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July 21, 2009

Economist's View - 7 new articles

Should Carbon be Sequestered?

Robert Stavins explains why he believes that biological carbon sequestration should be part of U.S. climate policy:

What Role for U.S. Carbon Sequestration?, by Robert Stavins: With the development of climate legislation proceeding in the U.S. Senate, a key question is whether the United States can cost-effectively reduce a significant share of its contributions to increased atmospheric CO2 concentrations through forest-based carbon sequestration. Should biological carbon sequestration be part of the domestic portfolio of compliance activities?

The potential costs of carbon sequestration policies should be one major criterion, and so it can be helpful to assess the cost of supplying forest-based carbon sequestration. This is a topic which I've investigated in a series of papers with various co-authors over the past ten years ... [list of cites in full version.].

Human activities — particularly the extraction and burning of fossil fuels and the depletion of forests — are causing the level of CO2 in the atmosphere to rise. It may be possible to increase the rate at which ecosystems remove CO2 from the atmosphere and store the carbon in plant material, decomposing detritus, and organic soil. In essence, forests and other highly productive ecosystems can become biological scrubbers by removing (sequestering) CO2 from the atmosphere. Much of the current interest in carbon sequestration has been prompted by suggestions that sufficient lands are available to use sequestration for mitigating significant shares of annual CO2 emissions, and related claims that this approach provides a relatively inexpensive means of addressing climate change. ...

Among the key factors that affect estimates of the cost of forest carbon sequestration are: (1) the tree species involved, forestry practices utilized, and related rates of carbon uptake over time; (2) the opportunity cost of the land-that is, the value of the affected land for alternative uses; (3) the disposition of biomass through burning, harvesting, and forest product sinks; (4) anticipated changes in forest and agricultural product prices; (5) the analytical methods used to account for carbon flows over time; (6) the discount rate employed in the analysis; and (7) the policy instruments used to achieve a given carbon sequestration target.

Given the diverse set of factors that affect the cost and quantity of potential forest carbon sequestration in the United States, it should not be surprising that cost studies have produced a broad range of estimates. Ken Richards and I identified eleven previous analyses that were good candidates for comparison and synthesis, and we made their results mutually consistent... We also employed econometric methods to estimate the central tendency (or "best-fit") of the normalized marginal cost functions from the eleven studies as a rough guide for policy makers of the projected availability of carbon sequestration at various costs.

Three major conclusions emerged from our survey and synthesis. First, there is a broad range of possible forest-based carbon sequestration opportunities available at various magnitudes and associated costs. The range depends upon underlying biological and economic assumptions, as well as analytical cost-estimation methods employed.

Second, a systematic comparison of sequestration supply estimates from national studies produces a range of $25 to $75 per ton for a program size of 300 million tons of annual carbon sequestration. The range increases somewhat- to $30-$90 per ton of carbon-for programs sequestering 500 million tons annually.

Third, when a transparent and accessible econometric technique was employed..., the resulting supply function for forest-based carbon sequestration in the United States is approximately linear up to 500 million tons of carbon per year, at which point marginal costs reach approximately $70 per ton.

A 500 million ton per year sequestration program would be very significant, offsetting approximately one-third of annual U.S. carbon emissions. At this level, the estimated costs of carbon sequestration are comparable to typical estimates of the costs of emissions abatement through fuel switching and energy efficiency improvements. This result indicates that sequestration opportunities ought to be included in the economic modeling of climate policies. And it further suggest that if it is possible to design and implement a domestic carbon sequestration program, then such a program ought to be included in a cost-effective portfolio of compliance strategies when the United States enacts a mandatory domestic greenhouse gas reduction program. Large-scale forest-based carbon sequestration can be a cost-effective tool that should be considered seriously by policy makers.

Of course, this raises the question of whether a policy that will bring about such biological carbon sequestration cost-effectively can be developed, whether as part of a cap-and-trade system, a related offset scheme, or through some other policy mechanism. That is a question without easy answers (as I've noted in a previous post on the Waxman-Markey legislation), but the cost analyses I've reviewed in this post suggest that it is important to explore possible ways of incorporating biological carbon sequestration in future U.S. climate policy.

