Why the US Government Can't See Economic Bubbles

In yesterday's NY Times, Jared Bernstein (former chief economist to Vice President Joe Biden) wrote a perspective-from-experts piece (here) titled "Undoing the Structural Damage to Potential Growth". Dr. Bernstein presumably gets the attention of policy makers in Washington and in this piece he aligns himself with the Congressional Budget Office (CBO)  for support. What is striking about the piece is that, without saying as much, he completely rejects the ideas that there was a Subprime-Mortgage Bubble which became visible in 2008 and argues that government policy could get us back to the peak level of GDP that was generated by the bubble. Let me try to summarize his argument.

The CBO (in the graphic above) has made two forecasts for "potential output," that is output the economy could maintain under full employment. The first forecast (bold dashed line) was from January 2007, right before the Subprime Mortgage bubble burst. It showed accelerating GDP growth into the foreseeable future. In February 2014, the CBO modified their forecast to show a lower rate of potential GDP  growth, 7.3% below the old forecast line which Bernstein translates into 10 million jobs lost. The Federal Reserve has argued that this labor market damage cannot be undone. Bernstein argues that it could if we ran a "high-pressure" economy fueled by government spending.

The theory underlying all this is an analogy derived from the physical sciences. When a physical system undergoes a permanent change (say the parts start wearing out because the system has been in production for a long time) the effect is referred to as hysteresis. Bernstein describes how the analogy works for economies:

When a cyclical problem morphs into a structural one, economists invoke the concept of hysteresis.  When this phenomenon takes hold...the economy undergoes a downshift that lasts through the downturn and well into the expansion, reducing the economy’s speed limit. 

The bottom line of his argument is that hysteresis can be reversed by "high-pressure" economic policy. He claims that results by "a number of top economists" are about to be published confirming the relationship between fiscal policy, hysteresis and reverse-hysterists.

To me, none of this argument is very clear: (1) If hysteresis is a permanent change how can it be reversed by spending more money rather than replacing the system's parts, the parts that are wearing out? (2) What is it about the Subprime Mortgage crisis that you would call cyclical? This is the worst recession since the Great Crash of 1929. That's a pretty long cycle. (3) What precisely is the mechanism that changes a cyclical problem to a structural problem (but it wasn't a cyclical problem)? What exactly is a structural problem, the parts wearing out? (4) Is the economy "downshifting" because the transmission is wearing out and gears are slipping or because the economy exceeded some speed limit (bubble)? OK, I'm really confused, but maybe this makes sense to Washington policy makers.

What's really going on here underneath all the analogies and mixed metaphors? Let's go back to the original CBO "potential output" forecasts. They use some basically simple equations to make these projections. If employment is a function of output then L = e(GDP), that is, employment is proportional (e) to GDP. If we reverse the equation and we assume some number for full employment, (L*)/e = GDP*, where L* is the assumed full-employment labor force and GDP* is full-employment output. This exercise is really just equivalent to picking some historical date and then drawing lines on graph paper--anyone can do it, not just the CBO.

In the graphic above I've plotted real GDP (GDPC96) over time (the solid black line). The dashed lines are the dynamic attractor paths for US GDP. I've written in more detail about how this plot and the attractor paths above were generated (here and here). The attractor path was basically generated by a state-space model of the US economy. It clearly shows the Subprime Mortgage Bubble and shows that we are currently pretty much on the attractor path in 2014. For understanding what the CBO is doing, you do not really need a model or even a simple equation.

You can pick any historical date and start drawing some lines. If you think 2003 was a reasonable place for the US economy to be, just connect it to another low point such as 2000 and you have a forecast out to 2009. If you think 2008 was a reasonable place for the US economy to be, as does the CBO and Jared Bernstein, then draw line B going off into infinity. If you changed your mind after the Subprime Mortgage Crisis, as the CBO did, draw line C and hope it returns to line B at some point in the future. Or, if you think 2012 was a reasonable GDP level for the US economy, draw line D which corresponds pretty well with the attractor path generated by the USL20 model.

