The Walgreens Inversion

Good news - Max Sawicky has returned to blogging:

The Gov needs money. I’m as entertained as anyone else by speculations about how to improve the tax code. It certainly could be improved. But there is a much simpler way to increase collections — enforce the tax code we already have. About one in six dollars owed is not paid on time, or ever. The solution is simple: give the over-burdened Internal Revenue Service more money.

Bad news – American corporations are back to the inversion game:

Walgreens, our country’s biggest pharmacy chain, is trying to dodge paying its fair share of taxes. It may soon shift its corporate address from Illinois to Switzerland, a tax haven. After it completes a planned merger with Alliance Boots, a Swiss pharmacy chain, Walgreens can take advantage of a tax loophole to reincorporate itself offshore. This may let the company avoid $4 billion in U.S. taxes over the next five years, leaving the rest of us to pick up the tab. Walgreens would still be controlled from the U.S. It would still benefit from our roads, bridges and infrastructure, and it would will still have more than $70 billion in annual U.S. sales.

Walgreens does tend to sell around $72 billion a year in products but mostly to U.S. customers. Its profits tend to be around $4 billion a year yielding a 5.5% operating margin. When I first read this story, I was puzzled how simply being tax domiciled in Switzerland would impact the U.S. tax obligations for what is essentially a purely domestic enterprise. Ben Hallman offers two possible explanations:

The tax savings of moving a corporate address abroad can be enormous. Companies are no longer on the hook for paying U.S. taxes on profits earned abroad, potentially a huge benefit for companies with big overseas sales. Walgreens, because its stores are located primarily in the U.S., would likely realize big tax savings in a different way: By shifting large amounts of debt from its foreign operation to its domestic operation in order to offset profit, said Frank Clemente, the executive director of Americans for Tax Justice.

Walgreens has virtually no third party debt right now. I’m not an expert on whether or not one can just have a U.S. affiliate pay interest expenses on debt generated by a foreign affiliate so if any of you are international tax law experts – feel free to comment. But it is this second scenario where I would like to comment:

One common way U.S. companies exploit such shell companies is by transferring patents or trademarks abroad, and then paying their subsidiary licensing fees for the right to use those patents, thus reducing domestic profit.

We need to do what the tax attorneys call a section 367(d) analysis. Let’s assume that the 5.5% operating margin being generated by these Walgreens stores can be decomposed into a 3% routine return versus a 2.5% royalty rate for the use of various intangibles (patents, trademarks, etc.). Hallman is suggesting that the Swiss affiliate could charge $1.8 billion per year in royalties. But under section 367(d), the Swiss affiliate would have to pay the U.S. affiliate the fair market value for the transferred intangible assets. What is a reasonable estimate of this fair market value? Is it closer to $20 billion or to $2 billion? I’m sure Walgreens could get some hack who pretends to be a valuation expert to argue for the lower figure. But if one looked at the balance sheet as well as the current market value for the equity of Walgreens and tried to deduce the market’s valuation of its intangibles, this figure would be closer to $40 billion. But as Max notes – we note a properly funded IRS to make the argument.

"A Very Complicating Influence on the Theory of Distribution"

Google co-founder and CEO, Larry Page:

I totally believe we should be living in a time of abundance, like Peter Diamandis' book. If you really think about the things that you need to make yourself happy - housing, security, opportunities for your kids - anthropologists have been identifying these things. It's not that hard for us to provide those things. The amount of resources we need to do that, the amount of work that actually needs to go into that is pretty small. I'm guessing less than 1-percent at the moment. 

So the idea that everyone needs to work frantically to meet people's needs is just not true. I do think there's a problem that we don't recognize that. I think there's also a social problem that a lot of people aren't happy if they don't have anything to do. So we need to give people things to do. We need to feel like you're needed, wanted and have something productive to do. 

But I think the mix with that and the industries we actually need and so on are-- there's not a good correspondence. That's why we're busy destroying the environment and other things, maybe we don't need to be doing. So I'm pretty worried. Until we figure that out, we're not going to have a good outcome. 

One thing, I was talking to Richard Branson about this. They don't have enough jobs in the UK. He's been trying to get people to hire two part-time people instead of one full-time. So at least, the young people can have a half-time job rather than no job. And it's a slightly greater cost for employers. I was thinking, the extension of that is you have global unemployment or widespread unemployment. You just reduce work time. 

Everyone I've asked-- I've asked a lot of people about this. Maybe not you guys. But most people, if I ask them, 'Would you like an extra week of vacation?' They raise their hands, 100-percent of the people. 'Two weeks vacation, or a four-day work week?' Everyone will raise their hand. Most people like working, but they'd also like to have more time with their family or to pursue their own interests. So that would be one way to deal with the problem, is if you had a coordinated way to just reduce the workweek. And then, if you add slightly less employment, you can adjust and people will still have jobs.

It's not a new idea. Sandwichman has been on this file for a couple of decades. As some media commentators observed, Keynes mooted the idea of a 15-hour workweek back in 1930. But it wasn't a new idea then, either.

Prince's Tavern, Princess-street, Manchester,

Monday, Nov. 25, 1833. At a meeting called, at the above time and place, of the Working People of Manchester, and their Friends, after taking into their consideration—

That society in this country exhibits the strange anomaly of one part of the people working beyond their strength, another part working at worn-out and other employments for very inadequate wages, and another part in a state of starvation for want of employment;

That eight hours' daily labour is enough for any human being, and under proper arrangements, sufficient to afford an amply supply of food, raiment, and shelter, or the necessaries and comforts of life, and that to the remainder of his time every person is entitled for education, recreation, and sleep ;

That the productive power of this country, aided by machinery, is so great, and so rapidly increasing, as from its misdirection, to threaten danger to society by a still further fall in wages, unless some measure be adopted to reduce the hours of work, and to maintain at least the present amount of wages:— It was unanimously Resolved, 

1. That it is desirable that all who wish to see society improved and confusion avoided, should endeavour to assist the working classes to obtain ' for eight hours' work the present full day's wages,' such eight hours to be performed between the hours of six in the morning and six in the evening; and that this new regulation should commence on the first day of March next. 