"Bernanke's Bold Prose"

Mohammed El-Arian says Ben Bernanke can talk all he wants, but the credibility of his message about inflation depends upon the actions of fiscal authorities and is thus largely out of his hands:

Mohamed El-Erian on Bernanke's bold prose, FT Alphaville: From Pimco's chief executive…

While it may not rank quite as high as his appearance on the US news show '60 Minutes' a few months ago, Chairman Bernanke's Op Ed in today's Wall Street Journal is nevertheless notable and important. It represents a bold attempt by the Federal Reserve to reach out broadly and pre-empt mounting concerns about the challenges facing monetary policy.

Bernanke's bottom line is clear: "Overall, the Federal Reserve has many effective tools to tighten monetary policy when the economic outlook requires us to do so." ... Bernanke is signaling that the Fed is aware of the need to re-assure markets of its ability to strike that delicate balance between deflationary and inflationary concerns. ...

While ... this is important, it does not constitute major news as such. Indeed, Bernanke has today confirmed a view that has increasingly prevailed in financial markets: there will be no early hike in interest rates; and when the time comes to tighten monetary policy, the sequence will involve dealing first with the excess reserves. Yet this is not sufficient to ensure that the US is indeed able to balance well deflationary and inflationary risks.

To move from a necessary condition to one that is both necessary and sufficient, one must also consider what, increasingly, is the large elephant in the room when it comes to policies — namely, the design and conduct of fiscal policy. This is an area where challenging short and longer-term imperatives need to be reconciled over time, and at several level of local, state and national governments. ...

After being heavily involved in stabilizing a highly disrupted economy, the Fed is transitioning from the driver seat to the passenger seat.

By virtue of its greater flexibility and responsiveness, the Fed ended up assuming the main role in responding to the crisis, with fiscal and other agencies (including the FDIC) playing important support roles. It is now the turn of the fiscal agencies to assume the main role, with the Fed and others playing the support roles.

Bottom line: we have now entered the phase where fiscal policy is the more important determinant of the ability of the US to balance the risks of deflation and those of inflation. And, here, the jury is still out.

If we fail to make the changes in health care reform that are needed to bring the long-term budget into better balance, there will come a time when the Fed faces a choice about whether to monetize the debt and create inflation, or to refuse to monetize the debt potentially send interest rates very high causing the economy to stall. So it's not completely out of their hands. The Fed has faced this choice before, and its independence allowed it to send a message to fiscal authorities that it was willing to take whatever steps are necessary, including causing a recession, to prevent monetizing the debt and creating an inflationary environment. As Thomas Sargent notes in his book "Dynamic Macroeconomic Theory":

A game of chicken seemed to be occurring in the United States from 1981 to 1985 because the Fed announced a policy that is feasible only if the budget swings toward balance in a present value sense, whereas Congress and the President set in place plans for government expenditures and taxes that imply prospective net-of-interest deficits so large that they are feasible only if the Fed eventually creates more inflation. In such a situation, something has to give.

And, due to the degree of independence that it had, it wasn't the Fed that eventually gave in. With a less independent Fed, I'm not sure we get that outcome. (I should note that people such as Jamie Galbraith argue that fighting inflation during this time period was the wrong policy to pursue - one part of the the argument is that it suppressed wages and made workers worse off - but this is a point on which we disagree, and the general view within the profession is that the Volcker Fed acted wisely.)

"Three Myths about the Consumer Financial Product Agency"

Elizabeth Warren responds to some of the worries about creating a Consumer Financial Product Agency:

Three Myths about the Consumer Financial Product Agency, by Elizabeth Warren: I've written a lot about the creation of a new Consumer Protection Financial Agency (CFPA)... Today, though, I'd like to post specifically about some of the push back that has developed on this issue. In particular, I'd like to focus on three big myths – myths designed to protect the same status quo that triggered the economic crisis.