Does anyone else beside the CBO and Jared Bernstein think that 2008 was a reasonable level for GDP? If you do, you do not believe in economic bubbles. You cannot take action to pop bubbles because bubbles do not exist. If you accept the Federal Reserve's argument that the Labor Market damage from the Subprime Mortgage Crisis cannot be undone and your common sense tells you that there was a Subprime Mortgage Bubble, the time to act was sometime between 2004 and 2006. The problem is that among those who accept the common sense idea of economic bubbles, no one can agree on how to identify a bubble (Line A or the USL20 attractor path) so policy makers cannot act. And, those who do not believe in bubbles are left with lines B, C and a comforting theory of potential output--or the harsh reality of line D.

Compare US to the EU: Stimulus vs. Austerity

Last Sunday, Fareed Zakaria (above) did an instructive comparison between the economies of the US and the EU in the aftermath of the Subprime Mortgage Crisis. The histories of the two economies are different: the US followed an expansionary fiscal and monetary policy while the EU embraced austerity. Expansionary economic policy involves decreasing interest rates, increasing government spending and increasing the deficit. Austerity involves fighting (imaginary) inflation, reducing government spending and decreasing deficits. As far as historical experiments go, the results are pretty clear. The US is forecast to grow modestly next year while the EU is forecast to contract.

These lessons of history are hard for the right wing to understand: expansion means growth and austerity means contraction. The presumptive Republican presidential candidate, Mitt Romney, has been preaching austerity for the US as the correct response to the Financial Crisis (here). The Tea Party movement is also preaching austerity (for example, Rick Santelli of CNBC and Senator Ron Johnson, R-WI). Their arguments are based on Rick Santorum's Old Time Religion: when you've been profligate, you need to repent. Their arguments are just not based on history as it is unfolding or did unfold during the Great Depression of the 1930's.

What Caused The Financial Crisis? 21 Different Views!

In the video above, CNBC analyst Steve Leisman interviews Andre W. Lo who recently wrote Reading About the Financial Crisis: A 21-Book Review, available on Prof. Lo's website (here). You might know Andrew Lo from another book he wrote A Non-Random Walk Down Wall Street which argues that the random-walk view of financial markets is not quite accurate (for more on this, see my other blog piece here).

In the interview above, Prof. Lo argues that two of the myths surrounding the Financial Crisis of 2007 are probably wrong: (1) the argument that there was excessive risk taking (investment banks taking risks with other people's money) ignores the fact that many investment bankers lost large amounts of their own personal fortunes during the crisis and (2) the argument that mortgage lenders engaged in predatory borrowing seems contradicted by the sophisticated attempts of average home owners to purchase and "flip" house to make quick profits.

One might quibble with the quick points Prof. Lo made during the interview, but his lengthier paper reviewing the 21 books about the Financial Crisis is worth reading. The bottom line is that we still do not understand the financial crisis and well-intentioned policy attempts to prevent future crises, such as the 2010 Dodd-Frank Act, may or may not be trying to solve problems that either don't exist or are the symptoms of deeper, poorly understood, more fundamental factors.

Wealth Tax: Both Left and Right Have It Wrong.

Today on CNBC (video above) and in an earlier piece in the Financial Times (here), Edmund Phelps presented a new and interesting view of financial crises. Phelps was specifically talking about the current EU Sovereign Debt Crisis but I also would argue that it is applicable to the entire late-2000 Financial Crisis.
I've simplified Phelps' argument in the causal diagram above. First consider the two negative feedback loops in the lower part of the graph that describe long-cycles in the economy (start reading on the bottom). In the outer loop, described explicitly by Phelps, economic growth increases income inequality (wealth) which reduces productivity (why work when you're wealthy) and thus decreases growth. I have added another loop to Phelps' argument, a loop I have talked about in more detail in an earlier post (here), and that is the effect of inequality on directly generating financial crises. To simplify, rich people have a lot of excess income seeking high rents in risky places. When the financial house of cards collapses, the effects on growth are negative.

Now, here is the interesting argument from Phelps. Before the financial crisis hits, the government needs to "unlock" the unproductive wealth and put the money to work through a wealth tax. Let's assume for the moment that the government knows what to do with that wealth in terms of improving the physical and social infrastructure that is undervalued by the private market (rather than using it, for example, to fight a foreign war).

Phelps' argument suggests that both the right and the left have it wrong. The right-wing home remedy for any crisis is to reduce taxes. This just makes matters worse because it increases inequality and locks up more wealth (since there is no aggregate demand, the surplus funds are saved rather than invested in productive activity that might create jobs).

