Deepish Thought

I just came across this intriguing article on using the dollar auction as a model for understanding the war in a Iraq. This is not the only applicable economic model. For example, you could gain insight into the administration’s decision making on Iraq by considering the Asset Substitution Problem.

Imagine a firm that is mostly financed by debt. The bondholders of the firm will tend to prefer that management adopt a conservative strategy, in order to maximize the chance that the debt will be paid off.  However a conservative  strategy has little appeal for shareholders, since low risk implies low return and thus low net profits.  For this reason the shareholders will tend to prefer higher risk/higher reward strategies, since these increase the probability that there will be something left over after the debt has been paid.

Since the shareholders control the firm, they can have management adopt a strategy that increases the chance of losses for the bondholders in the hope that there will be some return to the shareholders. In effect, the shareholders can choose to gamble with bondholder’s money.

Applying this model to the situation in Iraq, the American public are the bondholders while the the administration takes the role of shareholder.

At this point the President’s reputation is pretty much shot. If he adopts a conservative strategy in Iraq, say phased withdrawal, his administration will almost certainly be remembered as one of the worst in US history. If however he adopts a riskier strategy, like continuing the surge, there is a slight chance that the situation will turn around, which in turn might redeem his standing.

From the President’s perspective there is nothing to lose, his reputation already being shot, and everything to gain. A small chance at redemption is very much better than no chance at all. It should thus not come as a surprise that the President is vigorously opposed to any admission of defeat in Iraq.

It should also not be surprising that the American public, who will ultimately carry the cost of the much more likely negative outcome of gambling in Iraq, are less than enthusiastic about doubling down.

In the commercial world bondholders control the gambling tendencies of stockholders through including covenants (contractual limitations on management) in debt agreements, which is generally effective.

In the political sphere, Congress is supposed to counter any executive tendency towards gambling with the lives and treasure of the nation. However, with the focus on not appearing soft in the run-up to the 2008 election, there seems to be little stomach in Congress for reigning in the President. For the moment it appears that our only alternative is to hope that the President’s gamble pays off.

In his latest thundering rant on immigration, that insightful genius Lou Dobbs quite rightly blasts the ungrateful scumbag president of Mexico for taking an utterly unwarranted interest in the welfare of those Mexican citizens sneakily trying to evade their justly deserved poverty north of the border.

The Mexican president should clearly be more worried about fixing problems at home. After all, the continued poverty there is scandalous. Particularly when you consider, as Mr Dobbs very cleverly does, the extraordinary assistance that the US so generously provides:

“The United States provides Mexico with an annual surplus of $65 billion in trade, an estimated $25 billion in remittances from Mexican citizens living and working here illegally, and at least another $25 billion generated by the illegal drug trade across our southern border.”

Never before had I considered the possibility that the international drug trade might be an exceedingly generous form of humanitarian assistance to the world’s less fortunate.

Less insightful commentators have suggested that the United States’ stubborn insistence on recreational chemicals being the exclusive business of criminal cartels might have had some minor negative effects on the rule of law in Mexico (not to mention the rest of Central and South America). However, when considered from the proper (Dobbsian) perspective, what might once have been characterized as a horrendous curse that breeds violence and corruption, while thoroughly undermining civil society, becomes truly enlightened social policy.

Lou Dobbs is clearly one of the towering intellects of this, or any other, generation.

I just watched Thomas Friedman, in a particularly insightful interview with Jim Lehrer, give an excellent explanation of why putting a price on carbon is important if the US is even remotely serious about addressing global warming. It went a little bit like this:

Imagine I came to you 25 years ago (before cell phones) and said, “I have this brilliant new product. For just a $1000 I’ll sell you a phone with no wires that is small enough to carry around in your pocket. It’ll change your life.” You might say something like, “Well a $1000 is a lot of money, but you know what, this will change my life – I’ll buy one”. I could then take your $1000, do some more research, and then come back a year later and say, “You know that phone I sold you, well now I have a smaller, better one – only $850” and so on. Pretty soon everyone would have a cell phone.

Now imagine I came to you and said, “You see these lights in the ceiling here. They cost you about $100 a year to run. Well I have a new, carbon free way to power those lights. It’ll only cost you $150 a year.” What would be your likely response?

Unlike for the cell phone, the low carbon power supply won’t improve your life in any obvious way (unless global warming is actually keeping you up at night), so there is very little incentive to pay extra for the low carbon alternative.

Now imagine that the cost of carbon externalities were being included in the price of energy and I come to you and say, “You see these lights that cost you $160 a year. Well I have a new, carbon free way to power those lights. It’ll only cost you $150 a year.” What would your response be now?

Of the two scenarios, which is more likely to result in a low carbon energy infrastructure in the US?

There are a couple of ways we might include the environmental costs of CO2 in the price of energy. A carbon tax or a system of tradable carbon credits.

A carbon tax is politically difficult for any politician to advocate because it would (obviously) raise the price of energy. However there is an approach that might make a carbon tax politically viable. Harvard economist Greg Mankiw has suggested that the US could replace FICA taxes (payroll taxes that fund Social Security and Medicare) with a carbon tax. This might work politically because the total tax burden wouldn’t increase. It is particularly attractive economically because it would shift the burden of taxes from an economically positive activity (work) to a negative externality (global warming).

The main problem with a carbon tax is that it falls evenly across all CO2 producing activities. The result of such a tax is likely to be a modest reduction in emissions, through higher prices reducing demand and motivating efficiency improvements, across the whole spectrum of CO2 generating activities. This is not an economically optimum result.

From an economic perspective we would like to maximize the economic value we get from utilizing the limited resource that is the environment’s ability to safely absorb CO2. In other words, we would like for whatever CO2 emissions we find acceptable to be associated with those high value activities where avoiding emissions is either difficult or prohibitively expensive.

In order to achieve this result we need a system for allocating our carbon emissions around the economy. This is the genius of tradable emissions credits. By creating a market for trading CO2 emissions we would also be creating a mechanism that allowsthe economy to reorganize itself in order to to achieve maximum output for the allowable level of CO2 emissions.

This is not simply pie in the sky economic theory. A cap and trade system has been used very successfully to control SO2 emissions in the US. Under this system the government allocated a fixed supply of pollution permits amoung SO2 emitters. Permit holders that managed to reduce their emissions at reasonable cost were then able to sell their excess credits to organizations that faced more expensive constraints. The system led to a rapid reduction in SO2 emissions in the US at very little overall cost to the economy.

Despite its success, the SO2 system is not without issues. Simply allocating emissions credits to existing polluters is a somewhat questionable approach. It distorts the market in favor of existing SO2 generating activities, which receive credits for free, over possibly higher value new activities, which would have to buy them. This wasn’t a big issue for SO2, which is created by a limited number of activities, but would be a significant problem if the same approach were applied to CO2. In addition, the system potentially created an incentive for companies to increase SO2 output prior to the start date so as to receive higher emission allocations when the system got under way.

Quite apart from these criticisms, an SO2 style cap and trade system for CO2 would not generate any new sources of government revenue, which would mean foregoing the non-environmental benefits of Mankiw’s tax approach.

Fortunately, there is a way of combining both approaches in order to achieve maximum economic benefit. Instead of simply allocating CO2 credits to existing polluters, the government could have an annual auction of credits for the coming year (the credits being subsequently tradable). The revenue from this auction could then be used, as carbon tax revenue would have been in Mankiw’s proposal, to replace FICA taxes.

In addition to being economically sound, this proposal combines six great political selling points, adding up to across the spectrum political appeal:

1. No net new taxes
2. Higher employment (through eliminating tax on employment)
3. Harnessing the power of the market
4. Rewarding innovation
5. Punishing polluters
6. Aggressively combating global warming

The question is whether there are any politicians out there, especially viable presidential candidates, who would be willing to champion such a radical approach?

It recently came to light that everybody’s least favorite Attorney General, Alberto Gonzales, has acquired new powers to “fast track” death penalty cases in federal courts. While the headline may play well with the Republican base, which remains infatuated with the death penalty, the measure itself is extremely limited and probably won’t make all that much difference to the rate at which death row inmates meet their ends.

The death penalty itself remains intensely controversial and thus politically useful. Support for the death penalty is the tough, god fearing, law upholding, capital “C” conservative candidate’s favorite way of distinguishing himself from all those namby-pamby, soft on crime Democrats who like nothing more than pandering to criminals and recklessly compromising the safety of honest Americans.

Not being particularly enamored with the culture wars, I would like to propose a solidly conservative argument for dispensing with the death penalty and it’s accompanying political, legal and media circus. My hypothetical pragmatic Republican candidate might make an argument something like this:

“I have not one single shred of sympathy for the inmates on death row. They are undoubtedly the vilest of criminals and thoroughly deserve to be put to death.

Nevertheless I oppose the death penalty, not because it is cruel, but because it is far too kind.

Consider what happens when a convict is placed on death row. For a start he is handled with extraordinary care by his jailers least some incident provide grounds for appeal, or the psychological stress of his situation render him medically unfit to be executed.

Once comfortably installed on death row the convict is practically overrun with sympathetic media types and bleeding-heart liberal lawyers, who explain to the convict, in the most understanding tones, how he is really the victim.

This wouldn’t be so bad were it not for the glacial pace of the legal system. Our laudable desire to ensure that no innocent citizen is ever put to death has resulted in a near endless menu of legal avenues by which liberal lawyers can seek to delay or subvert the course of justice.

On being convicted of a capital crime the criminal knows two things. He will enjoy at least 15 years (probably many more) of the most comfortable accommodation the prison system can provide while the appeals process plays out. He will also receive attention, understanding and sympathy that he absolutely doesn’t deserve and may even achieve a measure of celebrity. What is absolutely not certain is whether he will ever be executed.

Is it any wonder that the death penalty isn’t much of a deterrent?

The people who really suffer in a capital case are the victims. Ignored in the outpouring of concern for the criminal, the victims are deprived of any sense of finality or justice. Through the years, as appeal follows appeal, the victims can be called back any number of times to reiterate their testimony, always knowing that one slip in testimony or error in memory may be enough to allow their attackers to escape punishment.

For the sake of justice, for the sake of the victims, I call on all true conservatives everywhere to write to the president and ask that he commute the sentences of every death row inmate to life with hard labor and no possibility of parole. We may not be able to make the death penalty work, but we can sure as heck make our worst offenders wish they were dead.”

Some interesting insights into inequality and unhappiness. Particularly interesting given that inequality will likely be a big issue in the democratic primary and possibly in the 2008 election.

Inspired by reading a review of Bryan Caplan’s book, “The Myth of the Rational Voter: Why Democracies Choose Bad Politics“, I have decided to take on the herculean task of attempting to justify democracy (I am such a hero).

Mr Caplan has apparently taken a careful look at the voters who form the bedrock of the democratic system and come to the (some would say obvious) conclusion that democracy is built on very shaky ground. This is not an entirely new idea. Winston Churchill clearly anticipated Mr Caplan’s case when he observed that, “The best argument against democracy is a five minute conversation with the average voter.”

The problem with Mr Caplan’s argument is the implied assumption that we should expect good government from democracy. Good government, whatever that may be, is far too lofty a goal for any political system. Certainly, I’m not aware of any such system that has consistently provided it.

Flawed as it obviously is, democracy does have two very important benefits that justify Mr Churchill’s other famous observation, “It has been said that democracy is the worst form of government except for all the others that have been tried.”

Firstly, while it does not by any means guarantee good government, functional democracies are reasonably effective at moderating bad government. The worst governments tend to be those in which one narrow section of society is able to seize control and relentlessly pursue their own interests. In a working democracy, the need to capture majority support means that the government is always a coalition of interest groups (although these interest groups may all belong to one “broad church” political party). These interest groups may all want to pursue dubious policies, but they don’t ever all want the same dubious policies. The resulting tension between interest groups within the ruling coalition tends to prevent the government from careening off the rails in obedience to the desires of one narrow section of society.

Secondly, democracy provides a means of transferring power between different groups without resorting to firearms. Whether for demographic, economic, social or technological reasons all societies from time to time experience shifts in the balance of power. In non-democratic countries these shifts are often accompanied by violence, as new power structures forcibly supplant the old. In functional democracies however voting provides a signal to the existing regime that it is time to go. The quid pro quo for a government that accepts the will of the voters is not being subject to retribution from the new regime, and in fact having the opportunity to regain its former perks at some later date.

Since the consequence of losing power in democracy is merely a period of opposition followed by a probable return to power, there is very little incentive for the ruling group to resist being dumped out of office. For this reason there tends to be very little political violence in genuine democracies, an observation that is sadly not true for most non-democratic states.

So while democracy may be a decidedly mediocre system of government dependent on the will of disinterested, ill informed and often wildly irrational voters, it at least avoids the worst pitfalls of the known alternatives.

Recently the political climate in the United States has tilted towards protectionism. Politicians on both sides of the aisle (and more than a few economists) have been loudly proclaiming that the national interest of the United States would be best served by restricting trade. Or at least, in true mercantilist fashion, by restricting imports.

This raises the interesting question of what exactly constitutes the national interest. If the national interest would be best served by maximizing the wealth of the United States then the best policy would be the elimination of trade barriers (a point about which there has no doubt whatsoever since the ‘logic’ of mercantilism was blown out of the water 200 years ago).

But what if wealth maximization is not the primary determinant of the national interest. There are at least three feasible alternative explanations of what our political leaders mean when they refer to the national interest.

(1) The Cynical View:

Our political leaders may simply equate the national interest with the narrow sectional interests of politically important special interest groups. From a politician’s perspective this is entirely logical.

For example, in 2002 it was clearly in the best interests of the nation that President Bush be re-elected (at least in the mind of President Bush), which is why the supposedly free trade supporting President suddenly found it necessary to impose economically asinine tariffs on imported steel (At the time steel producing Ohio, Pennsylvania and West Virginia were expected to be key swing states in the 2004 election).

(2) The Greater Wisdom View:

Wealth is in many ways a rather crude measure of wellbeing. In attempting to maximize the overall wellbeing of the nation, our political leaders may be taking into consideration factors not included in financial calculations. For example, it is plausible to argue that the nation would be better off with fewer goods and a cleaner environment, which is why it might make sense to attach environmental conditions to trade deals.

It may well be that this is how politicians actually think about trade. However, a cynic might point out that there seems to be a surprisingly high correlation between the trade policies that politicians believe will maximize national wellbeing and those that happen to be politically expedient.

(3) The Relative Power View:

It could be that what really matters is relative wealth. Our political leaders may be less interested in the absolute wealth of the United States, than they are in its wealth relative to potential strategic competitors.

While free trade would certainly enhance the wealth of the United States, it would likely benefit other trading nations even more, reducing the economic differential between the United States and the rest of the world. Since military power is highly dependant on economic strength it might be considered better for the United States if its trading partners, in particular China, remained relatively poor, even if this meant failing to maximize the economic potential of the United States.

From a relative power perspective the United States has every incentive to discourage free trade. If you are in the lead there is little incentive to do anything that might help the other guys catch up. Of course it is unlikely that this view would ever be publicly expressed since suggesting that the United States should restrict trade so as to maintain its relative military and economic advantages might be viewed as more than a little mean spirited.

Recently 3 out of 10 Republican candidates proudly proclaimed their disbelief in evolution. While this public exhibition of willful ignorance was undoubtedly disturbing, it did at least offer a fantastic opportunity for satire.