2. That in order to carry the foregoing purposes into effect, a society shall be formed, to be called 'the Society for Promoting National Regeneration.' 

3. That persons be immediately appointed from among the workmen to visit their fellow-workmen in each trade, manufacture and employment, in every district of the kingdom, for the purpose of communicating with them on the subject of the above Resolutions, and of inducing them to determine upon their adoption. 

4. That persons be also appointed to visit the master manufacturers in each trade, in every district, to explain and recommend to them the adoption of the new regulation referred to in the first Resolution. 

5. That the persons appointed as above shall hold a meeting on Tuesday evening, the 17th of December, at eight o'clock, to report what has been done, and to determine upon future proceedings.

O.K., but it wasn't yet a respectable idea when just a bunch of working people and their friends thought it up. Thirty-nine years later, Thomas Brassey Jr. made it respectable, with the publication of his book, Work and Wages, which was based on the extensive empirical evidence accumulated in the account books of the worldwide railroad engineering firm established by his father, Thomas Brassey Sr. Chapter Six of Work and Wages was titled "Hours of Labour" and presented the empirical observation that, no more than wages are an adequate measure of the cost of labor, "the hours of work are no criterion of the amount of work performed."

Thomas Brassey, Senior

Another 35 years would pass before Sydney J. Chapman would provide the theoretical explanation for Brassey's observation, published in the Economic Journal in an article conspicuously titled, "Hours of Labour." Chapman, who had been one of Alfred Marshall's star pupils at Cambridge, also collaborated with Brassey on a three-volume "continuation" of Work and Wages, with Brassey providing the introduction to each volume.

Chapman's collaboration with Brassey wasn't "out of the blue." In The Wages Question (1876), General Francis Amasa Walker, credited Brassey's Work and Wages as containing "by far the most important body of evidence on the varying efficiency of labor..."

Mr. Brassey's father was perhaps the greatest "captain of industry" the world has ever seen… The chief value of Mr. Brassey, Jr.'s work is derived from his possession of the full and authentic labor-accounts of his father's transactions.

Fifteen years later, in his Principles of Economics, Alfred Marshall praised "the lead taken by General Walker and other American economists" for its effect in:

...forcing constantly more and more attention to the fact that highly paid labour is generally efficient and therefore not dear labour; a fact which though it is more full of hope for the future of the human race than any other that is known to us, will be found to exercise a very complicating influence on the theory of Distribution." 

What those complications are can only be fully comprehended in the context of Chapman's analysis of the hours of labor. Brassey to Walker to Marshall to Chapman (to Pigou to J. M. Clark to Kapp) OR (to Robbins to Hicks to oblivion).

Eric Helleiner

Good news!  Eric Helleiner, whose work is about as good as it gets in international political economy, has published a pair of new books.  The first, Forgotten Foundations of Bretton Woods: International Development and the Making of the Postwar Order, has been out for a few months, and the second, The Status Quo Crisis: Global Financial Governance After the 2008 Meltdown, is hot off the press.

It's convenient that they're being released in the summer, when there's more time to read for pure curiosity.  Sight unseen, they get a high recommendation from me.

A Short Note on the Climate Misconceptions Series

These posts have a very negative tone. For heuristic purposes, they exaggerate conceptual problems I have observed in various wings of the climate movement and take them down.  They are short on nuance, balance and compliments for all the good things climate people say and do.   Many of the views I criticize are held by folks I regard as my allies in the larger scheme of things.

I’m not happy about this.  But my goal was to air out what I regard as debilitating confusions in shortest, fastest way possible.  I have other things to do too, you know.  So I apologize for everyone whose toes I’ve stepped on so brutishly, and I hope I have an opportunity in the future to make the same set of arguments in a more civilized, congenial context.

Climate Misconception #13: Population growth is the underlying problem behind climate change

In my experience, this meme shows up primarily among people who have studied biology, and who mistake human beings for Drosophila.  Yes, under controlled conditions fruit fly populations will increase exponentially until they reach carrying capacity and crash.  It’s a powerful image, and whenever an environmental issue comes up, there will be students of Drosophila, cultured bacteria and other life forms who tell us that, whatever we think the cause is, the real, underlying cause is overpopulation.

For the record, I think there are too many humans on the planet, and I hope population growth stabilizes quickly.  There is certainly pressure on many natural resources because of our numbers, and we displace the habitats of other organisms in our zeal to maximize our exploitation of the planet.  Besides, it would be nice to have more natural areas for solitude and recreation.

But this has little to do with climate change.  The argument is essentially the same as in the previous post concerning economic growth.

We have to systematically reduce fossil fuel use until it hits zero by mid-century.  Isn’t is obvious from simple arithmetic that the key variable has to be carbon consumption per capita and not the number of capita’s?  Short of a mind-bending catastrophe, how can human population fall sufficiently over the coming decades to make a significant dent in greenhouse gas emissions?

In any case, humans aren’t fruit flies.  Throughout history and what we know of prehistory we have regulated our reproduction in various ways.  At this point, the majority of the world’s people live in societies that are at or near the final stage in the demographic transition—low death rate, low birth rate.  There are still hundreds of millions that have yet to arrive, however, and of course they should be encouraged.  The measures that have been shown to work are the extension of education and women’s rights, social welfare programs and economic growth, all of which are desirable in themselves.  Stabilizing the world’s population at, say, eight rather than nine billion people would be a wonderful thing, but at best it could take us only about an eighth of the way toward reaching our carbon goals—and actually a lot less because demographic stabilization is way too slow.

