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The Economics of Energy
!"#$%&'(&')$*+,,#-# ./+0+12/3$4#(2#5 would like to thank
!"#$%&'(&')$ 6#7&'81#08$+9$./+0+12/3 for their generous support of this issue.
H C E R VOL. 3 ISSUE 2 On the Cover:
Is a Path to Better Infant Health Through Mothers’ Labor Supply?
)#"*+,(%#2():9#96;:4
5
Michael Baker
The HCER brings together academics and practitioners to analyze the changing nature of energy economics and its implications for energy costs, economic growth, and the energy industry.
The Economics of Renewable Energy Richard Green
Solar Power Paul Komor
Radical Religions: New kids On the Block or Have They Been around the Block? 16 20 22
Is a Cap-and-Trade System a Disguised Tax? Charles D. Kolstad
The Sustainable Supply Chain
24
27
Rebeca Jiménez-Rodríguez and Marcelo Sánchez
Energy and the Environment: Identifying Our goals George S. Tolley
Felix Zhang
Africa in the Global Tourism Economy
9
Peter U. C. Dieke
A Different Source of Renewable Energy: Collaboration
33
James E. Austin
Narendra Mulani and Seb Hoyle
The Importance of Oil Price Shocks For the Economy
7
30
Interview with Richard Fisher
36
Expanding Neuroeconomics
39
Howard C. Nusbaum and John T. Cacioppo
Keyne's Stimulus, Polanyi's Moment
45
William Milberg
Keynes’s Stimulus, Polanyi’s Moment William Milberg
Cover photography by LeeAnn Suen
45
L F E Dear Reader, EDITORIAL BOARD
Editors-in-Chief Anna Rosenblatt Raviv Murciano-Goroff Business Directors Yuriy Shteinbuk Gina He Content and Editing Directors Natalie Bau Pamela Ban Publication and Layout Directors Alee Lockman Samuel Chang
CONTENT
Ilyes Kamoun !"Senior Associate Aleksandra Karabasevic !"Senior Associate Marianna Tishchenko !"Senior Associate Jacek Rycko !"Senior Associate Felix Zhang !"Senior Associate Xiaoqi Zhu !"Senior Associate Kevin Lee Suhas Rao Jennifer Xia
BUSINESS
Athena Jiang!Manager Michael J. Ding!Manager Marianna Tishchenko!Senior Associate
In this issue, we hope to respond to the growing public focus on renewable energy and “green” economics. A variety of articles delve into the issues underlying energy usage, the limitations of government regulation, and the challenges of incorporating energy considerations into economic decisions. Richard Green discusses the economics of renewable energy, from its costs and benefits to the effects of externalities and government intervention. Paul Komor evaluates the economic efficiency of solar power and questions the politics behind its regulation. The cap-and-trade system for carbon emissions is examined by Charles Kolstad, while Narendra Mulani and Seb Hoyle make the case for the integration of sustainability measures into supply chain operations. Rebeca Jiménez-Rodríguez and Marcelo Sánchez assess the macroeconomic impacts of oil price shocks. Lastly, George Tolley draws attention to the non-market costs and benefits of energy and environmental policies. Also in this issue, an interview with Richard Fisher examines the Federal Reserve’s response to the current financial crisis. Finally, James Austin advocates collaboration as part of the solution to socio-economic problems. We hope that this edition of The Harvard College Economics Review provides insight into a variety of issues—from the corporate, to the social, to the environmental—and offers a unique perspective on the challenges facing our economy today. Best regards,
IT DIRECTOR AND WEBMASTER Michael Ding
E-mail: hcer@hcs.harvard.edu Website: www.harvardeconreview.com COPYRIGHT 2009 HARVARD COLLEGE ECONOMICS REVIEW. ISSN: 1946-2042. All rights reserved. No part of this magazine may be reproduced or transmitted in any form without written permission of the Harvard College Economics Review. Opinions published in this periodical are those of contributors and do not necessarily reflect those of the editors.
Anna Rosenblatt
Raviv Murciano-Goroff
B?/A<)D(><F)!
<(=%5.(59(>"55"*(?#@%#5(A"%'5.( -.*98+.(B95."*4C(D%&9*(3800',E Maternal care may promote children's well-being
M
ost children spend a lot of time with their mothers in the first months of life. As more mothers with small children work during this period, maternal care has necessarily decreased. The importance of the motherchild relationship at this age leads us to wonder whether these changes in mothers’ labor supply have had an impact on infant health. Most developed countries have laws— maternity leave mandates—that accommodate the changing labor supply of mothers. These laws allow women to take time away from work following childbirth. When they come back to work, they have the right to return to their old (or similar) jobs, and while on leave they often receive monetary benefits that replace part of their lost earnings. Some of the most generous leave policies are in Europe. In the United States, the law that provides maternity leaves for women is the Family and Medical Leave Act (FMLA). The FMLA is
different from the laws in other countries in a number of important ways. First, only females who work at establishments with 50 or more employees are covered by the FMLA. It has been estimated that this restriction leaves up to 50% of private sector employees without a legal right to time off from work after birth. Second, the leave provided by FMLA is unpaid, although in some states income replacement may be available through temporary disability insurance. Third, the FMLA provides up to twelve weeks of leave on a yearly basis, which is quite short compared to the leave periods guaranteed in other countries. One argument for mandating maternity leaves is that they promote the health of mothers and children. Without a law mandating maternity leave, employers and employees may come to private agreements about time away from work around birth. Some employees will not be offered any leave. Other workers will be offered time off by employers as an in-
centive for mothers to return to work after giving birth. If this is the status quo, then a mandate could improve children’s health if, 1) there are significant benefits when mothers stay at home longer after birth than most workers currently do, and 2) mandates prove to be an effective way of increasing the amount of time mothers are at home after giving birth. Therefore, the most consistent narrative claims that laws mandating maternity leave affect children’s and mothers’ health by changing mothers’ labor supply. Perhaps because the FMLA is relatively recent, there is not much research on the effects of maternity leave mandates. Also, like many other areas of social science, it is difficult to get solid answers to important questions. The reason reflects the fact that we do not get many opportunities to observe mothers randomly assigned to different leave packages or laws, as we might if we were able to construct our analysis as they do in drug trials. Instead, we usually
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SPRING 2009
observe the choices women make to work at different firms that offer different maternity leave benefits. Suppose that you wanted to spend a long period at home with your child after birth. Presumably, you would seek out an employer who offered a generous leave benefit. But it is difficult to extrapolate from your behavior how an individual who is less enthusiastic about taking a long maternity leave would behave if provided with a similarly generous leave package. One way maternity leave mandates might affect children’s health is by changing breastfeeding behavior. Public health and medical associations unanimously recommend that babies be breastfed. The American Academy of Pediatrics recommends exclusive breastfeeding until six months and then breast milk with other foods until at least twelve months. The reason for this unanimity is that many benefits are attributed to breastfeeding, ranging from lower rates of allergies and respiratory ailments to higher IQ scores. It is puzzling therefore that breastfeeding behavior falls well short of these public health goals. Of children born in 2004, only 42% were being breastfed at six months and only 21% were at twelve months (statistics are from the National Immunization Survey). After the first couple of months of breastfeeding, the primary reason that surveyed mothers stopped breastfeeding was their return to work. Therefore, if maternity leave mandates can change the amount of time mothers stay home after birth, it makes sense that they could also affect the amount of time children are breastfed. In a recent study with Kevin Milligan of the University of British Columbia I tried to discover how maternity leave mandates affect breastfeeding behavior. Our study looked at the effects of a recent change in Canada’s maternity leave law. At the end of 2000, mandated leave was increased from six months to one year in Canada. While our study did not involve random assignment, it may have some of the positive characteristics of a random design if we can think of births as being randomly distributed before and after the change in the law. We find that this change in the mandate did affect how long mothers stayed home after birth. For mothers covered by the laws, we estimate that the average amount of time they were at home in their child’s first year of life went up by 50%— from just over six months to nine months.
Does this mean that these children were breastfed three months longer? No. As in the United States, mothers in Canada breastfeed their children for a shorter period than public health associations recommend. As a result of the change in the laws, these mothers increased the period they breastfed their children by just over one month. The period of exclusive breastfeeding increased by roughly onehalf month. More impressive is that the proportion of mothers exclusively breastfeeding at least six months increased by at least 39%. What effect did this increase in breastfeeding have on children? The research on the effects of breastfeeding is very interesting. Almost all of it compares the children of mothers who choose to breastfeed for a long time to the children of mothers who choose to breastfeed for a shorter period. As mentioned above, research design based on the choices people make has significant problems. Kramer et al.’s 2001 study of breastfeeding in Belarus, however, does use a randomized design. A World Health Organization training program was randomly assigned across hospitals and clinics in Belarus. Health care workers were trained to provide breastfeeding support to mothers. The result was a significant increase in the duration of breastfeeding in those sites that received the training. The results of this study appear to pare down the list of benefits of breastfeeding. For example, the researchers found that increased breastfeeding duration reduced gastro-intestinal ailments and eczema, but not respiratory ailments or obesity. The most recent follow-up study found higher IQ scores among those children who were breastfed longer. This study has its limitations. For example, while the random assignment of the training affected breastfeeding duration, it had no effect on the proportion of mothers who started breastfeeding— and some benefits of breastfeeding may be linked simply to whether or not a child is breastfed, rather than how long he is breastfed. Nevertheless, this study marks a substantial step forward in breastfeeding research. In our study of Canada, we were able to look at a limited number of children’s
health outcomes, mostly related to respiratory problems. Like the study of Belarus, the change in the Canadian law affected the length of breastfeeding, not the start-up. We find very little impact of the increase in breastfeeding duration on our measures of children’s health. Another dimension of children’s health that may be affected by maternity leave mandates is children’s cognitive and behavioral development. Research on mothers’ employment after birth suggests that if a mother works (especially full time) in the first year of her child’s life, her child will have lower cognitive development by age three. Because the change in Canada’s maternity leave mandate changed mothers’ employment exactly at this age, we have also studied the developmental effects of the legal change. Interestingly, we found that following changes in the law, maternal care increased and the use of unlicensed childcare decreased. Therefore, children were more likely to be with their mothers and less likely to be with someone who was not a relative and who was not accredited to look after children. We studied a variety of measures of children’s behavior: their social and motor development, the type of parenting they received, and the activities they shared with their parents. In almost every dimension we could find no evidence that the increase in maternal care led to better outcomes. Neither of our studies finds direct evidence that an increase in maternal care in the first year of life affects children’s health. It is important to put these conclusions into context. First, we looked at a limited number of dimensions of children’s health. One of the best known studies of maternity leave, Ruhm’s 2000 study of leave mandates in Europe, finds that laws that provide longer leaves are related to reductions in infant mortality. Infant mortality, as well as a host of other child outcomes, was not available in the data we studied. Second, as noted earlier, there is limited research on the impacts of maternity leave. As more states pass laws like California’s paid family leave program, there will be new opportunities to explore the impacts of mothers’ labor market decisions after giving birth on the well-being of their children. H
Michael Baker is the RBC Chair in Public and Economic Policy at the University of Toronto Department of Economics.
K)D?L(MA<7N
!%2;:%'(!"';+;9#4G 7"$(F;24(H#(5."(>'9:I(9*(A%J"(-.",( >""#(<*98#2(5."(>'9:IE A conversation with Dr. Eli Berman
I
n an innocuous-looking building tucked away in Harvard Square lies the National Bureau of Economic Research (NBER). Presided over by MIT Economics Professor James Poterba, the NBER provides nonpartisan research to promote a greater general understanding of how the economy works. In addition to providing reports to policymakers, including the President, the NBER brings together the finest minds in economics to apply the theories of classical economists such as Smith and Keynes to questions of the modern world. Last month, the NBER hosted such a conference, bringing together sixteen economists— representing organizations ranging from the US Military to other universities—to discuss the latest research in the national security applications of economics. Presentation topics included economic conditions and their effects on the quantity of suicide terrorist attacks, monetary consequences of the Iraq war, and the impact of labor spending on the number of
insurgents. One of the highlight lectures of the summit was given by Dr. Eli Berman, a professor at University of California San Diego and a research fellow at the NBER. Dr. Berman is a renowned economist who has challenged the assumption that those who are part of radical religious groups are fundamentally irrational. Dr. Berman instead maintains that these people may be motivated by economics just as much as they are by theology. Dr. Berman’s lecture began with a brief description of “The Minerva Project,” a government project focused on funding the research of economists like him and the others gathered in the room. The government is naturally deeply interested in the results of their research, as it could having lasting implications for understanding religious groups such as Al Qaeda. Dr. Berman’s lecture at the National Security summit was entitled “Sects and Violence for Economists or What would Adam (Smith) Do?” The lecture opened with a quotation
by the venerable Adam Smith: “Times of violent religious controversy have generally been times of equally violent political turmoil.” Yet Smith’s comment does not describe radical Islam, but rather refers to the Mennonites of the sixteenth and seventeenth centuries. Indeed, much of Dr. Berman’s lecture centered on the similarities between the development of radical Islam and the radical past development of Christianity and Judaism. In the sixteenth century, during the great Protestant Revolution of Martin Luther, religious zealots took cities by force, creating theocracies and waging religious wars. Many such conflicts, maintains Dr. Berman, were caused not by differences in theology but rather by disputes for control. “Radical” religions, like the Protestants in the sixteenth century or later the Anabaptists, were repressed by the ruling religions of the time and thus became community orientated, instead of depending on feudal lords, churches or governments. In a sense,
8
SPRING 2009
these religious communities became dependent solely on local public goods. Modern radical Islam was produced by the very same situation that spawned many of the minority Christian religions that later went on to become today’s “mainstream” religions, and has followed the same path as radical Jewish and Christian sects. The fraying of control and government in the Islamic lands as colonial powers withdrew led to the creation of many sects. People turned to religion during these times of political chaos because religion offered the unique ability to deal in “credence goods,” offering supernatural promises and allegiance to a higher power rather than to normal leaders. Religious groups were often much more effective than the government at providing basic services as well, which subsequently spawned communities of followers. However, with today’s urbanization, the model religious community is threatened, which in turn threatens its leaders. Leaders, in turn, demand more of an “upfront sacrifice” to galvanize their followers. This, of course, leads to a stricter sect. This “upfront sacrifice” can be seen in the divide in each religion when its more
orthodox form separates from its less strict counterpart. In more strict Islamic nations, for example, women must wear Hijabs, while many Muslims do not adhere to such a dress code. Orthodox Judaism also imposes certain dress and living restrictions that less strict followers do not abide by. This rise in radical sects is not new, but rather a repetition of a historical theme resembling the radicalization of Christian sects following the loss of power of the Catholic Church. Because of the power vacuum, religious leaders began to compete intensely with each other: leaders had a “race to the bottom,” in this case, each undercutting the others with tighter restrictions and creating more and more of a radical group in order to solidify their power. At the time, David Hume proposed “brib[ing]t the indolence of the clergy.” Hume concluded that by giving the religious leaders safe jobs, they would stop competing. Adam Smith, however, champion of laissez-faire economics, said that free entry would cause a “race to the top” in terms of
tolerance. Smith said that states should not commit to having any state religion, thus forcing competition upon the different religious groups and in turn forcing them to tolerate each other. What does this mean for our world today? Is the "Global War on Terror" really a war between Islam and the West, or is it one between minority Islamists and their own governments and religions? Christian minority sects fought bloody wars, suffered and retaliated with oppression. Some sects fled, finding new homes in the newly discovered America, while others perished. Are Bin Laden and Al Qaeda simply following a historical trend, or have they transcended religious radicalism and moved onto an entirely different sort of war? Dr. Berman would conclude that the United States government and the public should come to their decisions on this question with the understanding that radical religions are nothing new, nor will the suicide bombers in Israel and those responsible for 9/11 be the last. H
Felix Zhang is a sophomore Economics concentrator at Harvard College.
!"#$%&'(&')$*+,,#-#$./+0+12/3$4#(2#5 would like to thank
!"#$:03828;8#$+9$<+,282/3 for its generous support of this issue.
