Easy as MSB = MSC

There are some things that seem so obvious after intermediate microeconomics, but unfortunately much of the citizenry hasn't had that pleasure... One example is the use of Pigouvian taxes on externalities to equate marginal social costs and benefits. In the NY Times, Greg Mankiw makes the case for a carbon tax:

IN the debate over global climate change, there is a yawning gap that needs to be bridged. The gap is not between environmentalists and industrialists, or between Democrats and Republicans. It is between policy wonks and political consultants.

Among policy wonks like me, there is a broad consensus. The scientists tell us that world temperatures are rising because humans are emitting carbon into the atmosphere. Basic economics tells us that when you tax something, you normally get less of it. So if we want to reduce global emissions of carbon, we need a global carbon tax. Q.E.D.

Mankiw explains why a carbon tax is preferable to fuel economy regulations and cap-and-trade. Politically, its a tough sell. Mankiw offers an idea to make it go down easier:

Yet this natural aversion to carbon taxes can be overcome if the revenue from the tax is used to reduce other taxes. By itself, a carbon tax would raise the tax burden on anyone who drives a car or uses electricity produced with fossil fuels, which means just about everybody. Some might fear this would be particularly hard on the poor and middle class.

But Gilbert Metcalf, a professor of economics at Tufts, has shown how revenue from a carbon tax could be used to reduce payroll taxes in a way that would leave the distribution of total tax burden approximately unchanged. He proposes a tax of $15 per metric ton of carbon dioxide, together with a rebate of the federal payroll tax on the first $3,660 of earnings for each worker.

Eminently sensible, but I'm not holding my breath. Mankiw is advising Mitt Romney's campaign - if he can get Romney to come out for a payroll for carbon tax swap, I will be very impressed, with both of them.

Now He Tells Us

The Washington Post's Bob Woodward managed to get his hands on Alan Greenspan's memoir ahead of its release on Monday (maybe someone gave it to him in a parking garage!). He reports:

Alan Greenspan, who served as Federal Reserve chairman for 18 years and was the leading Republican economist for the past three decades, levels unusually harsh criticism at President Bush and the Republican Party in his new book, arguing that Bush abandoned the central conservative principle of fiscal restraint.

While condemning Democrats, too, for rampant federal spending, he offers Bill Clinton an exemption. The former president emerges as the political hero of "The Age of Turbulence: Adventures in a New World," Greenspan's 531-page memoir, which is being published Monday.

Greenspan, who had an eight-year alliance with Clinton and Democratic Treasury secretaries in the 1990s, praises Clinton's mind and his tough anti-deficit policies, calling the former president's 1993 economic plan "an act of political courage."

But he expresses deep disappointment with Bush. "My biggest frustration remained the president's unwillingness to wield his veto against out-of-control spending," Greenspan writes. "Not exercising the veto power became a hallmark of the Bush presidency. . . . To my mind, Bush's collaborate-don't-confront approach was a major mistake."

Greenspan accuses the Republicans who presided over the party's majority in the House until last year of being too eager to tolerate excessive federal spending in exchange for political opportunity. The Republicans, he says, deserved to lose control of the Senate and House in last year's elections. "The Republicans in Congress lost their way," Greenspan writes. "They swapped principle for power. They ended up with neither."

Of course, Greenspan played a key role in the shift from Federal budget surpluses in the late 1990's to deficits today. His January 2001 testimony to the Senate Budget Committee helped get President Bush's tax cuts - which led to the deficits - passed. His stated reason was concern that the budget surpluses would eventually lead to the government becoming a large owner of private assets - i.e., after repaying the existing Federal debt, the government would invest the surpluses in stock and bond markets. The key sentence from his testimony:

In general, as I have testified previously, if long-term fiscal stability is the criterion, it is far better, in my judgment, that the surpluses be lowered by tax reductions than by spending increases.

That is a reflection of Greenspan's political preferences (he calls himself a "libertarian Republican"), and completely unrelated monetary policy, which is the Fed's purview. In a NY Times column titled "Et Tu, Alan" Paul Krugman wrote:

...The headlines were all about Mr. Greenspan's endorsement of tax cuts -- something the Fed chairman must have known would happen. And when you look at the tortured logic by which Mr. Greenspan arrived at that endorsement, you have to wonder whether those headlines weren't exactly what he wanted...

