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Archive for December, 2010

In a series of posts (most recent here), I’ve noted that oil and natural gas prices have become unhinged from each other. Oil (denominated in $ per barrel) used to trade at 6 to 12 times the price of natural gas (denominated in $ per MMBtu). But lately that ratio has been north of 20, thanks to a surfeit of new gas in the United States (and elsewhere) and, recently, growing global demand for oil.

The wide spread between oil and natural gas prices provides a tempting incentive for any innovators who can figure out how to use natural gas, rather than oil, to make transportation fuels.

Over at the New York Times, Matthew Wald identifies one possibility, using natural gas to produce diesel:

Diesel and jet fuel are usually made from crude oil. But with oil prices rising even as a glut of natural gas keeps prices for that fuel extraordinarily cheap, a bit of expensive alchemy is suddenly starting to look financially appealing: turning natural gas into liquid fuels.

A South African firm, Sasol, announced Monday that it would spend just over 1 billion Canadian dollars to buy a half-interest in a Canadian shale gas field, so it can explore turning natural gas into diesel and other liquids. Sasol’s proprietary conversion technology was developed decades ago to help the apartheid government of South Africa survive an international oil embargo, and it is a refinement of the ones used by the Germans to make fuel for the Wehrmacht during World War II.

The technology takes “a lot of money and a lot of effort,” said Michael E. Webber, associate director of the Center for International Energy Environmental Policy at the University of Texas, Austin. “You wouldn’t do this if you could find easy oil,” he said.

But with the huge spread between oil and gas prices, and predictions of oil topping $100 a barrel next year, the conversion technology could be a “a money-maker for whoever is a first mover in that space.”

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Yesterday, the Congressional Budget Office released its long-awaited report on the future of Fannie Mae and Freddie Mac. Fannie Mae, Freddie Mac, and the Federal Role in the Secondary Mortgage Market (written by Deborah Lucas and David Torregrosa, with input from a cast of dozens — including, full disclosure, me as an outside reviewer) provides an outstanding overview of Fannie and Freddie’s history, the arguments for and against a government role in the secondary mortgage market, the flaws of the precrisis structure of Fannie and Freddie, and the pros and cons of possible reform models.

Readers may recall that last spring Phill Swagel and I proposed a reform in which Fannie and Freddie would be privatized, the government would sell guarantees on mortgage-backed securities composed of conforming loans, and that this guarantee would be available not only to Fannie and Freddie but also to qualified new entrants. (Here’s the blog version; here’s the full paper.)

CBO provides a thoughtful overview of such hybrid models:

A Hybrid Public/Private Model

Many proposals for the secondary mortgage market involve a hybrid approach with a combination of private for-profit or nonprofit entities and federal guarantees on qualifying MBSs. At its core, the hybrid public/private approach would preserve many features of the way in which Fannie Mae and Freddie Mac have operated, with federal guarantees (combined with private capital and private mortgage insurance) protecting investors against credit risk on qualifying mortgages. However, most hybrid proposals would differ from the precrisis operations of Fannie Mae and Freddie Mac in several important ways: A possibly different set of private intermediaries would participate in securitizing mortgages backed by federal credit guarantees, the guarantees would be explicit rather than implicit, and their subsidy cost would be recorded in the federal budget.14 As the public-utility and competitive market-maker models illustrate, a hybrid approach could be implemented in a way that involved more or less federal regulation of participants in the secondary market and a smaller or larger number of competitors in that market.

Advantages of a Hybrid Approach

Regardless of its exact design, a hybrid model with explicit federal backing for qualifying privately issued MBSs would have several advantages over the precrisis model, as well as over either a fully federal agency or complete privatization (approaches that are discussed below). An explicit federal guarantee would help maintain liquidity in the secondary mortgage market, in normal times and particularly in times of stress, and could retain the standardization of products offered to investors that Fannie Mae and Freddie Mac bring to that market. Compared with the precrisis model, imposing guarantee fees would ensure that taxpayers received some compensation for the risks they were assuming.

Compared with a fully federal agency, a hybrid approach would lessen the problem of putting a large portion of the capital market under government control, encourage the inflow of private capital to the secondary market, and limit the costs and risks to taxpayers by having private capital absorb some or most losses. Putting private capital at risk would also provide incentives for prudent management and pricing of risk.

Compared with a fully private market, hybrid proposals would give the government more ongoing influence over the secondary market and an explicit liability in the case of large mortgage losses that would be reflected in the budget. That arrangement might have the advantage of leading to a more orderly handling of crisis situations.