The left also has it wrong when relying on deficit spending. As Keynesian economics argues, during a crisis it is necessary to increase government expenditure to make up for shortfalls in aggregate demand. Unfortunately what happens is that increasing the deficit increases borrowing costs which starts the deficit hawks clamoring for a reduction in government expenditure (they are usually successful as they were in the Recession of 1937-1938 in the US). Increases in the deficit can, at the same time (potentially) create the conditions for future inflation.

The shortcoming in Keynesian theory in my view (you can read Phelps' view here) has always been that it didn't really offer an explanation for why crises occur in the first place. It just offered a policy response that didn't make things worse by contracting aggregate demand further. Phelps seems to offer a better explanation of why crises occur in the first place and a policy response for preventing the development of a crisis in the first place. You can access more of Edmund Phelps academic work, if you're interested, from his website at http://www.columbia.edu/~esp2/.

Confidence and Credibility

John Taylor is an economist at the right-wing Hoover Institution. His specialty is monetary policy. He is best known for proposing the Taylor Rule, a simple rigid formula for how the central bank should change its nominal interest rate based on departures from targeted inflation rates and differences from potential GDP.

The purpose of the Taylor rule is to systematically reduce uncertainty and increase the credibility of future central bank actions to foster price stability and full employment. In the video above, Taylor extends his uncertainty-credibility analysis beyond the central bank to all areas of government policy, to include fiscal policy, health care policy, regulatory policy, etc.

The extended generalization hinges on whether uncertainty-credibility are at the root of our current financial crisis. Taylor thinks that business would be hiring if the government was "credible" (instituted austerity programs) and business had "certainty" (business can be certain that they can do whatever they want without regulatory interference).

The Keynesian response to the "business confidence" argument (stated here and critiqued here) is that actual demand is more important to investment. What's the point of investing if there is no demand? In the current financial crisis where investment has been chocked off with the evaporation of liquidity, we're in a situation where consumption (C) and employment (L) are at low levels consistent with the downturn in GDP. We might hope that exports (a positive balance of payments, BOP) might help, but that's unlikely because the world system is also in recession.

Eliminate "Investment" and "BOP" from the graph above and you are left with government expenditure (deficit spending) as the only way to increase consumption and employment. You can lower the interest rate as much as you want and it won't stimulate investment because (1) current capacity is not being fully utilized and (2) the interest rate cannot go below zero.

John Taylor's arguments about uncertainty-credibility make sense in a business-as-usual environment when inflation and GDP are near their targeted values. To make these arguments during the Great Recession, when inflation and GDP are well below targeted values doesn't even make sense using Taylor's own formula (see below).

THEORY: The Taylor Rule is roughly i = i* + a(P - P*) + b(GDP-GDP*) where i is the interest rate, P is the price level, GDP is gross domestic product, and the starred values are desired, equilibrium or attractor levels. If P* and GDP* are a lot greater than P and GDP, respectively, the interest rate becomes negative, the dreaded zero-bound when the Taylor Rule no longer applies.

Analyzing the Taylor Rule would, by itself, be an interesting topic for a future post. For me, the key issues here are how to specify the dynamic attractors for inflation and GDP and how well changes in nominal interest rates would lead to price stability and full employment. The fact is that central banks do not use the Taylor rule so its application is purely counterfactual.

Keep Your Eye on the Ball

Last night, President Obama gave his State of the Union speech (full video below). The speech marked the end of President Obama's Keynesian phase and his rebirth as a neoclassical growth economist. In his Keynesian phase, it was all deficit spending and employment. In his neoclassical growth phase, it will be all technology, capital investment and competitiveness.

The graphic above shows a causal diagram of neoclassical economic growth theory. Everybody that can work is fully employed. Production involves the combination of capital, labor and technology within a free market system. But wait, how does that work? Neoclassical growth theory is about the long-run. Unemployment is still above 9% (here). Is neoclassical growth theory really applicable? And, doesn't more production mean more greenhouse gas (GHG) emissions (what ever happened to cap-and-trade and Carol Browner)?

