An amazing thing has happened over the last five years.   Against all expectations, American emissions of carbon dioxide into the atmosphere, since peaking in 2007, have fallen by 12%, back to 1995 levels.  (As of 2012. US Energy Information Agency).   How can this be?   The United States did not ratify the Kyoto Protocol to cut emissions of greenhouse gases below 1997 levels by 2012, as Europe did.  

Was the achievement a side-effect of reduced economic activity?   It is true that the US economy peaked in late 2007, the same time as emissions.   But the US recession ended in June 2009 and GDP growth since then, though inadequate, has been substantially higher than Europe’s.  Yet US emissions continued to fall, while EU emissions began to rise again after 2009 (EU).  Something else is going on. 

The primary explanation, in a word, is “fracking.”   In fourteen words: the use of horizontal drilling and hydraulic fracturing to recover deposits of shale gas.  

One can virtually prove that shale gas is the major factor behind the fall in US emissions.  Natural gas, especially when burnt in combined-cycle gas turbine power plants, emits only half as much greenhouse gas (GHG) as coal.   Ten years ago domestic natural gas production appeared to be reaching its limits; the industry was so sure of this that it made big investments in terminals to import Liquefied Natural Gas (LNG).  Yet the fracking revolution has increased the supply of natural gas so rapidly since then that LNG port sites are being expensively converted to export.   Clean natural gas occupies a rapidly increasing share of the generation of electric power.   It has come largely at the expense of coal’s share.  Within power generation, natural gas is up 37% since 2007, while coal is down 25%.  As a result, natural gas has drawn close to coal as the number one source of US power — unthinkable a short time ago. Renewables have been rising, but still constitute only 5% of power generation in the US.  This is less than hydroelectric and far less than nuclear, let alone coal or gas.

Meanwhile, the role of coal - the dirtiest fuel — has been rising in the energy mix of the rest of the world, not falling (IEA, Dec. 2012).  Coal’s share of power has even risen since 2010 in Europe (EC), where some countries are phasing out emission-free nuclear power and no shale gas boom has appeared.    (The trans-Atlantic comparison does not offer grounds for self-righteousness, however.   GHG emissions remain far higher in the US than in Europe.)     

The advent of shale gas in the United States has had a variety of implications for the economy, national security, and the environment.  The implications are surely more good than bad. 

Short-run economic advantages include job creation.   Medium-run economic advantages include the “re-shoring” of some manufacturing activities.   Long-run advantages include reducing macroeconomic vulnerability to future global oil shocks such as those that led to serious recessions in the 1970s.  (It would be wrong to claim job creation as an advantage in the long-run.  Jobs that are created in the oil and gas sector would otherwise be created somewhere else.  But during the last five years of high unemployment, every new job has helped.) 

Moving beyond economics, the reduction in net energy imports is good for US national security.  What happens in the Middle East will still matter, but as oil imports fall American foreign policy will not be as constrained as in the past. US net oil imports have already fallen by half since 2007 and the downward trend is expected to continue.   In Europe, the new developments can help break Russia’s troublesome stranglehold on the supply of natural gas.

That leaves the environment.  Here as well the effects on net appear beneficial.   As already noted, the substitution of natural gas in place of coal slows global climate change. Indeed the United States is now on track to meet the Obama administration’s international commitment of emissions 17% below 2005 levels by 2020.  But natural gas is also better for local air quality.  Burning coal puts sulfur dioxide, nitrous oxide, mercury and particulates into the air. 

Yet it is among environmentalists that heartfelt opposition to fracking has arisen.  Why?

Environmentalists seem to have three sets of fears.  First, they worry that shale gas will displace renewable energy sources such as wind and solar power.  But the fact is that GHG emissions can’t be reduced without cutting coal emissions and that shale gas is already displacing coal in the US.  This is not speculation about the future.  It has already been happening.  If renewables or fusion or something else currently unknown can take over after 2050, then great.  But we would still need natural gas as a bridge from here to there. 

Put differently, if the world continues to build coal-fired power plants at the rate it has been, those plants will still be around in 2050 regardless what other technologies have become available in the meantime.  Solar power can’t stop those coal fired plants from being built today.  Natural gas can. 