...Mr. Greenspan was out of bounds. Since when is it the Fed's business to say that we should have a tax cut rather than, say, a new prescription drug benefit -- or for that matter a missile defense system?...

But the really strange thing about his argument was that he seemed to ignore the fact that the main reason the federal government will one day become an investor is the buildup of assets in the hands of the Social Security and Medicare systems -- and those funds must accumulate assets to prepare for the future demands of the baby-boom generation. Indeed, by all estimates even the huge projected surpluses of those trust funds will be inadequate to the task. ''Certainly,'' Mr. Greenspan declared, ''we should make sure that Social Security surpluses are large enough to meet our long-term needs.'' Well, I'm sorry, but you can't do that without allowing the federal government to become an investor.

So if that prospect was what was really worrying Mr. Greenspan, he should have focused on the problem of how to prevent the government's position as an investor from being abused. And there are many ways to do that -- including, by the way, realistic plans for partial privatization of Social Security, which (unlike the fantasy promises of the Bush campaign) would require the federal government to ante up trillions of dollars to pay off existing obligations, solving the ''problem'' of excessive surpluses quite easily.

But Mr. Greenspan seemed determined to arrive at tax cuts as an answer...

When a man who is usually a clear thinker ties himself in intellectual knots in order to find a way to say exactly what the new president wants to hear, it's not hard to guess what's going on. But it's not a pretty sight.

The criticisms Greenspan makes in his book of Republican policies might have made a difference if he'd offered them earlier - in 2004, perhaps. Would he have been overstepping the bounds of his role as chairman of the Federal Reserve to do so? Possibly. However, it is legitimate for the Fed chairperson to weigh in on the fiscal position of the government, but only insofar as it affects monetary policy. For example, the Reagan tax cuts and associated deficits in the early 1980's forced the Fed to raise interest rates even further. If the economy is a "car with two drivers" - monetary and fiscal - Reagan's stepping on the fiscal "gas" forced the Fed to hit the monetary "brakes" ferociously, resulting in the worst recession since the depression. In such a situation, it would have been appropriate for the Fed to point out that tax cuts caused interest rates to be higher than otherwise.

At the time of his testimony, the US was coming to the end of the longest economic expansion in its history. Stock tickers were ubiquitous. Greenspan was a celebrity and viewed as somewhat of an economic oracle - "Maestro," Woodward's book about him, was on the bestseller list. What he did in 2001 was to use his prestige to push his own - Ayn Rand-influenced (yikes!) - view of the role of government in society. Now that its too late, he tells us he regrets the consequences.

Update (9/18): Brad deLong has a favorable (and amusing) take on Greenspan and his book. Krugman is not amused. Current Bush admin. official and former House Budget chair Jim Nussle sees Monday morning quarterbacking.

Central Bank Trash Talk

The NY Times reports:

In an unusual public display of discord, the British central bank criticized other central banks yesterday for injecting cash into the financial system to help stabilize credit markets, saying that such a policy amounted to a bailout of investors who made bad decisions.

The swipe came in this testimony submitted by Mervyn King, the Governor of the Bank of England (Britain's central bank - King's position is equivalent to Ben Bernanke's in the US) to a Parlimentary committee:

The main thrust of his written testimony to Parliament, however, was a sharp warning about “moral hazard” — a term used to describe the downside of policies that effectively rescue investors when their bets turn out wrong.

“The provision of such liquidity support undermines the efficient pricing of risk by providing ex-post insurance for risky behavior,” Mr. King wrote. “That encourages excessive risk-taking and sows the seeds of a future crisis.”

He didn't name names - the British do that understatement thing - but that could be taken as a strong implicit criticism of the Fed and European Central Bank, which have actively tried to inject funds to stabilize financial markets (earlier posts on the Fed's actions here and here).

Update (9/14): Perhaps he spoke too soon. The Bank of England is bailing out Northern Rock, a mortgage lender. Willem Buiter says: "I can only conclude that the Bank of England is a paper tiger. It talks the ‘no bail out’ talk, but it does not walk the talk."

Economic Development and Economic History

I really should have attended the Economic History Association conference in Austin this weekend. Brad DeLong has posted his talk "Marx, Rostow, Kuznets, Gerschenkron" from a session on "The role of economic history as a guide to economic development." The talk is full of interesting ideas, combining intellectual history with a strong case for the importance of economic history in understanding development.

