“The U.S. financial system remains fragile and banks subjected to additional economic stress might need as much as $76 billion in capital, according to the results of International Monetary Fund stress tests.”

We at CERF have been long concerned about the strength of our financial sector.  In fact I suspect that the IMF study may be understating the severity of the situation.  That would be a problem.  Ask the Japanese what a weak banking sector can do to an economy.  The weakness of their financial sector, and their failure to correct those weaknesses, were a significant contributor to their 20 years of economic malaise.

Failure to promptly deal with our weak financial sector can have similar consequences for us.  You may think the new financial regulation fixes our banks.  It doesn’t.  It creates a new regulatory environment but it does nothing to address the problems that are keeping our banks from fully participating in our economy, inadequate capital and bad assets on their books.

The paper is clear, and that’s not what I’m confused about. I’m confused because Christina Romer is one of the administration’s top economists, and the insights in her research are not being reflected in policy.

Romer and Romer find that there is a large negative tax multiplier, perhaps over three percent. That is for one percentage-point change in taxes as a percentage of GDP, you get an opposite three percent change in output, GDP. So, a one percentage point increase in taxes, as a percentage of GDP, results in a GDP decrease of about three percent. Conversely, a one percentage point decrease in taxes generates about three percent GDP growth.

The size of the tax multiplier stands in stark contrast with the best estimates of the spending multiplier. For example, Valerie Ramey, in a very recent paper that is currently unpublished but will surely be published in a top journal, uses a methodology very similar to the Romers’ and finds the spending multiplier is positive and in the range of 0.6 to 1.2.

The implication of the research is clear. Tax policy is a far more powerful economic stimulus tool than is spending policy. Why isn’t this research reflected in current policy?

Beats me.

Given the popular belief that economic conditions are important to a party’s reelection, ignoring this research appears to be irrational.

The Romers’ paper has other insights. One is that the purpose of the tax change seems to matter. Tax increases intended to reduce deficits are less harmful than a random tax increase. The authors speculate that part of this phenomenon is that tax increases to reduce deficits are usually accompanied by complementary spending cuts.

The most fascinating result is that the multiplier works mostly through investment. A tax increase has a small negative effect on consumption, but a large negative effect on investment. Similarly, a tax cut’s stimulative effect is mostly through investment and not consumption.

These findings have important implications for today. A lack of investment is a key characteristic of this business cycle. If we are in a recovery, this is why it will be so weak. Obviously, raising taxes would be the opposite of a stimulus, and best avoided for now. Instead, we need the mother of all investment tax credits.

There is only one problem with DJ.  He doesn’t know squat about economics.  It’s not because I haven’t tried.  He refused to believe what I tried to share from my first economics class back in 69/70.  He’s refused to believe anything about economics that I’ve tried to teach him since.  DJ’s a communist, and he’s darn proud of it too, and he’s probably never going to learn, but I’m going to keep trying.

Which brings us to today’s topic.  DJ posted a link to this Robert Reich blog entry and a taunt on Facebook today.

In the blog, Reich correctly points out that inequality is a growing problem in America today.  Then, he starts getting things wrong, very wrong, basically coming to the conclusion that if we reduced managements’ incomes and increased workers’ incomes all would be well with the world.

I can’t believe that Reich really believes that if we just set a higher minimum wage and instituted a new maximum wage, we’d have prosperity for all.  It is well understood in economics that minimum wages increase unemployment and price ceilings create shortages.  Reich’s policy would cause output to fall, unemployment among lower-wage workers to dramatically increase, and management to move to someplace else, say Singapore or Hong Kong.

Inequality is problem, a serious problem and a growing problem.  The causes are a failed educational system, a completely inadequate safety net, and a lack of commitment to opportunity in far too many communities.

While returns to education have been increasing, our educational system has been declining.  The failure to prepare students for the workforce, particularly those who will not go to college, is paid for by the student.  It is paid for in lower income throughout their work life, and in more frequent and longer-lasting income interruptions.