Disadvantages of a Hybrid Approach

Relative to other approaches, a public/private model has a number of potential drawbacks, the importance of which differs depending in part on the specific design chosen. Experience with other federal insurance and credit programs suggests that the government would have trouble setting risk-sensitive prices for guarantees and probably would shift some risks to taxpayers. A hybrid approach also might not eliminate the tensions that exist—with regard to risk management and pursuit of affordable housing goals—between serving private shareholders and carrying out public missions.

Another concern is that over time, the secondary-market entities might push for broader guarantees of their product lines and attempt to reestablish themselves as too-big-to-fail institutions backed by implicit federal guarantees. Consequently, regulators would need to be vigilant to control risks to the financial system and avoid regulatory capture, while also being open to market innovations.

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The Economics of Al-Qaeda in Iraq

Follow the money. From Al Capone to Watergate and beyond, that’s been sound advice for anyone trying to understand the workings of shady organizations. In the latest installment, a group of researchers at the RAND National Defense Research Institute have analyzed accounting ledgers that document the activities of Al-Qaeda in Iraq (AQI) in Anbar province during 2005 and 2006.

In their new report, “An Economic Analysis of the Financial Records of al-Qa’ida in Iraq,” the researchers (Benjamin Bahney, Howard J. Shatz, Carroll Ganier, Renny McPherson, Barbara Sude with Sara Beth Elson, Ghassan Schbley) trace how AQI organized its activities, raised and spent its money, and compensated its members.

For example, they find that during this period, most of AQI’s resources in Anbar came from stolen goods, spoils, and car sales:

From June 2005 to May 2006, AQI’s Anbar administration raised nearly $4.5 million or roughly $373,000 per month (Figure 3.2). AQI in Anbar was financially self-sufficient. This is consistent with the concept of al-Qa‘ida’s franchising strategy as described by [Steve] Kiser (2005), who argued that al-Qa‘ida central provides seed capital to its franchises but pushes them to quickly become financially self-sufficient.

The group obtained more than 50 percent of its revenue from selling what appear to be stolen goods, most of which were highly valuable capital items, such as construction equipment, generators, and electrical cables. In contrast to what has been suggested in much news reporting, the data do not support the claim that the group was largely financed by selling stolen oil, as the revenue garnered from oil appears to be fairly negligible in the context of total group revenues at this level of administration (note that oil revenues are not shown separately in Figure 3.2 but are instead a small portion of the stolen goods entry in the figure). However, it is also entirely possible that oil revenues were garnered by one of the many Anbari AQI sectors that we do not have data on, as well as by the national AQI administration, which had a number of purported ministries and claimed to have a specific “oil minister.”

Another interesting finding: Al-Qaeda’s foot soldiers aren’t in it for the money:

Individual members of AQI made less money than ordinary Anbaris—AQI average annual household compensation was $1,331 compared to $6,177 for average Anbar households—but faced a nearly 50-fold increase in the yearly risk of violent death. AQI compensation included monthly payments for members and their dependents, as well as monthly payments to the families of imprisoned and deceased members. These latter payments constituted a form of insurance unavailable to civilian Anbar households, but still resulted in lower risk-adjusted expected lifetime earnings.

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Cotton prices hit another record earlier today. As noted by the San Francisco Chronicle:

Cotton futures in New York jumped to a record, gaining by the daily limit for a third day, on signs that growers may struggle to meet mounting demand from China, the world’s biggest consumer.

Cotton for March delivery gained 2.7 percent to $1.5412 a pound on ICE Futures U.S. in New York at 4:15 p.m. Tokyo time. Prices have more than doubled this year, heading for the biggest annual gain since 1973.

Output in China’s Shandong province, the nation’s second-biggest producer, dropped 22 percent this year from 2009 after natural disasters hurt crops, the region’s Agriculture Information Center said in a report Dec. 17. Demand in China is forecast to exceed supply by 17 million bales in the year ending July 31, according to the U.S. Department of Agriculture.

What’s behind this move? Well, judging by everything I’ve read so far, it sounds like good old-fashioned demand (up) and supply (down).

But just to be sure, I decided to check in with two famous economic commentators. I tracked down the talking “bunnies” over on YouTube (ht SK) and, sure enough, they agree that supply and demand fundamentals are what’s driving the cotton market.*

Unfortunately, the critters have a much more serious tone than in their famous explanation of QE2 (except for some gratuitous language at the very end, which tries to pay homage to their earlier work). But they do speak with authority

Update: Unfortunately, the critters have gotten shy. No public video now (12/22).

