Those poor New Classical Economists...

Fiscal stimulus works, and it works more than most economists and analysts give it credit for. Since the field of econ has slowly steered away from studying short-run effects, in favor of focusing on supposedly long-run topics, it seems have ignored the fact that fiscal stimulus works exactly like the neo-Keynesian model says it should. One can still credbly argue whether or not stimulus is worth it, but you can't argue it doesn't work. There are still a few prominent (mainly Chicago school?) new classical economists arguing that even short-run effects of tax cuts are negligible to non-existant; if reality doesn't change their minds, I don't know what will.

It seems like all those bogus and unrealistic assumptions about: perfectly "rational" people with "rational" expectations (people that take into account their entire life-cycle at all times when making decisions and are in the aggregate generally 'correct' about their expectations), costless information gathering, perfect inter-generational altruism, etc, ... are exactly that - bogus.

From Bloomberg (quotes)
Tax cut effect on income/GDP:
"The gain in income was almost five times larger than the median forecast of a 0.4 percent gain. Disposable income, or the money left over after taxes, surged 5.7 percent, the largest increase since May 1975. "

Tax cut effect on spending:
"Adjusted for inflation, spending rose 0.4 percent, the biggest gain since December [Holdiays] 2006. "

Having said that though, there is a 'kernal of truth' to ricardian equivalence and rational expectations. Tax cut effect on savings:
"Because the increase in spending was smaller than the gain in incomes, the savings rate jumped to 5 percent, the highest since March 1995, from 0.4 percent in April. " ... That's a huge jump in savings, but I would suspect that spending will continue to be higher than normal for the next few months because of the tax decrease - which will serve to depress the savings rate during that timeframe.

All in all though, it seems like all those bogus and unrealistic assumptions about: perfectly "rational" people with "rational" expectations (people that take into account their entire life-cycle at all times when making decisions and are in the aggregate generally 'correct' about their expectations), costless information gathering, perfect inter-generational altruism, etc, ... are exactly that - bogus.

Why am I all of a sudden agreeing with Mankiw....

First I was persuaded about the oil speculation topic, now I find myself agreeing with Mankiw about opening our immigration laws to allow more higher education seekers into our country.

I've spoken on this topic before, and have been advocating this for some time myself. Nothing is more important in terms of long run growth than education and the knowledge and positive network effects and externalities that can flow from that.

I would actually go farther. I understand the need to limit immigration to some degree, but in my opinion, foreigners that want to come to our country to pursue high degrees (Masters or above) should be given an automatic and speedy path to citizenship (providing the individual agrees to stay in the United States X number of years), in addition to the instant access to a green card.

Oil Speculation - debunked?

Thanks to Mankiw for this.
Both Paul Krugman and Alan Reynolds (and Mike Moffatt) don't believe oil specualation is significantly driving prices.

Last week I made the argument that it could be, in so far as more and more speculators enter the market (as perhaps measured by increasing volume of "buys" in the oil futures markets).

I also noted that perhaps speculation itself was feeding global demand (inventories etc).

But I think the empirical data presented particularly by Alan Reynolds suggests otherwise.

So I concede the point. It's the fundamentals stupid.

Temporary Irrationality (re: craziness) Hits Home

Sticker shock at the pump, as I mentioned, I believe has caused a kind of temporary mass hysteria - with large corporations changing production plans, and people making rash decisions, like this one here via my hometown newspaper.

I'm confident the craziness will abate, but until then, it is kind of comical.

The mental image of using golf carts to save a few bucks on gas to drive on busy streets (in some cases) going 20 MPH and causing huge traffic jams and congestion is funny and really makes no sense to me whatsoever.

I drive a little Miata - not altogether unsafe car, but not the safest car in the world either due to its size. Imagine getting hit by a Ford F150 when you are in a golf cart.

The fact that it is even a debate is crazy.

A Sad Day for this World

I teach about Zimbabwe in my Intro To Macroeconomics class. We use it as a case study as to how corruption, out of control government spending, money printing and dictatorship can destroy the economy of a country.

It appears the continued collapse of the once relatively strong Southern African nation will only continue now thanks to Dictator (he's technically not one, but given how he operates his government he is one de facto) Robert Mugabe.

The fact that the U.S. and Britain and many of Zimbabwe's African neighbors have only paid lip service to the plight of the Zimbabwe people is nothing short of disgusting to me. The fact that major Western powers continue to waste lives, money and general resources in Iraq while failing to assist one iota the suffering Zimbabwe people who currently live with inflation in the hundreds of thousands and 80+% unemployment is proof positive that our notion of "priority" is backwards to say the least.

