Wednesday, July 28, 2010

Postmortem on Waxman-Markey: The Politics of Cap-and-Trade

As recently as 2008, the prospects for cap-and-trade climate change legislation looked good. Both major-party presidential candidates in that year's election supported the concept, and there was bi-partisan support in both houses of the U.S. Congress. Now, as of July 2010, cap-and-trade is dead. The Senate will not bring the House-passed Waxman-Markey cap-and-trade bill to a vote, nor will it propose a substitute. What has this experience taught us about the politics of cap-and-trade?

Textbook analysis tells us there are two market-based approaches to controlling carbon emissions. One is a tax of a fixed amount per ton of carbon emitted. The other is to impose a cap on emissions and then issue tradeable permits. Under proper conditions, the equilibrium price of permits would settle down to the same value as the optimal tax, and the environmental effects of the two approaches would be equivalent. If the permits were auctioned off, the budgetary effects of cap-and-trade would also be equivalent to those of a tax.

More advanced economic analysis reveals second-order effects that may break the equivalence in favor of carbon taxes. For example, some economists argue that permit prices would vary greatly from year to year, introducing an element of uncertainty that could discourage pollution control investments. The volatility of EU carbon permit prices lends support to this concern. However, if cap-and-trade were more attainable politically, many economists would accept it as a second best.

Unfortunately for supporters of climate change action, the Waxman-Markey experience raises doubts about the politics of cap-and-trade. The old argument was that cap-and-trade made it easier to put together a climate action coalition. The main idea was that by giving away a limited number of permits for free, some polluters could be won over to the cause of limiting emissions. A secondary political benefit is that a cap-and-trade scheme would not, strictly speaking, be a tax. In the past, that was enough to garner the support of at least a few Republican legislators who would never dream of voting for a tax increase.

The lesson of Waxman-Markey is that the coalition-building powers of cap-and-trade were greatly overrated. In order to assemble a winning coalition in the House, not just a few, but nearly all permits were handed out for free. (Recall that Candidate Obama's 2008 campaign platform on cap-and-trade had called for all permits to be auctioned.) Worse than this, some permits were to be squandered on a bizarre scheme that would have protected consumers from higher energy prices, thus undermining a crucial incentive for energy conservation. Finally, the bill was loaded up with a grab-bag of command-and-control provisions, for example, renewable energy mandates for utilities. What was left was a weak measure that departed widely from the market-based efficiency of a textbook cap-and-trade plan.

When the debate moved over the the Senate, the cap-and-trade coalition collapsed entirely. So much had been given away to win a House majority that there was little room left for maneuver. When the Republican leadership decided to re-brand cap-and-trade as "cap-and-tax," the few remaining Republican supporters dropped away.

The bottom line: The demise of Waxman-Markey seems to be more than a tactical setback for the cap-and-trade approach to climate change. Right now, there seems to be no political appetite at all for climate change legislation. If demand for action emerges again in the future, the case for a straight-up carbon tax seems stronger than before, and the case for cap-and-trade weaker.

Follow this link to download a free set of classroom-ready slides that explains the basic economics of both carbon taxes and cap-and-trade, and discusses the specifics of the Waxman-Markey bill.

Saturday, July 24, 2010

Will Extension of Unemployment Benefits Help or Hurt the Economy?

On July 22, President Obama signed an extension of unemployment benefits. Benefits averaging $300 per week, normally available for a maximum of 26 weeks, can now be paid for up to 99 weeks. Such an extension had been in force previously during the recession, but it had lapsed. Benefits will be paid retroactively for the 7 weeks during which the extension was not in force.

Politically, the extension was highly controversial, passing the Senate by a single vote. The close vote reflects the likelihood that extended unemployment benefits will have both good and bad effects on the economy.

The case favoring extension begins from the fact that long-term unemployment is now at a post-World War II high. Some 45% of all unemployed workers have been out of work for 26 weeks or more. The long-term unemployment rate always rises during a recession, but the previous peak number of long-term unemployed, in the early 1980s, was less than half of the current number. If we add the fact that unemployment disproportionately affects the lowest-paid and least educated workers, it is not surprising that many people see the extension as good social policy.

