The Polluter Pays (Voters) Principle

There may soon be an American approach to curbing greenhouse gas emissions that has the potential to garner popular support without requiring consensus about climate change.  The “cap-and-dividend” mechanism outlined in the Senate bill co-sponsored by Maria Cantwell and Susan Collins requires importers of fossil fuels to purchase permits (in currency at auction, not political influence) thereby establishing a limit on carbon emissions.  The inevitably higher energy prices would be offset by a lump sum transfer from the auction revenues directly to households, something that would not be possible under the proposed regime established by the House bill since 85% of permits would be grandfathered  (see A Refreshing Dose of Honesty from The Economist print edition).  The transfer to households (voters), in addition to having some obvious political advantages,  is attractive to economists since it provides one of the benefits of imposing carbon taxes while avoiding the uncertainty of actual abatement levels that accompanies a tax mechanism (see Markandya 2009).

 

G8 or G20 Protests and Computable General Equilibrium (CGE) modelling and its Dual Instability Problem

By HopeForTheDismalScience (William P Bell)

This article discusses why Computable General Equilibrium (CGE) models are important to the G8 or G20 protests and why CGE models are unsuitable for policy analysis for the following two reasons, CGE lacking microfoundations and the dual instability problem.

First, why are CGE models important to the G8 or G20 protests?  An example of a global CGE model is the Global Trade Analysis Project (GTAP 2009) coordinated by the Centre for Global Trade Analysis, Department of Agricultural Economics, Purdue University.  GTAP (2009) claims that their model provides a common language for global economic analysis; they cite the use of GTAP in three of the five quantitative studies at the 1995 conference of the WTO’s Uruguay Round Agreement and in virtually all the quantitative work for the 1999 Millennium Round of Multilateral Trade.  This example indicates the credibility and perceived importance of CGE.

Regarding CGE lacking microfoundations, the ‘general equilibrium’ of CGE models comes from balancing macro Keynesian simultaneous equations, in which equilibrium is imposed from above that makes CGE models ‘top–down’ models, which makes the ‘general equilibrium’ of CGE models an assumption.  In comparison, the ‘general equilibrium’ of the Applied General Equilibrium (AGE) and General Equilibrium Theory (GET) of the Arrow–Debreu–McKenzie (ADM) models derives from finding a prices vector that balances the supply and demand of the agents, where equilibrium is calculated, thus AGE and ADM models are ‘bottom–up’ models and seek to provide proof of ‘general equilibrium’.  However, my post ‘The G8 protests and the logically inconsistent foundations of neoclassical economics’ discusses how these ‘bottom–up’ models lack microfoundations because they failed to find a stable price vector that is ‘general equilibrium’ hence these models and neoclassical economics are built on theoretically inconsistent foundations or axioms.

 

The Anatomy of a Bubble

On January 9th, the Economist magazine addressed the fear that current economic conditions will lead to market bubbles… again. With the combination of high prices, low interest rates and huge deficits these fears may be justified. The recovery of the global economy will dissuade authorities from raising interest rates and may incentivize investment in risky assets. The article explains that bubbles start with a “displacement” or a shock to the financial system such as the introduction of a new technology that in turn creates the rational for widespread investment. Next comes rapid credit growth “which inflates the bubble” and as investors borrow money to purchase more of the asset, the price rises, justifying the investment. With rapid growth comes the hysterical notion that the price will continue to rise but, as we have seen, the bubble must eventually burst, generally when the asset runs out of new buyers. As for the present situation, the article explains that while some argue (notably, Alan Greenspan) that it is impossible to predict a bubble, if the interest rates of developed countries stay low, bubbles are likely to emerge somewhere. What to do with this information is a far more complex debate.

While this Economist article provides us with the financial nuts and bolts of an asset bubble, Jacqueline Best attempts in, “How to Make a Bubble: Toward a Cultural Political Economy of the Financial Crisis” to take an analytical approach to the process that combines the literature of sociologists, anthropologists, and geographers, “adding a cultural dimension to critical political economy, bringing economic insights to the cultural turn in IR, and emphasizing the political character of cultural economic processes.” It is the goal of the author to marry accounts of bubble formation as presented in the Economist with those of the average person whose bubble is quite literally burst buy the process- reminding us of the ways that everyday aspirations such as home ownership are at the center of such a crisis.

 

How many senators have read The Grapes of Wrath? Chairman Bernanke almost certainly has.

