Democrats turning record Republican deficits into record surpluses is valuable even if Republicans turn them right back again, for learning alone

With regard to Mark Thoma's excerpt of Brad DeLong's article, "The Democrat's Line in the Sand":

It's important to point out here that just because Republicans more than un-did all of the good of Clinton in turning their record deficits into record surpluses, in just 8 years, that doesn't mean that Clinton didn't do a very good thing, with lasting benefits.

He gave a stunning demonstration of how much better Democrats were in this important regard, that was glaringly obvious to almost all voters. If Obama again turns record Republican deficits into record surpluses, and a booming economy, just like Clinton did, will it all have been for nothing if a successive Republican administration just turns them right back again into record deficits? No way.

The first time that happened it severely discredited Republican brain dead economics. If it happened yet again, it would rightly devastate the credibility of Republican alchemy economics with the voting public. This learning would be very valuable to protect us in the future against the great economic inefficiency and costs of their ideology.

However, the biggest and most important thing Democrats can do is to pass universal health care. This would be like when the Democrats pushed through, over the Republicans, old age Social Security and Medicaid. The programs were enormously popular once they were enacted and people got a chance to see the truth of how good they were, rather than the Republican lies. They greatly improved our quality of life and now can (probably) never be taken away.

The same would be true of universal health care. Once it was enacted people would see just how much better, and less expensive it was, due to vast free market imperfections in this area, such as externalities, asymmetric information, great economies of scale and monopoly power, inability to patent, inability to price discriminate well (a very important market inefficiency, especially for products with a large idea/information component, that doesn't get enough attention), and more.

The Democrats gained enormous political -- and ideological -- capital after they passed the new deal and the vast majority of voters saw how much better it made their lives and the country. This moved the country, and thus by necessity, the Republican party, far in the progressive direction. The momentum lasted for decades, and some of the most important changes made are so embedded and clearly demonstrated to be of great value, like old age social security (of at least some substantial kind), that they will (probably) never be undone .

Likewise, the political capital Democrats would get from bringing universal health care to the American people, greatly increasing their security, wealth, and quality of life would be vast. It would greatly increase their ability to do good in any area. Global Warming may be the most important issue, but the best way to fight it is to pass universal health care. That would give Democrats the political capital necessary to pass far more ambitious projects to combat it, maybe even a Manhattan Project, or Moon race, to replace fossil fuels with alternative energy and nuclear.

There's nothing more important for Democrats than passing universal health care (which is not at all incompatible with running a budget surplus), and it's very doable...Stay tuned for my next post.

The tax increases are well worth it for what you get in return, even for a family with a $300,000 income

In response to Lane Kenworthy's June 24^th post, "Making Ends Meet on $300,000 a Year":

Clearly this family is living very luxuriously, $500/month for a country club, $75,000 in cars every 4 years, $9,000 per year for vacations -- ever heard of camping, driving to Six Flags and staying at the Holiday Inn. And, a $600,000 house, with commensurate maintenance, insurance, and property tax costs. I know in Orange county, this just buys a very nice middle class house in a nice suburb, but in the vast majority of the country you need less than half this much for such a house.

A key thing though is, it's not that Obama would be making them pay extra taxes for no benefit in return. Even at their income level the benefits from Obama's tax increases would be substantial. These include a great decrease in their health insurance costs, and the health insurance costs of their employers, which should eventually be passed along in higher wages.

The tax increases would increase public health and safety, substantially benefiting the quality of life of them and their children.

College would become a lot more affordable, so their children wouldn't be saddled with $150,000 in student debt like they are, and they would have to save less for their children's education.

Public recreation would be better, so maybe they could play on the public tennis courts or send their children to a free public community center. And how about neighborhood public parks that families can freely go to, instead of so many people being walled off in gated communities. These neighborhood public parks were much more common before conservative Republicans took over 28 years ago.

The list goes on and on.

Even for a family this wealthy, I would guess the benefits substantially outweigh the costs, and this is overwhelmingly true for the median family.