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Climate Misconception #12: Economic growth is the underlying problem behind climate change

Two things stand out about this misconception.  First, it is widespread and growing in popularity.  A large swath of climate activists swear by it.  Second, it is completely, indefensibly and obviously wrong.  A little thought blows it away.  How can you put these two facts together?  Is it that relatively affluent environmentalists want to feel guilty?  I don’t know, but let’s take a moment to see how deeply misguided this view actually is.

1. Start with this simple point: if economic growth is bad, recessions are good.  The Great Recession that came down on us in 2008-2009 should have been a cause for celebration.  Maybe we need to get slammed even more next time.  Does this make sense to you?

2. The anti-growth crusade smacks of rich-country myopia.  The majority of the world’s population has immense unmet needs.  They desperately need an inclusive form of economic growth that allows for rising living standards and a margin of security.  If the global economy does not grow over the next few decades, it will be a disaster.

3. Hostility to economic growth seems to be based on a fundamental misunderstanding of what the term means.  GDP is the product of final demand, goods and services directly consumed by households or capital goods purchased by firms, and the prices they command in the market.  (Government production of goods and services is valued at cost.)  It’s by no means a perfect gage of anything, but there it is.  One way GDP can grow is if an economy produces more “stuff”—more cars, buildings, electronic gadgets and so on.  Another way is by producing more services—more education, more live music, more health care.  A third way is by producing better, higher-valued goods and services—skilled craftsmanship, elegant design, innovative technologies.  Only the first of these is tied to an environmental burden; the second two are largely burden-less and may even reduce the footprint our economy leaves on the natural world.  This should be obvious.

In case it isn’t, let me show you two chairs.  On the left is one you can by for $60 at a big box store.  It is cheaply made, with lots of plastic and shoddy adhesives, and it will be junk within a few years.  On the right is a beautiful, hand-produced chair made of sustainably harvested wood with a stunning design—built to last a lifetime.  Of course, it costs $600.  For the price of the chair on the right you can have ten of the ones on the left.  If society used to produce five of the cheap chairs and now produces one of the expensive ones instead, that’s economic growth.  In fact, as basic needs are met, there is a tendency in modern economies to shift toward higher quality rather than more stuff.  We could have policies that encourage this shift to happen even faster.

4. Suppose, in spite of everything, you still want to end economic growth—how will you prevent it?  Will you prevent people from starting businesses?  Or buying what they want to buy?  What exactly is the plan that’s going to prevent economic growth from occurring?

5. Ah, but now I hear that the anti-growth people aren’t really anti-all-growth, only anti the growth of bad, unnecessary things.  That sounds more reasonable, but who gets to decide which items are “good” or “bad”?  And how will you prevent people from making or buying the “bad” stuff?  If we’re talking about climate change, “bad” ought to mean “uses fossilized carbon”, putting us back in the world of ordinary policy, like carbon taxes and caps.  But that isn’t anti-growth, just anti-carbon.  And it doesn’t impose anyone’s judgment of what items are “unnecessary” on anyone else.

6. Did I mention that, outside a small echo chamber of environmental enthusiasts, ideological hostility toward economic growth is political suicide?  What coalition can you put together on this platform?  The carbon budget timetable is very tight, and it would help to have a viable political strategy.

7. Finally, suppose it really is all about economic growth, and there’s no other way to stop the carbon juggernaut—by how much does the world’s economy have to shrink to do the job?  Remember, we are talking about reducing total carbon consumption by about 2.5% per year, more in the rich countries, less in the poor ones.  By mid-century we have to be at near-zero use.  Seriously, how much impact will a few percentage points more or less of global GDP have on this immense change in fossil fuel consumption?  Isn’t it obvious that the struggle is over what and how we produce, not whether the aggregate economic value is going up or down?

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Climate Misconception #11: Done right, climate policy can be nearly costless

The politics are straightforward.  Forces representing business interests and the free market crowd resist climate policy every step of the way, complaining that the economic cost is too high.  The environmentalists fire back: wrong, they say, if we use the right tools we can achieve our carbon objectives at minimal cost.  Some, invoking the Porter hypothesis, even claim that getting off fossil fuels can be a net economic boost—this without taking into account the economic costs of climate change itself.

It’s obvious why environmentalists would say this.  I truly wish they were right.  But they are not, and their evasion damages their credibility and muddles their politics.

Why does this big-payoff-at-little-cost meme persist?  If you look at the arguments of people who promote it, they generally cost out programs that fall well short of meeting carbon budget constraints like the one proposed by the IPCC.  They look at small carbon taxes or modest caps whose goal is to slowly ramp up to an annual emission target in 2050 or so.  Recall, however, that it’s the area under the emission path, not its eventual settling point, that tells us how much greenhouse gas accumulation we’re going to have.  If you do the calculation, you’ll see that these paths come in way over budget.

Here’s a demonstration.  A clever website is trillionthton.org: you enter the maximum amount of global warming you’d like to allow and the amount of uncertainty you’re willing to accept, and the engine spits out the date on which the corresponding carbon budget is maxed out under business as usual, as well as the annual rate of emissions decline necessary to meet the budget constraint if we start right now.  So let’s pick two degrees celcius and “cautious” with regard to uncertainty.  The engine tells us a straight-line emissions path that adheres to these stipulations requires an annual decline of somewhat over 2.5%—this year, next, year, and essentially forever.