If the Financial crisis of 2007-2011 is over, maybe it's time to forget bailouts and stimulus packages and think about the long run (take our eye off the ball?). A lot of people are more than happy to forget Keynesian economics. Whether you agree or not with John Maynard Keynes, however, he did produce some great quotes:

"The ideas of economists and political philosophers, both when they are right and when they are wrong are more powerful than is commonly understood. Indeed, the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually slaves of some defunct economist."
— John Maynard Keynes

"The long run is a misleading guide to current affairs. In the long run we are all dead"
— John Maynard Keynes

GM and Executive Compensation

GM CEO Dan Akerson in a speech to the Economic Club of Washington, D.C. complained that GM needed to increase it's level of executive compensation to retain top talent. This is at the same time that the Obama-McConnell compromise is promising tax cuts for wealthy Americans and Federal employees are being subjected to a compensation freeze.

Aside from demonstrating that Dan Akerson is not politically very adept, maybe he should wait until the current GM executive team (him included, who is making $9M/year) can demonstrate some results before bellying up to the compensation trough. My forecast for GM stock (above) does not predict a very bright future, at least through 2020.

The Stimulus and Globalization

A recent editorial in the NY Times from the US Business and Industry Council argued that the government expenditure contained in the US economic stimulus package leaked away as consumers purchased imports from foreign countries. The council's suggestions: (1) buy American and (2) impose Tariffs. Each of these policy interventions can be analyzed using the causal model presented in an earlier post. Part of the causal model is displayed above (click on the graphic to see a larger image).

Government expenditure with a "Buy American" requirement would stimulate domestic sales, increase production, create jobs and create more demand (some of which would go to imports). Tariffs (taxes) on imports would make them more expensive and reduce demand.

Beggar-my-neighbor trade policies have been tried before. The Smoot-Hawley Tariff didn't work during the Great Depression and may have made things worse. But, the Business and Industry Council argues that tariffs worked during the Nixon Administration when, in 1971, Nixon imposed tariffs on Japan, Germany and other countries that refused to let their currencies rise. The tariffs were part of the Nixon Economic Shock (to include wage and price controls) in response to inflation generated by the Vietnam War.

Neoclassical economists argue that tariffs are a bad idea because they raise the price of domestic goods and damage the world economy. We would need a causal model of the world economy to discuss the later point (maybe in a future post). However, the effect of tariffs depends on what is being taxed. If we impose tariffs on countries with substandard environmental controls (green- or eco-tariffs), we benefit our own economy and benefit world environmental systems.

What do you think are the chances that the US Congress would impose tariffs? How about the chances that the US Congress would impose eco-tariffs?

The President's New Plan

It's getting close to the mid-term elections in the US and President Obama has a new plan for business tax breaks. Robert Reich gave a great commentary on NPR's Market Place and the commentary seemed to be based (with some embellishment) on the causal model above (click on the graphic for an enlarged view).

The president is proposing corporate tax cuts for R&D. Tax cuts will lead to the development of labor-saving technology that reduces jobs. Profits might also generate some investment (if there is demand). Otherwise, profits will be expended on CEO pay and Shareholder dividends which fuel the Stock Market casino (didn't that all start the Great Recession in the first place, that is, too much easy money sloshing around).

The problem we're having right now is inadequate demand created by the Great Recession (you can see the vicious circle in the graph: lack of demand leads to lack of sales leads to lack of production which leads to unemployment which decreases demand, etc.). Interest rates could be lowered by the Federal Reserve but they are almost at zero (the zero-bound) right now. Exports could be increased but the rest of the world is also in recession. Imports could be reduced (e.g., automobiles) but that requires demand for US products.

What remains is the Keynesian economic prescription: government spending. There is only one problem with increased government spending: it is being blocked by deficit hawks, fiscal conservatives, sound money evangelists, and bond vigilantes. The same dynamic played out during the Great Depression until WWII intervened.

So, the President's New Plan will be counterproductive (R&D tax cuts could decrease jobs), the Fed is at the zero-bound, and government expenditure will not increase unless we have another World War. What's going to happen?

Eventually, the markets will have their way and, in the words of Andrew Mellon (Herbert Hoover's Treasury Secretary), the markets will:

...liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate… it will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people.

For people that believe in markets and for people that do not, Mellon makes an important point. All markets will eventually adjust to bubbles created in other markets (e.g., housing and the stock market). The adjustments are brutal and painful if not necessarily swift. Subdivided ghost towns will be bulldozed or left to decay, jobs will be shipped to low-wage countries, companies will fail, people will drop out of the work force or take jobs below their skill level, and eventually there will be a new equilibrium.

