30 Aug 2008

Does Tyler Cowen Really Not Endorse ABCT, Or Is He Just Yanking My Thread?

All Posts 1 Comment

In a previous post, I explained that Tyler Cowen unwittingly proved the predictive power of Austrian business cycle theory (ABCT) several years ago, in a post titled (a la OJ Simpson) “If I believed in Austrian business cycle theory…”

But oops Tyler did it again in his recent New York Times article. Seriously, there are some very ABCT-ish passages in this article, such as:

Behind every financial crisis there is usually a crisis in the real economy, based in some underlying structural deficiency…

The third problem is that lower consumer spending will require the American economy to make some shifts. That may mean fewer Starbucks and fewer new homes but more tractor production for export to foreign markets. In the long run, shifting some consumption to investment is probably beneficial to the economy; in the short run it means job losses and costly readjustments.

In addition, there are still excess homes on the market, and housing prices need to fall further. Of course, such price declines can make banks less solvent and thus worsen the credit crisis. And politicians would like to moderate this fall in prices, again prolonging the adjustment process…

What should policy makers do? One path that is likely to prove counterproductive is further fiscal stimulus in the form of tax rebates. Such stimulus can raise consumer spending and bolster the economy in the short run, but it works — if it works at all — only by pushing consumers to spend rather than to save. It merely postpones needed adjustments by providing a grab bag of goodies at exactly the wrong time.

Now I grant you, Tyler’s* article isn’t a canonical exposition of the ABCT; for that, I naturally direct you to something I wrote.

But what’s really touching/frustrating, is that Tyler is begging for a business cycle theory to organize all of his (good) intuitions. In the MR post where he promotes his NYT article, Tyler explains:

I’ve become increasingly interested in how an economy can be “tangled up,” a notion I first learned from Axel Leijonhufvud. The literature on self-organizing critical systems considers this idea, but I don’t think it has been expressed in simple, intuitive form and in a manner that can be integrated with other macroeconomic ideas.

Seriously, folks, ABCT is just what the doctor (not an MD, mind you) ordered. The Austrian theory explains how artificially low interest rates (caused by Fed injections of phony credit) lead to unsustainable investments. The economy’s capital structure is a complex web of interrelated processes, and most schools of thought don’t model it at a rich enough level to capture this. So that’s why only the Austrians have a chance of explaining what happened in the recent housing boom-and-bust. There’s more to the story than simple “greed,” because speculators and real estate agents were greedy in the 1990s too.

If you really want to see the Austrian story of how the Fed sets in motion an unsustainable expansion–how things get “tangled up” if you like–I encourage you to watch Roger Garrison’s phenomenal PowerPoint shows. Really first rate stuff.

* After you criticize someone in 25 separate blog posts, you earn the right to call him by his first name, correct?

29 Aug 2008

McCain Picks a Woman VP!!

All Posts No Comments

Wow, this presidential season is just showing how awful I would be as a campaign manager. Back in January I thought it was a foregone conclusion that Hillary Clinton would not only be the Democratic nominee, but the next president. And three months ago I was sure Obama was going to clean McCain’s clock,* but now I think it’s going to be a nail-biter. You have to hand it to the McCain camp (and I read that he switched managers fairly late into it, but I forget the new guy’s name), with the drilling issue and now picking Alaska governor Sarah Palin (instead of white male Romney), they are putting up a fight.

* If you say that three times fast you will probably make a naughty.

29 Aug 2008

If Obama Wins, Can You Ask for a Raise?

All Posts No Comments

Von Pepe (not his real title) emailed me and declared:

“But, I am thinking that [redistributive] tax policy has CAUSED more income inequality. The highly productive have such high taxes that they demand much higher wages (which later gets redistributed). So, as taxes go higher the wealthy’s wages go much higher.”

He then went on to say that he is letting his boss know that if Obama wins, Von Pepe expects a big raise to cushion the blow to his take-home paycheck.

