Macro: people vs. institutions

I hope Paul Krugman isn't talking about me when he writes:

The macroeconomics [centrist dodge] looks like this: a concerned writer or speaker on economics bemoans the state of the field and argues that what we really need are macroeconomists who are willing to approach the subject with an open mind and change their views if the evidence doesn’t support their model. He or she concludes by scolding the macroeconomics profession in general, which is a nice safe thing to do – but requires deliberately ignoring the real nature of the problem.

I don't want to be arrogant enough to think that people are noticing a small-time blogger such as myself, but...perhaps one of those "concerned writers" is me? I did say this, after all:

The root problem here is that macroeconomics seems to have no commonly agreed-upon criteria for falsification of hypotheses...So as things stand, macro is mostly a "science" without falsification. In other words, it is barely a science at all. Microeconomists know this. The educated public knows this. And that is why the prestige of the macro field is falling. The solution is for macroeconomists to A) admit their ignorance more often (see this Mankiw article and this Cochrane article for good examples of how to do this), and B) search for better ways to falsify macro theories in a convincing way.

Look, here I am praising John Cochrane, neoclassical stalwart and fire-breathing political conservative, for saying macroeconomists are ignorant! I'm executing a "centrist dodge", right?

Well, no, I don't think I am. It's all about people vs. institutions.

Krugman writes that good macro evidence exists, and that the reason some people have refused to accept it is because they are political conservatives:

[I]t’s not hard to find open-minded macroeconomists willing to respond to the evidence. These days, they’re called Keynesians and/or saltwater macroeconomists...But then there’s the other side – freshwater, equilibrium, more or less classical macro...rather than questioning its premises, that side of the field essentially turned its back on evidence, calibrating its models rather than testing them, and refusing even to teach alternative views. 

So there’s the trouble with macro: it’s basically political, and it’s mainly – not entirely, but mainly – coming from one side.

This seems to me to be pretty much true. Some economists are politically conservative. They don't like government intervention in the economy, so they want to reject "Keynesian" or "saltwater" theory, which says that government has a constructive role to play in stabilizing business cycles. So they want to believe in other models, models where business cycles are driven by things like technology shocks or government policy or "Great Vacations". Unfortunately, those "neoclassical" models have a very hard time getting prices to go down when a big recession hits. And they have a very hard time getting interest rates to stay low even though the Fed prints a bunch of money. So conservative economists basically tend to ignore the behavior of prices and interest rates during episodes like the current one.

So I think Krugman is right. Most of what looks an awful lot like willful ignorance of the evidence generated by the current crisis seems to come from political conservatives. Meanwhile, other macroeconomists have shown a lot of willingness to change their mind about the world since 2008.

BUT, I think Krugman fails to address a bigger question: How did things get this way? How did neoclassical macro become the mainstream in the first place? One answer is that it's all down to money - departments like Chicago, Washington University, and Minnesota, according to this argument, were funded by people with politically conservative views, and these institutions basically became political propaganda mouthpieces.

I don't know how much truth there is to that. There are certainly instances of conservatives providing funding to a department known for its outspoken political conservatism - take, for instance, George Mason University, whose econ department is heavily funded by the Koch brothers. And I know that Washington University macroeconomists get paid nearly twice what their counterparts at places like Michigan get paid (it's a pretty sweet gig!). So I don't discount the possibility, I guess.

But conservatives do not fund the Nobel Prize committee. Rich donors did not pressure a bunch of Swedish guys into giving big gold medals to Edward Prescott and Robert Lucas, the fathers of neoclassical macro. Nor do shadowy conservative gazillionaires own the AER or the JPE or the QJE. Journal editors' arms are not being twisted into publishing models based on technology shocks.

Instead, I think what happened was that the neoclassical people made an argument that sounded convincing at the time (the 70s and 80s), and the field bought it. And the field bought it because there are just no agreed-upon ways to falsify or support macro theories with data. This is not to say there exist no such ways. Data was not kind to Prescott's 1982 RBC model. But that was not considered sufficient grounds for the profession to reject the RBC idea. Macro is just not a profession where people say things like "Hey, inflation goes down in most recessions, this RBC thing can't be right!" It's a profession where people say things like "RBC is telling an interesting story that doesn't seem to explain the Great Depression, but seems like it could explain the stagflation of the 70s, but more importantly it developed a methodology that we all now want to use (DSGE), so let's give it a Nobel Prize."

And that, I think, is the bigger problem. Macro doesn't just have a bunch of conservative people running around being conservative. It also has broken institutions. Without a firm commitment to rejecting wrong theories, and without agreed-upon standards for doing so, it's very hard to overcome the politics. Sure, you can get a gang of liberal-minded people together and try to push back against the conservatives, but in the end the best you can hope for is a bitterly divided profession, resulting in a massive loss of prestige in the eyes of microeconomists and of the educated public. Which is exactly what we have now. It's not liberals' fault, there's just not much they can do to fix the situation.

If the data does not speak, bad ideas will persist. And without the proper institutions, the data will not be allowed to speak.

I found a Bizarro Economics World!

I have located a Bizarro Economics World. It is entire subculture in which people discuss economic issues, ideas, and policy. But it appears to be entirely cut off from the economics profession, the econ blogosphere, and undergraduate economics programs. Really. It exists. And the things that people in this Bizarro Economics World believe are really...bizzare!

I will now give you an insight into the BEW. Steve Randy Waldman recently wrote a post about the redistributive effects of inflation. It was pretty standard, Econ 101 stuff. Inflation redistributes wealth from nominal savers to nominal borrowers, etc. Nothing controversial, from the standpoint of any economics department or blog. I don't think even Marxists would argue.

But here is a forum thread from the "Market Ticket Forums" - which appears to be a finance forum - discussing Steve's post. I will excerpt some of the forum posts below.

User JStanley01, from San Antonio, Texas, writes:

Who is this jack wad?...That's one of the closest things to pure evil, masquerading as "economics," that I've ever read. The statists who rationalize the Nanny State nowadays, having been grafted onto the same Marxist roots, are way slicker than the Commies ever were in their heyday. And IMHCO in the long run, more dangerous. Much more... 

Somehow the destruction of the country's capital base via such bullshit isn't factored into this f*****'s [(Waldman's)] computer model. 

The thought that a few elite "brainiacs" can supplant the operation of the price mechanism by the free market, which is the product of the collective brainpower of EVERYONE who buys and sells is EVIL.

Original poster Mayorquimby writes:

They are full of shit and their silence cannot come soon enough... 

The benefit of hyperinflation is that these people are silenced for another 75 years.
The downside is that so is everyone else... 

You guys should know that [Waldman] was invited to the Treasury to meet with Geithner along with Yves [Smith] and couple of other bloggers a few years ago.

User Widgeon writes:

gov is trying to "pick winners" by keeping prices (and wages) high(er) some sectors while attacking prices & wages elsewhere. That does indeed set up a vicious dynamic; but the root cause is gov picking winners & losers.

And user Mrbill writes:

Mindbogglingly stupid. Just have the government provide everything, then you don't even need prices!! Gimme a Nobel!!... 

Never read [Waldman's] blog. He's into Nominal GDP like it's a god, not much different from MMT and their accounting identity worship.

"The destruction of the country's capital base"??? What does that even mean? Hyperinflation? Really? And how is NGDP targeting a form of "picking winners"??? Charitably speaking, these people do not seem to be informed by mainstream economics discourse. Uncharitably, they are nuttier than a Whole Foods trail mix bulk bin.

