimulative, and the Fed began to raise the federal funds rate. It's repeated increases in the federal funds rate, however, were not aggressive enough to push the Baa rate up. The overly expansionary monetary policy in this period added fuel to the fire of the housing bubble that was already underway.

By mid-2006 one could argue that the federal funds rate was about at its neutral level, so that monetary policy was appropriate. The real Baa rate, however tells a different story: it was still over a percentage point below its neutral level, fueling excessive growth and speculation.



The Fed would have done better, Bob and I argue, had it paid attention to what was happening with the Baa rate - in particular, the spread between the Baa rate and 10-year Treasuries. This is shown in the graph below. In 2006-07 the Baa-Treasury spread (blue line) was considerably below its long-run average of two percent and even further below the moving average line in red. As Hyman Minsky argued long ago, excessively low risk premia are characteristic of the "ponzi finance" phase of the business cycle that precedes the crash. Bob and I argue that the correct policy strategy is to adjust the nominal federal funds rate one-for-one with the credit spread; had the Fed followed this policy it would have raised the federal funds rate by a further 50 to 100 basis points in 2006. (Note: the graph also suggests that monetary policy should have been tighter in late 2007 and early 2008, which would clearly have been disastrous. This is due largely to the spike in inflation that occured in that period, which reduces the real Baa rate as I've measured it. If you ignore the spike in inflation, monetary policy looks close to neutral in late 2007-early 2008.)



So I think the Fed's mistake occurred in the period 2004-06 when it neglected to raise the federal funds rate sufficiently to offset the shrinking risk premium on corporate bonds. Having said that, however, I have to acknowledge that in 2004 I criticized the Fed for raising interest rates when the economy had not yet recovered from the recession. In fact, I had a brief discussion with Paul Krugman at a conference in September 2004 in which he expressed puzzlement at the Fed's apparently aggressive actions. Smart people (I'm referring to Krugman here, not me) would not necessarily have avoided Greenspan's mistake.

The price of progress

The Waxman-Markey bill has been criticized from a number of quarters for giving permits away rather than auctioning them and also for awarding offsets for projects that would have been undertaken anyway. (See e.g. the post by Ted Gayer referenced in the previous post). The bill, in other words, involves large arbitrary redistributions of wealth that do nothing to advance the cause for which the legislation is intended.

This is a valid criticism of the bill. It should be noted, however, that is a problem that occurs naturally in just about every piece of legislation you can think of whose objective is to provide incentives for people to change their behavior. It is almost unavoidable, or at least unavoided in previous cases.

Take the Bush tax cut of 2003 for example. Formally called the "Jobs and Growth Tax Relief and Reconciliation Act of 2003," the legislation reduced the top marginal tax rate for interest, and dividend income from 38% to 15% and for capital gains income from 20% to 15%. The idea was to increase the incentive for people to buy stocks and real assets, thereby stimulating investment. At the same time, however, the legislation by necessity produced a large windfall gain to anyone who happened to own stocks, bonds, or real assets at the time the legislation passed. That is, though it was intended to reward new investment, the bill also retroactively rewarded past investment, which does nothing to benefit the economy in the present.

So large windfall transfers occur routinely with most legislation involving tax cuts or subsidies. And in fact the Waxman-Markey bill does go further in trying to limit these kinds of subsidies than is usually done (by auctioning off some of the permits and by attempting to count only new carbon-reducing initiatives as valid offsets). The windfall transfers have to be accepted as the price of progress. For the most part they are temporary: five, ten years down the road all carbon reduction measures are "new" worthy of being showered with incentives. Hopefully the permit grants to polluting industries will be temporary as well, though I don't know what the legislation says about this exactly.

Cap and Trade

Passing legislation to control greenhouse gas emissions is and is going to be very difficult. How do you get the public to swallow significant increases in energy costs? How do you get Congress to overcome opposition to the bill from a multitude of powerful corporate lobbies and stick to its guns when the inevitable faux-populist backlash hits?

If you're Barack Obama, Nancy Pelosi, Edward Markey, Henry Waxman, and a few other legislative leaders, you roll up your sleeves and cobble together a highly imperfect bill that makes the compromises with special interests that are necessary to assure passage of the bill while not (hopefully) detracting from its overall effectiveness. It's ugly, but progress is made.

If you are the Bush Administration and the Republican leaders of the House and Senate in recent years, you bury your head in the sand, pretend the problem doesn't exist, and stand ready to demagogue any serious attempts at resolving the problem of global warming.

