Correcting Krugman

Correcting Krugman on Climate

Mises Daily by Robert P. Murphy

In a previous article, I argued that Paul Krugman's recent articles in support of government efforts to mitigate climate change — and in particular the Waxman-Markey legislation pending in Congress — were typically misleading. Specifically, Krugman's estimate that "serious" efforts to fight climate change would cost only 2 percent of GDP by the year 2050 was much lower than what the IPCC "consensus" itself said about aggressive measures like Waxman-Markey, and in any event these estimates all assumed that politicians worldwide implement the policies in textbook fashion.

In the present article I wish to continue my criticism of Krugman's writings in support of Waxman-Markey. We will see that even on mainstream, neoclassical economic terms, Waxman-Markey fails a cost/benefit test by a huge margin. It's not even close.

Krugman Trick to Downplay Costs Would Also Minimize Benefits

In a passage intended to show just how cheap even aggressive climate action can be, Krugman writes,

Consumers would end up poorer than they would have been without a climate-change policy.

But how much poorer? Not much, say careful researchers, like those at the Environmental Protection Agency or the Emissions Prediction and Policy Analysis Group at the Massachusetts Institute of Technology. Even with stringent limits, says the M.I.T. group, Americans would consume only 2 percent less in 2050 than they would have in the absence of emission limits. That would still leave room for a large rise in the standard of living, shaving only one-twentieth of a percentage point off the average annual growth rate.

Elsewhere I have written about this neat little trick of translating a fairly large impact into an apparently negligible amount, by switching from the level of the impact into a reduced rate of annual growth. After all, two percent of global output in 2050 is a fantastic amount of income. To give a ballpark, in 2007, using the "purchasing power parity" approach, global GDP was about $66 trillion.

So if we conservatively assume that real global GDP (and yes we're ignoring all of the Austrian critiques about such a concept) grows at 3.5 percent annually, then MIT's estimate of the cost of fighting climate change works out to $5.8 trillion in the year 2050 alone. In other words, we're not talking about a one-shot cost here; we're saying the annual cost in the year 2050 will be $5.8 trillion (in 2007 US dollars). Somehow I think that if Dick Cheney suggested that fighting the global war on terror would "only" cost 2 percent of world output by 2050, Paul Krugman might raise more of a fuss.

In any event, Krugman's column seems rather one-sided, doesn't it? After all, when trying to decide if a particular policy makes economic sense, the standard mainstream thing to do is check whether the costs are lower than the benefits. And yet, the modeled benefits of fighting climate change aren't mentioned anywhere in Krugman's column. It is simply taken for granted that the US government must do something — and quick! As Krugman says in another column (again without pointing to any specific evidence), "It's time to save the planet."

Yet this is rather noneconomist talk, isn't it? It sounds a bit like saying, "Teachers should get a huge pay raise, because education is very important."

Yes, if the planet itself were in jeopardy, then just about any forfeited economic output would be worth it, if it could avert that catastrophe.

But of course "the planet" isn't in danger. What people really mean by such language is that "the desirability of living on earth as judged by our descendants" is at risk. Well then, exactly what are the risks? And let's be scientific and objective about this, folks! No consulting fringe "deniers." I want to draw from the consensus of world experts, as codified in the Intergovernmental Panel on Climate Change (IPCC) Fourth Assessment Report (AR4).

Now things get really interesting, and we see why Krugman and other proponents of Waxman-Markey haven't been talking about the quantitative, net benefits of their plans. As Jim Manzi points out, according to middle-of-the-pack estimates of various dials (such as the level of global emissions without strict government controls, the sensitivity of the climate to these emissions, the vulnerability of future generations to warmer temperatures, etc.), the IPCC reports that the hit to global GDP would be between 1 and 5 percent, for 4 degrees Celsius of (additional) warming that would probably not occur until the 22nd century.

Yikes, up to a 5 percent loss in total global output — an inconvenient truth indeed! Oh wait, Krugman has shown us how to deal with such alarming numbers. If we just shave 0.05 percentage points off of global GDP growth — for example, if the world economy grows at 2.95 percent per year, rather than 3 percent — then, as Krugman has already demonstrated, global GDP in the year 2050 will be 2 percent lower than it otherwise would have been.

Now if we just let the simulation run until the year 2114, the gap between 3 percent growth and 2.95 percent growth will have grown exponentially into a 5-percentage-point difference.