The main reason is that Obama's and the Democrats spending programs, by and large, recognize what the scientific academic economics community learned long ago. An intelligent government role can greatly increase efficiency, wealth, and welfare, due to problems with the pure free market like externalities, asymmetric information, inability to perfectly price discriminate, inability to patent, large economies of scale and monopoly power problems, especially with idea, knowledge products, and more.

The Republicans of the last three decades have a hostility towards science, and thinking in general, when it interferes with their ideology, and their simple-minded, pure free market is always the best and magic, slogan economics, has cost us greatly.

One other thing, which is huge, is the prestige externalities, prominently researched and written about by Cornell economist Robert Frank.

The taxes would be paid by everyone in one's peer group, by and large, so if you ended up spending $5,000 less on your car, on average, so would your peers, so you wouldn't lose any prestige. As typically, the utility of a luxury car, versus an average one, may be at least 90% prestige, the utility cost of that $5,000 less in spending may by more like $500, but the whole $5,000 in taxes would go to health care, education, public safety, cancer research, etc. (inconspicuous consumption as Frank would call it).

The same goes for spending on clothing and accessories and country club, and even vacation hotels are highly context related in their utility.

Furthermore, if their income goes down X%, so does their peers who bid against them for homes, so there will be a savings in home prices. It's not a complete free lunch, because, for example, older couples moving from a larger home to a smaller one will on average pocket less of a difference, but there will be far more gainers from this than losers.

The blame for high gas prices rests on simple-minded Republican ideology not speculators

In Paul Krugman's June 27th column he writes:

"Why are politicians so eager to pin the blame for oil prices on speculators? Because it lets them believe that we don’t have to adapt to a world of expensive gas."

A perhaps even bigger reason why Republicans want to blame speculators for sky high gas costs is that they don't want the public to put the blame where it's really due – on them.

For decades Republicans have constantly blocked Democratic attempts to increase fuel mileage and many other efficiency and conservation measures. They've also constantly blocked or cut spending on alternative energy, all the while mindlessly chanting "Free market". The economics community had proven long ago that there are many situations and ways where a government role can add greatly to efficiency, wealth, and welfare, but this is a party that long ago refused to think beyond slogans. They acted as though not being simple-minded was a vice, liberal and un-American, when in fact, thinking, and believing in science, evidence, and logic is one of the things that made this country great, and the richest and strongest in the world.

Now we're paying a big price for Republican ideology in energy and so many other things. Had the Democrats not been outvoted, filibustered, and vetoed from enacting their "big government" mileage, conservation, research, and other energy measures over the last almost three decades, gasoline might be less than half its price today, and mileage more than twice as high, making the gas cost per mile less than a quarter of what it is now.

And, of course, it wouldn't hurt that this would have starved the terrorists,and some of the worst authoritarian regimes in the world of money, and greatly decreased the momentous risks of global warming, trivial benefits that aren't taken into account by the magical free markets. By the way, such things are called externalities by serious academic economists...There they go again, those elitist, liberal, academic economists and scientists with their fancy book learnin'.

You Don't Mess with the Krughan

In response to Arnold Kling's June 24^th post:

Arnold, you're not wrong in saying that your misinterpretation of a Krugman quote is wrong. The problem is that Krugman never meant what you think he meant.

Here's the quote you refer to:

"Well, a futures contract is a bet about the future price. It has no, zero, nada direct effect on the spot price"

You're interpreting it as though Krugman said it has no effect on the spot price. He didn't say that. He said it has no direct effect on the spot price. And just two sentences later he goes on to say, "Any effect on the spot market has to be indirect...".

What did Krugman mean by all of this?

The Futures market and price is clearly related to the spot price, and can clearly affect it. You don't have to get all flowery and philosophical to see the key direct way, which is through arbitrage. The futures price cannot get too much higher than the spot price or else there will be arbitrage opportunities that are easy to see and will be jumped all over, bidding the futures price down and the spot price up.