And if you're Greg Mankiw, who believes that global warming is a problem, supports a carbon tax to solve the problem, but served as economic spokesman for the Bush Administration and still apparently has a toolshed full of political axes to grind against Democrats in the White House and Congress? In that case, apparently, you stand on the sidelines and snipe at the people who are actually trying to solve the problem. You criticize them for passing an imperfect rather than a perfect bill, trying hard to forget your (modest) role in stymying progress in the past.

Hence Mankiw's latest post on cap-and-trade, headlined "The Ugly Cap-and-Trade Bill." The post is just a link to two articles critical of the legislation just passed by the House. Both point out real weaknesses in the legislation. The article by Alan Viard criticizes the bill because most of the emissions permits are given away rather than auctioned. No argument there - auctioning makes a lot more sense, giving away the permits is just a payoff to corporate interests so they won't stand in the way of passage. But this is the price, apparently, that has to be paid for passage, and we're all better off paying the price. And as Viard points out, the payoff does not affect the incentives facing the polluting firms so it doesn't reduce the effectiveness of the bill. By contrast, imagine the kind of horsetrading that would accompany Mankiw's preferred solution, the carbon tax. In this case, the easiest type of deal to make would be various exemptions from the tax (farmers don't pay! certain corporations hiring so many workers producing certain types of products in particular Congressional districts don't pay!). These payoffs would affect incentives and therefore would reduce the effectiveness of the bill.

The other article Mankiw links to, by Ted Gayer, likewise makes reasonable criticisms of the way the bill handles carbon offsets. But these are details that can be ironed out in the future. The important thing is that we are now on the way to adopting a framework to finally reducing carbon emissions. It's ugly, there are problems, but it's a real step forward. People who genuinely care about global warming need to hop aboard this real, existing steam locomotive and stop waiting for the perfect, shiny TGV that's never going to come.

George Will: liberals are unfairly ignoring flawed academic studies critical of their agenda

In yesterday's Washington Post (via RealClearPolitics), George Will criticizes the Obama Administration in particular and Democrats and liberals in general for failing to acknowledge research showing that investment in green energy technology costs jobs. It's a curious argument: he argues that the proponents of green technology investments should take the research he cites (a study by Spanish economist Gabriel Calzada) seriously even if it is wrong and ideologically motivated:

It is true that Calzada has come to conclusions that he, as a libertarian, finds ideologically congenial. And his study was supported by a like-minded U.S. think tank (the Institute for Energy Research, for which this columnist has given a paid speech). Still, it is notable that, rather than try to refute his report, many Spanish critics have impugned his patriotism for faulting something for which Spain has been praised by Obama and others...

What matters most, however, is not that reports such as Calzada's and the Republicans' are right in every particular... Still, one can be agnostic about both reports while being dismayed by the frequency with which such findings are ignored simply because they question policies that are so invested with righteousness that methodical economic reasoning about their costs and benefits seems unimportant.

Very strange. I would think that a requirement for an argument to be taken seriously is that it be logically sound and not obviously self-serving. But then what do I know, I'm not a public intellectual of the standing of George Will.

For the record, Calazada's study does seem to be an honest attempt at measuring the effects of spending on solar technology in Spain on job creation. Its major and fatal weakness is its analysis of how spending on solar "crowds out" private sector job creation. The macroeconomics is just plain wrong.

Calazada's argument is:

- The Spanish government spends 28.7 billion euros on solar power subsidies to create 50,200 jobs, or 571,138 euros per job. In the private sector, on average, each job "costs" 259,143 euros.
- So if the government creates one job in solar power, it takes 571,138 from the private sector; this money would have employed 571,138/259,143 = 2.2 workers, so there's a net loss of 1.2 jobs per new job created in solar.

There are all sorts of things wrong with this analysis from a standard textbook macroeconomic perspective.

- We are in a recession, in which there are a lot of unused resources (unemployed workers, idle factories, etc.). In this environment, when the government employs someone in the solar industry or in any other industry, there is no need for employment to fall in other sectors to "pay for" these additional jobs. The new jobs in solar can be filled by the previously unemployed. Of course there may be bottlenecks due to a shortage of workers with particular skills, but the general message is that the author's estimate is going to vastly overstate the extent of "crowding out" of private employment.

- On average over long periods of time a capitalist economy operates at full employment; that is, all workers who want to work are able to find a job. If you're a neoclassical economist like the author of the study (and George Will's sympathies would be here as well), full employment is arrived at naturally through the magic of markets; if you're a Keynesian, full employment is achieved by the adroit use of monetary and fiscal policy. Either way (in the basic framework used by macroeconomists), no policy intervention is capable of changing the overall level of employment in the long run. If investment in solar energy reduces demand for labor the effect is to reduce wages, not employment. I'm not sure if Obama has ever claimed that investment in green technology would increase employment in the long run (as opposed to stimulating the economy during the recession or providing "good jobs" that pay high wages), but if he has, he's guilty of the same logical error.