MYTH #1: CFPA Will Limit Consumer Choice and Hinder Innovation

At a recent hearing on the CFPA, Rep. Brad Miller challenged an industry representative to identify one consumer who chose double-cycle billing to be included within the terms and conditions of his or her credit card contract. It was a great moment. If the status quo is about choice, then explain why half of those with subprime mortgages chose high-risk, high-cost loans when they qualified for prime mortgages. ...

The truth, of course, is that no consumer "chooses" to accept the tricks and traps buried within the legalese of financial products. ... The CFPA will not limit consumer choice. Instead, it will focus on putting consumers in a position to make choices for themselves by ... making financial products easier to understand and compare. ... Once consumers can understand the risk and costs of various products – and can compare those products quickly and cheaply – the market will innovate around their preferences.

Daniel Carpenter ,,, at Harvard University ... has written a great deal about the modern pharmaceutical industry. While anyone with a bathtub and some chemicals could be a drug manufacturer a century ago,... drug companies were willing to invest far more in research and development ... once FDA regulations drove out bad drugs and useless drugs. Good regulations support product innovation.

MYTH #2: The CFPA Will Add Another Layer of Regulation and Increase Regulatory Burden

Current regulations in the consumer financial area are layered on like pancakes... Today, seven different federal agencies have some form of regulations dealing with consumer credit. The result is a complicated, fragmented, expensive, and ineffective system. With consolidated and coherent authority, the CFPA can harmonize and streamline the regulatory system—while making it more effective.

But the real regulatory break-through for the CFPA would be the promotion of "plain vanilla" contracts that would likely meet the needs of about 95% of consumers. These contracts would have a regulatory safe harbor. By using an off-the-shelf template for a plain vanilla contracts..., a financial institution can legally satisfy all its federal regulatory requirements—no need to do more. ...

A streamlined new regulatory regime would have a serious impact on the credit industry. Today's complicated disclosure system favors big lenders that can hire a legion of lawyers to navigate the rules—and spread the costs among millions of customers. Those complex rules fall much harder on a smaller institution that must navigate the same regulatory twists and turns, but with far smaller administrative staffs. Plain vanilla contracts will be particularly beneficial for community banks and credit unions that will be able to divert fewer resources toward regulatory compliance and more toward customer service and innovation.

MYTH #3: Prudential and Consumer Regulation Cannot Be Separated

Make no mistake: This is a fancy claim for the status quo. If the CFPA can be left with the current bank regulators, then it can be smothered in the crib. For decades, the Federal Reserve and the bank regulators (the OCC and the OTS) have had the legal authority to protect consumers. They have brought us to this crisis by consistently refusing to exercise that authority.

The agencies' well-documented failures ... are largely the result of two structural flaws. The first is that financial institutions can now choose their own regulators. By changing from a bank charter to a thrift charter, for example, a financial institution can change from one regulator to another. The regulators' budget comes in large part from the institutions they regulate. If a big financial institution leaves one regulator, the agency will face a budget shortfall and the agency will likely shrink. Knowing this, financial institutions can shop around for the regulator that provides the most lax oversight, and regulators can compete by offering to regulate less. Regulatory arbitrage triggered a race to the bottom among prudential regulators and blocked any hope of real consumer protection.

The second structural reason that prudential regulators failed to exercise their authority to protect consumers is a cultural one: consumer protection staff at existing agencies find themselves at the bottom of the pecking order because these agencies are designed to focus on other matters. ... Consumer protection issues are—at best—an afterthought. The CFPA would create a home in Washington for people who wake up each morning thinking about whether American families are playing on a level field when they buy financial products. ...

In 2001, Canada created an independent agency much like the proposed CFPA. I recently spoke with some Canadian economists, and they not only said the system works, they also expressed bewilderment about the idea that prudential and consumer regulation would be combined. ...

At the end of the day, industry lobbyists try hard to invent myths and make things sound confusing to intimidate the public and to keep policymakers from acting. ... The CFPA would put someone in Washington—someone with real power—who cares about customers. That's good for families, good for market competition, and good for our economy.

Ben Bernanke: The Fed's Exit Strategy

Ben Bernanke says that when the economy starts to recover, the Fed will take the steps needed to prevent an outbreak of inflation (the substance of the arguments can be found in the full version):

The Fed's Exit Strategy, by Ben Bernanke, Commentary, WSJ: The depth and breadth of the global recession has required a highly accommodative monetary policy. Since the onset of the financial crisis nearly two years ago, the Federal Reserve has reduced the ... federal-funds rate ... nearly to zero. We have also greatly expanded the size of the Fed's balance sheet through purchases of longer-term securities and through targeted lending programs aimed at restarting the flow of credit.

These actions have softened the economic impact of the financial crisis. They have also improved the functioning of key credit markets...

My colleagues and I believe that accommodative policies will likely be warranted for an extended period. At some point, however, as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem... We are confident we have the necessary tools to withdraw policy accommodation, when that becomes appropriate, in a smooth and timely manner.

The exit strategy is closely tied to the management of the Federal Reserve balance sheet. When the Fed makes loans or acquires securities, the funds ... ultimately appear in the reserve accounts held at the Fed by banks and other depository institutions. These reserve balances now total about $800 billion, much more than normal. ...

But as the economy recovers, banks should find more opportunities to lend out their reserves. That would produce faster growth in broad money (for example, M1 or M2) and easier credit conditions, which could ultimately result in inflationary pressures—unless we adopt countervailing policy measures. When the time comes to tighten monetary policy, we must either eliminate these large reserve balances or, if they remain, neutralize any potential undesired effects on the economy. ...

[W]e have two broad means of tightening monetary policy at the appropriate time: paying interest on reserve balances and taking various actions that reduce the stock of reserves. We could use either of these approaches alone; however, to ensure effectiveness, we likely would use both in combination. ... [T]hese policies would help to raise short-term interest rates and limit the growth of broad measures of money and credit, thereby tightening monetary policy.

Overall, the Federal Reserve has many effective tools to tighten monetary policy when the economic outlook requires us to do so. As my colleagues and I have stated, however, economic conditions are not likely to warrant tighter monetary policy for an extended period. We will calibrate the timing and pace of any future tightening, together with the mix of tools to best foster our dual objectives of maximum employment and price stability.

As I've said many times, I'm not particularly worried about inflation, reserves can be removed or neutralized as described. The worry is not so much that they will be too slow at removing reserves, it's that they will get trigger happy and start raising interest too soon potentially stalling the recovery or perhaps even sending the economy back downward. The Fed will need to be sure that things are getting better before beginning to raise interest rates, that's why it's good to hear them use the phrase "extended period" twice when describing how long interest rates will stay low. But there are long lags associated with monetary policy, and by the time the Fed knows for sure that economy is heading solidly in the right direction, it won't have much time left to reverse course and begin removing reserves. Even so, they need to be patient and avoid the more serious mistake of raising interest rates too soon.

Milton Friedman's Letter: I Do Believe There is Gold in Them There Hills

I came across this letter today while digging in my desk for something else, and decided I should make a digital copy since it was starting to show its age. Having done so, I decided to post it here (after thinking about whether it would seem to self-serving, or whatever, which it probably does).

This is why I will always have a soft spot for Milton Friedman. I was a relatively new assistant professor when I received this in response to a paper I sent to him. The paper was based on his Plucking Model, but I never expected a reply, and given the demands on his time, I'm still amazed he responded at all. Some parts, such as this, relate at least tangentially to debates we are having today:

In a frictionless world in which money was completely neutral, the impact of monetary growth would always be solely on inflation. In the real world, given the lags that I have described and taking for granted that positive money growth is not reflected in inflation for a considerable period, it must be reflected somewhere. The obvious candidates are output, interest rates, and buffer money stocks. When the economy is operating below capacity, it is easy for part of the impact to be taken up by real output and a lesser part by interest rates or by buffer stocks. But when the economy is operating at full capacity, it cannot be taken up by output. It will therefore have to have a stronger influence on the two other components.

Milton Friedman was my dissertation advisor's dissertaion advisor, so I guess he's my intellectual grandpa. Here's the letter (at this time, monetary aggregates were used to measure policy, and the debate over the use of M1 versus M2 in empirical work was not yet fully resolved) (pdf):

HOOVER INSTITUTION ON WAR, REVOLUTION AND PEACE Stanford, California 94305-60I0 June 24, 1991
Professor Mark Thoma Department of Economics University of Oregon Eugene, Oregon 97403-1285
Dear Mark Thoma: I was delighted to receive your paper "Asymmetries and the Effects of Money." Needless to say, I am pleased that my paper stimulated you to do further work along these lines. I do believe there is gold in them there hills.
I am not competent to judge the details of your statistical analysis. I have not kept up with recent statistical developments, particularly those associated with the VARS. Hence, my comments will be on a much more general level; I assume that you have done the details correctly.
On the series employed, I believe that M2 is preferable to M1 in most such analyses. It has had a stabler meaning over time and a more consistent relationship with other economic magnitudes. Interestingly enough the first two articles in the May issue of the Journal of Money, Credit, and Banking, which has just come my way, reach the same conclusion.
It would be highly desirable to extend your analysis to a longer period. Monthly data are available on M2 for as far back as on Ml, both to 1907. The current M2 series can be regarded as a continuation of the M3, or for a trivial improvement, the M4, series in Table 1 of Anna Schwartz's and my Monetary Statistics of the United States. Linking those data with the current Federal Reserve Board M2 series gives a reasonably homogeneous and continuous series. Similarly, linking our Ml series with the Federal Reserve's does the same. Interest rate series are of course available way back. Monthly industrial production indexes are available back at least to 1919 and perhaps earlier. In short, the same analysis carried back to encompass the whole period from about 1907 on should be entirely feasible and would give a much sounder base for any conclusions.
Returning to the period you considered from 1959 on, I suspect deflated personal income would be a more useful monthly measure of real output than the industrial production index, which is rather limited in its coverage and does not always track total output very well.
One further point re the interest rate data that you used. The appropriate variable is not the Treasury bill rate or the commercial paper rate by itself, but the difference between the Treasury bill rate and the interest paid on money. In our Monetary Trends, we used an approximation computed by assuming that implicit interest was paid on demand deposits. Bob Hetzel
Professor Mark Thoma June 24, 1991 Page 2
at the Federal Reserve Bank of Richmond has constructed a better series of the interest paid on M2 as well as a series on the differential interest, that is, the excess of the interest earned on outside assets over the interest earned on money. I do not recall whether his series are monthly; they may be quarterly. However, the interest paid on money is a rather slow-moving series with high serial correlation, so it should not be difficult to interpolate it. In any event, you might want to get from Bob his series.
Turning to your mathematization of the idea, I am struck that it is extremely ingenious and I have no comments to make on that. In re the conclusions, I am not greatly disturbed that positive money growth shocks do not have a large impact on inflation when the economy is operating at maximum level. We have consistently found that changes in money lead changes in inflation by about two years, and there is no reason why that lag should not be just as operative at upper turning points as elsewhere. You include, as I understand it, a lag of at most six months. True, the impulse response functions implicitly extend the lag, but I suspect that is not the same as allowing for a very much longer lag. Changes in money tend to affect output after something like about six to nine months, and inflation only after another 18 months, by which time the effect on output is negative rather than positive. Hence, it is not surprising that the short-term reaction is on interest rates rather than on inflation. In a frictionless world in which money was completely neutral, the impact of monetary growth would always be solely on inflation. In the real world, given the lags that I have described and taking for granted that positive money growth is not reflected in inflation for a considerable period, it must be reflected somewhere. The obvious candidates are output, interest rates, and buffer money stocks. When the economy is operating below capacity, it is easy for part of the impact to be taken up by real output and a lesser part by interest rates or by buffer stocks. But when the economy is operating at full capacity, it cannot be taken up by output. It will therefore have to have a stronger influence on the two other components. A measure of buffer stocks conceivably could be obtained from velocity figures, but this is rather questionable since empirically velocity tends to be positively related to the cycle, implying that buffer stocks are less at the peaks. However, this conclusion is for measured velocity which is not necessarily the appropriate variable. What you would really like is the difference between actual and desired money stocks; that would depend on long-term variables such as permanent income rather than current nominal income. Perhaps some of the people who have done research on buffer stocks have constructed estimates of their size. David Laidler would probably know. If there were a convenient series available, it would be interesting to introduce it as an additional nominal variable.
The disturbing finding is that negative money growth shocks have a negligible impact on real activity when the economy is at its maximum level. I did not expect that and so any explanation I suggest will be a rationalization. The
Professor Mark Thoma June 24, 1991 Page 3
rationalization that appeals to me most is very much along the line of the distinction between permanent and transitory components of consumption. The counterpart is the following. You have divided your dates into three batches: corresponding to maximum output, average output, low output. Money is by no means the only factor that accounts for the economy being at the stage it is. Of the many other factors at any point in time, some are likely to be favorable, some are likely to be unfavorable. Consider the group of dates corresponding to maximum output. The method of selection of those dates assures that favorable factors dominate. Conversely, at dates corresponding to low output. At dates where other factors are disproportionately favorable, negative money growth shocks might simply be offsetting other unduly favorable factors, while at the bottom they would be reinforcing disproportionately unfavorable factors. A way to get around this regression bias would be to classify dates by the level of the money series as opposed to the level of the output series. One could then see whether the influence of downward plucks in money was different at high levels of the money series, which means that the money series was relatively favorable to the level of output than they are when the money series was average or low.
I am not sure what to expect from this experiment. It would not surprise me if the downward plucks had roughly the same effect at all three money levels. I have stated this suggestion in my statistical language not yours, but I trust that you can translate it.
These are off-the-cuff comments on a paper that I clearly found interesting. Keep it up.
Sincerely yours,
Milton Friedman Senior Research Fellow F:v