The politics of all this are a little infantile: The US father figure (the president) is expected to fix the mess yet, at the same time that he is expected get out of the economy by reducing expenditure and regulation. I just heard another great Catch-22 in NPR Marketplace tonight: all the stimulus funds have not been spent because there are not enough federal workers to manage the contracts.

Are There Automatic Stabilizers in the Economy?

In July 1944, John Maynard Keynes addressed the Bretton Woods Conference (pictured above) arguing in favor of government spending during recessions and depressions. The Christian Science Monitor has recently reported that Keynesian economics failed, in of all places, England where Keynes was born. Whether or not Keynesian economics is a failure, there is a bigger question of whether there are automatic stabilizers that keep the economy on course and, if not, should there be? Keynes' argument was that the automatic stabilizers did not work in the way envisioned by neoliberal economists. This is a particularly important question to answer in the aftermath of the Financial Crisis of 2007-2010.

This list of potential mechanisms for automatically stabilizing the economy is fairly short: (1) unemployment benefits, (2) manipulation of the Fed Funds Interest rate, (3) Keynesian deficit spending and (4) market discipline. The US Senate failed to extend unemployment benefits even though unemployment is still high. The Fed is at the zero-bound (interest rates cannot go lower without money essentially being free). In a reprise of Herbert Hoover in 1932, the "bond-vigalantes" are calling for a return to austerity to end deficit spending and bolster "confidence". And, a bubble in the housing market is what got us in to this mess in the first place (the opposite of a bubble is a deflationary collapse).

Paul Krugman recently took on the issue of unemployment benefits. Yes, unemployment benefits create mild disincentives for people to look for and accept lower pay or poorer quality jobs. The lack of job creation, however, trumps the incentive effects. The jobs aren't there and without unemployment benefits, consumption isn't there to create a recovery.

Deficit hawks on the right are arguing that it's time to "cut, cut, cut, irrespective of the economic consequences" according to Carolyn B. Maloney, D-NY. Interestingly enough, the argument for austerity is the same argument made to countries on the periphery of the world system going through debt crises. Republicans (e.g., Kevin Brady, R-TX) are even arguing that "the United States may experience a debt crisis similar to Greece." In other words, the government should step back and let the market that created the crisis solve the crisis through the discipline of unemployment and enforced hardship for the working class--even though with low interest rates and a high demand for government bonds, now would be a good time for the government to increase borrowing.

Sadly, the same arguments were made to Herbert Hoover at the start of the Great Depression by the American Banker Andrew W. Mellon: "...liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate...it will purge the rottenness out of the system." Andrew Mellon vs. John Maynard Keynes: what do you think? One problem with deficit spending is the likelihood that a period of deficits will not be followed by a period of surplus. Although the Clinton administration did run surpluses, it seems we cannot count on Republican administrations to run surpluses in good times (their preference is to provide tax cuts for those at the higher end of the income scale). Given the effect that weird politics (conservatives actually aren't fiscally conservative) have on the "automatic stabilizers," Melon's brutal, heartless, Republican home remedy for recession and depression becomes ever more likely. And, "those who do not read history are doomed to repeat it".

Deflation and Inflation in the World System

The Economist recently commented on the possibility of deflation after the world-wide financial crisis of 2007-2010. The major worry is deflation in the core countries and inflation in the peripheral economies of the world system. Current events demonstrate the strong dependency relationship between the core and the peripheral countries (core countries in deflation, peripheral countries booming or vice versa). Currency manipulations and tighter monetary policy in the core countries are being offered as the appropriate policy response to get the world system back on the track to unlimited growth.

History suggests, however, that none of these policies will be a panacea. When monetary conditions in the rich world are loose, emerging economies are prone to lending binges and asset bubbles. The price of avoiding deflation in the rich world today may be a bust in the emerging world tomorrow.

The NY Times is also reporting that Latin American economies are booming based on increased Asian demand for commodities (iron ore, tin and gold). Latin America has had its share of debt crises since the 1980's. We're probably witnessing the beginning of another cycle. It's a fundamental feature of the current world system and the division of labor between core and peripheral countries. Policies designed to increase short-term growth (especially in extractive industries which are subject to swings in commodity prices) will only make the next crisis that much more severe in the future.