Now, if it were just a few fools on a forum, I would dismiss it. I'd even dismiss an entire forum full of fools (look at the rest of the threads on the site and you'll see what I mean). But I swear I've seen similar ideas popping up everywhere - in my facebook feed, in casual conversations, elsewhere on the net. And all of these people say the same things. Hyperinflation is just around the corner. Paper money is a Ponzi scheme. The Fed is evil, etc.

And the thing is, these Bizarro Economics Worlders seem to really like talking about economics. They have a lot of opinions and ideas on the matter. They are very convinced of the authoritativeness and correctness of these ideas. And they assert them incredibly strongly and frequently.

Who the heck are these people? I know some mainstream economists (Steve Williamson) who think that montetary policy basically can't stabilize the economy, and who worry about inflation. I know of people who say that we worry too much about unemployment and not enough about inflation (Narayana Kocherlakota, Charles Plosser). I know of models in which monetary policy only causes inflation (RBC).

But I don't know anyone who disagrees with the idea that unexpected inflation redistributes wealth from nominal savers to nominal borrowers. That is just obvious to any economist. But these Bizarro Economics World people seem to think that this assertion is somehow an endorsement of industrial policy, central planning, etc.

It is really bizarre. I have never seen anything like it. Not even Marxists are this weird.

Is there a secret cabal of Dark Economists out there, providing these people with their talking points? From what intellectual source do the Bizarro ideas emanate? Where is the pulsating pit of extra-dimensional energy that sends forth its tendrils into our reality, creating the Bizarro Economics World?

Help me, Normal Econ Blogosphere. I am really confused.

"Science" without falsification is no science

Simon Wren-Lewis notes that although plenty of new macroeconomics has been added in response to the recent crisis/depression, nothing has been thrown out:

Because although the crisis has added material, nothing has really been thrown away as a consequence of what has happened. We have not, either individually or collectively, decided that the Great Recession implies that some chunk of what we used to teach is clearly wrong and should be jettisoned as a result.

He goes on to say that this is a good thing, because undergrad macro is all Keynesian, and the crisis has proved Keynesianism right. But - setting aside the debate over whether Keynesianism is right or not - undergrad macro is really beside the point when it comes to the state of economics as a science. The frontier of economic research and thought is the academic journals.

And I'm pretty sure that Wren-Lewis' statement that "nothing has really been thrown away" applies to the journals too. Four years after a huge deflationary shock with no apparent shock to technology, asset-pricing papers and labor search papers and international finance papers and even some business-cycle papers continue to use models in which business cycles are driven by technology shocks. No theory seems to have been thrown out. And these are young economists writing these papers, so it's not a generational effect.

The rest of the profession seems to be aware of this fact. Diane Coyle writes:

[M]acroeconomists simply do not realise how low their stock has sunk in the eyes of their microeconomist colleagues. When popular critics attack ‘economics’, they mean macro. It’s bringing us into disrepute, we fear. Although macroeconomists will insist that there are known scientific facts, they do not appear to agree on what these are.

If smart people don't agree, it may because they are waiting for new evidence or because they don't understand each other's math. But if enough time passes and people are still having the same arguments they had a hundred years ago - as is exactly the case in macro today - then we have to conclude that very little is being accomplished in the field. The creation of new theories does not represent scientific progress until it is matched by the rejection of failed alternative theories.

The root problem here is that macroeconomics seems to have no commonly agreed-upon criteria for falsification of hypotheses. Time-series data - in other words, watching history go by and trying to pick out recurring patterns - does not seem to be persuasive enough to kill any existing theory. Nobody seems to believe in cross-country regressions. And there are basically no macro experiments.

I can think of two exceptions to this. Both involve central bank policy. The first is Paul Samuelson's claim that a Phillips Curve represents a static menu of policy options for the Fed. The second is Milton Friedman's claim that the Fed could control the growth rate of M1. Most or all macroeconomists seem to regard these two claims as having been proven false. What happened in both cases was that a famous economist recommended a policy and gave specific predictions for the outcome, the policy was then explicitly tried by the Fed, and the outcome wasn't what was predicted. In other words, the Fed helped the field by carrying out an experiment on the whole economy. Obviously we can't do that sort of thing for every macro paper that comes out in the AER.

So as things stand, macro is mostly a "science" without falsification. In other words, it is barely a science at all. Microeconomists know this. The educated public knows this. And that is why the prestige of the macro field is falling. The solution is for macroeconomists to A) admit their ignorance more often (see this Mankiw article and this Cochrane article for good examples of how to do this), and B) search for better ways to falsify macro theories in a convincing way.

iPhone Apps for Insurance Companies

Over the last year mobile applications for smart phones have begun to pop up amongst the different insurance companies that Fey Insurance represents. It started with Travelers and Progressive and has expanded into Safeco, Chubb and now Cincinnati Insurance Company. The applications all allow you to view your current policies and auto ID cards. They help give you contact information to report claims as well as advice on what to do during a claim. Some of the applications actually allow you to report the claim directly from the mobile device.

So how do you get your insurance carriers mobile application? First go to your most recent insurance policy declaration page for either your home or auto insurance. Double check which company you have. Once you know which company you have your insurance with then pull up the applications icon on your iPhone. In the search box type the company name. Once you have located the insurance company's application be sure to download it to your device. Some of the applications will allow you to setup your account right in the app but others may require that you first go to the insurance companies website and create a login.

When you are all finished creating a log in you are then set to use the app and have your personal insurance information handy at any time. Each app also has a button you can press to give us a call directly for more detailed assistance. Try it out today.

Why did the finance industry get so big? (guest post by Dan Murphy)

Dan Murphy is a fellow graduate student here at the University of Michigan, and will be going out on the job market next year. We were having a discussion about why the finance industry might have gotten so large in the U.S. in recent decades, and he decided to write up his thoughts on the subject, so here they are!

***

In an earlier post Noah solicited possible explanations for the increasing share of value added of the finance sector over the past half century, and especially the rapid increase in the 2000s.  I thought I’d throw a few ideas into the conversation.

To understand why the share of income received by finance has increased, it is first important to discuss how finance adds value and generates income.  I can think of three primary services that financial institutions provide:

1) Making Markets:  Financial institutions often act as a marketplace, matching buyers with sellers.  In return for this service the institutions charge a fee, and this fee is counted as their value added.  This function of financial institutions can be compared to the function of a farmers’ market that provides a centralized meeting place for farmers to trade their produce.  A group of people organize the market (find the location, provide tents and porta-pottys, etc), and in exchange the market organizers are paid a percentage of every transaction that takes place.  The organizers have an incentive to promote trade because their income is growing in the volume of transactions.  In the U.S. economy, financial institutions are the market organizers, and their income grows with the volume of transactions (GDP).  For example, credit card companies facilitate our purchases, and they earn a fee every time we buy something with a credit card.

2) Managing Risk:  This is really a specific subset of the first category, but it is an important enough function to warrant further discussion.  Financial institutions manage counterparty risk, and in exchange they are paid a fee (often referred to as a “haircut”).  More concretely, consider a wheat farmer (let’s name him Fred) who observes that the current price of a barrel of wheat is $10.  At that price he is willing to plant enough seeds for X barrels of wheat.  The problem for Fred is that the price of wheat may fall by the time of harvest, in which case he will wish that he hadn’t put in so much effort planting wheat.  Financial institutions can solve this problem for Fred by promising to purchase wheat from him for just under $10 at the time of the harvest.  Fred is willing to accept the slightly lower price in exchange for price certainty.