What does all this mean? Quite simple: the differential in growth rates that Krugman considers quite negligible when weighing the costs of fighting climate change works just as well for the differential in growth rates that the IPCC middle-of-the-pack forecasts say the world would suffer under unrestricted emissions.

In other words, by Krugman's own criteria, the best-guess IPCC estimate of the benefits of fighting climate change are just as negligible as Krugman considers the MIT estimate of the costs of fighting climate change.

Mainstream Economic Models Would Never Justify Waxman-Markey

The more I have investigated these matters, the more shocked I become. One doesn't even need to rely on Austrian or public-choice arguments to show that Waxman-Markey is crazy.

For example, William Nordhaus is one of the pioneers in the field of climate-change economics, and he is no laissez-faire ideologue; Austrian readers may recognize Nordhaus as Samuelon's coauthor of a textbook that is sympathetic to "market failure," to say the least.

Yet according to Nordhaus's "DICE" model of the global climate and economy, if the whole world were to implement the stringent emissions caps (83% below 2005 levels by the year 2050) contained in Waxman-Markey, the net loss of the policy would be enormous.[1] It's true, such stringent limits would reduce the amount of climate damage future generations would suffer, but the harms imposed on the economy (because of the emission caps) would more than outweigh these benefits. Indeed, Nordhaus's model says that the present discounted value of these different impacts (i.e., slowing climate change but also slowing economic growth) is somewhere in the range of negative $14 trillion to negative $21 trillion, measured in 2005 US dollars. (I give more details of this derivation here.)

Conclusion

Paul Krugman is a very sharp guy, conversant in many different fields. Yet his analysis of the economics of climate change is as wrongheaded as his analysis of depressions. Relying just on the IPCC "consensus" estimates as well as a leading model such as Nordhaus's, it is impossible to justify the draconian emission cuts in Waxman-Markey.

Partisans on both sides of the debate concede that if the United States imposes unilateral emission cuts, there will be a negligible effect on global temperatures. But, ironically, if the whole world were to foolishly follow us down this path, one of the leading mainstream models projects that the globe would be many trillions of dollars poorer for it — and that figure includes the alleged benefits of mitigating harmful climate change.

Correcting Quiggin on Austrian Business-Cycle Theory

Mises Daily by Robert P. Murphy

Australian economist John Quiggin

The Mises-Hayek theory of the business cycle — and of our recent housing bubble in particular — is gaining more and more adherents in the "real world." To give anecdotal evidence: Five years ago, when I'd write a Mises Daily article, the fan mail would pour in from college students. But now, I get questions from hedge-fund managers and others working in the financial sector. Austrian economics is no longer a hobby; this is serious stuff.

Because of the popularity of the Austrian message — where Exhibit A is the Ron Paul campaign — mainstream economists are taking the time to explain why (in their opinion of course) the Mises-Hayek theory is nonsense. In the past I've answered Tyler Cowen and Paul Krugman's objections, but today's focus will be the recent critique penned by Australian economist John Quiggin.

Quiggin's piece deserves careful scrutiny. In the interest of brevity, I am going to dive right into his objections. If you need a more introductory exposition of Austrian business-cycle theory (ABCT), try this collection or, if you prefer a PowerPoint presentation, check out Roger Garrison's amazing creations.

Business Cycles Predate the Fed

Quiggin's first objection is understandable:

The data Mises and Hayek had to work on was that of the business cycle that emerged with industrial capitalism at the beginning of the 19th century and continued with varying amplitude throughout that century. In particular, it's important to note that the business cycle they tried to explain predated both central banking in the modern sense of the term and the 20th century growth of the state. The case of the US is of particular interest since the business cycle coincided with a wide range of monetary and banking systems: from national bank to free banking, and including a gold standard, bimetallism and non-convertible paper money.

Quiggin is right, in that many casual expositions of ABCT say things like, "The Austrians believe the business cycle is not a feature of the free market, but instead is caused by the manipulations of the central bank." Since there were boom-bust cycles in countries and time periods that did not have a central bank, this strong statement is obviously wrong.

However, the problem here is one of loose language, not a flaw in the underlying theory. It is far more accurate to say that ABCT blames the boom-bust cycle on fractional-reserve banking. Specifically, when banks are allowed to issue paper money (or increase customers' electronic bank deposits) without an actual act of saving by somebody in the economy, then the resulting drop in interest rates is artificial. The false interest rate sets in motion an unsustainable boom period, which leads people to erroneously consume capital and which sows the seeds of the inevitable bust.

