Wednesday, March 25, 2009

A polite letter to the editors of Marketwatch

Dear whoever is responsible for this article at Marketwatch,

You wrote: "Exports dropped 49.4%, while imports fell 43% in February, the Ministry of Finance reported in its provisional trade statistics." 

Let's get one thing straight—if exports actually dropped by half in the month of February alone, the apocalypse is upon us. At that rate, or anything close to it, active trade between Japan and the rest of the world will no longer exist after a few months, and the nation will be inhabited by emaciated, diseased folk scavenging open landfills for scrap metal.

Yet this is what I first thought when I saw your article, because you didn't even come close to an accurate description of the statistic, and the first few other media outlets I checked made the same moronic mistake. Listen up: if exports in February were 49.4% lower than in February 2008, that 49.4% decline did not happen in the month of February. It happened over an year—which is still really, really bad. 

When writing about a monthly statistic, you have to communicate one very simple piece of information: whether this data shows (1) a year-over-year change, (2) a single-month change at an annualized rate, or (3) just a single-month change. Your failure to do this is so embarrassing and incomprehensible that I'm tempted to give up even trying to read financial media.

Matthew Rognlie

Tuesday, March 24, 2009

The real argument for a carbon tax (or better cap-and-trade)

In his speech at the Brookings institution a few weeks ago, Larry Summers made a great point about uncertainty:
As Federal Reserve Chairman Ben Bernanke’s doctoral thesis demonstrated 30 years ago, unresolved uncertainty can be a major inhibitor of investment. If energy prices will trend higher, you invest one way; if energy prices will be lower, you invest a different way. But if you don’t know what prices will do, often you do not invest at all. That is why we must move forward as rapidly as possible to reduce uncertainty and carefully create a new cap-and-trade regime.
This is quite right. Uncertainty is a major inhibitor of investment. It's important to consider, however, the kind of uncertainty that's relevant for investors in green technology: uncertainty in prices. If you plan to invest in carbon-free electricity generation that will cost 5 cents more per kilowatt hour that coal, you want to be sure that the price of carbon is at least enough to increase the cost of coal generation by 5 cents, so that your project will be competitive in the future.

Unfortunately, this is exactly the kind of uncertainty that a basic cap-and-trade regime does not eliminate. Instead, a cap eliminates quantity uncertainty, and although the idea of reducing emissions by some precise amount has acquired wide (and unjustified) support in the environmental community, it is meaningless to investors running cost/benefit analyses. If I'm investing in a big project, I don't care that exactly X tons of carbon will be emitted in 2020. I care about the price implications, because they will determine my profit.

In fact, fixed caps will lead to high volatility in the price of carbon. The American public is painfully aware of the massive rise in gas prices in the previous two years, where slight shifts in supply and demand (both nearly constant in the short run) required a massive price runup to bring the market to equilibrium. We are also well aware of the sudden price collapse that came once the economy headed downhill and demand fell. The moral is clear: when supply and demand are inelastic, changing little in the short run in response to price, we get large and unpredictable swings in prices. With cap-and-trade, the problem is even a little worse, because supply is not only inelastic but actually fixed—I can only imagine the populist rage during price spikes! Needless to say, this will not help investors feel secure.

This is the best argument for a carbon tax over cap-and-trade: although both create markets in carbon and are in many ways very similar, the crucial difference is that price certainty is much more important that quantity certainty. Indeed, in a very different context, this is why the Federal Reserve targets interest rates (prices) rather than monetary aggregates (quantities). You can even see the effects of a hard quantity cap in historical data: just look at how unstable the effective federal funds rate became when the Fed announced a move to monetarist targeting in 1979, and how it settled down when the Fed finally changed course. (To be fair, the Fed's embrace of monetarism was really a ploy to get the public to accept the massive increases in interest rates—and the ensuing recession and unemployment—it thought necessary to end inflation. But this doesn't discount the powerful evidence their decision provided on how fixed supply can lead to massive price volatility.)

