Tuesday, 21 February 2012
One of the finest economics posts of all time
For my own future reference, a link to Noah Smith's post.
Thursday, 9 February 2012
The Economics of Independence
I don't know, but perhaps the expectation that there are "tremendously negative economic consequences for Scotland" with independence, is the mainstream view? [Quote from an international MSc Economics student]. Is this a reasonable view? Let's analyse this from both short run and long run perspectives.
In the short run surely the most relevant way to answer the question is to take Scotland's capital stock and productivity as given and look at its current fiscal and external position relative to the UK as a whole. The fiscal position according to the latest GERS report (see p26) is that Scotland was running a net fiscal balance deficit of 10.6% in 2009-10 relative to a UK net fiscal balance deficit of 11.1%. So whilst neither Scotland nor the UK have particularly healthy public sector finances, the current situation reflects a small fiscal transfer (approximately 0.5% of Scottish GDP) from Scotland to the rest of the UK (this includes a geographic share of North Sea oil revenues).
Scotland's external position, its trade deficit, is in a similar position: it's not great, but it's not quite as bad as the position of the UK as whole (again taking the North Sea into account). The other short run indicator we might look at is productivity, here again Scotland does relatively well as the third highest ranked region of the UK in GVA per capita terms (after Greater London (which to be fair is way out in front), and SE England). The short run position then is fairly clear. Whilst independence could be associated with some transaction costs (in the main these will be job creating transaction costs since they will be incurred due to the fact that some functions of government have to be created here), the fiscal, external and productivity positions suggest that the economic situation would be broadly unchanged.
The other issue that impacts on the short run, but also on the long run, is monetary policy. The eurozone crisis has highlighted the risks of monetary union without fiscal integration - which given the stated policy of keeping Sterling initially, looks like an economic cost of independence. However, as Martin Wolf at the FT (and others) have pointed out, the best predictor of difficulties within the eurozone was balance of payments problems, where at a fixed price (exchange rate) the peripheral nations were net importers of goods and services funded by capital flows from the core. Scotland is not in this position: our economy is 'pre-adjusted' to this fixed exchange rate, and there are not massive balance of payments imbalances. Eventually, with policy divergence, this currency arrangement may no longer be appropriate. However, by then we will have a government with the power to change it and either join a reformed supranational currency area (Sterling or Euro) with transfer payments, or start a Scottish currency.
This brings us on to the long run. Energy resources and a favourable long term climate situation, as well as other advantages like a strong university sector and ownership of the Scotch label for putting on bottles of whisky(*) suggest that Scotland has the resources to prosper in the long term, at least as well as any other country of similar size. But what about the effects of being part of a country of 5 million relative to being part of a country of 60 million?
Economic theory, in the main, is pro free trade and the regime in which trade is free-est is within a single state/regulatory area. This theory underpins international moves towards globalisation, reductions in trade barriers and the creation of the EU and NAFTA etc. Two important contributions to these theories are increasing returns to scale, and a survival of the fittest mechanism that leads to only the more efficient firms surviving in larger economies. Both these mechanisms have a persuasive appeal and probably apply to some extent. However, if they were the dominant effects then we would expect to see a systematic effect of larger countries being wealthier than smaller countries. We do not see this relationship which suggests that there must be offsetting benefits that come with being small.
My favourite mechanism by which Scotland could benefit economically from independence is to do with agglomeration and increasing returns to scale. Currently I think that large UK companies are 'agglomerating' head office functions in London to realise economies of scale. This may produce some private efficiencies, but it has social costs at the level of the lifestyles that it imposes upon the workers in London (2 hour commutes for City workers, impossible living costs for public servants, and monopoly rents paid to landowners) and at the level of career opportunities that it leaves for people outwith London (move to London or never reach the top). I believe Scottish independence could lead to some companies 'agglomerating' their head office functions near policymakers in Scotland, so that we have a self-sustaining business ecology here too.
