The efficient markets hypothesis goes berserk

Keneth Miles, Brad de Long and a lot of slashdotters have been all over this report that the Pentagon was on the verge of setting up a futures market in terror attacks.

Apparently, the genius behind this idea is Admiral Poindexter of Iran-contra fame.

Leaving aside the obvious points about moral hazard and insider trading that have already been made, I’m impressed that the most magical version of the efficient markets hypothesis, in which markets can divine the future better than any individual, still holds sway in Washington in the wake of the bubble. Perhaps these guys have been in some sort of bunker since 1999. I wouldn’t be surprised to learn that they planned to run the thing over the Internet, have an IPO and use the billions of dollars they made to fund the Defense budget.

Oil and Economics

The issue of oil is still coming up as one of the issues regarding the war in Iraq, and US relations with the Middle East more generally. To get a bit of perspective on this it’s useful to look at some numbers. Currently world oil production is about 80 million barrels each day, of which the US consumes about 20 million. This is about a third of total energy consumption. (a useful conversion factor, if I have it right is that a million barrels of oil yields about 5 terajoules of energy, which is about the output of 10 1000MW power plants).

Saudi Arabia typically produces about 8 million barrels per day, but has the flexibility to range between about 6 and 10. Prewar Iraq was producing around 3 million barrels per day. An optimistic outlook is that a functional government there could produce up to 6 million barrels per day.

There are various ways of looking at this, which I’ll discuss, but a convenient starting point is to focus on a change of 3 million barrels a day in the supply-demand balance. This is the amount of extra Iraqi oil in the optimistic scenario, and was the amount that Saddam could have cut off at short notice if he’d been left in place and in unfettered control of Iraqi oil. It’s also a pretty good measure of Saudi capacity to swing the oil market around.

3 million barrels a day is equal to 15 per cent of US oil consumption and about 5 per cent of US energy consumption. Over the short run, say a year, it would be easy to meet such a shortfall by drawing on stocks (including the ‘strategic reserve’) and by modest rationing measures like ‘odds and evens’. To look at the longer-term economic impact, it’s best to think what tax change would be required to yield this kind of reduction in use. I’ll assume the medium-term elasticity of demand for oil products is about 0.5, which implies that a 30 per cent tax would be needed. Some more rough calculations, available on request, suggest that the economic welfare cost of such a tax would be around $10 billion per year. (This assumes that the price is right to start with. It seems more likely that gasoline is undertaxed in the US, relative to the social costs of car use, and that a tax would be welfare-improving.)

Clearly the cost of domestic action to reduce US oil demand by 3 million barrels a day is a lot less than the cost of the Iraq war (amortised over any plausible time span) or the continuing cost of an expanded military.

The upshot of all this is that any* analysis of the war that places heavy weight on the role of oil implies that the US has adopted a policy adverse to its own interests. This could be because the Administration doesn’t understand the issues, because it thinks a war would be more popular than a petrol tax or because it is acting at the behest of oil industry interest groups. Alternatively, it might be better to conclude that oil (Iraqi or Saudi) was not one of the primary motives for war.

* I leave aside the idea that Iraq is supposed to serve as a springboard for an invasion of Saudi Arabia. If the US wanted to invade Saudi Arabia, it could do so easily, with no need for a springboard, and 9/11 provided the best pretext that’s ever likely to arise.

Monday Message Board

I’m on the move again, to Montreal, so I don’t know when I’ll next be able to post. In the meantime, there’s the home-made fun and entertainment of the Monday Message Board. Post your views on any topic (civilised discussion and no coarse language, please!).

Suggested discussion starter: Collective blogs – is the whole more than the sum of its parts?

What I'm reading, and more

The Paradox of American Democracy: Elites, Special Interests, and the Betrayal of Public Trust by John Judis. This book was published in 2000, but the analysis is still relevant. What’s interesting, particularly from an Australian perspective, is that the book is not, as might be expected, a diatribe against elites and interest groups. Judis argues that the American system relies on participation by interest groups representing real constituencies and by disinterested elite groups – his models are the Brookings Institution and the Committee on Economic Development.

But now, Judis says, most interest groups have no real members, and are merely “letterhead groups” relying either on business lobbies or direct mail appeals for their funding, while the elites have capitulated to business. The result is a corrupt, money-driven system of politics.

