Five heterodox groups of economists who should be brought out from under the shadow of the orthodox economists who have no answers for financial crises

If you are as interested as I am in the fact that the most prestigious groups of economists were totally surprised by the recent financial meltdown, have no models or theory to explain it after the fact, and are continuing their virtual reality games as though nothing happened, you'll want to read this paper by Jamie Galbraith in the NEA Higher Education Journal. My summary:

While the two mainstream schools, Chicago (or freshwater or neoclassicists) vs. MIT (or saltwater or new Keynesians), have contended vigorously with each other over details, they remain united in a commitment to an all-encompassing theory expressed in mathematics.  They are in the same "gentlemen's club" in which nobody loses face for predicting things that don't happen, failing to predict things that do happen, or maintaining positions that outsiders can clearly see are goofy. Galbraith describes five heterodox groups that did predict the recent crisis and similar crises in the past and says we would be better off if they had more resources and influence.

The hoariest are the "American Marxists" who believe the economic system is fundamentally flawed by conflicting power relationships and that its eventual collapse will be triggered by one of several events (they don't all agree on the specific type) like a collapse in the dollar, accumulating current account deficits, overextension of debt in the financial system, etc. Since these economists are "habitual Cassandras" and are uninterested in policy adjustments for what they think is a unsalvageable system, it's hard to see how they are helpful, but they did predict the financial crisis.

Dean Baker and others have predicted asset bubbles by observing large deviations from their means of relationships such as P/E ratios, home ownership prices to rents, etc. Critics complain that it relies on the assumption that the chosen relationship will revert to a mean not because there is a theoretical reason why it should but only because it always did in the past. The lack of theory is troubling to other economists, but these folks were right about the financial crisis and have a methodology that predicts reasonably well the sizes of adjustments.

Another group in Cambridge (UK) and the Levy Economics Institute studies relationships in the National Income and Product Accounts (which generate GDP) and argue, with some theoretical underpinnings, that large increases or decreases in Consumption, Private Investment, Government Spending, or Net Exports must induce opposite changes in certain other accounts and that at some point these shifts are unsustainable and must reverse. They too were right about the financial crisis.

Hyman Minsky and his followers like Barkley Rosser and Ping Chen developed a theory that stability in markets breeds instability and that self-generated boom-bust cycles are inevitable unless government intervenes to prevent hedging, which normally morphs into speculation (the obvious need to refinance in the future), from passing into the Ponzi phase (where ever-increasing amounts will have to be refinanced). This group warned against the policies of Alan Greenspan and Larry Summers that not only facilitated but actively encouraged what was obvious Ponzi financing, and they predicted the financial crisis.

The economics of John Kenneth Galbraith in The New Industrial State (1967) sought to focus less on markets and more on institutions (big corporations, labor unions, governments, etc.) and how those institutions function internally and in relation to each other. The mainstream economists hated and marginalized it. Jamie Galbraith followed this tradition in The Predator State (2008), arguing that after about 1970 there was a withering of internal controls in corporations, less governmental oversight, and other pressures that led to managements running amok, often blindly. As several financial crises (S&L, Dot.com, Enron/Worldcom, Sub-prime) were autopsied, a lack of control and irresponsible behavior is at the center of all. Other economists studying these institutional dynamics have pointed out recurrent patterns not only of irresponsibility and chaos but of fraud and looting and warned of recurrences if the institutions were not reformed. This group also predicted the financial crisis.

Finally, Galbraith argues that the "gentlemen's club" must be circumvented by university administrators, foundations, students, and others outside the mainstream economics departments to create academic space and public visibility for these versions of economics.

The Copenhagen meeting on global climate change failed in part because economists’ blather about “efficiency” distracts from the real issues.

After the failure in Copenhagen to reach an agreement to save the planet, pundits are grappling with the question, "Now what?" Typical are this op ed by Joe Stiglitz and this post by Robert Stavins. I react below to Stiglitz's (perfectly mainstream) suggestion that we proceed by getting every nation to adopt the same "carbon price" (whether by taxes, tradeable permits, or otherwise), and he suggests $80 per ton of CO2. Essentially, I'm saying—for the nth time—that economists don't understand the real world.

In addition to the very real political problems, there is a very practical problem that I guess is too mundane and simple for the pundits, economists, and other policy experts to discuss: At no point in time can there be a single carbon price that makes sense for both coal and petroleum. A carbon price that will kill off coal entirely will make no noticeable dent in petroleum consumption, and we need to reduce both dramatically. Here's the arithmetic.

According to EPA (see Figure ES-6), combustion of fossil fuels in the electricity generation and transportation sectors accounted for 62% of all US CO2 emissions in 2006. (Industry was 19%, and agriculture, commercial and residential were all single digits.) Electricity generation is overwhelmingly a coal problem—accounting for 83% of CO2 emissions from this sector. A ton of typical steam coal contains about 1400 lbs. of carbon, which will turn into 5,133 lbs. (2.57 tons) of CO2. If CO2 is assessed at $80 per ton, the price of a ton of coal would increase by $205. Since the national average coal price was $31.26 in 2008 (EIA link), that price increase would cause electricity generators to close their coal-fired plants as soon as possible and switch to natural gas, renewables, and (maybe) nuclear.

In contrast, $80 per ton for CO2 would raise the price of gasoline by only $0.80 per gallon (a gallon of gasoline generates ~20 lbs. or 1/100 of a ton of CO2). Obviously, that won't discourage use of highway fuels very much even though it would cost $110 billion per year in the aggregate. (EIA says US gasoline consumption is 138 billion gallons per year.) That's almost $1,000 per family per year and almost as much as the AIG bailout, and there's no substantial benefit. According to CBO, even a CO2 price of $191 per ton would not significantly reduce US gasoline consumption, in the short term or the long term, leaving its current 28% contribution to CO2 emissions to continue unabated.

Economists are guilty of setting a "perfect" efficient market-based system at war with "pretty good" solutions for the CO2 emissions problems. The most affordable solution for petroleum is CAFÉ standards (but if we make them as stringent as we need to, we'll have too much refining capacity, not a congenial thought for those still in my former industry). The most affordable and politically possible way to deal with coal may be to buy the mines and turn them into parks because anything else that comes close to making coal uneconomical will result in massive, protracted litigation about compensation for a "regulatory taking." The whole legislative conversation about markets, offsets (preserving rain forests, etc.), and carbon capture and sequestration ("CCS") grows out of the fantasy that we can achieve adequate CO2 emissions reductions without shutting down all coal mines and closing many refineries. We can't. Deal with it.

A version of this post appears as a comment on Mark Thoma's blog here.

Update on Thursday, January 14, 2010 at 08:55AM by Skeptic

From my response to an email correspondent who asks about my calculation of 80 cents per gallon and finds it hard to believe that would not significantly reduce demand:

My 80 cents per gallon calculation is just $80/ton x the CO2 yield of one gallon of gasoline (20 lbs.).  I understand it is recommended that the carbon price be imposed as far upstream as possible for administrative reasons.  I assume that means it would be imposed on the production or importation of crude oil, and at that level $80/ton of CO2 would be about $30-35 per barrel.  If owners of crude oil at various stages have enough market power, they’ll try to pass through not only the carbon price but their additional inventory holding costs, but it’s also possible that the whole carbon price cannot be passed through and that producers will have to offset in the wellhead price some portion of the carbon price.  So how about 80 cents per gallon at the pump plus or minus 20 cents? 

Why would you find it hard to believe 80 cents a gallon would not have significant effect?  Crude oil prices reached $147 in July 2008 and gasoline consumption hardly wavered:  

Distillate volumes varied more because they are used in trucks and other businesses which are more sensitive to economic conditions than consumers. The Great Recession officially started in December 2007 and was depressing consumption even before the oil price peaked. 

But, you might argue, that’s just the short-term effect; when people understand gasoline will always cost 30% more than they’re used to, they’ll opt for more fuel efficient cars when it comes time to trade.  I agree.  But, according to OMB, existing CAFÉ standards are going to cause that result anyway.  The more fuel efficient cars and trucks will presumably cost more, and the gas hogs will presumably cost a lot more so manufacturers can ration them to make their CAFÉ numbers.  Adding artificially high motor fuel prices would presumably push people to choose the same more efficient new vehicles, but they will also be paying more to operate them (nearly $1,000 per year in my calculation).  Also, the prices of new fuel efficient passenger cars should be higher than in the CAFÉ-only scenario because people will want those vehicles more and the gas hogs less. 

I’m not actually opposed to a carbon price on petroleum products.  I’m only opposed to the belief that carbon prices of $50 or $100 or even $200 per ton of CO2 will dramatically reduce the amount of petroleum consumed.  I’ve been following this issue for about three years and have read stuff from lots of carbon price proponents and I’ve never seen any analysis with prices, vehicle miles traveled, MPG, etc. that predicts a big reduction in demand.  It’s all just arm-waving, which is the reason I wrote this post—to try to get policy grounded in some quantified costs and quantified benefits.  Further, squeezing coal out of the mix may INCREASE the demand for distillates, which can after all run gas turbines as well as natural gas.  Having the same CO2 price on petroleum as on coal might help mitigate that tendency, and that would be a reason to do it.  I think reducing US dependence on oil, especially imported oil, should be a priority—not to prevent global climate change but to put our balance of payments more in order and to reduce the vulnerability of our economy to big petroleum price spikes (which always cause recessions).  Reasonable people can disagree about that as a policy goal, but there’s a lot less room for a data-backed argument about the effectiveness of highway fuels prices to achieve that goal, imho. 

Update on Monday, January 18, 2010 at 11:54AM by Skeptic

Trucks and SUVs over 8,500 pounds gross weight including Hummer H-1 and H-2 (H-2 rated 10 mpg city and 14 mpg highway) and Ford Excursions (rated 8-10 mpg city and 12-14 mpg highway) have not been subject to CAFE standards, but the demand for them fell so much when fuel prices began to rise from $1.50 in 2003 to over $3.00 in 2007 that they have been dropped from Detroit's product lineup.  The vast majority of SUVs (including Hummer H-3, Ford Explorers and Expeditions, Cadillac Escalades, and Lincoln Navigators) have been subject to the light truck CAFÉ standards since 1979, and the standards were raised starting in 2004. But even before the CAFE increases could have much effect, there was a shift in buyer preference away from SUVs, toward passenger cars.  (The passenger car market share hit an all-time low of 45% in 2004 and has since climbed back to over 50%, according to CBO.) Therefore, it seems these changes in consumer preferences should be attributed to fuel price changes and only slightly, if at all, to CAFE standards. But the key question is how much these price changes, or additional increases from carbon pricing, will increase fleet fuel economy when consumers have fully reacted to them.