Being a trained economist, my first reaction was to scoff. After all, if your boss can afford to give you a big raise, why do you need to wait for an Obama win to ask for it?

However, even as I was typing this, I felt as if my standard analysis was leaving out some important things. First, contrary to popular belief (and which you will even see spelled out in the Greatest Economics Book Ever), in a free market workers do not get paid their marginal product. There is a tendency for this to happen, but there are all sorts of things that prevent it from literally occurring. There are obvious “frictions” from lack of perfect information and transactions costs, but even besides that, there is the fact that specialized workers are very heterogeneous, and so their marginal product at one firm (especially if they’ve been there for years) might be higher than it would be at any other firm. So for these workers, there is a surplus available that must be split according to bargaining strength.

For example, suppose there is a partner at law firm who adds $1 million in net revenue to the firm every year. That is to say, if he died, the firm’s revenues from clients would be $1 million lower. However, suppose that the next-best option he has is to work for a rival firm, whose clients he doesn’t know etc. If he worked for them, even after he found his groove, he would only add $800,000 per year.

So there is a $200k gap that he and the first firm must haggle over. Competition in the labor market will not ensure that the lawyer earns $1 million in the long-run. He will definitely earn at least $800,000 (assuming no information deficiencies or high transaction costs), but there’s no reason he needs to get all of the $200k pie.

If Von Pepe is in a situation like this, then his boss could indeed afford to give him a raise, and maybe the guilt trip of “Obama is making me pay my fair share!!” gives Von Pepe a bargaining edge that he lacked before.

There is a second issue involved in all this, however. Even if we make all the textbook assumptions, it is still the case that Von Pepe might ask for, and get, a raise if Obama wins and jacks up tax rates. This is really no different from saying that the market price of oil will rise, if Obama imposes a windfall profits tax on oil producers.

The subtlety is that Von Pepe’s marginal productivity itself might rise (indirectly), because of Obama’s tax hike. With lower after-tax returns, rich people work less. The supply of skilled labor shifts left, and so its market price rises. So those remaining in the industry get paid more in pre-tax dollars.

In conclusion, I endorse Von Pepe’s plan to ask for a raise in the event of an Obama victory. It just took us a few email exchanges for me to get past the stumbling block of my PhD in economics to see why he was right.

29 Aug 2008

Is Offshore Drilling a Realistic Solution?

All Posts No Comments

Like playing with a canker sore, I can’t help checking out the Env-Econ blog. In a recent post, John “I’m funny enough to compensate for my tree-hugging views” Whitehead was urging his readers to go vote against offshore drilling in a poll hosted here. Now if you click that link and check out the context, you will see some amazing objections to offshore drilling:

* It will be 10 years before oil will start to be pumped into refinery pipelines, from the point the exploring begins.

* Oil will start being pumped out in 10 years, but maximum capacity isn’t expected to be reached until 2030.

This is irrelevant, as I explain in this post. If producers with current excess capacity (such as Saudi Arabia) anticipate greater competition down the road, they will pump more now. This seems to be what happened just recently, when oil prices started dropping the DAY that President Bush lifted the executive moratorium on offshore drilling.

* As the oil is pumped from these new leases, it will just be auctioned off into the global market, and the highest bidder will buy the oil. It will not be set aside solely for Americans, unless we are planning to change the way we participate in free global markets.

Oh my gosh, somebody help me back into my chair… Did they really just say that? Global demand curves slope downwards. If you throw more oil on the global market, the global price of oil goes down, meaning Americans pay less for their imported oil. The really ridiculous thing is, suppose they did pass a law requiring any new production to be sold to Americans. That would simply lower Americans’ demand for imported oil, which would lower the world price, which would redirect some of the previously imported oil to the highest bidders elsewhere in the world. Good grief, if you don’t know the first thing about economics, why are you setting up a website making economic “points”?!

* Even though the [Gang of Ten] plan projects to raise $84 billion for alternative energy projects, drilling in these off-limit areas will risk serious environmental damage to our coastlines.