All is not lost for cap-and-trade, however. There are a few basic ways we can alter the policy to make prices more stable, essentially bringing it closer to a simple carbon tax:

First, we can implement a safety valve that allows polluters to buy additional permits at some preset price. This effectively puts a maximum on the price of permits in a cap-and-trade system, preventing prices from rising outrageously high in a supply crunch. It's inevitable that Congress would take some ad-hoc action to limit prices after a severe increase anyway, and a safety valve only systematizes this response and makes it more predictable. Although some commentators are extremely critical of safety valves, I think that most of the complaints are off-base. Granted, a very low safety valve renders cap-and-trade almost useless, but that doesn't imply that all levels of safety valve are inappropriate. Critics also seem to miss the fact that the lower uncertainty offered by a safety valve allows us to be more aggressive in setting the cap targets themselves—we don't have to tread lightly because of the worry that a tight cap will cause the price to explode to $500 a ton. The one possible weakness is that a safety valve might be inconsistent with an international carbon-trading regime—but we're not going to have such a regime in the immediate future anyway, and we could design a new one to incorporate features like a universal safety valve.

We can also allow borrowing and saving of emissions permits across years. This will substantially ease the volatility that arises from a fixed cap: when prices spike, polluters can "borrow" future permits from the government (with interest, of course) to ease the supply crunch, and when prices collapse speculators can scoop up permits to sell for more down the road. It also relieves the unnatural focus on yearly emissions embedded in a cap-and-trade system—it's much more important that only X tons of carbon are emitted in the next decade than that exactly X/10 tons are emitted in each year, and Herculean efforts to ensure the latter goal are pointless.

In an ideal world, I'd probably implement both of these changes—especially borrowing and saving of permits, which is perfect for smoothing prices—but even just one of them would be an enormous improvement. Price uncertainty is a serious weakness of the cap-and-trade concept, particularly when compared to a carbon tax, which by its very nature enforces price certainty. A few simple reforms can make it a lot better.

I don't need to tell this to Larry Summers, of course—he's a great economist, he's 1000 times smarter than I am, and he's well acquainted with these issues. In fact, I suspect that he implies at least one of the two proposals above when he talks about "carefully" creating a cap-and-trade regime. I just hope that the rest of Washington is smart enough to get this policy right.

An admissions lottery?

Chad Aldeman makes the case in Inside Higher Ed today that selective universities should replace their current admissions systems with a simple lottery. The idea is to establish a threshold level, based on standard criteria like high school GPA and SAT scores, above which all students will have an equal chance at admission through a randomized drawing:
At many institutions, in other words, it is a far more random process than colleges would like students to believe. The myth of a meritocracy, on which the selective admissions system is built, is substantially a lie.

Selective colleges did not mean for this to happen; rather, they are victims of their own success, along with the emergence of a truly national higher education market and the rise of a rankings-driven consumer culture. But, there is no going back now, so colleges should embrace the unavoidable randomness and go from a lottery-like system to a true lottery.

Institutions would set a threshold based on high school grades and SAT score and then open the lottery to anyone meeting those levels...

This idea is so bad on so many levels that it's hard to know where to start. First let's consider how the threshold will be set: Aldeman suggests that it should be a function of grades and SAT scores. Of course, making it a function of "grades" won't work, because this will virtually eliminate the incentive for high schools to give any grade less than A, and transcripts will become little more than worthless pieces of paper. (This will be especially true at the richest and most college-oriented schools, whose students are presumably not the ones Aldeman hopes to benefit.) You can correct for this by making the threshold a function of class rank instead, but this merely leads us to a different set of adverse consequences: students will have an incentive to attend the shoddiest and least competitive schools they possibly can. This would be an interesting adventure in egalitarianism, but I don't think it should become the basis of education policy.