Meanwhile, consider a baker (let’s name him Ben) who purchases wheat to bake bread.  He can sell a loaf of bread for $5, and his profits from the sale depend on how much he must pay for the wheat.  Ben is happy when the price of wheat falls, and he very unhappy when its price increases.  Therefore he is willing to pay a small fee to guarantee that he will be able to purchase wheat for around $10 a barrel for the next year. Financial institutions help Ben by promising to sell him a barrel of wheat after a given amount of time for just over $10.  In doing so, they offset their risk exposure to their contract with Fred through their contract with Ben, and in the process they earn a fee.

3) Investment Intermediaries:  Financial institutions manage investments for clients and offer advice (on investing, planning for retirement, etc).  Many savers are willing to pay for these services because they a) believe that financiers have expertise that will earn them a higher return on their savings, and b) because they need an intermediary to help them purchase assets (if I want to buy gold (I don’t), presumably I’d ask a financial institution for help rather than walking around with cash and a wheelbarrow).

Borrowers pay financial institutions to help match them with willing lenders.  Often this takes the form of duration transformation, in which finance companies borrow from short-term savers to lend to borrowers over a long time horizon.  For example, financial institutions help cities issue long-term municipal bonds to pay for roads and schools.

Now that we’ve laid out some of the basic functions of the finance industry, let’s see if we can find a reason that its value added should increase so drastically.

Making Markets:  Based on our example above, it appears that the value added of making a market is in “greasing the wheels” of trade in goods and services.  If this is true the value added of financial institutions should grow in proportion to the growth of output (trade), holding constant the cost of greasing the wheels.  Of course the costs of facilitating trade have likely decreased over the past half decade.  Consider credit cards:  You may purchase the same amount of groceries as you did twenty years ago, but since your now use a debit card instead of a check, the cost to your bank of facilitating that purchase is much lower.  Could such cost-cutting increase the profit share of the finance industry?  If the banking services industry is noncompetitive, then perhaps, but even in this case it’s difficult to explain such a drastic increase, especially between 2000 and 2007.

Managing Risk: One reason that the value of risk management could grow more than the aggregate value in the economy is that as the economy grows, there is more risk to hedge.  For example, as aggregate income grows, consumers want to insure against more events in their lives (life insurance, for example).  Our ancient ancestors’ income was so low that it was all spent on food.  Since all adults spent their time hunting and gathering just enough to feed their own families, there were no “financiers” available to help people insure against a wolf killing the head of the household.  Contemporary Americans can produce food at much lower cost, and thus we can devote labor resources to managing insurance contracts.  But people have been able to insure against a range of events in their lives (floods, fires, death, etc) for decades, so I can’t imagine that an increase in demand for life insurance can fully account for the increase in the value of the finance industry.  It is true that firm-level risk has increased through the 80s and 90s (Diego Comin has done extensive research on this topic), and this increase in risk could correspond to higher demand for insurance.  But again, the acceleration in finance’s value added share in 2000 did not correspond to acceleration in idiosyncratic risk.

Investment Intermediaries:  Here I think is our answer for the rapid increase in the observed value added of the finance industry around 2000.  My guess is that the average person believes that financiers have superior knowledge of investing, and that this superior knowledge will earn them higher returns on their savings.  There are two primary effects that increase the computed share of value added attributed to the finance industry:  Fist, when returns are high, as had been the case in housing and stock markets until the recession, retail investors (and even pension funds) are less concerned about the fees they pay to fund managers (my wife didn’t know she paid fees, she just sees how much money is in her account, and if it’s more than the last time she looked, she’s happy.  I hear that some pension funds operate under similar rules of thumb).  If I give you $10, and you return me $20, I’m not overly concerned with the fact that you could have returned me $25 but instead kept $5 for yourself.  You tell me that you are special, and that you earned it, and I am happy enough that I just doubled my net worth that I don’t think twice, especially when other supposedly talented fund managers are also charging high fees.  This effect will be exacerbated when cash and bonds offer low returns while other assets (stocks, housing) offer sky-high returns because investors are even more likely to believe that the fund managers were special enough to earn higher returns than those offered by the savings account at the local credit union.

Note that this explanation does not require that we specify why returns for some assets are higher than others.  But I will simply suggest that if investors seek high yields by investing with managers who hold an appreciating asset (perhaps housing), that behavior could contribute to a price bubble and increase the share of value added attributed to the finance industry.  Interestingly, finance’s share of value added grew disproportionately along with the price of housing leading up to the recession in 2008 and fell during the recession.

Of course the high fees paid to financial intermediaries raise the following question:  Why has competition among financiers not prevented high fees from increasing their share of the returns to asset price appreciation?  In other words, if you reap a massive profit by charging me $5 to manage my money, why does someone else not offer to charge me $4?  One reason may be that you are Goldman Sachs, and you have established a reputation that you are worth the $5 (regardless of whether this is true). Since I don’t know the “true” value that your service adds, I simply assume that you are worth the $5.

Similar phenomena occur in other markets.  For example, I bought basketball shoes last week, and because I haven’t bought shoes in ages I have no idea which brand is the highest quality.  Nikes were $30 more expensive than what appeared to be a similar shoe from another brand.  Since Nike has established in my feeble mind a reputation for making quality basketball shoes (through advertising perhaps), I forked over the extra $30.

I have not had the opportunity to purchase services from Goldman Sachs (my piddly graduate student stipend essentially becomes cash temporarily stored under my mattress).  But I imagine that if I did have reason to do so, especially before the financial crisis, I might be willing to pay their exorbitant fees, especially if they are selling the opportunity to make money.  If Nike sells me the chance to dunk, I will gladly buy even if some Nike employee gets to dunk ten times as much.  Likewise, if Goldman sells me the opportunity to make more money at the cost of some money, I will buy even if doing so allows them to makes lots of money as well.

So yes, I do believe that some of the rising value of the finance industry is in its ability to efficiently facilitate trade and manage risk.  But another reason, which I would attribute to the acceleration in the growth of finance’s value added and profit shares around 2000, is likely due to the financiers’ ability to sell their services, an ability that grows in strength when certain assets are appreciating because investors are willing to pay to hold appreciating assets.  If this appreciation is due to technological improvements, as in the 90s, then investors are, over time, benefiting from the financial services, even if at a high price.   But if the appreciation is due to a bubble, or to expected economic growth that does not materialize, then the incomes in the finance industry will increase without a corresponding increase in aggregate income, translating into a rapid rise in the finance industry’s observed share of value added.  

I think Stephen Gordon gets trade wrong

Stephen Gordon writes about trade in the Globe and Mail:

[T]he [Canadian] Conservatives are selling trade agreements with the European Union and India...as a way of increasing Canadian exports. 

[But t]he real benefit to international trade is the opportunity to obtain goods more cheaply than by producing them domestically. The proper way to view exports is as a cost: in an ideal world, foreigners would provide us with an infinite amount of imports for free.

It seems to me that this is misleading and incomplete. Here's why.

The "ideal world", in which foreigners provide us with infinite free imports, is impossible. In the real world, imports must always be paid for, either today or tomorrow. We pay for them with exports - either current exports or future exports. But pay we must.

Suppose I increase imports by one dollar today without increasing exports. Am I better off? According to Gordon, yes I am. But in reality it is not clear. Because the way I pay for that dollar of imports - since I don't export anything in return - is with a financial asset. I give one dollar of stocks, or bonds, or real estate, or collectible trading cards, to the foreigner who gave me the dollar of imports. 