There are other arguments that follow from analogy with ecology, for example: multi-polar centres of power, or a diversity of localities with political and economic power, could lead to a diversity of opinions and strategies. In the same way as genetic and species diversity leads to robust ecosystems, a diversity of economic strategies, policies and companies is more likely to lead to a robust global economy.
Therefore, the main conclusion that I draw on the subject of the economics of independence for Scotland, is that the evidence is probably consistent with making an argument in either direction, but that the central expectation should probably be for little impact either way. Independence or union are both economically feasible, and our choice between these options is political rather than economic.
(*) Personally I think this is overvalued but if other countries are willing, in aggregate, to pay vast sums for a product that could be produced anywhere but just not labelled 'Scotch' then that's up to them!
In the short run surely the most relevant way to answer the question is to take Scotland's capital stock and productivity as given and look at its current fiscal and external position relative to the UK as a whole. The fiscal position according to the latest GERS report (see p26) is that Scotland was running a net fiscal balance deficit of 10.6% in 2009-10 relative to a UK net fiscal balance deficit of 11.1%. So whilst neither Scotland nor the UK have particularly healthy public sector finances, the current situation reflects a small fiscal transfer (approximately 0.5% of Scottish GDP) from Scotland to the rest of the UK (this includes a geographic share of North Sea oil revenues).
Scotland's external position, its trade deficit, is in a similar position: it's not great, but it's not quite as bad as the position of the UK as whole (again taking the North Sea into account). The other short run indicator we might look at is productivity, here again Scotland does relatively well as the third highest ranked region of the UK in GVA per capita terms (after Greater London (which to be fair is way out in front), and SE England). The short run position then is fairly clear. Whilst independence could be associated with some transaction costs (in the main these will be job creating transaction costs since they will be incurred due to the fact that some functions of government have to be created here), the fiscal, external and productivity positions suggest that the economic situation would be broadly unchanged.
The other issue that impacts on the short run, but also on the long run, is monetary policy. The eurozone crisis has highlighted the risks of monetary union without fiscal integration - which given the stated policy of keeping Sterling initially, looks like an economic cost of independence. However, as Martin Wolf at the FT (and others) have pointed out, the best predictor of difficulties within the eurozone was balance of payments problems, where at a fixed price (exchange rate) the peripheral nations were net importers of goods and services funded by capital flows from the core. Scotland is not in this position: our economy is 'pre-adjusted' to this fixed exchange rate, and there are not massive balance of payments imbalances. Eventually, with policy divergence, this currency arrangement may no longer be appropriate. However, by then we will have a government with the power to change it and either join a reformed supranational currency area (Sterling or Euro) with transfer payments, or start a Scottish currency.
This brings us on to the long run. Energy resources and a favourable long term climate situation, as well as other advantages like a strong university sector and ownership of the Scotch label for putting on bottles of whisky(*) suggest that Scotland has the resources to prosper in the long term, at least as well as any other country of similar size. But what about the effects of being part of a country of 5 million relative to being part of a country of 60 million?
Economic theory, in the main, is pro free trade and the regime in which trade is free-est is within a single state/regulatory area. This theory underpins international moves towards globalisation, reductions in trade barriers and the creation of the EU and NAFTA etc. Two important contributions to these theories are increasing returns to scale, and a survival of the fittest mechanism that leads to only the more efficient firms surviving in larger economies. Both these mechanisms have a persuasive appeal and probably apply to some extent. However, if they were the dominant effects then we would expect to see a systematic effect of larger countries being wealthier than smaller countries. We do not see this relationship which suggests that there must be offsetting benefits that come with being small.
My favourite mechanism by which Scotland could benefit economically from independence is to do with agglomeration and increasing returns to scale. Currently I think that large UK companies are 'agglomerating' head office functions in London to realise economies of scale. This may produce some private efficiencies, but it has social costs at the level of the lifestyles that it imposes upon the workers in London (2 hour commutes for City workers, impossible living costs for public servants, and monopoly rents paid to landowners) and at the level of career opportunities that it leaves for people outwith London (move to London or never reach the top). I believe Scottish independence could lead to some companies 'agglomerating' their head office functions near policymakers in Scotland, so that we have a self-sustaining business ecology here too.