For example, suppose the futures price of oil in one month were $140, and the spot (today) price were $130. An investor with good credit and access to funds could sign a futures contract to sell 100 million barrels in one month. Then, he could borrow $130 million and use it to buy 100 million barrels of oil.today. He would store the oil for one month, and then sell it at the price guaranteed in the futures contract, $140/barrel. With no risk, he would guarantee himself a profit of millions because interest costs on the $100 million he borrowed for one month, and the storage costs of the oil for one month, will be less than the $10 million difference between 100 million barrels bought at $130, and sold at $140.

Arbitrageurs will jump all over this and keep buying at spot and selling at futures until the futures and spot prices get close enough that the difference between them won't be big enough to pay the interest and storage costs. So, the futures price can never get too much higher than the spot price. And when the futures price is bid up – perhaps by speculators, this will pull up the spot price with it – but notice how; through arbitrage, through speculators buying on spot and holding in storage – hoarding! Just like Krugman said.

Speculation is only going to boost the spot price if there is some hoarding.

But an important issue, still, is how much hoarding is necessary. I discussed this in my June 17th post, and Columbia economist Guillermo Calvo eluded to it as well in a June 20^th post; the amount of hoarding necessary to push up the price a lot depends on how inelastic the supply and demand curves are in the short run, or very short run.

If you look at Krugman's graph in his May 13^th post , he has the supply and demand curves drawn pretty diagonally, indicating a lot of elasticity in both the supply and demand. The empirical reality in the very short run might, however, be that those lines are very inelastic, very close to straight vertical lines. In that case, when you boost the price, the gap between them that develops is very narrow, indicating that not that much has to be hoarded.

So, if supply and demand in the short run, or very short run, are inelastic enough, then perhaps a small enough amount would have to be hoarded that it could go undetected by the oil inventory records. Theoretically, this is possible, but I'm just not expert in oil inventory recording and the empirics of oil elasticity, so I can't really say how likely this is in the real world.

In any case, Krugman is right that speculators can only hurt us if they're hoarding. That's the only way they can affect the price, and this is true for anything. Speculators helped bubble up housing because they bought homes and held them for like a year or more. They held them, hoping the price would keep going up. They didn't sell them the next day, and when they did start selling them that really helped deflate the bubble. Speculators helped bubble up tech stocks in the late 90s because they bought them and held them for like a year or more, hoping the price would keep shooting up. If they sold them the next day, they would not have contributed to that bubble.

No time to blog, but hey, it's homeownership!

With regard to Mark Thoma's June 23rd post, "Paul Krugman: Home Not-So-Sweet Home", there's really a lot I'd like to say, but I'll have to restrain myself. The fact is, I got into blogging largely because I was hired to design and run a personal finance website for the University of Arizona and thought knowledge of blogging would help, especially for inexpensive promotion. It's been great, but alas, at this point in my academic and business careers, I can't justify spending much time at it.

That said, some quick but I think important things regarding this post:

First, I promote it a lot, but I think my brief working article, "Let's Cut the Ammunition to the Housing Arms Race Permanently", really explains well some of the best things we can do to help homeowners over the long run.

Second, one of the most important things in deciding whether the government should promote something is whether it produces net positive externalities (and how much). I think home ownership does have large net positive externalities, but only for people in certain situations, not for all people in all situations. So government promotion of homeownership could be efficiency and welfare enhancing – if well designed.

Third, a huge issue which could really change things in as little as the next 10 or 20 years is advances in video conferencing and other telecommunications. It's possible that in 10 or 20 years video conferencing could get so good that 25% to over 50% of skilled jobs could be done from anywhere. You could imagine say business managers or engineers communicating with each other via life-size ultra-high resolution monitors with an array of extremely accurate computer controlled mobile cameras and microphones. And you could imagine this and much more amazing telecom equipment being relatively inexpensive.

At that point, many or most skilled people could do their jobs from home anywhere, in Oak Park, Michigan, Podunk, Nebraska, anywhere. And if they didn't want to work at home, they could work in a Kinkos rent-an-office, or small satellite office, or complex, anywhere. When this happens it will really change society. It will make it so that homeownership makes sense for many more people, as you typically have to live in a home for at least 3-5 years without moving for it to make economic sense. Extended families will be able to stay together, rather than parents having to move far from their parents, siblings, and old friends for work. There will be a great savings in energy and decreases in pollution. The implications are huge. This is certainly something academics should be studying heavily for many reasons, one of which is, with the great net positive externalities, how, and how much, should the government be supporting this, the advancement of these telecom technologies.

Fourth, a really common misconception regarding homeownership, that I even heard once from a top finance professor, is that a benefit of homeownership is the leverage. But with a home, the leverage actually works against you both in risk and expected return. It hurts you. A typical mortgage rate is about 6%, the average return on a home, historically, as in Yale's Robert Shiller's, Irrational Exuberance, 2nd Edition, is only 0.4% above inflation, so the leverage not only increases the risk, it lowers the average return too! The expected home price appreciation is about 3.4%, but you're borrowing at 6%. Of course, this can be worth it because of the savings on rent, but you save on rent buying even the cheapest home. Every extra $100,000 you spend after that on a home costs 6% per year and brings in only 3.4% per year in average home price appreciation, and that's not even counting additional maintenance, utility, and insurance costs (taxes are usually about a wash, with the benefit of interest deduction balanced by the cost of property taxes). Still, it may be worth the expense if you enjoy the more expensive home enough, but as Harvard's Elizabeth Warren and I advise, never let your Must-Have (fixed) expenses get above 50% of your after tax income (with rare exception, like if you're a student, even renting a cheap room in a house may push your Must-Haves above 50%, but this is a temporary situation. For more information I strongly suggest Dr. Warren's book, "All Your Worth: The Ultimate Lifetime Money Plan").

OPEC Conversation with Steve Waldman, Part 2: Optimize Revenue, and Invest It Well

Steve's reply to my previous post is here. I answer back here:

I agree that if all they care about is maximizing their own wealth, then they will optimize current revenue as monopolists, which usually means withholding some supply.

But they would do it only to increase current revenues, not to save the oil for later because they think it's better to hold as an asset, for like 40 years, than stock or other conventional assets they could have purchased instead.

And, if they hold the oil in the ground as a form of saving it as an asset, the only possible time horizon for that would be like 40 years. What if they say, oh, I'll hold it in the ground as an investment for just 1 year, then sell it? What return would they get? In a year they should just still sell the optimal amount for a monopolist to maximize revenue, and in a year they would still have way more than enough from other oil in the ground to do that, or to sell any feasible quantity, so that unit that they held aside as an investment would just sit there.

It would do the same thing next year, and the year after, and the year after. It would only make a difference and actually be sold in about 40 years when they ran out of other oil in the ground. So it would just sit and make no money for 40 years, and then make it's selling price 40 years later.

For that selling price to make even a paltry 1% real return, the real price of oil would have to go from $130 today to $194. And the odds are great that in 40 years the price of oil will collapse due to the advance of substitute and efficiency technology. From what I've read, reliable sources, plug-in hybrids and pure electrics should become inexpensive and common in only like 20 years or less, pushing average global mileage per gallon into the hundreds, if not thousands. And for electricity there's nuclear, solar (see the Scientific American article mentioned in my previous post), coal (hopefully with carbon sequestering), etc.

Investing the $130 in keeping the barrel in the ground is a terrible idea. Yes, there is risk to stocks, but it's reasonable. The risk to keeping that barrel of oil in the ground as an investment for 40 years is much greater than the risk with stocks, and the expected return is much lower. Any conventional investment is much better than this. If I had to, I would estimate that the marginal revenue from an additional barrel of oil would have to be way below $130 for keeping it in the ground to be a good investment.

With regard to how good an investment a diversified stock portfolio is over the long run, I'd say it is the best for any single asset class, not just due to the historical performance and the arguments of Siegel (not all of which I agree with), but due to a tremendous amount of other evidence, theory, and other logic, which would take about 50 pages to really explain well even at a basic level.

