05 Sep 2011

Ozone, Krugman, and Landsburg

Economics, Krugman 25 Comments

The White House recently backed off a proposal to tighten ozone regulations. (The proposal was really absurd. It would have required possibly 0.06 ppm, or 60 parts per billion–the equivalent of less than a cup of water in an Olympic-sized swimming pool. The EPA itself said that up to 96 percent of the monitored counties in the country would be in violation of the new rule. I saw others claiming [not sure if the EPA admits this] that there are areas in Yellowstone National Park that would be in “non-attainment” with the lower threshold.)

Paul Krugman was, naturally, aghast. He didn’t focus on kids suffering from asthma or other environmental issues, but instead looked at it from a liquidity trap perspective:

As some of us keep trying to point out, the United States is in a liquidity trap: private spending is inadequate to achieve full employment, and with short-term interest rates close to zero, conventional monetary policy is exhausted.

This puts us in a world of topsy-turvy, in which many of the usual rules of economics cease to hold. Thrift leads to lower investment; wage cuts reduce employment; even higher productivity can be a bad thing. And the broken windows fallacy ceases to be a fallacy: something that forces firms to replace capital, even if that something seemingly makes them poorer, can stimulate spending and raise employment. Indeed, in the absence of effective policy, that’s how recovery eventually happens: as Keynes put it, a slump goes on until “the shortage of capital through use, decay and obsolescence” gets firms spending again to replace their plant and equipment.

And now you can see why tighter ozone regulation would actually have created jobs: it would have forced firms to spend on upgrading or replacing equipment, helping to boost demand. Yes, it would have cost money — but that’s the point! And with corporations sitting on lots of idle cash, the money spent would not, to any significant extent, come at the expense of other investment.

It’s that last part in bold that puzzles me; it seems Krugman has made an elementary mistake. In basic economics, a firm will allocate its wealth among different outlets until the marginal benefit (MB) is equalized among them. So if a firm is spending, say, $1 million on its R&D budget, and $6.8 million on advertising, and yet is keeping $2 billion in the form of short-term Treasuries (“cash”), this is because on the margin the firm sees no gain from reallocating those dollars. To switch $10,000 from cash into advertising would make the firm worse off, from its narrow perspective.

Now, if the government comes along and imposes stricter ozone regulations, then the marginal benefit of spending on factory revamps goes way up. So how should the firm respond to the new situation? It seems to me that basic economics would say that the firm would cut back on spending across all areas, and it would also reduce its cash holdings a little. (I think Daniel Kuehn agrees with me.)

So it seems Dr. Krugman has forgotten a principle from basic economics. The new investment spending flowing from tighter ozone regulations would have largely come from cutbacks in spending in other areas, and only partially out of cash reserves. (The crucial point here is that cash reserves aren’t “idle”; they serve a function to the entity holding them.)

This is all the more interesting a mistake, since it was only a few days earlier that Krugman had (incorrectly) used the same apparatus to chastise Eric Cantor. Steve Landsburg explained why, in that context, using the idea of small changes to MB was not correct–neither Cantor nor Krugman would have conceded that the government’s spending priorities were initially in an “optimal” arrangement. Krugman admitted that Landsburg was right.

And yet it seems that Krugman took the lesson too much to heart. It’s true that “basic economics” doesn’t say anything how a government should respond to a change in spending priorities (such as the need to address a sudden disaster). But basic economics does shed light on how a private firm will respond to a change in its spending priorities (such as the need to address stricter ozone regulations).

25 Responses to “Ozone, Krugman, and Landsburg”

  1. Daniel Kuehn says:

    Ya – I do agree with you on that point you highlight.

    This of course is a much more complicated case. We would argue that the whole reason for the regulation in the first place is that firms are spending more on all non-pollution abatement margins than the marginal benefits produced by that spending, and that it spends too little on pollution abatement relative to the marginal benefits produced by that activity. But that’s a whole different can of worms.

    From the externality perspective, a window is being broken here and nobody is spending to fix it (even partially out of idle resources): the worst of both worlds.

    • Daniel Kuehn says:

      You say the reg itself was absurd – I can’t speak to this. I’m just thinking environmental regs in general that people I would defer to think would make sense.

      The news story has been that it was rejected because of appeasement – do you think it’s plausible it was rejected because the administration agreed with you on its absurdity? I just ask because you probably have a broader view of what is “absurd” than many people do – but is this generally considered absurd?

    • bobmurphy says:

      DK, right, Krugman could say that the marginal social benefits are much higher than the marginal social costs. I might disagree with that analysis, but it’s not relevant to the narrow point of what will happen to the firms’ private MBs across various projects.

  2. joshua says:

    I’m not learned enough (yet) to completely follow the liquidity trap back-and-forths, but I’m surprised Krugman didn’t go for the asthma angle, cuz it seems pretty slam dunk: Pollutants from power plants cause a negative externality when they leave the power plant’s property and trepass on an individual’s property and enter his lungs and make him sick. Then you have the “official” estimates that the health savings to society will outweigh the costs of compliance, and, boom, case closed.