Government intervention is still very much involved in this sordid enterprise. Were it not for favored legal privileges granted to banks, the practice of fractional-reserve banking would be "regulated" by market competition. Even if banks were legally allowed to extend more loans than they had cash (or gold) in the vaults, they would be very cautious with their overissue so long as a bank run would spell ruin. Yet time and again, even before the establishment of central banks, governments would allow the banks to "suspend specie payment" during panics. In other words, when customers had contractual claims on big bankers who had behaved recklessly and gotten caught with their pants down, the government officials told the little guys, "Tough."

This practice of absolving privileged bankers of their legal obligations was simply institutionalized (in the United States) with the creation of the Federal Reserve. It is no coincidence that the worst boom-bust in US history occurred sixteen years after the formation of the modern American central bank.

Rational Expectations?

Quiggin then moves on to the most typical mainstream objection to ABCT:

There's an obvious implication about the (sub)optimality of market outcomes here… If investors correctly anticipate that a decline in interest rates will be temporary, they won't evaluate long-term investments on the basis of current rates. So, the Austrian story requires either a failure of rational expectations, or a capital market failure that means that individuals rationally choose to make "bad" investments on the assumption that someone else will bear the cost. And if either of these conditions [applies], there's no reason to think that market outcomes will be optimal in general.

Let's deal with the last sentence first: Quiggin is saying that if people in markets screw up, then markets aren't perfect. Well, yes, that's certainly true. But from this it does not follow that Austrians are wrong for preferring a voluntary, competitive market process to a coerced, monopolistic government process. It is not the Austrians but rather certain members of the Chicago School who actually theorize as if people on Wall Street were supercomputers.

The Austrians know that free individuals often make mistakes — even systematic mistakes — but the Austrians also know that government bureaucrats lack the one true criterion for successful entrepreneurship, namely the profit-and-loss test. Quiggin's (implicit) argument is akin to pointing out a case of scientists pursuing an erroneous theory, and then calling for government commissions to oversee the refereeing process in scientific journals to avoid such mistakes in the future.

Specifically, Austrians have offered two types of defense against this typical "rational expectations" objection. First, Austrians point out that individual entrepreneurs who know a boom is underway are powerless to prevent their more reckless competitors from taking cheap (or now free) government loans and bidding away scarce resources. Workers don't care whether their paychecks come from genuine saving or from the Fed's printing press, and every few years there is always a fresh crop of naïve employers willing to borrow money and start new projects.

Second, Austrians emphasize that interest rates communicate information to entrepreneurs. The way some critics describe it, you would think "everybody knows" that the true interest rate ought to be 5 percent, and so the Fed's efforts to push it down to 3 percent should be easily corrected. Yet nobody knows what the truly free-market interest rate is. That's why market prices are important in the first place, and why government distortions of these prices lead to real imbalances in the economy.[note]

Consumption and Unemployment

Let us return to Quiggin:

[U]nless Say's Law is violated, the Austrian model implies that consumption should be negatively correlated with investment over the business cycle, whereas in fact the opposite is true. To the extent that booms are driven by mistaken beliefs that investments have become more profitable, they are typically characterized by high, not low, consumption.

Finally, the Austrian theory didn't say much about labour markets, but for most people, unemployment is what makes the business cycle such a problem. It was left to Keynes to produce a theory of how the non-neutrality of money could produce sustained unemployment.

On the first point, Quiggin seems to be saying that Austrians don't believe in "idle" resources, and so if investment goes up during the boom, then consumption must go down. After all, the government can't make the economy more physically productive simply by pushing down interest rates, so how could businesses possibly produce more investment and consumption goods during the boom?

The answer is that Quiggin needs to appreciate the Austrian approach to capital theory. This is one area where the "sophisticated" modern theorists are childishly simplistic, in comparison to the "obsolete" verbal analysis of 19th-century writers like Böhm-Bawerk. The low interest rates of the boom period mislead entrepreneurs into borrowing too much, but they also mislead consumers into borrowing too much and saving too little. This is physically possible because resources that otherwise would have gone into replenishing the capital structure are instead devoted to new projects or additional consumption goods. As I illustrate with a simple story here, this "eating of the seed corn" can take a while to manifest itself in a complex, modern economy.

