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August 29, 2009

Economist's View - 4 new articles

Stiglitz: Thanks to the Deficit, the Buck Stops Here

Joseph Stiglitz repeats a warning that he and others have made in the past that, like it or not, the dollar's days as a reserve currency are numbered. Thus, instead of resisting this change -- as we have -- "it's better for us to participate in the construction of a new system than have it happen without us":

Thanks to the Deficit, the Buck Stops Here, by Joseph E. Stiglitz, Commentary, Washington Post: Beware of deficit fetishism. Last week we learned that the national debt is likely to grow by more than $9 billion. That's not great news -- no one likes a big deficit -- but President Obama inherited an economic mess from the Bush administration, and the cleanup comes with an inevitably high price tag. We're paying it now. ...
There are ... consequences, however, that we're missing in the debate over all this red ink. Our budget deficit, as well as the Federal Reserve's ballooning lending programs and other financial obligations, will accelerate a process already well underway -- a changing role for the U.S. dollar in the global economy.
The domino effect is straightforward: Higher deficits spark market concerns over future inflation; concerns of inflation contribute to a weaker dollar; and both come together to undermine the greenback's role as a reliable store of value around the world. ...
Anxieties about future inflation can lead to a weaker dollar today. So, are these anxieties justifiable? ... The worries are justified, even though Fed Chairman Ben Bernanke ... assures us that he will deftly manage monetary policy... This is a tough balancing act... Anyone looking at the Fed's record in recent years will be skeptical of its forecasting skills and its ability to get the balance right.
In addition, international markets understand that the United States may face strong incentives to reduce the real value of its debts through inflation...
Like it or not, out of the ashes of this debacle a new and more stable global reserve system is likely to emerge, and for the world as a whole, as well as for the United States, this would be a good thing. It would lead to a more stable worldwide financial system and stronger global economic growth. ... Discussions on the design of the new system are already underway. ...
The United States has resisted these changes, but they will come regardless, and it's better for us to participate in the construction of a new system than have it happen without us. The United States has seen great advantages with the dollar as the world's reserve currency..., particularly the ability to borrow at low interest rates seemingly without limit. But we haven't seen the costs as clearly: the inevitable trade deficits, the instability, the weaker global economy. The benefits to us are likely to shrink, and rapidly so, as countries shift their holdings away from the dollar. ...
America should show leadership in helping shape this new structure and managing the transition, rather than burying its head in the sand. We may have preferred to keep the old system, in which the dollar reigned supreme, but that's no longer an option.


Hoover's "Pro-Labor Stance" Did Not Help to Cause the Great Depression

In a new paper, Lee Ohanion claims that Herbert Hoover's call for "business leaders to be gentle to their workers" helped to cause the Great Depression. Brad DeLong explains why this claim does not hold up to closer scrutiny:

Herbert Hoover: A Working Class Hero Is Something to Be, by Brad DeLong: Oh Noes! Andrew Leonard reads Lee Ohanian:
Herbert Hoover: The working man's hero - How the World Works - Salon.com: I did not need a cup of coffee to wake up this morning -- I just checked my e-mail, and saw the subject header: "Hoover's pro-labor stance helped cause Great Depression, UCLA economist says."
Without reading the message, I knew instantly who the economist must be -- Lee Ohanian.... Last we saw of Ohanian... he was arguing that FDR's New Deal policies extended the Great Depression and resulted in "less work than average" for American workers. Which might be true, if you don't count anyone who got a job through "the Works Progress Administration (WPA) or Civilian Conservation Corps (CCC), or any other of Roosevelt's popular New Deal workfare programs." Makes sense -- if you don't count Roosevelt's pro-labor programs, he doesn't end up very pro-labor!
So now we have "What -- or Who -- Started the Great Depression?," a 68-page paper Ohanian has been working on for four years that is sure to become a never-to-be-extinguished talking point for New Deal haters, union-busters, and opponents of all kinds of government intervention in the economy. Here are some key points, taken from the press release pushed out by UCLA.
Pro-labor policies pushed by President Herbert Hoover after the stock market crash of 1929 accounted for close to two-thirds of the drop in the nation's gross domestic product over the two years that followed, causing what might otherwise have been a bad recession to slip into the Great Depression, a UCLA economist concludes in a new study. "These findings suggest that the recession was three times worse -- at a minimum -- than it would otherwise have been, because of Hoover," said Lee E. Ohanian, a UCLA professor of economics.
According to Ohanian, these pro-labor policies including pressure for job-sharing and propping up wages handcuffed industry's ability to respond flexibly to the post-crash economic contraction.
After the crash, Hoover met with major leaders of industry and cut a deal with them to either maintain or raise wages and institute job-sharing to keep workers employed, at least to some degree, Ohanian found. In response, General Motors, Ford, U.S. Steel, Dupont, International Harvester and many other large firms fell in line, even publicly underscoring their compliance with Hoover's program. "By keeping industrial wages too high, Hoover sharply depressed employment beyond where it otherwise would have been, and that act drove down the overall gross national product," Ohanian said. "His policy was the single most important event in precipitating the Great Depression."
Hoover as the pro-labor liberal! Never mind that Hoover spent decades after his spectacularly failed presidency bemoaning the country's New Deal turn to Bolshevism. And never mind that the definitive conservative economic treatment of the Great Depression, Milton Friedman and Anna J. Schwartz's "A Monetary History of the United States," pinpoints monetary policy mistakes by the Federal Reserve as the crucial catalyst that turned a stock market crash and recession into a Depression. Never mind the now-fading cultural memory of the United States, which somehow remembers Hoover as being bad for labor, and Roosevelt being good. All that pales against the necessity of making a key political point relevant to today's financial crisis.