HARVARD COLLEGE ECONOMICS REVIEW
=)-)!(OP(/P(Q?)F)
<@*;:%(;#(5."(N'9&%'(-98*;46():9#96, Trend patterns, issues, and future perspectives
T
his article examines the development prospects for Africa in the globalized tourism economy. The article pays particular attention to international tourism trend patterns as the basis for analysis, since such trends are a necessary and influencing parameter to analyze regional prospects. In considering this subject, the article focuses on four parts: first, it discusses the growing significance of tourism in the global economy and the implications of using tourism as an economic and social development force. With reference to the overall pattern and performances, the second part identifies and discusses certain conditions that influence these trends and have specific impacts on Africa. The third section looks to the future and considers the major challenges that might stimulate and inhibit the development of the tourism sector in the region in the 21st century. Finally, the article discusses the wider relevance of the analysis. In this article, “Africa” refers to those countries south of the Sahara (or subSaharan Africa). These countries have a wide range of levels of development and share, if anything, certain common structural characteristics. Many of the structural deficiencies, including an international debt burden, changing geo-political landscapes, acute problems of unemployment, inflationary pressures, and so on, pose considerable challenges to their development efforts. Continuation of these problems and difficulties may possibly increase the continent’s marginalization in the global system with wider implications for the development process and test regional cohesion. Also, “development” is defined as an improvement of both economic opportunity and quality of social life and conditions in a country, region or society through the encouragement of tourism-based initiatives, to overcome those “areas of concern.” “Region” follows the United Nations World Tourism Organization’s definition of five regional classifications of countries, which encompasses: Africa, the Americas, Asia and the Pacific, Europe, and the Middle
East, for the purpose of tourism statistics. As used here, “issues” describe the challenges and opportunities associated with the process of developing tourism: the reasons they arise, the responses to them, and the outcome of the measures. The Importance of International Tourism in Development Many countries, both developed and developing, have recognized the advantages that tourism can contribute to their development efforts (Jenkins, 2007). These advantages can be encapsulated in six areas: earning of foreign exchange, contribution to government revenues, creation of employment opportunities, generation of income, stimulus to inward investment, and regional development. In this article there is no space to explore these impacts in detail. However, it is worth noting that, in most less-developed countries and Africa, invariably emphasis is given to the economic advantages of tourism. As Robert Erbes once noted: “Everything seems to suggest that developing countries look upon tourism consumption as manna from heaven that can provide a solution to all their foreign settlement difficulties” (1973: 1). It is argued that these economic benefits from tourism, as seen,
will accrue to regions with otherwise limited economic potential. In such societies, tourism is perceived as a panacea for their fragile economies that are characterized by a scarcity of development resources such as finance and expertise. These resources are needed to increase the economic surplus, without which these societies would be forced to rely solely on international aid to support their development efforts. This axiomatic view of tourism has, for a long time, gained some support in part because tourism is a highly visible activity. It is unfortunate if this notion of tourism as “manna from heaven” is accepted without questioning. Thus, critics might conversely argue that this notion of tourism is rather absurd, if not overly simplistic, given the wellrecognized weaknesses of tourism as a viable development option in less developed countries (Rogerson, 2007). On the whole, tourism has not delivered its expected benefits; the economic, socio-cultural and environmental costs of tourism outweigh the benefits, in the areas of high revenue “leakages” related to either repatriation of profits and salaries or imports, and therefore low net expenditure retention; the dominance of foreign companies and the instability of the sector; the lack of low in-
9
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SPRING 2009
ter-sectoral or backward linkages. Tourism has also been criticized for exacerbating the problems of societies: the destruction of social patterns, neo-colonialist relationships of exploitation and dependence, and the insensitivity of foreign operators to social and cultural norms of host communities. All these objections may raise doubts about whether tourism has a “development” impact on societies. Both positions, admittedly, have merit. This article takes a more balanced view, explores the preceding issues within a broader framework of international tourism economy, relates the synthesis to African tourism perspectives, and assesses the development potential for international tourism in Africa if the continent is to successfully compete in the global tourism marketplace. Trends in Global and Regional Tourism To further appreciate the relative importance of tourism, it is necessary to situate the discussion in a wider perspective of global tourism and to compare regional variations and performances, in order to distill from the analysis a number of underlying issues of relevance to the subject in focus. On this score, Tables 1 and 2 show the dispersion and growth rate of international tourism as measured in volume (or tourist arrivals) and value (or tourism re-
ceipts) terms and related to country groupings for the relevant years. These trends are considered on two platforms – global and regional, as can be gleaned from Tables 1 and 2, followed by a synthesis. Global Context According to the United Nations World Tourism Organization’s (UNWTO) latest (2008) estimate (Table 1), 903 million tourists traveled worldwide in 2007 (or 56 million more arrivals in 2007 than in 2006), a growth rate of 6.6% in comparison with 2006 and a 5.5% increase recorded in 2005. It is further estimated (Table 2) that US$856 billion were generated in international tourism receipts in 2007 (or US$114 billion more in 2007 than 2006), i.e. 5.6% higher than in 2006. It is expected that by 2010 global arrivals will reach 1 billion, and will be 1.6 billion by 2020. Tourism receipts will reach US$2 trillion in 2020.
growth of tourist arrivals, better than in previous years, achieving over 142 million arrivals. Europe maintained its position of leadership in global tourist arrivals, which grew by 5% to reach 484 million, accounting for 54% of all international tourist arrivals. Relative growth in real receipt terms (Table 2) was particularly strong in Asia and the Pacific (+11%) – at double the world average – in Africa (+8%) and in the Americas (+6%). The performance of the Americas was a significant improvement over the previous year’s 2% growth. In subregions, the strongest increases came from South-East Asia (+13%) and North-East Asia (+12%), followed by Central America, North Africa and Central and Eastern Europe (all three at +9%). Only one subregion, the Caribbean, did not increase its receipts in 2007 (-0.4%), largely as a result of stagnation in arrivals.
Regional Context Regional trends can also be discerned from Tables 1 and 2. The indication (Table 1) is that the Middle East led the growth ranking in 2007, with an estimated 16% rise to nearly 48 million international tourist arrivals. Asia and the Pacific (184 million) followed with +10% over 2006. Africa increased its arrivals by 7% to 44 million. The Americas (+5%) showed a substantial
Synthesis These statistics highlight several interesting features: first, the extent to which many countries, developed and developing, have become tourist destinations for foreign travelers, and the competitive nature of tourist activities in which these countries are fiercely competing to increase their share of the market in volume and value terms. Second, the trend data sug-
Table 1: International Tourist Arrivals (for selected years) World & Regions
International Tourist Arrivals (million) 1990
1995
2000
2005
Market Share (%)
2006
2007*
2007*
Change (%) 06/05
07*/06
Average Annual Growth (%) 00/07*
World
436
536
683
803
847
903
100
5.5
6.6
4.1
Africa North Africa Sub-Saharan Africa
15.2 8.4 6.8
20.1 7.3 12.8
27.9 10.2 17.7
37.3 13.9 23.3
41.4 15.1 26.3
44.4 16.3 28.2
4.8 1.8 3.1
11.0 8.4 12.6
7.4 7.9 7.1
6.9 6.8 6.9
Americas North America Caribbean Central America South America
92.8 71.7 11.4 1.9 7.7
109.0 80.7 14.0 2.6 11.7
128.2 91.5 17.1 4.3 15.3
133.2 89.9 18.8 6.4 18.2
135.8 90.6 19.4 7.1 18.7
142.5 95.3 19.5 7.7 19.9
15.8 10.6 2.2 0.9 2.2
1.9 0.8 3.4 9.9 2.8
4.9 5.2 0.1 9.6 6.4
1.5 0.6 1.9 8.6 3.9
Asia and the Pacific North-East Asia South-East Asia Oceania South Asia
55.8 26.4 21.1 5.2 3.2
81.8 41.3 28.2 8.1 4.2
109.3 58.3 35.6 9.2 6.1
154.6 87.5 48.5 10.5 8.1
167.0 94.3 53.1 10.5 9.1
184.3 104.2 59.6 10.7 9.8
20.0 11.5 6.6 1.2 1.1
8.0 7.7 9.4 0.4 11.8
10.4 10.6 12.2 1.7 8.2
7.8 8.6 7.6 2.2 7.1
Europe Northern Europe Western Europe Central/Eastern Europe Southern/Mediter. Europe
262.6 28.6 108.6 31.5 93.9
311.3 35.8 112.2 60.6 102.7
393.5 43.0 139.7 69.4 140.8
440.3 52.8 142.4 87.8 157.3
462.2 56.4 149.5 91.5 164.8
484.4 57.6 154.9 95.6 176.2
53.6 6.4 17.1 10.6 19.5
5.0 6.8 5.0 4.2 4.7
4.8 2.2 3.6 4.5 7.0
3.0 4.0 1.5 4.7 3.3
9.6
13.7
24.4
47.8
40.9
47.6
5.3
8.2
16.4
10.0
Middle East
Source: UN World Tourism Organization (2008), Tourism Highlights 2008 edition, page 3. http://www.unwto.org/facts/menu.html
HARVARD COLLEGE ECONOMICS REVIEW
Table 2: International Tourism Receipts International Tourism Receipts (billion) 1990
1995
2000
2005
2006
Change Current prices (%) 2007*
Local currencies
Change Constant prices (%)
05/04
06/05
07*/06
05/04
06/05
07*/06
6.3
8.5
9.1
3.1
5.1
5.6
US$
264
405
475
680
742
856
7.3
9.2
15.4
3.8
5.8
12.1
Euro
207
310
513
544
584
625
7.3
8.2
5.7
5.2
5.9
3.5
World & Regions
Change local currencies constant prices (%)
Share (%)
US$
Euro
Receipts
Receipts
(billion)
Per arrival
(billion)
Per arrival
05/04
06/05
07*/06
2007*
2006
2007*
2007*
06/05
07*/06
00/07*
World
3.1
5.1
5.6
100
742
856
950
591
625
690
Africa North Africa Sub-Saharan Africa
10.9 15.3 8.8
10.5 19.1 6.5
7.5 8.7 6.9
3.3 1.2 2.1
24.6 8.7 15.9
28.3 10.3 18.0
640 640 640
19.6 6.9 12.7
20.6 7.5 13.1
460 460 470
Americas North America Caribbean Central America South America
4.3 4.5 3.3 9.3 2.0
1.8 0.8 1.9 10.3 6.8
6.4 7.4 -0.4 8.9 8.0
20.0 14.6 2.6 0.7 2.0
154.1 112.5 21.7 5.5 14.4
171.1 125.1 22.6 6.3 17.2
1,200 1,310 1,160 810 860
122.7 89.6 17.3 4.4 11.5
124.9 91.3 16.5 4.6 12.5
880 960 850 590 630
Asia and the Pacific North-East Asia South-East Asia Oceania South Asia
4.2 7.9 0.0 1.0 4.1
11.1 12.1 16.0 2.5 10.7
11.4 12.5 13.0 8.1 5.4
22.1 10.4 6.3 3.8 1.6
156.5 75.2 43.6 26.6 11.2
188.9 89.2 54.0 32.3 13.4
1,020 860 910 3,020 1,370
124.7 59.9 34.7 21.2 8.9
137.9 65.1 39.4 23.6 9.8
750 620 660 2,200 1,000
Europe Northern Europe Western Europe Central/Eastern Europe Southern/Mediter. Europe
1.7 8.4 -0.2 0.1 1.4
3.9 7.7 3.7 8.2 1.6
2.7 3.9 2.1 8.6 1.1
50.6 8.1 17.4 5.6 19.4
376.9 60.3 131.6 38.2 146.9
433.4 69.7 149.1 48.3 166.4
890 1,210 960 510 940
300.2 48.0 104.8 30.4 117.0
316.2 50.8 108.8 35.3 121.4
650 880 700 370 690
Middle East
2.5
3.6
6.3
4.0
29.9
34.2
720
23.8
25.0
520
Source: UN World Tourism Organization (2008), Tourism Highlights 2008 edition, page 4. http://www.unwto.org/facts/menu.html
gest that tourism is historically a growth industry. It has, with a few exceptions in certain years, exceeded the growth of world trade over the same time period. This trend clearly demonstrates that tourism is a sustainable, long-term growth industry on a global basis. The emphasis is important as it does not follow that a global trend is reflected in every country or region. For example, over the last fifty years Europe (and particularly Western European countries) has received over 50% of international tourism arrivals and receipts, although this is now declining. The distribution of both arrivals and receipts is highly skewed, with approximately 80% of international tourist arrivals and 78% of international receipts being received in developed countries. Third, in relation to forecasting longterm trends in an industry, the projection can be considerably dislocated in the shortterm by such events as September 11, 2001 in the United States, the second Iraq war in 2003 and ongoing, and the SARS virus/
pandemic, all of which have their dangers in realizing the forecasts. Brief comments on the above trends might be appropriate, particularly relating to short-haul versus long-haul international travel. Much of intra-European travel (that is, travel within and between Western European countries) is relatively short-haul (and therefore more comparable with a lot of domestic travel in large countries like Australia, Canada, and the United States). This distinction is important because it helps to explain the dominance of Europe, in volume and value terms, in the global tourism marketplace. Additionally, there has been a global redistribution in the foci of tourism activity associated with the emergence of the â&#x20AC;&#x153;tiger economiesâ&#x20AC;? of the Asia-Pacific Rim. Economic growth in these countries has fueled both growth in demand and the awareness of new tourist destinations. Finally, from this comparative data we can say that not only is tourism an industry of growing importance in the global
economy, but it is expected to sustain its vitality. It should also be noted that the financial revenues generated by tourism activity (international tourism receipts) are always understated because, due to National Accounting conventions, international fare payments are not included as tourism receipts but are counted in the Transportation Account of the Balance of Payments, maintained by the International Monetary Fund. It is for these reasons that the UN World Tourism Organization and the United Nations have endorsed a move towards compiling Tourism Satellite Accounts as a means to improve the collection of tourism financial and economic data and to facilitate comparisons between countries of the impact of tourism activity. Africa and International Tourism: Broad Trend Changes The extent and impact of international tourism 2005-2007 have been noted (Tables 1 & 2). Table 3 presents the disper-
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sion of tourist arrivals and tourism receipts for the 25 major tourist destinations in Africa for the same periods, which might be usefully summarized as follows. Africa was one of the best performers in 2007, with a growth of 7% to 44 million arrivals. The region confirmed its good momentum averaging 7% growth a year since 2000. International tourism receipts increased by 8% (in real terms) and reached US$28 billion. In North Africa, Morocco continued to advance its arrivals with a 13% rise in 2007. Algeria also did well (+6%), especially in the adventure tourism segment. In Sub-Saharan Africa, a number of countries, among the ones with data available, turned in double-digit results, notably Angola (+60%), Cape Verde and Madagascar (+10% each), Malawi (+12%), Mauritius (+15%), Reunion (+36%), the Seychelles (+15%), Tanzania (+10%) and
Uganda (+19%). South Africa (+8%), the leading destination in Africa with 20% of all arrivals to the region, benefited from the devaluation of the rand (national currency) and increased marketing in core markets, with a focus on segments such as sports and adventure tourism. Awareness of the destination continues to grow in the build-up to its hosting of the FIFA World Cup in 2010. Synthesis In the wider context of development, a number of conclusions can be drawn from these facts and figures, as has been stated elsewhere (Dieke, 2003:290-291). First, the statistics illustrate the nature and scope of international tourism in Africa and the significance of tourism in some countries, which is clearly influenced by the broader nature of economic development. Second, there are considerable variations in the
scale of tourism development in Africa, from the dominant (i.e. developed) in theoretical development continuum to the Johnny-come-lately (i.e. least developed or late starters). As seen (Table 3), some countries in the region, for example Kenya in the east, Mauritius and the Seychelles in the Indian Ocean, Morocco and Tunisia in the north, South Africa and Zimbabwe in the south, Ghana and Senegal in the west, are well-established, ‘successful’ tourism destinations. There are others, like Nigeria, Cameroon Eritrea, and Sierra Leone, which for a number of reasons have limited tourism development and therefore have not made the table league of major players in tourism, and have limited tourism development but considerable potential. Third, the statistics further highlight possible underlying reasons why there is relatively little tourism in some countries and more in other others. The dominance
Table 3: Tourist Arrivals and Tourism Receipts of Africa’s 25 Major Destinations (for selected years) Major Destinations
Series*
International Tourist Arrivals (1000)
Africa
International Tourism Receipts
Change (%)
Share (%)
(US $)
Share (%)
2005
2006
2007*
06/05
07/05
2007*
2005
2006
2007*
2007*
37,260
41,369
44,430
11.0
7.4
100
21,820
24,602
28,292
100
Algeria
VF
1,443
1,638
1,743
13.5
6.4
3.9
184
215
—
—
Angola
TF
210
121
194
-42.2
59.8
0.4
88
75
—
—
Botswana
TF
1,675
—
—
—
—
—
562
537
546
1.0
Cape Verde
TF
198
242
267
22.2
10.4
0.6
127
228
344
1.2
Ethiopia
TF
227
290
303
27.7
4.3
0.7
168
162
177
0.6
Ghana
TF
429
497
—
16.0
—
—
836
861
—
—
Kenya
TF
1,536
1,644
—
7.0
—
—
579
688
909
3.2
Lesotho
VF
304
357
300
17.6
-15.9
0.7
31
36
—
—
Madagascar
TF
277
312
344
12.4
10.4
0.8
183
159
176
0.6
Malawi
TF
438
638
714
45.8
11.9
1.6
24
24
—
—
Mali
TF
143
153
164
6.9
7.4
0.4
148
175
—
—
Mauritius
TF
761
788
907
3.6
15.1
2.0
871
1,007
1,299
4.6
Morocco
TF
5,843
6,558
7,408
12.2
12.9
16.7
4,621
5,967
7,264
25.7
Namibia
TF
778
833
—
7.1
—
—
348
384
434
1.5
Reunion
TF
409
279
381
-31.8
36.5
0.9
442
309
446
1.6
Senegal
TF
769
866
—
12.6
—
—
242
250
—
—
Seychelles
TF
129
141
161
9.3
14.7
0.4
192
228
285
1.0
South Africa
TF
7,369
8,396
9,090
13.9
8.3
20.5
7,327
7,875
8,418
29.8
Sudan
TF
246
328
—
33.5
—
—
252
262
0.9
—
Swaziland
THS
839
873
870
4.1
-0.4
2.0
78
74
—
—
Tanzania
TF
590
628
692
6.4
10.2
1.6
824
950
1,037
3.7
Tunisia
TF
6,378
6,550
6,762
2.7
3.2
15.2
2,143
2,275
2,555
9.0
Uganda
TF
468
539
642
15.1
19.2
1.4
380
309
356
1.3
Zambia
TF
669
757
897
13.2
18.5
2.0
98
110
—
—
Zimbabwe
VF
1,559
2,287
—
46.7
—
—
99
338
—
—
Source: UN World Tourism Organization (2008), Tourism Highlights 2008 edition, page 8. http://www.unwto.org/facts/menu.html *Key: TF=International tourist arrivals at frontiers (excluding same day visitors; VF=International visitors arrivals at frontiers (tourists and same day visitors; THS=International tourist arrivals at hotels and similar establishments; TCE=International tourist arrivals at collective tourism establishments.