Obviously, increasing fuel prices have a much bigger impact on the  behavior of people who own gas hogs than they do on the owners of fuel efficient vehicles.  If you buy a lot of gas, a small price increase may make a big difference to you on a monthly or annual basis.  If you buy only a few hundred gallons per year, you may be relatively indifferent to price changes.  In other words, the more efficient your current vehicle is, the bigger gasoline price increase will likely be required to motivate you to switch to a more efficient vehicle. Assuming 12,000 miles per year, here's how MPG rating translates into gallons per year and declining impact of price increases with increasing MPG.  

MPG rating	Gallons per year	Annual fuel cost at $2.00 per gallon	Annual fuel cost at $3.00 per gallon	Annual cost increase caused by $1.00 price increase	Could save at $3.00 per gallon by substituting a vehicle that gets 10 MPG more
10	1200	$2,400	$3,600	$1,200	$1,800
20	600	$1,200	$1,800	$600	$600
30	400	$800	$1,200	$400	$300
40	300	$600	$900	$300	$180
50	240	$480	$720	$240	$120
60	200	$400	$600	$200

At 12,000 miles per year, the owner of a (discontinued) Ford Excursion will have to buy about 1,200 gallons of gasoline, whereas the owner of a Cadillac Escalade hybrid (rated 22 MPG) would only need to buy 545 gallons. At $3.00 per gallon, that's a difference of $1,965 per year; at $4.00 per gallon, $2,620 per year. Apparently, tens of thousands of buyers were influenced by economics like that, drying up the market for extreme gas hogs.  To take the next big fuel economy step would involve switching to something much smaller like the Ford Escape hybrid (rated 32 MPG). That would save an additional 170 gallons per year, $510 per year at $3.00 per gallon and $680 at $4.00 per gallon, which is only 26% of the savings of switching from the Excursion to the Escalade.

Going toward the bottom of the table, the owner of a Toyota Prius (rated 46 MPG) uses only 261 gallons of gasoline per year. If that owner switched to a plug-in auto that used no gasoline at all, his/her annual gasoline cost savings would be only $783 at $3.00 per gallon and $1,044 at $4.00 per gallon. In this price range, it's hard to see much incentive for a Prius owner to make that change unless the plug-in auto has identical or more desirable characteristics and is subsidized in some fashion. 

Notes:  The national average gasoline price spiked at over $4.00 per gallon in 2008 and is now $2.81, per EIA. The CBO economic and budget issue brief, Climate-Change Policy and CO2 Emissions from Passenger Vehicles is an excellent meta-analysis and summary of CAFE, carbon pricing, and gasoline price elasticity as they relate to passenger vehicle fuel consumption. EIA projects that the effects of growing population and vehicle fleet will just be offset by the mandated fuel economy of the new CAFE standards. Link. Thus, whether or not there is a cap/trade program or other carbon price mechanism, it appears there will be no reduction (or increase) in US use of petroleum over the next dozen years and that our contributions to GCC from petroleum use will also be stagnant. It's all about coal.

Update on Tuesday, February 9, 2010 at 09:18AM by Skeptic

Robert Stavins discusses some of the pending legislative and regulatory alternatives for addressing global climate change here.  Using the same basic insight about the relative impact of carbon pricing on coal and other fossil fuels, I posted the following comment on the Stavins piece on Economist' View. 

The closer we get to the real issues, the more interested I get in GCC legislation. Although showing promise, Stavins is still behind the curve in that regard.

There is probably no more important political fact than that carbon pricing is very bad for coal interests, nearly neutral for petroleum, and very good for natural gas. This results from starting by appeasing the god of economic efficiency with a system that generates a single price for all CO2 emissions regardless of source. That leads to the drama in Congress about trying to prevent the shuttering of the coal mining industry and write-off of coal-fired power plants (e.g., by making it possible to substitute “offsets” by “preserving” Amazon rain forests, etc.) and/or obscuring the attack on coal by assigning to the “market” responsibility for determining outcomes (so that elected representatives of the people can deny responsibility for lost livelihoods). A more realistic legislative approach might be to buy all the coal mines and turn them into wildlife preserves and soccer fields.

In support of the first sentence above, consider the following. According to CBO, a price of $191 per ton of CO2 would not reduce consumption of highway fuels at all below what they will be under existing CAFÉ standards. To see why this is so, consider how the $80/ton price recently proposed by Joseph Stiglitz would affect coal and gasoline. A ton of typical steam coal contains about 1400 lbs. of carbon, which will turn into 5,133 lbs. (2.57 tons) of CO2. If CO2 is assessed at $80 per ton, the price of a ton of coal would increase by $205. Since the national average coal price was $31.26 in 2008, that price increase would cause electricity generators to close their coal-fired plants as soon as possible and switch to natural gas, renewables, and (maybe) nuclear.

In contrast, $80 per ton for CO2 would raise the price of gasoline by only $0.80 per gallon (a gallon of gasoline generates ~20 lbs. or 1/100 of a ton of CO2). Obviously, that won't discourage use of highway fuels very much even though it would cost US consumers $110 billion per year in the aggregate. In the US, about 60% of petroleum is converted into gasoline; other major products are motor diesel, jet fuel, home heating oil, and a variety of industrial uses, none of which were addressed by the CBO report; however, I doubt a price increase of 20-30% in these fuels would dramatically reduce consumption of them either, but you use your own business judgment. Bottom line: a price of $80/ton of CO2 could cause an INCREASE in consumption of petroleum products as utilities switch from coal fired units to gas turbines (which were originally designed to burn petroleum distillates, not natural gas, in the stratosphere).

So why does the petroleum industry seem so upset by cap/trade? I suggest they are not really upset but are just routinely opposing and exploiting opportunity. They have a budget and team for federal government relations and will devote it to whatever issues on are on the table, which at the moment includes threatened government “interference” in their business—even if the “interference” might help their business. In contrast to this routine opposition, if you want to see what a petroleum industry full court press looks like, if you want to see the sky over DC darkened by corporate jets and the finance chairs of Senate re-election campaigns worked to exhaustion booking contributions, bring a repeal of the IRC oil depletion allowance close to a floor vote. Furthermore, it is routine in Washington to demand something of value in exchange for any legislative initiative that can be plausibly claimed to have an adverse effect on one's industry. This isn’t a crisis for the oil industry—it’s an opportunity.

From EPA’s most recent report on US contributions to global climate change, using 2006 data: CO2 accounts for 85% of total greenhouse gas emissions, 94% of which come from burning fossil fuels, and about 41% of that comes from coal. If petroleum consumption will not change substantially and natural gas consumption will increase, any aggregate net change must come from reducing coal consumption. Legislation that does not respond head-on to this reality may pave the way to re-election of incumbents but won’t ameliorate the GCC problem.

Will we bring back manufacturing or outsource innovation too?

Innovation must be located near manufacturing because so much of innovation is learning from and improving manufacturing, according to GE CEO Jeffrey Immelt on this CNBC forum, The Future of "Made in the USA." Others who understand the innovation process have made the same point. I think I first heard it about 30 years ago from Donald Firth after he left the UK's National Engineering Laboratory in Glasgow. This directly contradicts the naïve view that the US can be the global center of high-skill, high-pay "innovation" jobs and that it makes economic sense for low-skill routine manufacturing jobs to go to Asia. In reality, China can do everything the US can do to assemble the best and brightest in innovation centers, but increasingly only the Chinese can locate them near manufacturing centers.

During and after WWII, the US government provided numerous substantial financial incentives for innovation (favorable tax treatment, government contracts, grants to higher education, etc.), and the many resulting innovations created whole new industries and millions of jobs in the US. However, Government subsidies for innovation make much less sense now—and perhaps make no economic sense at all—because now the odds are that most of the jobs resulting from future US innovations will be created in Asia instead of here. This means that nations like China can get much more bang for their innovation subsidy bucks than can the US because a much higher proportion of the benefits will be in China.

Bad as that is, we're helping our competitor nations by educating more of their students and fewer of our own in America's best universities, and not many of them plan to stay here. Those who still believe the world sees the US as the land of opportunity should recalibrate. A survey of 1,224 foreign nationals from India, China, and Western Europe studying at U.S. universities and colleges - or who had graduated by the end of the 2008 academic year - primarily in engineering, business and economics, computer science and biological sciences, funded by the Ewing Marion Kaufman Foundation and reported here, found:

Just 7 percent of Chinese students and 25 percent of Indian students surveyed said the best days for the United States economy lie ahead.

Approximately 74 percent of Chinese students and 86 percent of Indian students said their home countries' economies will grow faster in the future than they have in the past decade.

Most foreign students said innovation will occur faster over the next 25 years in India and China than in the United States.

Some 76 percent of Chinese students and almost 84 percent of Indian students said it would be difficult to find a job in their field in the United States.

While 58 percent of Indian, 54 percent of Chinese and 40 percent of European students want to stay in the United States for a few years after graduation, only 6 percent of Indian students, 10 percent of Chinese students and 15 percent of European students said they wanted to remain permanently.

Circling back to Jeffrey Immelt, under his leadership GE has located its clean coal technology global innovation center in China. My advice to American teenagers who want to achieve big things in science or engineering: Become fluent in Mandarin and accept the idea of being part of privileged technocratic class in a politically oppressively and highly-polluted nation.

Update on Sunday, January 3, 2010 at 10:24AM by Skeptic

From this op ed by a distinguished chemistry professor at Brandeis University:

At many top schools, including my own, international students constitute from 30% to 70% of the doctoral candidates in math, physics and chemistry.

The situation might be tolerable, if embarrassing, were it not for recent changes in world economies and attitudes toward science and education. As a result of dramatically increased investment by other countries in science, the brain drain is not just slowing, it appears to be changing direction.

International students and post-docs are returning to their home countries in much greater numbers after reaping the benefits of an American education, and many who have worked for years at U.S. companies and universities are being lured home by offers of new labs, easy access to research funding and the comforts of their native culture.

UPDATE 1/5/10: As relative incomes, wealth, tax bases, and preparatory education systems in the US decline versus China, India, etc., financial pressures on US universities, especially state-supported universities, will lead to admission of an even higher proportion of foreign students. Current events at Berkeley:

The chancellor also decided to gradually increase Berkeley's out-of-state inrollment from 9.5 to twenty percent.  Out-of-state students pay more than triple the in-state fees, and the admissions measure would eventually generate an extra sixty million dollars for the campus--while, of course, reducing access for Californians.

