When economists go bad

Paul Krugman used to be an economist I enjoyed reading. He was sensible, logical and most importantly even handed with hypotheses and data. He made well founded arguments that didn't rely on fallacies of authority and he treated all data with the caution and respect it requires.

But something has happened. Something has changed. Paul seems different. A bad case of Nobelitis? Or maybe, just maybe, Paul sees a political future for himself rather than an academic one.

This is only the most recent comment from Paul on the issue of Dangerous Climate Change. In it he displays none of the reason that I enjoyed in the past. He is instead a shrill voice waving papers, citing some extraordinary claims (without providing details of the supporting data) and most importantly making a political case rather than an economic one. Read it for yourself and make your own judgement, but I would provide one illuminating sentence:

I couldn’t help thinking that I was watching a form of treason — treason against
the planet.

Yep. Treason.

And what could prove this is such a disaster in the making?

The fact is that the planet is changing faster than even pessimists expected: ice caps are shrinking, arid zones spreading, at a terrifying rate. And according to a number of recent studies, catastrophe — a rise in temperature so large as to be almost unthinkable — can no longer be considered a mere possibility. It is, instead, the most likely outcome if we continue along our present course.

Facts apparently. Something a Nobel Economics prize winner should be pretty hot on and was until recently. But in this case it is worse than even pessimists expected and occurring at a terrifying rate, but he doesn't even identify what these data are or where they can be found.

What data is being analysed suggests that climate change, as measured by everyone's favourite metric of mean global temperature anomalies, is occurring more slowly than thought. Look here for a fact-based appraisal of temperatures to date compared with the "scenarios" produced in 1997 and 2001 by the IPCC, which had become increasingly alarming. It indeed appears that the more pessimistic the "experts" - like those modellers at MIT Paul mentions - become, the more benign the outcomes appear to be. Actual changes in temperature are falling well below those expected. Paul would serve himself well to familiarise himself with such analysis, which I would be inclined to call genuine science.

Such failure isn't surprising, because in other areas the reality of climate is falling short of the predictions of the doomsayers. Claims that tropical cyclones (hurricanes) were increasing in number and intensity - which was all the rage around the time of Katrina - are now scarce because there has been very subdued activity.

And of course the worst sin of all for an economist, in particular one I regarded so highly until recently, is the blind support for complex modelled forecasts - something I talk about here. I know that will cause him such immense embarassment among his peers at some point in the not to distant future.

More on this "small open" economy

It only took a couple of days following my opening missive on this topic,
(http://geckkosworld.blogspot.com/2009/06/irish-economy-notes-1-is-it-small-open.html)
but sure enough a politician, no less than the Minister of Finance, Brian Lenihan, proclaimed that Ireland was an "open" economy in which any increase in demand would quickly leak away into imports. Of course he knew that because imports are high relative to GDP in this country and because everyone says so.

He wasn't reading this blog to be sure.

So I thought I might revisit this with some pesky data. Now the place to go looking for evidence of high "import multipliers" (i.e. that increases in demand will provide more stimulus to output abroad than domestically, compared with low import multipliers) is not under the national accounts estimates for national expenditure (that is the Y=C+I+G+X-M familiar to most econ 101 students), but deep within the Input-Output and Supply and Use tables of the national accounts.

These tables are clever things that try to track the flows of demand and output between different pre-defined industries and into some final point of demand, like to exports, or consumption or capital expenditure. These allow us to attempt to see if:

• A drop (increase) in world demand might dramatically reduce (increase) demand for output in Ireland, or instead simply reduce (increase) demand for imports.
• An increase in household consumption of government expenditure might be met mostly by imports (output produced abroad) rather than domestic output.

And these tables can track not just the first round effects, but all the way back up the production lines in the course of a year. That way we will know that if someone bought a computer from Dell, it would be comprised of a very large proportion of imports (originally) even though the final item itself came out of a factory in Ireland.