I would add that If you follow a balanced money plan (see Harvard Professor Elizabeth Warrens book, "All Your Worth") or my INDV 102 course syllabus, it's not that hard to sock away a substantial amount in a well diversified stock portfolio each month. Following Dr. Warren's Plan means keeping your expenses, especially your fixed expenses, low enough that if the market swings up and down 5, 10, even 15+ percent, most people won't feel that stressed because they will know that their savings are still quite high relative to their expenses and income. And, the modern stock markets of the U.S. and Western Europe are quite different from the ones of 1950 and earlier. The odds of a communist takeover and expropriation, or anything like that, are virtually zero. The odds of something like the great depression happening are very tiny with the learning, track record, and resulting support of Keynesian-type policies.

Finally, with regard to heavy investing by OPEC pushing demand for stocks up and risk-adjusted returns down. First, note that the world stock market is vast even relative to OPEC money, but also, I have a working paper on the issue of whether a substantial increase in stock demand would push down risk-adjusted returns, or push them down much.

The main idea is that mostly due to the high prevalence of constant and increasing returns to scale in many productive processes and endeavors, the supply curve of investment opportunities may be very long and flat even for amounts of stock investment much higher than today's level. It might even curve up for a while due to increasing returns to scale.

Not the best investment strategy for the OPEC countries

In response to Steve Waldman's June 19th post, "Market power, asset allocation, and oil prices":

It is possible that OPEC countries are thinking that it's more valuable to leave some barrels of oil in the ground than to sell them for $130, and use the $130 to buy western stocks, but this appears to be a huge mistake.

First, there's a gigantic time value of money issue. I don't have time to research this, but I recall seeing estimates of how long the world oil supply will last of like 40 to 50+ years. Suppose it's 40 years, then if the Saudi's leave a barrel of oil in the ground today, instead of running out 40 years later, they will have that extra barrel in the ground and can sell it.

Let's compare the two alternatives:

A) Sell the barrel of oil now, and get $130. Then, invest that $130 for 40 years.

B) Sell it 40 years from now.

Which will make them wealthier? It depends on the rate of return, and on the price of oil in 40 years.

Without loss of generality, let's talk in terms of real dollars. Suppose they invest the money in a diversified U.S. stock portfolio (say the Wilshire 5000) and get the historic average real return of about 7%. After 40 years the $130 they got for the barrel of oil in 2008 would grow to $1,947. Do you think the real price of oil will be $1,947 in 2048, or anywhere near that.

From what I've read, it looks likely that inexpensive plug-in hybrids and pure electrics will be the norm long before then, and hooked up to electricity supplied almost exclusively from nuclear, solar, and other non-oil sources. Scientific American has a great article by a noted scientist on a solar grand plan that would "supply 69 percent of the U.S.’s electricity and 35 percent of its total energy by 2050" for "$420 billion in subsidies from 2011 to 2050". That's a fraction of the cost of the Bush tax cuts for the rich over that period, tax cuts that John McCain wants to make permanent – Yes, more and bigger yachts and mansions would be better for the economy and the globe than a vast solar network. – I'm not saying you're for that Steve; that's just a general comment about disastrous Republican policies.

Suppose the stock market did worse than its historic average. First, note that according to Wharton Financial Economist Jeremy Siegel's data set, between 1802 and 2006, stocks have never had a non-positive 20 year return period (Stocks for the Long Run, 4th edition, page 24). But suppose that the real return over the next 40 years was just 3%; still, by 2048, that $130 from selling a barrel in 2008 would grow to $424.

And stocks are a great inflation hedge because they are claims on real assets. Moreover, over a period of 40 years, I would certainly expect purchasing power parity to approximately hold, at least for tradable goods.

So, if OPEC governments are savvy, it certainly doesn’t look like they would want to pump less than the amount that maximizes revenue in the short term. Doing otherwise seems not qualitatively better than investing long term in gold instead of stocks. By the way, adjusting for inflation, a dollar invested in gold in 1802 grew to $1.95 in 2006. That same dollar invested in stocks grew to $755,163.00! (page 11 of Siegel's book)