    And I’m honestly not sure where I stand on that. I don’t really trust the “official” estimates on the cost/benefit analysis, and there’s a typical knowledge problem with how to set ideal levels, but in theory I don’t have a problem with government restricting externalities… does that make me a bad pseudo-libertarian? (I’m here to learn….)

    • joshua says:

      On second thought, of course I know why Krugman had to argue that the regulations would have helped the economy: because the Republicans are arguing that they would have hurt the economy and Krugman has to tell everyone that Republicans are categorically wrong.

  3. AP Lerner says:

    ” $2 billion in the form of short-term Treasuries (“cash”)”

    short treasuries are equivalent to cash?

    • Richard Moss says:

      Ask the Greeks.

      • MamMoTh says:

        The Greeks don’t have their own currency.

    • S Andrews says:

      I thought you would be an expert on GAAP accounting.

    • bobmurphy says:

      AP, do they use quotation marks in the MMT literature? It refers to when you are quoting a term as used by other people.

    • Mattheus von Guttenberg says:

      That’s why he put it in quotes.

      And yes, short-term treasuries are very liquid assets.

  4. Joseph Fetz says:

    “The crucial point here is that cash reserves aren’t “idle”; they serve a function to the entity holding them.”

    I thought the same exact thing when I read that line.

    There is something that Krugman left out, though. I work in Ohio and the surrounding states (I do environmental remediation and demolition). As a result of the fact that most in my region were expecting these EPA regulations to go through, we have been bidding on a lot of power plant jobs. Only, we weren’t bidding on these to help in any upgrades and renovations needed in order to comply with the new standard, rather we are bidding to completely tear the power plants to the ground as a result of the new standard. Yep, that’s right, if the EPA regs had gone through then the energy companies would have been demolishing a good number of power plants. And, what is more, they had no plans of rebuilding new ones.

    Of course, I am sure that Krugman, in his strange understanding of Bastiat, would have me believe that we are all better off. He would probably point to the fact that my coworkers and I are now employed to tear down the power plant. Except this would ignore the fact that in the absence of such regulation we would merely have been employed elsewhere. Usually, my work is done in preparation for new construction, this would not be true in the case above. Also, while we may indeed be employed to tear down the plant, this also means that those who worked in the plant no longer have a job.

    Of course, one cannot forget that with less power plants around there will be a lesser supply of power. Other than the obvious increase in prices that would happen, there would also be a lesser quality of service. During times of high power demand there would not be enough generators to fully meet that demand (brownouts/rolling blackouts, etc). Also, in cases of damaged/worn out transmission lines (very common), the built in redundancy of the power grid will have large gaps. So, if one station cannot provide power to the grid, there is no firing up a few boilers on another plant to fill the gap, because now most stations would be running at near-full capacity just to handle the current load (sic).

    So, while a Keynesian might point to the increased spending needed to hire my company, the spending that my coworkers and I might undertake, and the increased spending on the part of power customers due to the increased price, etc as a net gain, they would be ignoring the fact that while nominal spending may have very well increased temporarily, there are now power plants that no longer exist as well as the jobs that go with it.

    I am sorry, but I see this as a net loss of utility, not a net gain.

    • bobmurphy says:

      Joseph, is there any kind of objective thing I can cite, to show that power plants were going to shut down and not reopen? I am writing up something on this topic, and that would be a great factoid to have.

      • Joseph Fetz says:

        I wish there was. Unfortunately, the bids of demolition projects aren’t something that gets very much coverage or citation. Usually, the only time our work gets cited anywhere is if what we are tearing down is going to be the home for something new and big, we tear down or remediate something monumental, we turn in our notifications to the various depts/agencies, or we really screw something up…. http://www.youtube.com/watch?v=GRvD-41UL5A

        Luckily, we subbed out the explosive demo in the above case.

        Sorry, man. But, you kind of have to be a guy in the business to know this stuff. Interestingly, I did hear a rumor a few weeks ago that this reg wasn’t going to go through, but I took it as just that- a rumor. Actually, I doubted it. One thing that I do know is that this reg is only one of a few coming down the pipeline (so, things aren’t rosy just yet). If you’d like, I can try to find out more info about the other regs.

        • bobmurphy says:

          Thanks Joseph. Do you care if I quote you? If that’s OK, pls email me and give a statement in the exact way you’d want it. I can also keep it anonymous; just tell me how to refer to you. E.g. “According to one source in a demolition crew with 3 years experience,” or whatever.

    • MamMoTh says:

      That’s a very good case for the government to introduce the regulations, and build new environment friendlier power plants.

      That would provide a real net gain, unless some libertarian decides to smash the windows of the public power plants.

      • Richard Moss says:

        Don’t forget tearing down and rebuilding areas of Yellowstone National Park; to make it more environmentally friendly.

      • Bob Roddis says:

        Keep yapping, Mam-mouth. Tell the folks exactly what you want to do.

  5. Bob Roddis says:

    Is this a different set of regulations than future regulations that will shut down coal-fired plants?