Now for some economic arithmetic.  Obviously it won’t do to have every country in the world cutting its emissions at the same rate.  Some, like the US, have immense legacy emissions that tip the scales against them, and it’s reasonable that poor countries, where energy use per capita is a small fraction of what it is in the rich ones, should have much looser carbon caps.  To make things simple, suppose this means that, rather than reduce at the rate of 2.5% per year, the US has to cut back by 5%.  To simplify further, let’s just look at oil.  (Each fossil fuel needs to be considered separately, since the mix will change over time.)  Suppose its use has to go down at this average rate, with coal going down faster and natural gas slower.  There is great uncertainty over the long run price elasticity of demand for petroleum, but .5 is a plausible point estimate.  Put it all together, and you have gas prices in the US needing to rise at 10% a year in real terms.  Using the handy rule of 70, that’s results in about a seven year doubling time.  If gas is $4 a gallon at the pump today, by 2028 it needs to be $16, not factoring in inflation.

But this is a low-end estimate.  First, the US will not immediately begin to follow this reduction path, and the longer we delay, the faster we have to reduce.  Second, a factor of two for the US compared to the global average is probably much too low.  A large majority of the world’s population lives in low income countries, and their standard of living needs to rise.  Barring some disaster, it is inconceivable that their combined fossil fuel consumption will actually fall over the next decade or two.  Third, reduced consumption has to apply to all fossil fuel sources, not only oil, simultaneously.  Fourth, there is no guarantee that elasticities will remain constant as we cut ever more deeply into fossil fuel use; on the contrary, they should probably go down, driving up costs that much more.

This will not be cheap.

It’s possible that increased investments in renewable energy can cap these costs.  Perhaps substitutes can be found that will enable the US and other industrialized countries to convert to other energy sources at a less-than-astronomic price.  It could happen, but at this point we don’t know.  When it comes to energy costs, environmentalists should fess up.

There is another dimension to this problem, however, that is largely off the radar.  We have inherited a capital stock predicated, directly and indirectly, on relatively low-cost energy supplies.  If energy prices begin to rise rapidly, what will happen?  Economists usually assume that capital items will amortize according to plan, and that costs will be incurred only when new, possibly more expensive investments are needed to replace the old ones.  That would be nice, but don’t count on it.  Logically, there is a tipping point at which it becomes uneconomic to operate or maintain a capital investment when the costs of inputs go up or the value of outputs go down.  In other words, serious carbon policy will require a portion of our capital stock to be written off.

How big a problem is this likely to be?  It’s hard to say.  If you want historical antecedents, one place to look is the oil price hikes of the 1970s.  These were very large in percentage terms, but they were also temporary, one-time events and applied only to one energy source.  They did trigger a pair of intense business cycle downturns, although capital stock replacement was mostly orderly.

Possibly a more relevant case is the Eastern European experience post-1989.  For decades capital investments in that region were based on a closed trading system.  If you wanted a car, and you lived in the Soviet Bloc, you had to buy a Trabi or a Škoda or a Lada; that’s what there was.  Then the walls came down, and suddenly Eastern European automakers had to compete with western products.  Quickly, it became apparent that the price cut needed if consumers were to buy one of their cars rather than a VW or a Ford was too great to justify any further production; so they shuttered their factories and laid off their workers.  It’s not too far off the mark to say that the massive recessions of the early 1990s in the ex-Soviet Bloc, which cut output by 20-50% depending on the country, was the result of widespread capital writeoff of this sort.  (Now some of these cars are back on the market, but produced with completely different technology.)

Question: how much of the capital stock of today’s industrialized countries would become uneconomic if the world were to shift to a fossil fuel path that adhered to the IPCC’s carbon budget?  As far as I know, there are no economists at all studying this.  They are all too busy debating whether the hypothetical social cost of carbon is a few dollars more or less per ton (and therefore whether we should try to meet the IPCC’s carbon target or not).  There is scope for a change in priorities.

As we’ll see later, when we look into the political economy of climate policy, industrial interests are aware of this problem and intensely motivated by it.  When they look at their own operations, they think they’re at risk.  They are probably better placed than environmentalists to know their exposure.  Meanwhile, it doesn’t make the political job of getting tough climate policies enacted any easier if supporters underestimate the sources of resistance.

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Climate Misconception #10: To set the proper climate policy we need to know the social cost of carbon

This comes right out of the Econ 101 playbook.  To simplify, suppose there is just one fossil fuel whose use contributes to climate change.  Further suppose that the demand curve for this fuel represents the marginal benefit (MB) society gets from burning each unit, and the supply curve represents the marginal cost to society of supplying it—except for the climate externality.  Then we get the standard model:

The social cost of carbon (SCC) is the difference between the full marginal cost of the fuel, MC, and its supply curve S.  (It changes as the quantity of fuel consumed changes.)  Economic efficiency requires that we set output where MC=MB, at Q2, rather than at Q1 where the market alone would put it.  There are two main ways we could do this.  One would be to charge a production tax equal to the SCC; this would cause producers to raise their price by the amount of the tax, so that MC becomes the new S.  The other would be to institute a carbon cap that limits fossil fuel production to Q2, which would lead to a higher price due to consumers’ willingness to pay at that quantity.  Both require that you know what the gap is between S and MC or, somewhat equivalently, between Q1 and Q2.  (I’ll get into the comparison between these two approaches in a later post.)

This explains why economists expend so much effort to estimate the social cost of carbon.  If you don’t know what it is, how can you possibly have a rational, efficient carbon policy?

For starters, an analysis like the one above makes a number of standard assumptions, some of which are probably close to the mark and others far from it.

1. It assumes that the market is competitive and governed by economic self-interest.  In fact, while there is quite a bit of competition in fossil fuel markets—even taking OPEC into account—most of the deposits are owned by governments, and those who set production policy are not necessarily the profit-maximizers you find in the textbooks.  In particular, governments tend to be myopic, concerned with generating revenue in the short run without much interest in the rate at which their resources are depleted.  For ample fuels, like coal and natural gas, that is probably not a big deal, but it’s a very big deal for petroleum.  Even without climate change, petroleum prices are probably too low, because the effects of depleting the available deposits are not fully taken into account.