HARVARD COLLEGE ECONOMICS REVIEW
of countries of the northern sub-region, e.g. Morocco, is explained not only by the sub-region’s proximity to the major European generating markets but, more importantly, by its long-standing economic, political, and other ties with these areas. There was also the suggestion back in 1972 that the sub-region is “... simply a natural extension of European resorts, in the path of the inevitable southern push towards the sun and, initially at least, towards less crowded beaches” (Hutchinson, 1972: 45). It is further argued, on a wider scope, with respect to many less developed countries that “where foreign enterprises were present in a country’s tourist industry they would be the most successful...” (Britton, 1982: 340). This explained why southern and eastern Africa are, in tourism terms, significant, as the case study of Kenya shows: “pioneer facilities were in place because Kenya had a vigorous expatriate community which sought to advance foreign commercial interests, including tourism” (Dieke, 1993: 13). In relation to those “Johnny-comelately” (or late starter) countries in Africa, some critics might argue, albeit harshly, that the problems in Africa’s tourism are closely related to structural imbalances in their overall development pattern. There are no clear strategies for development in general or for tourism in particular, and tourism has not been integrated with other economic sectors. As a consequence, where tourism development in some countries has been insufficient (as in Cameroon and Nigeria), in others (for example, Kenya) it has been uncontrolled and excessive. Organization of the tourism sector has been inadequate, which has contributed to a lack of profitability in many operations, and promotion prospects are poor, with massive reliance on expatriate staff. Above all, the major setback is inadequate training. These development issues, briefly presented here, are discussed in the following section. Some Development Issues in Africa’s Tourism There are a number of general development issues that can be associated with tourism in Africa, about which so much has been written (Dieke, 1995, 1998, 2000, 2001, 2003). The issues stem from several factors, including: (1) the general disappointment with the economic returns from the tourism sector; (2) insufficient
knowledge of the market mix of international tourism; (3) the social and political discontent with tourism and, in particular, the market-driven nature of the sector; (4) the inability of governments, because of their bureaucratic structure, to react to market changes or market signals; (5) lack of human resource availability; and (6) general level of development of the region (see also Jenkins, 1994). No attempt will be made in this article to pursue these issues in detail. Instead, discussion will center on general factors that influence the global tourism trends noted above. The demand determinants are really of two components: economic and non-economic. Given that tourism is essentially a leisure activity (excluding the important business travel market), these conditions not only influence global tourism trends but also have specific impacts on Africa. Economic factors As a leisure activity, tourism is heavily influenced by economic conditions in the main generating regions, which are primarily the United States and Europe. When these economies are buoyant, there is a correlation between disposable per capita income levels and the propensity to travel. In the current circumstances, when the United States and European Union economies are both suffering economic uncertainty and rising unemployment rates, people are cautious about committing themselves to travel and holiday expenditure. Although there is evidence that consumers give a higher protection to potential travel and holiday expenditure in their annual budgets, economic downturns do affect outbound travel. Personal Threats As a general proposition it can be said that perceived threats to tourists will decrease international tourism flows and cause a substitution effect. For example, the terrorism incidents in the United States have not only drastically decreased the number of residents and citizens traveling outside the country (international tourism) but have caused many not to forgo their holidays but rather to take their holidays within the United States (domestic tourism). Some of these personal threats can be classified as follows:
Security Tourists will not travel to countries or areas within large countries where they feel threatened. Some relatively recent examples are the September 11, 2001 events in the United States, the bombing in Bali on October 12, 2002, and the Iraq war of March, 2003 (and ongoing). When such events occur there is an immediate and often massive dislocation to country and regional travel. Health The outbreak of the SARS virus, the AIDS pandemic, and the outbreak of bubonic plague in India some years ago had a major influence on both the volume and direction of international tourism flows. Natural disasters There are many examples, including floods (Central and Eastern Europe in 2002); foot-and-mouth disease in the United Kingdom in 2002; and bird-flu in Hong Kong and parts of China in 2002. A combination of economic decline together with some of the circumstances described will have immediate effects on personal travel plans and business travel. Unfortunately, as tourism is a multi-sector activity, there will be collateral affects. These we can observe in the global airline industry, hotels, and in other tourismrelated activities. These are very difficult times for tourism businesses and some will not survive the current crisis. However, for those that survive, there is some good news. Historical analysis shows us that tourism crises do not last long. For example, the first Iraq war in 1991 devastated regional travel, but visitor arrivals had generally recovered by 1993. The Asian financial crisis beginning in Thailand in 1997 had serious implications for the region but had bottomed-out by 1999 and tourism in many countries had recovered. The Luxor Temple massacres in Egypt abruptly stopped tourism inflows, but increased security measures and massive advertising restored tourism trends within two years. Recovery periods can be quicker but in general seem to average around eighteen months. A problem in one country may benefit another, as many tourists do not forgo their holiday but rather substitute a perceived “dangerous” destination for a “safe” one. However, if a region is considered to be politically unstable or threatening in any
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way, tourists will tend to avoid it. Over the long-term this explains why regions such as Africa, South Asia and the Middle East have received only a small share of international tourist arrivals. Prospects for Africa’s Tourism Development In looking to the future there are a number of factors that will support Africa’s international tourism development. First, the three “A’s” It is now generally accepted that prerequisites for tourism development are attractions, accommodation, and access. Without attractions – either natural (climate, landscapes, coast, mountains,) or manmade (historic sites, theme parks, festivals) – tourism cannot develop. A combination of these attractions often put destinations on the tourism map. Las Vegas is the quintessential man-made destination, and Egypt is an example of a country that has benefited from its history and culture. When at the site the tourist needs support services, particularly accommodation. Even if both are available, there has to be good access to the destination. Many international tourists today are described as being “cash rich and time poor.” Direct access to a destination by road or air is an important factor in development, as it saves time on traveling by indirect routes. In Africa there are many top quality natural
and manmade attractions, high standards of accommodation and infrastructure and a good transportation network; the basics for tourism development are in place and are being added to and improved all the time. Second, growing regional competition The many regional countries (including Africa) now entering the international markets are providing a wider range of destination options for tourists. Competition will ensure that standards and value-for-money will eventually determine which countries and destinations will be most successful. An important consideration here will be how to improve service standards in a world where tourists are becoming more frequent travelers and accumulating tourism experience, which allows them to determine value-for-money destinations and to compare service standards. In the long-term the availability of trained human resources may be the determining factor between success and failure of tourism investment. At present much of the labor force in tourism is expatriate. Any program to facilitate indigenous employment will require careful planning, a change in cultural perceptions and encouragement from the political hierarchy. Third, investment capital In some of the African countries there
is no shortage of investment capital, but perhaps a reluctance to invest in the tourism sector. To a large extent such caution is linked to current experience where growth in tourism has been slowed, and in some cases, stopped by the “threats” described earlier. However, our trend data has demonstrated that in the medium and long term, tourism is a robust industry and one that has greater sustainability than others. Creating a destination in a highly competitive market is not a short-term objective; it is essentially an incremental activity just like development in general. The strategic vision has to be long-term, and the huge investment in infrastructure is a long-term commitment without which tourism will not develop. Fourth, the private sector Most of the regional infrastructure has been provided by governments. This reflects the fact that infrastructure is capital intensive, fixed and has a long-term payback period in financial terms. These conditions limit the interest of the private sector in investing in this area. More attention is being given now to Public Private Partnerships in which the government is building the infrastructure to facilitate the private sector’s providing facilities for tourists (and other users). As risk-takers, the private sector companies will only invest in areas where viable returns are expected from the investment. They are in the marketplace and their survival depends on their understanding of the market and, in particular, what the client wants and for what he is prepared to pay. In the region, there are signs that governments are moving to a more supportive and facilitating role in the tourism sector and leaving the development to private companies. This does not mean that governments only have a supportive role in the sector; as representatives of the people, government is the ultimate arbitrator of many of the important considerations in the sustainability of the industry, such as what type of tourism should be developed, where and on what scale. Fifth, the environment Environmental quality is a factor that has reached a world-wide audience. It is fundamental not only to the development of tourism but also to the lives of residents. There is some evidence that many tourists are reflecting their concern for the envi-
HARVARD COLLEGE ECONOMICS REVIEW
ronment in their choice of destinations. Those destinations offering environmental quality can often charge higher prices for services, but it may be that in the longer term, destinations that have deteriorated environments will not be competitive at all. Again, there is evidence in many regions that environmental management is now regarded as an integral part of development planning. Sixth, market demand Despite the impressive growth trends in international tourism, the market is very under-developed. Using the UN World Tourism Organization's statistics, only 3.5% of the world's population travels internationally. Even in the United States, one of the richest countries in the world, less than 10% of the population has passports. The longer-term potential for greater penetration of this market exists. Of course, to constitute a market, people must have disposable income to afford to travel, but as per capita disposable income increases people travel more. Initially travel is domestic, then intra-regional and eventually, long-haul international. Best estimates of all travel show that 80% is domestic and 20% international. To emphasize the importance of some domestic markets, it is interesting to note that in 2000, the UN World Tourism Organization estimated international tourist arrivals to be 693 million; in China alone, domestic tourism movements were estimated to be in excess of 700 million. The question of what might be the constraints on future demand are outside the scope of this article, but one can safely predict that there is a growing and largely untapped market for tourism. Conclusion This article has dealt with some aspects of Africa’s development prospects in the globalized tourism economy, namely the role that global tourism has played and will play in the continent’s economic development process. The main emphasis has been on the implications of using tourism as a viable development option. There are a number of development issues that might threaten such prospects. Unless these challenges are addressed, they might further undermine or erode the progress already made, in general development terms, given that “development” is not immediate but is incremental. They will further marginalize Africa in the global “pleasure periphery.”
Suggestions have been made as to how some of these problems and difficulties might be overcome, and particular reference has been made to the need for basic facilitating investment in tourism: attrac-
tions, accommodation, and access; the importance of respecting and appreciating the relative roles of both the private and public sectors; the need for continued investment in the sector; and the significance of the growing regional competition. H
Dr. Peter U. C. Dieke is Associate Professor of Tourism and Events Management at George Mason University, USA. A leading scholar in international tourism development, he has written extensively on the developmental aspects of tourism in less developed countries, focusing on policy, planning, and implementation issues, including regional interests in sub-Saharan Africa. Dr. Dieke is the Africa regional editor for Tourism Review International and also serves on the Editorial Boards of many other scholarly tourism journals, e.g. Annals of Tourism Research. References Britton, Stephen G. (1998), The political economy of tourism in the third world, Annals of Tourism Research, 9(3): 331-358. Dieke, Peter U. C. (1991), Policies for tourism development in Kenya, Annals of Tourism Research, 18(2): 269-294. Dieke, Peter U. C. (1995), Tourism and structural adjustment programmes in the African economy, Tourism Economics, 1(1): 71-93. Dieke, Peter U. C. (Ed.) (2000), The Political Economy of Tourism Development in Africa, Elmsford, NY: Cognizant. Dieke, Peter U. C. (2001), Human resources in tourism development: African perspectives, in Harrison, D. (Ed.), Tourism and the Less Developed World: Issues and Case Studies, Oxford: CABI, pp. 61-75. Dieke, Peter U. C. (2003), Tourism in Africa’s economic development: policy implications, Management Decision, 41(3): 287-295. Dieke, Peter U. C. (2008), Introduction: Tourism development in Africa: challenges and opportunities, Tourism Review International, 12(3). Hutchinson, Alan (1972), Africa’s tourism leaps ahead, African Development, 45. Jenkins, Carson L. (1994), Tourism in developing countries: the privatization issue, in Seaton, A. V., Jenkins, C. L., Wood, R. C., Dieke, Peter U. C., Bennett, M. M. and Smith, R. (Eds.), Tourism: the State of the Art, Chichester, United Kingdom: John Wiley, pp. 3-9. Jenkins, Carson L. (2007), Tourism development: policy, planning and implementation issues in developing countries, in Cukier, Judie (Ed.) (2007), Tourism Research: Policy, Planning and Prospects, Occasional Paper #20, University of Waterloo, Canada, pp. 21-30. Erbes, Robert (1973), International Tourism and the Economy of Developing Countries, Paris: OECD. Rogerson, Christian M (2007), Reviewing Africa in the global tourism economy, Development Southern Africa, 24(3): 363-379. UNWTO: United Nations World Tourism Organization (2008), Tourism Highlights, 2008 Edition, Madrid: UNWTO.
15
THE ECONOMICS OF R
B
!?/A<!Q(N!))7
efore f the h iindustrial d i l revolution, l i practically i ll all ll our energy was renewableanimal power, wood, wind and water. Now, only about 13% of it is, and almost all of the rest comes from fossil fuels like coal (26%), gas (21%) and oil (34%). These are finite resources, and while oil and gas companies are getting better at finding remote deposits, extracting a greater proportion of what’s in the ground, and developing “unconventional” sources of energy, it is certain that at some point, our consumption of fossil fuels will have to decline.