Cheap natural gas also helps with heating buildings and increasingly with transportation as well - particularly if electric plug-in cars become more widespread.  In overall primary energy production, natural gas at 31% has now surpassed coal, at 26%. The graph below shows the two lines crossing. (Table 1.2,  US EIA).  Solar and wind together account for only 2% of US primary energy production.  

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     I have argued that the best way to think of “black swan” events is as developments that, even though low-probability, can in fact be contemplated ahead of time.  Even if they are the sort of thing that has never happened before within an analyst’s memory, similar things may have happened before in the distant past or in other countries.   

     What current possible shocks have probabilities that, even if fairly low, are high enough to warrant thinking about now?  Some have been discussed ad infinitum, others hardly at all.

• Most widely discussed is the danger of a break-up of the euro. Considered unthinkable a short time ago, the probability that one or more euro members will drop out is now well above 50%. Currency unions have disintegrated before.
• Another is the possibility of a hard landing in China, analogous to the crisis that hit Korea and other East Asian markets in 1997.
• An oil crisis in the Mideast is the classic black swan event. Each one catches us by surprise: 1956, 1973, 1979, and 1990 (among others). Oil prices can rise for lots of reasons, not just crises in the Mideast, and have done so in recent years. But the most likely crisis scenarios currently stem from either military conflict with Iran or instability in some Arab government. The threatened loss of supply to world markets typically shows up as a sharp increase in demand for oil inventories and thus in prices.
• The most worrisome financial threat is a crash of currently over-priced bond markets. In theory such a crash could be precipitated by inflation (particularly commodity-induced inflation as in 1973 or 1979). But this seems unlikely. More likely triggers are (i) a breakdown in the eurozone or (ii) political dysfunction in Washington. A default in Greece or some other Mediterranean country could trigger a global debt crisis any time. The evidence of extreme dysfunction in US politics is already there for all to see, in the attempts by some politicians to repeat the macroeconomic policy mistakes of 1937 and in the debt-ceiling show-down of August 2011 (which led S&P to downgrade US government credit rating from AAA to AA). The obvious crunch date comes after the American election, as the “fiscal cliff” approaches in the last two months of this year. In theory, fears of what will happen January 1 should lead investors to start dumping bonds now. But it is still considered a sign of sophistication in financial markets to opine that, precisely because the consequences of going over the cliff would be so bad, the politicians will again find a last-minute way to avoid it. In truth, the fact that we haven’t gone over the cliff before does not necessarily mean we won’t this time. Perhaps observers think that a clear result in the election, one way or the other, would help settle things. A true black swan in the mix would be a repeat in November of the disputed 2000 presidential election; there has been no reform in the meantime to assure people that their votes will be counted or that a disputed outcome would be resolved by independent institutions rather than by interested political appointees.
• Scariest on the list is a terrorist attack with weapons of mass destruction. When politicians have used the specter of a September 11 repeat to scare the American public into supporting unhelpful policy responses, the mistake has been in the unhelpful policy responses, not in the “scare” part. There is long-standing gap between the probability of a nuclear event as perceived by terrorism experts and the probability as perceived by the public. Admittedly the probability is lower now that Osama bin Laden is dead.
• Last on this list is an unprecedented climate disaster. Environmentalists sometimes underestimate the benefits of technological and economic progress when they reason that a finite supply of resources must of necessity be exhausted eventually. But the disbelievers are just as faulty in their reasoning that because a global climate disaster has not happened in the past it can’t happen in the future.

       Throughout history, big economic and political shocks have often occurred in August, when leaders had gone on vacation in the belief that world affairs were quiet.   Examples of geopolitical jolts that came in August include the outbreak of World War I, the Nazi-Soviet pact of 1939 and the Berlin Wall in 1961.  Subsequent examples of economic and other surprises in August have included the Nixon shock of 1971 (when the American president enacted wage-price controls, took the dollar off gold, and imposed trade controls), 1982 eruption in Mexico of the international debt crisis, Iraq’s invasion of Kuwait in 1990, the 1991 Soviet coup, 1992 crisis in the European Exchange Rate Mechanism, Hurricane Katrina in 2005, and US subprime mortgage crisis of 2007.   Many of these shocks constituted events that had previously not even appeared on most radar screens. They were considered unthinkable. 