2. It assumes that the amount people pay for fuels is a proper measure of the benefit they get, and the social benefit is just the sum of these individual ones.  That’s standard utility theory, but utility theory has little to no scientific standing.  Ask any psychologist, whose day job is to study human behavior and indicators of well-being, what he or she thinks of it.  One of my favorite examples of the failure of utility theory, by the way, is the evidence that, even considering the benefits of employment and residence opportunities, more commuting is associated with less well-being.  These unhappy commuters, of course, are consuming fossil fuels for this privilege.

3. It assumes that there are no interaction effects between people or the things they make or buy that influence their production or consumption choices.  In other words, it assumes that the choices they make separately are the same ones they’d make if they were able to consciously coordinate them.  When you consider just the interaction-dense nature of location and transportation decisions, this can’t be true.  If you thought the model above applied to both American and European commuters, for instance, you’d have to assume that Americans have a greater “preference” for (get more “utility” from) driving cars, while Europeans have a greater preference for taking trains.  (Or you could compare commuters in the LA and New York metropolitan areas: more or less the same thing.)  Maybe so.  But maybe the difference in transportation modes reflects a greater degree of coordinated choice in some places and less in others.

These are generic arguments that apply to all economic models that try to shoehorn social well-being into a supply and demand diagram.  What about carbon in particular?

Careful readers will have noticed that my introductory posts on climate science said almost nothing about the items economists focus on when they try to estimate the social cost of carbon.  I did mention sea level rise and storm intensity a bit, along with passing references to drought and forest fires.  There was no general discussion of the impacts on agriculture, however, or the comfort or discomfort of hotter weather, or effects on tropical diseases or temperate zone pest infestations.  If you spend your waking hours calculating the social cost of carbon, these are important components.

There are three reasons why I skipped these issues.  The first is that it is almost impossible to forecast these costs, not only because of the uncertainties of how climate change will play out, but also because of the potential for human activities to adapt.  Take agriculture for instance.  Most regions will be subject to stresses in the form of different distributions of degree days, precipitation and pests.  Farmers, of course, will not plant the same old, same old.  They will turn to new seeds, new crops and new production methods.  How successful will they be in surmounting the effects of climate change?  Hard to say.  Or take sea walls.  Economists put a price tag on sea level rise by comparing the cost of building a physical barrier to that of abandoning coastal infrastructure, which makes sense.  But the best they can do is estimate them on the basis of today’s technology.  If it begins to look like we will experience faster-rising seas than anticipated, maybe more effort will go into new materials or construction techniques that reduce the cost of protecting shoreline.  Maybe these efforts will bear fruit, and maybe not.  Costing out these economic impacts of climate change is a guessing game.

The second is that the economics of climate change is all about time.  With a decades-long lag between cause (burning fossil fuels) and effect, the numbers depend immensely on how you incorporate the time factor.  This is referred to as discounting, where the formula for the value today of some cost C anticipated N years from now is

Here PV is the present value and r is the annual rate of discount.  For instance, today’s level of climate change, which is the result of fossil fuel use over the past 200 years, has apparently destabilized the West Antarctic ice sheet, likely irreversibly.  Its effect on sea level will be felt as soon as about 200 years from now and as late as a thousand.  Let’s make the most favorable assumption (for costs) and assume that 200 years is the correct prediction.  Suppose that the 12-15 foot sea level increase will cost our descendants a trillion dollars to cope with.  Also suppose that an appropriate rate of discount is 3%, which is a measure of the value of putting off a given cost for a year.  (This is in the range of commonly used discount rates.)  Guess what?  That trillion 200 years in the future comes out to around $2.7 billion today.  Not as scary, is it?

In fact, there has been a raging debate among economists over how much, if anything, to discount future costs since the Stern Report of 2006.  He outraged many of his peers by choosing a discount rate of 1.4%, which is about as low as one could go.  If you read the debate that ensued you will find reasonable arguments on all sides; personally I don’t see a compelling case one way or the other.

But the larger question is whether this debate matters.  Indeed, why should it matter?  The reality is that almost any economic question of interest that far out into the future is completely beyond prediction, even probabilistically.  Moreover, the question about how much weight to give today to impacts we are creating for future generations is not an economic question, but an ethical and political one.  Think of it this way: suppose I say that there is a program that can eliminate a cost that will otherwise arise of $2.7 billion.  This number could mean different things.  It could mean, a bill will be presented to us this year for $2.7 billion and we’ll have to pay it then and there.  Or it could mean, a bill will be presented to our heirs 200 years from now and they will have to pay $1 trillion.  Question: is it immaterial for the policy question (whether to adopt the program) which of these is the actual case?  If you believe in discounting, the answer is yes.  My guess is that most people will see it differently.

The final point is the biggest—in fact it’s very big.  The main worry about climate change is not that it is going to add this or that amount of economic cost to some everyday human activity, but that the entire carbon cycle will spin out of control.  If human releases of fossil fuels heat the earth enough to trigger further releases of stored methane, the result could be beyond reckoning.  Remember those alligators in the arctic.  And if there is a tipping point we don’t know where it is.

From this perspective, programs to combat climate change are less like an investment with a rate of return (the social cost of carbon view) and more like insurance, an amount we should be willing to pay in order to rule out the risk of catastrophic harm.  Obviously we can’t insure ourselves against everything.  Some risks are too minute, and the cost of reducing their probability to zero is out of all proportion to the benefit.  Climate change isn’t like that.  The physics at a macro level are pretty well understood, and runaway feedback effects, while they might horrify, would not greatly surprise anyone who has studied the issue closely.