The foreigner now holds a claim on my future output. Someday I must give the foreigner some real good, in order to pay back my debt. And the foreigner will charge me some interest, so I end up exporting more tomorrow than I imported today. 

Do I come out ahead or behind? It depends on the amount of interest, and on how much I value future consumption vs. present consumption. If I value future consumption very highly, and if the interest rate is very high, I should boost exports today, rather than imports. Yes, as Gordon says, these exports are a cost; but they are an investment, not a loss. This difference makes all the difference. It is perfectly reasonable to want to boost exports if you care a lot about the future.

OK, so that's the first point. Here's the second. Gordon says "The real benefit to international trade is the opportunity to obtain goods more cheaply than by producing them domestically." But that is not the only benefit of trade, even in the simple Ricardian model. Trade also allows countries to specialize in what they do best; some of the increased consumption from trade comes from increased domestic production, not from imports. In some cases, this effect can dominate. (Also, just to nitpick, in a less simple model of trade - Krugman's New Trade theory - trade doesn't just decrease price, it increases variety.)

So to say that the gains from trade come from cheap imports and not from increased domestic production is also misleading. A lot of the gains from trade come from increased domestic production. And exports are a way of getting future imports. The Canadian Conservatives are not, in this one case at least, misleading the Canadian people. And I think Stephen Gordon is oversimplifying the case for trade in a way that - I am guessing - is unlikely to resonate with Canadian voters.

Libertarians and the security state

Conor Friedersdorf and I couldn't find that much to disagree about in my first ever Bloggingheads diavlog. But we did manage to get some debate going when it came to libertarians and politics.

Basically, my argument was that, by vastly overemphasizing taxes and regulation as threats to liberty, the american libertarian movement allied itself politically with the conservative movement; the conservatives then created the Security State, which is now by far the greatest threat to liberty in America. Thus, libertarians ended up working against liberty.

Conor's points are that A) Obama has mostly maintained the Security State (true), and B) the actual Libertarian Party is not allied with conservatives (a bit beside the point).

Anyway, we mostly agreed on everything, including higher education.

On being a liberal economics blogger

To tribe or not to tribe? That is the question.

I don't get much of a kick out of being an iconoclast. It does not make me feel smug or special or superior to "buck my own team" - to disagree or argue with people who agree with me most of the time. Neither do I feel any particular need to be a "maverick" or a "sensible centrist", or to burnish my moderate credentials with "Sister Souljah moments". I do not crave invitations to Beltway cocktail parties reserved for journalists who cry "a pox on both houses". I don't like cocktails, and I only know the Beltway is a highway because I just Googled it.

In fact, it's nice to have a team. When the sneering RBC loyalists or ravening libertarian hordes show up in my comment threads to tell me what a crappy economist and crappy person and moron I am, it is nice to see them get jumped by an army of left-leaning commenters. It's nice to think that my decidedly anti-status-quo ideas about much of economics (especially macro) are going to win instant sympathy among those who think that the currently dominant paradigm produces too much inequality and unfairness.

I'm a "liberal economics blogger". I guess. Meaning A) I'm a liberal, and B) I'm an economics blogger. But also meaning that I stick up for Paul Krugman, and that I spend a lot of my time on this blog criticizing the dominant paradigm in economics, which currently is a conservative paradigm.

And yet sometimes I come out and say things like "internal devaluation can work over the long term". Or that we would benefit by admitting more high-skilled immigrants (Isn't that a supply-side measure? Aren't supply-side measures something the conservative team is supposed to like?). Or say "carbon taxes won't work". Or pat libertarians on the back for talking about public goods. Or admit that I really have no idea if fiscal stimulus is worth the cost.

This inevitably makes my "team" kind of mad. I get comments saying "Noah, what you don't realize is that the Koch-funded neoliberal conspiracy is destroying our nation and if you don't spend every post calling out those corrupt plutocratic scumbags, you're part of the problem!!"

When I see comments like that, I do not smile to myself and think "Ho ho, look how moderate and sensible I am! If I'm getting criticized by both extremes, I must be doing something right!" I am not Joe Klein.

But yet I say those things anyway. Why? Because as nice as it is to have a team, I have a stronger and deeper allegiance, which is to science. And by "science" I basically mean rational skeptical empiricism. My dad raised me on these ideas; they're very important to me, and I believe they are the best. So if I think an idea makes sense, I'm going to say why. If I don't buy a theory, I'm going to say I don't buy it. I believe that only by being intellectually honest can we find the best answers and the best policies.

Now here you may cross your arms and say "Economics isn't a science! Hrmph!" But if so, you're missing the point, which is that it can be a science and (according to Noah Smith's value system) it should be a science, and when it's not a science that's bad.

In fact, I think that politicization is a big problem - maybe the big problem - with economics. People believe theories not because the evidence solidly supports those theories, but because the policy implications support the goals of their tribe. Some people like RBC models not because they look out the window and see technology shocks, but because RBC models say that small government is good. Some people disbelieve in externalities just because they think the First Welfare Theorem will reduce their tax bill. Some people believe in the signaling model of education because they think college turns young people into communists. And so on. The list of top economists who publicly subscribe to standard Republican narratives of reality is long, long, long.

I get the sense that this is true on the "left" as well. Some people seem to (mistakenly) think of Keynesian stimulus as a kind of welfare-based redistribution scheme - or just as something involving government that conservatives hate, and therefore good. Some people consider immigration to be a globalist neoliberal plot, simply because it'll adversely impact their own relative wages.

In fact, it is increasingly clear to me that the vast majority of people in the world, including the vast majority of smart people and educated people and well-informed people, subscribe to tribal "knowledge" over actual knowledge.

Whatever. I can't jump on that boat. It would be nice to have an army at my back, but I can never betray science. My ideas may be wrong, or I may misapprehend the evidence, and that's fine - I try never to be too certain that I'm right. But I just can't bring myself to misrepresent my honest intellectual thought on a science-related topic just to appease the folks who are supposed to be on my "team".

I mean, come on, people. Why do you think "conservative economics" went off the rails in the first place? Was it because it was conservative, and conservatism is bad and liberalism is good? Many people are probably nodding their heads. Well, maybe that's why. But my money is on another explanation. I think that when economists who were conservative became "conservative economists" - when they let  their normative ideas guide their positive ideas - they allowed themselves to stop going by the evidence. And that diluted the quality of their theories, which is why there is such ample low-hanging fruit for liberal criticism of economics in this day and age.

I'm not going to do that. I like having a gang, but science has got to come first. If that gets me some angry comments, so be it. As Feynman said: "If we take everything into account, not only what the ancients knew, but all of what we know today that they didn't know, then I think we must frankly admit that we do not know. But in admitting this, we have probably found the open channel."

America, Land of the Nerds!

I have a new article over at the Atlantic, co-written with Adam Ozimek of Modeled Behavior. It's all about high-skilled immigration (or "HSI", as we like to call it); basically, we need lots lots lots more of it.

This has been a big deal in the news lately, with Fareed Zakaria doing a whole show about it, and lots of think tanks producing reports like this one. Adam and I thought we had some new thoughts to add to the mix, and we wanted to re-frame the issue as well. In particular, we wanted A) to depict high-skilled immigration as one of America's  key advantages throughout history, and B) to point out how high-skilled immigrants help the situation of working-class Americans (and hence, liberals should be rushing to admit more HSI).