* OK, these guys don’t really look like bunnies. More like stuffed animals — perhaps dogs or bears. Which, come to think of it, would make them even more expert on cotton markets.

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Google unveiled a new toy yesterday. The Books Ngram Viewer lets users see how often words and phrases were used in books from 1500 to 2008. Other bloggers have already run some fun economics comparisons. Barry Ritholz, for example, has does inflation vs. deflation, Main Street vs. Wall Street, and Gold vs. Oil.

In the humorous glitch department, I tried out the names of two Internet services I use everyday, Google and Wikipedia. For some reason, the Ngram viewer defaults to the timeperiod 1800 to 2000 (rather than 2008), and this was the chart I got (click to see a larger version):

It’s amazing to see references to Wikipedia as far back as the 1820s. Impressive foresight. Google overtook Wikipedia in the late 1800s and, with the exception of a brief period in the 1970s, has led ever since.

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Johnny Depp and the New Tax Law

When the President signs the big tax deal later today, will he be cutting income taxes for most families or sparing them a tax hike? Will he be slashing the estate tax or resurrecting it?

Those questions have a clear answer in the official budget world: the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 cuts both income taxes and estate taxes. Period. Why? Because current law is the official yardstick. And that law says that the 2001 and 2003 income and estate tax cuts will expire when the ball hits bottom in Times Square.

But existing law is not the only reasonable benchmark. Another way to look at things is to ask how taxes will change from 2010 to 2011. Viewed that way, extending the 2001 and 2003 cuts is not a tax cut; it’s a way to prevent a tax hike. And the estate tax deal is actually a tax increase: there was no estate tax in 2010, but there will be one—though small by historical standards—in 2011. In addition, as noted by my Tax Policy Center colleague  Bob Williams, many low-income families will see their taxes go up because the gains from 2011’s payroll tax holiday will be more than offset by the expiration of 2010’s Making Work Pay tax credit.

Depending on your perspective, then, today’s tax deal is anything from a tax increase to a major tax cut. It all depends what baseline you use for measuring.

Which brings us to Johnny Depp. Depp plays the title character in the new film “The Tourist”. He doesn’t know anything about budget baselines, but he does learn how perceptions depend on what your benchmark is:

Inspector: Now, you wish to report a murder?
Depp: No, some people tried to kill me.
Inspector: I was told you were reporting a murder.
Depp: Attempted murder.
Inspector: Ah, that is not so serious.
Depp: No, not when you downgrade it from murder. When you upgrade it from room service, it’s quite serious.

Should today’s tax deal be compared to room service or to murder? I leave it up to you, dear reader, to decide.

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Steve Martin–yes, the wild and crazy guy–has a new novel. “An Object of Beauty” tells the story of Lacey Yeager, an up-and-comer in New York’s art world in the mid-1990s. I’m 19% of the way through the novel (up to location 779 in Kindle-speak), during which Lacey has been climbing the ladder at Sotheby’s, the famous auction house.

Thus far, my favorite passage depicts how sensitive wealthy art collectors can be to taxes. Sotheby’s has sent Lacey to Washington to deliver a painting to the winning bidder in a recent auction. After getting off her train, Lacey heads over to Georgetown:

The white door of the brownstone swung open with a faint jingle-bell tinkle, and Saul Nathanson waved with full panic shouting, “Don’t come up the steps!”

So many interpretations. Was he shouting at Lacey, the painting, or the taxi driver? “Don’t step on the walkway!” Was the concrete wet? But Saul ran toward them more sheepish than commanding, and they all stayed put.

“I thought by having you bring the picture,” Paul said, panting, “that we were taking delivery of the picture in Washington. But it seems to be disputable that this might constitute taking delivery in New York.”

Lacey looked at Saul, then at the taxi driver. He pulled his cap back and scratched his head. “Oh yeah, sales tax,” he said.

“What?” said Lacey.

“My wife sells jewelry. There’s always a sales tax issue.”

Saul pointed at the driver with a silent “bingo.” “We’ve got to have it shipped to us from New York by a reputable carrier.”

Lacey muttered, “I’m reputable.”

“But unlicensed. We’ve got a questionable situation here. You’ve got to take it back. It’s a difference of almost ten thousand dollars,” said Saul.

The statement hung in the air, until the taxi driver said, “You mean that box is worth a hundred and fifty thousand dollars?”