RENEWABLE ENERGY
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SPRING 2009
Though the issues of waste disposal and weapons proliferation may restrict the expansion of nuclear power, I believe they must be part of the energy mix. To fill the remaining gap, we will need to use modern forms of renewable energy. That most of these forms also have very low carbon emissions is another urgent reason for switching away from fossil fuels. About two-fifths of the energy used in modern society is for transport, two-fifths for heat and one-fifth for electricity (some of which is also used for heat). There are renewable options in all three sectors, although the mid-term potential is greatest for electricity, where biomass (for burning), hydro, solar photo-voltaic and wind power are already established technologies, and companies are developing marine (tidal and wave) energy devices. Heat can be obtained from biomass or from heat pumps (effectively refrigerators running in reverse, which draw heat from the ground or the air outside the space to be heated). For transport, renewable electricity is one option, and biofuels another, although it is important to recognise that using large amounts of fertiliser to grow crops on land that could have been used for food or has been cleared from tropical forests does little to reduce carbon emissions. However, even biofuels have the advantage of diversifying a country’s energy sources, limiting the disruption that would be caused if any one energy supply was interrupted. The benefit of this diversity—which may not be taken into account by investors— is another reason for governments to support renewable energy. A final reason is that the costs of many renewable technologies are falling through the process of “learning by doing,” justifying an investment now in the hope that that they will be more competitive in the future. Most forms of renewable energy do need government support because their costs are higher than those of fossil fuels. There are exceptions: for example, large-scale hydro electricity schemes can have very low costs, and solar power can be cost-effective for remote locations not connected to an electricity grid. The cost disadvantage of renewable energy also depends on the price of fossil fuels—at the time of writing, with oil at less than $50 a barrel, renewable energy looks a lot more expensive than it did in the summer of 2008, when the price was three times as high. Government intervention in a market can be justified if there is an externality— that is, an effect on bystanders that private
decision-makers do not take into account— and the intervention is sufficiently welldesigned. The biggest externality in energy markets at present is the potential damage caused by climate change due to carbon dioxide emissions. This is an externality that could be tackled by making it more expensive to emit carbon dioxide, either through a tax or through the kind of cap-and-trade scheme that the United States already uses for emissions of sulphur dioxide, and that President Obama plans to introduce for carbon dioxide. The European Union already has an emissions trading scheme—companies have been given permits by their governments, and will have to surrender the number of permits corresponding to the amount of carbon dioxide they emit. If their emissions are higher than their allocation, they will have to buy permits from firms with lower emissions, or from overseas (via the Clean Development Mechanism that sponsors emissions reductions in developing countries). Emissions trading need not affect the price of power in a state with cost-of-service regulation (as in much of the United States), for unless companies have to buy in a lot of permits, their average costs will not change by much. If electricity prices depend on a wholesale market, however, (as in Europe, Texas, and much of New England), then the price of power will tend to rise. The marginal cost of increasing generation includes the cost of buying permits (or being unable to sell them) however many permits the generator was originally given, and wholesale prices depend on marginal costs, not average costs. This means that the cost of carbon emissions will be passed into the wholesale price of power, making low-carbon generators, such as renewable and nuclear power, more attractive. This leads us to the first of three cost comparisons shown in Figure 1. For an investor, the relevant comparison is between the direct costs of a renewable power station and the costs of a conventional station, including the cost of carbon. Absent other advantages, the investor would not build the renewable station if its costs were higher, which is the case in this figure—the arrow shows the cost disadvantage. The comparison that is relevant for the economy as a whole is shown in the centre of the figure, however. On top of the direct costs of generating electricity, we need to consider the system costs of ensuring that electricity is delivered to consumers in a reliable manner. These include the cost of build-
ing and maintaining the transmission grid, and of having reserve plants available in the event of breakdowns or unexpected increases in demand. As the proportion of renewable energy rises, these costs will tend to increase. Some renewable generators are intermittent, producing power only when the wind, waves, tides or sun are favourable. The tides are perfectly predictable long in advance, but the weather is not, which means that the system operator will have to hold more capacity in reserve to cope with unanticipated changes in renewable output. The total capacity required will also be higher, to cope with times when demand is high and renewable output is not. In the United Kingdom, a relatively small island where the weather tends to be similar across the country, the increase in these extra costs could add about 5% to the cost of generating power if it were to get onethird of its electricity from renewables (and mostly from wind). These costs might be lower in the United States, where it would be possible to import power from a distant area with more favourable weather conditions— provided that the transmission lines are strong enough. In the United Kingdom, the need to build more transmission lines to connect renewable generators, mostly in places remote from electricity consumers, will add roughly another 5% to the cost of generation. The cost comparison in the figure (which needs to be at the level of the power system, not the individual power station) does not add the cost of carbon to the cost of a conventional power system. This omission is deliberate, for it allows us to divide the extra cost by the amount of carbon emissions avoided, and thus to get a figure for the cost per tonne of carbon saved. If this is high, compared to other options (and there are many ways of increasing the efficiency of energy consumption that would actually save money), then renewables might appear to be an expensive way of reducing carbon emissions. Nonetheless, because they still bring benefits in terms of increasing energy security and future cost reductions, support may be justified. How should we support renewable energy? Many European companies use a feed-in tariff, which requires electricity companies to buy power from renewable generators at a pre-set price. The electricity companies then recover the cost of doing so from their customers. The great advantage of a feed-in tariff for most kinds of renewable generators is that both their costs and their revenues are then largely predictable—wind power
HARVARD COLLEGE ECONOMICS REVIEW
Cost Comparisons
g e n e r a t i o n renewable generators to cover their costs, compared to but if the scheme is badly designed, they Generator Cost Resource Cost Consumer Cost Consumer cost the target— may be much higher. (The United KingGenerator cost Resource cost if there is a dom has effectively fixed the total amount System large shortfall, of support paid to renewable generators in System costs costs c e r t i f i c a t e s each year, and since it has not been possible System Support will be much to build as much capacity as was hoped, the costs more valuable payment per kWh has been higher than inCarbon price than if the tar- tended.) System Market Market We can use this framework to ask how get is nearly prices prices Direct Direct much renewable energy will add to consummet. This costs Direct Direct costs costs costs ers’ electricity bills (or taxpayers’ burdens). means that Since any prediction has to depend on a because both forecast of the cost of fossil fuels, it will be of the generaRenewable Conventional Renewable Conventional Renewable Conventional uncertain—the cheaper fossil fuels are, the tor’s revenue more expensive renewable energy will be streams— in comparison. But economists can advise from the marpolicymakers about the likely range of extra stations cost a lot to build, but have very ket price and from the certificates—are risky, costs, and about the policies that will tend to low running costs. This reduces their risks, its cost of capital will rise. Evidence from the 1 minimise them. We might also estimate the allowing them access to cheaper finance— European Commission suggests that the benefi ts of renewable energy—lower depenimportant for a technology with high invest- tradable green certificate schemes tend to ment costs. have higher costs and are less effective in dence on fossil fuels, lower carbon emissions, The United States government uses tax terms of the amount of renewable invest- and the chance to improve the technology. The European Union is adopting a target credits—companies can reduce their federal ment than well-designed feed-in tariffs. for 2020 that 20% of its energy will come tax bills by 2.1 cents per kWh of wind generaOnce we know how renewable energy is from renewable sources. This is just over tion, or 1 cent per kWh of electricity gener- being supported, we can calculate the overdouble the current proportion, and while ated from municipal solid waste. This gives all cost to consumers, and the right-hand some more renewable energy can be prothe generator some certainty, but the rest of side of the figure shows how. In a marketduced quite cheaply (with benefits that will its revenue will have to come from the mar- based system, consumers will have to pay outweigh its costs), the incremental cost ket (or be agreed to by a regulator in a state the market price of power, the extra system rises sharply with the amount required. The that has not liberalised). With a long-term costs discussed above, and the costs of the European Commission has estimated that sales contract, the generator can minimise its support policy (in the case of a tax credit the most expensive energy needed to meet risks, but if no long-term contracts are avail- that cost is actually borne by taxpayers, able, the generator is exposed to changes in through the revenue forgone). The figure this target will require support of €45 per the market price, and will have a higher cost shows that the market price may actually MWh (about $57 at the current exchange of capital. This reflects the fact that while be lower in a system with a lot of renewable rate), on top of a carbon price of €39 per renewable energy can provide a more diver- energy, because it will be necessary to build tonne of CO2 (about $50). Since each MWh sified portfolio of energy sources for a na- a lot of spare capacity for times when con- of renewable energy only saves around half a tion, reducing the variability in the amount ditions are unsuitable for renewable gen- tonne of carbon dioxide, this implies that the it has to pay for its energy, a company in a eration, and this will tend to depress prices. cost per tonne of CO2 saved would be over liberalised market faces a different problem. Note that in the case of a conventional sys- $160. Even after reducing this figure to take When fossil fuel prices are high, any energy tem, the market price should be at least as account of the benefits from reducing depensource with largely fixed costs will be more great as the direct cost of generators plus dence on fossil fuels, it is still well above most profitable than when fossil fuel prices are their cost of carbon, since this is the only estimates of the damage caused by carbon low. From the point of view of a generating source of revenue to cover those costs. Sys- emissions. This suggests that the EU is going company, fossil fuels are a safe option—the tem costs will be higher, as discussed above. too far, too fast, in its move towards renewselling price of electricity can move up and Support costs have to be high enough for able energy. H down with the cost of buying them—while renewable and nuclear power are risky. The risks are even greater in countries that Professor Richard Green is the Director of the Institute for Energy Research and Policy at the use the third method for supporting renew- University of Birmingham. Many of the points in this article were made in a recent report by able energy: the tradable green certificate, of- the Economic Affairs Committee of the House of Lords on “The Economics of Renewable Energy” ten linked to a renewable portfolio standard. (available through www.parliament.uk). The views expressed in this article, however, are his Companies must buy a set proportion of the alone. electricity they sell from renewable generators or pay a penalty, giving renewable power Endnotes 1. European Commission (2008). The Support of Electricity from Renewable Energy Sources. Accompanying document a greater value than conventional supplies. to the Proposal for a Directive of the European Parliament and of the Council on the promotion of the use of energy The problem is that the value of the certififrom renewable sources. Commission Staff Working Document SEC(2008) 57, Brussels, Commission of the European Communities cate depends on the amount of renewable
19
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39'%*(=9$"* Clean electricity, but at what price?
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olar plants are gleaming examples of technical prowess, increasingly found in the western United States, silently generating electricity to satisfy the power needs of western cities. Some eastern states are starting down that path as well—led by New Jersey, which is increasingly dotted with solar photovoltaic systems on residential rooftops, parking garages, and commercial buildings. A closer look, however, suggests that these solar power plants, while technologically impressive, exist only because of very large direct public subsidies. Their public benefits, in contrast, are significantly less sizable. In addition, other technologies are readily available that can help meet policy goals at much lower costs. This raises questions about why these subsidies exist and whether the policies that promote them are economically desirable. A bit of background will make clear why these technologies, and the policies that make them possible, are in place. In response to a number of political drivers—notably climate change, increasing electricity prices, and carbon regulation risk—a number of states have passed poli-
cies requiring that an increasing fraction of electricity come from renewable sources. These requirements, called Renewable Portfolio Standards (RPSs), are now on the books in over half the states, and Congress is considering legislation that would establish a national RPS. Typically, the RPS sets a specific goal that electricity retailers must meet. For example, in New York, electricity retailers are required by law to ensure that at least 25% of the electricity they sell comes from renewable sources by 2013. The RPSs define renewables, but—in most cases— leave it up to the electricity retailers to decide what specific renewable technology to use. Electricity retailers have an incentive to keep costs low, so they generally look for the lowest cost renewable technology to meet the goal. In the western United States, this usually means wind power; in the East, wind and some forms of biomass are the lowest cost options. Overall, these RPSs seem to be working well in many states. New renewable– fueled power plants are being built and states are making some progress in shifting their electricity systems away from
a reliance only on fossil fuels. Costs— particularly in the West, where the levelized cost of electricity from wind is often comparable to that of electricity from new fossil-fired power plants—are modest. An analysis of the electricity price impacts of state RPSs estimated that these RPSs caused an average retail electricity price increase of just 0.7%.1 Where this policy approach seems to stray is in the several states that mandate particular technologies, rather than allowing electricity retailers to shop for the lowest cost option. Colorado, New Jersey, and Nevada, for example, all have solar “set-asides” that require some fraction of the required renewables to come from solar technologies. For example, New Jersey’s RPS requires that 2.1% of electricity must be from solar by 2021. Colorado and Nevada’s rules are similar in structure, although with different dates and percentage requirements. The results of these solar set-asides are unsurprising: electricity retailers required to get solar electricity are doing so, regardless of the costs. The investor-owned utility in Colorado, for example, offers a
HARVARD COLLEGE ECONOMICS REVIEW
rebate for residential solar photovoltaic systems that covers about one-half of the first cost. The utility does not own these systems or the electrical output of these systems; the rebate payment goes to homeowners who install the systems on their houses. The homeowners then use the electricity from the solar system to displace electricity they would have bought from the utility. The approximate cost of electricity from these systems (before the rebate and before any tax credits) is 30¢/ kWh.2 The Colorado utility also purchases electricity from an 8.2 MW solar photovoltaic system located in Southern Colorado. Contract details are confidential, but it’s likely that the utility pays 20 to 28¢/kWh for that electricity.3 Similarly, New Jersey utilities are paying large rebates to customers who install rooftop solar systems. The costs to the utility of these programs are covered by surcharges on all customers’ electricity bills. Clearly, these policies are “effective” in that they are driving new solar power plant construction. What’s less clear is whether they are “efficient.” Specifically, it is the costs that call the set-asides into question. For comparison, electricity from new wind turbines typically costs 4 to 5¢/ kWh. Wind, too, is subsidized; estimates are that wind prices without the federal production tax credit would be about 6.5¢/ kWh.4 Biomass costs are variable, however biomass-fueled power plants typically produce power at 7 to 14¢/kWh.5 In other words, electricity from solar power costs about three to five times more than electricity from wind turbines. Or, alternatively, public funds spent on wind yield three to five times more renewable electricity than public funds spent on solar. Wind and solar are both carbon-free, use renewable fuels, and can displace fossil fuels. Data on employment intensity (jobs created per kW or per kWh) are scarce: it’s likely that residential solar PV has a higher employment intensity than utility-scale wind. However, given the high cost of solar, it’s not likely that these jobs would survive if the subsidies were removed. So, it’s not clear what public purpose or benefit is served by spending public funds on solar rather than lower cost alternatives such as wind. Why do these set-asides exist in the first place? The explanation lies in politics,
not in economics: lobbying by solar advocates and industry representatives, a supportive public that just plain likes solar, and little political opposition, all add up to smooth sailing for set-asides in state legislatures. We live in a democratic society, and—in some situations—politics should trump economics. In this case, however, it’s hard to justify requiring ratepayers to pay 20 to 30¢/kWh for renewable electricity from solar when it’s available for less than 7¢/kWh from wind or 7 to 14¢/kWh from biomass. This is not the first time the United States has dabbled in technology-specific regulation. In 1978, Congress passed the Public Utility Regulatory Practices Act, which required electric utilities to purchase electricity from certain types of
non-utility electricity generators. Some states implemented this law, such that the rate utilities paid to those generators varied by technology. In California, for example, the regulated utility paid biomass electricity producers up to 13.5¢/ kWh for electricity—far above the costs from alternative technologies. When that subsidy was reduced, many of those highpriced biomass power plants shut down. Policies to promote solar energy are likely headed for the same fate. Policymakers would do well to consider carefully the pros and cons of technology-specific regulation, and consider as an alternative setting the goals and letting the market find the least-cost route to meeting those goals. H
Paul Komor is a Lecturer in the Environmental Studies Program at the University of Colorado Boulder and a senior adviser at E SOURCE, a Boulder-based energy research firm. Endnotes 1. R. Wiser, C. Namovicz, M. Gielecki, and R. Smith, “Renewable Portfolio Standards,” Lawrence Berkeley National Laboratory, LBNL-62569, April 2007. Available at http://eetd.lbl.gov/ea/EMS/ 2. This estimate, and all ¢/kWh estimates in this paper, is a levelized cost. This estimate assumes $7/watt first cost, 15 year lifetime, 5% discount rate, 26% capacity factor, and 0.1 ¢/kWh O&M cost. 3. California Institute for Energy and the Environment (CIEE), Renewable Energy Transmission Initiative (RETI), Phase IA Final Report, April 2008. Available at www.energy.ca.gov. 4. Wind costs from US Department of Energy, Energy Efficiency and Renewable Energy (EERE), Annual Report on US Wind Power Installation, Cost, and Performance Trends: 2007, May 2008. Available at http://eetd.lbl.gov/ ea/EMS/ 5. California Institute for Energy and the Environment (CIEE), April 2008.