This is great, and this is just what the Gang of Ten was supposed to accomplish. Now we’re arguing not over “offshore drilling” but rather the piddly little concessions offered in the Gang of Ten plan. The plan doesn’t call for revoking the federal ban, instead it calls for renewing the ban, and then allowing four coastal states the right to opt out of it (if their state legislatures so vote), BUT no matter what, even these four coastal states still can’t drill anywhere within a 50-mile buffer zone off their shores.

And anyway, what are we afraid of? I thought the evil oil companies were sitting on 68 million acres of leased land where they weren’t drilling. So why would they start drilling offshore if they were given the green light?

28 Aug 2008

Why Keynesian Macroeconomics Screws Up Financial Reporting

All Posts No Comments

Sorry for the delay, folks; my power lunch ran longer than expected, and so this post is coming a few hours later than I had intended. I hope it will be worth the wait. One final caveat: This post will be a bit longer and more academic than most, but I really want to get to the heart of this issue.

In this post I want to pinpoint exactly what is wrong with the typical financial reporting–and it’s not really the reporters’ fault, they’re just quoting the mainstream economists!–when it comes to the strength of the economy. We always hear the mantra that consumer spending represents some huge component (70 percent at the end of 2006) of GDP, and therefore is the key determinant of economic growth. Lately, we’ve heard things like, “The one silver lining has been the fall of the dollar, which has boosted exports and kept the economy out of recession.”

This is all palpable nonsense.

What has happened here is a classic confusion of correlation with causation. Ex post, if you want to measure the “total gross output” of an economy, it sort of makes sense to count up how much money people spent on stuff produced within the United States. (Even here there are serious methodological issues, but those aren’t relevant for the present post.) You can’t simply count up all the physical things being produced, because that would just give you an immense vector of different items: x amount of iPods, y amount of golden delicious apples, etc. There would be no way to just look at the gross physical output from one year to the next, and be able to say, “The economy grew 3.4% in real terms over the year.”

So the way economists get around this issue of aggregation is to use the money prices of the goods as a way to compare their relative importance. So if one more unit of something is produced that a buyer is willing to spend $100 on, that counts as twice as much “output” as one more unit of something that a buyer is willing to spend $50 on. Again, there are methodological problems here, but let’s ignore them to concentrate on an even more blatant mistake in the conventional approach.

Every transaction involves an expenditure and an equal receipt of income. That is, when you buy a TV for $100, that’s $100 more in “consumer spending” but it is also $100 more in “business revenue.” For various reasons–including accessibility of the data–macroeconomists focus on the expenditure side of the coin, and sum up all the expenditures in the economy in order to measure gross output for the period.

In an ex post fashion, there is nothing intrinsically wrong with this choice; any philosophical problems you had with it, would (I believe) also apply to measuring income.

However, the fundamental mistake comes in when people stop using the expenditure approach as a backward-looking bookkeeping trick, and instead use it as a forward-looking, causal theory of GDP growth. That is to say, the act of people spending money on consumer goods does not constitute economic growth.

This is so obvious that I feel funny spelling it out, but somebody needs to do this once in a while to remind everyone how ridiculous the standard commentary on GDP and recession is. If you want to boost economic growth, go work more, produce more stuff. Don’t go to the mall and buy things; that’s consuming, it’s not producing.

Although what I just said is a truism, the reason it’s a bit subtle is that (as I explained above) you really do need a link to consumer spending, in order to quantify how much your “production” is worth. If you go out and bust your butt for 8 hours “producing,” you really might not be very productive in an economic sense, if nobody wants to buy whatever it is that you made. So in a sense, it’s true that if nobody spent a penny on anything made within the US, then we could say “nothing” was produced that year (unless we bring in a timing issue, where people produce stuff that they plan on selling in the future). This subtlety notwithstanding, it should still be clear that consumer spending per se does not constitute production, or contribute to economic growth. It is rather a reflection of economic output.

When I tried to get this point across to my macro students, the best example I could think of was the component of depreciation. Here is the standard formula for GDP:

(1) Y = C + I + G + (X-M),

where X is exports and M is imports. However, we can rewrite this equation as

(2) Y = C + (N+D) + G + (X-M),

where N is net investment and D is depreciation. Back in equation (1), “I” stood for gross investment, and net investment is gross minus depreciation, so that’s why I = (N+D).

OK now just stare for a minute at equation (1). In the typical press discussions of the economy, they would say things like, “Consumers are getting increasingly worried about winter heating costs and gasoline prices, and so C is falling. That’s bad for total output, Y, so we might enter a recession. On the other hand, the weak dollar is boosting exports X, and reducing imports M, so that is tending to keep Y up, keeping us out of recession.” (Of course they don’t use the letters, but I’m trying to tie the verbal discussion into equation (1) above.)

As anyone with a background in old-school economics knows, this type of talk can’t be right; how in the heck is it “good for the economy” if people go spend like sailors, or if the dollar falls? That doesn’t make any sense. But what specifically is the mistake?

Here’s where equation (2) comes in. I’m going to employ the same reasoning, but with a new variable. I’m hoping that in this new context–where it hasn’t been hammered over your head by “expert” PhDs for your whole life–the absurdity will jump right out at you.

Looking at equation (2) above, suppose someone said, “Well Maria, the economy is experiencing tough times. Consumer spending is down, government spending is down, and net investment is down. However, the one silver lining in all this, is that because of a new type of road salt recently adopted, all of the nation’s tractor trailers are wearing out much more quickly than anticipated. Trucks that were thought to have 100,000 more miles in their useful life, are now expected only to eke out another 25,000 miles. Because of this sharp increase in depreciation, the economy might just barely skirt recession. Treasury Secretary Paulson is in fact calling on local governments even in southern states, where there is no snow, to begin salting their roads to promote this growth spurt from depreciation.”

OK, does everyone see how I used the exact same logic as the talking heads on CNBC, to “prove” that raising depreciation boosts economic output? Something is clearly crazy here.

I’ll end the suspense. Specifically, the problem is that people look at that accounting tautology–Y = C + (N+D) + G + (X-M)–and then mistakenly assume that if they increase a variable on the right-hand side, then the way the equation remains true is that the variable Y on the left-hand side goes up accordingly.

But duh, that’s not the only way to balance the equation. In the salt example, what happens is that if D goes up, then N goes down, so that the equation is still true. Gross output isn’t affected, but the capital stock grows less than otherwise, because more of the gross investment I (from eq. 1) is being sucked up by the wearing away of the tractor trailers.

It’s similar with the nonsense over the rebate checks. If people are good little citizens and do what Paulson wants, then yes C goes up. But that doesn’t mean Y has to go up, instead it can just push down I (in eq 1) or N (in eq 2). Duh! If you pay down your debts with your stimulus check, then that gives more loanable funds to the financial sector so some businessperson can borrow it and expand his operations.

Finally, what about the falling dollar? Again, just looking at the equation: If X goes up and M goes down, this isn’t necessarily balanced by a rise in Y. On the contrary, it could be offset by a fall in C and/or a fall in I. This should be obvious; a falling dollar makes foreign imports more expensive, and so of course Americans can’t consume as much (because part of what they consume is imported goods!). A falling dollar also makes inputs more expensive for US businesses, like, oh I don’t know, those who rely on petroleum products. (Duh!)

In conclusion, the GDP accounting tautology is true, if we ignore serious methodological problems. But because of Keynesian theory (not a tautology!), the causal relationships between the variables in the tautology are assumed to work in a particular direction. That is, it is Keynesian theory that says if you increase C (or G), the result will be an increase in Y. This is consistent with the tautology, but is not required by it.