Educational problems are not limited to k-12.  The rapid increase in the cost of a college degree is strong evidence that colleges and universities have managed to extract a significant portion of the gains to education, often leaving the student with debt that takes years to repay.  Too often that expensive, debt-funded, degree fails to provide the expected income, a result of a degree in a field with little market value or a program that lacked rigor.

The lack of an efficient safety net means that unemployed workers have an incentive to take the first available job offer.  That first job offer may be a perfect match, but it may not be.  The problem  is that without a safety net that would allow time for a search for a better match, or provide for geographic mobility, both  society and the worker are worse off.

Finally, communities limit opportunity in the service of quality of life, failing to recall that for many quality of life begins with opportunity.

Here are a few key findings:

• 2010 Q2 commitments only $1.9 billion, down 49 percent from 2010 Q1 and the lowest since 2003 Q3.
• 20101 first half commitments only $5.6 billion, down from $9.5 billion in the first half of 2009.
• 90 percent of United States survey respondents expect to see a decline in the number of venture capital firms in their country.
• A majority of respondents in China, India, and Brazil expect to see an increase in the number of venture capital firms in their country.

The pessimists cited unfavorable investment environments caused by economic uncertainty, increased regulatory uncertainty, increased taxes, decreased research spending, and problems in the exit markets.

This is a problem for the United States, and California in particular.  Our high-tech sector, supported by massive amounts of venture capital, has been one of our few relative strengths over the past decade, omitting real estate and finance for obvious reasons.  Given the continuing decline in manufacturing jobs, and the ongoing weaknesses in the real estate and finance sectors, it is hard to see the impetus for a strong rebound without vigorous venture capital activity.

“NASSCO-General Dynamics , the last major shipbuilder on the West Coast, laid off 290 of its 4,100 workers in San Diego on Monday because of a downturn in business and fluctuations in the repair work it does for the U.S. Navy.

The company, which is among San Diego County’s 20 largest employers, also eliminated the jobs of 270 subcontractors. The overall loss of 560 jobs was about half the number that NASSCO had said earlier it might have to cut.”

These are 570 highly-skilled and specialized people.  Most of them will leave California, because few, if any, other jobs requiring their skills exist in San Diego.  If NASSCO-General Dynamics ever considers expanding its San Diego operations, they’ll consider the lack of skilled workers, and it will make expansion less likely.

Losing highly-specialized, high-skilled, workers is a bit like losing infrastructure.  It reduces California’s ability to rebound, and it is a serious problem.  Domestic migration trends (mostly negative for 20 years now, depending on data source) imply that California has lost a lot of these workers.  California is worse for it now.  It will remain worse for it for years to come.

So it goes. Today’s political debate so often consists of empty slogans and name calling, with little no real discussion of the issues. Minds seem to be made up. Few people want any new information that challenges their views.

We were hired to assess the claims that AB32 would generate net-positive economic growth. The California Air Resources Board has said that AB32, the bill that would require California to reduce carbon emission back to 1990 levels, would create 10,000 jobs by 2020. To do this, we reviewed a few articles that supported the claims. We reviewed the evidence from some countries that are ahead of us in green house gas regulation. Finally, we reviewed the peer-review academic literature. We performed no primary research. We documented our conclusions.

We did not take a political stance as to the desirability of AB32. Assessing the risks of global warming is beyond our expertise. Deciding the appropriate expenses to incur to insure against those risks was beyond the scope of the project. Our research was specific and clear. Given that both advocates and opponents of greenhouse gas regulation claim that the opposing position will costs jobs, it was inevitable that some would be unhappy with our results.

So, what did we find? First, please recognize that the claim that AB32 would create net-positive economic growth is the same as saying something better than-a-free-lunch exists.

If that sounds too good to be true, it is. Evidence and theory indicate that some costs are unavoidable if we are to limit carbon emissions. That is: There is no free lunch, much less a better-than-free lunch. We also found that a refunded carbon tax minimizes costs. This is a tax where the tax is refunded against some other tax that distorts economic incentives. Income taxes are thought to distort incentives, and they would be an excellent candidate for the refund. This type of tax is widely accepted among economists as an efficient method of reducing an activity associated with negative externalities. If you want less of something, tax it.