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/A<!D)3(QP(FHD3-<Q
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limate change is close to the top of President Obama’s agenda. During the presidential campaign, he was quite specific about how he would rein in greenhouse gas emissions that contribute to climate change: cap-and-trade with full auctioning of permits. Cap-and-trade has become the favored way to reduce emissions. But there is another perspective, as articulated by the columnist George Will: “Cap-and-trade…is a huge tax hidden in a bureaucratic labyrinth of opaque permit transactions.”1 Where is the truth? Is cap-and-trade really a disguised tax? Or is the word “tax” so reviled in modern American politics that anything that costs money gets labeled as a tax? Although cap-and-trade has moved into the popular lexicon, it is important to remember exactly what it is without its
common connotations. Under cap-andtrade, the legislature stipulates an overall level of emissions (the cap) and a design for a market to determine which polluters emit what. The cap of so many tons of emissions overall is translated into allowances. If 10 million tons of emissions is the goal in 2010, then 10 million allowances will be issued. Typically, at the end of the year there is a reckoning whereby each polluter reports annual emissions and surrenders the requisite number of allowances (each allowance allows 1 ton of emissions). These allowances can be traded—bought and sold; hence the term cap-and-trade. The EPA sets a cap and issues allowances to cover the cap; trading occurs, and then at the end of the year a reckoning occurs between actual emissions and allowances held.
There are several real advantages to a cap-and-trade system. The primary advantage is that the trading of allowances generates a price for allowances that can be interpreted as a price on pollution. If a polluter emits one less ton, he will be able to use one less allowance, saving the money associated with the price of the allowance—there is an opportunity cost of emitting. Once polluters see that reducing pollution saves money, their incentives will be aligned with society’s goals. Another advantage of a cap-and-trade system is that the quantity of pollution is known (and equal to the cap). What is not known is what the price of the allowances will be; in fact, the price can fluctuate substantially (wide fluctuations were observed in the Los Angeles RECLAIM market and even in the national sulfur
HARVARD COLLEGE ECONOMICS REVIEW
allowance market). This is why some capand-trade programs involve a price ceiling (and even a price floor).2 A more subtle advantage of a cap-and-trade system is that the pollution price is induced by a market, not chosen by a bureaucrat. Although the cap is chosen by government, that one step removal from the price can provide some insulation from political pressure. One of the biggest issues in designing a cap-and-trade system is how the allowances should be allocated. Under the sulfur allowance system, established by the 1990 Clean Air Act Amendments, allowances are distributed at no cost to polluters, based on their historic emission levels. This has been criticized as a “give away” and by economists as generating “tax interaction” inefficiencies. Under the plan President Obama advocated, carbon allowances would be auctioned to the highest bidder. This would generate enormous revenue for the government, some of which would be used to help those most adversely affected by the elevated cost of carbon-intensive goods (for instance, the poor who must drive long distances to work). It is in fact this revenue that has prompted people like George Will to label cap-and-trade as simply a carbon tax in disguise. Of course the revenue from auctioning the allowances can be used to offset other taxes, effectively making the cap-andtrade system revenue neutral. What is the difference between a tax and a revenue-raising cap-and-trade? The primary purpose of a tax is to raise revenue; a secondary purpose is to modify incentives (perhaps even perversely). The primary and fundamental feature of a cap-and-trade system is that it induces a price on pollution, providing an incentive for polluters to innovate and clean up their act. A secondary feature is that revenue is collected. That secondary feature can be neutralized by reducing taxes elsewhere in order to make the program revenue neutral. This is why a cap-and-trade system is not the same thing as a tax. Interestingly, Rep. John Larson (Democrat from Connecticut) has introduced a carbon tax that is not a tax in the conventional sense.3 Rep. Larson’s proposal is that carbon be taxed at a modest level that will be slowly raised over time. Under his proposal, virtually all income from the carbon tax would be offset by reduc-
tions in the payroll tax. As an example, most wage earners pay Social Security taxes (roughly 14% of wages, including the employee and employer shares). Under Rep. Larson’s plan, income from the carbon tax would be used to reduce the Social Security tax rate from 14% to some lower number (whatever is possible, given the revenue from the carbon tax). Advantages of lower payroll taxes would be offset by higher prices of carbon-intensive goods.4 Those of us who find it easier to move away from carbon-intensive consumption could even come out ahead. Thus Rep. Larson’s carbon tax has as a primary purpose the introduction of incentives to polluters to reduce emissions. Since there is no net revenue collected by the tax, its secondary purpose of revenue
raising is absent. So this proposal should probably not be called a tax at all—perhaps a carbon incentive would be a better term. Proponents of cap-and-trade are focusing on the primary purpose of cap-andtrade: to make carbon emissions more expensive for polluters and thus provide the strongest possible incentive to reduce carbon emissions. Opponents of cap-and trade are focusing on a secondary aspect of some cap-and-trade systems: the revenue that is generated from the allocation of allowances. This suggests that revenue-neutral cap-and-trade, which cannot be labeled a tax, may have the easiest time making it through the tough political obstacles it faces. H
Charles D. Kolstad is a Professor with the Department of Economics and Bren School of Environmental Science & Management at the University of California, Santa Barbara. References 1. George Will, “Cap-and-trade an unjustified tax” (May 31, 2008). 2. A price ceiling is implemented by allowing the EPA to sell extra permits at the pre-determined price ceiling; a price floor involves the EPA always being willing to buy up permits at the pre-determined floor price. 3. John M. Broder, “House Bill for a Carbon Tax to Cut Emissions Faces a Steep Climb,” NY Times (March 8, 2009). 4. This is discussed in more detail in Grainger and Kolstad (2009): “Who Pays for a Carbon Tax?” (available on www.ckolstad.org).
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SPRING 2009
7<!)7Q!<(BOD<7?(<7Q(3)>(AHSD)
-."(3845%;#%&'"(3800',(/.%;# Developing business approaches that balance cost, customer service and carbon emissions to achieve high performance
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upply chain executives face ongoing pressure from their customers and from regulators to reduce carbon emissions from energy consumption and run "greener" operations. While the impression persists in many organizations that implementing more sustainable processes and technologies will be costly— and should therefore be postponed during the current economic circumstances—Accenture's recent High Performance Supply Chain research1 has suggested that there can be a positive business case for integrating sustainability within supply chain operations. We interviewed 245 supply chain executives across diverse industries and all global regions to identify the performance characteristics of supply chain organizations that are leaders in both cost effectiveness and customer service. We also asked several questions about their performance against key carbon management measures. The result? We found that the best-performing organizations in cost and service terms are typically also ahead of the curve in implementing sustainability across all parts of their end-to-end Chart 1
0%
20%
40%
60%
supply chain (Chart 1).
Key Findings Masters (organizations that achieved top quartile performance on both cost and service in 2008) unsurprisingly emphasized indicators of cost effectiveness and invested in improving service levels. Yet they also recognized the business imperative of sustainability in a world where 86% of consumers are either "extremely" or "somewhat" concerned by climate change and where energy cost volatility is expected to be a prolonged feature of the economic landscape.2 Masters are taking practical and cost effective steps to address their carbon impact through reduced energy consumption. They are not just looking at the highly visible "last mile" of distribution, but are taking an integrated view through their entire supply chain (Chart 2). Our findings show that masters are: • Actively managing down energy consumption to reduce their carbon footprint • Seeking the most pragmatic solutions to their environmental challenges • Choosing systems and processes that offer the best possible return on capital Masters • Benefiting from Average Performers an integrated view of Laggards sustainability across the supply chain • Designing products with sustainability in mind 80% 100% Masters recognize
that now is the time to take action on carbon emissions. With the renegotiation of the global climate change policy framework during 2009, there will be numerous policy developments that will have an effect on the supply chain. Governments have begun to pass laws that mandate carbon emission reductions and the expectation is that the cost of emitting pollutants will only grow. Consumers and shippers alike are also picking up on the climate change agenda. Globally, 59% of consumers would be willing to pay more for a product that helped reduce carbon emissions.3 71% of business executives are ready to take action on climate change4—action that will inevitably affect the supply chain. Three-Dimensional Thinking Masters are creating high-performance supply chains by maximizing performance across three measures to drive value: • Cost efficiency • Quality of service • Sustainability Simultaneously addressing all three measures can create opportunities for short-term profit improvement through operating-cost reduction and cash-flow augmentation. In the medium term, the approach can help achieve the strategic opportunities that come from linking investments in customer service with more sustainable business practices. Where a business case traditionally would have looked to find the best balance between cost effectiveness and quality of service over the lifetime of the invest-
Chart 2 - Masters take an integrated view of their entire supply chain Sustainability Integrated Across the Product Lifecycle Research and Development
Sourcing and Procurement
Manufacturing
Distribution and Selling
Consumption
Changing Customer Expectations Integrated into Decision-Making
End-of-Life and Disposal
HARVARD COLLEGE ECONOMICS REVIEW
Chart 3 - Masters apply a threedimensional approach to business case development 10
Service Quality
8 6 4 2 0
Cost-Effectiveness
Sustainability
As-Is To-Be
ment, Accenture suggests that masters are increasingly likely to develop a more sophisticated, three-dimensional business case to assess the value of supply chain projects (Chart 3). Here, return on investment can be optimized by considering the sustainability improvement from a project in addition to the cost and service implications. End-to-End Supply Chain Visibility To help achieve high performance across each of the three dimensions, masters take an integrated view of all aspects of their supply chain. By leveraging superior visibility up and down the entire supply chain, they can achieve increased energy efficiency and reduce carbon emissions by aligning along common goals and making better-informed executive decisions. Around 30% of masters routinely involve fulfilment considerations within their research and development processes, compared to only around 15% of the lag-
gard group (organizations that occupied the lower quartile in their performance in 2008). Masters are also twice as likely to model and actively manage their carbon footprint across all areas of their businesses and more commonly have a specific focus on reducing environmental impacts through product lifecycle management (Chart 4). Pragmatic View of Integrated Sustainability Masters select the most cost-effective and straightforward sustainable supply chain solutions. In their warehouse operations, masters are about 30% more likely than the laggards to implement a pragmatic energy consumption reduction solution, such as the simple introduction of more natural lighting to a warehouse or production facility. They are also more likely to implement the use of energy efficient lighting, as well as to enact a recycling program (Chart 5). Conversely, they are not particularly likely to adopt costly and more complex solutions such as solar walls or heat exchanging systems. In transportation, the same trend is seen: masters make significant investments in cost-effective and environmentally-friendly solutions such as streamlining or preventative maintenance. They are much less willing to invest in areas that bring higher commercial risk, such as switching to biofuels or purchasing hybrid fuel vehicles (Chart 6). A key characteristic of supply chain mastery is therefore a strong focus on the return made from an investment in carbon emission reduction, as masters are
much less likely to invest in those green technologies that have long payback periods or offer low returns on the investment. Anticipating Decarbonization Masters recognize that reducing consumption of fossil fuels in the supply chain is the most significant lever of carbon emissions reduction. In a sector where fuel purchases can range from approximately 5% to 35% of the total cost base, masters appreciate that reducing consumption can also substantially reduce operating expenses. Many supply chain organizations were significantly affected when oil prices spiraled up as high as $143/barrel in July 2008. Yet others, such as those that hedged at higher prices, were affected when prices fell back sharply. Decarbonization allows organizations to reduce their exposure to this energy price volatility. Additionally, reducing fossil fuel consumption allows masters to pre-empt future changes in legislation, such as potential environmental taxes, thus reducing the significant burden that comes with urgent change close to legal deadlines. For example, Accenture estimates that the implementation of the European Union's Emissions Trading Scheme in the aviation sector in 2012 will result in a 2% rise in the cost base of airlines if it is fully implemented at current spot-market prices for fuel and carbon. For masters, supply chain flexibility can be a valuable tool to both leverage reductions in carbon emissions and simultaneously exceed their customers' expectations. In their transportation operations,
Chart 4 - Masters leverage superior visibility in their supply Chart 5 - Masters implement pragmatic solutions in their chain warehouses 80%
35%
Masters Laggards
30%
Masters
70%
Laggards
60%
25%
50%
20%
40%
15%
30%
10%
20%
5%
10%
0% Fulfillment Routinely Involved in R&D Process
Specific Focus on Product Lifecycle and Inventory
Actively Model and Manage our Carbon Footprint
0% Use of Natural Light
Recycling
Use of Energy Efficient Lighting
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Chart 6 - Masters invest in proven, cost-effective transport technologies 30%
Chart 7 - Daily evolution in oil prices over the longer term Oil Price Oil Price, Adjusted for Inflation
Masters Laggards
20%
10%
Spot Price (WTI Crude, Cushing) in US $ / BBL
26
160 140 120 100 80 60 40 20
0%
1986 87 88 89 90 91 93 94 95 96 97 98 00 01 02 03 04 05 07 2008
Streamlined Vehicle Design
Hybrid Engined Vehicles
Chart 8 - Masters use flexibility to help achieve more sustainable operations
The High Perforthe supply chain, then consider mance Supply carbon as an integral part of the Chain study sugbusiness case for projects 40% Masters gests that there 4. Maximize return on investment in Laggards are five key steps the supply chain by adopting prag30% to help integrate matic solutions to environmental a sustainability issues and considering the total strategy within a cost of ownership 20% high-performance 5. Selectively deploy the most costsupply chain: effective, proven technologies 1. Develop an Many organizations are not yet deploy10% integrated view ing these steps in a systematic manner; of the end-to-end however, those that were identified as supply chain masters in our research are at least part0% Can Manually Re-route Use of Automated 2. Measure per- way through the journey. The organizaTransport While Telematics or GSM formance against tions that take the lead in developing inShipment is Underway Tracking the three headline novative supply chain strategies and then measures of cost- proactively embed carbon management our analysis shows masters to be more effectiveness, customer service within their operations will most likely able to re-route their fleet while making and sustainability improvement stay ahead on supply chain performance deliveries, thus eliminating unnecessary 3. Calculate the carbon footprint of over the longer term. H miles; over 30% of masters are capable of performing real time transportation opti- Narendra Mulani is the global managing director for Accentureâ&#x20AC;&#x2122;s Supply Chain Management mization, compared to only around 20% practice. Mulani has worked across a diverse set of retail, technology and manufacturing and of the laggards. distribution clients. Recognized as an industry leader in the field of supply chain management, Masters also appear in our research Narendra has presented at numerous industry conferences and has authored articles in the Wall to be twice as likely as the laggard group Street Journal, Harvard Business Review, Outlook Journal, Achieving Supply Chain Excellence to use automated data systems in their through Technology, Supply Chain Management Review, and The Journal of Consumer Research. fleet; these are important tools in pro- He recently led a research project with the World Economic Forum to identify and quantify opmoting efficient driver behaviors through portunities to reduce supply chain carbon emissions. Seb Hoyle is a Manager within Accentureâ&#x20AC;&#x2122;s driver feedback and training. These types Supply Chain Management practice. Based in London, England, Seb works with clients across of practical action are helping masters to the freight transportation, consumer goods and retail sectors. With previous operations experisimultaneously shift to lower carbon plat- ence in the transportation and waste management sectors, he is an acknowledged expert on the forms and reap business benefits. economics and policy implications of supply chain carbon emissions. He has recently contributed to articles in the Financial Times and The Economist, as well as supply chain journals European Implementing A Sustainable Supply Supply Chain Management and The Manufacturer. Chain As Accenture's research shows5, high Endnotes performance businesses are taking practi- 1. Accenture, The High Performance Supply Chain Study, 2008. Published at www.accenture.com. 2. Accenture, End-Consumer Observatory on Climate Change, 2009. Published at www.accenture.com. cal actions to embed sustainability mea- 3. Accenture, End-Consumer Observatory on Climate Change, 2009. Published at www.accenture.com. sures, such as energy efficiency, within 4. Accenture, Executive Survey on Climate Change, 2008. Published at www.accenture.com their day-to-day supply chain operations. 5. Accenture, The High Performance Supply Chain Study, 2008. Published at www.accenture.com
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luctuations in the price of crude oil have been held responsible for developments in key macroeconomic variables such as real GDP and inflation. Given that crude oil is a basic input to production, supply-side considerations indicate that a rise in oil prices would reduce output (except for the energy sector) and hike prices. At the same time, in the event of oil price hikes, aggregate demand would normally fall in oil importing countries and rise in oil exporting countries. Higher energy costs are expected to raise inflation and to reduce real output in oil importing countries. In oil exporting countries, the favorable terms-of-trade effect generated by rising oil prices would be partly offset by the induced appreciation in the exchange rate (the so-called “Dutch disease”). Econometric evidence has largely confirmed the previous theoretical predictions. The first empirical studies, which were carried out for the United States, showed a linear negative relationship between oil prices and real economic activity. This relationship lost significance in the mid-1980s, as the oil price declines of the second half of the 1980s induced smaller expansionary effects than predicted by the then existing (linear) models. This led to the introduction of non-linear specifications to analyze the connection between oil shocks and the macroeconomy. The four leading non-linear models have been developed by Mork (1989), Lee et al. (1995), Hamilton (1996), and Hamilton (2003). These models have outperformed linear
2009d) conclude that the scaled model is the best-performing among G7 economies. This specification controls for the time-varying conditional variability of oil prices, which suggests that, in addition to the magnitude and sign of oil price movements, one must consider the context in which the changes occur. For instance, in an environment of predictable oil price developments, the scaled model foresees that an oil shock would exert larger macroeconomic effects than if prices were initially volatile. For large economies, oil prices should not be a priori regarded as exogenous. Barsky and Kilian (2004) warn against doing so, and Jiménez-Rodríguez and Sánchez (2005) report block-exogeneity results in favor of bidirectional causality between oil prices and macroeconomic variables. Intuitively, large macroeconomies are seen to influence, as well as be influenced by, oil prices.