So what do these data tell us? Well, I first went to the "Use" tables, where we can see where all the exported output of Ireland comes from. Of the 95 odd industry groups identified, 80% of exported items come out of 10 industries (you can probably guess which ones, but chemicals, computer equipment, financial services feature prominently).

Next we go to what is call the "Leontief inverse" tables. These take output from every industry and calculate how much they rely on output from other industries (including those located overseas). So for our Dell computer example, these tables trace the origin of the inputs used to produce it, be they other domestic industries, or imported. It also tracks the origin of the inputs into those as well as adds them all up. The results we get are interesting to say the least.

For the industries that account for 80% of Irish exports (which is very large proportion of total output in the country), the "import multiplier" is about 0.58. That is 58% of the value of the output is actually provided from overseas in the form of imports. If you increase exports (i.e. the output of this group of industries) by 10%, you would expect imports to rise by around 6%. That is what we call "import leakage". The domestic affect will only be 4%. So Ireland isn't really an export led economy.

Compare with what you might normally expect to see. If you look at the same import multiplier for the entire rest of Irish industry (those whose output tends to go to meet domestic demand) you find a value of around 0.32. And this is interesting, because 30% is a number found just about everywhere else. if domestic demand increases 10%, imports increase by about 3%. This is half the size of the import leakage that might be expected to come from export demand.

Now this isn't the ideal form of analysis. It could be done more completely and address some of the shortcomings I have glossed over. But this was easy to do and the magnitude of the different import multipliers (for domestic oriented industries it was half that of export industries) makes this compelling.

So next time someone throws you the old "but Ireland is a small open economy" or "Ireland is an export-led economy" myths, ask them what the Leontief inverse tables of the input-output accounts indicate.

It is likely to shut their gob.

Is Ireland "giving away" its resources?

An article in today's Irish Times raises a popular issue in certain Left of centre circles in Ireland.

http://www.irishtimes.com/newspaper/opinion/2009/0619/1224249118435.html

This revolves generally around the licencing and leasing arrangements for oil and gas exploration in Irish Atlantic waters and more specifically as they related to the Corrib gas field.

The premise, as outlined in the article, by a Left wing activist academic at UCD, is that Ireland, often in contrast to other jurisdictions:

1. Takes no equity stake in these projects
2. Will impose no royalties on revenues from commercially exploited discoveries
3. Applies a lower tax rate to the commercial activities of the exploration and extraction companies
4. All of the above applied up until the 1980s

Let's consider those one by one and then take in the big picture.

1. Ireland indeed takes no equity stake in any companies. Neither does it provide any capital to such endeavours, nor does it assume any risk of failure. There are some estimates that approximately €2 billion in exploration and development costs have been expended through failed exploration in the last 30 years in 140 different ventures. Irish tax payers have not had to underwrite any of that.
2. Ireland does not impose any royalties on oil or gas revenues. Royalties are but taxes, levied on revenues. They make sense and work well when, in an uncertain venture, the potential costs of producing the revenue stream can be quite well estimated in advance. There is only one decent example of a successful energy extraction operation off the Irish Coast. That is in Kinsale, which is off the South coast. There is no other and nothing off the West coast where the Corrib field is located and other exploration is likely. When a company is facing an exploration project and has little idea of how much it might cost to extract any find, a tax on revenues (before any costs are allowed) can make the project appear unfavourable on financial terms - in fact any such company might find that the combined royalties plus development and extraction costs exceed the revenue.
3. Tax rates on energy extraction leases are levied on a scale that starts at 25% of earnings and increases to 40% as profit margins increase. This makes sense as it circumvents the cost uncertainty issue outlined above, but it also provides an effective "optional" royalty payment. That is, if costs are lower (or indeed if oil/gas prices rise) the tax rate goes up. So this does in fact allow some form of royalty factor, which kicks in if the project achieves an outcome at the more favourable range of potential outcomes.
   