There is a germ of information buried in the pile: Hoover did urge business leaders to be gentle to their workers because, he assured them, the Great Depression would soon be over.

But Hoover's interventions do not appear to have had much effect. If you take the degree of government-sponsored union power and wage rigidity in post-WWII Europe to be 100, then FDR's New Deal counts as a 30 and Herbert Hoover's "can't we all just get along?" White House meetings count as a five. If Hoover's inviting businessmen to the White House could push the unemployment rate up from 4% to 23%, simple extrapolation would then suggest that Roosevelt's labor-market policies ought to have pushed unemployment up to 118%--and unemployment in post-WWII Europe ought to have averaged 384%.

It simply does not appear as if Hoover's exhortations had much effects. Average wages in manufacturing stood at $0.55 in 1930, at $0.51 in 1931--an 8% cut--and $0.44 in 1932--a 20% cut. Coal miners' hourly wages went from $0.66 in 1930 to $0.63 in 1931 to $0.50 in 1932--a 25% cut. Skilled male manufacturing workers' wages went from $0.66 an hour in 1930 to $0.63 in 1931 and $0.56 in 1932. You had the same 20% cut in nominal wages over 1930-1932 as you had over 1920-22 (but a 50% decline in industrial production in the 1930 and only a 30% decline in industrial production in the 1920s). The argument would have to be that if not for Hoover, firms would have cut wages much, much faster than they in fact did. In 1996 Ben Bernanke and Kevin Carey, in their "Nominal Wage Stickiness and Aggregate Supply in the Great Depression," plotted real wages and industrial production levels in 1932 relative to 1929 for 22 countries:

Ip.and.w.in.depression

Four countries--Australia, Argentina, Hungary, and New Zealand--have low relative real wage levels in 1929 not because employers have cut wages but because they are small open economies and had already undergone massive currency devaluation by 1932: wages were more or less where they were in 1929 but the domestic price level was much higher because the currency was worth less. the rest of the countries were still on or not yet far off the gold standard. Some--Germany and the U.S.--had relatively low real wages and were doing horribly. Some--Norway and Japan--had relatively low real wages and were doing well. And some--Belgium, France, the Netherlands, the United Kingdom, and Switzerland--had relatively high real wages and were doing middling. The scatterplot strongly suggest that Hoover's interventions (a) were too feeble to make the U.S. a more-than-average country in the downward rigidity of its nominal wages, and (b) that at least as of the end of Hoover's term, how deep the Great Depression was in your country had very little to do with whether your internal nominal wages level had fallen far or not. As Eric Rauchway points out, to blame the Great Contraction of 1929-1932 on government interference in the labor market creates a very strong presumption that thereafter the Great Depression should have gotten much worse rather than eased--for the interferences in the 1930s, starting with the NIRA, were much larger deviations from laissez-faire:

[H]ere's the thing: if you want to say, "I'll take 'Causes of the Great Depression', Alex," you have to be prepared with an explanation for (a) why things got so bad under Hoover and (b) why they then got better under Roosevelt.
Monetarist models explain this: the gold standard was deflationary, and going off the gold standard helped countries out of the Great Depression. Hoover didn't go off the gold standard. FDR did. Things got better.
Keynesian models explain this: Hoover didn't do enough to stimulate demand. Roosevelt did more (though still not quite enough).
Ohanian's model doesn't explain this.

And I would like to raise a further caution. Ohanian is working in a framework in which nominal demand--the total dollar flow of spending--is constant. In such a framework lower wages lead businesses to cut their prices and so the same flow of demand buys more goods, and that induces firms to hire more people and produce more. Jacob Viner, Milton Friedman's teacher, strongly cautioned against this line of argument in 1933 because a decline in wages was part of an "unbalanced deflation." Wages fell, but debt principal and interest payments did not.

In Viner's view, and in mine, if wages had fallen faster and further, goods prices and real estate prices would have fallen further and faster, more banks would have gone into bankruptcy, the bank failures would have shrunk the money supply even more, the velocity of money would have fallen even further, and the Great Depression would have been even worse.

Larry Summers and I wrote a paper about this back in the 1980s.

Milton Friedman's teacher Jacob Viner always argued that it was "unbalanced deflation" -- i.e., declines in asset prices and wages and incomes while debts remained the same -- that was the cause of the Great Depression. So did monetarist school founder Irving Fisher. Ask yourself: if everybody's salary in America were to be cut right now by 25 percent -- but everyone's mortgage payment, everyone's credit card balance and interest payment, and every corporation's debt interest payments remained the same--would we see a recovery or another chain of financial bankruptcies that would push the economy down further?


"When Carbon is Priced, Who Ultimately Pays?"

Who pays the costs of a cap and trade system for carbon emissions? This analysis of who pays based upon the legislation passed by the House in June suggests that "the distributional consequences have been addressed fairly effectively," and that "Strong opposition to the legislation will probably be based more on ideological grounds than distributional concerns":

When carbon is priced, who ultimately pays?, by Corbett Grainger and Charles Kolstad, Vox EU: Climate change legislation is winding its way through the US Congress. In June (2009), the House passed complex legislation involving, among other things, a cap and trade system for carbon emissions in the US. The legislation passed by the slimmest of majorities – 219 to 212 with 3 not voting. Although most Republicans opposed the legislation, a significant number of Democrats, primarily those from coal-rich or rural districts, also voted no. Politics is local, even for global warming.

The Senate will consider similar legislation in September, and its passage is likely to be even more difficult. Several issues are at the core of the opposition:

  1. The competitive effect on industry. Will higher costs cause US industry to lose market share to foreign producers? In order to win over skeptics, legislators mandated import tariffs on goods from countries without climate legislation (such as China). President Obama has subsequently condemned such mandatory trade barriers.
  2. The burden of increased energy prices on lower-income individuals. The poor often drive older cars, commute further to work, and in other respects consume goods and services differently than wealthier members of society. Furthermore, to the extent that energy is a necessity, one would expect price increases to hit the poor particularly hard. In other words, carbon regulation may be regressive.
  3. The burden of higher prices for consumers in states heavily reliant on coal-based electricity. Coal has the largest carbon emissions per unit of heat energy of any of the fossil fuels (by a wide margin) and thus will be hit hard by any legislation.

Measuring the burden of a carbon price

It is important to distinguish between a tax's statutory incidence (i.e., who writes the check to the government) and its ultimate burden (who ends up paying the cost of the tax). A cap-and-trade system is not a tax in the normal sense, but it does induce a tax-like carbon price change. Raising the price of carbon increases the costs of doing business, and those costs may be passed on to consumers, workers, or owners.

The Congressional Budget Office estimates that the House legislation will result in an initial price of carbon on the order of $15 per ton of CO2 (CBO 2009a).1 Because CO2 is mostly O2, simple chemistry tells us that this amounts to a price on carbon of about $55 per ton.

When the price of carbon increases, the direct effect is that fuels that consumers and industry purchase will be more expensive. There is also an indirect effect, in the sense that industries that use fossil fuels will see costs rise and will pass some or all of those increased costs on through increased prices of goods and services. The simplest example is electricity. Higher fuel prices raise the costs of generating electricity, which may in turn lead to increased electricity prices. A subtler example is construction, which would face both higher fuel prices and higher raw materials prices, due to the carbon price faced by producers and transporters of those raw materials.