Concerning labor markets, the ABCT explains why a brief period of high unemployment is necessary. Workers who were channeled into unsustainable occupations need to be laid off, and their wages need to fall so that they can be reintegrated into useful niches elsewhere in the economy.

The persistence of high unemployment throughout the 1930s is not a task for ABCT to explain. Rather, this was a consequence of the destructive high-wage policies of both Hoover and FDR, not to mention massive deficits and tax increases that further eroded worker productivity and made employers less likely to hire people. It's a bit odd to say that only Keynes could explain the persistence of unemployment in the 1930s, when after all Hoover and then FDR were among the best Keynesians in US presidential history.

Miscellaneous Cheap Shots

Having dealt with Quiggin's serious objections, in this final section I'll point out some of his contradictory rhetorical eye jabs. For example, Quiggin writes:

The modern Austrian school has tried to argue that the business cycle they describe is caused in some way by government policy, though the choice of policy varies from Austrian to Austrian - some blame paper money and want a gold standard, others blame central banks, some want a strict prohibition on fractional reserve banking while others favour a laissez-faire policy of free banking, where anyone who wants can print money and others still (Hayek for example) a system of competing currencies.

But earlier in his piece he had written:

To sum up, although the Austrian School was at the forefront of business cycle theory in the 1920s, it hasn't developed in any positive way since then….The result (like orthodox Marxism) is a research program that was active and progressive a century or so ago but has now become an ossified dogma. Like all such dogmatic orthodoxies, it provides believers with the illusion of a complete explanation but cease to respond in a progressive way to empirical violations of its predictions or to theoretical objections.

I wish Quiggin would make up his mind. Are we Austrians a bunch of dogmatic zealots, worshipping at the altar of Mises? Or are we a bunch of illogical fools, who can't even reach the same conclusion from our shared assumptions? Quiggin is ridiculing us for (a) mindlessly parroting our dogma and (b) not agreeing with each other. What Quiggin sees as religion and confusion, the Austrian of course would describe as thinkers engaging in intellectual refinement of a great theory.

Ah, I've saved the best for last. Quiggin returns to his theme that the Austrians are silly for blaming business cycles on central banks, which after all weren't in existence for some big depressions:

Rothbard gets around this by defining central banking to cover almost any kind of bank that has some sort of government endorsement, such as the (private) Bank of England in the 19th century, and arguing for a system of free banking that would avoid, he asserts, these problems. But, on any plausible definition of the term, the US had free banking from the Jackson Administration to the Civil War and that didn't stop the business cycle….Overall, the US was much closer to free banking throughout the 19th century than in the period from 1945 until the development of the largely unregulated 'shadow banking' system in the 1990s, but the business cycle was worse then (how much worse is a matter of some controversy, but no serious economist claims it was better).

If you stop and analyze it, the portion I've emphasized above is absolutely hilarious. Note carefully the move Quiggin is pulling here. He wants to show that Rothbard is crazy for blaming the business cycle on central banking. So you might think a natural test of this thesis would be to look at business cycles in the United States pre-Fed (i.e., before 1913) and after the Fed was created (i.e., after 1913).

But that's not what Quiggin does. No, his approach compares US history before the Fed with the period of US history after the Fed has been established and in between the two worst financial crises in world history!

The Federal Reserve was founded in 1913, and so the Great Depression of the 1930s definitely occurred on the Fed's watch. But Quiggin throws out that particular "outlier" by starting his comparison after World War II. OK fair enough, maybe the Fed officials needed a few decades to get their hands dirty and learn the ropes. Yet surely the Fed should then be held responsible for what is easily the second worst global financial crisis in world history, occurring right now. Nope, that doesn't count as a strike against central banking either, because Quiggin stops his comparison in the 1990s. How convenient.

Conclusion

I am not here to tell you the Mises-Hayek theory of the business cycle is a work of art that has no flaws. If I said that, then I would be living up to Quiggin's caricature. What I will say is that the Austrian explanation of the boom-bust cycle makes more sense than any other explanation I've seen. In particular, most rival schools of thought say that the way to fix an economy plagued by overconsumption and reckless lending is to have the government borrow obscene amounts of money and to have politicians take over financial accounting. And it's the Austrians who allegedly cling to dogma in the face of overwhelming counterevidence?