models in capturing the macroeconomic effects of oil prices. The asymmetric specification (Mork, 1989) distinguishes between the effects of positive and negative changes in oil prices. In the scaled approach (Lee et al., 1995), the relevant oil variable controls for the conditional variance of the rate of change in oil prices from a non-linear representation —more specifically, AR(4)-GARCH(1,1). The net model (Hamilton, 1996) defines the oil price variable as the percentage by which oil prices exceed—if at all—the previous year’s maximum value. Finally, the net3 model (Hamilton, 2003) is a variant of the previous one that considers a three-year instead of one-year horizon. The most common explanation for non-linear effects on real output points to inter-sectoral adjustment costs that intensify the unfavorable consequences of rising oil prices. On the basis of statistical criteria, Jiménez-Rodríguez and Sánchez (2005, 2009b,
Table 1: Forecast Error Variance Decompositions real GDP Economies
inflation
after 1 year
after 2 years
after 3 years
after 1 year
after 2 years
after 3 years
Euro area
6.0
9.1
9.6
10.1
6.7
5.7
France
6.0
8.7
9.0
16.1
12.3
10.7
Germany
1.0
1.9
2.3
3.1
2.6
2.5
Italy
5.6
9.8
10.8
16.6
10.0
8.5
United Kingdom
3.2
5.2
5.8
14.0
13.3
13.6
Source: Jiménez-Rodríguez and Sánchez (2009a). Note: Entries are fractions of each variable's variance attributed to oil price shocks using the scaled specification.
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France
Euro area 1.5
2.0 1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0 -2.5 1972
1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0 1972
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UK 5.0 4.0 3.0 2.0 1.0 0.0 -1.0 -2.0 -3.0 -4.0 1972
1987
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US 4.0 3.0 2.0 1.0 0.0 -1.0 -2.0
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-3.0 1972
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F ig. 1. Historical decompositions of real G DP . (
1975
Actual;
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C ontribution of oil prices)
Assessing the impact of oil price shocks France
Euro area 1.5
2.0
1.0
1.5 1.0
0.5
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-0.5
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-1.0
-1.0
-1.5 1972
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-1.5 1972
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Germany 4.0
1.0
3.0
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2.0
0.5
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6.0
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-0.5
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-1.0
-4.0 -6.0 1972
1990
Italy
1.5
-1.0 1972
1987
-1.5 1975
1978
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1984
1987
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-2.0 1972
2002
F ig. 2. His torical decompos itions of inflation. (
Actual;
The empirical literature has analyzed the macroeconomic impact of oil prices. In a recent study, Jiménez-Rodríguez and Sánchez (2009a) report such effects on both economic activity and inflation for major G7 countries. Variance decompositions show that oil prices are a considerable source of variability in output and inflation (Table 1). Oil prices make a contribution of some 5% to 9% to real GDP variability in most cases. Oil prices appear to have had a milder output effect in the United States and United Kingdom compared with the euro area (except for Germany). Turning to inflation, the contribution of oil disturbances ranged from 6% to 14%, with a small-
1975
1978
1981
1984
1987
C ontribution of oil prices )
er role in the United States and especially Germany than in the rest of Europe. For the case of Japan, Jiménez-Rodríguez and Sánchez (2009d) report that oil disturbances explain a larger share of inflation variability than output variability. These shocks’ contribution to inflation hovered around 10% in the first two years, but were responsible for about 3% of industrial production variability after the first year and 6% at the end of the second year. Based on impulse response analysis, one can study the odds that oil disturbances induce a mix of higher inflation and output losses—that is, stagflation. Jiménez-
Rodríguez and Sánchez (2009c) find strong evidence of oil-induced stagflation in major G7 economies looking at conditional co-variances between inflation and output impulse responses to the shock (drawing on Den Haan and Summer, 2004). Other Considerations Here we analyze three issues that have attracted research attention over recent years —namely, (i) the question of whether the macroeconomic effects of oil price changes have decreased over time; (ii) the sectoral dimension of these effects; and (iii) the analysis of transmission channels—including monetary policy reactions—relating to the oil shocks. Concerning the first point, JiménezRodríguez and Sánchez (2009a) investigate the effects of oil shocks across phases of high oil prices. They do so by means of historical decompositions showing the contribution of oil prices to real GDP and inflation over time (Figures 1 and 2). For each of the latter two variables, we reproduce the actual series and the contribution of oil disturbances to the forecast, both computed as percentage deviations from a 4-quarter-ahead base projection. The five shaded areas correspond to high oil price periods. The response of real GDP is much more visible during the periods of high oil prices of the mid-1970s and early 1980s. Oil prices appear to have raised inflation in several economies, not only in those two episodes, but also at the time of the IraqKuwait conflict in 1990. It is also possible to observe that, in some economies, inflation rose following the higher oil prices of 19992000 and also over more recent years in the experience of the United States. Turning to the sectoral dimension of oil price effects, Lee and Ni (2002) show that oil price shocks have a variety of negative effects on US industries, with oil shocks mostly reducing the supply of oil-intensive industries and the demand of many other industries. More recently, Jiménez-Rodríguez (2008) reports the existence of homogeneity of (negative) industrial output responses across industries in Italy and the AngloSaxon countries (the United Kingdom and the United States), as well as the existence of cross-industry heterogeneity in three of the four euro area countries considered (France, Germany, and Spain). She also shows evidence of heterogeneity of output responses across the four euro area economies (France, Germany, Italy, and Spain) and evidence of homogeneity in the Anglo-Saxon countries.
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With regard to transmission mechanisms, the link between oil shocks and monetary policy gained prominence with the US study by Bernanke et al. (1997). The authors show impulse response evidence that, at the time of the first oil price shock in the first half of the 1970s, this disturbance did not contribute much to the sharp contraction observed in real output. They then propose a counterfactual exercise in which the Fed would adopt a policy of holding the Fed Funds rate constant irrespective of oil price movements. The resulting trajectory of real GDP would have been much less contractionary, inferring that oil-induced recessions, in principle, could have been prevented, at the cost of higher inflation, by simply stabilizing the Fed Funds rate. Hamilton and Herrera (2004) have questioned this implication by showing that it would take an implausibly large monetary expansion to keep the Fed Funds rate fixed at the level needed to avoid output losses. The analysis of various transmission channels relating to oil price disturbances has recently been done with dynamic stochastic general equilibrium (DSGE) models. Despite the renewed interest in DSGE research dealing with oil shocks, available models remain relatively stylized in terms of how oil price effects impinge on the domestic economy as well as its cross-country spillover implications. For example, Blanchard and Gali (2007) start by documenting that the oil price hikes of the 2000s have had mild effects on inflation and economic activity in major advanced economies by historical standards. By means of a calibrated DSGE model, they attribute this to a combination of four different circumstances, namely, (i) “good luck,” as implied by the occurrence of other events of a benign nature, (ii) more efficient energy utilization, (iii) enhanced labor market flexibility, and (iv) more effective monetary policy management. Another DSGE study is Sánchez’s (2008) estimated model for the euro area, which allows for a role of oil use in production as well as endogenous price mark-ups. He reports evidence of "countercyclical" mark-ups; while this amplifies the contractionary consequences of an oil price hike, the additional effect is estimated to be relatively small. He also finds that the importance of disturbances affecting monetary policy and oil prices has dropped in the period since 1990, which attests to the higher predictability of policy and the reduction in the persistence and—to a smaller extent— variability of oil shocks.
Conclusions The empirical literature has studied the effects of oil price shocks on industrialized economies. There is compelling evidence that the consequences of oil prices on real economic activity and inflation are non-linear. Jiménez-Rodríguez and Sánchez (2005, 2009b, 2009d) have detected a prominent role for one specific non-linear model, namely, the scaled specification. By controlling for the time-varying conditional variability of oil price disturbances, the context in which oil price fluctuations occur is allowed to play an important role. In this regard, the scaled model predicts that oil shocks should induce wider macroeconomic fluctuations when they take place in an initially stable price environment. The role played by oil price disturbances appears to have declined in importance since the first half of the 1980s. For instance, Jiménez-Rodríguez and Sánchez’s (2009a) historical decompositions show that the
contractionary consequences of oil prices are particularly visible during the oil crises of the mid-1970s and the early 1980s. Inflationary pressures are apparent in several countries not only in these periods, but also in later high oil price episodes: during the 1990 spike (related to the Iraq-Kuwait war), and more recently over 1999-2000 and—in the United States—from 2002 onwards. The reduced macroeconomic impact of oil price disturbances should not be seen as implying that this area of analysis has become irrelevant. Oil shocks continue to affect the economy, and the reasons underlying the smaller role played by them remains a not fully understood issue. Attesting to the continued interest in the economic consequences of oil prices are recent developments in fields, such as sectoral effects and transmission channels. This ongoing research should help greatly improve our comprehension of the ways oil shocks affect advanced economies. H
Rebeca Jiménez-Rodríguez is a professor at the Department of Economics at the University of Salamanca Campus Miguel de Unamuno. Marcelo Sánchez works in the Euro Area Macroeconomic Developments Division at the European Central Bank. References Barsky, R., Kilian, L. (2004) Oil and the macroeconomy since the 1970s, Journal of Economic Perspectives, 18, 115-134. Bernanke, B., Gertler, M., Watson, M. (1997) Systematic monetary policy and the effects of oil price shocks, Brookings Papers on Economic Activity, 1, 91-142. Blanchard, O., Gali, J. (2009) The macroeconomic effects of oil shocks: Why are the 2000s so different from the 1970s?, in J. Gali and M. Gertler (ed.), International Dimensions of Monetary Policy. Chicago, University of Chicago Press. Den Haan, W., Summer, S. (2004) The comovement between real activity and prices in the G7, European Economic Review, 48, 1333-1347. Hamilton, J. (1996) This is what happened to the oil price-macroeconomy relationship, Journal of Monetary Economics, 38, 215-220. Hamilton, J. (2003) What is an oil shock?, Journal of Econometrics, 113, 363-398. Hamilton, J. (2008) Oil and the macroeconomy, in S. Durlauf and L. Blume (eds.), New Palgrave Dictionary of Economics and the Law, 2nd ed. Hamilton, J., Herrera, A. (2004) Oil shocks and aggregate macroeconomic behavior: The role of monetary policy: Comment, Journal of Money, Credit, and Banking, 36, 265-286. Jiménez-Rodríguez, R. (2008) The impact of oil price shocks: Evidence from the industries of six OECD countries, Energy Economics, 30, 3095-3108. Jiménez-Rodríguez, R. (2009) Oil price shocks and real GDP growth: Testing for non-linearity, The Energy Journal, 30, 1-24. Jiménez-Rodríguez, R., Sánchez, M. (2005) Oil price shocks and real GDP growth: Empirical evidence for some OECD countries, Applied Economics, 37, 201-228. Jiménez-Rodríguez, R., Sánchez, M. (2009a) Oil shocks and the macroeconomy: A comparison across high oil price periods, Applied Economics Letters (forthcoming). Jiménez-Rodríguez, R., Sánchez, M. (2009b) Oil price shocks and business cycles in major OECD economies, mimeo. Jiménez-Rodríguez, R., Sánchez, M. (2009c) Oil-induced stagflation: A comparison across G7 economies and shock episodes, mimeo. Jiménez-Rodríguez, R., Sánchez, M. (2009d) Oil price shocks and Japanese macroeconomic developments, mimeo. Lee, K., Ni, S., Ratti, R. (1995) Oil shocks and the macroeconomy: The role of price variability, The Energy Journal, 16, 39-56. Lee, K., Ni, S. (2002) On the dynamic effects of oil price shocks: A study using industry level data, Journal of Monetary Economics, 49, 823-852. Mork, K. (1989) Oil and macroeconomy when prices go up and down: An extension of Hamilton's results, Journal of Political Economy, 97, 740-744. Sánchez, M. (2008) Oil shocks and endogenous markups: Results from an estimated euro area DSGE model, ECB Working Paper No. 860.