What is McCain (and Sen. Lindsey Graham) Thinking Pt. II

I know exactly the answer. Ok, I don't really, but I have an idea. The answer could be they aren't. They, like many, are making short-run irrational responses to the gas issue. Today on "Meet the Press," when asked why he (LG) himself has flip-flopped on the issue (he used to be against drilling off his State's shores, now he's for it). His response was that now he's for it because "gas is $4 a gallon." That just doesn't make sense to me. If he was against drilling a year ago when gas was $3.20 or whatever it was, does anyone honestly believe that now he's for it just because gas is a dollar or so give or take higher today? I seriously hope not ... Especially since drilling would not really increase supply for another 10 years out, and who knows what gas prices are going to be then. I think he, like perhaps some people and maybe some companies (GM? Ford?) are being a bit short-sighted and irrationally risk averse (more risk averse than they otherwise would/should be in the current economic climate) due to the negative psychological 'shock' that oil price spike, the recession, the wars, etc cause.

Obviously I have no hard evidence, but it seems to me the way things are going now, we could be creating something akin to the opposite of a bubble. With a bubble, irrational exuberance creates a boom, and then it bursts. What I think we are seeing now, is potential stagflation combined with all the other "bad" stuff going on globally causing an irrational malaise (beyond what you'd expect in a typical downturn) - a black hole that will only serve to further our economic downturn. Hopefully, and this is my belief - just like bubbles can burst, the malaise can and will be naturally "shocked" back into a sense of drive and relative risk seeking once people realize they are putting too much emphasis on gas prices etc.

Oil Speculation

Mike Moffatt doesn't necessarily think oil speculation is a substantial cause of price hikes (or rather that a ban on speculation would necessarily reduce prices).

My response:

Mike,
That logic makes sense to me, but couldn’t it also be that global demand issues (beyond futures markets) are confounding things a bit?

UPDATE: In fact, futures speculation, in so far as it increases the expectation of future price spikes of oil in the eyes of consumers might actually be a root cause of the increase in global demand now. If people expect prices to rise a lot in the future, and they use futures markets that they hear in the news to guage this, then we would expect demand for oil now to rise.

Also, could it further be that once you add ‘time’ into the mix, that prices temporarily rise at time t as speculation occurs, then as people sell back their futures as you suggest we would expect prices to fall, but by that time the seeds of a bubble have set in causing MORE speculators to enter the market at time t+1 meaning that prices actually appear to rise continually until such time that the bubble bursts. I think that is a pretty likely scenario.

For another more detailed and thoughtful explanation of how oil speculation may be feeding a longer-termed bubble, see econbrowsers thoughtful analysis.

What is McCain Thinking?

I'm not a huge fan of Obama's windfall profits tax idea by itself for much of the same reasons I don't like general Pigovian taxes on oil by themselves.

But, the idea, when viewed with the rest of Obama's energy proposals of investing in alternatives and increasing CAFE (all of which work to counteract the problem of oil dependency), looks to me like an ingenius way to sell a new tax / price increase to the American public. It's a bit more distortionary than a consumption tax since it would shift the burden to domestic oil prodcuers, but the tax itself is rather modest in the grand scheme of things. I'm still skeptical that it will all work out in the end, and unlike some of my econ friends, I am worried about "feeding the beast" in a time of war, etc.

Having said that, I like McCain's idea of offshore drilling much less. And I like the idea of incentivizing off shore drilling about as much as I like my teeth to be, well, drilled. Providing incentive against the environment sounds alot like GW Bush, and not a lot like the McCain I was rooting for in 2000. This is short-term thinking at its worst.

"McCain on Monday said incentives could possibly be provided for states that choose to permit exploration off their coasts, adding that "exploration is a step toward the longer-term goal."

Expect Food Prices to Shoot Up Even More

What with all the flooding, and news like this:

"Midwest floodwaters have killed five people, displaced 38,000 others and damaged $1 billion worth of crops in Iowa alone...."

... we can expect food prices to rise even more drastically than they have recently (which has been a lot).

I'm not the only one that thinks so apparently.

Stagflation: Negative Expectations Spiral?

Today we learned that inflation jumped by .6% in May, the largest jump in about 6 months.

We learned last week or so that unemployment and jobless claims spiked (unemployment grew month-to-month by the biggest amount in about 2 decades).

We also learned that the stimulus package had a significant effect on consumption last month.

But that news was not nearly as widely reported because of this reason.

But the news about how the stimulus was worsening our deficit was widely reported.

What does all this mean?:
rising unemployment, falling output, rising prices due to energy shortfalls?
Stagflation of course.

The potential stagflation is in my opinion more interesting than that of the 70s though because you have the demand-side problem of the housing crisis and the confounding factors of the
"war(s)" in Afghanistan and Iraq, and a political election pitting different ideas of how the government should intervene to aid the economy.