Later this year congress will sit down to consider the 2007 Farm Bill. This multi-billion dollar pork-fest will establish the direction of US farm subsidy programs for the next five years. Unfortunately for US taxpayers neither radical cuts nor outright abolition are on the table.

For America’s politically powerful farmers and rural lobby beholden politicians a rural economy without massive federal subsidies is simply unimaginable. I don’t pretend to know what would happen if congress succumbed to a sudden attack of economic rationality, but there is reason to believe that it might not be all bad.

Consider the experience of New Zealand:

“Many had worried that the end of subsidies would destroy agriculture in the country, yet the agricultural sector grew as a percentage of GDP. Today approximately 90 percent of farm output is exported, making up more than 55 percent of total merchandise exports. Productivity gains have allowed farmers to remain competitive in a world market where they compete with farmers in subsidized countries. Real farm incomes have recovered, and in some sectors income is even higher than it was under subsidies.

Instead of disappearing into the mists, the country’s farm sector became known throughout the world for high-quality, innovative, and efficient agricultural practices. After the initial failures, farm numbers held constant, and the amount of land in agriculture fell only slightly as marginal land went out of production. Decreases in farm employment have been offset by increases in employment in rural tourism. Thus, the percentage of the population living in rural areas remains virtually unchanged. Real land values, which initially plummeted, have recovered and surpassed their pre-reform level.”

This is a fairly reasonable summary of New Zealand’s experience with ending farm support. Farming did not collapse, civilization miraculously survived and, in a not unimportant consideration, the government that whacked the farm support system won the next election by a handsome margin.

So why couldn’t this happen in the US?

Our correspondent omitted to mention the political circumstances that made such a radical move possible. In 1985 the incoming Labor government discovered that the country was essentially bankrupt. New Zealand was in fact on verge of a massive Argentina style debt default. The impending financial meltdown focused minds and made the unthinkable not only possible, but necessary.

While the federal government is undoubtedly on an unsustainable fiscal path, the day of reckoning is still many years away. Only when the US is backed up against the fiscal wall will a radical reform, such as applying the chainsaw of economic rationality to the bloated paunch of farm politics, become possible.

Last week this year’s allocation of H1B visas was exhausted on the day that applications opened. Tech employers led by Microsoft are loudly demanding an increase in, or better still the elimination of, the H1B visa cap. Unfortunately with the increase in protectionist and anti-immigrant sentiment in Congress a cap increase is unlikely.

H1B visa opponents are obsessed with the idea that H1B visa holders put downward pressure on skilled wages and occupy positions that might otherwise go to Americans. This is an economics 101 type argument. As far as their argument goes the critics are correct.

Figure 1:

Consider figure 1. If supply 1 is the total supply of skilled labor (natives plus H1Bs) and supply 2 is the supply of native skilled labor then removing the H1Bs would clearly increase the price of skilled labor. Notice also that the number of Americans holding skilled jobs also increases if the H1Bs disappear (from Native Jobs 1 to Native Jobs 2).So if the H1B visa system were scrapped more Americans would have higher paying jobs. What is not to like?

Unfortunately the world is not so simple. To understand why excluding foreign skilled labor might not be such a hot idea all we need to do is apply a little more economics 101.

Figure 2:

Consider figure 2. By adding a second set of skilled labor demand and supply curves for the rest of the world we can develop a fuller understanding of the impact of ending the H1B visa program. Since H1B visa workers removed from the US labor pool don’t simply evaporate, the supply of skilled workers in the rest of the world increases and rest of the world price for skilled labor decreases. This increases the skilled labor price differential between the US and the rest of the world. This differential is a nice incentive for US employers to offshore their high skill work.

To put it another way, if US employers can move work to India and employ the same people they wanted to employ in the US for less money, what do you think is going to happen?

The point is that keeping foreign high skill workers out of the US is a very simple minded way of trying to improve the lot of skilled Americans. Long term it is likely to result in a decline in American competitiveness and the large scale export of high skill jobs.