The August Job Loss

The Bureau of Labor Statistics reported "nonfarm payroll employment was essentially unchanged," declining by 4,000 (out of 138 million) in August. That number came from the BLS survey of firms (the "establishment survey"). The most closely watched statistic about the labor market - the unemployment rate - comes from their survey of households; it was unchanged at 4.6%.

The household survey did have some bad news, though - it also reported declines in total employment, as well as in the labor force (the number of people working or looking for work). The number of unemployed persons also fell; the unemployment rate is the number of unemployed as a fraction of the labor force - in August both the numerator and denominator decreased, leaving the fraction the same. The decline in labor force participation may be a sign people are discouraged about job prospects.

The Wall Street Journal's Real Time Economics had reactions from Wall Street "economists", who were worried (hint, hint, Bernanke) and from politicians, who were - predictably - divided.

At Econbrowser, Menzie Chinn draws a parallel with the last recession.

As a caution on reading too much into one month's numbers, it should be noted that there are occasional bad months even during expansions - during the 1990's expansion, payroll employment declined in March 1993, May 1995, January 1996 and August 1997, and that the payroll employment figure is preliminary and subject to revision by the BLS.

To Laff er to Cry

In the New Republic, Jon Chait explains "How Economic Crackpots Devoured American Politics." He writes:

American politics has been hijacked by a tiny coterie of right-wing economic extremists, some of them ideological zealots, others merely greedy, a few of them possibly insane. The scope of their triumph is breathtaking. Over the course of the last three decades, they have moved from the right-wing fringe to the commanding heights of the national agenda. Notions that would have been laughed at a generation ago--that cutting taxes for the very rich is the best response to any and every economic circumstance or that it is perfectly appropriate to turn the most rapacious and self-interested elements of the business lobby into essentially an arm of the federal government--are now so pervasive, they barely attract any notice.

The article details the influence of the "Laffer Curve" - the proposition that, since at 100% taxation, there is no incentive to work and therefore (theoretically) no output would be produced and no revenues would be collected, a cut in tax rates would increase tax revenues. Logical enough, but this idea has morphed into the idea expressed by some politicians - indeed, it seems to be Republican dogma nowadays - that tax cuts raise revenues in general. Which is simply not true. Real economists, who happen to be Republicans, like President Bush's former economic advisor Greg Mankiw, don't believe it. But the idea refuses to die... In an earlier post I suggested it was a good example of "Agnotology," the production of ignorance.

The problem is not whether a particular tax policy is good or bad, but the terms of the argument - as Matthew Yglesias explains well:

There's a systematic effort by the right to convince people that tax cuts are not merely beneficial in some ways or beneficial all things considered but that there are actually no tradeoffs whatsoever.

Its easy to see why such a politically convenient idea might take on a life of its own. But it does raise an interesting question of why the economics profession has not succeeded in discrediting it, and whether people like Mankiw - who supported President Bush's tax cuts even though he never believed one of the main arguments the President frequently offers - bear some responsibility. Ezra Klein says:

Jon Chait is right that the supply siders are maniacs, but they aren't marginalized maniacs, and that's in part because that economics profession hasn't seen fit to marginalize them. Mankiw may say, in his textbooks, that they're charlatans, but when push came to shove he joined their cause, disagreeing, he says, with some of their nuttier claims, but nevertheless lending them and their claims -- which included, in the Bush administration, such ideas as "returning to Clinton-era levels of taxation would wreck the economy, that retirement security can best be provided to all by expanding tax breaks for rich people, that health care can best be improved by expanding tax breaks for rich people," etc -- his name and credibility.

Megan McArdle defends Mankiw, and Matthew Yglesias responds. The Economist's Free Exchange weighs in (they, too, cannot resist bad "Laff" puns).

Chait's article is excerpted from his new book, "The Big Con: The True Story of How Washington Got Hoodwinked and Hijacked by Crackpot Economics," which might be a better way of spending my weekend than painting the guest bedroom...

Cone of Silence

I was shocked to learn that my international trade students were unfamiliar with the Cone of Silence (not to be confused with the Cone of Diversification). I can only conclude that children today aren't raised properly - in front of the TV watching reruns - as I was. Or perhaps they just watched different reruns?