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N)H!N)(3P(-HDD)S
)#"*+,(%#2(5."()#J;*9#6"#5G ?2"#5;@,;#+(H8*(N9%'4 Moving from "buzz words" to real risk-benefit analysis
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resident Obama’s initiatives provide unprecedented support for green energy policy. These policies will more than offset negative effects on the environment resulting from the nation’s present severe economic downtown. The effectiveness of these polices differs from case to case. Crafting policies that relate to our underlying goals is difficult at best, but it is needed more than ever in present times. Where Do We Stand? To review major clean energy sources: wind and solar power utilization depend in part on electric utility demands driven by overall electricity use. Higher interest rates and demand downturns due to the recession are dampening electricity demand. Florida Power and Light has reduced wind power investments by 500 megawatts, and Duke Energy has dropped $50 million of solar power projects (The Economist, “Gathering Clouds,” November 6, 2008). State regulations favoring clean technologies are a plus factor for wind and solar, and Obama’s measures will magnify this effect. Tax credits and loan assistance for alternative energy supplies can increase their market competitiveness and foster private R&D on them. But whether Congress will strengthen existing solar and wind inducements remains to be seen. The hiatus in new home construction is dampening increases in the introduction of green technologies that conserve energy, conserve resources and reduce carbon footprints. The recession may have similar deleterious effects because of declines in commercial construction. But the Obama emphasis on green retrofitting of existing structures should lead to immediate public sector effects as federal funds are channeled into public buildings and transportation infrastructure, much of it to state governments starved for funds. Realizing the huge potential in retrofitting private buildings will require grant programs for individuals, tax credits and code changes— whose impacts will come about only after a
greater lag. On the supply side, investments by manufacturers of green technology equipment depend heavily on venture capital. Since venture capitalists are not among the mainstream providers of the nation’s credit, they could be affected less than others by the financial crisis. Some green technology firms are adversely affected, not by the credit crunch as such, but by price changes reducing the profitability, for example, of ethanol projects and of CNG expansion integral to the scratched T. Rowe Pickens plan (The Economist, ibid.) On net, “over 90 percent of venture capitalists and investors expect investment in green technology to increase in 2009” (Green Tech, “Credit crunch pinching clean-energy sector,” September 18, 2008). Whether Congress will extend solar and wind subsidies to clean coal and nuclear energy is moot. Clean coal technologies have not been developing, quite apart from the financial crisis, because conditions for it to enter the marketplace have not been met. The latest federally sponsored pilot clean coal project in southern Illinois was cancelled by the Bush administration because excess costs were encountered. Given President Obama’s repeated calls during his campaign for more reliance on clean coal, there could now be willingness to reinstate it—however, this implies greater government spending. Nuclear power, while environmentally green in the sense of having no harmful air emissions, is impeded by start-up expense and regulatory uncertainty, as well as controversy over nuclear waste, proliferation and safety. Candidate Obama did not take nuclear power “off the table.” While there is enthusiasm for nuclear power in some quarters of the public, it has not had a high profile as an issue for President Obama. Congress will have a say in the acceptability of the Obama carbon cap and trade plan to induce utilities and others to reduce carbon footprints, in part through sequestration of carbon in caves and underground
aquifers. Debate is hung up in part on the initial allocations of emissions rights and how they will be paid for, but even more so on the simple reluctance to bear a new tax. The political situation makes the future of cap and trade highly uncertain in view of the financial burdens, which initially fall on business but will inevitably be passed on to consumers. Cap and trade has slipped off the table as an Obama priority, at least for this year. The Obama goals for mileage standards and plug-in cars have not yet passed a reality test. Other options for the future include smart grid proposals and possibilities for more recycling, whose quantitative effects are unknown. Many advances remain tantalizingly just over the horizon, as they have for many years. Still, some progress is being made. Public R&D projects in the national labs in partnership with private companies are contributing to basic advances. Further progress will depend on support and effectiveness of this research, which relies largely on an uncertain future political climate. Another major source of uncertainty is the international price of oil, which influences clean technology adoption more powerfully than any US policy. Getting Real Clearly nothing approaching nirvana is at hand, nor is the future as rosy as sometimes depicted. Despite growth in usage and decline in costs, wind and solar remain more costly than coal and gas, as reflected in the fact that they still account for only about 2% of US energy use. Anticipated costs of the much discussed plug-in electric automobile remain perhaps $15,000 to $20,000 greater than gasoline powered automobiles and would require subsidies far greater than anything witnessed for wind and solar power, leading one to question the realism of projections of substantial sales of them. All this does not mean we should give up. Quite the contrary, there is a need to
HARVARD COLLEGE ECONOMICS REVIEW
get below the surface of stated goals of “energy efficiency” and a “clean environment,” which have become little more than buzz words. The goals need to be distinguished more intelligently and precisely, so as to focus our efforts effectively on what we care about and avoid wasting effort on things that matter less or cost more than they are worth. Energy Efficiency: Sometimes Yes, But as a General Rule, No Given the climate of enthusiasm for giving greater attention to energy, there is some danger of espousing an “energy theory of value.” Using this approach, policies are evaluated solely in terms of kilowatts or some other physical measure of energy saved. The “energy theory of value” is reminiscent of the 19th century “labor theory of value,” which measured the value of any good as the number of labor hours used in its production. According to the labor theory of value, the skill level of labor used makes no difference, non-labor inputs such as capital and land make no difference, and the natural environment has no value because no labor is required to produce it. Because of such absurdities, the labor theory of value was abandoned long ago. If today we get carried away with “energy efficiency”, we run somewhat similar dangers. We should be looking at “total efficiency,” which examines unit per output per unit of all inputs including not only energy but also labor, capital and any other inputs that are priced in the marketplace reflecting their opportunity cost in terms of alternative uses. Useful output includes the value of the outputs for which the energy is used. Energy is a more important input for some equipment than others, such as an industrial boiler whose chief purpose is to produce energy, as opposed to a refrigerator where resources must also be devoted to insulation and consumer amenities. The December 2007 report by McKinsey & Company, The Untapped Energy Efficiency Opportunities in the US Industrial Sector, has a great deal of useful information, but it would be more useful if put in the context of overall efficiency. The increase in energy efficiency for any one appliance may be a fair representation of progress in overall well-being obtained from that type of appliance, if the other inputs do not change markedly, as may be the case for some tech-
nical advances. Still, “energy efficiency” is at best a crude measure of the contribution of energy-using activities to overall wellbeing. Energy Is Not Our Ultimate Aim The more serious problem in being preoccupied with “energy efficiency” is that we do not really care about energy at all. What we really care about is the effect of energy on things we value. As just noted, one of the things we care about is contributions of advances in energy to total efficiency. A primary reason we care about total efficiency is that it contributes to continued advances in general levels of living that have been enjoyed for the last 200 years as manifested in economic growth. The failure to distinguish between the contributions of energy to energy efficiency versus its contributions to total efficiency does not get at other things affected by energy that we care about, and indeed care about more urgently today than energy’s contribution to economic growth. Here again, energy efficiency is an inferior measure of what we care about and runs the danger of more seriously mixing up policy priorities. Some of the things we care about that are affected by, but are far from identical to energy, include: • Minimizing foreign dependence on oil • Global warming
• Environmental effects on health • Sustainability as a value Two facts condition the discussion of the relation of energy to these things we care about. First, oil accounts for about 40% of US energy consumption. It is used mainly for cars and trucks, although significant amounts are used on airplanes and industry. Second, the remainder of energy consumption is from coal, natural gas, nuclear and renewables and is used mainly to produce electricity. Oil Exposure of the US economy to shortterm economic disruptions, caused by disruption of foreign supplies, constitutes a risk not reflected in market prices paid for oil and provides motivation for government action to retard oil imports. The prospect of long-term rise in world oil prices gives further reason to reduce oil use and develop substitutes. Energy efficiency in the use of oil, such as that brought about by mileage requirements for automobiles, contributes to reducing oil consumption. Greater energy efficiency in hybrid, electric plug-in, and hydrogen cars is also helpful, enabling them to enter the marketplace, but here again energy is a blunt goal, since the determinant of success in the marketplace is overall efficiency considering all resources used in production, not just energy efficiency. It would be helpful to try to calculate
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dramatic increases in R&D on alternative vehicles are needed and remain a missing part of the discussion on what to do about foreign dependence.
what it is worth to the nation to reduce oil dependence and compare this worth with the effectiveness of different specific measures aimed at this goal. Similar criticisms apply to oil’s contribution to global warming, as well as oil’s tail pipe contributions to ozone and nitrogen oxide. In these cases, we properly concentrate on air pollution controls directly and do not count on energy efficiency to solve these problems. In spite of Presidential vows going back to Carter to eliminate foreign dependence, oil imports have continued to grow inexorably. There is widespread agreement in the economics profession that a tax on oil or gasoline is high on the list of effective ways to reduce foreign dependence. However, Congress and the American public show no signs of accepting this approach. Initiatives have centered instead on developing hybrids, electric vehicles and hydrogen cars to replace gasoline powered cars. The problem here is that these alternatives remain long shots. At present levels of R&D funding, it could be many years before any of these alternatives can do more than capture niche markets for the small minority of people who are willing to pay a substantial premium for “green” cars. Short of a return to $4.00 per gallon of gasoline, order of magnitude increases in R&D funding may be needed to substantially speed up progress in making alternatives to gas-guzzling automobiles an economic reality. Out-of-the-box analyses of really
Coal and Natural Gas Energy efficiency in the production of electricity would save on coal and gas and thus reduce their harmful effects. Somewhat perversely, public attention has focused disproportionately on direct controls on greenhouse gas emissions to the exclusion of considering the contribution of greater efficiency in electricity production to reducing air pollution from coal and gas. Renewables Wind and solar power are growing but optimistically are unlikely to reach even 4% of US power generation by 2025. The story is similar for other renewables. The public has revealed a preference for modest subsidies for renewable power, as reflected in existing legislation. These subsidies have been behind some of the recent solar and wind power expansion and have given incentives to undertake private R&D contributing to decreases in their cost of production. While unlikely to make much of a near term dent in greenhouse gas emissions from substituting electricity generation from non-polluting renewables for pollution-emitting fossil fuels, they have a marginal impact and could have promise for the far distant future making them worth pursuing. They also contribute to satisfying green preferences for sustainable production as a value in itself, though again, it will be many years before there is anything but a small effect. Nuclear Power Something close to a full-fledged debate on nuclear power has been taking place, though clouded by much emotion. A
strong case, which will surprise many, can be made for building new nuclear plants in the United States, something that has not occurred since the 1980s. While too expensive to enter the marketplace unaided, “learning by doing” and more favorable regulatory experience reducing risk premiums required for funding could make new nuclear plants beyond the first few competitive. The nimby problem of disposing of nuclear waste can be solved by leaving the waste in dry cask storage where generated at the site of the nuclear plant. The rest of the world has moved ahead with nuclear power with little hesitation, making fears of international weapons proliferation from US production largely a dead issue. A big advantage of nuclear power is that it has no air pollution effects. A tax on carbon emissions would alone be sufficient to instantly make nuclear power cheaper in the marketplace than coal or gas generation. Nuclear power could be the only path available for the United States to significantly reduce its greenhouse gas emissions. Green Buildings and Green Jobs The “green building” approach, as reflected for example in use of LEED certification of a bundle of green-oriented measure in a building, has been growing on its own and promises to grow more rapidly under the Obama administration through use of funds for green building purposes. While promising, the green building approach consists of a potpourri of individual measures whose benefits and costs remain to be evaluated. The “green jobs” approach also remains in lack of systematic evaluation or even clear definition. It often refers to encouraging employment in the manufacture of goods used in environmentally motivated measures. Even more so than for green buildings, green jobs measures need to be evaluated on a case by case basis. A Theme Running Through It A common theme above has been the stress on the desirability of moving from buzzwords to systematic benefit-cost analysis of individual measures. Evaluating what some of the more difficult-to-value non-market benefits of energy and environmental policies are essential to identifying good policy approaches. H
George S. Tolley is Professor Emeritus of Economics at the University of Chicago.
HARVARD COLLEGE ECONOMICS REVIEW
T<B)3()P(<O3-?7
<(Q;@@"*"#5(398*:"(9@(!"#"$%&'"( )#"*+,G(/9''%&9*%5;9# Collaborations provide solutions to socio-economic problems
E
nergy enables action. In this time of crisis, sustained energy is essential for acting forcefully and innovatively in confronting the multitude of problems facing society. Collaboration is a pivotal and powerful vehicle for mobilizing new combinations of resources and generating creative solutions for tenacious socio-economic problems. We are entering the Age of Alliances. The Nature of Cross-Sector Collaboration Let us begin with an examination of collaborations between businesses and nonprofit organizations. Such cross-sector interactions have been occurring for decades, most commonly as “philanthropic relationships,” in which nonprofits request and receive donations from companies. Such collaboration provides significant resources to the social sector, amounting to $306 billion in 2007. The benefit flow in this type of relationship tends to be largely one way, from the donor to the beneficiary. The flow is very useful, although not usually vitally important to either organization, and involves infrequent interaction and modest administrative demands. My research revealed that such relationships can evolve into more robust alliances. A second type or stage of collaboration is “transactional relationships” in which specific objectives, activities, and responsibilities are set forth for a set duration, other resources in addition to monetary donations are mobilized, the benefits are mutual, the importance increases, and the interactions intensify. One common form of collaboration of this type of relationship is deploying corporate volunteers to assist the nonprofit in specific activities. This collaboration has proven to be an effective way of attracting, motivating, and retaining employees. Cause-Related Marketing activities would also fall into this category. In Cause-Related Marketing activities, a corporation sponsors a nonprofit’s activities or a shared event, and the company’s reputation is enhanced via the explicitly publicized association with the nonprofit and its cause.
A third type of relationship, while less frequent, is an even more powerful form of alliance and is labeled as “integrative relationships.” In an integrative relationship, organizations’ missions, values, and strategies mesh, the strategic importance of the relationship increases, the interactions intensify and deepen, resources deployed become greater and more diverse, activities broaden and innovation abounds, and the managerial complexity expands. This integrative relationship looks more like an ongoing joint venture than a finite deal or project. Taken together, the three types of crosssector relationships constitute a continuum. Figure 1 depicts this “Collaboration Continuum” and some of the characteristics of each of the three types of relationships. It is important to emphasize that this is a continuum along which relationships can evolve, rather than be static categories. Consequently, different parameters that describe a collaboration can fall at different points along the continuum, with some characteristics noted in the Collaboration Continuum looking, for example, more like a philanthropic relationship, while others look more transactional or even integrative. Furthermore, nothing is automatic about the evolution along the Continuum. Movement is propelled by the
energy of collaboration that produces decisions and actions. Research by the Social Enterprise Knowledge Network (www. sekn. org) confirmed that these patterns also hold in Latin America. An even more complex form of collaboration referred to as “public-private partnerships” involves businesses, governments, and nonprofits and combines their efforts to address a problem that is of interest to and requires coordinated action by all. By increasing the number and different types of institutions, one magnifies the complexity of collaboration, but also increases the potential power of the cooperation by increasing the size and richness of the resources deployed. The Critical Elements of Powerful Collaborations Collaboration sounds nice, but building strategic alliances across sectors is not easy. Challenges include different organizational cultures, conflicting objectives, time consuming interactions, and competing demands for scarce resources. However, all the obstacles are superable. Our studies of effective cross-sector collaborations reveal the following as vital ingredients contributing to successful strategic partnering.