There are other arguments that follow from analogy with ecology, for example: multi-polar centres of power, or a diversity of localities with political and economic power, could lead to a diversity of opinions and strategies. In the same way as genetic and species diversity leads to robust ecosystems, a diversity of economic strategies, policies and companies is more likely to lead to a robust global economy.
Therefore, the main conclusion that I draw on the subject of the economics of independence for Scotland, is that the evidence is probably consistent with making an argument in either direction, but that the central expectation should probably be for little impact either way. Independence or union are both economically feasible, and our choice between these options is political rather than economic.
(*) Personally I think this is overvalued but if other countries are willing, in aggregate, to pay vast sums for a product that could be produced anywhere but just not labelled 'Scotch' then that's up to them!
Tuesday, 31 January 2012
Modelling Peak Oil
On Wednesday 18th January we had another of our Energy Journal Club meetings. Sean was talking about Hamilton (2011) - Oil Prices, Exhaustible Resources, and Economic Growth, Jelte talked to Murphy & Hall (2010) - Year in review—EROI or energy return on (energy) invested, Sebastian covered Greene et al (2005) - Have we run out of oil yet? Oil peaking analysis from an optimist’s perspective, Erkal spoke to Hamilton (2005) - Oil and the Macroeconomy, and I talked about Holland (2008) - Modeling Peak Oil.
To summarise the Holland paper:
# It started from the usual no-arbitrage Hotellings condition (prices must move in such a way so that the owners of exhaustible natural resources are indifferent between: extracting the resources, selling them and investing the financial proceeds; and just sitting on the unextracted resources), but presented 4 models that were sufficient to generate a peak in production. You may have thought that since oil production started from zero in the mid nineteenth century and rose to the present day, and since oil is a finite resource, then any good model would show a peak in production. But most economic models of the oil market, including the basic Hotelling model, have peak production at time zero since this is when prices are lowest and demand is highest.
# The 4 models are models of cost reductions through technological change, demand growth, endogenous reserve additions, and site development. This last model in particular is novel to this paper, and is consistent with the story described in Hamilton (2011) - Oil Prices, Exhaustible Resources, and Economic Growth.
# I have two objections to this paper:
(a) It uses a partial equilibrium approach. This means that the interest rate, that the Hotelling mechanism says is the rate at which the oil price rises, is independent of the aggregate oil supply.
(b) It assumes that oil that is uneconomic to exploit now will be economic to exploit at a higher price. This ignores the possibility that the capital goods with which this future oil can be exploited do not change in price (or at least that their price doesn't rise faster than the oil price).
I'm being slightly unfair in my objections since the paper is following standard assumptions in the literature. However these objections essentially form the basis of my own work.
To summarise the Holland paper:
# It started from the usual no-arbitrage Hotellings condition (prices must move in such a way so that the owners of exhaustible natural resources are indifferent between: extracting the resources, selling them and investing the financial proceeds; and just sitting on the unextracted resources), but presented 4 models that were sufficient to generate a peak in production. You may have thought that since oil production started from zero in the mid nineteenth century and rose to the present day, and since oil is a finite resource, then any good model would show a peak in production. But most economic models of the oil market, including the basic Hotelling model, have peak production at time zero since this is when prices are lowest and demand is highest.
# The 4 models are models of cost reductions through technological change, demand growth, endogenous reserve additions, and site development. This last model in particular is novel to this paper, and is consistent with the story described in Hamilton (2011) - Oil Prices, Exhaustible Resources, and Economic Growth.
# I have two objections to this paper:
(a) It uses a partial equilibrium approach. This means that the interest rate, that the Hotelling mechanism says is the rate at which the oil price rises, is independent of the aggregate oil supply.
(b) It assumes that oil that is uneconomic to exploit now will be economic to exploit at a higher price. This ignores the possibility that the capital goods with which this future oil can be exploited do not change in price (or at least that their price doesn't rise faster than the oil price).