Here's the patriotic bit:

From the very beginning, the United States has enjoyed a unique advantage held by almost no other country on the planet: the ability to attract and retain a huge number of the world's best and brightest. Before independence, for example, America was the beneficiary of perhaps the most elite immigrant group in history. Millions of Scots, who constituted much of the intellectual and technological elite of the British Empire, left Great Britain to seek religious freedom and better economic opportunities in the 13 Colonies. Many of the Founding Fathers, including Jefferson and Hamilton, were partly or wholly descended from that Scottish wave, as were many of America's greatest early inventors, such as Thomas Edison. 

Other bursts of "HSI" have proven no less of a windfall. Two waves of Jewish immigrants, one in the early 1900s and another fleeing the Nazis, yielded a multitude of scientists and entrepreneurs. In the late 20th Century, a wave of immigration from Taiwan did the same, giving us (for example) the man who revolutionized AIDS treatment (David Ho), as well as the founders of YouTube, Zappos, Yahoo, and Nvidia. In fact, immigrants or the children of immigrants have founded or co-founded nearly every legendary American technology company, including Google, Intel, Facebook, and of course Apple (you knew that Steve Jobs' father was named Abdulfattah Jandali, right?)... 

Our most enduring strength - the thing that sets us apart and ahead - has always been that we are the country where the world's best want to live. In return for the chance to live here, immigrants have time and again helped our nation to maintain its pole position among the nations of the Earth.

And here's the part about the working class:

[T]here is an economic benefit from HSI that should be particularly enticing to liberals: High-skilled immigration works against inequality. 

Nowadays, the talk is all about "the 1 percent," top executives, and the finance industry. But equally important is the divergence of America's middle class that occurred in the 1980s. As returns to education skyrocketed, an educated upper middle class pulled away from a medium-skilled lower middle class. The disparity stopped increasing after the 80s, but it has never gone away. 

HSI will fight this trend. Boosting the supply of high-skilled workers makes low- and mid-skilled workers proportionately more scarce, increasing their relative incomes. Economist Enrico Moretti finds that earnings of a high school graduate increase 7% for every 10% increase in the percent of people in a city that are college graduates. While having more high-skilled workers around tends to raise everyone's salaries, Moretti's research shows that low-skilled workers benefit four to five times more than college graduates. Even as liberals work to find a way to counteract the problem of the 1 percent, they should view HSI as a step toward turning America back into a true middle-class society.

We also try to name-and-shame Senator Chuck Grassley (R-IA) as one of the people doing the most to hold back a needed reform of HSI policy.

Anyway, go read the whole article! There's plenty more there. Up with HSI!!

College is mostly about human capital, not signaling

Human capital formation, Stanford style

This is not an area I know a lot about, but I have some thoughts.

Some people think college is about signaling, not about building human capital. I'd say most economists believe this. But what exactly do they think is being signaled?

Intelligence? No, that doesn't make sense. It's way too easy to tell who's smart. To signal general intelligence, all you need to do is take some tests - AP tests and SAT 2's if you're trying to signal moderate intelligence, International Math Olympiad if you're trying to signal exceptional mathematical intelligence, and so on. You don't need 4 years at an elite school to show you can do some math problems or memorize some stuff.

In fact, in Japan, most employment decisions are based on exactly this sort of signal. High school students who want good careers spend all of high school studying for some really long college entrance exams, and employers basically pick the students who get the best scores on these exams. Yes, colleges also make their decisions based on those same exams. But Japanese college basically provides zero additional signal, because A) Japanese college kids do very little work, and B) Japanese employers don't even look at college grades. Whatever Japanese people's reason is for going to college, it isn't for signaling intelligence. No reason America should be any different.

So what else could people be signaling at college? The ability to do hard work in the face of massive leisure temptation? I actually think this is a reasonably big deal, especially in the U.S. If college performance is a signal, it's a signal of people's desire to study when they could be partying. (Update: Here's a signaling defender who agrees.)

But this doesn't explain Japan. In Japan, college students do mostly party. In fact, that is what you are supposed to do at college, especially at a top school like Tokyo University. It is encouraged. Fun fact: Many Japanese people call college "moratorium". As in, a moratorium on work.

Now, this could indicate that college is actually about consumption. Well, to some degree, it is; college is fun. But people tend to smooth consumption, and college is all concentrated at one time, so it doesn't make sense that college would be mostly about consumption.

This leaves human capital. Economists (including at least one in my PhD graduating class) have often tried to show that college doesn't produce useful skills. But I think that this is missing the point; useful skills, which you mostly learn on the job, are not the only valuable form of human capital. There are three extremely important forms of human capital that you can't acquire on the job:

1) Motivation,

2) Perspective, and

3) Human networks.

These, I believe, are the types of capital that college is designed to build, both in Japan and in the United States.

First, motivation. Motivation is widely recognized as the scarce quantity, or "limiting reagent" in an individual's human capital. This is the source of all those annoying motivational poster slogans. "Attitude is everything". "Your attitude determines your altitude". Or as Calvin Coolidge said:

Nothing in the world can take the place of Persistence. Talent will not; nothing is more common than unsuccessful men with talent. Genius will not; unrewarded genius is almost a proverb. Education will not; the world is full of educated derelicts.

These sayings are cheesy and annoying, but they are true; skills mean nothing if you don't have a reason to put them to work. Everyone knows that the biggest long-term threats to the career of any scientist or engineer are "burnout" and clinical depression. In poor countries, the threat of poverty provides ample incentive for hard work, but in rich countries - i.e., the countries where most smart people go to college - motivation is a more ephemeral thing.

What motivates smart people in rich countries? Here is where I start to conjecture, but my bet is: Human relationships. Friends and family. We work hard for other people. When we're young, we work because our parents want us to work. When we leave the nest, however, we need to find other relationships to motivate us. I can't tell you the number of people I've seen who excelled in high school under the watchful gaze of a Tiger Mom, only to lose much of their motivation once Mom was no longer looking over their shoulder (I can, however, tell you the name of one such person: Noah Smith).

To replace Mom, young adults need to form new relationships. Close friends. Romantic partners, and eventually a spouse (which in turn leads to kids, another motivator). But it is very difficult to form these relationships fast (which you need to do in order to start a career fast) without sacrificing quality; if you're just randomly searching, it takes a long time to find friends and a lover who really click with you, especially if you're a smart person who clicks best with other smart people.

This is where college comes in. College is an intense incubator where smart people meet other smart people. The large number of leisure activities and the close quarters in which people live facilitate the formation of friendships and romantic relationships, while the exclusiveness of college makes sure that the people you're meeting are pre-screened to be the type of people with whom you are most likely to click. In the U.S., the "college experience" includes parties, trips, clubs, athletic events, religious fellowships, communal drug use, study groups, endless late-night conversations, and more esoteric events like the one pictured above. In Japan, it includes "go-kon" (group blind date) parties, "nomikai" (pub nights), and clubs. American college works better, but it's much the same sort of thing.

The friendships and (especially) romantic relationships people form in college are a great motivator. That is an incredible boost to human capital.

Second, there is "perspective". This is about learning the set of possibilities for life. Before I went to college, I never knew people who went into the finance industry, or joined tech startups, or worked for the World Bank, or did sound engineering for movies, or taught English in foreign countries. In college I met people who did all of the above, and seeing them taught me a lot about the set of possibilities for human life. Simply knowing one's career choice set is a hugely important part of choosing the right career. And it's surprisingly hard to do. College is a great way to gain career and life perspective; if you go from high school straight to the workforce, you are basically assured of not meeting as diverse a group of high achievers.

That is part of human capital. It's much more important in America than in Japan (where careers are less differentiated and people switch careers only rarely). But it is very important. And it is more important for poor people, who grow up mostly seeing other poor people.