The bad guys in the book are the lobbying industry (“K Street”, in the intra-Beltway jargon) and members of the elite who act as mouthpieces for partisan interests – the prime individual example is Henry Kissinger, and the main institutional villain is the American Enterprise Institute. Having never looked into the history of the Institute, I’ve accepted Brad de Long’s judgement that it was once a reputable, if conservatively-inclined outfit. By Judis’ account, though, it was always a front group for partisan conservatives, and so, its recent activities (discussed here, here and here) can be seen merely as revealing its true colours.

Judis’ analysis is quite US-specific, but it is still helpful in trying to work out an appropriate response to the Australian debate over “elites” most of which is at a very low level.

Spooky, or what?

I’ve previously mentioned my blogtwin relationship with Tim Dunlop. Not only do Tim and I have the same views on a lot of issues, but we often think of the same posts, to the point where, if I have a good idea, I try to check that Tim hasn’t already posted it.

With my visit to the DC area, the link seems to get even closer. I had a very enjoyable dinner with Tim and his family and (as is fairly typical of me) left my glasses at his house. Next morning, Tim noticed the glasses and I noticed their absence. The problem arising immediately was to pick the appropriately civilised time to call and arrange a return. Tim and I chose exactly the same time, with the result that he got an answering machine and I got a busy signal. Fortunately, it was all cleared up and I can see clearly now. But I can’t help worrying that the blogosphere is generating some sort of obscure psychic network here.

The GST and the hidden economy

This SMH report says the GST has done nothing to reduce the size of the hidden economy. I haven’t seen the original research on which the report is based. Also, although the reported method of looking at the volume of “unexplained” cash is widely-used in the literature on tax evasion, I have some technical difficulties with it. But the basic result is entirely predictable, and was in fact predicted by every competent economist who looked at the problem. Simon Grant and Stephen King (both then at ANU) did a nice analysis and someone else (can’t recall name right now) published much the same thing in the Economic Record.

I gave a less formal exposition in the Financial Review in 1996. The key point

The silliest of the claims made in support of substituting a GST for income taxes is that it will put a stop to tax evasion, of the kind practised, for example, by plumbers who are willing to charge a lower price in return for payment in cash. It should be obvious, at least to anyone trained in economics, that a change in names will change nothing; plumbers who fail to report their income to the Tax Office will also fail to report their sales to the officials responsible for the GST. For those who prefer a formal general equilibrium analysis, a paper by Simon Grant and Steven King proves that replacement of an income tax by a GST will make no difference in the extent or incidence of tax evasion.

It looks as if the data is finally in on this one.

Word rates

My model in work is Anthony Trollope who turned out 50 or 60 three-volume novels despite having, for most of his life, a full-time (admittedly, not very demanding) job at the Post Office (he invented the pillar-box). According to his autobiography, Trollope achieved his output with a writing stint of three hours per day, starting at 5am. He set a target rate, with the requirement to write more if he fell behind for a couple of ideas.

All of this sounds crass, at least to those impressed with the Romantic notion of spontaneous expression, but, for those of us who aren’t tortured genii, I think Trollope’s rules are spot-on. To adapt a favorite maxim of the Labor Party, write early, write often and write lots.

That said, I can’t really believe Trollope’s claim that he regularly wrote 250 words a quarter-hour for a three hour stretch. I imagine my methods are similar to his, in that I have my pieces turning over in my head for a fair while before I sit down to write them, and so, when things go well, I’m basically constrained only by typing speed. I can manage about 30 wpm with moderate error count, so that, in principle I ought to be able to beat Trollope’s output rate handily, 450 words to 250. But even the most modest cleaning up – correcting typos and grammatical errors, rearranging clumsy sentences and so on, is going to take 5 minutes in every 15, which cuts my maximum rate to 300 words per quarter hour.

And, while I’m not Flaubert, agonizing over “le mot juste”, I care about picking the right words and so, pretty clearly, did Trollope. I spent 30 seconds or so in the previous para thinking about whether to write “typos” or “minor errors”, and this kind of delay is bound to hit you every few sentences, even when you have the main ideas clear before you start.

All up, I consider myself pretty satisfied when I can turn out a 750-word column in an hour and a half, which is a rate of 125 words every quarter hour, or half what Trollope claims. Given that Trollope was writing by hand, and had to rewrite anything he wanted to change, I don’t believe he could consistently achieve twice that rate.

Trollope described his methods in his Autobiography, which he ensured was published posthumously. He knew that his production-line work ethic would shock the Victorian public, and I suspect he stretched the truth a bit to increase the shock value. (425 words, 45 minutes!)