Financial Crises, Income Inequality and a Return to "American Values"

Today, in a CNN interview, Republican Marco Rubio (former Florida House Speaker) said that we need a return to "American values" that encourage the accumulation of wealth. Also, on Fareed Zacharia GPS, Lloyd Blankein CEO of Goldman-Sachs said no one should be "ashamed" to make a lot of money. Finally, it turns out that part of the reason for the Greek financial crisis is that wealthy people in Greece (there are a lot of them) are underreporting (OK, lying about) their income.

I'm, not sure what Mr. Rubio wants to return to, possibly the high levels of income inequality right before the Great Depression and the current Subprime Mortgage Crisis. For Mr. Blankfein, it probably doesn't matter (what's a million or two when you made $53.4 million US$ in 2006). And, of course, the wealthy use their accumulations for the benefit of society, just look at Greece and the US.

Turn Off the Bubble Machine

Today on NPR, Michelle Norris interviewed Lloyd Blankfein, the CEO of Goldman Sachs. When asked what Goldman might do in the future to prevent Financial Crises, Blankfein said "...recognize bubbles." On April 27, NOVA presented "Mind Over Money" asking "Can markets be rational when humans aren't?" Taken together, the Blankfein interview and the NOVA program beg a lot of questions.

First, it's not difficult to recognize bubbles (see earlier posts here). Even if Goldman were smart enough to recognize bubbles (I assume they are since they are the "smart money"), it's not their job. What would they tell the "dumb money"? Sorry, we won't place your bets! What would remain of investment banking? In fact, Matt Taibbi thinks Goldman Sachs is "The Great American Bubble Machine." If we wait for Mr. Blankfein and Goldman to recognize and do something about bubbles, we'll be waiting a long time.

How about the Federal Reserve? The Fed also failed to recognize past bubbles since it is the Fed's job to create growth rather than keep the economy from growing too fast.

How about the short-sellers who recognized the bubble and bet against it? They did their job and made a lot of "smart" money, but short-selling neither created nor defused the bubble.

Are there any other institutions that have the power to recognize and control bubbles? I can't find any and I'm not sure that breaking up Goldman would actually solve anything.

As with a lot of political issues, we probably aren't looking at the root cause. Since, 1990 there has been a sharp increase in the share of pre-tax household income held by the top 1% in the US. In 2005, it had almost reached 20%, the same level it had reached in 1929 before the Great Crash. There's a lot of money being held by people who's only objective is to make more money and Goldman is there to help them out (smart) or relieve them of their burden (dumb).

Even Alan Greenspan thinks income inequality is a problem (but doesn't connect it with bubbles) and the cause appears to lie in US politics.

Science as System

In the current global warming debate it would be helpful to have an idea about how the science system works when trying to evaluate the widely publicized outputs. Here is a meta-model discussed today in the Principles of Environmental Science.

Science is fundamentally about developing models. Usually the models are expressed mathematically or as computer code or both. Model development, however, is just the first step. The model must be tested against reality and revised if it doesn't fit the data.

After enough independent tests, revisions and validations, a model can be generalized into a theory (a model along with all its tests and revisions). Theories, so defined, accumulate our base of knowledge (scientia).

Is this the way it always happens? Not exactly! Many models in economics and system dynamics skip from model directly to theory and received wisdom. For example, consider William Norhaus' DICE model and the Limits to Growth models. I have been unable to find anything other than casual attempts to relate the model outputs to historical data.

Another approach in the global warming debate is to present tests without either a model or a theory. The work of Bjorn Lomborg provides a notorious example. Simple historical time plots are presented to "disprove" the global warming assertion and argue that things are actually getting better.

Compared to the two approaches above, the Intergovernmental Panel on Climate Change (IPCC) is doing science. The assessment and technical reports are essentially presentations of models along with results from testing. For some technical areas, there are no models. For some other technical areas, there are few tests. For the Integrated Assessment Models used to develop the family of Emissions Scenarios, it's sometimes hard to tell the status of the models. The testing probably needs improvement. Possibly that's why the IPCC publishes scenarios rather than forecasts with probability assessments. It's an important area that needs more scientific attention.