   Also consider, when looking at that 25-40% corporate tax rate - which will apply to an earnings stream that might not eventuate after €100m of costs - that the rate that applies to any other company in Ireland is 12.5%. Google, Dell, Intel and many other large companies channel massive amounts of revenue through Irish domiciled companies. They pay 12.5% tax on profits (and usually far, far less). This places things in perspective.
4. The final criticism is that Ireland once had royalties, higher taxes and equity stakes in ventures in the 1970s. Well, yes it did. But also understand that the only other major oil or gas discovery occurred in 1971, at Kinsale Head. Nothing of commercial significance since then.
   
   Of course the Kinsale find led exploration companies to fancy their own chances of making a viable discovery, culminating in 1978 14 exploratory and 8 appraisal and development wells were drilled. Even by the mid 1980s there were 24 exploration licences on issue. But there was no other discovery and interest, understandably, dropped off. Face it, who wants to invest tens of millions of Euros (Punts at the time) in a venture that looks increasingly unlikely to yield anything, but would attract royalties, a 50% tax rate and a dividend payment to an equity partner (who provided no risk capital) in the remote chance that it did? Of course it makes no financial sense and companies went elsewhere. By 1992 there was only 4 exploration licenses on issue.
   
   It is clear the the risk/reward ratio was far too unfavourable and a major factor in that was the large financial return being demanded by the Irish Government. So there was clear need to reform the system and address that risk/return trade-off.
   
   Hence the revision of terms and hence the response from the industry that saw those 4 exploration licenses in 1992 rise to 35 in 1997. If you want economic benefits from resources, you need people to go find and develop them, so this was successful. But there was ongoing exploration failure and exploration dwindled again before further reform promoted some more exploration. Among those ventures was the Corrib field.

The final strand of the article is the insinuation that this area of government policy was victim of the well documented political corruption that was occurring at the time. That can be neither confirmed nor disproved at present. It is certainly not outside the realm of possibility. However, we don't need to resort to such theories to justify the more favourable regime in place in Ireland today.

And it bears thinking a little more deeply about the economic nature of exploration of this kind. It is a feature of the uncertainty that surrounds potential future revenue streams (if any) and costs, combined with the sunk nature of a substantial proportion of those costs (i.e. exploration and development costs that would be lost in a failed venture) that allows governments around the world to take a higher or lower share of any realised earnings. At one end of the spectrum, it is almost impossible not to strike oil in Saudi Arabia, it is easy to extract and of a known quality. The Saudi authorities are able to impose very high effect royalties and tax rates in that case (essentially because the exploration and development adds a much smaller proportion of the final economic value). Or, indeed the authorities could retain the risk themselves, knowing that there is a high chance of success and higher certainty of revenue streams and costs.

Similarly for late development Norwegian and British exploration in the North Sea. Once large scale deposits of oil are found and quantified, governments can raise their economic interest without scaring off investors. So it was in the North Sea.

Ireland, unfortunately is at the other end of the scale. Not only is there significant uncertainty, but there is now a very long track record of low success rates. The opposite to the experience in the North Sea decades ago and hence the ability to impose higher effective tax revenues or royalties or equity deals has dwindled also.

Is Ireland being "robbed" of its resources? It wouldn't appear so. Test the theory yourself. Place your brand new 52" LCD High Definition television on the front lawn overnight. See if it is still there in the morning. So it is with natural resources and the people of Ireland aren't exactly beating off "thieves" intent on walking off with an easy prize.

Question about the Dangerous Climate Change hypothesis #1

A couple of points before we start (my bog, my rules):

We are talking about the Dangerous Climate Change Hypothesis, which I define as meaning:

An hypothesis that human carbon emissions are the predominant cause of a dangerous shift in climate to a higher energy state, resulting in, among other things, higher average global temperatures.

There, I have made it easy by highlighting the key points and they are not open to dispute. They are axiomatic on this blog.

Also, some rule of engagement.

If by some extravagant exhibition of the laws of probability someone actual a) finds this blog, b) stays long enough to read this blog, c) reads this or another post on this topic, d) even considers it worthwhile responding, they should not accuse me of "not understanding the science". Although only a humble economist by training, I have surprised many people by the way I have mastered the dark art of reading. Moreover, there are areas in the field of econometrics and statistics and in particular the nature and behaviour of large jointly determined and highly endogenous models of natural systems I am well qualified to understand some extremely important issues.