The bottom line is that, in trying to exactly calibrate carbon control costs to the economic impacts of climate change, economists have been chasing a chimera.  It’s the wrong framework for thinking about the problem and leads to cautious, myopic policy recommendations.  And a further tragedy is that, as we will see, there are truly urgent economic questions about climate policy and its impacts that almost no one is looking at.

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Deeply Misunderstanding How Our Economy Is Measured

A complete muddle in today's New York Times, where Lew Daly of the Demos Institute demonstrates that he needs to book up on some basic economics.  His motives are OK: he wants to show that the government plays (or at least should play) an important role in enhancing our economic well-being.  Alas, he gets just about every concept wrong.  To avoid overkill, I'll document just the biggest howlers:

1. GDP is not a measure of well-being.  It's a measure of monetary flows through the economy.  It was developed to tell us how fully employed our resources are, not how beneficially they are employed.  It measures bigness, not goodness.

2. True, government services are recorded at cost.  But there are no monetary flows beyond that as there are in the private sector (consumer payments).

3. Complaining that we don't recognize consumer expenditures financed out of transfer payments from the government is bonkers.  If you want to do that you should also deduct consumption that would have occurred if not for tax payments.  In fact, the economic definition of government spending used in GDP calculation excludes transfer payments, and taxes are measured net of transfers.

4. Economists measure the public capital stock (like publicly owned infrastructure) the same way they measure the private capital stock.  (There are lots of data in Piketty about this, for instance.)  But GDP is about the flow of income, not the stock of wealth.  If you want to get the stock data you have to go to the Flow of Funds accounts assembled by the Federal Reserve.  They measure balance sheets.

Well, at least we know that the right doesn't have a monopoly on nonsense.  (But why does the right's nonsense cast so many more votes in Congress than the left's?)

MaxSpeak . . . It's alive!

At maxspeak.net (or .org).

May not be quite as technical as this site and its learned contributors. Subject matter will be more wide-ranging.

When The Rate Of Return And The Rate Of Growth Do Not Matter Much For Piketty

So, I have finally gotten around to reading Piketty's monumental book.  Something struck me right away that I think many ignore, at least I have seen no one comment on it.  His emphasis on the importance of r > g, (rate of return on capital as he defines it greater than GDP growth rate) seems overblown.  Now I must admit that he repeatedly warns that the path of the distribution of income and wealth is hard to predict and that many factors are involved.  But it is also the case that he makes little of how often the direction of change does not correspond with the direction of change in this simple equation, that its effect is overwhelmed by other factors.

This can be seen by considering the first two figures in the entire book, which appear in his Introduction and that he declares are the most important in the book, what he is trying to explain ultimately.  The first shows the share of the top decile  of the US income distribution from 1910-2010 and the second shows the ratio of capital to income for Britain, France, and Germany from 1870-2010.  What is striking is how often changes in these have little to do with changes in r-g.  As it is, he argues in the book for the near constancy of r in all these nations over a long period of time, which means effectively that it is changes in g that largely drive this gap.

So, what do we see?  For the US the top decile starts out well off in 1910, reaching a peak just before the Great Crash, then it falls to the 1970s after which it rises again, reaching nearly its 1920s level by 2010.  However, what is not discussed much is that nearly all of the decline in inequality occurs in one tiny period: World War II.  He spends almost no time in this large book focusing on that peculiarity.  It is true that g was high in this period, but not that much higher than during the 1960s or for that matter the 1920s.  In the 1960s there was little change in this top decile share, which essentially got as low as it was going to go by 1945 and basically bounced around after that not moving much until it took off after 1980 or so.  And  in the 1920s rather than falling, the top decile share actually rose rather then fell.  It fell initially at the beginning of the Great Depression when g fell hard.

He does provide an explanation of the 1920s and early 30s, but it goes against his basic story about g.  What led to the peak at the end of the 20s?  A sharp rise in capital gains income.  And the following decline was the reversal of this with the stock market crash.  OK, that is almost certainly correct, but it goes against the story about g.  And how is it that essentially all of the decline in income inequality from 1931 to the 1970s occurred in the early 1940s?  He really does not focus on this, but he does indicate what is up, and it is important for his policy discussion at the end of the book.  That is when the US federal tax code went into its most progressive state, with the top marginal income tax rate moving up to the 90+% level in 1940, just in time for the war, where it would stay until the mid-1960s tax cut.  Of course there was a surge of g, and we know that increased employment of women and minorities helped lower inequality, but it is striking how much change in inequality was in these five years alone.

The story in Europe is slightly different, and, of course, it focuses on wealth rather than income.  There, with some minor differences between the three countries, wealth compared to output starts out very high in 1870 and stays there until  World War I, then only to massively collapse in all three countries, although not quite as much in the UK as in Germany and France.  Capital makes a slight recovery during the 1920s, when g was up compared to the previous decade (ooops, going the wrong way), only to decline after 1930 steadily, reaching a minimum in 1950 for all three.  For France and Germany it starts rising again, steadily in the case of Germany and continuing until now.  With Britain it sits at the same level 1950-1970, and then starts rising. 

But here is the catch.  During the 50s and 60s, economic growth was much higher in both France and Germany than in the previous two decades, and also it was higher than in Great Britain, which put in a sclerotic performance during those decades.  But if a higher g is supposed to be associated with less wealth inequality, that is the exact opposite of what we see here.  Wealth inequality declines during the troubled 30s and 40s, only to reappear in the high growth 50s and 60s in France and Germany, while failing to do so in the more stagnant UK. 