- I would wager that a big part of the reason that solar jobs are more expensive than average jobs is that solar power is a relatively capital intensive sector of the economy. You could theoretically apply the author's analysis to show that all sorts of private sector investments destroy jobs. For example, airline manufacturing, biotechnology, pharmaceuticals, and software engineering are all relatively capital intensive industries. So if someone decides to invest in one of those sectors, it's going to cost jobs - better (according to the implicit argument in the report) to invest our money in street sweeping, textile manufacturing, chicken processing, and other labor-intensive industries. But no self-respecting neoclassical economist would make that argument.

- In fact, according to neoclassical economic theory, investments in capital intensive sectors of the economy make the economy as a whole better off because wages in those sectors are higher than those in labor-intensive sectors. A complicated set of adjustments involving changes in the average level of wages, the relative price of skilled versus unskilled labor, relative prices of capital-intensive goods versus labor-intensive goods, and so on will result in full employment with higher wages, a larger capital stock, and higher GDP overall.

- The above analysis is true if the solar power industry truly has higher productivity than the rest of the economy. If, in the case of Spain and what is proposed for the US, resources are directed into solar power by government subsidies, then there may indeed be a net cost. The cost comes about because we're switching to a higher-cost source of energy (I won't address the issue of mismanagement of the program, which is obviously an issue that policymakers need to be aware of). But for those who want the government to do something about global warming, this is a given. The fundamental problem is that the market price of carbon-based fuels is too low, does not reflect the "externalities" of oil production and consumption - global warming, the need to spend gobs of money defending oil supplies in the middle east, etc. The low price of oil today reflects an implicit subsidy in the value of these externalities. Subsidizing solar power and raising the price of carbon fuels essentially replaces one subsidy with another. Standard neoclassical theory says we're better off having done this, assuming we've correctly priced the externalities, even though measured incomes will be lower.

Will's contention that proponents of green technology investment and other measures to fight global warming ignore research on their costs is wrong - it's the bad and self-serving arguments like those Will cites that are systematically ignored. Economic analysis by the Congressional Budget Office has played an important role in formulating the legislation now percolating in Congress. Case in point: the CBO report I cite in a blog post from a few days ago.

Apparently Ted Turner's father was not a fan of liberal arts education

Here's a letter Ted Turner's father wrote to him upon learning that his son wanted to be a Classics major at Brown University. It must be read in its entirety.

The Senate's health plan

Paul Krugman is p.o.'d about press coverage of the Congressional Budget Office's estimates of the cost of the Senate (HELP) health plan.

Both Igor Volsky and Ezra Klein catch major media organizations picking up completely false GOP talking points, and completely misrepresenting the CBO “scoring” that created so much consternation last week. Neither of the plans CBO studied contains a public option — yet people who got their news from allegedly reputable TV shows were led to believe that the CBO results were devastating news for advocates of a public option.

The failure of the media to report accurately on the CBO study is remarkable (I almost said astonishing, but nothing astonishes me anymore). It's not as if this is some technical detail that only an expert would have caught (though even then, you'd hope that some of these media analysts would be experts in the field they're analyzing or consult with experts before running their mouths about the topic). The CBO study is quite explicit about what elements of the plan it's looking at. Starting on page 1:

It is important to note, however, that those figures do not represent a formal or complete cost estimate for the draft legislation, for reasons outlined below...

Then again on page 2:

Important Caveats Regarding This Preliminary Analysis
There are several reasons why the preliminary analysis that is provided in this letter and its attachments does not constitute a comprehensive cost estimate for the Affordable Health Choices Act... [there follows some gobbledygook]

Then the explicit statement on page 8:

The proposal does not include a “public plan” that would be offered in the exchanges, nor does it contain provisions that would require employers to offer health insurance benefits or impose a fee or tax on them if they did not offer insurance coverage to their workers.

How could any educated person miss these caveats? Unless they didn't actually read the report...