The phrase “black swans” has come to be used to mean a very unlikely event of this sort.  Managers of Long Term Capital Management in 1998 or of most major banks in 2008 have suggested that they could not be expected to have allowed for a financial collapse such as the one that followed the default of Russia or the one that followed the bursting of the US housing bubble, because it was a “7-standard deviation event,” that is, an event of inconceivably tiny probability…in the realm of the probability that two major meteors hit the earth at the same time.   This is nonsense.  If the statistical model says the probability of a financial crisis is that low, it is the model that is wrong.  This is like the case when “hundred-year floods” turn up every few years.

A bit more enlightened are people who talk about Knightian uncertainty or “unknown unknowns.” Ignorance with humility is better than ignorance without it.    A still better interpretation is that statistical distributions have “fat tails,” in technical terms.  But it would be nice to get beyond the Jurassic Park lesson (”don’t be surprised if things go wrong”), to be able to say intelligent things about what causes tail events. 

       What does “black swan” really mean?   In my view, it should refer to an event that is considered virtually impossible by those whose frame of reference is limited in time span and geographical area, but that is well within the probability distribution for those whose data set includes other countries besides their own and other decades or centuries. 

      Consider five examples of mistakes made by those whose memory did not extend beyond a few years or decades of personal experience in a small number of countries.

1. “All swans are white.”  The origin of the black swan metaphor was the belief that all swans were white, a conclusion that might have been reached by a 19^th century Englishman based on a lifetime of personal observation and David Hume’s principle of induction.   But ornithologists already knew that there in fact existed black swans in Australia, having discovered them in 1697.  A 19^th-century Englishman encountering a black swan for the first time might have considered it an event of unthinkably low probability, even though the relevant information to the contrary had already been available in ornithology books.  It seems a waste of an excellent metaphor to use the term just to mean a highly unexpected event.  A better use of “black swan” would be to mean an event that would not have been quite so unexpected ex ante if forecasters had cast their data net over a broader set of countries and a longer time perspective.

 2. “Terrorists don’t blow up big office buildings.”   Before September 11, 2001, some terrorist experts warned that foreign terrorists might try to blow up tall American office buildings.   These warnings were not taken seriously by those in power at the time.   Many Americans did not know the history of terrorist events taking place in other countries and in other decades.  

 3. “Housing prices don’t fall.” Many Americans up to 2006 based their behavior on the assumption that nominal housing prices, even if they slowed down, would not fall.   After all, “they never had before,” which meant that they had not fallen in living memory in the United States.   They may not have been aware that housing prices had often fallen in other countries, and in the US before the 1940s.  Needless to say, many a decision would have been made very differently, whether by indebted homeowners or leveraged bank executives, if they had thought there was a non-negligible chance of an outright decline in prices.

 4. “Volatilities are low.”   During the years 2004-06, financial markets perceived market risk as very low.  This was most nakedly visible in the implicit volatilities in options prices such as the VIX.  But it was also manifest in junk bond spreads, sovereign spreads, and many other financial prices.  One of the reasons for this historic mis-pricing of risk is that traders were plugging into their Black-Scholes formulas estimates of variances that went back only a few years, or at most a few decades (the period of the late “Great Moderation”).  They should have gone back much farther - or better yet, formed judgments based on a more comprehensive assessment of what risks might lie in wait for the world economy.

 5. “Big banks don’t fail.”   ”Governments of advanced countries don’t default.”   ”European governments don’t default.”  Enough said.  Greece’s debt troubles, in particular, should not have caught anyone by surprise, least of all northern Europeans.   The perception was that euro countries were fundamentally different from emerging markets, that like Germany they were free of default risk.  Suddenly, in 2010, the Greek sovereign spread shot up, exceeding 800% by June. But even when the Greek crisis erupted, leaders in Brussels and Frankfurt seemed to view it as a black swan, instead of recognizing it as a close cousin of the Argentine crisis of ten years earlier, the Mexican crisis of 1994, and many others in history, including among European countries.

      My next blog post will list some of the shocks that, even though low-probability, have high enough probability that they should be treated as thinkable rather than unthinkable, they would have great consequences, and they therefore warrant some advance preparation.

