A Dollar of Oil..

There was an article written recently in the Wall Street Journal that touched on the subject of the weakening dollar contributing to higher gas prices.

If you look at the price of oil in the last 10 years in terms of dollars- it went up 350%.
In terms of the Euro- oil went up 200%.
Interestingly, if you look at oil in the last 10 years in terms of the price of gold- it has stayed flat.

The prices of soybeans and wheat increased by 75% in 2007, far outperforming oils increase of 57% in 2007. Neither OPEC, China, or any global cartels were responsible for this increase. The weakening of the dollar is the main factor.

If the dollar had kept pace with the euro these past 10 years, a barrel of oil would cost roughly 57$ compared to over 100$.Given our weakening economy, the Fed is under pressure to cut interest rates and provide banks with some liquidity. If this continues to weaken the dollar, we will continue to see the price of oil and other commodities rise.

Economic Analysis of the War in Iraq

Obama prides himself on the fact that he was the only one who opposed the war in Iraq to begin with it, claiming he will bring the troops back home promptly . Hillary and McCain, on the hand, are more concerned about withdrawing from Iraq to soon. From a purely economic perspective, which of the presidential candidates' policies is superior?

I came across an interesting paper that conducted a cost-benefit analysis of the war in Iraq. I will refer to this paper during my presentation on the presidential candidates' foreign policy, so if you have some spare time feel free to peruse it so that we can have an interesting discussion on Wednesday.

In a nutshell, the paper points out that while the U.S. treasury allocated $212 billion, there are also direct economic costs to the war not included in this budgetary allocation (for example, the costs of lives lost, injuries, and lost civilian productivity of the reserve troops). On the hand, believe or not, the war generated cost savings, mainly the costs associated with enforcing UN sanctions and Saddam Hussein's brutal regime.

The paper thus monetize the direct and avoided costs of the war through 2015. These are rough estimates, but nevertheless can provide useful figures when analyzing policy regarding the Iraqi war.

In terms of figures, the researchers estimated that the total cost of the war for the US during the first two years reached $225 billion, with avoided costs estimated around $32 billion (Net Present Value adjusted to 2005 dollars). That is quite expensive, more than $100B year. However, the authors estimated the costs of the war from 2005 to 2015 to be $349 billion, with avoided costs of $85 billion. That is, a net cost of $260 Billion over a 10-year period, or roughly speaking $26 billion a year in 2005 dollars.

From a purely economic point of view, policy makers should consider the costs already incurred in Iraq as sunk costs. In addition, policy makers should consider what is the cost of the alternative, that is, withdrawing from Iraq. It might certainly be the case that withdrawing from Iraq will cost American tax-payers more than $26 Billion a month.

Thus, the future president should consider what is the return on investment (ROI ) associated with $26 billion a year over, say, a 10-year period. Put differently, given the costs of the alternatives and disregarding sunk costs, Americans should ask whether bringing the troops home without delay is really the most efficient, prudent policy that will yield the highest ROI?

This is where I should point out that the paper fails to monetize the indirect costs of the Iraq war. It doesn't consider other intangibles like macroeconomic impacts, the effects on oil price, the value of a stable democracy in Iraq, etc. So I guess it all comes down to how much we value and what probability we assign to a prosper, democratic Iraq (or alternatively what will be the costs associated with withdrawal).

Going back in History to 1945, I think the coalition forces did an outstanding job transforming what used to be a Nazi dictatorship into one of the world's strongest democratic nations and a close ally to the US. Moreover, this democracy has also spread out the values of freedom, respect, and the rule of law, bringing about other democracies in the region (Eastern Germany, Romania and other Eastern European countries, even Russia ). For me, the prospect of rapid democratization process in the middle east, similar to the one we are now witnessing in Eastern Europe, is priceless. But I am not a presidential candidate.

McCain Outlines Broad Proposals for U.S. Economy

This article shows that numerous changes to the tax system will be a central component of "McCainomics." Specifically, Senator McCain favors reducing corporate tax rates from 35 to 25%, doubling dependency deductions from $3,500 to $7000, eliminating the alternative minimum tax, and allowing citizens to file a simpler tax form. He also plans to make current President Bush's tax-cuts for the upper income-brackets permanent.