I'm being slightly unfair in my objections since the paper is following standard assumptions in the literature. However these objections essentially form the basis of my own work.
Sunday, 29 January 2012
Limits To Growth
The New Scientist recently had an article on Limits To Growth, and this week's issue features a letter from me in response to this article. They've edited my letter somewhat, the original is reproduced below:
"The article states that economists' objections were that future innovation was not included in the model. This is to misrepresent economists' concerns to a certain extent: what is missing from LTG are prices and incentives.
LTG is essentially a 'fixed factor' model so that output is associated with certain inputs. Assuming a path for output and some endowment of input factors, we can always make the model overshoot and collapse, no matter how abundant we choose these input factors to be.
Economic models on the other hand require that these inputs be purchased by the sectors creating output. Under standard assumptions, scarcity drives up prices - a continuously rising price may spur innovation, but if it doesn't then it will instead restrict demand. Rising prices incentivise innovation, substitution or a smooth contraction in activity. Because of this, it is quite hard to construct an economic model that displays overshoot and collapse i.e. in most economic models we are automatically in the 'stabilising scenario'.
I think LTG is likely to prove closer to the truth than e.g. the endogenous growth models with exhaustible resources of Dasgupta & Heal, Stiglitz, and Solow. However, this is not because LTG is right and economists are wrong. It is because prices and and incentives have not responded to the finite nature of resources in a manner consistent with a model with rational and perfectly foresighted agents. These are wrong assumptions in much the same way that a model without prices and incentives contains the wrong assumptions.
Non-economists will get nowhere in convincing the economists, by producing models that lack economic mechanisms and incentives. Instead economists and non-economists alike have to work together to tease out the correct economic mechanisms and incentives."
"The article states that economists' objections were that future innovation was not included in the model. This is to misrepresent economists' concerns to a certain extent: what is missing from LTG are prices and incentives.
LTG is essentially a 'fixed factor' model so that output is associated with certain inputs. Assuming a path for output and some endowment of input factors, we can always make the model overshoot and collapse, no matter how abundant we choose these input factors to be.
Economic models on the other hand require that these inputs be purchased by the sectors creating output. Under standard assumptions, scarcity drives up prices - a continuously rising price may spur innovation, but if it doesn't then it will instead restrict demand. Rising prices incentivise innovation, substitution or a smooth contraction in activity. Because of this, it is quite hard to construct an economic model that displays overshoot and collapse i.e. in most economic models we are automatically in the 'stabilising scenario'.
I think LTG is likely to prove closer to the truth than e.g. the endogenous growth models with exhaustible resources of Dasgupta & Heal, Stiglitz, and Solow. However, this is not because LTG is right and economists are wrong. It is because prices and and incentives have not responded to the finite nature of resources in a manner consistent with a model with rational and perfectly foresighted agents. These are wrong assumptions in much the same way that a model without prices and incentives contains the wrong assumptions.
Non-economists will get nowhere in convincing the economists, by producing models that lack economic mechanisms and incentives. Instead economists and non-economists alike have to work together to tease out the correct economic mechanisms and incentives."
Tuesday, 24 January 2012
Just Testing
Just testing whether I can put videos into this blog - but I'm sure there's an economics angle here: asymmetric information maybe...
Wednesday, 23 November 2011
The necessity of growth
Chris Dillow had a thoughtful post recently on why governments, and by extension the rest of us, really want economic growth. This post, indirectly, reminded me of Tim Jackson's 2009 book: Prosperity Without Growth. I didn't like it, even though I think that many of its conclusions are probably sound, the analysis is very weak.
In particular, Jackson sets up a straw-man of a ‘conventional macroeconomics’ in which GDP growth is necessary, and then shows that this is not ecologically sustainable. However it’s not clear that ‘conventional macroeconomics’ does require this: disappointed growth expectations may lead to recessions etc due to frictions, but if the central expectation of economic growth was zero (and debt levels etc were consistent with this expectation) then in what way would our ‘conventional macroeconomics’ require a positive growth rate? (I link back to Chris Dillow's post for some thoughts on why there may be such a requirement - but you won't find any such thoughtful analysis along these lines from Tim Jackson).
I think that the postulate of ‘a conventional macroeconomics’ is just a disparaging line of attack from someone who chooses not to engage with economics and wants to portray it as monolithic and wrong. See these links for other complaints along these lines.
It is clear that ultimate limits exist but it’s in no way clear that this precludes a capitalist system, because it is in no way clear that a capitalist system ‘requires’ growth.
Wednesday, 16 November 2011
Accounting for growth - Ayres & Warr
Interesting paper from 2005 published in Structural Change and Economic Dynamics: http://www.fraw.org.uk/files/economics/ayres_2005.pdf
This paper starts by noting that under normal assumptions, i.e. a constant returns to scale production function, changing factor endowments cannot explain the change in economic output over the 20th century. We need to postulate an additional factor: usually `technological progress'. This conclusion is qualitatively unaltered even if we expand the factors we consider from labour and capital to also include energy inputs.
However, if raw energy inputs are converted into `useful work' using estimated efficiency factors, then the change in labour, capital and useful work, at least over the 1900 - 1970 period, does seem to explain the change in economic output.
Is this an anodyne statement? Is every technological improvement basically just an improvement in the conversion of energy resources into useful work? Should we be surprised by this result? In particular, are we comfortable with idea that the productivity of labour has stayed constant and it's just that each unit of labour has more capital and joules to play with?
The paper can be criticised for introducing non-standard production functions that just serve to confuse the issue - they may fit the data better, but if the driver is just the use of useful work as a factor of production then they should keep it simple by explaining the issue purely in these terms. The authors claim that their results hold even if we just use a Cobb-Douglas production function.
The other interesting issue brought out by this paper is the divergence of their economic output as predicted from labour, capital and useful work, with actual economic output, post 1970. The authors postulate that this could be due to labour and capital using useful work more efficiently as prices increased in the 70's oil shock (this explanation is akin to Hassler, Krusell & Olovsson) or perhaps to to the rise of information technology. My only thoughts here were that it's interesting that this is also the point in time at which there is the divergence (at least in the US) of GDP per capita and median income, and between the GDP deflator and the CPI index (so that the economic statistics are "either overstating inflation (and hence understating income gains) or overstating economic growth").
This paper starts by noting that under normal assumptions, i.e. a constant returns to scale production function, changing factor endowments cannot explain the change in economic output over the 20th century. We need to postulate an additional factor: usually `technological progress'. This conclusion is qualitatively unaltered even if we expand the factors we consider from labour and capital to also include energy inputs.
However, if raw energy inputs are converted into `useful work' using estimated efficiency factors, then the change in labour, capital and useful work, at least over the 1900 - 1970 period, does seem to explain the change in economic output.
Is this an anodyne statement? Is every technological improvement basically just an improvement in the conversion of energy resources into useful work? Should we be surprised by this result? In particular, are we comfortable with idea that the productivity of labour has stayed constant and it's just that each unit of labour has more capital and joules to play with?
The paper can be criticised for introducing non-standard production functions that just serve to confuse the issue - they may fit the data better, but if the driver is just the use of useful work as a factor of production then they should keep it simple by explaining the issue purely in these terms. The authors claim that their results hold even if we just use a Cobb-Douglas production function.
The other interesting issue brought out by this paper is the divergence of their economic output as predicted from labour, capital and useful work, with actual economic output, post 1970. The authors postulate that this could be due to labour and capital using useful work more efficiently as prices increased in the 70's oil shock (this explanation is akin to Hassler, Krusell & Olovsson) or perhaps to to the rise of information technology. My only thoughts here were that it's interesting that this is also the point in time at which there is the divergence (at least in the US) of GDP per capita and median income, and between the GDP deflator and the CPI index (so that the economic statistics are "either overstating inflation (and hence understating income gains) or overstating economic growth").
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