Sunday, May 30, 2010

The Gulf Oil Spill and the Myth of Affordable Energy

The gulf oil spill (more accurately, the underwater gusher) has brought a new focus on U.S. energy policy. The spill has put the oil establishment on the defensive, but it is trying desperately to use the mantra of "affordable energy" to deflect criticism. "We need the oil that comes from the gulf to keep the economy moving," Sen. Mary Landrieu (D-LA) told the Wall Street Journal. "Affordable energy affects every sector of the economy," a spokesman for the American Petroleum Institute wrote in a letter to the New York Times.

If we cut through the rhetoric, do the facts support the thesis that countries with "affordable" (read: cheap) energy perform better than those with more expensive energy? They do not. The price of crude oil is about the same everywhere in the world, so we can use retail gasoline prices as a proxy for national energy policy. (A chart of retail gasoline prices and related data can be found in the PowerPoint slides that accompany this post.) Retail gasoline prices range from over $5 per gallon in much of Europe to just a few cents a gallon in countries like Iraq, Iran, and Venezuela.

One argument is that higher energy prices would undercut U.S. exports. However, among the world's four biggest exporters, Germany and Japan, the world export leaders in per capita terms, have far higher retail energy prices than the U.S. and China.

Another claim is that high energy prices would deepen the recession and worsen our already serious budget problems. But Norway, a rarity among energy exporters that keeps domestic retail prices purposely high, has experienced a far milder recession than the U.S. or the OECD average. Where the U.S. national debt is high and rising, the Norwegian government has net assets equal to 140 percent of GDP, bankrolled in part with high energy taxes.

The countries that outdo all others in the "affordable energy" sweepstakes are economic basket cases like Iran and Venezuela. They suffer high inflation and unemployment, and their energy policies are paralyzed by fears of social unrest. Iran actually has to import much of its gasoline, a dire threat to national security at a time when the country is threatened with sanctions.

Why does cheap energy undercut an economy? It's simple. For a market economy to function properly, prices should reflect opportunity costs. U.S. gasoline prices, and the prices of many other forms of energy, fall far short of opportunity cost because they do not reflect externalities like climate change, oil spills, smog, and traffic congestion.

Abraham Lincoln had a favorite riddle: "How many legs does a dog have, if you call a tail a leg?" Answer: Four. Calling a tail a leg doesn't make it a leg. By the same logic, calling cheap energy "affordable" does not make it affordable. If we don't pay the true cost of energy at the pump, we have to pay for it through economic distortions, pollution, and threats to national security.

The bottom line: We can't afford "affordable" energy. There Ain't No Such Thing as a Free Lunch!

Click here to download a free set of PowerPoint slides with data, text, and charts related to the myth of affordable energy. Cut-and-paste the slides into your economics lectures, or assign them as independent readings.

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Saturday, May 29, 2010

Recent Energy Trends: Hope or Despair for Climate Change?

A pair of recent reports from the Energy Information Administration show both good news and bad news regarding energy trends and CO2 emissions.

In the short run, the news from the US economy is good. Carbon emissions from energy use fell sharply in the United States during both 2008 and 2009. Falling GDP during the recession explains part of the decrease in CO2 emissions, but not all; total emissions fell faster than GDP. There was a decrease both in the energy intensity of GDP and in the carbon intensity of energy. (The decrease in the carbon intensity of energy was due, in part, to the increasing role of natural gas. See the post on this blog for February 27, 2010 for additional details.)

On a global scale, the outlook is not so good. Although total energy-related carbon emissions from wealthy OECD countries are expected to stabilize over the next 25 years, the EIA projects that without major policy changes, total carbon emissions will rise steadily. Although energy intensity of GDP and carbon intensity of energy will decrease in both developed and emerging market countries, rapid growth of GDP in the latter will swamp all other effects.

The policy changes needed to slow the growth of energy-related carbon emissions would have to include either a much stronger price signal, through higher energy taxes or a cap-and-trade system, or greater support for technological changes speeding development of low-carbon energy, or both.

Follow this link to download a free set of PowerPoint slides containing graphs and text related to energy and carbon trends. The slide set includes discussion questions to use in your economics class. If you like this teaching resource, please post a comment to tell others how you use it in your classes.

Tuesday, May 25, 2010

Why Exchange Rates Matter in a Crisis: Latvia vs. the Czech Republic

The focus of economic crisis watchers has shifted to Europe. The European Union, and especially the core countries that comprise the euro area, are struggling with budget deficits, possible defaults, and the threat of a double-dip recession. One of the factors causing headaches for European policy makers is the fact that most EU member countries have fixed exchange rates relative to one another, either within the euro area or through other fixed-exchange rate arrangements. Only a few EU members have fully flexible exchange rates. A comparison of Latvia, with its fixed exchange rate, and the Czech Republic, with a floating exchange rate, can show why exchange rates matter in a crisis.

Latvia is not a member of the Euro area, but its currency, the lats, has been firmly pegged to the euro since the country joined the EU in 2004. The fixed exchange rate has helped promote trade and financial integration, but it has also created problems for stabilization policy. During the boom years from 2004 to 2007, Latvia enjoyed the fastest growth in the EU, but also suffered the most rapid inflation. With a fixed exchange rate, the central bank could not use monetary policy to cool the boom. Rising prices and wages undercut competitiveness.

In contrast, in the Czech Republic, the post-accession boom was accompanied by rapid appreciation of the Czech koruna, which strengthened from 33 per euro to 23 per euro in just 4 years. The strong currency kept import prices low and helped restrain inflation. Without the need to hold the exchange rate fixed, the Czech central bank was able to use monetary policy to avoid excessive wage increases or a housing bubble. When the crisis hit, the koruna depreciated as quickly as it had earlier strengthened, quickly restoring competitiveness. The recession in the Czech Republic was among the mildest in the EU.