Should there be more stimulus, to whom should it go to, and in what ways will that worsen the inflation problem, and if it does worsen the inflation problem (while at the same time not being strong enough to positively affect output) can that lead to a decline in consumer confidence (especially since the only news we tend to hear about the economy is bad news) thereby further worsening the demand-side problem... and the spiral continues....

And what if the Iraq situation worsens, or what if Al Quadea emerges from Afghanistan, and what if, what if, what if??? I don't bring this up to set off an alarm or anything, I simply bring it up to draw attention to the fact that there are so many different variables pulling in opposing directions and so many confounding ones now that it is impossible to really guage where we are at, let alone where our economy will be a year from now.

"Deadweight Loss" Needs to Die - Necessity vs. Wants

An arugment often cited for taxes (and sometimes cited by pigovian and gas tax advocates) goes like:

"Since the demand for GOOD X is inelastic, a tax on GOOD X is a good way to raise revenue because it does not lead to much of a deadweight loss."

The above statement is true. And if we take a look at the market for oil/gas, where both supply and demand are arguable very inelastic, we can see that the deadweight loss for a feasible tax increase could be quite small (as would any effect on output much to the shagrin of gas tax advocates). The benefit it is argued is the large amount of revenue the government can collect on the tax.

Maybe. But it's important to keep in mind, beyond the fact that government may not always be the best steward of our money (Iraq War ahem), that "small" deadweight loss is the net loss to consumer and producer surplus due to an action, and those concepts are something made up - by economists (so this is cause for concern).

Let's just foucs on consumer surplus for this purpose. What is consumer surplus? Well it is basically a made up concept that attempts to guage consumer well being. Applying our inelastic situation above to the concept is a way for economists to say, "this tax would not hurt consumers much, and the government would get huge revenues. " All seems to be ideal right? Wrong. Consumer surplus is determined by individuals' demand for a good at a given price, which is determined by individuals' utility, which is deterimined by consumer preferences, which is determined by the world we live in.

The problem with using deadweight loss and consumer surplus etc. as measures of wellbeing is the world we live in and how people perceive the world and its products.

In this world, gasoline is in the set of all consumption possiblities of a person's utility function. (That's econ speak for people value gas). Ok there. In this world, people have a prefernce for gas over other goods (ie, consumers can rank gasoline relative to all other things in their brain). Given this, we can get an idea of what persons' demand for gasoline may look like at given price points. People really value gasoline over and above many other types of goods and services because for most people in a modern society, it is a vital and necessary consumption that is largely unavoidable (if not completely so in the short-run). This in turns means the demand for gasoline is largely inelastic such that as the price of it goes up (via a tax for example), people will still consume a large amount of it.

The problem is in the philosophical understanding of the ideas of "value" and "welfare".

Value and welfare are determined by the world we live in, which is useful since economics typically assumes (as supply and demand does via preferences) that the world is one static moment in time and has therefore one equilibrium and that equilibrium is optimal. That is useful as far as constructs and some analysis goes, but it fails when talking about policy in many instances, since policy has to measure "value" as not just representing the welfare at a given point in time and for a given static set of preferences, but it has to measure value as something whereby welfare may change over time and preferences may change over time.

Most important though is that economists' measures of value and welfare are simply based on the fact that people have "utility" for something. But policy makers have to deterimine WHY they get utility from it in the first place and whether or not the loss in utility in one group is greater or lesser than the gain in another. Economists, by the use of standard models, can't do that. This is actually a problem in how "utility" is measured. Utility is not happiness (which again is a useful but often misused assumption). Utility is just a measure of indistinguishible needs and wants. But these needs and wants can't easily (mathematically) be compared across people or situations.

What makes a thing valueable in the first place economists put no stock in (but perhaps should take a cue from psychologists and do so). In the case of gas/oil, policy has to measure the utility of something that in large part is determined by the utility of necessity and not the utility of want.

Proposal 1:
Someone that gains from something (via a tax cut for example) they HAVE to have or do is surely more well off than someone who gains the same economic measure of value from doing or having something they WANT to do. (ceteris paribus of course - if you are talking about a gas tax holiday - that's just stupid).

Proposal 2:
Someone that loses from a policy (like a tax hike) regarding something they HAVE to have or do is surely less well off than someone who gains the same economic measure of value from doing or having something they WANT to do.

I think the above two proposals may be fairly common sense. The only reason consumer surplus doesn't fall much as the price of a good with inelastic demand rises is because the loss is just the difference in price (given be a tax or price rise) multiplied by half the loss in quantity demanded.

Whether or not gasoline is something we want or need is time-dependent (ie. dependent on preferences and needs of the day). And my sole assumption is therefore that gas is largely only valueable as a "need" based good at this time and will be for the forseeable future. It fits proposal 2 above.

Few would argue that people want to buy gasoline now (say for automobiles, to cook, to mow the lawn etc). Surely if it were just as cheap and useful people would prefer to use leftover trash to fuel their cars or perhaps gas of the methane variety, but the fact is, every day millions of people go to the pumps out of necessity. Unless you like to drink gasoline of course - which I don't think many do. Tax gas to a set price point, and while the direct consumer surplus may not fall by much, real consumer wellbeing surely would.

Herein lies a key difference between a tax on gasoline versus a tax say on cigarettes. Cigarettes are largely a utility of "want" not "necessity." Further, it has been deemed by medical professionals and the government to be an undesireable want. Therefore, it makes sense to tax cigarettes to reduce consumption, raise some revenue etc. The loss in real consumer wellbeing (a want or desire but not a need) is palpable but not on the same order in the long-run as addiction dies off. IE, absent a "need," the welfare loss of making something costly is not as great.

This is directly opposite of gas which may provide more or less revenue that could be shifted back to consumers (under a gazillion other assumptions) BUT would cause a direct harm because the fall in real consumer value would be great - the necessity would now be costlier.

Of course costly necessity items tend to also be regressive (hurt the poor more). This is another problem. A potentially bigger problem not talked about is that necessity items that become costly can have huge indirect costs. Again consider our gas tax vs. our cigarette tax examples. With a cigarette tax, few people are hurt other than cigarette manufacturers and smokers. Cigarettes aren't necessity items for production or consumption. But gasoline is a necessity item for consumption - meaning people will have to consume much the same amount and pay more for it - the costs of which are passed on to the family in terms of less income available to spend elsewhere (unless you rely on the government to give back revenues the right way, which I do not). The bigger effect here though is not on the consumption side, but on the supply side! Firms need gasoline to transport goods, to run factories. Oil is an input to many many types of goods in our economy. The ripple effect of higher gas/oil prices would be huge with respect to our production possibilities.

For all these reasons, typical textbook economics fails with regards to certain types of tax policy, and I believe the above shows how many economists may be applying partially unreliable models to some of today's most important tax policy discussions.

Evidence that People are Over-reacting to Gas Prices.

...or is the media hyping something that really isn't there. It seems to me more and more that people's expectations of gas prices are grossly out of whack with reality, and that individuals and corporations that make decisions based on these potentially misguided expectations are going to be in for a rude awakening. But I don't think people are going to drive less in droves, and (perhaps after hysteria of price expectations dies down) I don't think people are going to want to sell their luxury SUV's in the middle of a recession in order to buy a SMART car.

Cigarettes: The Right Kind of Pigovian Taxation

http://www.indystar.com/apps/pbcs.dll/article?AID=/20080603/LOCAL18/806030373

As I talk about in my last blog post, it would be fool-hardy to attribute the entire 18% decline in cigarette sales to the increase in the tax, but unlike with gasoline, the tax surely did have a large effect. As the article mentions, the last time the tax was increased for cigarettes, we saw a similar decline in sales.

GM making the right move?

Of course I don't know. There are many factors companies usually consider when deciding to close factories. But I was struck when listening to GM's announcement the other day, and when listening to NPR's description of that announcement, as a decision by GM to close 4 of its truck manufacturing plants in the US due to slowing sales largely if not entirely due to gas prices.

As someone who does not believe that gas price fluctuations in the ranges the US is seeing is a determining factor in a person's decision to buy a car versus a truck or a reduction in gas consumption to any significant level, I am skeptical of GM's decision and NPR's discussion of it. The discussion and indeed GM's own spokespeople talk about how the sales of their larger vehicles have declined by some 27% from last years level in large part due to escalating gas prices. I would hope that the decision to close the plants was not made on that judgement. Sales and indeed the amount of gas demanded is not very responsive to price changes in the short-run, and in my opinion, the long-run as well.

The fact that GM's sales have declined so much this year and that gas prices have risen is a correlation not a causation. Lot's of things have happened in the past year that are far more likely to have significant impacts on sales of GM trucks, namely: the recession, rational or irrational (but temporary) expectations about the future trend of gas prices, the housing crises, etc. just to name a few. The fact that gas has risen from $3 to $4 seems like a minuscule and insignificant cause for the sales decline when compared to the above stated more serious concerns.

I hope (and assume) that GM made its long-term business decision based on the obvious fact that their sales have not just fallen dramatically this year, but have actually been weakening for the past number of years - largely due to the en vogue "green" movement and due to shifts in consumer preferences, NOT due to gas prices.