UPDATE 7/15/10: The Los Angeles Times reports that Berkeley actually increased out-of-state enrollment to 22.6% and UCLA to 14.9% in this fall's entering classes, all very deliberately to offset decining State government subsidies. The less prestigious UC campuses have lower percentages of out-of-state and foreign students. 

Update on Sunday, January 3, 2010 at 11:58AM by Skeptic

Tyler Cowen exults that China, India, Indonesia, and Brazil have enjoyed a decade of very robust growth “while it’s questionable whether the decade as a whole has been good for Americans, economically speaking. Median wages have not risen much, if at all, and the costs of the financial crisis and irresponsible fiscal policies have become increasingly obvious.”  But that’s OK, he says, because the wealth and innovation of other nations will be good for America too, "if only for the longer run,” which he does not define. 

It might be pleasant to boast that America is — or should be — a world leader in every area, but the practical reality is that if some other country solves the problem of green energy, so much the better for us.

The subtler point is that a wealthier China, India, Brazil and Indonesia will lead to more customers for new innovations, thereby producing greater rewards for successful entrepreneurs, no matter where they live. There are so many improvements in cellphones these days because there are so many cellphone customers in so many countries.

To put it bluntly, if the United States takes one step back and the rest of the world takes two steps forward, even in purely selfish terms we should consider accepting the trade-off, if only for the longer run. Most of us gain from the wealth and creativity of other countries, even if we can’t always feel like the top dog.

Cowen implies that the benefits of innovation get distributed equally among trading partners and that, therefore, it doesn’t matter where innovations occur and that we can be a free rider on the investments of other nations. I’m pretty sure that’s not how those other nations intend to divide up the benefits. If America does not write for its future a script that does not depend for success on mere slogans like “education” and “innovation,” our future will be written for us by the Chinese.  Here’s a preview of what that could be like. 

Update on Wednesday, January 6, 2010 at 07:44AM by Skeptic

The new Google smart phone may have been innovated in Silicon Valley, but it will be entirely manufactured in and shipped from Taiwan, completely eliminating the American distribution/retail system, according to this LAT report:

In an ambitious bid to expand its reach even to consumers on the go, Google Inc. on Tuesday unveiled the widely anticipated Nexus One smart phone as it launched a bold new business model that could shake up the mobile phone industry.

The Internet giant began selling the phone -- manufactured to its specifications by a Taiwanese firm -- directly to consumers through its website rather than through retail outlets and service providers.

Update on Wednesday, January 6, 2010 at 10:35AM by Skeptic

This NYT story illustrates another way in which manufacturing is connected to innovation—venture capital.  Asian manufacturers are desperate to get in on the ground floor of innovations because stagnation would endanger their core manufacturing business.  (Once everybody in the world owns one of your gizmos, your business is finished unless you can replace all the gizmos with the next new thing.)  Therefore, they will outbid US venture capitalists for control of Silicon Valley innovators—i.e., they will take bigger risks and accept the potential of lower returns than the VCs. 

The investment arms of large Taiwanese and Chinese manufacturers have created an investment network in Silicon Valley operating under the radar that pumps money into a variety of chip, software and services companies to gain the latest technology. As a result, some Asian manufacturers have proved more willing than entrenched Silicon Valley venture capitalists to back some risky endeavors.

“In the past, the manufacturers would sneak around and get inside information on technology by investing in these companies,” said K. Bobby Chao, the managing partner at DFJ DragonFund China, a business that invests in technology companies in China and the United States. “Now, they’re more involved, more visible and charging after more complex maneuvers.”

. . . .

Asian investments in Silicon Valley present some risks for America’s top technology companies, which could lose their connection to top innovations.

Asian manufacturers like Foxconn or Quanta, as a result, could wrestle away the edge in research and design.

“The manufacturers have gotten more competitive as it relates to innovation, and in some instances they’re already competing directly with their customers,” said Patrick Moorhead, a vice president at Advance Micro Devices, a major PC chip maker.

. . . .

Some former manufacturers have already made the transition and are gaining global brand recognition. Acer and Asustek are Taiwan’s most prominent computer brands, but both companies were contract fabricators for major American companies. Some of their executives steeped in this manufacturing tradition now run the investment arms of the companies.

. . . .

The Asian companies often back projects that Silicon Valley’s financial heavyweights pass on because pay offs are too low and take too long. The Asian companies are “thinking that they didn’t get their fair share of the technology pie in the past,” Mr. Chao said. “Now they have money and will take the risks needed to build up new levels of expertise.”

And this statement from the same article presages Asian companies bringing the innovation effort to Asia, either altogether or at an earlier stage in the development process than Americans would hope. 

With $115 million at its disposal, Innovation Works, based in Beijing, has pledged to “build dream teams to collect, analyze, prioritize and execute on the most promising ideas” in the Internet and mobile computing markets.

Update on Thursday, January 7, 2010 at 08:28AM by Skeptic

More anecdotes about top Chinese scientists going home and China's determination to outspend the US on innovation, in this NYTimes piece today:

China’s leaders . . . . are [d]etermined to reverse the drain of top talent that accompanied its opening to the outside world over the past three decades, they are using their now ample financial resources — and a dollop of national pride — to entice scientists and scholars home.

The West, and the United States in particular, remain more attractive places for many Chinese scholars to study and do research. But the return of Dr. Shi and some other high-profile scientists is a sign that China is succeeding more quickly than many experts expected at narrowing the gap that separates it from technologically advanced nations.

China’s spending on research and development has steadily increased for a decade and now amounts to 1.5 percent of gross domestic product. The United States devotes 2.7 percent of its G.D.P. to research and development, but China’s share is far higher than that of most other developing countries.

Chinese scientists are also under more pressure to compete with those abroad, and in the past decade they quadrupled the number of scientific papers they published a year. Their 2007 total was second only to that of the United States. About 5,000 Chinese scientists are engaged in the emerging field of nanotechnology alone, according to a recent book, “China’s Emerging Technological Edge,” by Denis Fred Simon and Cong Cao, two United States-based experts on China.

A 2008 study by the Georgia Institute of Technology concluded that within the next decade or two, China would pass the United States in its ability to transform its research and development into products and services that can be marketed to the world.

“As China becomes more proficient at innovation processes linking its burgeoning R.&D. to commercial enterprises, watch out,” the study concluded.

Update on Saturday, January 9, 2010 at 09:46AM by Skeptic

Here's another example of almost all of the job-creation benefits of US innovation being realized in China. ESolar, a part of well-known technology incubator IdeaLab, is transferring its solar thermal power generation technology to China where all of the manufacturing will be done.

ESolar already manufactures its heliostat arrays in China, and under the terms of the agreement with Penglai it will also build its power plant receivers there. Gross said that ESolar would retain control of the intellectual property behind the technology's design and operation.

Nathaniel Bullard, a solar energy analyst with consulting firm Bloomberg New Energy Finance, said the ESolar deal indicated China was moving aggressively to pinpoint technologies around the world that could help it meet its ambitious renewable energy goals.

"If you're identified by China as a leading technology developer, the technology will be imported with the implication that your technology will over time become local," he said. "You effectively have one stakeholder, the government, which makes development much easier."

Emphasis added. No doubt ESolar will receive a royalty for the use of its technology, probably in the neighborhood of 5%. That means for every $100 of economic activity generated in the manufacture, $95 will enter the Chinese economy through payments to its suppliers, workers, taxes, and payouts to capital, and $5 will enter the US economy through payments to ESolar. As far as I know, other than investment tax credits, there was no US public money invested in ESolar, nor should there be public money invested in similar technology development ventures (or even tax benefits) when the benefits fall so disproportionately abroad.

Update on Monday, January 11, 2010 at 10:43AM by Skeptic

Here’s an example of how many jobs can be created by successful innovation compared to the small number of jobs involved in the actual innovation:  

The Obama administration will announce on Monday funding for nine projects designed to significantly increase fuel efficiency in heavy trucks and passenger vehicles, with more than half the money coming from the $787 billion stimulus package.

. . . .

According to the administration, the nine recipients are expected to create more than 500 research, engineering and management jobs, with 6,000 more positions anticipated when the technologies go into production and assembly.

This investment by USG could be a good deal for America if those 6,000 production jobs were going to be long-term jobs for Americans, but if those 92% of the total jobs created are going to be in China, “American” companies should apply to the Chinese government for the R&D funding.

Update on Tuesday, January 12, 2010 at 12:09PM by Skeptic

Here's another example, reported by Tom Friedman, of how innovation centers get collocated with manufacturing. Applied Materials in Silicon Valley makes the machines that make computer chips and photovoltaic solar panels. It has equipped 14 PV plants around the world, generating $1.3 billion in the last year. How many of those PV plants are in the US?  None.  Five are in Germany (a high wage nation), four are in China, one is in Spain, one is in India, one is in Italy, one is in Taiwan, and one in Abu Dhabi.

Joe Romm, whose post today brought this to my attention, and Friedman also make another good point, that a big reason why PV plants are being built where they are is that national governments have arranged in various ways to make sure there are big and growing domestic markets for PV power generation. (I wonder to what extent those "arrangements" favor domestic manufacture.) China has recently made a big and credible commitment to green power.  The US has not. Friedman:

In October [2009], Applied will be opening the world’s largest solar research center — in Xian, China. Gotta go where the customers are.

If America wants to keep the high-paying innovation jobs, it also needs to keep the manufacturing jobs to which they are related, and there also need to be big domestic markets for the manufactured goods.  The industrial force can't function with all the generals and colonels here and all of the privates and sergeants an ocean away.

Update on Thursday, February 11, 2010 at 10:21AM by Skeptic

A recent report by Silicon Valley researchers, reported here in NYT, looks beyond the deep recession and high unemployment rates there and sees this (emphasis added): 

Even when the trauma of the financial crisis subsides, Silicon Valley will still be at risk because of deeper, long-term challenges, the report said.

Sixty percent of the region’s scientists and engineers are foreign-born, but foreign immigration to the region dropped 34 percent over the last year. The home countries of foreigners are increasingly luring them back, while the United States government’s policies have made it harder for them to stay, the report said.

To combat the brain drain, California must do a better job educating local students, said Stephen Levy, director and senior economist of the Center for Continuing Study of the California Economy, who also serves as an adviser to the annual study. “We’re not going to be able to live on global talent forever,” Mr. Levy said.

However, 5 percent fewer high school graduates are meeting requirements for entrance to state universities, the number of science and engineering degrees has leveled off and state general fund spending on higher education dropped 17 percent last year, according to the report.