A Cold North Wind for Neoliberalism

Iceland is in the midst of of a financial crisis after its economic bubble burst. The bubble was driven by neoliberal, free-market philosophy and now the party is over. Johannes Por Skulason is heading a group opposed to the terms of repayment (austerity) being imposed on Iceland. Here is the basis of his opposition:

"I can be very frank about it: What we want to do is abolish this neo-liberal greed philosophy that was driving things in the bubble years," he says. "What we want to re-establish in Iceland is a strong Nordic welfare society with equal justice and equality."

Good luck to you, Mr. Skulason!

A Framework for Policy

Today in the Principles of Environmental Science, Cal DeWitt described a framework for the course that has wider application.

The framework involves three related considerations: science, ethics and praxis. From the policy perspective, to put something into practice, the framework suggests that the science and ethics of the policy also need to be considered. For example, if one believes that forests should be economically productive, forest biomass can be used as an energy source. However, the science tells us that forests need the biomass (dead trees, rotting vegetation, etc.) for their own survival, thus returning to the ethical dilemma.

As a result of the subprime mortgage crisis, debate over this framework has started within economics. N. Gregory Mankiw, a Harvard economist, recently wrote a paper on The Macroeconomist as a Scientist and Engineer. He argues that the current disagreements in macroeconomics are between the economic scientists (neoclassical, neoliberal, free market) and the economic engineers (Keynesian). If the goal of science is defined narrowly as figuring out how the world works, the subprime mortgage crisis pointed out the weaknesses in economic science. The framework above also points out the weaknesses of the ethical foundations, not withstanding welfare economics.

A Future for Nuclear Power?

The New York Times is reporting that a US DOE loan program combined with cap-and-trade legislation may give new life to the moribund US nuclear power industry. However, the future of nuclear power is not very bright given the problems, to include: "high relative costs; perceived adverse safety; environmental and health effects; potential security risks stemming from proliferation; and unresolved challenges in long-term management of nuclear wastes." A study in the Bulletin of the Atomic Scientists is equally pessimistic given problems with the existing fleet of nuclear power plants.

My own forecasts (using a three-factor index model of the US economy) are more optimistic. Net generating capacity (the top panel above) peaks after 2040 at about a 30% share (lower panel) of total electricity generation.

My forecast should be contrasted with the very pessimistic forecast from the US EIA (the solid line above) compared to my forecast (the dotted line) for net generation in billion kilowatt hours. The EIA forecast is based on an analysis of plans and goals of the nuclear power industry. Time will tell; no one knows the future. The EIA forecast seems more reasonable.

P.S. The first new uranium mill built in the US in 25 years is about to come on line...

Airline Re-regulation

The process of airline re-regulation is about to start with DOT's decision to fine airlines that keep passengers waiting in planes for more than three hours before takeoff. Airline deregulation started in 1978 and there are two views about how successful it has been. The first view, advanced by neo-liberal and neo-conservative economists is that airline regulation has had "... overwhelmingly positive results." Any small problems (poor service, bankruptcy, safety violations, monopoly practices, overloaded traffic control systems, NIMBY constraints on more airport construction, lack of profitability, luggage fees, TSA shake-downs, intransigent unions, terrorist attacks, etc.) would be solved by more free market fundamentalism.

The other view is that airline deregulation has been an unmitigated disaster--for all the same reasons. Environmentalist would also add that air travel has a very large carbon footprint (even higher than automobile travel). In fact, airlines will be the first industry (even before coal-burning power utilities) to face cap-and-trade requirements in the European Union.

Which side of the argument you favor depends to some extent on your view of the future. If the future holds unrestrained exponential growth in air travel with continually decreasing prices, your projections about the future are probably based on assumptions about how increasingly free markets generate unlimited economic growth. If the future doesn't look that positive, you probably favor some kind of airline re-regulation. You might also favor a broader perspective that looks at a range of transportation alternatives (you probably recall that the Penn Central railroad failed a few years before airlines were deregulated and marked the end of long-haul private-sector passenger service in the US).

So, how well does the airline free market work and what are the predictions for the future? The figure above (data from the US Bureau of Transportation Statistics) shows a forecast for the airline market with airfare prices on the bottom graph and airline operations on the upper graph. Prior to 2009, there was a huge expansion of airline operations peaking in 2008 with very modest price movements (actually, prices have been highly variable, increasing to 2001, decreasing to 2005, increasing again to 2008 and then collapsing during the subprime mortgage crisis--the time plot is just compressed due to the large forecasted price increase).