Classical (and modern Austrian) economic theory would say that in general, when people save more, this lowers interest rates and leads to higher investment, and so doesn’t affect Y in the near-term. With freely floating wage rates, it doesn’t matter how much of their income people “spend” versus how much they save. If consumers start saving 25% of their income, the relative prices and wage rates adjust so that teenagers who used to flip burgers and tear movie ticket stubs, are now working in factories cranking out tractors and drill presses. Total gross output (which includes both consumer and capital goods) doesn’t need to fall, and in fact will grow at a faster rate year after year, the higher the savings rate and hence the higher net investment is every period.

Alas, when it comes to the financial press–and even free market economists who ought to know better–“we are all Keynesians now.”

28 Aug 2008

Recession Episode III: The Revenge of Keynes

All Posts No Comments

I have to run to a power lunch* but when I return, I promise to explain why these financial press discussions of recession are absurd. Reading these conventional analyses, you would think that if the dollar just kept falling, and consumers ran up their credit cards to buy DVDs and steak dinners, then we would have strong economic growth.

*Note on nomenclature: A “power lunch” is one in which I scrounge for money from possible clients. In preparation, I have been studying beagles and how they droop their eyelids.

28 Aug 2008

Six More Join the Gang

All Posts No Comments

Oh great, the Gang of Ten is now the Gang of Sixteen. These terms are thrown around as if they’re funny, when the serious truth is that the entire Congress is a Gang of 535. (Fine fine, Ron Paul fanatics, the Gang of 534.)

If you want to see a point-by-point critique of the original Gang of Ten plan, go here (pdf). In this post, I just want to elaborate on the political context.

Back in June, there was both a congressional and an executive ban on (new) offshore oil drilling in large portions of federally controlled areas. On July 14, President Bush rescinded the executive ban. (Incidentally, that’s the exact day when oil prices began dropping like a stone.)

The congressional moratorium expires on September 30 with the federal fiscal year. That means the Congress will have to take positive steps to renew the ban, and the White House will have to sign it into law.

So you can see the pickle that the anti-drilling forces (mostly Democrats) are in. A substantial majority of Americans tell pollsters they want more domestic energy production. So the Democrats can’t come out and renew the ban; the Republicans would have a field day in November with that.

Enter the Gang of Ten. By adopting a Paris Hilton compromise, it seems they are being very sensible and above politics–hey, that’s so touching that they have five Republicans and five Democrats! Aww, I’m tearing up.

But this “compromise” is nothing of the kind. The plan has $84 billion in subsidies and tax credits for lefty pet projects (fuel efficient cars, biofuels, etc.), and it will pay for $30 billion of this by removing the manufacturing tax credit on oil and natural gas companies. (They didn’t specify where the other $54 billion will come from, but I imagine it’s not the Tooth Fairy.)

Oh, but at least it allows for more offshore drilling, right? Well, barely. It allows four coastal states to opt out of the current ban, if their state legislatures approve. BUT, even so there will still be a 50-mile buffer zone, meaning that even these four states still won’t be allowed to drill anywhere near their coasts, even though some of the most promising known deposits are within 50 miles of the shore.

This is why commentators at the Wall Street Journal and the Excellence in Broadcasting Network are so mad at the Republicans who joined the Gang of Ten (Sixteen). The Republicans had a straightforward, winning issue by championing drilling. But now the Democrats can point to the bipartisan compromise plan, putting the onus back on Republicans to oppose it–and thereby risk a government shutdown blamed on them, if they can’t agree on a new bill to fund the government by October 1–or to accept it, even though this will yield a piddling amount of new domestic energy production.

I think this is why purists couldn’t believe I was wasting my time working for a think tank, trying to educate politicians about sensible policies. Even if it looks like the strategy is working–the voters are for it, the economics is right, and the “free market” politicians will be popular by supporting it–something will always happen to ensure that inefficiency wins the day.

28 Aug 2008

"Presumptive": One Down, One to Go

All Posts No Comments

At this point, the press can stop referring to Obama as the “presumptive nominee,” right? It would be interesting to do a graph of how often the word “presumptive” was used in news stories during 2008. I’m guessing there was a bit of a spike in the last few months…