Update on Friday, February 26, 2010 at 06:29AM by Skeptic

Harvard Business School Professor Willy Shih has a pending paper titled The US Can't Manufacture the Kindle, and That's a Problem. Although key parts of the device, including the "ink" were innovated by US companies they outsourced the bulk of the manufacturing value added to Asia.  According to Shih, further innovation in these components is now likely to occur where the manufacturing is done.  It gets worse. The Cambridge, MA "ink" innovator, E Ink, is trying to sell itself to its Asian manufacturer, which seems to be making more profit on the screen than E Ink is.  Mark Muro reported this here in The New Republic. Thanks to Christine for the link.

Update on Wednesday, March 24, 2010 at 09:00AM by Skeptic

Boeing's most advanced wing technology--composite constructions--developed in part with US government financing is being offshored to reduce manufacturing costs, according to Charles A. Hamilton in the Seattle Times:

The global alignment of economic power and technology leadership is changing. Boeing has given composite wing technology to its Japanese business partners and outsourced much of its manufacturing to others in the interest of "shareholder value" and the harvesting of its product line. One wonders, in the end, whether Boeing may have set the stage for the destruction of its strategic value to the United States.

Update on Saturday, March 27, 2010 at 11:06AM by Skeptic

Bye, bye, Mark Pinto. The chief technology officer of Applied Materials and the firm's technology center have both moved from Silicon Valley to China.

In addition to moving Mr. Pinto and his family to Beijing in January, Applied Materials, whose headquarters are in Santa Clara, Calif., has just built its newest and largest research labs here. Last week, it even held its annual shareholders’ meeting in Xi’an.

Update on Friday, May 14, 2010 at 10:16AM by Skeptic

Chinese wind turbine companies are squeezing out Western companies like GE and Vestas, who have superior technology, with buy local policies. Although Western companies are getting royalities on the older technology they have licensed to Chinese companies, a royalty is smaller than a manufacturing profit, and it creates no US jobs. From this Bloomberg report:

Chinese companies have kept costs down by licensing older technology from overseas rivals, including Vestas, Japan’s Mitsubishi and others that sell their own turbines in China.

While the Chinese pay royalties to the foreign firms, those payments don’t come close to making up for the business the foreign companies are losing in China, according to Emerging Energy Research’s Hays.

China’s so-called “buy local” policy steers most state- financed energy contracts to domestic players, said Magued Eldaief, a GE Energy executive who formerly oversaw the Fairfield, Connecticut, company’s Asia Pacific unit.

“There’s no question preference is given to Chinese companies,” Eldaief said. “It’s a reality you have to live with.”

Update on Tuesday, September 7, 2010 at 10:17AM by Skeptic

The US is continuing to shift to Asia better and better high tech jobs, according to this NYT report: 

[C]omputer scientists, systems analysts and computer programmers all had unemployment rates of around 6 percent in the second quarter of this year, [which is] significantly higher than the unemployment rates in other white-collar professions.

If and when there is a cyclical uptick in US high tech employment, it will probably continue to be overwhelmed by the structural downward trend for this work to be done offshore. 

The disappointing hiring trend raises questions about whether the tech industry can help power a recovery and sustain American job growth in the next decade and beyond. Its tentativeness has prompted economists to ask “If high tech isn’t hiring, who will?”

“We are talking about people with very particular, advanced skills out there who are at this point just not needed anymore,” says Bart van Ark, chief economist at the Conference Board, a business and economic research organization. “Even in this sector, there is tremendous insecurity.”

Update on Wednesday, March 9, 2011 at 11:15AM by Skeptic

When Immelt said innovation and manufacturing must be co-located it was no slip of the tongue or off-hand remark. He hammers this theme every chance he gets, in this December 2010 CNBC clip, for example.

Update on Friday, July 1, 2011 at 10:14AM by Skeptic

The domestic printed circuit board industry has departed for Asia, leaving only enough at home to supply the US military. But that can last only as long as the US military doesn't need the latest technology because PCB innovation has moved where the manufacturing is.  An interview with Doug Bartlett on his decision to liquidate the oldest PCB manufacturing operation in America is here.

Update on Wednesday, July 20, 2011 at 03:58PM by Skeptic

Chinese venture capitalists are becoming big players in high tech and clean tech, and their funding is easier to get than in the US.  Climate Progress has the story here. This is a further indication that the notion that America can let go of manufacturing but keep innovation isn't working and can't work.

Update on Tuesday, January 17, 2012 at 03:30PM by Skeptic

Dave Johnson's lede today in National Science Board Report: US Losing R&D Jobs To Asia:

The United States is losing ever more jobs and becoming ever less competitive as our universities are cut back and companies move R&D jobs to Asia. We lost 687,000 high-tech manufacturing jobs lost since 2000. Universities cut back 20% on public research. 85% of growth in R&D employment by American companies occurred abroad.

Update on Saturday, October 15, 2016 at 10:43AM by Skeptic

Apple is moving more R&D to China for just the reasons explained above.  From the Los Angeles Times:

Apple Inc. plans to open its second research and development center in China, a move that could help bolster the tech giant’s presence in a lucrative market.

The Cupertino, Calif., company said Wednesday it would open a facility next year in the manufacturing hub of Shenzhen.

In a statement, Apple said the center would allow the company’s engineering team to “work even more closely and collaboratively” with its manufacturing partners.

“The Shenzhen center, along with the Beijing center, is also aimed at strengthening relationships with local partners and universities as we work to support talent development across the country,” Apple said.

Is Wall Street too politically powerful to regulate?

Justin Fox, Time's Curious Capitalist, summarizes several other posts on the lobbying agenda of Wall Street and who is doing their bidding and why.

Barry Ritholtz has a good summing-up of a new paper (pdf) by three IMF economists on the link between lobbying and risk-taking by lenders. The gist: Firms that made the riskiest loans spend the most on lobbying Congress. And what were their lobbying aims?

• prevent any tightening of lending laws that reduce the benefits of short-termist strategies over long-term profits;

• allow systematic underestimation of default probabilities by overoptimistic bankers;

• not just to originate loans that carry more risk, but to convince legislators that such lending is prudent;

• to thwart bills aimed at lax lending standards and riskier loans;

• to tighten regulations that restrict entry by others preventing competition;

• to have a higher probability of receiving preferential treatment in a crisis.

The Huffington Post also has an epic new examination of what it calls "the cash committee"—the House Committee on Financial Services. The gist is that the committee's Democratic ranks are heavy on  moderate-to-conservative first- and second-termers that House leadership put on the committee so they could raise lots of money from financial interests, thus increasing their chances of getting reelected but decreasing the committee's chances of passing meaningful financial reform. The general takeaway here is that Congress is a bit, ahem, compromised when it comes to dealing with the financial sector. It's compromised in dealing with lots of other industries too, of course, but the finance-insurance-real-estate crowd is bigger and richer than any other industry, plus it just caused the worst economic downturn since the Depression. Those who would address the financial problems of the past few years with better laws and regulations (a group of which I am a member) have a big problem when the rulemakers are captured not just by the industry they regulate but the dodgiest parts of that industry.

The linked HuffPo piece gives examples of how the junior members of "Barney Frank's Committee" are frustrating his efforts to enact legislation that actually changes the legal environment for the financial industry.

Obama’s poker play in Afghanistan: Raise, fold, or call?

Using a poker analogy, Rory Stewart argues persuasively that Obama has rejected advice to fold and cut our losses in Afghanistan as well as advice to raise the bet in a bold effort to win a larger victory, and has decided instead to stay in the game at minimum cost. Stewart parses Obama's December 1, 2009 speech at West Point to show that he has definitively rejected the goal of winning a counterinsurgency campaign and the minimum of 600,000 troops that US military doctrine would require to accomplish that. He has also rejected withdrawal. He has instead decided on a strategy of just staying in the game, perhaps for decades, and having a sufficient presence to influence events in Afghanistan and the region and, hopefully, to avert the worst possible outcomes but not to control them. Stewart generally approves but thinks Obama could have explained it better. Here is part of Stewart's explanation:

But perhaps even more importantly, defining a more moderate and limited strategy gives him leverage over his own generals. By refusing to endorse or use the language of counterinsurgency in the speech, he escapes their doctrinal logic. By no longer committing the US to defeating the Taliban or state-building, he dramatically reduces the objectives and the costs of the mission. By talking about costs, the fragility of public support, and other priorities, he reminds the generals why this surge must be the last. All of this serves to "cap" the troop increases at current levels and provide the justification for beginning to reduce numbers in 2011.

But the brilliance of its moderate arguments cannot overcome that statement about withdrawal. With seven words, "our troops will begin to come home," he loses leverage over the Taliban, as well as leverage he had gained over Karzai and the generals. It is a cautious, lawyerly statement, expressed again as "[we will] begin the transfer of our forces out of Afghanistan in July of 2011." It sets no final exit date or numbers. But the Afghan students who were watching the speech with me ignored these nuances and saw it only as departure.

This may be fatal for Obama's ambition to "open the door" to the Taliban. The lighter, more political, and less but still robust militarized presence that his argument implies could facilitate a deal with the Taliban, if it appeared semi-permanent. As the President asserted, the Taliban are not that strong. They have nothing like the strength or appeal that they had in 1995. They cannot take the capital, let alone recapture the country. There is strong opposition to their presence, particularly in the center and the north of the country. Their only hope is to negotiate. But the Taliban need to acknowledge this. And the only way they will is if they believe that we are not going to allow the Kabul government to collapse.

Afghanistan has been above all a project not of force but of patience. It would take decades before Afghanistan achieved the political cohesion, stability, wealth, government structures, or even basic education levels of Pakistan. A political settlement requires a reasonably strong permanent government. The best argument against the surge, therefore, was never that a US operation without an adequate Afghan government partner would be unable to defeat the Taliban—though it won't. Nor that the attempt to strengthen the US campaign will intensify resistance, though it may. Nor because such a deployment of over 100,000 troops at a cost of perhaps $100 billion a year would be completely disproportional to the US's limited strategic interests and moral obligation in Afghanistan—though that too is true.

Instead, Obama should not have requested more troops because doing so intensifies opposition to the war in the US and Europe and accelerates the pace of withdrawal demanded by political pressures at home. To keep domestic consent for a long engagement we need to limit troop numbers and in particular limit our casualties. The surge is a Mephistophelian bargain, in which the President has gained force but lost time.