In promoting such a drastic reduction in the corporate tax rate, Senator McCain is already drawing fire from both Senator Obama and Clinton's electoral campaigns as well as liberal voters. Both democratic candidates have publicly chastised his proposed break for corporations, arguing that middle-class Americans, not corporate entities, need help. While this plan might directly cost left votes, it might also indirectly add support for his campaign by allowing him to continue adhering to his strict free-trade policies.

His consistent support for open trade policies has draw criticism from those particularly sensitive to offshoring. McCain favors reducing and eventually eliminating nearly all trade barriers - a move likely to send American manufacturing jobs to other countries. Although it's entirely possible that workers in these affected sectors will be able to transition to other well-paying jobs in different industries, the issue is still highly controversial.

The corporate tax cut will help combat opposition to his free-trade stance. Specifically, Senator McCain believes that a reduced corporate tax rate will make it more profitable for companies to remain in America, thereby directly reducing offshoring. Thus, while supporting a reduction in corporate taxes from 35% to 25% might indeed cost votes from those in favor of high corporate tax rates, it might also add support from workers in industrial sectors who are wary of losing their jobs.

Clinton Details Premium Cap in Health Plan

During the class discussion on the health care policy positions of presidential candidates, we saw that affordability of health coverage is a central qusetion in health care reform. All three candidates - Clinton, Obama and McCain - came up with measures that would reduce the cost of health care, including tax credits to purchase insurance, government subsidies for low-income households and safe re-importation of drugs from Canada.

According to the article "Clinton Details Premium Cap in Health Plan" in New York Times, Hillary Clinton proposed that individuals and families should pay no more than 5 to 10 percent of their income on health insurance. This proposal for "premium cap" definitely makes Clinton's universal health care plan seem more reasonable; she is going to control the cost before making everyone purchase health insurance.

However, this proposal raises some questions. The article states that the average cost of a family policy bought by an individual was $58,526 in 2006 and 2007, or 10 percent of the median family income of $58,526, although some policies cost up to $9,201. If Clinton sets the cap at around 10 percent of income for everyone, how would this affect the median family that is typical of the American household, if it is already suffering from high cost? Also, Clinton prefers to set the limit at a single level for all Americans rather than varying it by income. Although it might seem fair, lower-income families will have harder time paying 10percent of their income on health insurance than more affluent families do. This problem may be alleviated if government subsidies work well enough to cover the insurance costs for lower-income families.

The article also quotes Jonathan Gruber, a health economist at the Massachusetts Institute of Technology, in speculating that Clinton's plan is realistic at close to 10 percent, but not at 5 percent. While Clinton talks about covering all 47 million uninsured people and requiring insurers to cover every applicant regardless of age or health status, insurers might respond to the cap by crafting cheap policies with less benefits. Clinton does not address the issue of controlling and maintaining the insurance quality.

People are starving, but I need Iowa

The recent food crisis has hit the world with full force--prices have risen dramatically, hunger is all too common, and political regimes are growing increasingly vulnerable as violent riots continue to erupt. The effects have even reached the U.S., with the price of organic milk now as high as $7. And yet the candidates have paid little attention. Politics--and agricultural lobbyists in particular--cloud their eyes and the routine of campaign topics lets them off too easily.

Though analysts have occasionally referenced supply factors (like Australia's recent drought) as the source of rising prices, most food experts agree that this crisis is the result of shifts in demand. The rise of bio-fuel production, the fall of the dollar, and China and India's economic growth (which leads to increased direct demand for grain, and also significantly increases indirect demand through rising meat consumption) have influenced demand most. Though Bush has looked to the third factor for a solution, unrealistically and perhaps even offensively hinting that India should decrease its grain consumption to help lower prices, the 2008 candidates have wisely chosen to focus on domestic ethanol policy instead.

The current US ethanol policy is ludicrous. We require a high level of production for this relatively expensive good and simultaneously subsidize the producers involved. Production quotas and subsidies are economically suspect in general as they alter incentives in the relevant market and generally move it away from efficiency. In this case, however, the effect reaches beyond the ethanol market, hurting the food market as well. Ethanol production quotas and subsidies convince farmers to shift land towards corn production and therefore away from other staple crops, changing supply significantly. More importantly, because that corn is used for ethanol--which is more expensive than the corn itself--and is also subsidized, its price rises sharply. This then bleeds into other grain prices (which can be treated economically as corn substitutes). Thus, the overall price of food must rise.

The economic case for changing ethanol policy is therefore clear. The political one, however, is anything but.

McCain, the bravest of the three candidates when it comes to this issue, was the first to criticize ethanol subsidies and production requirements. Obama held to pro-ethanol arguments for longer, heralding it as a cleaner energy source and framing the issue as an environmental one in an effort to justify a position that would keep him popular in Iowa. Recently, however, he has changed his tune, finally acknowledging the link between ethanol and food prices. Clinton, though edging ever closer to Obama's position, still lags behind.

The rising food prices represent a dire crisis. The U.S. has the power--and perhaps even the responsibility, given the significant market distortions our farm policy creates--to curb it. And yet politics, and particularly the power of the American farmer, are eerily close to keeping the candidates quiet.

More attention needs to be paid to the crisis, both by the politicians and the voters. And credit--as well as support--must be given to those candidates that do address the issue effectively. It's the least we can do to counterbalance the strength of the agricultural lobby.

Innovating Our Way to Financial Crisis

This article illustrates one point that I brought to the class discussion; whether the financial innovation leads to a financial crisis. I somewhat agree and disagree with Pual Krugman, the writer of this article.

I disagree with him about financial innonvation as a cause of the crisis. It is not the financial innovation itself that causes the crisis but rather the people who use them. For example, the aim of the mortgage-back securities is actually to reduce the risk of the mortgage holders by pooling many mortgages together to diversify the default risks on the loans. Nevertheless, many people purchase them for the sake of speculation.

However, I agree with him that one way to reduce the chances of misuses in such financial innovation is to always make the regulation about the financial systems up-to-date. This may be infeasible and require a massive cost on monitoring the whole financial system. The more possible way is to not allow the creation of new financial products at all. This may reduce potential problems in the future, but it also limits the use of good financial innovation as well.

Pop Economics

I was looking for something to disagree passionately with for my final blog post when I came across this little beauty of an opinion piece from the National Review, an eminent conservative journal. It was well-written and sobering, but it was another example of the kind of thinking that's been upsetting me for some time now: the use of simplistic Econ 1 concepts to explain the real world.

Everyone knows you can't directly apply Econ 1 concepts to actual situations. The real world is just much too complex. For example, in today's global economy, there is no such thing as an "exogenous" upward shift in demand (a shift in demand that comes from outside the system) because there is NO "outside the system." Rising demand for staple crops is linked to rising energy demand through ethanol. Free trade agreements and commodity deals have effects that reverberate differently depending on the institutions of the countries in question. To quote a speech in the fantastic 1975 movie Network, the world is a "holistic system of systems, one vast and immane, interwoven, interacting, multivariate, multinational dominion of dollars. Petro-dollars, electro-dollars, multi-dollars, reichmarks, rins, rubles, pounds, and shekels." Economics is complex, and policy analysis is hard.

So when Michael Novak simplifies and caricatures the Democrats' economic policies using exactly the kind of univariate, static-world thinking I disparaged above, my hackles go up a little bit. Novak argues that raising income taxes on the wealthiest 2% to their 1990s levels "will give them enormous incentives to alter their behavior, so as to show lower income." He forecasts "dramatically lower" revenues, a financially hamstrung and chronically deficit-plagued federal government, and the end of civilization as we know it. Obama, he says, "will learn the hard way" about the disastrous results of his tax-hiking policy.

No one's denying the existence of incentive effects, but substantial questions exist as to their magnitude. While "enormous" reads well, it may be an overstatement--I don't remember tax receipts being dramatically lower before the 2001 and 2003 tax cuts. In fact, they were higher. And guess what? We still had economic growth. In fact, we look back on the 1990s as a period of enormous productivity growth! Despite the fact that marginal tax rates for the top 2% were higher in the 1990s, the economy prospered and America, somehow, endured. But there is no mention of that fact in Novak's piece, because Novak is no economist--just a guy using the words "incentive effects" and praying no one remembers the counterexample of a decade ago.

If Obama is elected, there is reason to believe that Novak will have to learn the hard way that you can't forecast the future of the federal budget, the economy, or the country solely from a simplistic univariate analysis.