Finally, there are the human networks built by college. I won't talk a lot about this, because other people have done so quite a lot, and there are a bunch of scientific papers about it. And it's pretty obvious, just from looking at MBA programs, which cost more than college and are well known to be all about professional networking. (Note: As a commenter points out, this is actually called "social capital".)

All three of these types of human capital have to do with bringing people together. It is not something that can be built online. It is not something that can be built on one's own, or in high school. There is a reason why college is called "college", meaning "gathering".

So anyway, I don't want to drag this on too long, and I've made the basic points. College is useless as a mechanism for signaling intelligence. It's probably somewhat useful for signaling the ability to work hard and resist temptation, at least in the U.S. where many colleges require hard work (but not in Japan). It is about consumption, but it's too concentrated in time to be mostly about consumption. College is really about human capital, of the kind not conveyed in classes - motivation, perspective, and networking. Rather than a hideously, inefficiently expensive signaling mechanism, college is an ingenious technology for building the kinds of human capital that are scarce among smart people in rich countries.

Robot Barro?

Robert Barro is the third most cited economist in the world. He's the true inventor of "Ricardian" Equivalence, to which he was too humble to attach his own name. He's also the creator of the "rare events" theory of asset pricing, which I personally believe to be an epic win for finance theory. Most consider it inevitable that he will be awarded a Nobel Prize.

And yet today when I read Robert Barro's editorial in the Wall Street Journal (hat tip Greg Mankiw), I found myself significantly underwhelmed.

Most of Dr. Barro's column is dedicated to showing that our economy is recovering much more slowly than it should. This is fine, I guess; it's the same thing everyone else is saying. It would have been nice to see Barro at least acknowledge the possibility that the GDP "trend" is not a law of the universe. He could have given a nod to Greg Mankiw's "unit root" hypothesis (which holds that shocks to GDP are permanent). But all in all, I'm not going to argue with the idea that our recovery could and should be faster.

I have more problems with Barro's diagnosis of what ails us. Basically - you guessed it - it's "Obama's socialist policies", as documented by - you guessed it - Casey Mulligan:

What's interfering with a real recovery? Perhaps the Obama administration should stop casting blame elsewhere and examine the policies it has implemented to ease the pain of recession and falling housing prices... 

Consider the expansion of social-safety-net programs, including food stamps, unemployment insurance, Medicaid (prospectively) and housing and mortgage programs. In a study published last month by the National Bureau of Economic Research, University of Chicago economist Casey Mulligan observed that, because these programs were means-tested (falling or ending as income rises), expanding them raised the effective marginal tax rate on labor income. 

Specifically, Mr. Mulligan estimates that the effective marginal tax rate for low-income households went from around 40% in 2007, before the recession started, to about 48% in 2009, at the start of the recovery. Thus, while these programs may be attractive from the standpoint of assisting poor families, they dilute incentives to work.

Hmm. Really? I guess this might be right. So, with unemployment insurance ending right now, we should see a big, sudden rise in employment and GDP growth as these de-motivated people go get jobs, right? And we should expect to see the growth bump happen first in places where unemployment insurance ends earlier, right?

Let me know how that one works out, Casey.

After relying on the dubious hypotheses of C. Mulligan to diagnose the slow recovery, Barro offers his prescription (and it is here where I really become annoyed):

To achieve a real recovery, government policy should focus on individual incentives to work, produce and invest. Central here are tax rates and regulations, including especially clarity about future policies. In a successful policy package, the government would get its fiscal house in order and make meaningful long-term reforms to entitlement programs and the tax structure.

So, basically, the recommendation is "the exact same bunch of policies that Republicans have been pushing on America without pause since the days when people listened to 8-track tapes." Cut taxes, cut spending, deregulate. Cut taxes, cut spending, deregulate. Cut taxes, cut spending, deregulate. Cut taxes, cut spending, deregulate. We get it!

So now it's time for me to haul out all the old counterarguments to the standard Republican program. First of all, there's the obvious question: What happens when we've cut all the taxes and spending and deregulated all the regulations, and we happen to have another recession? What do we do then? Throw up our hands?

Then there's the historical point: Bush cut taxes and deregulated back in the early 2000s, and that didn't exactly do wonders for the economy. That can't have escaped notice, can it?

Then there's the fact that real government spending per capita is no higher than at the end of the 2009 recession. And the fact that the countries that have recovered quickly from the recession (South Korea!) have not cut taxes, cut spending, or deregulated. And the fact that fiscal austerity has not done wonders for any of the countries that have tried it since 2009.

And so on, and so forth. All of these points have been made before and will be made again. Because the advocates of "cut taxes, cut spending, deregulate" never seem to waver. They simply march ahead, blaring the message from the pages of the Wall Street Journal editorial page with all the self-doubt of an army of robots.

I mean, I like "individual incentives to work, produce, and invest". That sounds awesome to me; sign me up. Incentives rule. I just have an incredibly hard time believing that the things that are disincentivizing us from working, producing, and investing are taxes and regulation. There has got to be a lot more to the story! And what's more, it seems to me that recession-fighting policy should be something in addition to stuff we should do 365 days a year, 10 years a decade.

The thing is, Robert Barro is a really, really smart guy. He can come up with something better than the same old Republican chestnuts. Or does he think that sort of thing is needed to balance out Paul Krugman's constant calls for stimulus, in a Hegelian, dialectical, "I don't totally buy this but I'm going to say it to cancel out the guy on the other side" sort of way?

Economic theory that actually works

Economic theorists have worked hard to lower expectations for their field. The standard line (originally due, I think, to Keynes?) is that, unlike a science like biology that can be applied to the real world, economic theory merely gives people a way to think about complex issues in an intellectually disciplined, rigorous manner. One subtext is that economic theory need not be subjected to the rigors of the scientific method; that theory need not match data, and that the criterion for judging a theory a success should basically be that other economists think the theory is cool. Another implication is that the study of economic theory need not ever be justified by the present or future creation of useful technologies. In other words, it doesn't have to be right or useful, only interesting.

In a recent interview, game theorist Ariel Rubinstein says this of his own field:

Is game theory useful in a concrete sense or not? Game theory is an area of economics that has enjoyed fantastic public relations...I think it’s a very tempting idea for people, that they can take something simple and apply it to situations that are very complicated, like the economic crisis or nuclear deterrence. But this is an illusion...I don’t respect the claims that [game theory] has direct applications... 

Game theory is about a collection of fables. Are fables useful or not? In some sense, you can say that they are useful, because good fables can give you some new insight into the world and allow you to think about a situation differently. But fables are not useful in the sense of giving you advice about what to do tomorrow, or how to reach an agreement between the West and Iran. The same is true about game theory... 

In general, I would say there were too many claims made by game theoreticians about its relevance. Every book of game theory starts with “Game theory is very relevant to everything that you can imagine, and probably many things that you can’t imagine.” In my opinion that’s just a marketing device... 

[We do game theory] because it is interesting...I believe that intellectual thinking – philosophy or logic or game theory – is very useful in the cultural sense. It’s part of the culture, it’s a part of our perpetual attempt to understand ourselves better and understand the way that we think. What I’m opposing is the approach that says, in a practical situation, “OK, there are some very clever game theoreticians in the world, let’s ask them what to do.” I have not seen, in all my life, a single example where a game theorist could give advice, based on the theory, which was more useful than that of the layman... 

I categorically cannot see any case where game theory could be helpful.

Naturally, this opens the economics field to the obvious criticism of "Well, fine and good, but then why do we pay econ theory professors so much more than literature professors?" (That, as you might expect, is not a question that many economic theorists are eager to bring up in conversation.)

But here - surprise! - is where I come to game theory's defense. Rubenstein seems to be talking about the national defense applications of game theory, which were much-ballyhooed in the Cold War but (I agree with Rubinstein) were pretty heavily oversold. Yet, although I am not a game theorist, I believe I know of some very useful real-world technological applications of game theory that have nothing to do with nuclear deterrence.

I'm talking about auction theory. Auction theory describes a situation where the sequence of moves is known, and the payoffs are (close to) constant - i.e., just the kind of situation where game theory allows concrete predictions. And lo and behold, auction theory is used to power the internet's most successful advertising technology: Google's AdWords. Everyone except Google has had trouble making money off Web advertising (look at Facebook), but with the help of auction theory, Google has built one of America's most profitable technology businesses.

That's real technology based on economic theory. It's really just one subset of mechanism design, which (people tell me) is the hottest sub-field of game theory right now. Mechanism is deep, pure economics - it's the science of incentives. And because there are real situations in which incentives are observable and well-defined, you can use mechanism design to predict and control the outcomes of certain kinds of transactions and interactions. That's applied economic technology, just as surely as your smartphone is applied computer science technology.

So why do we pay all these theorists all this money? Are a few auction applications really such a big deal? To this I respond: There may be big payoffs in the future. If economists can use theory to understand the business cycle, then this may lead to technologies that allow companies to anticipate and prepare for downturns, as well as - even more importantly! - government policy technologies that allow the government to prevent or effectively fight recessions. That would be a huge prize. In fact, many people believed (and some still believe) that the development of monetarist/New Keynesian/demand-based macro theory in the mid to late 20th Century has dramatically improved central banks' ability to fight recessions. If so, then that is a very important economic technology. But maybe we can do a lot better than that.

One obvious question raised by this post is: Why is there essentially no game theory in macroeconomics?...

Update: Speak of the devil. I'm now watching Gunter Strobl of the NY Fed UNC Chapel Hill present a model that uses game theory (with adverse selection and moral hazard) to explain liquidity cycles. Not sure how well the model works yet, but glad to see people doing this sort of thing...

Update 2: I am now watching Marcus Opp of Berkeley add I/O-style game theory to a macro model to show how oligopolistic competition could amplify business cycles. Love it. Not sure why Opp doesn't follow Rotemberg & Woodford (1992) and use AD shocks (he uses RBC-style productivity shocks). I do like that the model uses inelastic labor supply.

New Ohio State Wide Texting Law

On June 1st Ohio Gov. John Kasich signed into law a state wide texting while driving ban. The law will go into force in 90 days from June 1st. This new law has tougher restrictions on those under 18. If you are under 18 you are not allowed to use a cell phone at all in a car when you are driving, hands free or not. Those over 18 are still allowed to make phone calls on their phones and are allowed to use the phone to dial while driving. They are just not allowed to send or read texts while driving. Also, for those under 18 the phone use law is a first offense meaning if a police officer sees a person under 18 using a phone while driving they can be pulled over and ticketed just for that offense. Those over 18 can only be ticketed for texting while driving if they were also pulled over for another violation such as speeding, running a red light, etc.

The law is a misdemeanor for drivers with fines up to $150. If you are under 18 you’re first offense could be $150 fine with a 60 day license suspension. A second offense for those under 18 is $300.

Carbon taxes won't work. Here's what will.

Or, "In which I am regrettably forced to heartlessly massacre the entire Pigou Club, of which my advisor has just declared himself a member." (Actually, this was the original title of the post, but I realized it wouldn't fit in a Mark Thoma link bullet, so...)

It fills me with great sadness to write this post, since I think that global warming is a huge threat, that economists should think more about externalities, that Pigovian taxes in general are a great idea, and that most of the people in the Pigou Club are intelligent, well-meaning, insightful, civic-minded folk, i.e. exactly the type of folks we need more of in this country. But I can no longer in good conscience stop myself from making the following argument:

Carbon taxes are not going to work.

Instead of one simple overwhelming reason for thinking this, I have a number of reasons that all pile themselves into a mountain of evidence. In no particular order, here they are.

1. Carbon taxes are politically infeasible in the U.S. A few people have tried to introduce carbon tax bills. There has been essentially no interest. This may be because there is no concentrated special-interest constituency for carbon taxes (the Pigou Club notwithstanding), or because politicians instinctively realize the existence of some of the other reasons I'm going to cite. Also note that the more well-known, Obama-supported "cap-and-trade" idea also went nowhere fast.

I cited this reason first because it's the weakest; political infeasibility should not stop economists and other intellectuals from recommending the right policy.

2. Global carbon taxes present a basically insoluble coordination problem. The U.S. emits about 1/6 of global carbon emissions. Cut U.S. emissions by 30% (a huge cut) and you cut global emissions by 5%; not enough to make a dent in global warming. Now realize that China, which now emits about 1/4 of global carbon emissions, has now twice scuttled international efforts to coordinate a reduction in carbon emissions (first at Copenhagen and then at Durban). How about Europe and Japan and Russia and Canada? Well, they agreed to carbon restrictions at Kyoto, and then promptly broke their quotas and went right on increasing their emissions.

Coordination problems are really really hard.

3. Carbon taxes are undermined by free trade. If you put a tax on carbon-emitting activity in the U.S., it'll raise the domestic price of (for example) coal. This will provide an incentive for U.S. coal miners to export their coal to other countries, especially China, as they are now trying to do. It will also provide an incentive for Americans to buy more imports from countries where it is still cheap to burn coal (e.g. China). In other words, if you tax the burning of American coal by American companies, you will increase the burning of American coal by Chinese companies, and the de facto burning of Chinese coal by American consumers. These effects will not completely cancel out the effect of a U.S. carbon tax, but they will work against it substantially. The only way to stop this would be to tax both carbon exports and the implied carbon content of imports. This would lead to big rises in tariffs.

It is hard to imagine the Pigou Club, most of whose members support free trade, uniting around the import/export tariffs needed to make a U.S. carbon tax work.

(Addendum: And you know what the U.S. can't tax? Cheap-carbon Chinese-made products replacing expensive-carbon U.S.-made products in global markets.)

4. The economic costs of carbon taxes are very hard to estimate. Pigovian taxes work by balancing the benefit of the tax with the costs. The cost of a carbon tax is the economic activity that is curtailed by the tax. But this is very hard to measure. Taxing carbon would tax driving, which would make commuting much harder for a lot of the Americans who have chosen to live in suburbs. A big carbon tax could conceivably make those suburbs economically unviable, through agglomeration effects, requiring much of the country to completely overhaul its physical infrastructure. Those agglomeration effects are very hard to predict, and might be very large. And I almost never see economists thinking about agglomeration, urban, or spatial effects or taking them into account.

Now I must admit that this reason is slightly disingenuous, since I think the benefits of higher density are massively unappreciated, and that it would be a good thing for us to dismantle much of the far-flung exurbs and replace them with walkable neighborhoods accessible by public transit. But I think that once the members of the Pigou Club start seriously thinking about the infrastructure costs associated with taxing driving, they will be less sure of their case.

5. Carbon taxes can be revoked in the future. When it comes to global warming, what matters is the total amount of carbon in the atmosphere, not the rate of emissions. Carbon stays in the atmosphere for anywhere from decades to centuries, and maybe even a lot longer than that. If a carbon tax passes at a time when the harm is relatively small, but is revoked as soon as fossil fuel prices go up (due to increasing extraction costs, i.e. "peak oil" and "peak coal"), the total effect of the carbon tax will be close to zero. And I think there is ample evidence that carbon taxes would be revoked as soon as voters started feeling pain at the pump, since "cut gas taxes" is the first thing you hear politicians saying when gas prices go up.

6. A little bit of emissions reduction is barely better than none at all. As mentioned in the previous point, carbon stays in the atmosphere a long time. What this means is that to work, carbon taxes have to reduce emissions a lot; for you nerds out there, the benefit of emissions reductions is highly convex in the amount of reduction. When it comes to carbon, a little bit of reduction is essentially no better than none at all.

And I think the previous 4 reasons are sufficient to show that a U.S. carbon tax would only reduce global emissions by a little.

There you have it: no single deal-breaker, but an accumulated weight of reasons to think that a carbon tax won't have any significant impact on global warming. The Pigou Club is a good bunch and their idea is a good try, but it just won't be enough.

So what do we do? Throw our hands up in despair and hope that global warming won't be as bad as many fear? No. I think that there is something our government can do to make a huge dent in carbon emissions, in a relatively short time frame.

 The International Energy Agency reports that America's carbon dioxide emissions have fallen by 450 million tons in the past five years. That is a drop of about 7.5% - not a slowing in the growth of emissions, but an absolute decrease. It's a big, big drop. Bigger, in fact, than any other country experienced over the same time period.

What caused this huge drop? Natural gas. Because of the shale gas boom, America has been switching from coal power to gas power, and gas emits less carbon for a given amount of energy. Now, this is only a partial solution, since gas does emit carbon, and since there's not enough gas in the world for every country to make this shift. But what it shows is that when there is a low-carbon technology available that is cheaper than a high-carbon technology, an economy will rapidly switch to the low-carbon technology, and emissions will plummet quite rapidly. And this will happen without any sort of carbon tax, cap-and-trade-system, or other emissions-limiting policy.

So the way for the U.S. government to beat global warming is this: Subsidize research into low-carbon energy sources. For electricity generation, this essentially means solar power. Solar costs have been falling exponentially, and even without a method to store solar energy during the night, solar is already cheap enough (with not-very-large subsidies) to replace much of fossil fuel power during the daylight hours.

Government money for research and development will accelerate this process. This means both basic research (which the government, in particular the military, does far better than anybody) for breakthrough technologies, but even more importantly, it means subsidies for solar companies that make the minor, incremental improvements that add up over time, driving costs steadily down. These subsidies should be seen not as government acting as a venture capitalist - most of the supported companies will eventually fail - but as government subsidizing the kind of incremental research that is not best accomplished by Defense Department grants.

Research is a public good. The day that solar becomes cheaper than coal will be the day that China and India start mothballing their coal mines and throwing up solar factories. Yes, this means that the U.S. will be subsidizing the rest of the world. Yes, it means that cheap Chinese and Indian competition will put a lot of our own solar companies out of business (as it is doing already). But it is worth it. Since there exists no global government, the only hope of stopping global warming is for one national government to kill the problem all by itself. Saving the climate (and reducing energy costs in the process!) will be worth a whole lot of Solyndras.

So at this point some of you may be reading this and saying "Wait a second. Noah Smith wants us to ignore a policy (carbon taxes) that is supported both by clear, simple economic theory and by some of the most eminent economists in the world from both sides of the political spectrum, and instead throw heaps of taxpayers' money at a bunch of companies that we know are going to fail?" And I say: Yes. That is exactly what I want. That may sound crazy to you, but everyone is entitled to one or two crazy beliefs, aren't they?

Update: Miles points out that global warming is not the only reason to reduce fossil fuel use; it is also useful in reducing the price of oil that petrostates like Iran receive. That's a topic for another post, but I'm not sure spiking Iran's economy is worth the sacrifices it would take to unilaterally bring down the world oil price through a reduction in U.S. demand (besides, a petroleum tax would be more effective for this purpose than a general carbon tax). Miles does, however, say "I second [Noah] in advocating scientific research as the most effective way to address global warming." Yay!

Update 2: Via commenter Amy, here is a Daron Acemoglu working paper that basically says the same thing I'm saying in this post. Yay!

Update 3: In fact, there is a precedent for government doing exactly the kind of R&D effort that I'm advocating here. The technology? Fracking, which produced the current shale gas boom. The potential payoff for solar is ever greater than shale gas (since solar never runs out and produces zero carbon), so if there's any energy technology the government helps to improve, it should be solar.

How does this "fake GDP" work?

Actually, it's incredibly easy to create fake GDP. You simply scratch my back and charge me $10, and then I scratch your back and charge you $10. Repeat that 750 billion times, and you'll double the GDP of the United States. I'm dead serious. Expenditure and income will both go up by $15 trillion, all of it in the "back-scratching services" sector.

Just have fun paying the income tax. 

Really, the question is why you'd want to create fake GDP. If you got $10 in additional income, you probably wouldn't spend it on a back scratch you didn't want. Economists typically assume that the dollar transactions that go on in our economy represent exchanges of scarce resources - that people would prefer to spend their money on things they want rather than things they have no need for.

So I just do not understand why so many people keep on insisting that our GDP before the financial crisis was "fake". Here's Steve Pearlstein:

Indeed, there is a suspicion that at least some of the downturn [in the UK] is a statistical mirage caused by the necessary adjustment to wages and prices following the bursting of that financial bubble. If the financial sector never really added as much genuine value to the economy as was indicated from all those inflated salaries and bonuses, then at least some of the decline in GDP since then may merely reflect a healthy repricing of labor, financial assets and goods across the economy rather than a worrisome loss of output. Low inflation, slowly rising employment, little or no growth in measured productivity, household incomes and GDP — these are all consistent with that story of statistical mirage.

This via Tyler Cowen.

OK, I just don't get it. First of all, if all that has changed are prices, not quantities, that should show up in the price level, as measured by the GDP deflator. Maybe Pearlstein thinks the GDP deflator is mismeasured, and that Britain has actually been experiencing a deflationary boom? How would such a thing be possible, unless some sort of secret supply shock had actually given the British economy a big boost? Is the UK secretly doing better than ever?

(Answer: No it's not. Look at unemployment.)

Anyway, if the GDP deflator is not grossly mismeasured, then the contraction in the financial sector entails not just a fall in prices, but a fall in the quantity of financial services performed. Pearlstein seems to be saying that yes, this has happened, but that this is OK, because these vanished financial services had not been adding value equal to their price.

Which makes us ask: If these services were not worth the price, why were people paying for them? People could have taken the money that they spent on financial services and spent it on cars or video games or sandwiches instead, or left it to their kids. 

If you think that people were paying for useless crap before the crisis, then you must believe that people were tricked into throwing away their money on things they didn't need or want. Maybe that's true! Maybe people in a free market can be tricked en masse into flushing their income down a toilet. George Akerlof, for example, has spent a lot of time arguing that this is not just possible, but common.

But if you believe this, you believe that free markets are not always a great way of allocating resources. If people can be tricked to such a degree that the size of the trick makes the difference between a boom and a depression, well...that's one big trick! It would be a waste of resources as big as any war, except perpetrated by the invisible hand of markets instead of the visible hand of government. In other words, it would mean that free markets tend to fail, and fail massively.

So am I getting things wrong? Do Pearlstein and others mean something else when they claim that part of GDP is a "statistical illusion"? What is this "fake GDP" they speak of, and how does it work??