Correcting perceptions

Discarding the negative old stereotypes

M. Ashraf Haidari

As we and our international partners strive to secure Afghanistan, three misperceptions about corruption, narcotics and popular support for international presence have gained currency in certain capitals of our nation-partners.

A reality check against each misperception propagated by the media is necessary to help us build upon our shared achievements thus far and to work together toward overcoming the challenges we face today. Failure to do so is certain to strengthen our common enemies - the Taliban and al Qaeda - in further destabilizing Afghanistan and the whole region.

• Corruption is not a cause but a symptom of weak governance due to severe underinvestment both in capacity and resources in Afghanistan's key state institutions over the last eight years. Because the judiciary and the police constitute the first point of contact between public and government, people tend to judge the government's legitimacy and performance based on their daily experience with those institutions.

When the international community re-engaged in Afghanistan in 2001, the country was completely stateless, and our partners had to begin building the state institutions from the ground up under harsh circumstances. Hence, the strength or weakness of governance in Afghanistan today is clearly a function of how much effective, coordinated aid has gone into building a functional state in the country.

For example, it is apparent from the meager level of resources committed so far to reforming and building the Afghan judiciary and police that corruption prevails in these two key state institutions today. It is obvious that better-paid, better-trained and better-equipped officials in any government in any part of the world would have less incentive to be corrupt - and Afghanistan is no different from others.

Nonetheless, the Afghan government has frequently taken serious action against corrupt officials and introduced drastic measures to curb corruption in the whole government. Several inept ministers and more than a dozen corrupt administrators, governors, police chiefs and diplomats have been fired.

The Afghan government recently appointed a new interior minister to accelerate the reform and building of the police, while establishing the High Office of Oversight and Anti-Corruption to fight systemic governmental corruption that is at the heart of the problem.

• Generalizing Afghanistan as a "narco-state" is misleading and diverts our attention from how to fight narcotics as a transnational security threat rather than as an Afghan problem alone. The fact is that since 2001 Afghanistan's share of licit economy has outstripped that of its illicit, which is now less than a third of our annual gross domestic product. But we know from international experience that global demand for narcotics finds supply in environments where state institutions are weak, where general instability is high, and where poverty is rife. Although Afghanistan is in such a dire situation today, the number of drug-free provinces in the country has increased from six in 2006 to 18 in 2008. This means no opium is grown in more than half of the country's 34 provinces. This progress has been made in provinces where the government has been in firm control, delivering alternative assistance to farmers and prosecuting drug traffickers.

To be effective, counter-narcotics efforts must target all players in the long chain of the opium trade, including traffickers, distributors and dealers, who pull in about 80 percent of the export value of Afghan narcotics. We need proactive international cooperation to implement the United Nations Security Council resolution 1818 of July 2008 to curb the flow of precursor chemicals into Afghanistan and export of narcotic products out of our country to the end markets through neighboring states.

At the same time, farmers must have the opportunity and resources to grow alternative crops. To make these crops more lucrative, investments in infrastructure are needed. In addition to water, seed and fertilizer, farmers must have access to reliable farm-to-market roads or to cold-storage facilities to preserve products for later export.

• Finally, there are frequent and absolutely incorrect references to Afghanistan as a "graveyard of empires," where democratic nation-building is impossible. A monthlong stay among the Afghan people will reveal to any serious observer that the hardships and suffering the Afghan people have endured during the last 30 years have changed their worldview. The youth who constitute more than 60 percent of the Afghan population look to the future in today's globalized context.

Afghans demand security, justice and pluralism, which they know can only be restored by long-term international engagement. We understand that premature international disengagement from Afghanistan in the early 1990s made the country a no-man's land where transnational extremists, terrorists and criminals freely roamed and used the stateless country to endanger international peace and security. The tragedy of Sept. 11, 2001, is a sad reminder.

Hence, irrelevant comparisons such as premodern wars or the 1979 Soviet invasion of Afghanistan to the 2001 international re-engagement to free Afghans of the tyranny of the Taliban are neither accurate nor helpful.

Afghans view American and NATO forces as their liberators, while they perceived the Soviet forces as invaders and occupiers with a godless ideology.

Historical comparisons often no longer hold true, and they do not in Afghanistan. We should rather focus on delivering on the basic expectations of the Afghan people: security, rule of law and jobs - expectations that have given them hope after 2001.

M. Ashraf Haidari is the political counselor of the Embassy of Afghanistan.