Libyans have a new lease on life, a feeling that, at long last, they are the masters of their own fate. Perhaps Iraqis, after a decade of warfare, feel the same way. Both countries are oil producers, and there is widespread expectation among their citizens that that wealth will be a big advantage in rebuilding their societies.

Meanwhile, in Africa, Ghana has begun pumping oil for the first time, and Uganda is about to do so as well. Indeed, from West Africa to Mongolia, countries are experiencing windfalls from new sources of oil and mineral wealth. Adding to the euphoria are the historic highs that oil and mineral prices have reached on world markets over the last four years.

Many countries have been in this position before, exhilarated by natural-resource bonanzas, only to see the boom end in disappointment and the opportunity squandered with little payoff in terms of a better quality of life for their people. But, whether in Libya or Ghana, these countries’ current leaders have an advantage: most are well aware of history, and want to know how to avoid the infamous natural-resource “curse.”

To prescribe a cure, one must first diagnose the illness. Why do oil riches turn out to be a curse as often as they are a blessing?

Economists have identified six pitfalls that can afflict natural-resource exporters: commodity-price volatility, crowding out of manufacturing, “Dutch disease” (a booming export industry causes rapid currency appreciation , which undermines other exporters’ competitiveness), excessively rapid resource depletion, inhibition of institutional development, and civil war.

Oil prices are especially volatile, as the large swings over the last five years remind us. The recent oil boom could easily turn to bust, especially if global economic activity slows.

Volatility itself is costly, leaving economies unable to respond effectively to price signals. Temporary commodity booms typically pull workers, capital, and land away from fledgling manufacturing sectors and production of other internationally traded goods. This reallocation can damage long-term economic development if those sectors are the ones that nurture learning by doing and fuel broader productivity gains.

The problem is not just that workers, capital, and land are sucked into the booming commodity sector. They also are frequently lured away from manufacturing by booms in construction and other non-tradable goods and services. The pattern also includes an exuberant expansion of government spending, which can result in bloated public payrolls and large infrastructure projects, both of which are found to be unsustainable when oil prices fall. If the manufacturing sector has been “hollowed out” in the meantime, so much the worse.

Another pitfall is excessively rapid depletion of oil or mineral deposits, in violation of optimal rates of saving, let alone preservation of the environment.   

Even if high oil revenues turn out to be permanent, pitfalls nonetheless abound. Governments that can finance themselves simply by retaining physical control over the oil or mineral deposits located within their borders often fail in the long run to develop institutions that are conducive to economic development.  Such countries evolve a hierarchical authoritarian society where the only incentive is to compete for privileged access to commodity rents. In the extreme case, this competition can take the form of civil war. In a country without resource wealth, by contrast, elites have little alternative but to nurture a decentralized economy in which individuals have incentives to work and save. These are the economies that industrialize.

What can countries do to ensure that natural resources are a blessing rather than a curse?  Some policies and institutions have been tried and failed. These include, in particular, attempts to suppress artificially the fluctuations of the global marketplace by imposing price controls, export controls, marketing boards, and cartels.

But some countries have succeeded, and their strategies could be useful models for Libya, Iraq, Ghana, Mongolia, and others to emulate. These include: hedging export earnings - for example, via the oil options market, as Mexico does; ensuring countercyclical fiscal policy - for example via Chile’s kind of structural budget rule; and delegating sovereign wealth funds to professional managers, as Botswana’s Pula Fund does.

Finally, some promising ideas have virtually never been tried at all: linking bonds to oil prices instead of dollars, to protect against the risk of a price decline; choosing Product Price Targeting as an alternative to either inflation targeting or exchange-rate targeting, to play the role of anchor for monetary policy; and distributing oil revenues on a nationwide per capita basis, to ensure that they do not wind up in elites’ Swiss bank accounts.

Leaders have free will. Oil exporters need not be prisoners of a curse that has befallen others. Countries can choose to use their resource bonanzas for the long-term economic advancement of their peoples.

[This column originally appeared at Project Syndicate.  Comments can be posted there.]

The prices of minerals, hydrocarbons, and agricultural commodities have been on a veritable roller coaster. Although commodity prices are always more variable than those for manufactured goods and services, commodity markets over the last five years have seen extraordinary volatility.