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Figure 1. The Collaboration Continuum Nature of Relationship Level of Engagement Importance to Mission Magnitude of Resources Type of Resources Scope of Activities Interaction Level Trust Managerial Complexity Strategic Value
Stage I Philantrophic Low Peripheral Small Money Narrow Infrequent Modest Simple Minor
Stage II Transactional
Stage III Integrative High Central Big Core Competencies Broad Intensive Deep Complex Major
Source: James E. Austin, The Collaboration Challenge (San Francisco:Jossey-Bass Publishing, 2000)
Alignment. The missions, values, and strategies need to be aligned. This does not mean complete congruency, but rather sufficient overlap that produces common ground and shared perspectives for working together closely. A shared purpose generates the energy for collaborating, and compatible interpersonal relations provide the cohesion. Like with a pair of shoes, even if they appear attractive, if the fit is not right, they will cause pain later. Value. Social purpose partnering is about generating value to the partners and to society. Each of the partners is likely to be seeking distinct benefits because of differences in their institutional needs and objectives. Companies can benefit, for example, through enhanced reputations that strengthen relations with consumers, employees, communities, and governments. Nonprofits can benefit through additional resources, reputation, skills, infrastructure, exposure, access to contacts, etc. Governments can benefit through access to complementary capabilities that improve implementation capacity and constituency engagement and support. In robust alliances, each partner is continually asking, “How can I create more value for my partner?” When all the partners share that focus, they create a virtuous circle of increasing value generation. The more value received, the greater the motivation for reciprocal effort. The key to generating value resides in leveraging the core capabilities of each organization. This means deploying for the partnership all those assets that make each organization successful in their own operations, such as special knowledge, technology, skills, relationships, infrastructure, reputation, products, and services. Money matters, but other resources may be even more valuable. For businesses, choosing
causes that are most relevant to their business will increase the likelihood of being able to mobilize core competencies and of harvesting benefits for the company. Innovation. It is not just the mobilization of each partner’s key competencies and assets, but their combination into new constellations of resources that enables innovative approaches and solutions to the socioeconomic problems being addressed. Doing more of the same will not be sufficient to make the powerful breakthroughs needed. Different approaches need to be created and cross-sector collaboration enables those novel approaches. Continuous Learning. The strongest alliances seem to have a discovery ethic that motivates them to search continually for innovative ways to generate new value and to work together more effectively. In effect, the partnerships are learning organizations. Regardless of progress, there is no room for complacency. Communication. The collaborating organizations take great care to communicate along three dimensions. First, between one another there is open, continual, and frank communication, which helps build the trust essential to effective partnering. Second, internal communication to members of each organization helps promote understanding of the strategic importance of the relationship and motivation to support it. Third, communication to stakeholders fosters understanding (and avoids misinterpretation, given that cross-sector interaction can be seen by some as suspicious) and support. Accountability. Collaboration seems like an intrinsically nice thing to do, but it is mere window dressing if it does not produce important results. Consequently, strong partnerships specify responsibilities vital to
performance and then hold each party accountable for fulfilling those commitments. When fulfillment falls short, strong partners do not point fingers but rather provide constructive criticism and joint problem solving. Commitment. Strategic alliances require strong support from each organization’s top leadership. The leaders send the signals and authorize the resource deployment that create an enabling environment for the rest of the organization to build a strong partnership. The strongest collaborations view the relationship as long term, which means that it will evolve and build over time. Problems, even crises, will arise, but they are dealt with as learning opportunities rather than reasons for abandonment. The Collaboration Plethora Some brief examples will illustrate aspects of the foregoing framework. Readers can find fuller descriptions in the end note references and sources for further reading. Timberland, the boot and outdoor apparel company, has a 20 year relationship with City Year, the youth community service nonprofit. This collaboration evolved from a modest philanthropic donation of boots into an integrative partnership through which the two organizations shaped each other’s organizational values and operating practices and enabled each other to achieve transformations that have contributed to their respective success and societal impact. This included enabling City Year to recruit other corporate partners and expand nationwide. Starbucks entered into a strategic alliance with Conservation International to develop organic coffee cultivation by small growers in Chiapas, Mexico, which not only significantly enhanced the farmers’ incomes but also helped to preserve a habitat buffer zone around one of Mexico’s largest biosphere reserves. Conservation International brought to the project its environmental expertise and ability to work with the small farmers, and Starbucks contributed its knowledge of quality coffee production and provided a marketing outlet at premium prices for the growers. The combination enabled the development of a more environmentally and economically sustainable production system. This experience led to expansion in other countries and to the elaboration of a new procurement system for Starbucks that provided preferred access and premium prices to growers that met a set of quality, envi-
HARVARD COLLEGE ECONOMICS REVIEW
ronmental, social, and economic standards. Merck partnered with the Gates Foundation and the government of Botswana to create an integrated approach to combating HIV/AIDS in the country. Additional companies, UN agencies, and nonprofit organizations joined in this multifaceted, multiyear collaboration which produced significant progress and also provided a learning laboratory for other countries. The Bidwell Training Center, which provides skill development for unemployed minorities in Pittsburgh, joined the Bayer Corporation to address the company’s need for chemical technicians and its interest in increasing the diversity of its workforce. Bidwell recruited the candidates and managed the program at their Center, and Bayer supplied the instructors and equipment and hired the graduates. The combination of competencies created a missing educational service that generated new employment opportunities. Tetra Pak, the world’s largest producer of multilayer packaging, created an alliance in Mexico between social organizations, local government agencies, other manufacturers, and distributors to create a program to recycle multilayer packaging. Prior to this, Mexico City had to dispose of 35 million of these containers monthly in landfills. Increasingly, even nonprofits and businesses that were adversaries have discovered the benefits of collaboration. The Nature Conservancy, the largest private owner of nature preserves in the United States, partnered with Georgia-Pacific Corporation, a major forest products company, to combine their distinct competencies to manage jointly unique forested wetlands in North Carolina, developing sustainable forestry practices that preserved vital habitat areas. The Brazilian forestry products company Orsa worked with the Forest Stewardship Council to obtain certification for sustainable forestry of its nearly one million hectares of Amazon forests. The endorsement that the company’s practices met all the FSC’s environmental and social standards facilitated the marketing of the company’s products to European buyers, which paid a small premium. Britain’s venerable retailer Marks & Spencer worked with a variety of nongovernmental entities and stopped selling endangered fish species and was recognized as the leading United Kingdom retailer for sustainable fishing. It also converted all of its coffee and teas sales and various fruits to certified Fair
Trade sources. The number of powerful partnerships continues to grow. They are found in almost every area with socioeconomic problems: arts, education, environment, health, homelessness, housing, human rights, poverty, unemployment, and others. By crossing sec-
tors and combining distinctive competencies, we tap into new constellations of problemsolving capacity. Collaboration will constitute a vital source of renewable energy for confronting the challenges of the twenty-first century. H
James E. Austin is the Eliot I. Snider and Family Professor of Business Administration, Emeritus, at Harvard Business School. References Austin, J. E. (2002) ‘Business Partnering Frontiers: Social Purpose Alliances’. New Academy Review. Austin, J. E. (2000) The Collaboration Challenge: How Businesses and Nonprofits Succeed Through Strategic Alliances, San Francisco:Jossey-Bass Publishers Austin, J. E. (Fall 2000) ‘Business Leadership Coalitions’ Business and Society Review 105, no. 3. Austin, J. E., Barrett, D. and Weber, J. "Merck Global Health Initiatives (A)." Harvard Business School Case 301-088; "Merck Global Health Initiatives (B): Botswana." Harvard Business School Case 301-089. Austin, J. E., Elias, J. and Strimling, A.L. "Cleveland Turnaround: Leadership in Action, Video." Harvard Business School HBS Case Video 797-501. Austin, J., Reficco, E., et alli (2004) Social Partnering in Latin America: Lessons Drawn From Collaborations of Businesses and Civil Society Organizations, Cambridge: Harvard University Press (2004). Austin, J. and McCaffrey, A. (2002) ‘Business Leadership Coalitions and Public-Private Partnerships in American Cities: A Business Perspective on Regime Theory.’ Journal of Urban Affairs 24, no. 1: 35-54. Austin, J. E. and Reavis, C. "Starbucks and Conservation International." Harvard Business School Case 303-055. Bailey, D., and Koney, K. M. (2000) Strategic Alliances among Health and Human Services Organizations. Thousand Oaks, California: Sage Publications, Inc. Conroy, M. E. (2007) Branded! How the ‘Certification Revolution’ is Transforming Global Corporations. Gabriola Islands, BC: New Society Publishers. Epstein, M. J. and Hanson, K. O., Eds. (2006) The Accountable Corporation: Business-Government Relations. Volume 4. Westport, CT: Praeger Publishers, Inc. Galaskiewicz, J. and Shatin, D. (1981) ‘Leadership and networking among neighborhood human service organizations’, Administrative Science Quarterly 26: 434-448. Giving USA Foundation (2008) “Key Findings,” Giving USA 2008. Indiana University: Center on Philanthropy. Gray, B. (1989) Collaborating: Finding Common Ground for Multiparty Problems. San Francisco: Jossey-Bass Publishers. Glasbergen, P., Biermann, F. and Mol, A. P. J., Eds. (2007) Partnerships, Governance and Sustainable Development: Reflections on Theory and Practice Cheltenham, United Kingdom: Edward Elgar Kanter, R. M. (1999) ‘From spare change to real change: The social sector as a beta site for business innovation’, Harvard Business Review, 1(5). Marchington, M. and Vincent, S. (2004) ‘Analysing the influence of institutional, organizational and interpersonal forces in shaping inter-organizational relations’, Journal of Management Studies 41(6): 1029 Miles, R.W., and Snow, C.C. (1992) ‘Causes of failure in network organizations’, California Management Review 34(4): 53-72. Ring, P.S, and Van de Ven, A. (1994) ‘Developmental process of cooperative interorganizational relationships’, Academy of Management Review 19: 90-118. Rangan, V.K., Quelch, J., Herrero, G. and Barton, B. Eds. (2007) Business Solutions for the Global Poor: Creating Social and Economic Value edited by San Francisco: Jossey-Bass Publishers Reich,M. R. Ed., (2002) Public-Private Partnerships for Public Health. Cambridge: Harvard Series on Population and International Health. Harvard University Press. Sagawa, S. and Segal, E. (1999) Common Interests Common Good: Creating Value through Social Sector Partnerships. Boston: Harvard Business School Publishing Sarason, B.S. and Lorentz, M.E. (1998) Crossing Boundaries: Collaboration, Coordination, and the Redefinition of Resources. San Francisco: Jossey-Bass Publications. Sarkar, M.B., Echambadi, R., Cavusgil, S. T., Aulakh, P.S. (2001) ‘The influence of complementarity, compatibility, and relationship capital on alliance performance’, Academy of Marketing Science Journal Selsky, J. (1991) ‘Lessons in community development: An activist approach to stimulating interorganizational collaboration’, Journal of Applied Behavioral Science 27: 91-115. Vangen, S., Huxham, C. (2003) ‘Nurturing collaborative relations: Building trust in interorganizational collaboration’, Journal of Applied Behavioral Science 39(1): 5-31. Weiss, E.S., Miller, A.R., and Lasker,, R.D. (2002) ‘Making the most of collaboration: Exploring the relationship between partnership synergy and partnership functioning’, Health Education & Behavior (29):683. Williamson, Oliver, E. (1994) ‘Transaction Cost Economics and Organization Theory’, in Neil J. Smelser and Richard Swedberg (Eds.). Princeton: Princeton University Press and Russell Sage Foundation. Wood, D., and Gray, B. (1991) ‘Toward a comprehensive theory of collaboration’, Journal of Applied Behavioral Science 27(2): 139-162.
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ichard Fisher has been the President of the Dallas Federal Reserve Bank since April 2005. Before joining the Federal Reserve, Mr. Fisher held the position of assistant to the Secretary of the Treasury (during the Carter administration), oversaw the implementation of NAFTA, and successfully founded his own capital management firm. During a recent visit to the Harvard Kennedy School of Government, Fisher sat down with the HCER to discuss his views on the Federal Reserve's response to the financial crisis, inflationary policy, and the independence of the Federal Reserve.
HCER: A lot of people have been comparing the current financial crisis to the great depression. But we have much more sophisticated financial tools today than we had then to stimulate the economy. Can you discuss how the Fed has approached today’s crisis, and how past experience informs how we respond today? Fisher: Well, first, we live in a different world than we did in the 1930s. We are more interlinked with the rest of the world. We did not have the cross-fertilization of product services and money that we currently have. Not only are the tools different, but also the circumstances are significantly different and much more complicated than they were in the 1930s. We have experienced a period of enormous political change as well—which we had after the First World War, but this is quite different. Capitalism has been embraced in one form or another by every society. With the fall of the wall in ’89, Mao’s death, and so on, we have an entire world that converged, driving economic growth with a tailwind and with enthusiasm in a really unprecedented way. With populations dedicated toward improving their lifestyles and standards of living, and financial instruments that were created, mathematized, and utilized with supercomputing power, we have made for a much more complicated situation than we had back then. Having said that, unfortunately, humans tend to repeat mistakes over and over again. There’s nothing unique about
markets overshooting. The financial instruments we have today correspond in many ways to the complexity of the world, but also have their limitations to the complexity of the world. The Federal Reserve has taken extraordinary action beyond just cutting rates to zero. We have created all these new facilities to jumpstart credit markets that had come to a screeching halt because they had fallen on the weight of their own complexity.
We and other central banks have been asked to utilize a toolkit which is new in its nature, but old in its form. The playbook for this was written by Walter Bagehot and Henry Thornton back in the early 1800s. What they discovered during the bank panic of 1825 was that you need to pull out all of the stops. That is essentially what we’re doing now. We are trying to use our powers as a central bank and as a lender of last resort to put our fingers
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in the dike now and prevent the flooding that comes with the unwinding of hypercomplicated financial instruments. These financial instruments were created upon the presumption that you could quantify risk without understanding the quality of the risk. I would say we’re in a holding pattern, and what we need to do now is better understand the nature of those risk instruments, give them definitions and parameters, so that there is a defined playing field where there used to be a boundary-less field. Sarkozy, when he was running for the presidency, had a very interesting quote on trade. To paraphrase—he said that globalization is like gravity, or the movement of clouds. You can’t stop it. What you need to do is figure out how to harness it and use it to your advantage or work with it. Going along those lines, financial markets and financial operators have a duty to create risk management instruments. What we have to do is figure out a way to regulate them in a way that incentivizes them to be used towards mitigating risk and improving economic vitality rather than being abused. And I would not think only about current complex instruments that are on the table. It’s a question of providing a regulatory framework that incentivizes the private sector rather than gives it leeway to create the kind of abuse that we are now trying to correct. The next phase of all this is defining who’s going to regulate whom. It is clear that the regulations we had, and the regulators we had, including the Federal Reserve, did not see what was happening and did not understand what was happening. So there is now going to be an effort to define new regulatory capacity and authority, and that will be worked out by the Congress, the regulators, and the new administration. HCER: It seems that the Fed is addressing the liquidity issues while the fiscal authorities are addressing the solvency issues. To what degree has the Fed been successful in what it wanted to do? And where do the fiscal authorities have to step in? Fisher: We have committed an enormous amount of resources to what I call the left-hand side of the balance sheet— the asset side. This is different from what the Japanese did when they just built up the right-hand side of the balance sheet
by building up reserves, hoping that it would also build up the asset side of the balance sheet. We have addressed the asset side directly, and because of the nature of matching accounting, our reserves are being built up as well. You have to take into account the power of discounting what you are going to do and the actual power of what you do. For example, one of our keen interests was to drive down LIBOR. Although it is not widely known in this country, most of the mortgage resets on variable rate loans, particularly those that are going to be maturing in 2009, 2010, 2011, are set to LIBOR. The spread between LIBOR and federal funds rate was enormously large. Through our dollar lending markets, our swap lines, and our own activities aimed
“
The next phase of all this is defining who's going to regulate whom.
”
at driving rates down, we have managed to narrow that spread dramatically. LIBOR rates have come down significantly. That has been a positive accomplishment. In terms of the commercial paper facility that we have set up, it is actually shrinking in size as we speak because commercial paper is beginning to be issued again. Commercial paper is a particularly key instrument for men and women who run private businesses, but also important for public businesses. You cannot have a commercial system without commercial paper issuance. We intervened directly in the A1P1 market, but we’ve also seen a rollover into the lesser quality A2P2 market . And I would argue that thus far, it has been successful. This is one reason why our balance sheet has shrunk from a little over $2 trillion to $1.75 trillion as of Friday [2/20/09]. As for mortgage-backed securities, we
have driven the posted rate for qualifying mortgages to the lowest rate since the 1970s. I think that’s been a constructive development. Despite lower rates, it is still not that easy to get a mortgage because of more stringent qualifications, and much uncertainty remains as to what will happen under the new administration’s program. Lastly, we are just beginning to address asset-backed securities through a program announced this week. As for automobile receivables, student loans, small business administration loans, and perhaps some other asset-backed securities, we will see how that obtains. These are examples of the toolkits that we have enabled, and the Fed's direct involvement and intervention in credit markets that were not working. Although liquidity is a key issue, much of what we have addressed through these different instruments is not purely liquidity issues. There has also been what we call discounted party risk and rollover risk. In the fall, under market stress, three-party arrangements and multi-party arrangements just stopped. That is a liquidity matter, but there are also underlying solvency and basic credit concerns. On the fiscal side, the key is to make an attempt to assure that the banking system continues to operate without threatening the financial system. That is still up to debate. There has been a lot of mind-changing, a lot of confusing signals sent to the marketplace, and now the current administration is grappling with the residue of that confusion without providing much clarity yet. Clearly, we have a supervisory responsibility, but we are not alone. It is a solvency issue for some institutions, or at least the capacity to deal with economic blows and the question of whether they can handle the stress. There will have to be some serious discussion regarding how we mitigate and resolve the risk that is outstanding in the system, particularly in very large financial institutions. HCER: Do you think that the enormous expansion of the Fed’s toolkit and the scope of its responsibility have the potential of undermining the Fed’s independence and reputation going forward? Fisher: The issue of independence is a very good question. What has made for a strong central bank has been strong central bank independence. Particularly, dur-
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ing the Volcker era, the independence of the Federal Reserve was strongly asserted, and I would argue that the Volcker Fed pulled the economy back from the precipice of disaster. We want to make sure that we do not compromise our independence. We are independent within the government. On the organizational chart, we are part of the executive branch but commissioned by Congress. Strong Fed leadership and strong Fed open market committees have always guarded their independence. I think it is very important that the independence be enshrined. If you begin to politicize the process of managing the money supply and of the credit markets, inevitably you will get to the allocation of credit. Inevitably you will get to the monetization of deficits and social programs. We know from history, from ancient Rome to modern Zimbabwe, that that does not work. And there have been lots of little accidents along the way such as the Carter administration’s credit controls, which had a perverse and negative influence. It is very important that the Fed not take on so much that we become a political punching bag or a political target. With that said, I think there is a significant probability that we will be asked to do more. I would say within the panoply of regulators, we are still held in high regard, probably highest regard. It is not clear yet how much we can do and how well we can do it. Do we have the human capital and the management structure to take on more responsibilities? We are working on that. HCER: There has been a lot of debate about whether the Federal Reserve and central banks around the world should adopt specific inflationary targets. We have not adopted an inflation target in the United States, although some people argue that we have done it implicitly. Where do you stand on that debate, and have recent developments in policy influenced your views? Fisher: We are charged by Congress with creating the monetary conditions for sustainable, noninflationary employment growth. The key operative word in that sentence is "sustainable." We have a dual mandate, as it is called, and in my view, to have sustainable economic growth, you need to have price stability. This gets back to the previous question
about political interference. You would not want to adopt a target for inflation, and then have a reaction from the political class saying what you ought to have is an employment target as well. Personally, I am comfortable with an inflation target. The question is at what cost should we get it. For example, once you decide that you are comfortable with having an inflation target, what instrument do you use? Do you use the PCE? