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July 31, 2008

Economist's View - 5 new articles

The Antikythera Mechanism

Lee Arnold sends this along, and says:

Nature magazine has put up a great new video about the Antikythera mechanism. It includes computer animations of the mechanism from 3-D x- rays of the object and someone who is building a working replica.

This is an astounding thing.

The video is here.

A Solar Power Revolution?

Instead of all the drivel about offshore drilling from Republicans, this is what we need - technological solutions as described below. We aren't going to solve our energy problems, or even make a noticeable dent in them, by allowing offshore drilling. That's a ruse to capture votes. The solution lies in alternatives and conservation, and if the claims made below are correct, this looks like a big step in the development of solar power:

'Major discovery' from MIT primed to unleash solar revolution, Anne Trafton, News Office: In a revolutionary leap that could transform solar power from a marginal, boutique alternative into a mainstream energy source, MIT researchers have overcome a major barrier to large-scale solar power: storing energy for use when the sun doesn't shine.

Until now, solar power has been a daytime-only energy source, because storing extra solar energy for later use is prohibitively expensive and grossly inefficient. With today's announcement, MIT researchers have hit upon a simple, inexpensive, highly efficient process for storing solar energy.

Requiring nothing but abundant, non-toxic natural materials, this discovery could unlock the most potent, carbon-free energy source of all: the sun. "This is the nirvana of what we've been talking about for years," said MIT's Daniel Nocera ... senior author of a paper describing the work in the July 31 issue of Science. "Solar power has always been a limited, far-off solution. Now we can seriously think about solar power as unlimited and soon."

Inspired by the photosynthesis performed by plants, Nocera and Matthew Kanan, a postdoctoral fellow in Nocera's lab, have developed an unprecedented process that will allow the sun's energy to be used to split water into hydrogen and oxygen gases. Later, the oxygen and hydrogen may be recombined inside a fuel cell, creating carbon-free electricity to power your house or your electric car, day or night.

The key component in Nocera and Kanan's new process is a new catalyst that produces oxygen gas from water; another catalyst produces valuable hydrogen gas. The new catalyst consists of cobalt metal, phosphate and an electrode, placed in water. When electricity -- whether from a photovoltaic cell, a wind turbine or any other source -- runs through the electrode, the cobalt and phosphate form a thin film on the electrode, and oxygen gas is produced.

Combined with another catalyst, such as platinum, that can produce hydrogen gas from water, the system can duplicate the water splitting reaction that occurs during photosynthesis.

The new catalyst works at room temperature, in neutral pH water, and it's easy to set up, Nocera said. "That's why I know this is going to work. It's so easy to implement," he said. ...

James Barber, a leader in the study of photosynthesis who was not involved in this research, called the discovery by Nocera and Kanan a "giant leap" toward generating clean, carbon-free energy on a massive scale.

"This is a major discovery with enormous implications for the future prosperity of humankind," said Barber, the Ernst Chain Professor of Biochemistry at Imperial College London. "The importance of their discovery cannot be overstated..."

Currently available electrolyzers, which split water with electricity and are often used industrially, are not suited for artificial photosynthesis because they are very expensive and require a highly basic (non-benign) environment that has little to do with the conditions under which photosynthesis operates. More engineering work needs to be done to integrate the new scientific discovery into existing photovoltaic systems, but Nocera said he is confident that such systems will become a reality. ...

Nocera hopes that within 10 years, homeowners will be able to power their homes in daylight through photovoltaic cells, while using excess solar energy to produce hydrogen and oxygen to power their own household fuel cell. Electricity-by-wire from a central source could be a thing of the past. ... The success of the Nocera lab shows the impact of a mixture of funding sources - governments, philanthropy, and industry. ...

"The 'Big Push' and Economic Development in the American South"

David Beckworth on evidence for The Big Push theory of economic development, the idea that "publicly coordinated investment can break the underdevelopment trap by helping economies overcome deficiencies in private incentives that prevent firms from adopting modern production techniques and achieving scale economies." Given recent debate over using infrastructure spending as a means of stimulating the economy, the long-run supply-side effects of stimulating the economy through spending on infrastructure are noteworthy:

The 'Big Push' and Economic Devlopment in the American South, by David Beckworth: One of the great stories from 20th century U.S. economic history is the great economic rebound of the American South. From the close of the Civil War up through World War II, this region's economy had been relatively undeveloped and isolated from the rest of the country. This eighty-year period of economic backwardness in the South stood in stark contrast to the economic gains elsewhere in the country that made the United States the leading industrial power of the world by the early 20th century. Something radically changed, though, in the 1930s and 1940s that broke the South free from its poverty trap. From this period on, the South began modernizing and by 1980 it had converged with the rest of the U.S. economy. But why the sudden break in the 1930-1940 period? A new paper by Fred Bateman, Jaime Ros, and Jason E. Taylor provides a fascinating answer: the economic rebound of American South was the result of a 'Big Push' from large public capital investments during the Great Depression and World War II.

A novel contribution of this paper is that it appears to provide a real-world example of the 'Big Push' theory. Never heard of the 'Big Push' theory? Well, here is how the authors describe it:

According to the "big push" theory of economic development, publicly coordinated investment can break the underdevelopment trap by helping economies overcome deficiencies in private incentives that prevent firms from adopting modern production techniques and achieving scale economies. These scale economies, in turn, create demand spillovers, increase market size, and theoretically generate a self-sustaining growth path that allows the economy to move to a Pareto preferred Nash equilibrium where it is a mutual best response for economic actors to choose large-scale industrialization over agriculture and small-scale production. The big push literature, originated by Rosenstein-Rodan [1943, 1961], was initially motivated by the postwar reconstruction of Eastern Europe. The theory subsequently appeared to have had limited empirical application... [S]cholars have found few real-world examples of such an infusion of investment helping to "push" an economy to high-level industrialization equilibrium.

Until this paper, that is. The authors continue:

We argue here that the "Great Rebound" of the American South, which followed large public capital investments during the Great Depression and World War II, is one such application. Although 1930s New Deal programs are typically presented in the context of their attempt to bring relief and recovery to the U.S. economy through demand-stimulating public expenditures, the long-term economic effects of these and subsequent wartime expenditures were profound for the South. Specifically, and consistent with big push theoretical literature, the infusion of public capital—roads, schools, waterworks, power plants, dams, airfields, and hospitals, among other infrastructural improvements—fundamentally reshaped the Southern economy, expanded markets, generated significant external economies, increased rates of return to large scale manufacturing, and encouraged a subsequent investment stream. These improvements helped create the conditions that allowed the region to break free from its low-income, low-productivity trap and embark on its rapid postwar industrialization.

This paper deals with the break from the South's poverty trap. The sustained nature of the South's postwar economic recovery has been covered by other studies: Connolly (2004) looks to improved human capital formation, Cobb (1982) points to industrial policy, Beasley, Persson, and Sturm (2005) finger increased political competition, and Glaeser and Tobio (2008) discuss the merits of the climate or Sunbelt effect. (I will also note I have seen somewhere the advent of air conditioning did wonders for development in the South).

In short, this paper tells an interesting and under reported story of 20th century U.S. economic history. In so doing, it also provides what appears to be a good example of the 'Big Push'. Read the rest of the paper here.

Unemployment and Hours of Work over the Business Cycle

Why has unemployment remained relatively low even though the economy is sputtering?:

A Hidden Toll on Employment: Cut to Part Time, by Peter S. Goodman, NY Times: ...On the surface, the job market is weak but hardly desperate. Layoffs remain less frequent than in many economic downturns, and the unemployment rate is a relatively modest 5.5 percent. But that figure masks the strains of those who are losing hours or working part time because they cannot find full-time work — a stealth force that is eroding American spending power.

All told, people the government classifies as working part time involuntarily — predominantly those who have lost hours or cannot find full-time work — swelled to 5.3 million last month, a jump of greater than 1 million over the last year.

These workers now amount to 3.7 percent of all those employed, up from 3 percent a year ago, and the highest level since 1995.

"This increase is startling," said Steve Hipple, an economist at the Labor Department.

The loss of hours has been affecting men in particular — and Hispanic men more so. ... Some 28 percent of the jobs affected were in construction, 14 percent in retail and 13 percent in professional and business services...

"The unemployment rate is giving you a misleading impression of some of the adjustments that are taking place," said John E. Silvia, chief economist of Wachovia in Charlotte. "Hours cut is a big deal. People still have a job, but they are losing income."

Many experts see the swift cutback in hours as a precursor of a more painful chapter to come: broader layoffs. Some struggling companies are holding on to workers and cutting shifts while hoping to ride out hard times. If business does not improve, more extreme measures could follow.

"The change in working hours is the canary in the coal mine," said Susan J. Lambert of the University of Chicago,... an expert in low-wage employment. "First you see hours get short, and eventually more people will get laid off." ...

The growing ranks of involuntary part-timers reflect the sophisticated fashion through which many American employers have come to manage their payrolls, say experts.

In decades past, when business soured, companies tended to resort to mass layoffs, hiring people back when better times returned. But as high technology came to permeate American business, companies have grown reluctant to shed workers. Even the lowest-wage positions in retail, fast food, banking or manufacturing require computer skills and a grasp of a company's systems. Several months of training may be needed to get a new employee up to speed.

"Companies today would rather not go through the process of dumping someone and hiring them back," said Dean Baker, co-director of the Center for Economic and Policy Research in Washington. "Firms are going to short shifts rather than just laying people off." ...

And it works just the opposite way on the other side when GDP begins to recover. At first, firms will increase hours rather than employment. Firms won't invest in new workers until they are sure that the economy is improving, and that doesn't happen with just a single month or a single quarters worth of improved data. It takes a time for enough data to accumulate to convince firms that business really has taken a turn for the better, that what they are seeing is not just a temporary blip, and that it is worthwhile to pay the costs of hiring and training new workers.

This provides one potential explanation for why employment growth has been sluggish in the recovery period after the last two recessions, both of which occurred after the revolution in digital technology. To the extent that technology has increased training costs over time, the delay in the recovery in employment would be even longer. With higher training costs, firms would need to be even more certain that things have improved, i.e. they would need to wait for and analyze more data than before to be convinced that it's worthwhile to pay the cost of investing in new workers, and that increases the delay between the uptick in GDP and the uptick in employment (and to the extent that technology can substitute for labor, the employment response could be even more sluggish and muted).

links for 2008-07-31

July 30, 2008

Economist's View - 5 new articles

Marginal Company

Robert Reich on what not to take to the beach:

Robert Reich, Marketplace: Ordinarily, I'd never recommend you take a book by an economist to the beach. I wouldn't even recommend you take an economist to the beach. ...

An example of an economist at the beach? Robert Reich again:

Moral Hazard, by Robert Reich: One day while sitting on a beach last summer I overheard a father tussle with his young son about whether the child was old enough to take out a small sailboat. The father finally relented. "Go ahead, but I'm not gonna save you," he said, picking up his newspaper. A while later, the sailboat tipped over and the child began yelling for help, but father didn't budge. When the kid sounded desperate I put down my book, walked over to the man, and delicately told him his son was in trouble. "That's okay," he said. "That boy's gonna learn a lesson he'll never forget." I walked down the beach to notify a lifeguard, who promptly went into action. Letting children bear the consequences of their risky behavior -- what some parents call "tough love" -- is equally applicable adults, and conservatives have made something of a fetish out of it. A few weeks ago, as George W. announced a paltry plan to help out a few of the millions of homeowners who got caught in the sub-prime loan mess, he reiterated the credo: "It's not government's job to bail out ... those who made the decision to buy a home they knew they could not afford." It's true that people tend to be less cautious when they know they'll be bailed out. Economists call this "moral hazard." But even when they're being reasonably careful, people cannot always assess risks accurately... When it comes to risky behavior in the market, America has a double standard. We're told that economic risk-taking as the key to entrepreneurial success, but when big entrepreneurs take big risks that fail it's amazing how often they get bailed out. Indeed, the history of modern American business is littered with federal bailouts, loan guarantees, and no-questions-asked reorganizations. ... CEOs get away with stupid mistakes all the time. .... But... If you're an average American who gets canned from his job, even through no fault of your own, you probably won't even get unemployment insurance (only 40 percent of job-losers qualify...). Conservatives tell us that unemployment insurance reduces their incentive to find a new job quickly. In other words, moral hazard. Some CEOs use bankruptcy as a means of getting out from under pesky labor contracts they might have "known they could not afford" when they agreed to them (Northwest Airlines most recently, for example). Others use it as a cushion against bad bets. Donald ("you're fired!") Trump's casino empire has gone into bankruptcy twice -- most recently, last November, when it listed $1.3 billion of liabilities and $1.5 million of assets -- with no apparent diminution of the Donald's passion for risky, if not foolish, endeavor. After all, his personal fortune is protected behind a wall of limited liability, and he collects a nice salary from his casinos regardless. But if you're an ordinary person who has fallen on hard times, just try declaring bankruptcy to wipe the slate clean. A new law governing personal bankruptcy makes that route harder than ever. Its sponsors argued -- you guessed it -- moral hazard. Bush's "ownership society" has proven a cruel farce for poor people who tried to become home owners, and his minuscule response to their plight just another example of how conservatives use moral hazard to push their social-Darwinist morality. The little guys get tough love. The big guys get forgiveness.

Economists see economics in everything. If you take them to the beach, or pretty much anywhere else, you're just going to have to put up with that.

Robert Reich is going on vacation again, and he notes:

The Myth of Summer Vacation, by Robert Reich: I'm about to take a few weeks off. If you are, too, we're in the minority. A Conference Board poll last April found fewer than 40 percent of Americans planning a summer vacation.

Of course, for most Americans, there's not much summer vacation to begin with. The average American employee gets a total of 14 days off each year. If you want to take a few of them around Thanksgiving, between Christmas and New Years, and maybe when the kids are home on spring break, summer vacation is already practically gone.

Those 14 days, by the way, are the fewest vacation days in any advanced economy. The average French worker gets 37 days off annually; In Britain, it's 26.

And even when we take those 14 days, we don't always get paid for them. The Bureau of Labor Statistics tells us 1 out of 4 workers gets no paid vacation days at all. Every other advanced nation -- and even lots of developing nations -- mandate them.

On top of all this comes the current economic squeeze. That figure of 40 percent of Americans planning a summer vacation is the lowest in 30 years.

Not incidentally, consumer confidence in the economy is the lowest it's been in 28 years. In other words, there's a correlation between the small number of Americans taking a vacation this summer and this very bad economy.

It's not that we're too busy to vacation. Just the opposite: There's not enough work go around. Which means we don't dare leave work, lest we lose us a customer who might just happen to want us when we're gone. Or we could even lose the job, because employees on vacation might seem expendable to an employer looking for a way to cut costs.

Despite all this, you need a summer vacation. I do, too. ...

Should the government require firms to offer paid vacation after some period of time, say after a year of employment? If so, how much?

Whistles Along The Low Road Express?

The NY Times blog discusses Not The One's new ad:

Do Mr. McCain's strategists actually think they can win the White House by whining incessantly about how popular their opponent is? What sort of message is that?

"Vote for McCain. Nobody Likes Him."

The WSJ's Washington Wire gives this interpretation:

McCain Ad: Celebrity (Obama) vs. Hero (McCain), Washington Wire: The McCain campaign tried to turn Barack Obama's fame against him Wednesday with a new advertisement slamming his "celebrity" status.

The 30-second spot ... is the first campaign-created ad to feature footage from Obama's appearance in Germany... On top of chanting as the soundtrack and video from the rally with a crowd of 200,000, the spot includes flashes of actual celebrities Britney Spears and Paris Hilton.

The ad's female narrator asks, "He's the biggest celebrity in the world. But is he ready to lead?" ...

Senior adviser Steve Schmidt, who runs the day-to-day operations of the campaign, chimed in with this swift punch: "Do the American people want to elect the world's biggest celebrity or do they want to elect an American hero, somebody who is a leader, somebody who has the right ideas to deal in a serious way with the problems we face?" ...

The Obama campaign responded Wednesday to both the ad and the recent attacks. "On a day when major news organizations across the country are taking Senator McCain to task for a steady stream of false, negative attacks, his campaign has launched yet another"...

As noted above, the ad includes Britney Spears and Paris Hilton. Why? Of all the celebrities they could have chosen, why these two? According to the NY Times blog:

This ad, which smacks of desperation, would be bad enough it could be dismissed as mere silly schoolyard name-calling.

But it has more sinister overtones, a ham-handed attempt to belittle Mr. Obama as a person that brings back unpleasant memories of the racist campaign run by the Republican Senate campaign committee against Harold Ford in Tennessee in 2006.

The low point of that campaign was the "Fancy Ford" website, where the Republicans showed pictures of Mr. Ford, along with expensive restaurants, high-end cigars and Playboy bunnies, all of whom were white. (Nudge. Nudge. Say no more.).

What's next?

They call the campaign "The Low Road Express." That's too kind. [Update: See also ...Dana Milbank Calls Barack Obama 'Uppity'... for another facet of the latest attack. Also.]

Is it wrong to interpret this ad as dog whistle politics?

Kenneth Rogoff: The Global Economy is Still Growing Too Fast

Kenneth Rogoff says we need to raise interest rates to prevent inflation, to quit trying to stimulate the economy with fiscal policy, and allow financial institutions to fail:

The world cannot grow its way out of this slowdown, by Kenneth Rogoff, Financial Times: As the global economic crisis hits its one year anniversary, it is time to re-examine not just the strategies for dealing with it, but also the diagnosis underlying those strategies. Is it not now clear that the main macroeconomic challenges facing the world today are an excess demand for commodities and an excess supply of financial services? If so, then it is time to stop pump-priming aggregate demand while blocking consolidation and restructuring of the financial system.

The huge spike in global commodity price inflation is prima facie evidence that the global economy is still growing too fast. ...

Absent a significant global recession..., it will probably take a couple years of sub-trend growth to rebalance commodity supply and demand at trend price levels (perhaps $75 per barrel in the case of oil...) In the meantime, if all regions attempt to maintain high growth through macro­economic stimulus, the main result is going to be higher commodity prices and ultimately a bigger crash in the not-too-distant future.

In the light of the experience of the 1970s, it is surprising how many leading policymakers and economic pundits believe that policy should aim to keep pushing demand up. In the US, the growth imperative has rationalised aggressive tax rebates, steep interest rate cuts and an ever-widening bail-out net for financial institutions. The Chinese leadership, after having briefly flirted with prioritising inflation..., has resumed putting growth as the clear number one priority. Most other emerging markets have followed a broadly similar approach. ... Of the major regions, only ... the European Central Bank has resisted joining the stimulus party... But even the ECB is coming under increasing ... pressure as Europe's growth decelerates.

Individual countries may see some short-term growth benefit to US-style macroeconomic stimulus... But if all regions try expanding demand, even the short-term benefit will be minimal. Commodity constraints will limit the real output response globally, and most of the excess demand will spill over into higher inflation.

Some central bankers argue that there is nothing to worry about as long as wage growth remains tame. ... But as goods prices rise, wage pressures will eventually follow. ...

What of the ever deepening financial crisis as a rationale for expansionary global macroeconomic policy? ... Inflation stabilisation cannot be indefinitely compromised to support bail-out activities. However convenient it may be to ... bail out homeowners and financial institutions, the gain has to be weighed against the long-run cost of re-anchoring inflation expectations later on. Nor is it obvious that the taxpayer should absorb continually rising contingent liabilities...

For a myriad reasons, both technical and political, financial market regulation is never going to be stringent enough in booms. That is why it is important to be tougher in busts, so that investors and company executives have cause to pay serious attention to risks. If poorly run financial institutions are not allowed to close their doors during recessions, when exactly are they going to be allowed to fail? ...

[T]he need to introduce more banking discipline is yet another reason why the policymakers must refrain from excessively expansionary macroeconomic policy ... and accept the slowdown... For most central banks, this means significantly raising interest rates to combat inflation. For Treasuries, this means maintaining fiscal discipline rather than giving in to the temptation of tax rebates and fuel subsidies. In policymaker's zealous attempts to avoid a plain vanilla supply shock recession, they are taking excessive risks with inflation and budget discipline that may ultimately lead to a much greater and more protracted downturn.

Where I differ is on the risk of inflation over the longer run - I am more inclined toward Mark Gertler's view - and on the fragility of the financial system. Inflation is a concern, but raising interest rates too fast risks throwing the financial sector into a tailspin, and that would bring the economy down with it, and that's a risk I'd rather not take. We need to keep an eye out for signs that inflation is becoming embedded and self-reinforcing, but we need to be even more concerned about a domino effect taking hold in the financial sector. That danger is not yet over.

As for fiscal policy, first, I am not worried about one shot increases in spending creating the continuous increases in demand needed to fuel a long-run inflation (see here for a summary of the estimated effects of the stimulus on GDP). However, beyond that, it's important to remember that our problems are not just from high world demand causing high commodity prices. If that was the only problem we face - it this was just a "plain vanilla supply shock recession" - I'd be inclined to agree. But we are also having a financial crisis and that requires a different response (and makes our policy needs different from countries that are not having a mortgage meltdown - our problem isn't plain vanilla). The evaporation of credit represents a shock to demand, and unless that demand is replaced during the period when financial markets are recovering, we will have lower output and employment growth than we are able to sustain.

Update: Paul Krugman:

The Rogoff doctrine, by Paul Krugman: Ken Rogoff is one of the world's best macroeconomists, so I take whatever he says seriously. But — you know that's the kind of statement that is followed by a "but" — I'm having a hard time understanding his demands for a world slowdown.

Ken tells us that

The huge spike in global commodity price inflation is prima facie evidence that the global economy is still growing too fast.

And then he calls for

a couple of years of sub-trend growth to rebalance commodity supply and demand at trend price levels

Um, why? Basically, the world is employing rapidly growing amounts of labor and capital, but faces limited supplies of oil and other resources. Naturally enough, the relative prices of those resources have risen — which is the way markets are supposed to work. Since when does economic analysis say that the way to deal with limited supplies of one resource is to reduce employment of other resources, so that the relative price of the limited resource returns to "trend"?

Presumably there's some implicit argument in the background about why a sharp rise in the relative price of oil is more damaging than leaving labor and capital underemployed. But that argument isn't there in Ken's recent pieces. Model, please?

I agree that

Dollar bloc countries have slavishly mimicked expansionary US monetary policy

and that's a real issue: the Fed is pursuing very loose policy to deal with a US financial crisis, and that's inflationary in countries that are pegged to the dollar without facing our problems. But that's an argument for breaking up Bretton Woods II; it's not an argument for tighter Fed policy.

Since this is coming from Ken Rogoff, I assume that there's some deeper analysis here. But I can't infer it from the articles I've read. Please, sir, can I have some more?

Bandwidth Competition

A call for more competition in the market for broadband connections to information and entertainment services:

OPEC 2.0, by Tim Wu, Commentary, NY Times: Americans today spend almost as much on bandwidth — the capacity to move information — as we do on energy. A family of four likely spends several hundred dollars a month on cellphones, cable television and Internet connections, which is about what we spend on gas and heating oil.

Just as the industrial revolution depended on oil and other energy sources, the information revolution is fueled by bandwidth. If we aren't careful, we're going to repeat the history of the oil industry by creating a bandwidth cartel. ... That's why, as with energy, we need to develop alternative sources of bandwidth.

Wired connections to the home ... are the major way that Americans move information. In the United States and in most of the world, a monopoly or duopoly controls the pipes that supply homes with information. These companies [are] primarily phone and cable companies...

But just as with oil, there are alternatives. ... Encouraging competition...

After physical wires, the other major way to move information is through the airwaves, a natural resource with enormous potential. But that potential is untapped because of a false scarcity created by bad government policy.

Our current approach is a command and control system dating from the 1920s. The federal government dictates exactly what licensees of the airwaves may do with their part of the spectrum. These Soviet-style rules create waste... Many "owners" of spectrum either hardly use the stuff or use it in highly inefficient ways. At any given moment, more than 90 percent of the nation's airwaves are empty.

The solution is to relax the overregulation of the airwaves and allow use of the wasted spaces. Anyone, so long as he or she complies with a few basic rules to avoid interference, could try to build a better Wi-Fi and become a broadband billionaire. These wireless entrepreneurs could one day liberate us from wires, cables and rising prices. ... The Federal Communications Commission promised this kind of reform nearly a decade ago, but it continues to drag its heels.

In an information economy, the supply and price of bandwidth matters, in the way that oil prices matter: not just for gas stations, but for the whole economy. ...

Americans are as addicted to bandwidth as they are to oil. The first step is facing the problem.

links for 2008-07-30

July 29, 2008

Economist's View - 7 new articles

"Why Does Gasoline Cost So Much?"

This column concludes that recent increases in gas prices are due to stagnant oil supplies and growing global demand from emerging Asian economies, not speculation, and that these factors are likely to keep gas prices relatively high in the future:

Why does gasoline cost so much?, by Lutz Kilian, Vox EU: At the end of 2007, both gasoline and crude oil prices (adjusted for inflation) were at levels last seen in 1981 and they continued to climb throughout much of 2008. While Europe has been cushioned in part from these developments, as the dollar depreciated against the euro, the fundamental forces that drove up US gasoline prices have done the same in Europe.

With retail gasoline prices in the US persistently above $4 per gallon, the determinants of gasoline prices is no longer an esoteric topic best left to industry insiders. The debate has moved into the mainstream. Congressional committees as well as media pundits have advanced explanations and proposed policy changes to stem or reverse the increase in gasoline prices.

Why did this surge occur? To answer this, it is important to distinguish between:

  • the price of gasoline and other motor fuels, and
  • the price of crude oil in global markets.

A distinction often ignored in discussions of higher energy prices. In a recent Vox column, Francesco Lippi discussed the price of crude. My column focuses on the US gasoline market, which is an interesting case for understanding the underlying market forces because of the availability of high quality data for extended periods.

Supply and demand shock in the US gasoline market

Recent research has stressed the importance of identifying the demand and supply shocks underlying unpredictable shifts in the price of imported crude oil.[1] The same distinction between demand and supply shocks obviously applies to the retail gasoline market.

While crude oil is the main input in the production of motor gasoline, the US retail price of gasoline is also affected by gasoline-specific demand and supply factors, such as the ability of US refiners to process crude oil. Refinery fires, changes in the regulatory environment or refinery outages caused by hurricanes, for example, may cause increases in the retail price of gasoline that are not driven by events in the crude oil market.

But the US market does not operate in isolation. We can only hope to understand the evolution of US retail gasoline prices if we also account for the global demand and supply shocks that drive the price of crude oil.

In recent research, I propose such a model where global and US demand and supply shocks co-exist and there is feedback between the markets. Estimating it on US data, my analysis helps us understand the forces been behind the surge in US gasoline prices since 2002.[2] The model allows for five distinct demand and supply shocks:

  • global crude oil supply shocks;
  • shocks to the demand for industrial commodities (including crude oil) that reflect fluctuations in global real activity;
  • demand shocks that are specific to the crude oil market;
  • domestic gasoline supply shocks (such as refinery outages); and
  • domestic gasoline demand shocks (reflecting changes in the degree of urbanisation, driving habits, tastes, etc.).

Given the importance of crude oil imports, it is natural to focus first on developments in global crude oil markets as the likely cause of the gasoline price increases in recent years.

Crude price hikes: it's the demand shocks not the supply shocks

The model results show that unpredictable global oil supply disruptions (such as unanticipated production cutbacks by OPEC or disruptions of oil production in Venezuela or Nigeria, for example) played no role in the recent build-up of gasoline prices. Rather the bulk of the increase in US gasoline prices since 2002 has been associated with a series of unanticipated increases in global demand for crude oil (along with other industrial commodities).

Where did the extra crude demand come from? It can be shown that this sustained growth of demand was driven not so much by unusually high economic growth in OECD countries – although some of these economies experienced robust growth – but by additional demand from emerging Asia.

In addition to fluctuations in oil demand driven by global real activity, the model allows for demand shocks that are specific to the oil market. Economic theory suggests that growing uncertainty about future oil supply shortfalls boosts demand as oil companies attempt to build inventories to protect themselves from being caught short.[3] As uncertainty shifts may be sudden, large and persistent, such "precautionary" demand shocks are a natural suspect in explaining the recent surge in oil (and gasoline) prices.

Precautionary inventory holding was not to blame

Such shocks played an important role in the oil price shocks of 1979 and 1990. My estimates, however, show that such shocks have not played a major role in recent years.

This evidence is important. There has been a lot of public discussion in recent years about the alleged role of speculators in crude oil markets and how speculators may be reigned in by legislative changes and regulatory supervision.[4]

A speculator in this context refers to someone who buys crude oil now, stores it, and hopes to sell it at a higher price later in anticipation of future shortages. If there were speculation in global crude oil markets, the resulting extra demand in the model would by construction be reflected in an increase in the component of the price of oil driven by precautionary demand.

My model estimates clearly tell us that there is no such increase, suggesting that speculation is not behind the recent gasoline price increases. The same conclusion is reached when looking at petroleum inventory data. If speculation were important, we would expect to see a noticeable increase in OECD oil inventories. The data show no such increase.

Finally, this conclusion is also consistent with the fact that most industrial commodity prices – not only the price of oil – have been growing at rapid rates in recent years. This pattern is consistent with a general increase in the global demand for industrial commodities but not with explanations that are specific to the crude oil market.

Having reviewed the role of shocks in the global crude oil market, I now turn to the role played by US domestic gasoline demand and supply shocks.

The US gas market: shocks to US refining capacity matter

A striking result is that US domestic gasoline demand shocks have had virtually no impact on the US retail price of gasoline in recent years. This is not surprising, as US consumption of gasoline has been moving very slowly and predictably. Indeed, that evidence is fully consistent with the notion that increased demand for crude oil and refined products comes from emerging Asia rather than the US.

In contrast, US domestic gasoline supply disruptions have played a role – in particular following Hurricanes Rita and Katrina in 2005. The primary effect of these exogenous events was not the reduction in US crude oil production (which was negligible on a world scale), but the reduction of crude oil refining capacity in the Gulf of Mexico.

Given that other US refineries were already operating close to capacity at the time, this event constituted a major unanticipated reduction of the supply of gasoline in the US, which would be expected to raise the price of gasoline sharply (while lowering slightly the price of crude oil, as demand for oil imports falls). The model indeed shows a sharp increase of US gasoline prices driven by adverse refinery shocks in late 2005. Only half a year later, the price seems to have stabilised again, although there is evidence of intermittent unanticipated refining shortages in 2006 and 2007 as well.

In short, the primary reason for the recent surge in gasoline prices has been growing global demand driven by developments abroad, given fairly inelastic global oil supplies. This evidence helps us understand why gasoline prices have risen to record levels, but what about the future?

Forecasting the future

Predicting gasoline prices is an all but impossible task even at horizons as short as one year. In recent co-authored work (Alquist and Kilian, 2008), I have shown that simple no-change forecasts are the most accurate forecasts of the price of crude oil in practice. In other words, the change in the price of oil is unpredictable.

Given the close relationship between global crude oil prices and domestic retail gasoline prices, the same result is likely to apply to US gasoline prices. The problem with forecasting the change in gasoline prices is not so much that we do not understand its economic determinants, but that it is difficult to predict the future evolution of these determinants. The fact that many media pundits disagree on the future course of gasoline prices reflects to a large extent the fact that they disagree on the future evolution of these determinants. It is this uncertainty that renders the no-change forecast of gasoline prices a good approximation.

Conjectures on the future price of US gasoline

It is instructive to speculate about the future evolution of the determinants of the price of gasoline. Abstracting from unpredictable refinery outages, the future evolution of US gasoline prices will depend primarily on developments in the global crude oil market.

Although past oil price increases have been followed by substantial increases in crude oil production with a delay of a few years, there is reason to be sceptical of the idea that substantial increases in oil production will be forthcoming in the foreseeable future. This is not a problem of the geological scarcity of oil. The problems are:

  • Oil exploration had been neglected, as the price of oil fell in the late 1990s.
  • The political environment in many oil-producing countries discourages oil companies from making the much-needed large-scale investments. In particular the threat of expropriation of successful investments in many countries prevents investments from taking place at the needed pace.
  • Additional crude oil likely to be available in the short run is heavy crude oil that US refineries are ill equipped to process. Building new refineries in the US takes many years.

Thus, a fair presumption is that the crude oil market will remain supply-constrained for the next few years.

With supply constrained, demand growth is the key

With crude oil production remaining flat or increasing only slowly, the price of crude oil and hence the price of gasoline will depend first and foremost on the extent to which countries in emerging Asia will continue to grow. Clearly, the current expansion in Asia will not continue unabated – all the more so as rising energy prices will leave their mark abroad while the US economy is already slowing. While a decline in demand seems inevitable, what is not clear is how soon that decline will occur and by how much global demand for industrial commodities will slow.

If past global expansions are a guide, global demand will recede only gradually. This is a direct implication of the model underlying this analysis. This suggests that US gasoline prices will remain high for the time being. Barring a major economic collapse in emerging Asia, prices will stabilise only as the world economy learns to economise on the use of oil and gasoline and as the supply of crude oil expands. Both corrective forces will take time to gain momentum.

In addition, there is reason to be concerned that oil-market specific developments, which for the most part have played no role since 2002, could become more important in the future.

Oil-market specific developments

Sharp shifts in the precautionary demand for oil reflecting uncertainty about political developments in the Middle East tend to occur only when demand for crude oil exceeds supply. When they do occur, they tend to cause sharp increases in the price of crude oil, as in 1990/91, for example. Under the current conditions, the world economy is particularly vulnerable to threats of military conflict in the Middle East. A good example is Iran's threat to close the Straits of Hormuz if Iran were to be attacked by Israel. Such developments could potentially cause US gasoline price movements that dwarf the effect of sustained strong global demand for industrial commodities.

In short, based on this interpretation of the evidence, the price of crude oil and hence the price of gasoline is likely to stay high for the foreseeable future, but there is considerable uncertainty in either direction.

1 Also see Kilian, L. (2008b), "Not All Oil Price Shocks Are Alike: Disentangling Demand and Supply Shocks in the Crude Oil Market," forthcoming: American Economic Review. 2 This article is based in large part on results in Kilian (2008a), "Why Does Gasoline Cost so Much? A Joint Model of the Global Crude Oil Market and the US Retail Gasoline Market," CEPR Discussion Paper No. 6919. 3 See Alquist, R., and L. Kilian (2008), "What Do We Learn from the Price of Crude Oil Futures," mimeo. 4 See the Vox column by Guillermo Calvo, and the reply by Paul Krugman.

Arnold Kling Doesn't Understand

Arnold Kling:

I Don't Understand Mark Thoma, by Arnold Kling: He writes,

But focusing on the immediate problems brought about by tax cuts and military spending should not divert us from the more formidable problem of solving the escalating health cost problem. If Obama wins and tries to institute some form of universal care, it will be opposed as a budget breaker (and for other reasons), but I think universal care will help a lot in bringing down health care cost growth.

There is health care spending paid for by the private sector. Call it P. There is health care spending paid for by the government. Call it G.

The problem with G is that it is busting the budget. I do not understand how reducing P and raising G represents a solution. Even if you think that government can do health care more efficiently, you are still raising G and making the budget problem worse.

P can grow as a percent of GDP as much as it wants to, and be as wasteful as it wants to, without affecting the fiscal outlook. Only G affects the fiscal outlook.

What happens when you take people out of P and put them into G? You might make people's lives better (that's a separate disagreement). You might increase the overall efficiency of the health care system (another separate disagreement). But you do not improve the fiscal outlook. You make it worse.

I absolutely do not see how anyone can say otherwise.

Agreed there is spending on health care in both sectors. That's why I wrote recently that:

At some point we do have to face budget realities... [T]his ... is mainly a problem with rising health care costs (and that will be a problem whether it's paid for publicly or privately)

I didn't explain fully, but the answer to Arnold's question is straightforward. Health care in the private sector is not free. Using his notation, when I think about moving P to G, I also think about moving the revenue stream with it (e.g. individuals would pay monthly premiums in taxes rather than to the insurance company). Thus, if we move all of P to G, we also move all of the revenue with it. Therefore I don't see why the budget problem has to get worse:

Even if you think that government can do health care more efficiently, you are still raising G and making the budget problem worse.

You are also raising T, taxes, to pay for more G (raising is the wrong word, moving the revenue stream is better). Since costs per unit fall (as he says, "You might increase the overall efficiency of the health care system"), you could provide the same overall service with an improved budget (smaller deficit), or provide better service (e.g. expand care) with no change in the budget deficit.

Why do costs per unit fall? Because of all the administrative savings, savings from buying drugs in bulk, and the ability to manage care (e.g. preventative measures, solving information problems that cause wasteful expenditures by doctors and consumers). Thus, if we did move all of P to G we would be able to rebate some of the taxes, expand coverage, etc.. Even if we did nothing but eliminate fights over who pays the bills, or eliminate the costs of screening out the unhealthy (who end up in public sector programs anyway), as we would, health costs would fall substantially.

For example:

[W]e spend more than twice as much on health care, on average, as the 21 countries in which life expectancy exceeds ours. American costs are so high in part because the reliance on private insurance multiplies administrative expenses, currently about 31 percent of total outlays.

Most health economists agree that government-financed reimbursement is the only practical way to control these expenses, many of them stemming from insurers' efforts to identify and avoid unhealthy people. ... A single-payer system that did nothing more than reduce administrative expenses to the levels of other countries would save roughly $300 billion annually.


Some say that we can't afford universal health care... But every other advanced country somehow manages... Americans spend more on health care per person than anyone else... Yet we have the highest infant mortality and close to the lowest life expectancy of any wealthy nation. How do we do it?

Part of the answer is that our fragmented system has much higher administrative costs than ... the rest of the advanced world. ... In addition, insurers often refuse to pay for preventive care ... because [the] long-run savings won't necessarily redound to their benefit. And ... we lag far behind ... in the use of electronic medical records, which both reduce costs and save lives by preventing many medical errors. ...


According to the World Health Organization, in the United States administrative expenses eat up about 15 percent of the money paid in premiums to private health insurance companies, but only 4 percent of the budgets of public insurance programs, which consist mainly of Medicare and Medicaid. The numbers for both public and private insurance are similar in other countries - but because we rely much more heavily than anyone else on private insurance, our total administrative costs are much higher.

According to the health organization, the higher costs of private insurers are "mainly due to the extensive bureaucracy required to assess risk, rate premiums, design benefit packages and review, pay or refuse claims." Public insurance plans have far less bureaucracy because they don't try to screen out high-risk clients or charge them higher fees.

And the costs directly incurred by insurers are only half the story. Doctors "must hire office personnel just to deal with the insurance companies," Dr. Atul Gawande, a practicing physician, wrote in The New Yorker. "A well-run office can get the insurer's rejection rate down from 30 percent to, say, 15 percent. That's how a doctor makes money. ... It's a war with insurance, every step of the way." ...


McKinsey & Company ... recently released an important report dissecting the reasons America spends so much more on health care than other wealthy nations. One major factor is that we spend $98 billion a year in excess administrative costs, with more than half ... accounted for by marketing and underwriting - costs that don't exist in single-payer systems.

And this is just part of the story. McKinsey's estimate of excess administrative costs counts only the costs of insurers. It doesn't ... include other "important consequences of the multipayor system," .... The sums doctors pay to denial management specialists are just one example.

Incidentally, while insurers are very good at saying no to doctors, hospitals and patients, they're not very good at saying no to more powerful players. ... McKinsey estimates that the United States pays $66 billion a year in excess drug costs, and overpays for medical devices like knee and hip implants, too.

To put these numbers in perspective: McKinsey estimates the cost of providing full medical care to all of America's uninsured at $77 billion a year. Either eliminating the excess administrative costs of private health insurers, or paying what the rest of the world pays for drugs and medical devices, would by itself more or less pay the cost of covering all the uninsured. And that doesn't count the many other costs imposed by the fragmentation of our health care system.

Or, finally:

[I]f costs are to be controlled, someone has to act as a referee on doctors' medical decisions. During the 1990's it seemed, briefly, as if private H.M.O.'s could play that role. But then there was a public backlash. It turns out that even in America, with its faith in the free market, people don't trust for-profit corporations to make decisions about their health. ...

Eventually, we'll have to accept the fact that there's no magic in the private sector, and that health care - including the decision about what treatment is provided - is a public responsibility.

"No Time to Think, Liberalize!"

Not too long ago, I posted a Vox EU article on the controversy over how large the benefits from trade are for the U.S. Josh Bivens of the EPI is mentioned in the article, and he would like to respond:

No time to think, liberalize!, by Josh Bivens: Hufbauer and Adler's VoxEU piece doesn't really advance the ball much further down the field in this debate. But, just to sum up for any interested readers: a paper by Bradford, Hufbauer, and Grieco (BGH, henceforth) was released in 2005 that had estimates of the US gains from trade liberalization that were far, far outside those estimated by previous research: they claimed past trade liberalizations had added almost a trillion dollars to the US economy by 2004, and, future liberalizations offered the promise of adding another half-trillion.

Dani Rodrik didn't think much of it. And, after seeing these numbers used to great effect in the political debate, I wrote a long-ish working paper and two associated issue briefs detailing why they were unreliable. My over-arching critique was that their study was a literature review that cherry-picked the research for the absolute maximum gains that could be attributed to liberalization while ignoring any reasons (even within this same literature) as to why these gains might be much, much smaller. In the end, I found nothing to shake my belief (based on staid, mainstream economics) that the real gains from liberalizations are closer to a tenth or less of what they claim.

Given that I was named in the Hufbauer/Adler piece, I feel obliged to respond, but, am hard-pressed to find much to say given that their piece mostly just describes the approach taken in the original paper (which I still don't like, but, the papers linked above are where readers should go if they care why), and, their specific pushback against my own work consists mostly of snark and non sequiturs.

On the first, it's a little unclear why the back-of-the-envelope calculation of the gains from trade liberalization that I used is "simple-minded". It's textbook economics, after all, and, it yields an estimate of the gains from trade that is quite close to that provided by the World Bank study cited by Rodrik, and, it even provides a pretty liberal estimate compared to what is identified by the (behemoth) USITC study on the Economic Effects of Significant Import Restraints. I guess they just like the insult.

As to the non sequiturs, they argue that I "ignored Solow's landmark finding (1956) that productivity gains explain above 80% of US economic growth". They're right, I did. I am familiar with this finding; I know, for example, that it was actually from Solow (1957), not Solow (1956), and, much more importantly I know that it is utterly irrelevant to the debate at hand. If there's a convincing link between the arguments of BGH and Solow, it sure wasn't made in the original paper, which includes no citation of Solow in its 5-page bibliography. This argument gives hand-waving a bad name.

Hufbauer and Adler also complain that my critiques in the longer paper are "repetitive". Well, yes, because it was reviewing the BGH paper which made the same mistake over and over again: cherry-picking the studies they review for the maximum number they can pin on the gains from trade liberalization while ignoring anything that cuts in the other direction.

The VoxEU piece does offer one significant change in emphasis relative to the BGH work - Hufbauer and Adler argue that "Rapidly falling transportation and communication costs are perhaps more important features of the globalisation story [than policy liberalization]". The original BGH piece claimed that all future gains it identified stemmed solely from policy liberalization. It was precisely claims about the scope of gains from policy liberalization that were so hard to swallow, especially those regarding future payoffs we should expect from signing ever more trade agreements.

To give one example why, table 2.4 in the original BGH paper gives the most transparent accounting of their claims regarding a major "policy-only" impact of trade, and, even given their very generous interpretation of the study upon which the calculation is based, what it shows is that between 1982 and 2002 trade liberalization added all of $1 billion to the US economy.

This is twenty years that saw the signing of the North American Free Trade Agreement (NAFTA), the completion of the Uruguay Round of the General Agreement on Tariffs and Trade (GATT) which led to the formation of the World Trade Organization (WTO), and the permanent normalization of trade relations with China as well as its entry into the WTO. $1 billion seems like a pretty small payoff for twenty years of liberalizations that were politically wrenching, and, it seems like an awfully thin reed upon which to claim that future liberalizations will somehow yield payoffs exponentially larger.

Hufbauer and Adler (and other proponents of continuing the globalization status quo) often hold out the service sector as an explanation for how future liberalizations will yield much greater benefits than past ones. Anything's possible, I guess, but, service-sector trade as a share of US GDP is still less than a third as large as goods trade, and, more importantly, it is awfully hard to measure just how protected the service sector is.

The studies they cite regarding future benefits from service sector liberalization generally take the full value of price (actually gross margin) differences between service sector output in the US and trading partners as de facto evidence of barriers to trade in services. This just won't do - there are plenty of reasons for prices to diverge that have nothing to do with protectionism, and, assigning the full value of the difference to trade protection is, again, just cherry-picking for the highest number one can get regarding the prospects for trade liberalization to improve US incomes.

Probably needless to say at this point, I also disagree that empirical research shows no (or a trivial) role for trade flows in influencing income distribution. The more immediate point, however, is that we have time to get this debate and our response to globalization right: threats of huge income losses if we don't all get on board the next trade agreement that comes down the pike are empty, and the golden goose won't wander away if, say, the Colombia/US agreement or any other agreement is allowed to wither and die on the vine.

"Bush Midsession Budget: Profound Sadness"

Stan Collender is feeling down:

Bush Midsession Budget: Profound Sadness, by Stan Collender: It says more about me than I should probably admit, but back in 2000 I found the prospect of paying off the national debt to be very exciting.

To me, the pledge to do that, which Bill Clinton made towards the end of his presidency and George W. Bush made as his years in the White House were just beginning, was absolutely thrilling. Because of the lower annual interest payments that would result, no other change then being seriously talked about had the potential to alter the long-term federal budget outlook as positively and permanently.

That's why I found the mid-session review of the budget released yesterday to be so depressing. It was the official notice that the pledge, and all the good things that would come from it, would not be fulfilled. It was also time to admit that the budget politics, economics, and limits of the past decade would continue...and continue...and continue.

That's just not a happy occasion for anyone but those of us who blog, write, and talk about the budget. Business will be booming.

None of this was a surprise, of course. The prospects for paying down the national debt firmly ended back in the first year of the Bush administration. And the close to $490 billion deficit that OMB projected for 2009 has long been assumed or leaked.

Nevertheless, the release of the midsession review on July 28, 2008 should be noted as the official date when the dream of a very different budget debate and fiscal policy opportunities died.

I'll have more about the following shortly. But other observations:

The bad news absolutely is understated. The $482 billion projected fiscal 2009 deficit will actually be closer to $600 billion before the year is over.

The much-ballyhooed Bush administration pledge to cut the deficit in half was a gimmick. There clearly was no commitment to do it more than once (that is, if there really ever was a commitment to do it even once).

From a budget, deficit, debt, interest rate, and fiscal policy perspective, the Bush administration is leaving the country so much worse off than it found it that it will likely hamstring the next president and Congress in ways that aren't yet fully understood.

Based on what we now know for sure about next year's budget, none of the presidential candidates' promises should be taken seriously. Unless they, the country, and those lending us money are willing to tolerate much higher nominal deficits and a larger debt than has so far been imaginable, the next president's options will be severely limited.

More to come.

How should Democrats respond? Recall Brad Delong's thoughts:

[S]hould Barack Obama become president. Those of us who served in the Clinton administration and worked hard to ... turn deficits into surpluses are keenly aware that, after eight years of the George W. Bush administration, things look worse than when we started back in 1993. All of our work was undone by our successors in their quest to win the class war by making America's income distribution more unequal.

A chain is only as strong as its weakest link, and it seems pointless to work to strengthen the Democratic links of the chain of fiscal advice when the Republican links are not just weak but absent. Political advisers to future Democratic administrations may argue that the only way to tie the Republicans' hands and keep them from launching another wealth-polarizing offensive is to widen the deficit enough that even they are scared of it.

They might be right. The surplus-creating fiscal policies established by Robert Rubin and company in the Clinton administration would have been very good for America had the Clinton administration been followed by a normal successor. But what is the right fiscal policy for a future Democratic administration to follow when there is no guarantee that any Republican successors will ever be "normal" again? That's a hard question, and I don't know the answer.

Fear of a deficit didn't stop the Republicans from putting their agenda into place, should Democrats take the same approach? Medicare, Social Security, and other programs for the elderly aren't going away, not with an aging population that will have considerable political power, so the question is how we pay for these programs.

The current budget problem is mainly from tax cuts and increases in military and domestic security expenditures, but the problem going forward is mainly health care costs. We can't cut enough out of the budget or raise taxes high enough to meet projections if the current health care system is unchanged, so this comes down to one question, how do we reign in health care costs?

I don't mean that health care spending shouldn't grow as a percentage of GDP as we get wealthier. It is quite reasonable for us to devote new income from growth toward health care spending. But even so, current projections are that growth in health care costs will need to be lowered to be sustainable.

All of the focus on getting the budget in shape in the short-run is necessary, though we should recognize that as a percentage of GDP deficits have been much higher in the past without disastrous consequences, so there's no need for drastic cuts in programs to make ends meet and tax increases are probably out of the question (and actual fat should not be eliminated from the budget, but there's not much there). This would be easier if Republicans hadn't squandered the surplus they inherited. But focusing on the immediate problems brought about by tax cuts and military spending should not divert us from the more formidable problem of solving the escalating health cost problem. If Obama wins and tries to institute some form of universal care, it will be opposed as a budget breaker (and for other reasons), but I think universal care will help a lot in bringing down health care cost growth. But whatever we do, it's time to get started.

"Another Quasi-Governmental Agency that's Lending Hundreds of Billions to Troubled Banks"

Daniel Gross on another GSE we haven't heard much about:

Freddie and Fannie's Healthy Cousin, by Daniel Gross: The Federal Reserve's extraordinary efforts to help investment banks have effectively put the taxpayer on the hook for enormous potential losses..., we could end up paying tens or hundreds of billions...

But the actual amount of credit extended so far through these public-rescue efforts pales in comparison with the credit that has quietly been extended to banks in the past year—another lifeline that taxpayers could end up paying dearly for. ... For the past 12 months, an obscure agency created by President Herbert Hoover during the Great Depression has come to the rescue of the banking industry. It is called the Federal Home Loan Banks.

Like Fannie Mae and Freddie Mac, the FHLB (here's ... a brief history, and an overview) is a government-sponsored enterprise. But it differs from the wounded giants in some significant ways. Instead of being owned by public shareholders, as Fannie and Freddie are, the 12 independent regional FHLBs are owned by their 8,100 members. Banks large and small, representing about 80 percent of the nation's financial institutions, own shares in the FHLB and share in the profits.

The FHLB has a simple business model.... Basically, it funnels cash from Wall Street to banks on Main Street. Member banks present mortgages they've issued—high-quality ones, not junky subprime ones—as collateral to the FHLB and borrow money so they can have more cash to lend. To finance its activity, the FHLB sells debt to big investors in the capital markets. As with Fannie and Freddie, the FHLB benefits from a unique status. ... While the FHLB takes pains to note that "Federal Home Loan Bank debt is not guaranteed by, nor is it the obligation of, the U.S. government," there's an assumption afoot in the marketplace that were the FHLB to encounter serious trouble, the government would step in. In return for this special treatment, the FHLB provides some vital public services. Twenty percent of its net earnings are used to help cover interest on debt issued by the Resolution Funding Corp., which paid for the Savings & Loan bailout. The FHLB also channels one-tenth of its profits to affordable-housing loans and grants.

During the mortgage boom, FHLB quietly did its job and avoided many of Fannie and Freddie's excesses. ... Subprime holdings were minimal. And since commercial banks were able to raise capital from Wall Street to make any kinds of loans they wanted, they didn't have all that much need for the FHLB's services. As the chart ... shows, the number of loans extended to member banks rose modestly in the boom years, up 7 percent in 2005 and only 3 percent in 2006. ...

But last year the mortgage house of cards began to collapse. And as Wall Street's securitization machine, which had enabled banks to raise cash with alacrity, broke down, banks staged their own run on the FHLB. .... Since ... the broken-down Wall Street mortgage securitization machine was sold for scrap, FHLB loans to member banks ...[rose] to $914 billion at the end of this June. In the past 12 months, FHLB loans to its members have risen by 43 percent, representing an additional $274 billion in real credit provided by the system to its member banks. That sum dwarfs the actual amount of credit extended to investment banks by the Fed—or by the government to Fannie and Freddie.

Does the increase in FHLB's balance sheet mean taxpayers may be on the hook for another trillion dollars in mortgage debt? It's unlikely. FHLB has a much better track record than Fannie and Freddie. Because it maintains high standards, it has never suffered a credit loss on a loan extended to a member. It doesn't spend hundreds of millions of dollars each year on executive compensation or lobbying, as Fannie and Freddie did. And it didn't lower standards ... as a way of increasing market share.... Seventy-six years after it was created by a president whose administration was hostile to government intervention in markets, the FHLB stands as an enduring and (so far) effective example of socialism among capitalists.

Why does the FHLB exist at all?:

The Housing Giants in Plain View, by William R. Emmons, Mark D. Vaughan and Timothy J. Yeager , FRB St. Louis, July 2004: ...The Federal Home Loan Bank System was the first housing GSE. The FHLBanks were established by Congress in 1932 to advance funds against mortgage collateral. At the time, the country was in the midst of an unprecedented wave of depositor runs. Depository institutions faced the risk that loans would have to be liquidated at fire-sale prices to pay off anxious depositors. The FHLBanks enabled their members, primarily savings and loan associations and savings banks, to obtain cash quickly should depositors come calling. This access to ready cash reduced the liquidity risk of mortgage lending, thereby freeing FHLB members to originate more home loans.

The FHLBanks also allowed the thrifts to offer better terms on mortgage loans. At the time, there was no secondary market for mortgages; so, thrift institutions were forced to hold loans until maturity. Consequently, they made only very short-term loans—three to five years at most. Moreover, these loans were nonamortizing "balloons"—upon maturity, the borrower either repaid the loan in full or paid a fee to renew the loan. Few families had the incomes necessary to get funding under these terms; so, few families owned their own homes. The FHLBanks stepped in and provided a source of long-term stable funding, thereby allowing member institutions to separate the credit risk and the liquidity risk of mortgage lending. ...

Many of the conditions that were present when the FHLB was created have now eased or been eliminated (e.g. by the FDIC which resolves the depositor run problem, at least for small depositors, financial innovation, etc.). So why does the FHLB still exist?:

Although advances against mortgage collateral remain the focus of FHLBank activities, the justification for this focus has widened beyond support for home ownership. Now, the system sees its mission as including support for community banking. Community banks are relatively small institutions that specialize in making loans to and taking deposits from small towns or city suburbs. Community bankers find FHLB membership and services attractive... FHLB advances are dependable and convenient... Indeed, the FHLBanks offer a wide variety of maturities, from overnight to over 20 years.

The FHLB web site adds:

In a time when cash deposits in community banks are dwindling, the funds provided by the Federal Home Loan Banks guarantee a stable source of funds for mortgages and community lending. Without the Federal Home Loan Banks, most depository institutions would not have access to medium- and long-term sources of funding.

By supporting community-based financial institutions, the Federal Home Loan Bank System helps to strengthen communities.

What are the costs of the FHLB? Going back to the St. Louis Fed article:

Many economists believe that the implicit subsidization of the housing GSEs distorts the allocation of scarce funds in the capital markets. Left alone, these markets would allocate funds to the business and household borrowers capable of putting them to the best use. Cheaper funding for the housing GSEs means more new homes, more larger homes and higher rates of home ownership. On the other hand, this distortion might lead to fewer funds being available for business investment, possibly resulting in slower economic growth. ...

Three problems are clearly associated with housing GSEs...: moral-hazard problems related to risk-taking, incomplete pass-through of subsidies intended for mortgage borrowers, and risk-shifting to the Federal Deposit Insurance Corp.

Moral Hazard

When a firm can take risks, enjoy the full benefits and avoid the full costs, economists say a moral hazard is present. The hazard is that the firm will respond to these incentives by increasing risk to imprudent levels. Moral hazard is a problem for the housing GSEs. Because the capital markets view their debt as virtually free of default risk, Freddie, Fannie and the FHLBanks can enjoy all the upside of risk-taking and little of the downside. ... The burden of the extra risk does not, of course, go away just because the housing GSEs do not bear it. Indeed, taxpayers ultimately would bear the extra risk if the federal government were to stand behind a failing GSE.

Taxpayer exposure to risk-taking by housing GSEs is not limited to potential losses from default. Risk-taking by housing GSEs could undermine the stability of the financial system because so many banks depend on them for liquidity. Commercial banks hold more than one-half of their securities portfolios—a key source of emergency liquidity—in the form of mortgage-backed securities and GSE debt. Moreover, the portion of commercial bank loans backed by real estate is at an all-time high. Banks are comfortable holding mortgage-related securities because these securities can be sold quickly with minimal transaction costs, and banks are comfortable holding real-estate-backed loans because these loans can be pledged against advances from the FHLBanks or sold to Freddie or Fannie. A severe shock to one or more of the housing GSEs could lead to a market lockup, in which investors become reluctant to hold GSEs' direct or indirect obligations. This could, in turn, lead to a temporary suspension of mortgage purchasing, mortgage securitizing or mortgage "advancing," thereby forcing the Federal Reserve to intervene to re-liquefy the mortgage markets.

Incomplete Pass-Through of Subsidies

Who actually benefits from the subsidy—homeowners or the employees and shareholders of GSEs? As noted, the implicit guarantee against default lowers housing-GSE funding costs. Lower funding costs can be used to reduce mortgage rates for homeowners or to raise employee salaries or dividends for housing-GSE shareholders. Estimates vary about the division of the subsidy; one recent study estimated that the subsidy to Freddie and Fannie lowered mortgage interest rates by about 7 basis points (0.07 percent), yielding a savings to homeowners of about $44 billion. At the same time, the gain to Freddie's and Fannie's shareholders was estimated at $72 billion. ...

Shifting Risk to the FDIC

Of the three housing GSEs, the FHLBanks are the least likely to increase their own risk. The shareholders of the 12 regional FHLBanks are also the customers. Therefore, the cost of excessive risk-taking by an FHLBank would fall on the same parties that enjoy the benefits. Still, the FHLB System may create moral hazard through another channel by implicitly encouraging its members to ramp up risk.

Advances from the FHLBanks may encourage risk-taking at member institutions because the FHLBanks have little incentive to demand higher interest rates when the credit risk of a borrowing bank increases. Advances are heavily collateralized—the market value of mortgage collateral typically covers 125 to 170 percent of the advance. This protection explains why the FHLB System has never lost a penny on an advance. Because advances carry no credit risk, the individual Home Loan banks can set terms that are largely independent of the failure risk of the borrower. Put another way, borrowing from the FHLB enables a bank to avoid any market-imposed penalty for failure risk. Moreover, the FDIC, which covers losses to insured depositors in the event of a bank failure, cannot make up the difference by hiking deposit-insurance premiums. Many observers believe that the current cap—27 cents a year per $100 of deposits—is too low to deter risk-taking. In short, greater risk-taking by FHLB members implies a higher failure rate over time. A higher failure rate, in turn, implies greater losses to the deposit-insurance fund. Taxpayers ultimately stand behind this fund.

Unless someone can identify the substantial government failure that this program solves, show that the FHLB provides liquidity insurance banks cannot get from the discount window or through other means, or make the case that the private sector, even with all of the recent financial innovation, would not make the necessary array of financial services available to smaller communities without the implicit government guarantee standing behind the FHLB, and further make the case that financial services, like telephone service or electricity, are essential services that all communities should have, then we should follow the recommendations we've heard for Fannie and Freddie and slowly eliminate the implicit government support of this institution.

Trash Talk: Pay-As-You-Throw Systems

Should communities adopt "pay-as-you-throw systems" for garbage collection to reduce the amount of garbage flowing into landfills or incinerators?:

Kicking the Cans, by Robert Tomsho, WSJ: Plymouth, Mass. -- In this historic community ... garbage has become ... a touchy subject...

During months of debate, Mr. Quintal, chairman of the town's governing board of selectmen, argued that people who throw out more trash should pay higher disposal bills. "I got emails from people saying they thought I was right," he says. "But there were just as many from those who thought I was an idiot."