Now he does provide quite detailed stories of what was going on in these nations, although his focus is most detailed for France.  War, inflation, and bankruptcy destroy fortunes, although the direct damage of war is not really all that important.  The end of all this allows for capital to reaccumulate, at least in France and Germany, if not Britain.  But this simply emphasizes how these other factors can easily overwhelm what is going on with g.

Indeed, the vast majority of the decline is not in the Depression or the much more physically destructive World War II, but in the decade of World War I.  Here is where capital simply plunges, falling by more than half in both France and Germany, and by about a third in Britain.  What is curious is that the largest part of this decline is in foreign holdings, which simply collapse.  His discussion of the increase in foreign assets in the nineteenth century involved the colonial empires of these nations, although this was not so important for Germany, which he really does not discuss.  But, while Germany lost its foreign empire, if anything those of Britain and France increased due to  WW I, reaching their peaks in the 1920s as they picked up former colonies of Germany, as well as ones in parts of the former Ottoman Empire.  Piketty simply never acknowledges this.

What else happened?  Oh, the Bolshevik Revolution, which led to the repudiation of tsarist Russian debts, many of whose bonds were owned in these countries, and also the expropriation of foreign company holdings in Russia.  Needless to say this has nothing to do with g.

So, a number of critics have argued that policy really drives all this more than his grand dynamics of r and g.  Offhand looking at his own numbers, this would appear to be the case.  In many decades what is happening to distribution is going in quite the opposite direction from what should be the case if one just looks at r and g (mostly just g).  If it is not policy that is causing this, it is some exogenous shock.

Of course for his current policy discussion, he argues that everything is now working to increase inequality.   The growth rate has fallen and policy has moved to favor the wealthy and those who inherit (particularly in the US on the latter).  So, policy must be changed if we are not to end up a patrimonial capitalism.  On that he probably is correct, but he may well have overstated the role of his grand dynamics and understated the role of everything else in his discussion, even as he provides many caveats on this point.

Barkley Rosser

Climate Misconception #9: Investing in clean technologies will solve the climate problem

Here we continue with Misconception #3, with a few more wrinkles to consider.

It has become popular in some circles to say that a fixation on reducing the use of fossil fuels—the thou-shalt-not approach to carbon policy—is a political non-starter.  No one will support a movement that’s so negative.  Instead, they say, we should emphasize the positive.  Let’s ramp up investment in clean technologies, provide lots of green jobs, and fossil fuels will take care of themselves.

I’ve already tried to explain why generating more renewable energy is not the same thing as reducing fossil fuel use by an equivalent amount, so I won’t repeat myself.  Here I’d like to broaden the focus and consider energy-saving technology in general.

The first point to make is that it isn’t always clear what the energy-saving technology is or how much it saves, once we take account of all the upstream inputs that go into it.  On a mundane level, this has come up in the debate over local laws that mandate the use of paper rather than plastic shopping bags at retail stores.  It’s a complicated problem of industrial ecology, and the answer is not likely to be the same in each city.  But this difficulty arises in nearly every technology choice, such as which materials to use for auto parts, what criteria should determine LEED (green building) certification, and so on.  This is our old friend the economic calculation problem: modern interconnected production systems are just very complex.  If we ever put a significant price on carbon, the price mechanism will tell us where net carbon savings actually lie.

The second point is that innovation is difficult to forecast.  Often the methods and products that prove to be the most successful were not the ones you would have bet on during the early stages of R&D.  This is not an argument against promoting research in green tech, but it suggests we need a large portfolio of research projects, anticipating that most will lead to a dead end.  Public R&D needs to be as entrepreneurial as private—perhaps more so, since the stakes are higher.  But the portfolio approach leaves us in doubt regarding the pace and direction of technological development.  We simply can’t know going in what and how much we’re going to get out of it.

And that leads to the main consideration, which is time.  As discussed earlier, what matters for climate change is the accumulation of greenhouse gases in the atmosphere.  Every day we extract and burn more fossil fuels, this accumulation goes up.  A brilliant breakthrough that lowers the economic cost of transitioning away from fossil fuels doesn’t help very much if it occurs decades into the future, after we have already surpassed our carbon budget.

To put it bluntly: the physics of climate change imposes a timetable on us, summarized in the form of a carbon budget.  The longer we delay, the faster we have to reduce future fossil fuel consumption.  If we delay too long, no plausible transition path will keep us under budget.  But the development of new technology has its own timetable, which we can’t know for sure going in.  If nature’s schedule moves at a faster pace than technology’s, which it almost certainly will, we have to make a choice: more climate change or more economic disruption.  The point of our whirlwind tour of climate science at the beginning was to convince you that nature really calls the shots.

Consider an example.  One large contributor to fossil fuel use is air travel.  If you fly a few times a year this is probably your biggest individual carbon consumption item.  Living within the IPCC’s carbon budget means that, within a few decades, we have to get to near-zero use—and the path has to head downward sooner rather than later.  What will this mean for air travel?  With current technology the picture is bleak.  Biofuels can be used to power jets, but only at much greater cost, and if we try to substitute biofuels for hydrocarbons in all uses their cost would go through the roof.  There’s no getting around it: with today’s technology there needs to be a lot less flying.  Maybe future technologies can get around this; I really hope they can.  But if we take climate change seriously we can’t afford to wait for new technology before cutting back on air travel.  I realize this is not the positive message that, according to marketers, has the biggest political appeal, but the climate problem is inconvenient on many levels.

The upshot is that it would be great to increase investments in green tech.  In the current macroeconomic environment, with unused productive capacity and rock-bottom interest rates, it’s crazy not to.  But this is primarily about helping people adapt to the demands of fossil fuel reduction; it’s not a substitute for it.

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Climate Misconception #8: Local direct action against carbon-emitting projects will stop climate change

Before I say another word, I should make it clear that activism on behalf of serious climate policy is needed at every level, from global summits down to your own neighborhood.  One level does not take the place of another; we need all of them.