The effects of the crisis on Latvia were entirely different. Without a devaluation, the only way Latvia could restore competitiveness was through deflation of prices and wages. This strategy, often called "internal devaluation," has been extremely painful. The unemployment rate has soared to 22 percent as prices and wages fall. Meanwhile, unemployment in the Czech Republic has risen only slightly and has remained below the EU average throughout the crisis.

The bottom line: During good times, the fixed exchange rate policy of euro area countries and others with pegs to the euro helps promote trade and integration. However, during a boom, a fixed exchange rate makes it hard to avoid dangerous overheating and bubbles. When a crisis comes, a fixed exchange rate makes adjustment slower and more painful.

The euro has been a bold experiment, but today, the currency bloc is fighting to remain intact.

Follow this link to download a free set of PowerPoint slides with charts and data comparing the experience of Latvia and the Czech Republic. If you like the slides, please post a comment to let others know how you have used them in your economics courses.

Thursday, May 13, 2010

Afghan Opium Blight: Strategic Implications of Elasticity

In 2010, a blight has hit the Afghan opium poppy crop, and possibly also the crops of other Asian producers. Since opium production is an important source of revenue for the Taliban insurgency, the blight might superficially seem to be good news for the Afghan government and its NATO allies. However, a closer economic analysis suggests that the blight is may not be such a blessing after all.

UN officials estimate that the blight has destroyed a third of the poppy crop, sending the price up by 57 percent. Applying the midpoint formula to these numbers gives an estimated elasticity of demand of -.89 (inelastic demand).

When demand is inelastic, a decrease in quantity causes an increase in revenue. Part of the increase in revenue may accrue to farmers lucky enough to be less affected by the blight. However, observers think that much of the windfall profit goes to Taliban middlemen, who are believed to hold substantial stockpiles of previously produced opium. That would suggest that the blight is a curse both to farmers who have lost their crops, and to NATO forces fighting the insurgency.

Earlier in the war, NATO troops sprayed herbicides in an attempt to eradicate poppy crops. That policy produced an upward spike of prices, similar to that caused by the recent blight. Resources available to the Taliban increased, rather than decreasing, and farmers who lost their crops were turned against foreign forces. Having learned a lesson from the law of unintended consequences, NATO forces have largely abandoned eradication efforts in favor of positive incentives to switch to alternative cash crops. Ironically, the Taliban is now spreading rumors that the blight is caused by NATO bio-warfare efforts, a charge that NATO officials vehemently deny.

Follow this link to download a free set of PowerPoint slides showing elasticity and revenue calculations for Afghan opium. If you like the slides, please post a comment to tell others how you used them in your class.

Saturday, May 8, 2010

Jobs Increase, but So Does Unemployment Rate: Why?

The April 2010 employment report from the Bureau of Labor Statistics highlighted a paradox that often crops up in the early stages of a recovery. Payroll jobs rose by 290,000 in the month, the strongest growth in four years. The household job survey, which includes farm jobs and the self-employed, showed an even bigger gain of 550,000 jobs. Yet the unemployment rate rose from 9.7 to 9.9 percent, reversing its earlier decline. How can this be?

The answer lies in the way the unemployment rate is calculated, as the percentage of members of the labor force who are unemployed. With a few exceptions, to be counted in the labor force, a person must be either working or actively looking for work. That means "discouraged workers," who would like to work but don't look for a job because they think there is nothing out there, are not counted in the unemployment rate.

In the early stages of a recovery, there is often a period when an improving job market draws many previously discouraged workers back into the labor force. Some of these new job seekers, but not all, actually find work, so both the numerator and denominator of the unemployment rate increase. If the denominator (the labor force) increases proportionately more than the numerator (the number of unemployed), then the unemployment rate rises. That is exactly what happened in April, when 805,000 people entered the labor force but only 550,000 of them found jobs.

At times like the present, a less-noticed statistic, the employment-population ratio, can provide a more reliable indicator of the health of the job market. The Employment population ratio hit a low for the cycle in December 2009 and has risen each month since then, although it still lies well below its cyclical peak.

Follow this link to download a free set of PowerPoint slides interpreting the latest jobs reports. If you like the slides, please post a comment to let other readers know how you use them in your class.

Monday, May 3, 2010

GDP Data Show Continued Modest Growth

The advance GDP data for the first quarter of 2010 show continued moderate growth for the U.S. economy. The economy grew in the quarter at a 3.2 percent annual rate. Although slower than the 5.6 percent logged in Q4 2009, this was the third consecutive quarter of positive growth.

Consumer expenditure was the strongest driver of growth in the quarter. Private inventory accumulation, which turned positive for the first time since early 2008, also helped boost growth. Fixed investment was positive; a gain in its nonresidental component offset a slight fall in housing investment.

In the foreign sector, exports continued to grow, although less rapidly than in the previous quarter. Imports grew even more strongly, so net exports made a negative contribution to overall GDP growth. Government purchases grew slightly in absolute terms, but fell as a share of GDP, as stimulus spending winds down.

Overall, the report provides ground for cautious optimism. However, there are a few negative factors. One is the fact that consumer spending grew, in part, at the expense of saving, which fell to 3.0 percent of personal income. An increase in consumption at the expense of falling saving is not sustainable in the long run.

To download a free set of PowerPoint slides that presents the GDP data in a format you can use in your principles of economics course, follow this link. If you find the slides useful in your course, please post a comment!