The senate is expected to vote on whether to confirm Federal Reserve chairman Ben Bernanke this week for a second term.  The BBC reports that critics of the current chairman argue he has not balanced his attentions between Wall Street and the general American public.  In contrast, Mr Bernanke’s leadership style is described by Anne Khademian  as combining aspects of transparency, learning, and the “real” economy.  Khademian suggests this approach is rooted in the chairman’s interest in both economic theory and history, such that his “research specialty has been macroeconomics, and his passion, the study of the Great Depression” (page 144).  The theory of “rational expectations” is thought to drive efforts to re-vamp the amount of information available to the general public on the Fed’s activities.  The idea being participants in the market (including everyday Americans) make decisions based on the available information, and more complete information leads to adaptive learning.  The chairman’s grasp of the “real” economy, or, how policy decisions impact individuals and families, is presented as originating in his own life experience and inspiring an intellectual interest in the perspective of the individual during economic crisis, not the other way around.  Khademian’s characterization of Mr Bernanke is definitely in contrast to the Wizard of Oz image popular with Fed chairmans of past.  Perhaps the confirmation process will reveal something about the senate’s literary taste.

The Pracademic and the Fed: The Leadership of Chairman Benjamin Bernanke
Public Administration Review
Volume 70, Issue 1, Date: January/February 2010, Pages: 142-150
Anne M. Khademian

 

Capital Asset Pricing Model (CAPM) and Efficient Market Hypothesis (EMH) Contributing to the Global Financial Crisis (GFC)

By HopeForTheDismalScience
(William P Bell)

The Efficient Market Hypothesis (EMH) and Capital Asset Pricing Model (CAPM) are a framework and standard financial tool, respectively. Together, they provide a worldview for financiers and determine their decision-making in the financial markets.

Fama (1965; 1970) introduces the EMH in three market efficiency levels: a strong level where all relevant information regarding a stock is fully reflected in its price; a semi-strong level where all publicly available information is reflected in its price; and a weak level where current prices reflex all past history of the prices.

Fama and French (2004, p. 25) note that CAPM of William Sharpe (1964) and John Lintner (1965) marks the birth of asset pricing theory (resulting in a Nobel Prize for Sharpe in 1990). Four decades later, the CAPM is still widely used in applications, such as estimating the cost of capital for firms and evaluating the performance of managed portfolios. It is the centerpiece of MBA investment courses. Indeed, it is often the only asset pricing model taught in these courses.

However, Fama and French (2004) evaluate the performance of CAPM and conclude that empirical evidence invalidates the use of CAPM in applications, after finding that passive funds invested in low beta, small or value stocks tend to produce positive abnormal returns relative to CAPM predictions. This is relevant to EMH for two reasons; the criticisms come from the founder of EMH, Fama, and CAPM builds on the assumptions of EMH. Put simply, those using the CAPM invest more heavily in higher risk investments than is optimal, which contributes to the Global Financial Crisis (GFC). If these models continue to be taught in financial courses, they will help set the stage for the next GFC. Furthermore, this evidence is another nail in the coffin of neoclassical economics; the failings of neoclassical economics is discussed further in my posts ‘The G8 protests and the logically inconsistent foundations of neoclassical economics’ and ‘G8 or G20 Protests and Computable General Equilibrium (CGE) modelling and its Dual Instability Problem‘.

The EMH is discussed further in my post ‘Hormonal Male Traders producing a Momentum Effect contrary to the Efficient Market Hypothesis and Rational Choice’

References

Fama, EF 1965, ‘The Behavior of Stock-Market Prices’, Journal of Business, vol. 38, no. 1, pp. 34-105.

— 1970, ‘Efficient Capital Markets: A Review of Theory and Empirical Work’, Journal of Finance, vol. 25, no. 2, pp. 383-417.

— 1998, ‘Market efficiency, long-term returns, and behavioral finance’, Journal of Financial Economics, vol. 49, no. 3, pp. 283-306.

Fama, EF & French, KR 2004, ‘The Capital Asset Pricing Model: Theory and Evidence’, Journal of Economic Perspectives, vol. 18, no. 3, pp. 25-46.

Lintner, John. 1965. “The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets.” Review of Economics and Statistics. vol. 47, no. 1, pp. 13-37.

Sharpe, William F. 1964. “Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk.” Journal of Finance. vol. 19, no. 3, pp. 425- 42.

 

Lipstick on a neanderthal: is the beauty premium older than humanity?

by ESMinihan

Neanderthals used cosmetics and wore jewellery according to recently discovered archaeological evidence (see the BBC article Neanderthal ‘make-up’ containers discovered).  The leading archaeologist on the project, Professor Joao Zilhao, refers to this discovery as the “smoking gun” that rejects previously common characterizations of Neanderthals as “half-wits”.  The idea that beauty products serve as evidence of cognitive capacity according to archaeologists is not necessarily archaic. It seems modern day employers of homo sapiens tend to associate attractiveness with ability as well.  The use of ornamentation by our predecessors may have been a response to what economists have labelled the beauty premium: rents captured by workers of above-average beauty in the form of higher wages.  A cohort study of over 11 thousand individuals born in Britain during 1958 found that physical appearance impacts earnings for both men and women, favouring those deemed as more attractive (Harper 2008).

