Cap and Trade: Bargain Insurance

The Congressional Budget Office (CBO) has estimated the cost of the Waxman-Markey "cap and trade" bill, and found that it is modest - about $22 billion ($175 per capita) in 2020. That is an estimate of gross costs, and does not take into account the benefits of reducing global warming.

The benefits may be quite large. Separately, the CBO has analyzed the likely effects of global warming. Though they do not put a dollar value on it, $175 per year seems like a small price to (partly) avoid this: While there is some imprecision in estimating the exact implications of carbon emissions for the climate and the consequent economic costs, it is rational to pay small costs to reduce the probability of really, really, really bad outcomes. That is, in essence, why we buy insurance. Though I haven't (yet) managed to crash a car, it makes sense for me to write a check to a lovable, British-accented Gecko who will protect me from some the consequences if I ever do. In this case, the potential consequences are far worse than a car accident, and the costs of insurance are considerably less.

Moreover, as Ezra Klein notes, the cost estimates are likely overstated. Along those lines, Paul Krugman reminds us that market economies can adapt to relative price changes; he writes:

The point is that we need to be clear about who are the realists and who are the fantasists here. The realists are actually the climate activists, who understand that if you give people in a market economy the right incentives they will make big changes in their energy use and environmental impact. The fantasists are the burn-baby-burn crowd who hate the idea of using government for good, and therefore insist that doing the right thing is economically impossible.

The Engaged University?

An e-mail to faculty from Provost Herbst concludes:

I look forward to an exciting and rewarding academic year and ask you to join me in engaging our students in all facets of their Miami experience.

Does that mean that we're supposed to join in on stuff like this?

Personally, I'd prefer to stick with engaging our students in some facets of their Miami experience.

Keep the (Fiscal) Pedal to the Metal

And the thing to the floor...

The stimulus bill passed in February was somewhat a watered-down compromise at the time, and the recession has since proven even worse than expected. Brad DeLong amended a chart made by CEA chair Christina Romer and Biden economic advisor Jared Bernstein during the stimulus debate. He writes:

So my first point is that the Obama administration's federal fiscal stimulus programmes are on the low side of what is appropriate by a substantial margin. This is the largest economic downturn since the Great Depression and the standard tools of expansionary monetary policy are tapped out and broken right now.

My second, related point is that the need for federal-level fiscal expansion is reinforced by what state governments are doing right now. The federal government's discretionary actions are expanding aggregate demand by about $400 billion over fiscal year 2010, but state governments are right now cutting their spending and raising their taxes in order to offset this federal fiscal expansion more or less completely. On net, the government sector will be on autopilot as far as discretionary policy moves to stimulate the economy are concerned: federal-level expansion is offset and neutralised by state-level fiscal contraction. This is not an appropriate macroeconomic policy stance: this is the largest economic downturn since the Great Depression.

That is from his contribution to a roundtable discussion at The Economist of a column by Romer in which she revisits the recession that interrupted the recovery from the Great Depression in 1937. She writes:

The recovery from the Depression is often described as slow because America did not return to full employment until after the outbreak of the second world war. But the truth is the recovery in the four years after Franklin Roosevelt took office in 1933 was incredibly rapid. Annual real GDP growth averaged over 9%. Unemployment fell from 25% to 14%. The second world war aside, the United States has never experienced such sustained, rapid growth.

However, that growth was halted by a second severe downturn in 1937-38, when unemployment surged again to 19% (see chart). The fundamental cause of this second recession was an unfortunate, and largely inadvertent, switch to contractionary fiscal and monetary policy.

Therefore,

The 1937 episode provides a cautionary tale. The urge to declare victory and get back to normal policy after an economic crisis is strong. That urge needs to be resisted until the economy is again approaching full employment. Financial crises, in particular, tend to leave scars that make financial institutions, households and firms behave differently. If the government withdraws support too early, a return to economic decline or even panic could follow. In this regard, not only should we not prematurely stop Recovery Act spending, we need to plan carefully for its expiration. According to the Congressional Budget Office, the Recovery Act will provide nearly $400 billion of stimulus in the 2010 fiscal year, but just over $130 billion in 2011. This implies a fiscal contraction of about 2% of GDP. If all goes well, private demand will have increased enough by then to fill the gap. If that is not the case, broad policy support may need to be sustained somewhat longer.

It sounds like she is laying the groundwork to follow DeLong's advice. That may be hard to pull off, politically, as Andrew Leonard notes polls show concern about the federal deficit (as they did in 1935 and 36, Krugman points out).

In his column, Paul Krugman also argued it is not the time to let up:

The debate over economic policy has taken a predictable yet ominous turn: the crisis seems to be easing, and a chorus of critics is already demanding that the Federal Reserve and the Obama administration abandon their rescue efforts. For those who know their history, it’s déjà vu all over again — literally.

For this is the third time in history that a major economy has found itself in a liquidity trap, a situation in which interest-rate cuts, the conventional way to perk up the economy, have reached their limit. When this happens, unconventional measures are the only way to fight recession.

Yet such unconventional measures make the conventionally minded uncomfortable, and they keep pushing for a return to normalcy. In previous liquidity-trap episodes, policy makers gave in to these pressures far too soon, plunging the economy back into crisis. And if the critics have their way, we’ll do the same thing this time.

Update (6/21): Catherine Rampell of Economix puts those poll results in perspective:

2009’s federal deficit is projected to be a larger percentage of G.D.P. (12 or 13 percent) than it has been any year since 1945, and yet a measly 5 percent of Americans are complaining that deficit/debt/budget issues are the country’s biggest problem.

Gilded Angst

The traumatic effects of the 1923 hyperinflation linger in the German monetary psyche. This has been manifested in the overly-restrictive policies of the European Central Bank and now, in this:

Long attracted to the safety of solid gold, Germans will soon be able to sate their appetite for the yellow metal as easily as buying a chocolate bar after plans were announced on Tuesday to install gold vending machines in airports and railway stations across the country.

The venture by the TG-Gold-Super-Markt company, based near Stuttgart, aims to build on soaring retail interest in gold purchases after a loss in confidence in a range of other investments as a result of the financial crisis.

That comes to my attention via Yves Smith, who says "you cannot make this stuff up."

Update: More on this from the Times.

Internecine Strife

Someone's been spilling some of the beans about the fights within the Obama economic team. The Times has the scoop, including:

[Council of Economic Advisors Chair Christina] Romer was joking, she said in an interview, adding, “There are only a few times that I felt like smacking Larry.” Yet few laughed in the president’s presence.

"Larry" being National Economic Council chair Lawrence Summers.

Could it be that the other other members of the economic team resent the "brilliant but supercilious" Summers because he got a better office? That's what the graphic accompanying the article seems to imply: Of course, intra-administration battles over economic policy are nothing new... indeed, it would be strange if there wasn't any. TNR has a slideshow of the "Economic Feuds" in administrations going back to FDR.

As Matthew Yglesias notes, the real question is who is leaking and why?

The all-time classic of the economic advisor leak genre remains William Greider's 1981 Atlantic Monthly piece wherein David Stockman reveals the existence of the "magic asterisk."

Time to End the Amenities Arms Race?

In the middle of a rather depressing story about Reed College's financial woes, I did find some encouragement in this:

When he talks about Reed’s short-term response to the recession, [Reed President Colin] Diver concedes that he is torn, wondering whether a broader reassessment would be in order.

Perhaps it would be a good thing, he said, if the recession could refocus college administrators on the quality of higher education, rather than on investments in climbing walls (Reed does not have one) and other “country club” aspects of college life that have fueled an academic arms race reliant on tuition increases and fund-raising.

“The catering to consumer tastes — I keep trying to say, we are in the education business,” Mr. Diver said, describing the pressure to keep up with wealthier colleges and expressing a frustration rarely voiced publicly by college presidents. “The whole principle behind higher education is, we know something that you don’t. Therefore, we shouldn’t cater to them.”

Amen to that!

While I would attribute the increase in the relative price of higher education primarily to Baumol's cost disease, the positional arms race in amenities is no doubt an important secondary factor. Hopefully the recession will finally force a change in priorities.

Of course, I say that secure in the knowledge that the finishing touches are being applied to the new FSB building...

Hydraulic Keynesianism, Indeed

A.W. Phillips, who famously noted the relationship between inflation and employment that became the "Phillips curve," was also mechanically inclined... check out the Phillips machine, which models the stocks and flows of the economy with water circulating through a contraption of tanks, valves, pumps and tubes.


For more, see also this Guardian article.

Shoot Out at the Aid Corral

I think the message is that foreign aid is cool uptown, but not downtown. Development aid booster Jeffrey Sachs (Columbia) and critic William Easterly (NYU) are at it again, and this time it's personal.... (Dambisa Moyo is in on it too; she used to work at Goldman Sachs, which is downtown... coincidence?).

Mark Thoma has rounded up their exchange at Economist's View, and Easterly summarizes at Aid Watch.

Nancy Birdsall sees common ground beneath all the sturm und drang:

I am with the majority of students of aid who agree with both of them, yes both of them, on one thing they actually agree on: that aid has made a difference in improving people’s lives and that there ought to be more of it. You wouldn’t know that what they disagree about is not whether aid “works” but how aid programs should be designed and implemented – a subject that doesn’t get headlines but matters.

The Keynes That Can Be Diagrammed

is not the true Keynes...