Countries that specialize in the export of oil, copper, iron ore, wheat, coffee, or other commodities have boomed.  But they are highly vulnerable. Dollar commodity prices could plunge at any time, as a result of a new global recession, a hard landing in China, an increase in real interest rates in the United States, fluctuations in climate, or random sector-specific factors.

Countries that have outstanding debt in dollars or other foreign currencies are especially vulnerable. If their export revenues were to plunge relative to their debt-service obligations, the result could be crashes reminiscent of Latin America’s debt crisis in 1982 or the Asian and Russian currency crises of 1997-1998.

Many developing countries have made progress since the 1990’s in shifting from dollar-denominated debt toward foreign direct investment and other types of capital inflows, or in paying down their liabilities altogether. But some commodity exporters still seek ways to borrow that won’t expose them to excessive risk.

Commodity bonds may offer a neat way to circumvent these risks. Exporters of any particular commodity should issue debt that is denominated in terms of the price of that commodity, rather than in dollars or any other currency. Jamaica, for example, would issue alumina bonds; Nigeria would issue oil bonds; Sierra Leone would issue iron-ore bonds; and Mongolia would issue copper bonds. Investors would be able to buy Guatemala’s coffee bonds, Côte d’Ivoire’s cocoa bonds, Liberia’s rubber bonds, Mali’s cotton bonds; and Ghana’s gold bonds.

The advantage of such bonds is that in the event of a decline in the world price of the underlying commodity, the country’s debt-to-export ratio need not rise. The cost of debt service adjusts automatically, without the severe disruption that results from loss of confidence, crisis, debt restructuring, and so forth.

The idea is not new. (The oldest reference I know is Lessard & Williamson, 1985.)  So, why has it not been tried before? When one asks finance ministers in commodity-exporting debtor countries, they frequently reply that they fear insufficient demand for commodity bonds.

That is a surprising proposition, given that commodity bonds have an obvious latent market, rooted in real economic fundamentals. After all, steel companies have an inherent need to hedge against fluctuations in the price of iron ore, just as airlines and utilities have an inherent need to hedge against fluctuations in the price of oil.  Each of these commodities is an important input for major corporations. Surely there is at least as much natural demand for commodity bonds as there is for credit-default swaps and some of the bizarrely complicated derivatives that are currently traded!

It takes liquidity to make a market successful, and it can be difficult to get a new one started until it achieves a certain critical mass. The problem may be that there are not many investors who want to take a long position on oil and Nigerian credit risk simultaneously.

A multilateral agency such as the World Bank could play a critical role in launching a market in commodity bonds. The fit would be particularly good in those countries where the Bank is already lending money.

Here is how it would work. Instead of denominating a loan to Nigeria in terms of dollars, the Bank would denominate it in terms of the price of oil; it would then turn around and lay off its exposure to the world oil price by issuing that same quantity of bonds denominated in oil. If the Bank lends to multiple oil-exporting countries, the market for oil bonds that it creates would be that much larger and more liquid. It can serve an additional important pooling function in cases where there are different grades or varieties of the product (as with oil or coffee), and where prices can diverge enough to make an important difference to the exporters.  The Bank could link the bond it issues to an oil price index, a weighted average of various product grades.

An alternative for some commodity exporters is to hedge their risk by selling on the futures market. But an important disadvantage of derivatives is their short maturity. A West African country with newly discovered oil reserves needs to finance exploration, drilling, and pipeline construction, which means that it needs to hedge at a time horizon of 10-20 years, not 90 days.

Another disadvantage of derivatives is that they require a high degree of sophistication –both technical and political. In the event of an increase in a commodity’s price, a finance minister who has done a perfect job ex ante of hedging export-price risk on the futures market will suddenly find himself accused ex post of having gambled away the national patrimony. This principal-agent problem is much diminished in the case of commodity bonds.

If the international financial wizards can get together and act on this idea now, commodity exporters might be able to avoid calamity the next time the world price of their product takes a plunge.  The World Bank should take up the cause.

Korea may have an opportunity to exercise historic leadership, when it chairs the G-20 meeting in Seoul, November 11-12.    This will be the first time that a non-G-7 country has hosted the G-20 since the larger, more inclusive, group supplanted the smaller rich-country group in April of last year as the premier steering committee for the world economy.  With large emerging market and developing countries playing such expanded economic roles, the G-7 had lost legitimacy.  It was high time to make the membership more representative.    But there is also a danger that the G-20 will now prove too unwieldy, in which case decision-making might then revert to the smaller group.