In terms of its effects on the labor market, the extension of unemployment benefits can be expected to have both positive and negative effects. Unemployment benefits lower the opportunity cost of job search. Other things being equal, that will tend to increase the average duration and rate of unemployment. (It should be pointed out that that is not entirely bad--lowering the cost of job search can potentially improve matching of workers to jobs and thereby improve labor market efficiency.) At the same time, the extension of benefits will stimulate aggregate demand. To the extent doing so speeds the recovery of real output, unemployment will fall.

Critics of the extension pointed out that any short-term benefits must be offset against the fact that more current spending will complicate the job of bringing the federal deficit and debt under control over the medium term. The rapid rise in the debt during the recession has limited the government's room for undertaking additional short-term stimulus. Several spending and tax-relief provisions were stripped out of the recent bill before passage.

Follow this link to download a free set of classroom-ready slides that include both current unemployment data and a simple presentation of a job-search model of unemployment.

Saturday, July 17, 2010

Financial Reform: Why We Need It, and Why It Might Not Work

The Dodd-Frank financial reform act makes fundamental changes in the way the US financial industry will be regulated. It sets up a new oversight mechanism to spot early warnings of systemic risk, creates new resolution authority for complex financial firms, creates a new consumer protection agency, and introduces restrictions on several specific kinds of risky activity, including use of derivatives, proprietary trading, and ownership of hedge funds.

We can judge the likelihood that the Dodd-Frank Act will have its intended outcome by viewing the financial system in terms of the interaction of a risk-return frontier, shaped by market conditions and the regulatory regime, and the risk-return preferences of financial managers and regulators. Because of contagion, moral hazard, and agency problems, regulators tend to prefer a lower-risk point along the frontier than do managers.

The intended consequence of Dodd-Frank is to move the financial system downward along the risk-return frontier from management's preferred point to that of regulators. Provisions of Dodd-Frank that might help accomplish this include better oversight to avoid buildup of unnoticed systemic risks and the new authority to take over complex, at-risk financial institutions and wind them up if needed. Improvements to corporate governance and compensation practices could also have helped, although there is little of this in Dodd-Frank as finally passed.

On the other hand, provisions of Dodd-Frank that prohibit specific risk practices like proprietary trading or hedge-fund ownership carry a risk of unintended consequences. Such measures act by changing the shape of the risk-return frontier without changing management's underlying risk preferences. In response, managers will develop new strategies to reach their preferred risk-return point on the new frontier. Unfortunately, the new equilibrium is likely to be worse than the status quo ante from the point of view of both managers' and regulators' preferences.

Click here to download a free set of classroom-ready slides that develop the above points in greater detail, including a graphical analysis in terms of the risk-return frontier.

Thursday, July 15, 2010

New Feature: Tutorials

As part of my ongoing effort to make this blog as useful as possible to teachers of economics, I have decided from time to time to post short tutorials on economic concepts that I find useful in explaining current policy issues.

My first post in this series is a short tutorial on consumer and producer surplus. I have used these concepts in my recent post dealing with initiatives toward trade liberalization and the proposed US-Korea Free Trade Agreement. If you use the trade liberalization slide show in your classes, you may want to preface it with the tutorial, or assign the tutorial to your students as background.

You might also find the consumer and producer surplus tutorial to be useful in conjunction with some past posts on this site, including The Economics of a Soda Tax and The Gulf Oil Spill and the Myth of Affordable Energy.

Recent US Moves toward Trade Liberalization : Economics vs. Politics

The Obama administration has recently announced several initiatives to promote US international trade. One is a National Export Initiative aimed at doubling US exports over 10 years. Another is a renewed effort to revive stalled bilateral trade agreements with Korea, Columbia, and Panama.

Economists, with relatively few exceptions, tend to favor free trade. They are at home in a world of economic models where the interests of consumers, firms, and workers are balanced against one another in a neutral, unbiased manner. Using familiar conceptual tools like producer and consumer surplus, economists tally up the net gains and losses to trade liberalization and almost always find that lifting trade restrictions benefits both importing and exporting countries.