Grand so. Buckle the seat belt and off we go.

This entre to the minefield of climate science will start on familiar ground for me - forecasting. I know the IPCC and climate modellers hate using that word (and I know why they hate it), but any extrapolation of a time series into a period that extends beyond the availability of data is a forecast. Yes, they may be conditional on certain assumed states of the world, but they are still forecasts.

And forecasts are important and this is why. Testing the ability of any model to predict future outcomes is the only real test of its efficacy. Every time someone tells you how well climate models track past temperature trends or variations as "proof" of the robustness of the hypothesis, call bullshit on them. For a surprisingly large number of reasons this is simply not true and any trained statistician or econometrician will verify that fact.

So when I want to prove to myself (unfortunately I rarely take peoples' word for anything) that the Dangerous Climate Change (DCC) hypothesis might be true, I look to the ultimate test of our understanding of climate processes - forecasts. And this, surprisingly, is very hard to do. I say surprisingly, because for something that could tell us so much about the state of our knowledge on such an important issue, very few people involved in climate research bother to do it. Instead they seem to spend their $BILLIONS (yes it is that much) increasing the complexity of their models and churning out more and more forecasts of different types, simply leaving the older work behind like yesterday's newspapers.

So let do some of this work for them. First let's be realistic about the challenge here and some valid points that climate modellers would raise.

• Climate change is about decadal trends. A year or two means nothing, you really need to look at maybe 20 or even 30 years to begin to get enough information to draw any sort of conclusions.
• Given, as I point out earlier, we will be dealing with "conditional" forecasts, we need to consider the role of underlying assumptions (poor forecasts due to erroneous assumptions can still indicate that the underlying understanding of the process is sound).
• We are dealing with "stochastic" processes. That means random. In statistics you need to be simply close enough, not exactly correct to 2 decimal places.

That will do for now. Note I will deal with these points qualitatively where I see the need. I don't think this is the place for number crunching confidence intervals and the like (because I say so OK!?!).

Boy, that turned into a longer preamble than planned, so let's get down to brass tacks. Firstly we need to find a forecast we can have a look at. It needs to have some hard numbers in it and it has to be long enough in the tooth for us to have had time (ideally decades) to collect data to test it. Given that the field of DCC is very youthful in scientific terms, we aren't spoiled for choice here, but there is one excellent candidate. In 1988 James Hansen, considered by some as the Godfather of DCC produced a famous paper and in it he produced some forecasts. Here is the chart contained in that paper showing these forecasts:

This chart nicely summarises the data we are interested in. There are four lines. The first runs to 1988 and is temperature anomaly data available at the time of publication. The other three are conditional forecasts. The different "conditions" are assumptions about how much more CO2 (and other greenhouse gases - "GHGs") humans will pump into the air. The only important point to know about these three forecasts is that none of them assumed that there would be less GHG pumped into the atmosphere than actually occur ed from 1988 to present.

Now we simply take some temperature data and carefully overlay to see ho good these forecasts were:

OUCH! Actual global temperature over the 20 years since the forecast was made have risen far less than forecast. And don't fool yourself. Hansen himself described the lowest forecast (the best outcome for mankind) as being based on an assumption that "drastic cuts" would be made to GHG emissions. Don't come here arguing that the world has made "drastic cuts" to GHGs.

Now some will complain that I am being an evil, oil industry funded, creationist supporting, conspiracy nutter, right wing neocon sceptic about all this. They would say that I should be using Hansen's own data for global temperature (yes, for those uninitiated in the concept of science as it is practiced in climate circles, the most vocal, qualified campaigner manages his own measure for the existence of this DCC - the GISS surface temperature series). But I am nothing if not fair, so lets repeat with Hansen approved temperature measures:

Double OUCH! Hansen manages to keep those temps up compared with satellite derived measures (the UAH in the previous chart), but still the trend over 20 years is well below what Hansen himself forecast it would be had we made "drastic cuts" to our emissions.