The cost of Cap'n Trade

The Congressional Budget Office estimates the net costs of the American Clean Energy and Security Act of 2009, the legislation pending in the House that would institute a cap-and-trade system for greenhouse gas emissions. Opponents of the bill are concerned about the costs to the economy and to average Joes. The CBO reports (all figures are in 2010 dollars):

On that basis, the Congressional Budget Office (CBO) estimates that the net annual economywide cost of the cap-and-trade program in 2020 would be $22 billion—or about $175 per household. That figure includes the cost of restructuring the production and use of energy and of payments made to foreign entities under the program, but it does not include the economic benefits and other benefits of the reduction in GHG emissions and the associated slowing of climate change. CBO could not determine the incidence of certain pieces (including both costs and benefits) that represent, on net, about 8 percent of the total. For the remaining portion of the net cost, households in the lowest income quintile would see an average net benefit of about $40 in 2020, while households in the highest income quintile would see a net cost of $245. Added costs for households in the second lowest quintile would be about $40 that year; in the middle quintile, about $235; and in the fourth quintile, about $340. Overall net costs would average 0.2 percent of households’ after-tax income.

Richard Nixon: the gift that keeps on giving

The NY Times plucks a gem from the latest released tapes, right after the Roe v. Wade decision:

“There are times when an abortion is necessary. I know that. When you have a black and a white,” he told an aide, before adding, “Or a rape.”

I think even in 1973 that was a pretty retrograde attitude towards race-mixing.

Scariest graph of 2009

Paul Krugman keeps updating this graph, and it never gets less scary.

Healthcare spending and subprime lending

I've always had a hard time understanding the economics of our health care system. We know there's a ton of waste in the system, but where does it come from: is it because consumers don't have the incentive to look at sticker prices? insurance companies cherry-pick their customers? doctors run too many tests to cover themselves from malpractice suits? government subsidizes gold-plated insurance policies? pharmaceutical companies exploit their monopoly power and buy off Congressmen who stand in their way?

Atul Gawande's article in the New Yorker and a more technical piece on the Health Affairs blog by Amitabh Chandra have persuaded me that a big part of the problem in health care is the same problem that led to the subprime mess: rampant, uncontrolled pursuit of profit on the part of the product providers (alliteration unintended). Gawande asks why health care costs in McAllen, Texas are so much higher than in the demographically similar region of El Paso and finds that the reason is that doctors in McAllen have adopted an entrepreneurial model where the goal is to earn as many fees as possible by subjecting patients to (arguably) unnecessary procedures. Where hospitals focus on the health of patients rather than doctors' incomes - places like the Mayo Clinic in Minneapolis and hospitals in Grand Junction, Colorado - costs are much, much lower.

To the extent that this argument is correct - and it doesn't mean that there aren't other factors driving costs up as well - the problem in health care sounds an awful lot like the problems in subprime lending and investment banking. Start with a lightly regulated market with lots of distortions caused by problems of asymmetric information and government taxes and subsidies. Add a dose of the good ol' American can-do entrepreneurial ethos. Plop in uninformed, easily manipulated consumers, and presto - you've got yourself an explosion in irresponsible spending. And if the analogy is correct, the solution (or a big part of the solution) to the health care spending problem is the same as the solution to the subprime lending problem: lots of heavy-handed regulation. Chandra concludes with:

The key Dartmouth message is that regardless of whether the association between spending and outcomes is positive, flat, or negative, there are plenty of providers who’re able to deliver high-quality care without being high-cost suppliers. Reform efforts should focus on encouraging these organizations, which are accountable for all of my care, to replicate...

Congress needs to encourage Minneapolis-type care to emerge in Miami, while curtailing the incentives for Minneapolis to morph into McAllen. This involves doing much more than offering piecemeal adjustments to the reimbursement system. It requires rewarding the creation and expansion of already existing delivery systems that have the right incentives to check costs while delivering quality. It requires competition between these delivery systems for patients and their premiums. It requires that Congress and the president have the courage to fight the beneficiaries of the status quo, who have already begun to launch a bitter fear-campaign against attempts to implement accountability and value.

In terms of the health care reform debate now occurring in Congress, it would appear that whether there is a public insurance option or not is beside the point. We can have health care reform on the Swiss model - a private insurance system subject to tight regulation.

The parable of Jesus and Ford

From The Treatyist.

Rising bond yields is a sign that US policy is working

Martin Wolf makes many of the same points I made in an earlier post. I agree wholeheartedly with myself!

Fix the rating agencies!

There's much to like in Obama's financial regulation reform plan, but one glaring omission is that it does nothing to change the system under which rating agencies get paid by the companies whose bonds are being rated. Here's the story.

The broader issue is that in addition to regulating the behavior of financial institutions, reform needs to be focused on changing the incentives these institutions have. Obama's proposals on executive pay - empower a regulator to review pay packages to make sure they don't provide incentives to engage in overly risky behavior - seem to be an example of how to do this right. Failure to reform the rating agencies sets up a situation where the regulators are saying "be cautious" while the incentive structure is saying "full steam ahead." That's a system that won't work.