Like Plymouth, more and more communities are grappling with whether to abandon traditional garbage service and adopt so-called pay-as-you-throw systems. With PAYT, residents are charged based on how much garbage they generate, often by being required to buy special bags, tags or cans for their trash. Separated recyclables like glass and cardboard are usually hauled away free or at minimal cost. ...

PAYT represents an effort to curb garbage's impact on the ecosystem by pressuring consumers to create less of it. But the effort to make people change their habits has often stirred tension...

While Americans are accustomed to paying for utilities like water and electric based on use, that's not true about garbage in most places. ...

Tampering with that notion can be tricky in communities that switch to PAYT. Illegal dumping has cropped up in about 20% of such communities, according to a 2006 U.S. Environmental Protection Agency report. Local officials also complain about variations of the so-called Seattle stomp (named after one of the first PAYT cities), where homeowners try to beat the system by compacting huge amounts of trash into a single can or bag.

There has also been a recent backlash in some locales over costs and inconvenience...

Supporters of PAYT say it gives residents a direct economic incentive to recycle. Skumatz Economic Research Associates, a waste-consulting concern in Superior, Colo., estimates that PAYT programs lead to a 17% reduction in the flow of residential waste to incinerators and landfills... "Every analysis shows that this is a very cost-effective thing to do," says Lisa Skumatz, the firm's principal.

I should stop here and comment, every analysis doesn't show that, but we'll come back to the cost-effectiveness in a moment. Continuing:

...The system was supposed to go into effect July 1, but the grumbling began almost as soon as details were announced this year. While few Plymouth residents spoke out against the concept of recycling, there was criticism aplenty for the plan designed to pressure them to do more of it in a hurry.

At public meetings, senior citizens complained that, even with the reduced annual fee, their personal disposal costs would go up. Some critics said the new trash plan would be unfair to big families. ... [There are] also fears that PAYT will prompt residents to burn trash in their fireplaces and dump it illegally. ...

[The] board voted last month to hold off on overhauling the town's garbage system for at least another year. Mr. Hammond, the public works director, says the garbage debate has been an eye opener. "A lot of people don't want to recycle," he says. "They just want to throw everything in the bin."

I remember seeing a seminar on this awhile back. I think this was the paper:

Household Responses to Pricing Garbage by the Bag, by Don Fullerton and Thomas C. Kinnaman, The American Economic Review, September 1996: Introduction The average tipping fee paid by garbage collectors to landfills has tripled over a six-year period, largely due to rising land prices and new EPA regulations... Several communities and private firms have responded ... by implementing volume-based pricing programs that require households to pay for each bag or can of garbage presented for collection. These towns employ unit pricing not only for additional revenue, but to reduce their direct costs and external costs from using landfills and incinerators. Households might recycle more, compost more, and demand less packaging at stores. Unfortunately, they might also bum garbage or dump it along deserted roads. The attractiveness of unit pricing depends crucially on the extent of each such method of garbage reduction.

The price per bag might also induce households to compact garbage into fewer bags. This practice, known as the "Seattle Stomp," was noticed first when Seattle started an early unit-pricing program. It is not helpful, since collectors compact the garbage anyway.

This paper employs individual household data to estimate the effect of such a program on the weight of garbage, the number of containers, the weight per can, and the amount of recycling. We also provide two indirect measures of illegal dumping. The data are based on a natural experiment... On July 1, 1992. Charlottesville, Virginia, implemented a program to charge $0.80 per 32-gallon bag or can of residential garbage collected at the curb. Before and after the implementation of this program, we counted and weighed the bags or cans of garbage and recyclable materials of 75 households. In response to this new price, the average person living in these households reduced the weight of garbage by 14 percent, reduced the volume of garbage (number of containers) by 37 percent, and increased the weight of recycling by 16 percent. Our indirect measures suggest that additional illegal dumping may account for 28 percent to 43 percent of the reduction in garbage.

Based on these data, the change in weight of garbage is statistically significant, but small. The implied arc-price elasticity is only -0.076. We ... conclude that this pricing program has little effect on the weight of garbage. ...[H]owever, we find more substantial effects on volume, density, recycling, and illegal dumping. ...

We ... calculate the effect of introducing a minimum of one bag per week, and we conduct a simple cost-benefit comparison. Welfare benefits from unit pricing range from $0.08 to $0.15 per $0.80 bag of garbage, but administrative costs are likely to exceed $0.19 per bag.


Conclusion This paper has used original data gathered from individual households to estimate responses to the implementation of a price per bag of garbage. We find that households reduced the number of bags, but not necessarily the actual weight of their garbage. Thus households stomped on their garbage to reduce their costs. They also increased the weight of recycling, and they might have increased illegal dumping. The reduction in weight of garbage at the curb is 14 percent. If we account for the amount of illegal dumping, using our lower estimate, then the true reduction in garbage is only 10 percent. Recycling increased by 16 percent. Many in Charlottesville were already participating in the voluntary recycling program before unit pricing began. Thus the incremental benefit of unit pricing is small. In our simple comparison, this social benefit does not cover the administrative cost.

Here's something more recent from a Resources for the Future commentary. Skipping over the statistics on landfill usage and recycling, here's the part on the PAYT programs. It's from one of the same authors as the paper above, Don Fullerton, and its conclusions are similar but a bit more generous toward the program:

Trash Talk, by Don Fullerton and Margaret Walls, RFF, December, 2007: ...The economist's typical solution to an externality problem is a Pigouvian tax: charge a tax or fee per pound of trash exactly equal to the social damages imposed by that trash. That would reduce waste in landfills, but it raises two questions. The first is whether the social damages can actually be estimated. Even if policymakers know what to charge, however, the second question is whether any such fee can feasibly be administered and enforced.

Some communities charge for each can or bag of trash, under a system commonly called "Pay as You Throw" (PAYT). Households might be charged one monthly amount for one can a week, or a higher monthly amount for a larger can or two cans a week. But not every can gets filled every week, leaving households with no incentive at the margin to reduce waste. A better system, closer to true marginal cost pricing, requires households to buy a special bag at the grocery store, or a special tag to use on a bag of garbage of a particular size.

EPA estimates that approximately 7,100 communities in the United States use some kind of PAYT, making it available to approximately 25 percent of the country's population. The number of communities has risen over time and, in some areas of the country, is quite high. Some states (Wisconsin, Oregon and Minnesota) even have a law requiring that communities use PAYT.

Does it work? Results from the economics literature suggest that demand for garbage collection is relatively unresponsive to prices, but PAYT towns have experienced some reductions. And it is important to keep in mind that even if reductions are small, charging the right price may result in the right amount of garbage disposal. Fixed monthly charges - the norm in many places - set a zero price for an additional bag or can and thus provide no incentive for households to conserve.

The big question for PAYT communities, though, is what households are doing with the garbage they no longer place at the curb. To avoid paying the fee, households can reduce their waste by recycling, composting, consuming less in the first place, or disposing illegally - burning, finding a commercial dumpster, or throwing it by the side of the road. Recycling does increase with PAYT but not enough to account for all of the reduction in trash. Clearly, municipalities can help themselves by providing free curbside collection of a wide variety of materials for recycling and yard waste collection for central composting. Towns also must choose how much to spend on enforcement, and how to set penalties.

PAYT is most effective in small cities and suburban areas but has not worked so well in densely populated urban areas where apartment dwellers use chutes and dumpsters for their normal disposal (and might easily use vacant lots for everything else). PAYT is also not as well-suited to very rural areas where illicit dump sites are similarly easy to find. In general, it is most feasible where we can measure and monitor individual households' weekly trash and recycling.

Even in towns where a PAYT fee works well to reduce waste amounts without increased dumping, it does nothing special for separate handling of hazardous and other troublesome items like batteries, tires, or used electronic equipment. These products, especially, are candidates for some kind of deposit refund system (DRS). Experience has shown great success with a DRS applied to certain products: beverage containers in "bottle bill" states have recycling rates that range from 60-95 percent, significantly higher than in states without such a program; 96 percent of lead-acid batteries are recycled; and tires in states with a DRS are recycled at a 72 percent rate. But the idea can be generalized, in a "two-part instrument," a general sales tax on everything at the store - all of which eventually becomes waste - along with a subsidy per ton of waste handled at the recycling center. Products like computer monitors could still be specifically targeted with a special fee, but most items could be treated in bulk, without time-consuming transactions to count or weigh individual items.

Thus the "best" policy is not any single policy. PAYT can successfully be employed in at least some communities, and probably in more than are currently doing so. Other towns, however, need a two-part instrument - a general sales tax on new items at the store, plus a subsidy for recycling. And products that pose special problems may need targeted deposits or refunds. Different circumstances therefore call for different policies, PAYTs, DRSs, or two-part instruments. All of these policies have a key feature in common and one that economists invariably seek in all of their policy prescriptions: they provide the proper incentives to consumers and others to generate a socially desirable outcome.

links for 2008-07-29