Well, all I can say is thank crikey we weren't so stupid to have done that.

Irish economy notes #1 - is it a "small open economy"

One of my favourite pastimes is to exist in a state of self induced angst about the lack of any apparent comprehension by anyone of the nature and behaviour of the Irish economy. Well, at least anyone in any position to exert policy influence.

Egotistical and self absorbed, most probably. But the feeling is real I promise.
For the last number of years events have provided ample opportunity to wallow in this strange mixture of self delusion and rage. We all know what that was; the "Property Bubble". Of course it is a bubble now (it was the "Celtic Tiger" then) after the event, as bubbles invariably have to be.

So now I need a new focus for my angst and believe me I don't find them hard to come by. I though I would kick off with another "self evident truth", that sits up there with "Celtic Tiger" and that is the claim that Ireland is a small open economy.
My bollocks it is.

Let's start with what exactly we mean when we use the phrase small open, or even simply open, economy. Most non-economist (and probably a lot of trained economists) would invariably answer that it is an economy that trade a lot, or something like that; a lot of exports. At that point one would point to the national accounts of Ireland for handy proof that the market value of exports from Ireland are indeed large relative to total output - exports are approximately 80% of GDP. Grand so, as they say on the Emerald Isle.

Except this is a bit of a trap. You see there is at least two distinctly different ways in which external trade (exports and imports) can originate and occur. I would say that one of those is not an example of an "open economy" in the true sense - something I will expand on later.

What are these two different types of trade? The first is one when imports occur and are used and transformed into others stuff of use and value to other people, either domestically or abroad. For example, you import some coal to generate electricity to run a factory that produces washing machines. What I am trying to identify here is the amount of "value added" that occurs in transforming the imported commodity into something else; that this value is added withing the country and hence the income that accrues to that added value is income to that economy. If a lot of these washing machines etc. are exported and a lot of stuff is imported to help make them, this would be an example of an "open economy".

Let's look at the second type of trade. You import some coal and stick in on a train and ship it to a neighbouring country. Why would you do that? Well, maybe that neighbour is landlocked. A tiny amount of value is added as the commodity is imported into the country and then exported. There are many examples of such activity. Hong Kong is the classic. Goods come in from China and get shipped out around the world. Similarly it act as an import hub also. There are examples closer to home for Ireland, Belgium is one. Now this is something I would suggest is not an open economy, but a "re-exporter".
So that is the distinction and so what? Well, it is important to understand what is going on in the economy at any time and it is important to understand before you propose any economic policy. And here is the reason:

If there is a downturn in global trade (a global recession like now), the an open economy will suffer. The exports represent a large amount of value added, or income to that country. In terms of national accounts aggregates, exports will fall, but imports will not fall a great deal. OK, global recession is bad for an open economy.

But what about the re-exporter? If there is less demand for exports, this has less affect on income (because those exports represent less value added). In national accounts terms, exports will fall a lot, but imports will fall almost as much in direct response. Eagle eyed observers will note that the important factor here will be the proportion of value added compared with the scale of trade. Ireland has exports which are probably twice as large (scale adjusted) compared with other industrialised countries, but the value added is probably only a quarter.

So far so good. But so what? Well here are some of the relevant implications of this:

The Irish economy is not overly susceptible to global recession (government finance are, but that is a story for another day). In fact it is less exposed to a dip in foreign demand. So when a member of Government claims that Ireland's woes are due to "global recession", they are stretching the truth to say the least.

Another important implication is that domestic demand is relatively important. Low interest rates (perhaps lower than they should be) that help fuel a consumption and borrowing boom will inflate the economy. An "open" economy would import a lot more, effectively utilising the productive capacity of other countries to meet demand. However, as I suggest, Ireland is not an open economy in the true sense, but a re-exporter. A surge in domestic demand will not naturally divert massively into imports as in the case of a truly open economy. And ignorance of this is one source of the massive failings of the last 15 years of Irish economic policy