"A More Pleasant Society will then Evolve"

Do egalitarian societies cause egalitarian beliefs?:

How to upgrade human values, by Andrew Leonard: "As Karl Marx would have said," writes Yale economist John Roemer in the newest edition of the Economist's Voice, "under feudal rules we get serfs who desire only to subsist; under capitalism, we get capitalists who desire to maximize their wealth. Each mode of production (set of rules) determines to a large extent the values and the social ethos of the people who live within it."
But most economists, says Roemer, don't see people's values as contingent on modes of production; so when they think about ways to tinker with the "system" so that global economic meltdowns are less likely to clobber us, their premise is "that we must accept people as they are and design new rules that will prevent bad results from occurring."
Roemer believes that in a capitalist society individuals will always figure out ways to break or twist the rules. So he proposes what he calls "a less ambitious aim": Changing people. "If we follow a path leading to a society whose individuals are more solidaristic, then I believe it is much easier to design rules that will guarantee good outcomes."
So how does one go about this? Basically, Roemer suggests that if you build a more egalitarian system, people will change to reflect more egalitarian beliefs. He uses the oh-so-topical issue of healthcare as an example.
There is of course no social engineer who can command either that people change their preferences, or who can impose a new set of rules. Because we value democracy, rules must ultimately be approved by the voters. Nevertheless, history may produce a path that would engender the desired change in preferences and rules. Suppose, for example, that America succeeds in implementing universal health insurance; that is, that voters in their majority demand it. A more pleasant society will then evolve: people will be under less from the fear of losing their health insurance when unemployed, or because they contract a major disease; emergency rooms will be less clogged with poor, uninsured persons; insurers will have incentives to urge people to undertake more healthy life styles (to keep costs down), and so on. There is a good chance that citizens generally will like these changes -- not only because of their own increased financial security, but because civility will increase, and poverty will be, at least along one dimension, less glaring. Citizens may come to value equality of condition more than they previously did. This change in preferences may well render politically feasible other insurance innovations and increased financing of public goods -- more support for the unemployed with job training, perhaps more direct income support for the unemployed, and more support for intensive education for the disadvantaged.
Well, one can dream, can't one? ...

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