What can now be done to salvage the administration's position? Obama has acquired leverage over the generals and some support from the public by making it clear that he will not increase troop strength further. He has gained leverage over Karzai by showing that he has options other than investing in Afghanistan. Now he needs to regain leverage over the Taliban by showing them that he is not about to abandon Afghanistan and that their best option is to negotiate. In short, he needs to follow his argument for a call strategy to its conclusion. The date of withdrawal should be recast as a time for reduction to a lighter, more sustainable, and more permanent presence. This is what the administration began to do in the days following the speech. As National Security Adviser General James Jones said, "That date is a 'ramp' rather than a cliff." And as Hillary Clinton said in her congressional testimony on December 3, their real aim should be to "develop a long-term sustainable relationship with Afghanistan and Pakistan so that we do not repeat the mistakes of the past, primarily our abandonment of that region."

A more realistic, affordable, and therefore sustainable presence would not make Afghanistan stable or predictable. It would be merely a small if necessary part of an Afghan political strategy. The US and its allies would only moderate, influence, and fund a strategy shaped and led by Afghans themselves. The aim would be to knit together different Afghan interests and allegiances sensitively enough to avoid alienating independent local groups, consistently enough to regain their trust, and robustly enough to restore the security and justice that Afghans demand and deserve from a national government.

Except for the two "surges" approved by Obama this year, which will double the US troop presence in Afghanistan, Obama has adopted what I perceive to have been George W. Bush's actual strategy there (as distinguished from his rhetorical pretensions to "victory" with inadequate resources). It is also apparently not far different from what VP Biden urged. While it is possible that this strategy can have some beneficial effects in the region, it seems that the presence of Western troops there will continuously inflame Islamists and thereby increase our exposure to terrorist attacks at home, as Stewart seems to acknowledge. I recommend the whole article, which is a very plausible explanation of where we're headed.

The minimum medical loss ratio provision in the healthcare bills will raise healthcare prices.

The pending bills would require for-profit insurers to have medical loss ratios of at least 80% of premium revenues (Senate bill) or 85% (House bill) or rebate premiums to policy holders to achieve those ratios. This is being promoted by the Democrats as a way to rein in spiraling healthcare costs, but there is concern that insurers might evade the limits with accounting tricks and by neutering the necessary regulations. Kaiser Health News has a good summary here. The much more serious problem is that such provisions eliminate the incentive for insurers to grind down provider costs, and insurers are the only institutions in position to do that.

According to the KHN story, health insurers now pay out between 80% and 90% of premium revenues to reimburse providers for services rendered to policy holders—i.e., the "medical loss ratio." The rest of the revenue goes to the costs of running the insurance business (selling, underwriting, claims processing, general administration, executive salaries, rent, etc.) and returns to capital (interest and profit). One of the things an insurer can do now to increase profits, is to renegotiate its deals with healthcare providers to lower reimbursement rates, while keeping premiums the same; reduced reimbursements go straight to the insurer's bottom line. However, if the insurer's medical loss ratio is at the legal minimum, grinding provider prices would reduce the insurer's profits because its revenues would be reduced by rebates to policy holders. On the other hand, if the insurer in this legal situation eliminated costs of negotiating reimbursement rates, those cost savings would go to the bottom line.

It's possible that a law will set the minimum medical loss ratio so low that it won't affect insurance company behavior at all, but if the law does affect behavior it will be in the opposite direction from what healthcare consumers want. Naturally, some version of this law will pass because rising healthcare prices are wanted by everybody who can afford a Washington lobbyist. The healthcare system is broken, and so is the political system.

Update on Tuesday, December 29, 2009 at 09:57AM by Skeptic

I thought the perverse effect on insurer behavior would be obvious to all once I mentioned it.  Apparently that's not true.  So here are two examples of how the numbers work.

Assume a base case in which there is no legal minimum medical loss ratio and that Insurer's premium revenues are 100, medical losses are 80, operating expenses are 12, and profits are 8. 

Now assume an 80% minimum medical loss ratio is imposed and that Insurer's medical losses decline from 80 to 75.  In order to bring its medical loss ratio up to 80%, it will have to reduce its premium revenues to 93.75 by rebating 6.25 to policy holders.  In this case, 93.75 premium revenue less 75 in medical losses less 12 in operating expenses leaves a profit of only 6.75, down 15.625% from 8 in the base case. The shareholders will frown.

On the other hand, if Insurer increases medical loss payments to just 82 and it can maintain a medical loss ratio of 80% by raising premiums to 102.5, its base case profit of 8 will soar 31.25% to 10.5 and that will make Insurer's shareholders very happy. 

Update on Tuesday, April 26, 2011 at 09:05AM by Skeptic

In the first mainstream media acknowldgement I've seen that the perverse incentive of the minimum medical loss ratio is actually causing higher health insurance premiums, the Los Angeles Times says this editorially:

The fundamental problem with the current system, though, is that insurers and healthcare providers have a shared incentive to raise premiums. Providers want insurers to pay more to offset stingy Medicare and Medicaid reimbursements. And the new federal caps on overhead mean that the easiest way for insurers to increase revenue is to promise more to doctors and hospitals, which would justify proportionally higher administrative expenses and profits.

Ending the filibuster on the Senate “reform” bill is a victory for the healthcare industry.

The Obama Administration and Congressional leadership are claiming an historic victory in passing a cloture motion on the Senate bill, but it looks to me like the Administration and Congress lost every important negotiation with the healthcare industry, if indeed there ever was a serious effort to rein it in. Stock prices for the Health Care sector rose more in the last three months—when these "negotiations" were going on—than any other sector of the economy.

Current Sector Weighting Performance & Percentages*

Sector	Actual Market Weighting	1 Day Perfor mance	1 Week Perfor mance	1 Month Perfor mance	3 Month Perfor mance	YTD Perfor mance	1 Year Perfor mance
Telecommunication Services	2.75%	0.22%	-2.32%	4.59%	4.36%	2.20%	3.53%
Utilities	3.80%	0.45%	-0.51%	6.98%	5.67%	9.61%	10.25%
Consumer Staples	10.91%	-0.30%	-2.05%	-2.05%	3.76%	11.42%	12.22%
Energy	11.34%	0.28%	0.30%	-4.50%	1.36%	11.30%	14.20%
Financials	14.93%	1.39%	-0.92%	-4.98%	-6.17%	16.62%	15.83%
Health Care	12.72%	0.26%	-0.25%	2.70%	7.83%	17.55%	19.67%
Industrials	10.98%	-0.19%	-0.63%	-0.02%	2.38%	19.96%	21.46%
Consumer Discretionary	10.09%	0.53%	0.04%	1.65%	6.36%	39.94%	38.09%
Materials	3.88%	0.09%	-0.91%	-2.88%	0.39%	42.99%	38.67%
Information Technology	18.61%	1.56%	1.05%	0.43%	7.44%	56.99%	56.89%

* Performance: END OF DAY DATA, AS OF 12/18/09  4:00 PM ET. Sector Weighting: AS OF 12/16/09  4:00 PM ET. Downloaded from Fidelity 12/21/09.

Joe Scarborough and others make the same point here.

UPDATE 12/21/09 AT 1:30 P.M.:  Today was the first trading day after the Senate cloture vote.  While the S&P 500 index rose 1.05%, the five largest health insurance companies racked up these gains:  UnitedHealth Group, 2.00%; Wellpoint, 2.92%; Aetna, 4.71%; Humana, 3.47%; and Cigna, 3.94%.  If we ever get the reform we need, those numbers will move the other way. 

Update on Tuesday, December 22, 2009 at 06:36AM by Skeptic

The "Healthcare Providers and Services" subsector of Health Care rose 2.15% yesterday vs. 1.05% for the S&P 500.  In the last 3 months, this subsector rose 11.86% vs. 4.64% for the S&P 500. 

Sector Performance Against Benchmarks

AS OF 12/21/2009  4:00 PM ET

Sector or Benchmark	1 Day	1 Week	1 Month	3 Month	YTD	1 Year	3 Year	5 Year
Health Care Providers & Services	2.15%	1.83%	8.27%	11.86%	37.47%	39.69%	-7.33%	23.03%
NASDAQ	1.17%	1.16%	4.27%	4.66%	44.30%	43.04%	-7.38%	4.03%
Russell 3000	1.07%	0.24%	2.72%	4.26%	27.31%	27.61%	-20.66%	-5.38%
S&P 500	1.05%	-0.01%	2.08%	4.64%	25.08%	25.47%	-21.45%	-7.58%

Update on Tuesday, December 22, 2009 at 09:58AM by Skeptic

Reuters has posted a summary of Winners, losers in U.S. Senate health bill.  Health insurers are described as "losers" because of certain provisions in the bill that could, depending on how they are implemented, limit profits, but obviously those who make the stock market think profits are likely to improve. 

Update on Sunday, March 7, 2010 at 09:27AM by Skeptic

Goldman Sachs is recommending that investors buy shares in two big insurance companies, the UnitedHealth Group and Cigna, because insurance rates are up sharply and competition is down, according to this NYT report.

The Goldman Sachs analysis shows that while insurers can be aggressive in raising prices, they also walk away from clients because competition in the industry is so weak, the White House said. And officials will point to a finding that rate increases ran as high as 50 percent, with most in “the low- to mid-teens” — far higher than overall inflation.

Employers, who are in large part the victims of these insurers' growing market power don't see the pending healthcare reform legislation as a solution.

Asked by Goldman analysts about the effort to pass major health care legislation, Mr. Lewis [an insurance broker representing employers] said many employers experiencing increases in their insurance costs were nonetheless apprehensive about the president’s proposal.

“They’re very mixed in their reaction, quite candidly consistent with what we’re seeing in the polling numbers by party lines,” Mr. Lewis said. “I think most people would acknowledge that there’s a need for health care reform; employers continue to be very frustrated. So when they look at what the Obama administration and the Democratic majority state as their goals to increase access and lower cost and rail at what may be termed oligopolistic behavior of carriers in certain markets, I think employers really buy in to that message and have much of that frustration and anger at our lack of solutions.”

And yet, he said, there is little enthusiastic support from employers for the Democrats’ proposals.

“Many of them still view the legislation and the partisanship coming out of Washington as possibly the medicine worse than the disease,” he said. “So many employer groups that we’re talking to feel like it would be a shame to lose an opportunity to do something with respect to health care reform. But many are starting to feel like maybe nothing is better than something in this current environment.”

Can reducing deforestation really save the planet?

One of the climate protection initiatives being discussed in Copenhagen is "reducing emissions from deforestation and degradation in developing countries" ("REDD"). In fact, Obama endorsed the concept in Oslo last week, according to this report from Climate Progress:

President Barack Obama "made his first public intervention in the Copenhagen climate summit" by supporting the Norway-Brazil plan to allow rich countries to fund the protection of rainforests. "I am very impressed," Obama said after accepting the Nobel Peace Prize, "with the model that has been built between Norway and Brazil that allows for effective monitoring and ensures that we are making progress in avoiding deforestation of the Amazon."