Lacey turned to him. “Who are you, Rain Man?”

Saul was balanced on his toes. “I’m so sorry, Lacey, we tried to turn you around, but we just learned it an hour ago. Here’s something for you”–he handed her a folded hundred-dollar bill–“and don’t let the painting touch the walkway.”

“I’ll be a witness,” said the grinning taxi driver, implying there could be another tip due.

“I can’t even invite you in,” said Saul. Then he turned to the half-opened door. “Estelle! Wave hello to Lacey!”

Estelle poked her head out of an upstairs window. “Hello, Lacey. Saul’s insane!”

Or maybe he’s highly rational?

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Over at Forbes.com, Art Carden has a brilliant retelling of Dr. Seuss’s “How the Grinch Stole Christmas” (ht: Greg Mankiw). Carden recasts the story as a parable about externalities and property rights.

He starts with the Grinch’s view that Who singing is a nuisance:

He hated the shrieks of the Who girls and boys
For fifty-three years he’d put up with it now—
He had to stop Christmas from coming, somehow.
He asked and he questioned the whole thing’s legality
Then his eyes brightened: he screamed “externality!
He reached for his textbooks; he knew what to do
He’d fight them with ideas from A.C. Pigou.

As regular readers know, Pigou argued that externalities — pollution, singing Whos, etc. — could be addressed by levying taxes that reflect the harm imposed. So maybe, the Grinch might reason, he should help himself to some Who presents and roastbeast whenever they sing.

But wait, as Ronald Coase noted years ago, it takes two to tango … and to create an externality. So the Whos have a rebuttal:

“We know that we’re noisy all through Christmas Day,
But if you don’t like it, it’s you who should pay!
“For we were here first, and homesteaded the rights
To sing, to make noise, and to hang Christmas lights
“The costs of our Christmas joy helped you to save!
They were fully reflected in the price of your cave!”

I am so using this in my class in the spring.

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Courtesy of the BBC. here’s the newest version of Hans Rosling’s famous presentation on economic growth and life expectancy. Keep an eye out for the moments in history when life expectancy plummets.

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Two commenters (Jack B. and John L.) raise an important point about the $25 billion price tag that the Congressional Budget Office recently placed on the Troubled Asset Relief Program. Their concern is that the $25 billion figure includes some impacts that should rightfully be attributed to other government actions, not to TARP itself.

To illustrate, suppose that Treasury used TARP to buy $10 of preferred stock in Bank X in 2008 and that a year later Treasury sold its position for $12, including accrued dividends. This investment would be recorded as achieving a $2 profit in TARP (subject to one technical caveat, see below).

That’s the normal way of calculating profit on an investment, and is what CBO was instructed to do for its part of TARP oversight. But as Jack and John point out, there’s an important complication here. During the year, the federal government undertook many other policy actions which may have boosted the value of Bank X (remember all the new acronyms?). From the perspective of policy evaluation, some or all of the $2 gain should be attributed to those other policies, not TARP.

It could be, for example, that absent further action, Bank X would have struggled, leaving Treasury with stock worth only $6. Other government actions, however, breathed enough life into the company (or, at least, boosted the value of its assets) that the stock ultimately became worth $12.

In that case, you could argue that TARP, by itself, resulted in a $4 loss, while the other government actions created a $6 gain. That puts the budgetary impacts of TARP in a different light: a 40% loss versus a 20% gain in this example.

Of course, you could also argue that the $6 gain was only possible because of the TARP ownership stake. There’s certainly an element of truth to that. But the basic concern still applies: the $2 gain in this example reflects both TARP and subsequent government actions, not just TARP alone. That’s an essential point when trying to evaluate these policies after the fact, and we commenters should keep that in mind when interpreting CBO’s findings.

And that’s not all. The other government actions may also have imposed additional direct or indirect costs on the federal budget. As a result, the $2 gain in this example may be offset (or more) by other costs that aren’t included in the calculation.

Bottom line: One reason that TARP appears much less expensive than originally predicted is that many of its investments benefitted from other government actions whose costs show up elsewhere in the budget.

Caveat: CBO’s methodology actually judges the profitability of investments relative to benchmark rates of return. The details are surprisingly complex, but just for purposes of illustration, suppose that the appropriate benchmark rate of return for investing in Bank X was 10%. If Treasury sold the stock for $11 after one year, CBO would deem that as breaking even. If it sold it for $12, that would be a $1 profit.

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