The political game unfolds on a different playing field, for two reasons. First, although economists tend to focus on the net gains from trade, politics is very sensitive to the fact that any change in trade policy produces some losers along with the winners. Second, the political influence of winners and losers is not necessarily proportional to the magnitude of their economic gains or losses. Instead, well-organized groups, like corporations, farm groups, and unionized workers, have disproportionate political power compared to poorly organized groups like consumers and non-unionized workers.

As a case in point, consider the Korea-US Free Trade Agreement (KORUS FTA). It was originally negotiated in 2006 and signed by both governments in 2007, but it is not yet ratified. In the United States, the main opposition has come from the Big Three automakers and their unions. These control enough Democratic votes in Congress to have blocked ratification up to this point.

Ratification opponents claim that US-Korean automobile trade is inherently unfair because Korea exports 700,000 cars a year to the US, but imports more than 100 times fewer US cars. They less often emphasize the fact that KORUS FTA would lower Korean auto tariffs by more than US tariffs would be lowered, or that Korean and US automakers each produce many cars in the others' country, which do not show up in import figures, or that trade in auto parts is less unbalanced than trade in finished cars.

Will KORUS FTA be ratified? At the recent G20 summit in Canada, the presidents of the US and South Korea pledged a renewed push for ratification. A group of Republic senators has offered to help the ratification push. Still, as of mid-2010, the outcome is far from certain.

The bottom line: There is a big gap between the politics and the economics of trade liberalization. In Washington,  lobbyists for corporations and unions battle one another in a zero-sum game. Consumer interests and non-unionized workers are rarely heard from. In contrast, economic analysis tells us that when the interests of all groups are taken into account, trade liberalization leads to net gains for both importing and exporting countries.

Follow this link to download a set of free, classroom-ready slides with a more detailed analysis of trade liberalization and KORUS. The slides make use of the concepts of consumer and producer surplus. Click here if you think your students would benefit from a quick tutorial on producer and consumer surplus.

Tuesday, July 6, 2010

The Breakup of the Ruble Area (1991-1993): Lessons for the Euro

The recent problems of high-debt countries in Europe--Greece, Spain, and others--have led many observers to wonder if the euro area might break apart. Parallels have been drawn to the collapse of other fixed exchange-rate systems, ranging from the gold standard to the Argentine currency board. Less attention has been paid to what can be learned from the collapse of  the 15-nation ruble area of 1991-1993.

The ruble area came into existence when the Soviet Union was dissolved at the end of 1991. The former republican branches of the Soviet state bank (Gosbank) became the central banks of the 15 newly independent states. Superficially, it looked a lot like the 17-nation euro area.

Unlike the euro area, the ruble area suffered from its birth from high inflation. The inflation arose from three main problems.
  • First, there was the legacy of perestroika. Mikhail Gorbachev's failed attempt to reform the Soviet economy led to loss of financial control and growth of nominal demand without corresponding increase of real supply. Administrative price controls led to repressed inflation, which was released in a burst when controls were lifted in January, 1992.
  • Second, inflation arose from the monetization of budget deficits. With weak, corrupt, tax systems and no working financial markets to finance deficits through sales of bonds to the public, governments had no choice but to finance their spending with inflationary credits from central banks.
  • Third, there was a fundamental design flaw in the ruble area that led to a free rider problem. The Central Bank of Russia claimed a monopoly on the issue of paper currency, but each of the 15 central banks of the ruble area could inflate the money supply through creation of bank credits. Each government was able to gain the full seigniorage benefit of financing its deficit through its own central bank, while spreading the resulting inflation among the whole group of 15.
Given these flaws, it is not surprising that the ruble area did not last long. Starting with the exit of the three Baltic states in the summer of 1992, one member after another abandoned the ruble and introduced its own legal tender. Russia itself demonetized the Soviet ruble in 1993 and replaced it with a new Russian ruble. War-torn Tajikistan was the last to leave, in 1995.

What relevance does the demise of the ruble area have for today's euro? There are two main lessons.

The first lesson is to beware free rider problems. True, the ECB has more complete control over money creation than the Central Bank of Russia had, so the euro area does not have to worry about monetary free riders. However, it does have a problem with fiscal free riders. Countries that conduct irresponsible fiscal policies, in defiance of EU rules, gain the full short-term political benefits of high spending and low taxes, while shifting at least a part of the resulting costs to their neighbors. Well-intentioned safeguards, including a supposedly strict no bail-out clause, have provided less than full protection against free riders.

