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!)

Fixing the Murray (updated)

The need to rescue the Murray-Darling river system has given rise to some fairly outlandish cost estimates, as well as to the usual extremes of overdone pessimism and Panglossian optimism.

I thought of the following as a back-of-the-envelope exercise in cost estimation. Suppose the government bought back 1500GL of water at $40/ML/year, this would be an annual payment of $60 million, which could be financed from a capital sum of $1 billion at 6 per cent interest. I’d guess that increasing natural flows would solve about half the problem, which would imply a total cost of the order of $2 billion. This is incredibly crude, but I’d think the order of magnitude $1 billion – $10 billion is about right, and that we are likely to end up spending something around the low end of this range.

Update: My estimate doesn’t look too bad according to this report

Gary Sauer-Thompson has responded, arguing that the mess we’ve made of the Murray

puts into question the deployment of the modernist conception of the Baconian Enlightenment project by the liberal state to make Australia modern. This use of modernist science (reductionist and elimination of old ideas by new ones) involved an ahistorical, instrumental reason to improve the human condition coupled to an appeal to a tacit notion of progress. It has been thrown into question because its categories got things messed up


Everybody on both sides of the Iraq debate now seems to be agreed that the war wasn’t about weapons, and most people seem to be agreed that it wasn’t about terrorism. What’s left of the overt case put up before the war is the humanitarian argument that Saddam’s regime was so murderous that it needed to be ended, even if thousands of civilians and thousands more Iraqi soldiers died in the process. This was a minor element in the case put up by Bush and Howard, but a fairly major argument for Blair.

The latest tragic turn of events in Liberia gives us a good test of the extent to which Bush takes this argument seriously. The humanitarian payoff to intervention in Liberia would be far higher than in Iraq, and the cost far lower. Moreover, having been in effect the colonial power, the US could be expected to intervene even under the Cold War era rules where national sovereignty was supposed to preclude intervention except in cases, like the present one, of state failure.

When Bush went to Africa, he seemed set to announce a commitment, but now he looks to be going cold on the idea. A decision to do nothing would be a disaster for the US as well as for the Liberian people, especially if things turn really bad as they did when the French sat on their hands in Rwanda.

By comparison, Howard is looking relatively good. The decision to duck out of reconstruction in Iraq, about which I was pretty scathing at the time, can be justified in the light of the commitment to the Solomons.

Public choice = Marxism

Henry Farrell at Crooked Timber posted some critical remarks on public choice theory, and Kieran Healy chimed in with a piece on “Shake’n’Bake social theory” of the general form “A is really B”. For example, public choice theory can be stated as “politics is really a market for votes”. All of this can be applied at the meta-level, in the form “Theory A is really Theory B, with a change of names”. As it happens, I’ve used precisely this move to argue, that “Public Choice theory is really the Marxist theory of the state, and the associated political program is really Leninism”.

The central points of the Marxist theory are

(1) Politics is about struggle between economic classes. The state acts in the interest of the capitalist class as a whole, and arbitrates differences among Îfractionsâ of capital;
(2) Political ideas (except Marxism) are Îideologiesâ designed to rationalise class rule;
(3) The masses acquiesce because of Îfalse consciousnessâ associated with submission to a dominant or Îhegemonicâ ideology.

Translating to public choice theory, we get:

(1) Politics is about the struggle between interest groups. The state responds to the pressure of organised interest groups, typically tight coalitions of producer groups. Log-rolling between these groups produces an outcome which benefits them collectively at the expense of taxpayers and consumers;
(2) Political ideas (except free-market ideas) are ideologies designed to rationalise policies serving various interest groups;
(3) Voters acquiesce because of Îrational ignoranceâ which leads them to take little in-terest in politics and makes them easily subject to manipulation by political interests.

On the Leninist implications of both theories

If ideas do not matter, free speech is at best a luxury and at worst a distraction. Even if speech is not actually suppressed, it is debased. When political debate is seen as a charade by its participants, it naturally becomes one. Furthermore, since the system cannot be changed by reason, some form of ‘short sharp shock’ is required. The result is a cult of ruthlessness (the catchphrase here is ‘tough decisions’). Since opposition to oneâs policies is interpreted as a sign that interest groups are being hurt, it may be taken as evidence of correctness. The correct response is not to persuade oneâs opponents, but to override them.

This was in a piece published in, of all places, the Centre for Independent Studies journal, Policy. The editor in those days, Michael James, was an interesting person – too interesting for the CIS in the end, as I recall.

I’ve done one piece of historical revision in the above story. I didn’t explicitly identify authoritarian Marxism with Leninism in this piece, and I owe the idea of ‘Market Leninism’ to New Zealand economist Brian Easton.

If you want to read the entire article, it’s posted below.

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