Second, Aldeman oversells the extent to which admissions is a "random" process. No one can deny that there is a tremendous amount of luck involved in the process for applicants at the margin, whose credentials are neither so strong that they merit clear acceptance nor so weak that they demand automatic rejection. Admissions officers do not have the time necessary to make a full, reasonable evaluation of applicants' potential. This is, however, still far from a completely random process. The existence of a sizable random component in admissions decisions doesn't mean that there's no legitimate component, or that coin flipping would be just as effective.

Consider one piece of evidence: the results from last year's Putnam math contest. Out of the 74 top finishers listed on the results sheet, I count only 15 that are not from MIT, Harvard, Princeton, Stanford, Waterloo, Toronto, Caltech, or Duke. That's almost 80 percent concentration in eight universities—28 percent at MIT alone! Clearly admissions offices are doing a little more than "random" selection here. You might say, reasonably, that this is a special case, because success on the Putnam math contest is highly correlated with success and experience in high school math contests, which provide an easy and accessible measurement tool for admissions officers. But then we're admitting that there is a useful, objective tool beyond GPA and the SAT that guides colleges to productive admissions decisions. Should we include an adjustment to our threshold for success in math contests? What about the myriad other qualifications that are also useful predictors of performance? If we do, we gut the simplicity and transparency that Aldeman finds appealing in this system. If we don't, we're relying on a crude SAT cutoff and random number generator to match our most talented students to the appropriate universities.

Finally, you have to wonder why any school would commit itself to such a policy. If a lottery threshold of X will make Harvard receive 100 times as many applications as spots, what's to stop it from raising the threshold to X+1? This would raise the average quality of its students with absolutely no cost, except possibly forgone lottery fees. Indeed, why wouldn't Harvard want to raise the threshold so high that there's no lottery at all? You need to have a tremendous amount of faith in universities' commitment to the social goals of the lottery system (whatever they might be) to assume that they will refrain from taking a costless, painless measure that is guaranteed to produce a more qualified group of students. Even if there are societal benefits to Aldeman's system -- and I don't think there are -- the return to individual universities from defecting are simply too high for it to be stable. All it takes is one good institution to decide against a lottery, or a gradual upward creep (motivated by institutional self-interest) in thresholds until the "lottery" no longer exists.

All in all, this is a terrible policy proposal, one that will not be implemented and would produce disastrous consequences if it ever was. It's curious, in fact, how a seemingly smart and perceptive person like Chad Aldeman managed to conclude that this was a good idea. I blame it on the perverse appeal of counterintuitive thinking. The notion that we should raffle off college admissions seats sounds crazy, and if we convince ourselves that it's actually well-founded, we'll pat ourselves on the back for our brilliant analysis and ability to transcend mere intuition. The only problem is that it actually is crazy.

Thursday, March 19, 2009

Questionable college decisionmaking

Kevin Carey at the Quick and the Ed offers an amusing anecdote about the importance of college rankings, plus some great commentary on families' typical decision process:
If students are making college choices based on whether they got a good vibe from walking around the campus for a couple of hours or if they happened to be assigned to a charismatic tourguide with a knack for storytelling, they're probably going to end up making a lot of sub-optimal choices, which might got a little way toward explaining why transfer and dropout rates are as high as they are. They might be better off sticking with rankings.
Exactly! In the past few days, I've seen the crowds of prospective students and parents on admissions tours at Duke grow larger and larger. As far as I can tell, most families go on the official tour, stop by an information session, and then wander around the campus a little. I keep asking myself the same question: what the hell do they think they're accomplishing? Mere physical presence at the university doesn't give you much information, unless you plan to base your decision on how cool the buildings look, or how fresh-faced the tour guide is. If you want to make your trip a little more useful, you can talk to random students (rather than paid tour guides) about their experiences, and maybe a faculty member or two, but I don't see anyone doing this.

I think the explanation for this massive waste of time and money is that parents -- who often shell out ridiculous amounts of money for college, and micromanage their kids' lives to win acceptance in the first place -- want some sense of security and control in their children's college choices. In reality, it's hard for parents to obtain any useful information, because they can't have honest, non-awkward conversations with students and others on campus, but they're happy to accept the illusion of information, especially when it comes from an seemingly authoritative source like a tour guide or admissions officer. And so we see this silliness persist: millions of dollars every year spent travelling to campuses, taking a few superficial notes, and making "informed" choices that are in reality quite arbitrary.

Why you should study economics (David Roberts edition)

Once upon a time, Grist environmental policy blogger David Roberts and I found ourselves in a lengthy argument in the comments section of one of his blog posts. I won't get into the details here -- I criticized his economic reasoning, he disputed my critique, and so on -- but one important element of the conversation was the strong anti-"Econ 101" theme in his argumentation:
[Matt], any chance you are, or recently were, taking undergrad courses in economics? I ask because I've been talking intensively to economists in the last two or three weeks (for a piece I'm writing), running just this kind of stuff by them, and more than one has independently made the joke about how economists spend their lives unlearning what they learned in Economics 101.
I won't deny that there is some truth to this statement. Econ 101 is certainly not the end of the story in policy analysis, and the nasty market imperfections that come later play an important role. Some basic economic intuition, however, is critical, and I don't think I've ever seen a more compelling case than Roberts' own failure to understand carbon tax rebates:
There are lots of people who want to return money raised by a carbon program back to taxpayers via rebates.

(A "revenue neutral carbon tax" is one way to do this; "cap and dividend" is another; Obama's proposal is to auction pollution permits and return roughly 80 percent of the revenue via payroll tax rebates.)

I have a very basic question for such folks. Say you put a price on carbon and rebate the revenue. Business costs rise, but they get that money back by raising prices for consumers. Consumer costs rise, but they get that money back via rebates. Who, in this scenario, has any new incentive to shift to low-carbon electricity or efficiency?
Now, this is so ignorant that many smart bloggers have already piled on, including Adam Stein in a subsequent post at Gristmill, Tim Haab at Environmental Economics, and Matthew Yglesias. As far as I'm concerned, its faults should be a matter of basic logic: regardless of the rebate, if you use less carbon you pay less tax, giving you an obvious new incentive to move away from carbon.

It's worth considering, however, how much clearer this story becomes once you understand a few lessons from Econ 101. As far as carbon consumption is concerned, rebates from carbon tax revenues are a lump sum transfer: for all practical purposes, your rebate is the same no matter how much carbon you emit. And as any freshman who read his textbook knows, lump sum transfers only have income effects — they only change your consumption patterns by changing your income, and the tax rebates we're discussing will change most incomes by a few percent at most. Since we don't see massive changes in carbon consumption with only small changes in income, the effects of a rebate on emissions will be vanishingly small. (And it's worth remembering that whatever effects that do exist are a direct result of making people poorer!)

The tax itself, on the other hand, has both an income effect and a much larger substitution effect. Since a carbon tax changes the relative prices of polluting and nonpolluting alternatives, it will induce substitution from the former to the latter, just as high gas prices lead more commuters to take the train or bus. With a $100-per-ton carbon tax, for instance, coal would immediately slide below wind and combined-cycle gas, and probably nuclear and solar thermal as well. Power companies will change their strategies in response to such price signals, possibly in a dramatic way. 

Yes, by making consumers' disposable income slightly lower, carbon taxes also have a small income effect, but this is tiny in comparison to the substitution effect, and the overall emissions impact of the policy is not changed in any significant way by rebating revenues to taxpayers.

This is basic economics. It's a part of Econ 101 that's incontrovertibly true and universally useful. If David Roberts had spent a few days in a good-faith effort to understand the lessons of an introductory microeconomics textbook, rather than brushing them off as obviously simplistic and fallacious, he wouldn't be making such embarrassing mistakes. He'd be in a position to provide useful opinions about carbon policy. But instead, we're offered the spectacle of a full-time staff writer for an influential environmental news and commentary site who doesn't understand the first thing about environmental policymaking. Honestly, it's a little frightening.