As you move away from a pure rebated tax, costs tend to go up, particularly with command and control type regulation. In some cases, costs can be quite high, and we provided some examples. We concluded that command and control regulation, a significant component of AB32, could be very costly for California.

The debate over carbon emission regulation is a necessary debate. We should be discussing the risks associated with global warming. We should be discussing the appropriate amount to spend to insure against those risks. We should be discussing the most efficient ways to insure against those risks. Our work helps inform that debate, if anyone is listening.

The Office of Economic Analysis blog has a nice picture that does a good job describing the torpedo the good ship Oregon took to her hull.

This is net receipts from February though April for the last 14 years. Note how Oregon is $400,000 in the red in 2010, meaning we refunded $400,000 more than we took in during that period, and this is with 66 and 67.

What is going on?

…preliminary numbers show that the biggest culprit was capital gains. Following a 60 percent decline in capital gains income from the 2007 tax year to the 2008 tax year, we were expecting an additional 10 percent decline for the 2009 tax year. This was in line with what many other states were projecting (5 percent to -20 percent) based on an informal survey conducted early last winter. Unfortunately, preliminary estimates show that capital gains income likely dropped at least another 50 percent for the 2009 tax year. Going forward we believe that we will see an uptick in capital gains income, but carry forward losses and low levels of business transactions will limit growth.

Sigh.

The tax increase was supposed to solve Oregon’s problem.  It did not.  Proponents will blame the economy, but people respond to incentives.  These results were predictable.  In fact, we warned Oregonians about this in January.

You can’t tax yourself to prosperity.

“After nearly two years of global economic and financial upheaval, shockwaves are still being felt, as we have seen with recent developments in Europe and the resulting financial market volatility,” Naoyuki Shinohara, the IMF’s deputy managing director, said in Singapore on Wednesday. “The global outlook remains unusually uncertain and downside risks have risen significantly.”

They are right in that uncertainty and risk are high.  I don’t think they’ve changed much, though, in recent weeks.   What has changed has been people’s perception of the risk.

For some reason, unfathomable to me, people started getting giddy about our economic prospects last August or so.  There were some good data points, but you had to look at them only in a cursory manner, and you had to ignore other discouraging data to believe we were headed for a robust recovery.

A more in-depth analysis and a broad look at the data gave no reason for a giddy attack.  The gains were mostly transitory, driven by temporary government programs.  Consumers, businesses, and governments were still over-leveraged.  The financial sector was still weak.

Still, it became consensus that our economic challenges were behind us.  The stock markets soared, and this was taken as another sign of economic prosperity just around the corner.

Now, the stock markets are down again, and some economists are talking about new risk.  I’d say the risks were there all along, and our forecast reflected those risks.

The great French economist Leon Walras (1834-1910) showed that perfect markets result in an allocation of goods and services that can’t be improved on, in the sense that no one could be made better off without someone else being made worse off.

Of course, we don’t have completely unfettered markets. In fact, they have never existed. They will never exist. In particular, we economists like to talk about what we call negative externalities. These occur when I do something, but an unintended consequence is that it hurts you, and you have no recourse.

An example may make things clearer. Suppose I have a factory that spews out a deadly chemical, one that destroys all life downwind for ten miles. Obviously I’ve reduced the property values for the downwind property owners. (We’re simplifying here. There are many other issues.) There is no market for the damage I’ve done, and downwind landowners may not be able to afford to sue me, and there was a time when they would have likely lost such a case.

Society’s solution to the problem of negative externalities has been regulation. Until recently, the concept of negative externalities has been the rationale for most environmental regulation. Negative externalities’ victims have also been extended to include non-humans: flora, fauna, and “mother earth.”

Climate change regulation, though, is a bit different. In the first place, we don’t know how much of its justification, the claim of manmade global warming with long-term negative economic impacts, is accurate. Some, the “non-believers” completely deny the possibility of man-caused global warming. Others, “the believers” believe in man-caused global warming with a fervor that matches that of any religious zealot. Another group, me included, believes that manmade global warming is a possibility that should be considered as a factor in making long-term economic policy.