For the sake of cultural literacy, via YouTube, a demonstration of the cone, and the classic opening of the show, "Get Smart." Here's more about the show. The movie, starring Steve Carrell and Anne Hathaway should raise awareness of the threat from KAOS when it comes out next year.

Foreign Aid

In his review of Paul Collier's The Bottom Billion (today's Econ 202 reading), Niall Ferguson alludes to the broader debate over the effectiveness of aid to low-income countries. The most visible academic protagonists are Jeffrey Sachs of Columbia, who believes that more aid could considerably boost living standards, and William Easterly of NYU, who is a critic of aid.

Here are opinion pieces (pdf) from the LA Times by Easterly, "The Handouts That Feed Poverty," and Sachs, "Foreign Aid Skeptics Thrive on Pessimism." For a less polemical consideration of the issue, see "Aid: Can It Work?" by Nicholas Kristof in the New York Review of Books.

Easterly titled his latest book "The White Man's Burden" after a poem by Rudyard Kipling, implying a parallel between modern aid efforts and 19th century colonialism (not very nice!).

Swapping Lemons with China

The US trade deficit with China is essentially an exchange of goods for financial assets; rather than getting an equal amount of goods in exchange for what they sell to the US, the Chinese are getting financial assets - stocks and bonds, etc. - in return. Or, in other words, the Chinese are purchasing US financial assets with their goods.

Lately, there has been much attention the fact that some of the goods we are importing from China have turned out to be unsafe - toys with lead paint, for example. As Dani Rodrik explains, the recent credit crisis has shown that many of the financial assets that we are selling to the Chinese (and other foreign investors) are also, arguably, unsafe.

Misunderestimating Growth

The Economist's Free Exchange blog examines why the transformative power of economic growth is so little appreciated.

The now-well-documented historical record suggests that economic growth has done more for the welfare of humanity than any moral creed or non-economic initiative meant to improve the dignity and quality of human life. So why is there no treatise required of all undergraduates singing growth's praises and setting it out as a moral imperative for all decent peoples?

The post discusses several explanations: (i) people do not understand compounding growth, (ii) historically speaking, sustained growth is a relatively new phenomenon, and much of our religion and philosophy predates it and (iii) we find it easier to imagine future disasters than the positive effects of growth.

An illustration of the power of growth from principles class is that Japan and Mexico both had real per capita GDP of just over $1,000 (in 1990$) in 1890. Over the next 110 years, Mexico's per capita GDP increased sevenfold (!) to $7,249, and Japan's increased twenty-one times (!!) to $21,051. Mexico's average annual growth rate over the period was 1.8%, and Japan's was 2.8% - only 1% higher, but over 110 years that is the difference between being a "rich" and a "middle income" country. [data are from the best spreadsheet ever, Angus Maddison's Historical Statistics for the World Economy: 1-2003 AD]

One person who understood compound growth was John Maynard Keynes. In his famous essay "Economic Possibilities for our Grandchildren," he foresaw growth solving the "economic problem" of scarcity and making possible dramatic social changes and liberation from social values oriented towards capital accumulation:

When the accumula­tion of wealth is no longer of high social im­portance, there will be great changes in the code of morals. We shall be able to rid our­selves of many of the pseudo‑moral principles which have hag‑ridden us for two hundred years, by which we have exalted some of the most distasteful of human qualities into the position of the highest virtues. We shall be able to afford to dare to assess the money‑motive at its true value. The love of money as a possession ‑ as distinguished from the love of money as a means to the enjoyments and realities of life ‑ will be recognised for what it is, a some­what disgusting morbidity, one of those semi­criminal, semi‑pathological propensities which one hands over with a shudder to the specialists in mental disease.

With scarcity behind us,

for the first time since his creation man will be faced with his real, his permanent prob­lem ‑ how to use his freedom from pressing economic cares, how to occupy the leisure, which science and compound interest will have won for him, to live wisely and agreeably and well.

Although Keynes understood the power of growth, it seems he underestimated our ability to create new material wants, and perhaps overestimated how quickly our value systems could change.

As for why we still fail to appreciate economic growth, I would add a fourth reason: we don't really know how to improve it. Although there is quite a bit of fascinating research being done, the improvements of "total factor productivity" that are the main driving force of growth remain elusive. Moses Abramovitz once described the Solow residual (which is how total factor productivity is measured), as a "measure of our ignorance." That still holds some truth today.