The Union of Concerned Scientists has a very helpful discussion of important REDD concepts such as stocks vs. flows of CO2, additionality, leakage, carbon market offsets, and national baselines. It concludes by saying that, as a practical matter, REDD can only work if operated at a national level, with a national emissions baseline, effective monitoring, and demonstrated reduction of emissions at the national level. Not only are those requirements likely to overwhelm the institutional competence and integrity of developing nations, but it doesn't deal with the problem that deforestation effectively controlled in one participating nation may "leak" into a non-participating nation.

The same Climate Progress post goes on to report some possible progress in monitoring technology:

International approval for the Norway-Brazil proposal for a Reducing Emissions from Deforestation and Degradation (REDD) mechanism still has a ways to go, especially as targets for reductions of deforestation have not yet been determined. In a possible breakthrough for the integrity of such programs, Google presented tools for the accurate monitoring of the rates of deforestation via climate satellite data.

But today's news on the institutional side is not good:

In Copenhagen, officials from China and India have vowed to reduce carbon intensity, while other fast-developing countries like Brazil and South Africa also have taken pledges to reduce carbon. But they are fiercely protecting the right to make those goals voluntary -- or at least not subject to any penalties if they do go under review.

REDD is of great interest in industrialized nations because of the prospect that emitters there can defer or avoid emissions reductions by buying REDD "offsets," and financial institutions are very eager to participate in those transactions. I see a big risk that the US and Europe will eventually agree to a program that serves these business interests and does not actually protect the climate.

Update on Tuesday, December 22, 2009 at 10:21AM by Skeptic

From Robert Stavins favorable assessment of the results of the COP-15 conference that ended last week in Copenhagen:

9.      The developed countries commit to a goal of jointly mobilizing $100 billion annually by 2020 from sources both public and private.

Assessment: It is important that the Accord notes that the funds can come from either public or private sources.  Governments can — through the right domestic and international policy arrangements — provide key incentives for the private sector to provide the needed finance through foreign direct investments for emissions mitigation (clearly a role exists for government assistance for adaptation).  For example, if the cap-and-trade systems which are emerging throughout the industrialized world as the favored domestic approach to reducing CO₂ and other greenhouse gas emissions are linked together through the existing, common emission-reduction-credit system, namely the Clean Development Mechanism (CDM), then powerful incentives can be created for carbon-friendly private investment in the developing world.

Clearly the CDM, as it currently stands, cannot live up to this promise, but with appropriate reforms there is significant potential.  Of course, problems of limited additionality will inevitably remain.  Therefore, what is needed is for the key emerging economies to take on meaningful emission targets themselves (even if equivalent to business as usual in the short term), and then participate directly in international cap-and-trade, not government-government trading as envisioned in Article 17 of the Kyoto Protocol (which will not work), but firm-firm trading through linked national and multi-national cap-and-trade systems.

Such private finance stands a much greater chance than government aid of being efficiently employed, that is, targeted to reducing emissions, rather than spent by poor nations on other (possibly meritorious) purposes.

(Emphasis added.) This well illustrates my concern that US negotiators (with whom Stavins is well connected) are so determined to have a world-wide private trading program that they are willing to overlook the fact that "problems of additionality will inevitably remain."  Down that road lies a program that generates lots of transaction fees, provides developed nation money to elites in developing nations, and let's CO2 emitters in the developed world escape obligations to do things that would actually reduce CO2 emissions.  

Ahead of Paul Krugman this time

What took Paul Krugman ten years to figure out became clear to me in less than two years (but he's still smarter than I am):

When I first began writing for The Times, I was naïve about many things. But my biggest misconception was this: I actually believed that influential people could be moved by evidence, that they would change their views if events completely refuted their beliefs.

PK gives credit to Upton Sinclair for observing that “It is difficult to get a man to understand something when his salary depends on his not understanding it.”  Salary, campaign contributions, tribal status, etc.

A legal education is a poor investment.

It isn't just that recent law school graduates have had trouble finding jobs because of The Great Recession, law schools have become so expensive that a law degree is now a poor investment economically, according to this National Law Journal article. "A J.D. used to mean a first-class seat on the gravy train. Now? Not so much."

In fact, law school is always a bad choice from an investment perspective, according to a research paper titled "Mamas Don't Let Your Babies Grow Up To Be…Lawyers."

Herwig Schlunk, a professor at Vanderbilt University Law School, performed an investment analysis of the value of a law degree, taking into account the cost of legal education, the opportunity cost of not going directly into the work force and earning potential. He developed hypothetical scenarios for three student types: one who attends a second- or third-tier school with a 10% chance of landing a job at a major law firm, another who attends a low-first- or high-second-tier school and has 50% chance at a major law firm job, and a student with good grades at a top law school with a 90% change of landing a job at a big firm. He calculated that the net law school investment for those students ranges from $201,000 to $280,000, between tuition and lost wages.

Using what he termed a somewhat conservative calculation, Schlunk determined that the second- or third-tier student would need to earn a starting salary of just below $80,000 to justify the expense of law school. The middle of the road student would need about $113,000, while the top student would need to earn $150,000 out of law school. Schlunk calculated that the students actually can expect to earn starting salaries of $65,000, $105,000 and $145,000, respectively — a poor investment in all three cases.

Schlunk noted that his calculations were based on data gathered before the economic downturn, meaning that law school likely is a worse investment for his hypothetical students than he initially concluded.

I'm surprised that the financial analysis produces such a bleak result, but it supports my general thesis that we should be thinking much more critically about the economic effects of education than is typical in public discourse. The conventional wisdom seems to be that every dollar spent on education builds "human capital" that automatically creates well-paying domestic jobs and cannot result in so many educated people that their wages are bid down. This is wrong in so many ways.

A lack of educational achievement in America has not been one of the reasons for the economic stagnation that began in 1973. We have many, many college graduates working in jobs for which no college is required. Having a broadly well-educated population has not been a substantial cause of economic boom times when we have had them; rather education becomes more affordable during boom times, and much of education is a luxury consumer good instead of "capital" in an economic sense. Certain kinds of education seem to contribute greatly to innovation that drives economic growth, and other kinds of education are totally useless in that regard; so, to the extent we are using education as a growth strategy, we need to be specific about that. There is no level of education or professional degree that is immune from the forces of supply and demand; if we have too many lawyers, civil engineers, or teachers, their incomes will get bid down by market forces, and some of them will have to take work for which they are over qualified. Projections of the kinds of jobs that will exist in the future America do not require a dramatic increase in the general educational level (or a lot more lawyers). We need a good education system, just as we need a good transportation system, a good telecommunications system, a good justice system, etc., in order to have a good environment for private enterprise. But that's all those things do—create a good environment—and robust growth will still elude us so long as it is more profitable to invest and create jobs offshore than here. The naive expectation that education will automatically solve our jobs and growth problems keeps us from focusing on policy changes that actually could solve those problems. For other posts on education go here.

Update on Saturday, February 6, 2010 at 12:45PM by Skeptic

The president of the State Bar of California sees a trend toward diminishing incomes for big-firm lawyers because of client revolt at costs divorced from value and because of foreign competion.

For the legal profession, change is everywhere. The “Big Law” model of the graduates of the best law schools being hired at $160,000 a year and staying on an escalator of success is broken. Thousands of our best-educated, highest-performing lawyers who have relied on that model have been laid off and are looking for but can’t find work.

It is not just the economy. Clients are in rebellion at the billable hour business model. They have almost unanimously concluded that they want to buy value, not hours. Clients and firms of all sizes are now wrestling with alternative billing structures. Some may still be in denial that whatever the alternative, fees will be lower.

The cost of legal education has skyrocketed, not just at private schools. At Berkeley Law and UCLA, tuition alone is now around $38,000 a year. With many fewer jobs available, students are graduating with combined undergraduate and law school debt of well over $150,000.

International outsourcing, technology and the Internet are dramatically increasing the way clients can obtain legal advice. (See legalzoom.com as one example) In the United Kingdom clients of the large “magic circle” firms are sending significant amounts of legal work to India, to be worked on by qualified solicitors and barristers, at less than 20 percent of the cost of sending it to the London firms. In Beijing, there is an English language-only law school, headed by Jeffrey Lehman, former dean of the University of Michigan Law School and former president of Cornell University, that intends to award J.D. degrees and apply for accreditation as an ABA law school, permitting its graduates to take the bar exam in any U.S. jurisdiction. You can bet that, as from India, the services of its graduates will be offered from Beijing at significantly lower cost than those of highly educated lawyers in California. The days of clients paying $500 an hour for fifth- year graduates of leading law schools appear to be drawing to a permanent end. That is structural change.

In addition, in a way we are being insulated — for a while — from even more fundamental change. In England and Wales, legal services will soon be able to be offered by Alternative Business Structures (ABS) — companies wholly owned by non-lawyers. Solicitors and barristers are up in arms at the prospect of competing with “Tesco law” (Tesco being the rough equivalent of Walmart).

Update on Sunday, January 9, 2011 at 11:38AM by Skeptic

NYT phrases it as a question, Is Law School a Losing Game?, but the answer is emphatically the same as mine. The way in which law schools exaggerate the employment status of recent graduates embarrases even some law school professors and administrators and has them worrying about liability for fraud.

Whether you’re for globalization or against it, don’t imagine that it’s inevitable or irreversible.

One of the arguments made in favor of policies to facilitate globalization is that globalization is inevitable. One may resist only temporarily and incompletely before being overwhelmed, perhaps catastrophically, by the irresistible economic forces that must ultimately result in a single integrated world market system, is the more complete, but usually implicit, statement of the argument. To the contrary, Daniel Little discusses here several books on the history of transnational economic integration which remind us that these processes have ebbed and flowed considerably over the centuries.

Little includes the following quotation from Immanuel Wallerstein, The Modern World-System: Capitalist Agriculture and the Origins of the European World-Economy in the Sixteenth Century (1974):

One of the persisting themes of the history of the modern world is the seesaw between "nationalism" and "internationalism." I do not refer to the ideological seesaw ... but to the organizational one.  At some points in time the major economic and political institutions are geared to operating in the international arena and feel that local interests are tied in some immediate way to developments elsewhere in the world.  At other points of time, the social actors tend to engage their efforts locally, tend to see the reinforcement of state boundaries as primary, and move toward a relative indifference about events beyond them. (147)

For a more current effort to describe globalization, Little introduces Saskia Sassen, A Sociology of Globalization (2007) and makes this assessment:

Sassen makes an important point about international economic power that has a Wallerstein-like feel to it but that would probably not have been true in 1700 or 1970. This is her view that there has been an important process of "de-nationalization" that has removed traditional powers of the state and placed them in the scope of international economic and finance institutions that are significantly controlled by large economic actors and firms. We sometimes refer to this process as one of "liberalization"; Sassen makes the point that the construction of the new supra-national regulatory regimes is an extended historical process that can be studied in detail.  She refers to the result of this process as the global corporate economy.  One of Wallerstein's key arguments is that nations in the periphery were dominated and controlled by an economic system run by European nations. Sassen argues for the reality of a world system of regulatory arrangements that subordinates the sovereignty of even previously hegemonic nations to a non-democratic set of institutions and rules that implicitly favor one set of economic actors over others.  But Sassen's inference from this fact about international economic power is less about north-south exploitation and more about the rising likelihood of global exploitation of all ordinary citizens by powerful extra-national economic forces that are beyond the reach of democratic processes (what she refers to as the "democratic deficit").

Update on Thursday, December 24, 2009 at 06:41AM by Skeptic

Martin Wolf says the nougties of the 20th and 21st Centuries can both be described this way:

The only truly global power was in rapid relative decline. Not long before, it had won a pyrrhic victory in a costly colonial war. New great powers were on the rise. An arms race was under way, as was competition for markets and resources in undeveloped areas of the world. Yet people still believed in the durability of the free trade and free capital flows that had nurtured prosperity and, many believed, had also underpinned peace.

It all ended in catastrophe then, and the path forward now is uncertain.

Update on Sunday, March 7, 2010 at 07:16AM by Skeptic

Another recent book, Power and Plenty: Trade, War, and the World Economy in the Second Millennium, traces 1000 years of globalization and concludes that its floods and ebbs are fundamentally political, not technological. The authors discuss it in this VoxEU article. 

In another VoxEU piece, Acemoglu and Yared report on a perceived inverse relationship between globalization on the one hand and nationalist sentiment and militarization on the other.

In recent research . . . , we examine the political limits to globalisation in the modern era. We explore the claim that changes in domestic political factors might restrict international economic integration by examining the relationship between militarism and international trade flows. The evidence suggests that increased nationalist and militarist sentiments, measured by military spending and size, are negatively associated with trade. A country is less likely to open up to neighbours if the country is also becoming more militarised, and trade between two countries grows less rapidly when both countries become more militarised.

Why do people argue that globalization is inevitable and back away from discussing the pros and cons, the winners and the losers?  Perhaps it is because economists have chosen to make considerations of politics, nationalism, etc. "exogenous" to their models because they don't know how to model these factors. Perhaps it is because they think inevitibility absolves them from moral responsibility for the policy choices that are made.

Why Social Security needs restructuring and Medicare doesn’t

I think I've got the answer to why the Right wants to privatize, downsize, revamp, or even eliminate the Social Security system but seldom inveighs against Medicare, which is in much, much worse shape actuarially. Both programs benefit an almost identical group of seniors, but in addition to that constituency Medicare benefits healthcare providers and insurers who have real political power—on display now in the pending healthcare "reform" legislation.

Regulatory capture and boomtime politics caused the financial system collapse.

Regulatory limitations on financial risk-taking might be more useful if we control not just the obvious—excessive leverage and the nature of investment products—but also approaches that are more general and more subtle, according to Avinash Persaud in the Financial Times. Persaud is chair of the Warwick Commission on International Financial Reform, which found that the underlying causes of the recent financial collapse were "regulatory capture and boomtime politics."

It is not financial instruments but behaviour we need to change. A better defence will come from increasing capital buffers at financial institutions, making these buffers counter-cyclical, and focusing on structural – not statistical – measures of risk capacity. Liquidity risk is best held by institutions that do not require liquidity, such as pension funds, life insurers or private equity. Credit risk is best held by institutions that have plenty of credit risks to diversify, such as banks and hedge funds. No amount of extra capital will save a system that, because measured risks in a boom are low, sends risk where there is no capacity for it.

From the executive summary of the report:

This is not the first international financial crisis the world has seen. This tells us two things. First, in trying to prevent or dampen future crises, we must not focus too heavily on the specific character of the present crisis. We must focus on those factors that are common across financial crises. There will be a different financial innovation or product at the centre of the next crisis. Second, it is unhelpful to think in terms of increasing or decreasing the quantity of regulation. There is good and bad regulation. If elements of the current approach to regulation incentivised systemically dangerous behaviour, doubling up on existing regulation or spreading it more widely may make matters worse. While we doubt that financial crises can be prevented, we do believe strongly that policymakers, regulators and supervisors have the power to make them less frequent, shallower and with less spill over onto the welfare of ordinary households. The purpose of this report is to set out the regulatory approach that will help them do so across a variety of countries.

Large international banks have promoted the idea of a level playing field in regulation between countries (home country regulation) and within countries (unitary regulators and an end to ‘Glass-Steagall’ type segmentation of financial sectors). It seems heretical to argue against ‘level playing fields’, but in certain areas of finance, an unlevel playing field has merit. We need an unlevel playing field between countries as a result of the policy responses to economic cycles that are often less synchronised than they appear. We need to tilt the playing field within countries to reflect the unlevel capacity of financial institutions for different types of risk and to help risks flow to where they are best matched by risk capacity. We need a financial system that is robust to shocks, and that requires diversity, not homogenous behaviour derived from the blanket application of the same rules and standards on valuation, risk and trading. An unlevel playing field between countries is also desirable so as to best take into account different national political priorities, financial structures and institutional capacities.

The Commission recommends the following five key policy reforms in the Report:

1. Regulation needs to be formally more countercyclical, to offset the endogeneity of risk that arises from the credit cycle. Capital requirements, leverage ratios, maximum loan-to-value ratios must be tightened in the boom and loosened in the crash within a rule-based framework.

2. Risk-taking must be matched to risk capacity for the financial system to be resilient. One way to achieve this is through capital requirements for maturity mismatches (administered in a manner to avoid procyclicality).

3. Regulators must have the flexibility to apply tighter regulatory requirements on systemic institutions, instruments and markets. Regular system-wide stress tests should help to identify what is systemic.

4. Greater emphasis must be placed on host country regulation within a more legitimate system of international cooperation. Host country regulators must be able to require foreign and domestic banks alike to keep local capital against local risks. Accountable global institutions should coordinate host country regulations, share information and lessons in order to improve regulatory effectiveness and limit regulatory arbitrage, and regulate market infrastructure for global markets such as single clearing and settlement houses. They should also be engaged in capacity building for countries with less developed financial systems.

5. Incentives for the financial sector and for financial firms to grow in size and influence, and to concentrate on short-term activity, must be offset, perhaps through additional capital requirements for large institutions.

The weakest part of Obama’s speech about Afghanistan

From Obama's December 1, 2009 speech at West Point announcing he will raise the US troop level in Afghanistan to about 100,000 in support of his new strategy (which frankly doesn't sound very new):

First, there are those who suggest that Afghanistan is another Vietnam.  They argue that it cannot be stabilized, and we're better off cutting our losses and rapidly withdrawing.  I believe this argument depends on a false reading of history.  Unlike Vietnam, we are joined by a broad coalition of 43 nations that recognizes the legitimacy of our action.  Unlike Vietnam, we are not facing a broad-based popular insurgency.  And most importantly, unlike Vietnam, the American people were viciously attacked from Afghanistan, and remain a target for those same extremists who are plotting along its border.  To abandon this area now -- and to rely only on efforts against al Qaeda from a distance -- would significantly hamper our ability to keep the pressure on al Qaeda, and create an unacceptable risk of additional attacks on our homeland and our allies. 

I don't get the relevance of the broad coalition point. It wasn't the absence of a broad coalition that caused failure in Vietnam; we failed because half a million American troops couldn't control the place. Further, most of the support for our presence in Afghanistan is only lip service. There were 48 nations in the "coalition of the willing" that "supported" our 2003 invasion of Iraq. Most of them were more trouble than they were worth, and almost all withdrew long before we were ready to leave.

The notion that there is not a broad-based popular insurgency in Afghanistan seems just wrong. Whatever we face in Afghanistan is almost 100% local popular insurgency. I frequently see reports that US officials estimate there are fewer than 100 Al Qaeda types in Afghanistan. On the other hand, an important similarity between Vietnam and Afghanistan is that in both places the enemy did/can retreat to and operate from another nation that was/is no-go for us.

The third point, that we were attacked from Afghanistan but not from Vietnam, is certainly correct, but what's the importance of that? We have had our vengeance on many of the Al Qaeda leadership and operatives who were involved in the attack, and it is well understood that the rest are now elsewhere, probably Pakistan. From there, they could possibly return to Afghanistan if the Taliban took over, but they could probably as well move on to Somalia, Sudan, or some other failed state we are determined not to invade. Nevertheless, tenuous as it is, this is the only thing that sounds like a real reason for our involvement—we will have 100,000 American troops in Afghanistan to keep hundreds or perhaps a few thousands of Al Qaeda bottled up in the mountains of Pakistan. This is Mr. Obama's war.

This is a Tiger free zone.

Following Paul Krugman's example, I will not have anything to say about Tiger Woods.

The continuing education of Marie Antoinette—Social Security

As the federal deficit mounts, there are renewed calls for breaking the promises we've made to the millions of middle-class and poor folks who do or will depend heavily on Social Security benefits. Many who subscribe to the idea that the Social Security system is broke or unsustainable without major reductions in benefits do not realize, I suspect, that dramatic cuts in benefits would be disastrous to a vast majority of Americans. Paul Krugman reports that the one-quarter of the older population whose incomes are above the median but not in the top quarter rely on Social Security benefits for over half their income. On average, they get only 9% of their income from IRAs and other assets, and the bottom half gets even less asset income. Thus, asset prices are not particularly important for at least 75% of retirees. Here's the graph for the 50-75 percentile group.

Animal spirits and what else is wrong with neoclassical economics

A much discussed book this year has been Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism by George Akerlof and Robert Shiller. One of the best discussions is by John Gray in the London Review of Books. Link. He credits Akerlof and Shiller for their evisceration of neoclassical economics for assuming at its core rational behavior of human beings—conceiving them to be a species, homo economicus, that is not us. Gray goes beyond this and points out that even if we all were homo economicus, important parts of the future are always unknowable and cannot be quantified and factored into market decisions as probabilities. A third theme of the review is the hubris of the neoclassical school in assuming that the magic beans they had discovered would work in any environment and that, indeed, no other doctrine would lead to economic abundance. Unaccountably and regrettably, these ideologues appear not to have noticed in the real world the massive contradictions to that view. A few excerpts:

. . . . The trouble with prevailing theories, in Akerlof and Shiller's view, is that they assume human beings are more rational than they actually are. 'This book, which draws on an emerging field called behavioural economics, describes how the economy really works,' they claim. 'It accounts for how it works when people really are human, that is, possessed of all-too-human animal spirits.'