The misconception that bothers me, however, is one that has become rather widespread in the grassroots climate justice movement.  It opposes political action at the top and puts all its faith in direct action, hoping to end fossil fuel use one pipeline, rail line and mine at a time.

The problem is not the direct action, but the illusion which some have that this action is the policy itself and not just the politics to get there.

The first counterargument is the obvious one that there are simply too many pipelines, rail lines and mines; there aren’t enough local movements in the world to shut them all down.  Even if you could, the process would be driven by which fossil fuel operations are the most vulnerable to mass demonstrations, and the phaseout would be extremely disruptive from an economic point of view.  It will take decades to slowly turn off the carbon tap, and which sources continue to operate, for how long, and where the fuel goes are matters that should be subject to economic rationality, not the ups and downs of local politics.  (That said, the very high-carbon energy sources, like the Alberta oil sands, are candidates for immediate closure, and if direct action can bring this about, fine.)

Second, there are many sources of fossil fuel supply and a global demand to be served.  If you shut down one source, demand is likely to shift to others.  Unless direct action encompasses the whole system, the result is more likely to be displacement than an actual reduction in extraction.

Given the time frame available to us to meet carbon goals, there is no way to come close except through stringent laws at the highest possible levels.  Direction action can help create momentum to enact these laws and hold them accountable to environmental and social objectives, but they can’t substitute for laws all by themselves.

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Climate Misconception #7: The goal is for every organization to become carbon neutral

Has the carbon neutrality fad subsided?  It seemed a few years ago that every business, agency, college or other outfit wanted to achieve that vaunted status.  One hears less today.

Perhaps this post is unnecessary, but in case there are other carbon neutralists in the audience, a few points deserve consideration.

First, carbon accounting suffers mightily from the economic calculation problem.  It is difficult, bordering on impossible, for any fairly complex operation to determine its direct and indirect draw on fossil fuels.  One would need to know all the inputs into the inputs, and the inputs into them, and so on all up the line.  In practice carbon accountants rely on standardized measures of the carbon content of various items, but these are approximate at best.

Second, many of the accounting ploys in this line of work violate the strictures of the carbon cycle, as described in previous posts.  You can see this from the claim that arises from time to time that a particular enterprise is carbon negative.  No it’s not, at least not unless it engages in long-term sequestration of carbon that exceeds its own use, and no one I know of does that.

The carbon negative folks treat carbon uptake of vegetation like a simple deduction from the impacts of their other activities, thereby isolating this one moment of carbon flux from the larger cycle of which it’s a part.  (My own college does exactly this, by the way.)  It’s like saying that an airport must have a big population because so many people arrive there each day.

And of course the carbon accounting exercise often makes use of offsets, where the organization that purchases them gets credit for the carbon uptake of vegetation growth somewhere else–again in isolation from the carbon cycle as a whole.

The good news is that the carbon neutrality business is nearly carbon neutral.  It’s an unproductive use of human intelligence, but not much more than that.  The opportunity cost, however, is in what this intelligence could have accomplished if it were directed toward a more consequential goal.  Above all, organizations should give attention to how a significant shift in climate policy would affect their own operations—they should forecast and prepare.

Take my college, for instance.  They send students out to measure tree circumferences in the campus forest so they can broadcast their climate bona fides.  What they aren’t doing is examining what a dramatic rise in fossil fuel prices would do to their ability to attract students, especially commuters and those who come from out of state.  How would it affect their conference business?  The cost of their academic schedule compared to alternative start and end dates?  As we’ll see later on, there will be substantial, unavoidable economic dislocation if and when we ever start to get serious about phasing out fossil fuels.  Why not plan ahead?

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Climate Misconception #6: People who drive SUV’s are causing climate change; people who drive electric cars are the ones helping to solve the problem

This one is really just a corollary to the previous post, but it is so widespread it deserves its own moment in the sun.

1. There are lots of sensible reasons to drive an SUV.  They tend to be comfortable, if that’s what you’re looking for.  With their high clearance they are good for rutty Forest Service roads, which is often where you need to go to get to an interesting campsite or trailhead.  They are adept at hauling a trailer. They can carry more passengers and hold more gear.  Why second-guess the moral standing of every SUV driver you meet on the road?

2. Can you be sure that an electric car is a climate change lightweight?  First, focusing only on the direct relationship between your car and the atmosphere as you roll down the road falls into the climate-change-as-pollution trap discussed as Misconception #1.  Yes, there are no fossil fuels being burned in your car.  But your electricity has to come from somewhere, and the impact you have on the climate depends on the fuel source of the electric utility.  In fact, it may be more complicated than this.  Even if you are drawing power from a facility that uses only renewable energy, you might be displacing some other customer who has to switch to electricity from a fossil fuel source.  Without a rather detailed analysis it’s hard to say.

And then there’s the matter of the energy used up, directly and indirectly, in the production and maintenance of your car.  We are speaking here not only of the consumption of fossil fuels in the assembly process, but also the parts, and the parts of the parts, and the machines that make all these parts, and minerals that have to be extracted, processed and shipped for all of the above, and for the infrastructure that gets the juice into your car when you need it.

This is the economic calculation problem in spades.  If we ever get a real climate policy and carbon prices rise to where they ought to go, you’ll simply find out what the score is.

3. This post is not a diatribe against electric vehicles, any more than it is a defense of SUV’s.  And it’s completely agnostic on electric SUV’s.  The point is: don’t look for a solution to climate change based on shopping.  True, a vehicle is an expensive investment, so you might want to plan ahead and consider how you’ll be affected by climate policy, under the optimistic assumption that society will get its act together.  But if you want to do your thing to save the planet, get political, not shoppy.

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