It turns out that tracing the effect of an increased price of carbon through the US economy is not so hard. The US national accounts track how much industries buy from other industries in order to produce. It is straightforward to calculate how a CO2 price would affect the prices of different products in the US economy, assuming that industries are able to pass on all of their extra carbon costs to their consumers. Disaggregating the US economy into nearly 500 different industrial sectors and using a fairly recent characterisation of nationwide consumption patterns, we have estimated the increase in costs associated with a $15/ton price of CO2 (Grainger and Kolstad 2009).

This is probably an overestimate of the effect of a carbon price on product prices for two basic reasons:

  • Some industries will simply not be able to pass on the entire extra cost due to competitive pressures.
  • People and firms typically substitute away from goods that see price increases.

This may involve simply doing without or switching to other goods. Predicting how much of the carbon price can be passed on or how carbon users will change behaviour is not easy.

The effect of a carbon price on industry

The first political issue we address is how badly specific industries would be affected by a price on carbon. Of the approximately 500 industries considered, only five are estimated to see a cost increase in excess of 5%. Table 1 shows the top ten industries facing expected cost increases. Although some sectors do see significant cost increases, what is striking is how few industries see costs increase more than a few percent.

Table 1. Ten highest impact sectors from $15 per ton carbon price

How regressive is a carbon price?

A second political issue in the debate over climate regulation is how regressive a carbon price may be. The US Consumer Expenditure Survey tracks consumption decisions by households throughout the income distribution. Coupling that with data on interindustry transactions allows us to trace a $15 price on CO2 through industries to consumers. As before, this will be an overestimate of the effect on consumers, since we assume that industry can pass on the full carbon price to consumers and consumers do not change their behaviour in response to an elevated carbon price.

In order to understand how regressive or progressive a price on carbon may be, it is important to estimate the fraction of household income that may be absorbed by the carbon price. It turns out that there are several measures of income that may be relevant. One is simply conventional income. Another is lifetime income, based on current expenditures, smoothing out the fact that we tend to earn less early in life and more later but spend based on our expected lifetime income. Two more variations relate to household size. It is cheaper to keep one household of two people than two households of one person, so we can adjust income to "equivalent" income, reflecting the economies of scale in operating a household.

Figure 1 shows the carbon price burden as a fraction of income for different US income groups.

Figure 1. Burden of $15/ton tax on CO2 equivalent, as a fraction of income

Vox-burden2

As can be seen from the figure, a price on carbon is regressive in that lower income households spend a larger fraction of their income on payments to carbon. Although the effect differs depending on which measure of income is used, the qualitative story is the same. For very low income (less than $35,000 per year), the burden as a fraction of income is highly sensitive to income, increasing substantially as income drops. For greater incomes, the burden is somewhat regressive though not remarkably so, dropping from 1.5-2.5% for $35,000 incomes to 1-2% for the highest income bracket.

In fact, the House climate legislation contains specific provisions to offset the regressive aspects of the cap and trade program. The Congressional Budget Office has analysed these components of the bill and has concluded that the lowest quintile would actually see a gain of 0.2% whereas the highest quintile would see a cost of 0.1% (CBO 2009b). Virtually all of the regressivity has been neutralised, though regional differences may still persist, an issue addressed by Hassett, Mathur, and Metcalf (2009).

Summary

The politics of climate change regulation is as much tied up with the distribution of costs as their overall magnitude. Our analysis of the burden of the legislation passed by the House in June suggests that the distributional consequences have been addressed fairly effectively. Strong opposition to the legislation will probably be based more on ideological grounds than distributional concerns.

References

Congressional Budget Office (2009a) CBO Analysis 5 June 2009. Congressional Budget Office (2009b), "The Estimated Costs to Households From the Cap-and-Trade Provisions of H.R. 2454," (Washington, DC, 19 June 2009) EPA (2009) "EPA Analysis of the American Clean Energy and Security Act of 2009 HR 2454 in the 111th Congress," 23 June 2009. Grainger, Corbett and Charles Kolstad (2009), "Who Pays a Price on Carbon?", NBER Working Paper 15239. Hassett, Kevin, Aparna Mathur and Gilbert Metcalf (2009), "The Incidence of a US Carbon Tax: A Lifetime and Regional Analysis," Energy Journal 30.2 (2009): 155-177.


1 The CBO (2009a) estimates a price of $15 per ton of CO2 equivalent in 2011, rising to about $26 per ton in 2019. The EPA (2009) estimates slightly lower prices – $13 in 2015 and $16 in 2020.


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