The forecast suggests that we haven't seen anything yet: prices are going to skyrocket and operations are going to stagnate. If this happens, travelers are going to divert to automobiles (my wife and I are already doing this for long trips in the US). We would use long-haul passenger train service (as we do in Europe) but that was dismantled in the late 1970's. If only the system had not been dismantled in the brave new world of economic deregulation. Do you think we'll all ever have personal jet packs?

P.S. My forecasting model finds that there is very little interaction between quantities and prices in the airline market. That shouldn't be surprising since operations are flow-constrained. Market fundamentalism won't remove the current network and environmental constraints so the neo-liberal dreams of unconstrained growth in air travel are just dreams.

Cracks in Climate Policy

In today's keynote address at the Winter Simulation Conference, Undersecretary of Science Ray Orbach highlighted three major challenges for computer simulation: modeling cracks that form in the containment vessels of nuclear reactors, taking a systems approach to CO2 generation and absorption (a fixable flaw in the Kyoto Protocol and the U.S. Cap-and-Trade plans) and including human behavior in Global Circulation Models (GCMs). Each of these problems will require immense amounts of computing power and the U.S. Department of Energy has the computing power available through its Innovative and Novel Computational Impact on Theory and Experiment (INCITE) program.

I'll pick up these topics in later posts. Back to the conference...

Carbon Accounting and Policy in Copenhagen

The challenge for policy makers at the upcoming (Dec 7 - Dec 18) UN Climate Change Conference in Copenhagen can be seen from some simple carbon accounting and one equation (as discussed today in the Global Warming Debate).

The Figure above (from IPCC 2007 WG1 Ch. 7 Fig. 7.3) displays the estimated carbon cycle for the 1990's. What's important to notice is the equilibrium flows (up- and down-arrows). The black arrows indicate pre-industrial "natural" fluxes and the red arrows indicate "anthropogenic" (man-made) fluxes. The question here is how much carbon will the biosphere and the oceans absorb relative to how much is emitted. If you add together all the net fluxes for Weathering, Respiration, Land, and Oceans you get 4.4 GtC/yr of carbon absorbed by the biosphere and the oceans. Of course, notice the 6.4 GtC/yr unbalanced emission from fossil fuels.

To say it another way, the biosphere and the oceans are capable of absorbing about 4.4 GtC/yr (+/- 20%). The figure above shows the actual world carbon emissions from 1950 to 2010. In 2008, we emitted 8.59 GtC/yr which is about twice the absorptive capacity of the biosphere and oceans. In other words, sometime in the 1970's or early 1980's the world's carbon cycle went out of equilibrium. Ultimately, that equilibrium has to be restored.

The "Emissions Equations" shows our policy choices:

CO2 = (N) x (Q/N) x (E/Q) x (CO2/E)

(CO2 Emissions) = (Population) x (Output per capita) x (Energy Production per capita) x (Carbon Intensity)

(CO2 Emissions) = (Population) x (Output per capita) x (Energy Intensity) x (Carbon Intensity)

If we want to control CO2 emissions we can (1) reduce population growth, (2) reduce output per capita, (3) reduce energy intensity or (4) reduce carbon intensity. Since reducing population growth is off the table (only China has tried population control) and since reducing output per capita (economic growth) is off the table, we are left with the technical challenges of reducing energy intensity (heavily insulated buildings, electric cars, mass transit, etc.) and reducing carbon intensity using renewable energy sources (solar, wind, geothermal, etc.)

If only it was a "simple" as totally changing out our existing energy systems. The figure above shows a plot of the World's Ecological Footprint (EF), a measure of human demand on all the Earth's ecosystems. The figure above is calculated as a ratio of the number of Earths needed to support human demand over the number of earths actually available (one Earth). Interestingly enough, we exceeded the Earth's ability to meet human demands at about the same time in the 1970's that we exceeded the ability of the biosphere and the oceans to absorb our carbon emissions.

There is no immediate, quick fix technical solution (heavily insulated buildings, electric cars, etc.) for the EF problem. However, both the EF and the carbon cycle have to be brought back into equilibrium. To be successful in Copenhagen, policy makers will have to find a way to take us back the the 1970's in terms of our carbon emissions and our demands on the Earth's ecosystems. With population growth and economic growth taken off the table, they don't have a chance.