    • Chris says:

      This is not the big deal rule in terms of utility regulation; that’s the Cross-State air pollution regulation, which is still scheduled to come online. Though Obama may be using this ozone regulation to signal that he’s willing to negotiate on delaying the implementation of Cross-State. As well, the cross-state rule is of more limited impact, with Texas the only place where asset retirements would possibly threaten resource adequacy in the near term. A lot of coal retirements will be spurred in the Northeast/PJM as well, but total capacity should be fine.

  6. PCTrombly says:

    I’m getting sick of Krugman’s sophistry. Bastiat was right; there are no exceptions; Krugman is not “mostly wrong” – he’s just wrong.

    One minus one does not, cannot, ever, equal one.

    And it does not equal some fraction of one, either.

    One firm’s “cash reserves” equals another firm’s capital.

    Firms do not keep their “cash reserves” in safes, in safe deposit boxes or under mattresses. They keep them in BANK ACCOUNTS. Banks maintain only the cash reserves that they are required to maintain per the banking regulations – perhaps slightly more but not materially more. See, they have to generate enough interest margin to cover their overhead, which is why the Banks maintain only the reserves that thay’re required to maintain. The primary way to maintain margin is to lend those deposits out: to firms and individuals investing or consuming. Thus a reduction in one firm’s “cash reserves” equals a reduction in a bank’s deposits, which equals a reduction in the bank’s lendable funds, which equals a reduction in loans. It’s still one minus one, and it still equals zero.

    The other way for a bank to maintain margin is to buy Treasurys – but that’s just the crowding out of private sector investment via expansion of public sector debt (one minus one STILL equals zero).

    No matter how you slice it, all government investment comes at the expense, dollar for dollar, of private investment; all government spending comes at the expense, dollar for dollar, of private spending. Government has no accumulated earnings – it cannot invest capital that it did not first remove from the private sector. It can print money – but it cannot create capital out of thin air.

    It is ironic that the economists most critical of a gold standard would recommend policies that amount to the economic equivalent of alchemy.

    • MamMoTh says:

      You are more wrong than Krugman.

      Banks don’t lend out reserves. Loans create deposits (out of thin air if you wish, although no air is involved). So banks are not constrained by reserves to issue loans, they are constrained by their own capital.

      Moreover, when a company spends its own deposit at a bank, it becomes someone else’s deposit at some bank, to the penny. Reserves in the banking system remain unchanged. Only taxation removes reserves from the banking system.

      Cash, bank reserves and government bonds are actually capital of the private sector, created by the government, out of thin air.

      Government debt doesn’t crowd out anything. The money used to buy government debt comes from government deficit spending. Only government spending can crowd out real resources from the private sector when competing with it to acquire them.

      Reality feed? That was funny…

    • BW says:

      This post is spectacularly wrong.

      It rehashes the very same argument that Krugman and others have addressed multiple times. It’s actually quite embarrassing that they have to address it, because you don’t have to know more than basic freshman level macroeconomics to see that it’s wrong. In fact, you don’t even have to know that much. You simply need some common sense.

      There are many ways to show its incorrectness, but I’ll choose simple arithmetic.

      Y = C + I + G

      CI (Consumer Income) = C + S (consumer savings)

      Suppose there is an exogenous shock in consumer demand and C drops by 20%. Thus, S would go up by 20%. Does that mean that I must also increase by 20%, because S = I? If so, then the drop in consumer demand does not affect Y. Ergo, recessions would never happen. But they do, so your supposition is false.

      Here’s how things really work. C drops by 20%. S, however, does not go up by 20%. Rather, S goes up by X% < 20 and CI drops by 20-X. Thus, I increases by X% as well, but GDP falls by 20-X. The reason that S does not increase by 20% in response to the exogenous shock is precisely because investment opportunities do not appear by magic, especially in a liquidity trap when capital costs can no longer be reduced in response to sluggish demand. Thus, the holding of cash reduces GDP.

      Basic stuff.

  7. Charlie says:

    If the marginal dollar is being invested at the risk free rate, then the marginal benefit to an owner of the firm is the risk free rate of interest. It doesn’t matter to the investor whether she buys T bills or buys Microsoft who buys T-bills. It affects her portfolio the same way. Since the risk free rate of interest is very close to zero, the marginal benefit is very close to zero at most.

    The only way the marginal vendor can be much higher than zero is if there are significant costs to raising or liquidating capital, which seems pretty unlikely.

    What seems more likely is that there are large adjustment costs to shrink a business. In this case, the marginal benefit of several operations are effectively negative (if it could costlessly shrink it would), whereas cash’s marginal benefit cannot go below the market risk free rate, which is bounded by 0.

  8. wolfgang says:

    >> And with corporations sitting on lots of idle cash
    and the reason corporations currently have higher cash reserves than before 2008 is because they learned that the banking system cannot be trusted to provide for short term financing (commercial paper market).

    The only way to get out of this would be to restore confidence in the banking system, but the outlook is bleak on that front, see BoA, EU etc.