The second lesson is that barriers to exit from a currency area are asymmetrical. Much has been made of the fact that countries with weak economies, like Greece, would find it hard to leave the euro. Even a parliamentary debate on exit would be likely to trigger devastating bank runs and defaults on public and private debt. (See Barry Eichengreen for a good, short presentation of this view.)  However, the same barriers do not apply to countries with strong economies that want to leave a weak, inflation-plagued currency area. Estonia, Latvia, and Lithuania achieved a smooth exit from the ruble area. Introducing their national currencies quickly brought down inflation, helped stabilize financial systems, and made it easier, not harder, to attract foreign finance for public and private debt.

All this suggests a possible scenario for breakup of the euro. If a coalition of weak economies were ever to gain control of the ECB, they might be tempted to use inflationary policy to ease their debt burdens and stimulate their economies. Once that happened, stronger economies with greater aversion to inflation--Germany, in particular--might be motivated to leave the euro, and could do so without risk of bank runs or defaults.

Follow this link for more on the breakup of the ruble area and its lessons for the euro, including charts, data, and a free set of classroom-ready slides.

Thursday, July 1, 2010

Budget Basics (4): Why is it So Hard to Close the Budget Gap?

Previous posts in this Budget Basics series have shown that the U.S. federal budget deficit and debt are on an unsustainable path. It is easy to say how to close the budget gap--cut spending or raise revenues. Why, then, is doing it so hard?

As a working estimate of the budget gap, we will use the cyclically adjusted primary budget deficit, which was about 7 percent of U.S. GDP in 2009. Some estimates are smaller by a percentage point or two, and some, especially those that assume delays before starting to tighten policy, are larger. It is also necessary to take into account that tightening policy too soon could slow the recovery, and make the gap larger.

Politically, the easiest promise to make is to eliminate waste, fraud, and abuse. Often such political rhetoric is vague about just what programs should be targeted. The first place many people look for wasteful programs is in nondefense discretionary spending, but that part of the budget is surprisingly small, only 19 percent of all federal spending in the 2010 federal budget, or just 4.7 percent of GDP. Adding defense gives total discretionary spending of about 9 percent of GDP. At least a few areas of spending, like federal courts, U.S. embassies abroad, and operations of the Treasury would have to be protected in any program of cuts. It follows, as a matter of simple arithmetic, that any attempt to eliminate the budget gap through cuts in discretionary spending alone would have to cut defense spending by more than half, and eliminate most nonessential departments--HUD, agriculture, commerce, NASA, EPA and many others--entirely.

Long-term projections show that growth of entitlement spending is more important than discretionary spending in explaining growth of the budget gap in coming decades. To some extent, this is due to aging of the US population. The other big factor is excess growth of medical costs, which have been growing at a rate about 2.5 percent faster than the general price level. Bringing the growth of medical costs down to the rate of increase of other prices could by itself eliminate most of the budget gap. However, doing so would be politically difficult. Many cost-cutting proposals, ranging from malpractice reform to a public insurance option to removing tax preferences for employer-paid health plans were considered, but rejected, during the recent health care debate in Congress.

The budget gap could also be closed by raising revenues, but there are constraints here, as well, as shown in recent research by the Urban Institute-Brookings Institution Tax Policy Center. It would be difficult to close the gap simply by raising tax rates within the existing income tax system--essentially impossible if rates were raised only for higher tax brackets. Closing tax loopholes and preferences could make a substantial contribution, up to 5 percent of GDP. However, many tax preferences serve public policy purposes, so that eliminating them would have opportunity costs. New taxes like a VAT could also raise much of the revenue needed to close the gap, but there seems to be solid political resistance to a VAT for the time being.

The bottom line: Simple arithmetic suggests that no single approach can close the budget gap. A combination of spending cuts and revenue increases will be needed. However, it must be kept in mind that every line in the federal budget has its political supporters--otherwise it would not be there in the first place. Eliminating the budget gap and restoring fiscal sustainability will be very hard work.

Follow this link to download a free, classroom-ready set of slides that present graphs and tables showing options for closing the budget gap. Three earlier posts in this Budget Basics series appeared on this blog during June, 2010.