If manmade global warming was a certainty, you could reasonably argue that negative externalities justify regulation, the parties being hurt are just not yet born. That’s essentially what the believers are trying to say when they point to the imminent destruction of all life on earth.

However, once the existence of manmade global warming becomes a probability, it becomes an insurance question. This dramatically increases the level of complexity of the problem, and it dramatically complicates the political problem of reaching consensus about what to do.

So, proponents of climate-change regulation have tried to simplify the issue. One approach has been to turn everyone into believers, either by attempting to convince the skeptical—as it turns out by using gross exaggeration if necessary—or, failing conversion, excommunicating even the mildest skeptics from civil society.

Climate-change regulation proponents have also tried, with success, to use the novel argument that climate-change regulation is not only costless but will generate economic growth. The most enthusiastic proponents of this argument, California’s Governor Schwarzenegger among them, describe a utopian future of happy people enjoying previously-unknown prosperity in a pristine earthly heaven.

Sadly, this better-than-a-free-lunch deal is not likely to materialize. It is true that clever economists have constructed models where such an outcome is possible—models having to do with large-scale inefficiencies existing because of historical accident—but large-scale unrecognized opportunities are unlikely in today’s economy.

It is also true that some economists have found some evidence of small un-captured gains. I’ve participated in this literature. However, those gains are also unlikely to be of the scale necessary to achieve the promised new economic age. Indeed, most economists doubt their existence, arguing, reasonably, that the researchers failed to measure all of the relevant costs. Economists have a hard time believing that markets are so bad that unrecognized profitable opportunities exist in abundance.

Today, California is considering the repeal or postponement of its landmark global-warming regulation, AB32. Oddly, both sides are using the same argument. The forces arguing against the repeal of AB32 argue that the repeal will cost jobs. Those arguing for the repeal argue that failure to repeal will cost jobs.

They are both correct, and they can both prove it with their warring models, which brings us to our second great dead French economist.

Frederick Bastiat (1801-1850), not long before his death, wrote a piece What is Seen and What is Not Seen. In the essay, Bastiat gives the example of jobs created by breaking windows. The broken window creates work for the glazier, a multiplier is attached to that work, and it looks as if economic activity has increased. However, society is not better off. The problem is that we see, and account for, the work, but we do not see or count the costs associated with the initial destruction of capital.

So it is with California’s regulation. Proponents of the regulation have research to support their claim of job creation. The “green jobs” created by the regulation are seen and counted. The jobs lost to the regulation are not seen and are not counted.

The opponents of California’s regulation have estimated the jobs lost to the regulation, mostly a consequence of higher energy costs, but that research—the portion I’m aware of at least—has been criticized for ignoring the jobs created by the regulation. More importantly, they do not see the jobs that might be lost if global warming kills jobs. They only see, and show, the jobs lost to failure to repeal the regulation.

Creating jobs is easy; creating real economic growth is harder. Banning the use of any productivity-enhancing technology will create jobs, but this could occur at the cost of societal well being. We could achieve full employment by banning all agricultural technology created after the 17th century. There is no unemployment in a Malthusian economy. We’d all have “idyllic” jobs on the farm, yet this would in reality be back-breaking work. Many people would live on the edge of starvation. I don’t think anyone really wants that outcome. It is also easy to create subsidized jobs, even if those jobs add nothing to, or worse detract from, society’s well being.

Instead of jobs, the argument should focus on such things well being, consumption, income, probabilities, and the like. It is complicated by the uncertainty surrounding the theory of manmade global warming, and the uncertainty surrounding the economic impacts of any warming. But, the stakes are high. People’s lives will be changed. The debate deserves a higher-level of discourse than we’ve seen. Frenetic predictions of job losses or overly optimistic projections of employment created by a green economy will not do. Instead, let’s recognize the complexity of the issue and have a reasoned discussion.

This previously appeared at newgeography.com

I’ll talk about the environment as a luxury good. People who don’t know where their next meal is coming from don’t much care about the environment. It is also true that rich working women have very few children.

Obvious conclusion: Capitalism and Feminism can save the world.

For the Ventura River, we need to see some investment is removing the Matilija Dam, cleaning up the old oil refinery, and improving the sewage plant’s output.