When I teach the IS-LM / AS-AD apparatus to my intermediate macro students, I preface it with the caveat that some believe that the "textbook" Keynesian model is not a correct representation of the General Theory. Roger E.A. Farmer is among them. He writes:

In the FT’s Economists’ Forum, Benn Steil wrote a stimulating piece in which he argued that Keynes was wrong. His argument is that interpretations of Keynesian economics are all based on the assumption that wages and prices are sticky. But wages and prices are not sticky. Ergo - Keynes was wrong. Mr. Steil and I are in complete agreement that the Keynesians, interpreted in this way are, to use a technical term, out to lunch. But that does not imply that Keynes was wrong. At least not entirely wrong. Far from it.

My emeritus colleague, Axel Leijonhufvud, made a distinction in his 1966 book, on Keynesian Economics and the Economics of Keynes, between Keynes and the Keynesians. He meant that orthodox Keynesian interpretations of the General Theory, that began with influential papers by John Hicks in England and Alvin Hansen in the US, got it all wrong.

Keynes said three things in the General Theory. First: the labour market is not cleared by demand and supply and, as a consequence, very high unemployment can persist forever. Second: the beliefs of market participants independently influence the unemployment rate. Third: It is the responsibility of government to maintain full employment.

He was right on all three counts. But he was wrong about something else. Keynes thought that consumption depends on income. Two decades of research on the consumption function, following world war two, led to a different conclusion. Consumption, and this is two thirds of the economy, depends not on income but on wealth. This is no small matter: the theory of the multiplier and the implication that fiscal policy can get us out of the current crisis rests on exactly this point.

Whether the "Keynesians" got Keynes right and whether Keynes was right are separable issues. On the former, I am a little more sympathetic to the textbook version - it seems to me a correct, but highly incomplete, representation of what Keynes said in the General Theory. On the latter point, Farmer goes on to argue that because (in his view) consumption is dependent on wealth, not income, fiscal policies intended to raise demand through an increase in disposable income will not be effective. Instead, policy needs to focus on asset prices:

Where does this leave us? Keynes was right about three key points. 1) High unemployment can persist forever because the market is not self-correcting. 2) Confidence matters. 3) Government can and should intervene to fix things. But the orthodox Keynesians are wrong: fiscal policy cannot provide a permanent fix to the problem of high unemployment. We need a new approach that directly attacks a lack of confidence in the asset markets by putting a floor and a ceiling on the value of the stock market through direct central bank intervention.

Offhand, it seems to me that using monetary policy to prop up the stock market is not so radically different from increasing "M" in the textbook model. The transmission mechanism is different: Farmer would have the central bank buy stocks, instead of bonds, as it does in conventional open market operations (or instead of dropping money from helicopters, or burying it in bottles...), but the end result would still be an increase in nominal demand.

I suspect I may be missing something - Farmer had limited space to make his argument and the "textbook" Keynesian framework is pretty engrained in my thinking, so it is hard for me to think of these issues outside of it. I'll look forward to the longer version in his forthcoming books.

Too Low for Zero

The Taylor rule describes how the Fed adjusts monetary policy (by changing the target for the Fed funds rate) in response to output and inflation. The San Francisco Fed's Glenn Rudebusch plugged the Fed's forecasts for inflation and the output gap into the Taylor rule, and found that the Fed funds rate should be headed deep into negative territory:The problem is that nominal interest rates cannot be negative; it is better to hold money and earn no interest than lend it and get less back in the future. Thus, monetary policy is up against the "zero lower bound" (which it reached in Dec. 2008, when the Fed lowered the Fed funds target to a range of 0-0.25%), forcing the Fed to improvise. Rudebusch explains:

Toward the end of 2008, the recession deepened with the prospect of a substantial monetary policy funds rate shortfall. In response, the Fed expanded its balance sheet policies in order to lower the cost and improve the availability of credit to households and businesses. One key element of this expansion involves buying long-term securities in the open market. The idea is that, even if the funds rate and other short-term interest rates fall to the zero lower bound, there may be considerable scope to lower long-term interest rates. The FOMC has approved the purchase of longer-term Treasury securities and the debt and mortgage-backed securities issued by government-sponsored enterprises. These initiatives have helped reduce the cost of long-term borrowing for households and businesses, especially by lowering mortgage rates for home purchases and refinancing.

In terms of overall size, the Fed's balance sheet has more than doubled to just over $2 trillion. However, this increase has likely only partially offset the funds rate shortfall, and the FOMC has committed to further balance sheet expansion by the end of this year. Looking ahead even further over the next few years, the size and persistence of the monetary policy shortfall suggest that the Fed's balance sheet will only slowly return to its pre-crisis level.

That is, the usual adjustments to the Fed funds rate affect the short end of the yield curve (the relationship between interest rates and maturity of debt), but now the Fed is creating money to buy longer-term securities. Because bond prices and yields move in opposite directions, this should reduce rates further along the curve.