. . . .

. . . . If economists have failed to explain repeated crises, it is because they have interpreted economic activity through an unreal model of rational decision-making. Thinking of human behaviour in this way allows them to claim a high degree of precision for their discipline, which is presented as a kind of applied mathematics. But they have left psychology out of their equations.

. . . . The fact that markets are flawed seems novel only in the context of the economic orthodoxy that prevailed between the wars, and in the run-up to the recent crisis. It is wrong to imply, as Akerlof and Shiller do, that the classical economists believed otherwise. 'Just as Adam Smith's invisible hand is the keynote of classical economics,' they write, 'Keynes's animal spirits are the keynote to a different view of the economy – a view that explains the underlying instabilities of capitalism.' Here they are endorsing the caricature of Smith propagated by neoliberal ideologues anxious to confer a distinguished patrimony on an illegitimate intellectual offspring. . . .

If Akerlof and Shiller's grip on the history of economic thought is shaky, they also fail to grasp why Keynes rejected the idea that markets are self-stabilising. . . . [I]n his canonical General Theory of Employment, Interest and Money (1936) he concluded that there was no way anyone could make forecasts. Future interest rates and prices, new inventions and the likelihood of a European war cannot be predicted: there is no 'basis on which to form any calculable probability whatever. We simply do not know!' For Keynes, markets are unstable less because they are driven by emotion than because the future is unknowable. To suggest that the source of market volatility is unreason is to imply that if people were fully rational markets could be stable. But even if people were affectless calculating machines they would still be ignorant of the future, and markets would still be volatile. The root cause of market instability is the insuperable limitation of human knowledge.

. . . .

The central flaw of the economic orthodoxy against which Keynes fought in the 1930s was to imagine that an insoluble problem – human ignorance of the future – had been solved. The error was repeated in the 1990s, when economists came to believe that complex mathematical formulae could tame uncertainty in the murky world of derivatives. . . .

. . . . Hayek said that governments could never know enough to plan the economy successfully – a claim vindicated by the miserable record of central planning in Communist countries. At the same time, he attributed near omniscience to markets, and never doubted that if left to its own devices the economy would liquidate mistaken investments and return to equilibrium. Against this, Keynes had shown that there is no market mechanism that ensures revival; economic contraction can be self-reinforcing, and only government action can then create a way out.

. . . .

Akerlof and Shiller claim that their account of the role of psychology helps to explain the financial crisis. 'Our theory of animal spirits,' they say, 'provides an answer to a conundrum: why did most of us utterly fail to foresee the current economic crisis? How can we understand this crisis when it seems to have come out of the blue with no cause?' They are right that part of the answer lies in an intellectual default within economics, but they seem oblivious of the role of ideology in producing this default. The deformation of economics was not the result only of factors internal to the discipline, it was also part of the short-lived Western triumphalism that followed the end of the Cold War.

Those were the years when slackers throughout the world were enjoined to submit themselves to the rigours of 'the Washington consensus' – a mix of dogmatic policy prescriptions and hypocritical rhetoric that enjoyed the support of the great majority of economists. According to that consensus, the market regime that was installed in Britain, the US and a few other countries from the 1980s onwards could not only ensure stability and promote steady growth there but was a model – the only possible model – for countries everywhere. The one truly rational economic regime, free market capitalism, was also the most productive. As such it was bound to drive every other system out of existence, and would eventually be adopted worldwide. This faith in the universal spread of free markets animated much of the thinking of the American-led institutions overseeing the world economy, such as the IMF. Along with economists in university departments in much of the world, these institutions succumbed to a quasi-religious belief that the free market was the germ of a single, universal economic system.

Not everyone swallowed this creed. It was not accepted in China, which then as now displayed a well-founded contempt for Western advice – an attitude that has much to do with its astonishing economic success. Whether in the face of global recession China can continue to grow at the same rate is unclear – as Keynes would have put it, we simply don't know. Nonetheless, its emergence as an economic superpower poses questions for economics that are harder to answer than is generally recognised. Economists do not always take the neoliberal party line, according to which growth can be sustained only in a regime of deregulated capitalism; the evidence of history precludes any such simple-minded view. Liberal capitalism has achieved striking results (though in the US, often against the background of trade protection), but so have many varieties of dirigisme, from rapid growth in late tsarist Russia to Asian market economies in the decades after 1945. Economic historians whose minds are not befogged by ideology accept that there are many routes to growth. At the same time, nearly all Western-trained economists insist that sustained growth is impossible in the absence of a legal system that allows the independent rule of law and secure rights to private property. Without this framework, they believe, there will not be the incentives required for long-term saving and investment.

But China has achieved the largest and fastest industrialisation in history without having such a legal system. Until recently, Western economists, along with other Western observers, were adamant that China would continue to be successful only to the extent that it mimicked Western practice. Now that Western economies are in trouble this confidence has been shaken, and China is once again being perceived as alien and dangerous. There is no real attempt to try to understand the sources of its success. Like other branches of the study of society, economics remains culturally parochial, and its underlying concepts based on a few centuries of Western experience.

. . . .

Akerlof and Shiller intend their analysis to contribute to an intellectual reformation in economics, as a consequence of which the discipline will become more useful to policy-makers. It must be doubted, though, that the authors will succeed in persuading economists of the inadequacy of the conception of rational action. The profession is one of the few areas of human activity in which that conception is applicable. In its intra-academic varieties, at any rate, economics is insulated from the world not only by its narrow explanatory methodology but also because it rewards the mathematical modelling that resulted in nearly all of its members failing to anticipate the financial crisis. As institutionalised in universities, the notion of rational decision-making is self-perpetuating. Economics as currently practised may have only a slight grip on market behaviour, but it seems to be powerfully predictive of the behaviour of economists.

Thanks to Mort for bringing this piece to my attention.

Update on Saturday, December 19, 2009 at 07:37AM by Skeptic

Gavin Kennedy reposted parts of this and added his comments on Adam Smith's Lost Legacy. (Scroll to November 26, 2009.) Kennedy is an economic historian and an expert on Adam Smith, about whom he has written extensively, including two books. 

We’re all in this together.

Tom Petruno reports on pay cuts and the downward trend in the US employment cost index, primarily in the context of the Great Recession, but the included graph shows this is a long-term trend. See also this post and this one for confirmation of the long-term trend. It's related to globalization, and there are those who favor continuing to drive down US labor costs and say we can't have full employment unless we do.  From the Petruno piece:

There is, however, a hard-core camp in the economics world that believes the only way to put America's new army of jobless back to work is via a deep reduction in labor costs overall -- enough to make the U.S. far more competitive with overseas rivals.

Among the economists espousing that view are Edward Hadas, Martin Hutchinson, and Antony Currie of Breaking Views, and they say US wages should go down as much as 20 percent:

The big trade deficit is another sign of excessive pay for Americans. One explanation for the attractive prices of imported goods is that American workers are paid too much relative to their foreign peers.

Global wage convergence is great for the poor but tough on the overpaid. It’s possible to run the numbers to show that American manufacturing workers should take average real wage cuts of as much as 20 percent to get into global balance.

Many members of the professional and managerial class and small business owners presumably agree. They should reconsider. It's not going to be possible for them to maintain their incomes and revenues if their customers and taxpayers have declining incomes. Henry Ford understood this in 1914; everybody should understand it today. Globalization is a terrible thing for America.

Update on Monday, November 30, 2009 at 05:09PM by Skeptic

University of Chicago economics professor Gary Becker and federal judge Richard Posner, who share a blog, both argue that the best way to reduce unemployment is to drive down wages.  Becker:

The usual suggested remedies are either to stimulate demand for labor, or to reduce the real cost of workers to employers. The stimulus package has tried to stimulate demand. While I believe this package has failed to stimulate demand to any significant degree (see the discussion my earlier posts on January 11, 18, and November 1, 2009), and that the claimed employment effects of the stimulus are vastly overstated, I concentrate my discussion, as Posner does, on reducing the real cost of labor to employers.

If rigid nominal wages were the culprit, inflation would reduce the real value of labor costs, and hence stimulate demand by companies for workers. But deflation rather than inflation is the greater worry now, so this approach does not seem feasible at this time. The alternative is to cut the cost of labor to employers. . . .

It is wiser to cut labor costs in other ways. I fully endorse Posner's suggestions to cut the minimum wage, but I do not see that happening with the present Congress.

Hoover's Treasury Secretary, Andrew Mellon, would have approved, as he reportedly advised Hoover to "liquidate labor."  Obviously, Becker and Posner are not "in this together" with the unemployed.

Update on Friday, December 18, 2009 at 03:49PM by Skeptic

The recommendation to reduce unemployment by reducing the minimum wage, made recently by Becker and Posner and by others, has been attacked (successfully, I think) as being bad economics by Paul Krugman here and by others referenced deeper into the PK thread. 

Oil shale, the energy source of the future. And always will be?

The National Oil Shale Association has produced this video to describe how development of oil shale in Colorado, Utah, and Wyoming could help solve our energy security and balance of payment problems. A former colleague at The Oil Shale Corporation (Tosco Corporation) and now Executive Director of NOSA, Glenn Vawter, sent me the link.  The faces in the video are all new and the production values are much higher, but the story is essentially the same as it was 30 years ago in this Tosco report, Oil Shale: Part of the Solution. Oil shale developers are facing all the same problems we did 30 years ago, plus now we have concerns about global climate change. Supportive government policies were sought then and now. 

Healthcare costs could go down if Harry Reid takes Robert Reich's advice.

Robert Reich takes up the problem of cutting healthcare costs and encourages Harry Reid to draft a bill--or at least an amendment--that provides a robust public insurance option available to everybody, knocks out the provision extending for 12 years the monopoly for generic drugs, and holds Medicare reimbursement rates to the COLA formula enacted years ago. Cross posted at HuffPo. This would provoke determined opposition from insurance companies, drug companies, and the AMA, but it needs to be done because otherwise healthcare, which is already unaffordable for most Americans, will get even more so.  Reich says Reid should use the budget reconciliation procedure (requiring only 51 votes for passage) and get tough with Blue Dogs--if they don't vote for it, they should get no re-election help from the Democratic Senatorial Campaign Committee.

Hat tip to Christine for the link.