Beauty, Stature and the Labour Market: A British Cohort Study
Oxford Bulletin of Economics and Statistics
Volume 62, Issue 0, Date: December 2000, Pages: 771-800
Barry Harper

 

Hormonal Male Traders producing a Momentum Effect contrary to the Efficient Market Hypothesis and Rational Choice

By HopeForTheDismalScience (William P Bell)

Coates and Herbert (2008) study the role of the endocrine system in financial risk taking in a group of male traders in London. They find a positive relationship between a trader’s testosterone level and his daily Profit and Loss (P&L) and between his cortisol level and financial uncertainty, being measured by variance of economics returns and expected variance of the market. They note that rational choice is affected by the levels of the hormones. The more profits the trader made relative to his daily average the higher his testosterone became. Heightened testosterone increases a trader’s preference for risk. The process has a positive feedback, producing a financial variant of the “winner effect”. Additionally, short periods of high volatility increase a trader’s cortisol levels, which increase his motivation and his ability to focus, producing a euphoric feeling. However, prolonged period of elevated cortisol levels produce selective attention on mostly negative events and anxiety, reducing a trader’s preference for risk. Even if the number of traders is small, these hormonal effects could reinforce the momentum effect and cause markets to deviate from rational choice and the predictions of the Efficient Market Hypothesis (EMH).

See my post Capital Asset Pricing Model (CAPM) and Efficient Market Hypothesis (EMH) Contributing to the Global Financial Crisis (GFC) for a discussion of the empirical failure of the EMH.

Reference
Coates, JM & Herbert, J 2008, ‘Endogenous steroids and financial risk taking on a London trading floor’, Proceeding of the National Academy of Science of the USA, vol. 105, no. 16, pp. 6167-72.

 

Bringing the Coase Theorem to Copenhagen

The climate change summit convening in Copenhagen this month is unlikely to produce a binding legal agreement on carbon emissions considering “it is a prisoner’s dilemma, a free-rider problem and the tragedy of the commons all rolled into one” according to The Economist special report on the subject.

An alternative characterization of the complexity of climatic cooperation is in the context of property rights.  In his fundamental paper, The Problem of Social Cost, R. H. Coase posits that bargaining between agents can achieve a socially optimal outcome with respect to external damages caused by economic activity as long as property rights are well defined, meaning the responsible party is clearly liable for the damages (1960).

Unlike localized “end-of-pipe” pollution (or in Coase’s illustrative example end-of-cow mastication), the damages from greenhouse gas accumulation in the atmosphere cannot be directly connected to individual sources within the same political jurisdiction.  Therefore, an optimal contract between those benefitting and suffering from such pollution remains a “pipe dream” until legal liability is distributed amongst the international community.

R. H. Coase.  The problem of social cost. The Journal of Law and Economics, Vol. III, 1960, pp. 1-44.

 

As safe as… houses?

The falling value of real estate appears a world-wide phenomenon—I heard that even China (Kroeber and Kelly 2009) has a real estate bubble!

Foreclosure: A sign of the times

Housing prices have yet to fall here in Australia, and whether Australian home prices are about to burst is a major talking point. Will prices fall? By how much? When?

Throughout much of the developed world, debate still rages about the role of cheap money, poor lending practices, consumer practices and so on.

The meltdown of the US sub-prime mortgage market precipitated the 2008 global financial crisis, although the subprime lending may have been a symptom rather than the cause (Coleman, et al. 2008). In the UK and Ireland, house price inflation may have led to a boom in debt-financed consumer credit (Hay 2009).

Yet there is evidence that house price movements also affect the unsecured indebtedness of households (Disney, et al. 2009). Consumer spending has reflected changes in house prices — but they could both be driven by something else, such as expected future earnings (Attanasio, et al. 2009). There is also evidence that economic downturns are worse when they coincide with credit tightening and falling house prices (Claessens, et al. 2009).

For all these reasons, some have argued (see, for instance, Davies 2009) that central banks need to monitor asset prices as they monitor indices of consumer and producer inflation. That sounds like a smart idea to me.

 

EU acknowledges the failure of traditional economics to predict so adopts agent based modelling

By HopeForTheDismalScience (William P Bell)

“This long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.”
— John Maynard Keynes
A Tract on Monetary Reform (1923), 80.

Traditional economics has failed to predict the knock on effects of the financial crisis says the EU. The Eurace project is designed to remedy this failure, which uses an agent based modelling methodology as an alternative to the rational representative agent model that is a cornerstone of neoclassical economics. My earlier post, titled ‘The G8 protests and the logically inconsistent foundations of neoclassical economics’ discusses how the three basic axioms of neoclassical economics embodied in the rational representative agent are logically inconsistent, making the framework unsound and how agent based modelling offers the economics profession a scientific approach to modelling the economy as opposed to the mathematical axiom-proof-theory approach of neoclassical economics that includes the CGE and DSGE models.