When countries like China and India used to demand a larger voice in world governance based on their large populations, they did not get very far.   Substantive power in multilateral governance is allocated according to the Golden Rule: “He who has the gold rules.”    But after a few decades of miraculous economic growth rates they now have the economic heft.    China is now larger economically than Japan or Germany.   Brazil is also one of the seven largest economies.

Beyond GDP, we have recently seen a historic role reversal, in which debtor-creditor patterns have changed.    Many developing countries, breaking historic patterns, took advantage of the global boom of 2003-2007 to achieve high national saving rates, particularly in the form of strong government budgets, while the advanced countries did not.   As a result, the debt levels of the top 20 rich countries (debt/GDP ratios around 80%) are now twice those of the top 20 emerging markets.   And it is rising rapidly.   A number of emerging market countries now have higher credit ratings than a number of so-called advanced countries.  A stronger fiscal position is one of the reasons that countries like China could afford to undertake large and sustained fiscal stimulus in response to the 2008-09 global recession.   The United States and United Kingdom, by contrast, had wasted the preceding expansion running budget deficits, and hence by 2010 had come to feel heavily constrained by their debts.

It is understandable if Korea views its hosting of the G-20 as another opportunity for marking its arrival on the world stage (as when it hosted the Olympics) or for consolidating its status as an industrialized economy (as when it joined the OECD).  But it should make more of its opportunity than this.  Korea should seize the chance to exercise substantive leadership.   Otherwise, the risk is that its period in the chair could appear like a replay of the chaotic Czech presidency of the EU in the first half of 2009, which confirmed the feelings of some in the larger European countries that it was a mistake to let smaller countries take their turns behind the wheel.

Korea can serve as a bridge between the G-7 and the developing countries.  But chairing a successful meeting will be a challenge, with respect to both meeting management and substantive issues.

With regard to managing the meeting, the challenge comes from the size of the group.   There is always a tradeoff between legitimacy and workability.   The G-7 was small enough to be workable but too small to claim legitimacy.  The United Nations is big enough to claim legitimacy but too big to be workable.  The latest evidence of this was the Conference of Parties of the UN Framework Convention on Climate Change in Copenhagen last December.  The UNFCCC proved a totally ineffectual vehicle, in part because small countries repeatedly blocked progress.    President Obama was able to make more progress by spending a few minutes in a room with a few big emitting countries than the delegates had achieved in two weeks.

The G-20 has enough legitimacy for its purpose — which is more limited than the purposes of formal institutions such as the UN, IMF, and WTO.  It accounts for 85% of the world’s GDP, for example.    But it is too big to be workable as a steering group.  A principle of multilateral talk-shops is that conversation is not possible with more than 10 in the room.  With 20 delegations, each reads prepared statements;  there is no give and take and the communiqué is a watered down least-common-denominator press release.   Not only does the G-20 have more than 10 delegations; it actually has more than 20.

The G-20 needs a smaller informal steering group within the steering group, a G-6 or G-9 within the G-20.   It could meet in the evening before the main G-20 meeting and discuss how to organize the discussion in the larger group.

Who would be in the G-6 or G-9?   It would be unwise to be too specific at this point.  Nevertheless, the US, Japan, and Europe (represented perhaps by the EU Commission), must be there on the rich-country side; China, India, and Brazil must be there on the developing-country side.   Of course the pressure to expand is always irresistible.  Europe could be represented by both the U.K. and euroland.    In Seoul, Korea has to be there as the host. Who would be the 9^th country in the G-9?   It should be the country of which the person reading this blog post is a citizen.

What about the substance of the meetings?   The group will discuss whatever the bigger countries consider it most useful to discuss at the time.    Five possible topics include:

• At long last, giving more seats on the IMF executive board to big emerging market countries, in proportion to their rising economic clout,offset by consolidation of some of Europe’s seats.
• More financial regulatory reform, such as coordination of any small taxes or penalties that members want to apply to risk-taking banks.
• Global current account imbalances. Perhaps there will be a statement agreeing that large current account deficits or surpluses tend to lead to problem (absent some good economic justification), that exchange rates and budget deficits both bear some responsibility for current large imbalances, and that the burden of adjustment should be born by neither one alone, but rather by both.
• Macroeconomic exit strategies. I personally would favor an articulation of the proposition that concrete steps toward long-term fiscal consolidation in each country need not require premature withdrawal of current fiscal stimulus. An example would be to raise the future retirement age or take other steps today to reform public pensions, even while simultaneously enacting some short-term stimulus in the US and UK.
• Moving toward a new agreement on climate change to take the place of the Kyoto Protocol after 2012. Korea is in a good position to lead, as essentially the first post-Kyoto country to accept emission targets.

Don’t judge the outcome of the meeting by what appears in the media.   Press reviews usually pronounce such summits a let-down.   But occasionally such meetings are important, in ways that are often not clear until later.

Consider the London G-20 meeting of April 2009.    It was not obvious at the time that it had been a success in terms of substantive policies.   Observers even compared it to the infamous failed London Economic Summit of 1933, which was a way of saying that the world had not learned the lessons of the Great Depression.    But the 2009 meeting appears far better in hindsight.  Looking back on 2009, fiscal stimulus turned out to be more widespread in 2009 than one might have guessed.    Similarly, global monetary policy was easy, avoiding another big mistake of the 1930s.  The G-20 unexpectedly agreed to triple IMF resources and bring the SDR back from the dead.  Even in the area of trade policy, despite fears of protectionism, the outcome was not bad at all by the standards of past recessions, let alone in comparison with the Smoot-Hawley tariff of 1930.   Overall, policy-makers’ immediate response to the global recession in 2009 did not repeat the mistakes of the early 1930s.

Currently, however, the advanced countries are in danger of repeating the mistake that President Franklin Roosevelt made in 1937, when he cut spending prematurely and sent the US economy back into recession.  Perhaps the G-20 will be a venue in which the big emerging market countries can remind the U.S. and the U.K. of the lesson they once knew but have now forgotten — what it means to run a countercyclical fiscal policy.

[This column was written for Project Syndicate. Comments can be posted there.]

In the wake of the April oil well blowout off the coast of Louisiana, policy-makers are rethinking the issue of off-shore drilling.    Clearly the last decade’s neglect of safety rules by federal regulators needs to come to an end.   But what larger implications should we draw for domestic oil drilling? 

The tension has long been between those who give primacy to the environment, on the one hand, and those who give primacy to business on the other.    Probably some of the first group oppose all oil drilling and some of the latter support all oil drilling (even when the government unconscionably offers oil leases on federal lands at below-market rates, as it often has historically).    As so often, the right answer lies in between. (more…)

I was recently asked by the National Journal to comment on what I thought was a desirable path for tax reform, if one could wish away political constraints that normally handcuff politicians.   My answer was, of course, to tax energy, particularly carbon emissions, and use the revenue to reduce other taxes.  As I and many others have noted often in the past, taxes on oil or gasoline hit many birds with one stone.

Discussion of energy taxes has always been political suicide. But here are several twists that could potentially increase the ability of the electorate to swallow them politically:

1) The energy taxes would not go into effect until the economy fully recovers from the current recession, thereby avoiding an abortion of the recovery. But the plan would be announced in the near future (thereby sending desirable allocational signals to firms building power plants or pursuing renewable energy research).

2) Such measures could be on stand-by, to be enacted in the event of a major unfortunate geopolitical setback in the Middle East or a tragic terrorist event, which would galvanize public opinion to do something sensible for the first time about the extent of US dependence on oil imports.

3) A tax on, e.g, gasoline could be designed to put a floor under the current price. The status quo always generates less political resistance than a tax that raises the price.

4) The revenue from the first penny per gallon could be earmarked to fund the deficit in social security benefits of those retiring in 2027, for example. They were born in 1962, and know who they are. The revenue from the second penny could be used to finance the benefits of those retiring in 2028, and so on. (Numbers are illustrative. I haven’t done the actual calculations.) The result would be to create a constituency for keeping the tax in place, namely those whose retirement benefits are funded with the proceeds.

In the 1955 movie version of East of Eden, the legendary James Dean plays Cal.  Like Cain in Genesis, he competes with his brother for the love of his father, a moralizing patriarch.   Cal “goes long” in the market for beans, in anticipation of an increase in demand if the United States enters World War I.  Sure enough, the price of beans goes sky high, Cal makes a bundle, and offers it to his father to make up money lost in another venture.  But the father is morally offended by Cal’s speculation, not wanting to profit from others’ misfortunes, and angrily tells him that he will have to “give the money back.” Cal has been the agent of Adam Smith’s famous invisible hand:   By betting on his hunch about the future, he has contributed to upward pressure on the price of beans in the present, thereby increasing the supply so that more is available precisely when needed (by the British Army).  The movie even treats us to a scene where Cal watches the beans grow in a farmer’s field, something real-life speculators seldom get to do.
 
Among politicians, pundits, and the public, many currently are trying to blame speculators for the recent boom in oil and other mineral and agricultural products.    Are the soaring prices their fault?

Sure, speculators are important in the commodities markets, more so than they used to be.  The spot prices of oil and other mineral and agricultural products — especially on a day-to-day basis — are determined in markets where participants typically base their supply and demand in part on their expectations of future increases or decreases in the price.    That is speculation.  But it need not imply bubbles or destabilizing behavior.

The evidence does not support the claim that speculation has been the source of, or has exacerbated, the price increases.   Indeed, expectations of future prices on the part of typical speculators, if anything, lagged behind contemporaneous spot prices in this episode.   Speculators have often been “net short” (sellers) on commodities rather than “long” (buyers).  In other words they may have delayed or moderated the price increases, rather than initiating or adding to them.  One revealing piece of evidence is that commodities that feature no futures markets have experienced as much volatility as those that have them.   Clearly speculators are the conspicuous scapegoat every time commodity prices go high.  But, historically, efforts to ban speculative futures markets have failed to reduce volatility.

One can distinguish three kinds of speculation in the face of rising prices.   First, there is the “bearer of bad tidings” like Cal in East of Eden.  The news that, in the future, increased demand will drive prices up is delivered by the speculator.  Not only would it be a miscarriage of justice to shoot the messenger, but the speculator is actually performing a social service, by delivering the right price signal that is needed to get real resources better in line with the future balance between supply and demand.  Without him, the subsequent price rise would be even greater, because supply would be less.    Most economists agree that speculators did not play this role in the commodity boom that started earlier this decade:  as already mentioned speculation, if anything, lagged behind the spot price.   (An exception, however, is Alan Greenspan, who told Krishna Guha of the Financial Times that speculators played precisely this role, moving forward and smoothing out what would have otherwise been an even sharper peak in prices.)

Second, when the price is topping out, stabilizing speculators can sell short in anticipation of a future decline to a lower equilibrium price.   This type of speculator again adds to the efficiency of the market, and dampens natural volatility, rather than adding to it.

Third, in some cases, when an upward trend has been going on for a few years, speculators sometimes jump on the bandwagon. Market participants begin simply to extrapolate past trends.  Self-confirming expectations create a speculative bubble, which carries the price well above its equilibrium.  The markets don’t always get it right.   Examples of previous speculative bubble peaks include the dollar in 1985, the Japanese stock and real estate markets in 1990, the yen in 1995, the NASDAQ in 2000, and the housing market in 2005.

It is the third kind of speculation, the destabilizing kind (also called bandwagon behavior), about which people tend to worry.    As noted, there is little evidence that destabilizing speculation has played a role in the 2001-2008 run-up of commodity prices.    So far, that is.   Just because the boom originated in fundamentals does not rule out that we could still go into a speculative bubble phase.    The aforementioned bubbles each followed on trends that had originated in fundamentals (respectively:  rising US real interest rates, 1980-84;  easy money and rapid growth in Japan, 1987-89;  US recession, 1990-91, and Japanese trade surpluses; the ICT boom in the late 1990s; and easy US monetary policy after 2001).  

It is not hard to identify in economic fundamentals the origins of this decade’s boom in commodity markets:  easy money in the US; rapid growth worldwide, but especially in China and India; instability among oil producers, especially in the Middle East; misguided ethanol subsidies; drought in Australia, etc., etc.  

[Any readers wishing to comment on this blog post: I suggest you go to the RGE version.]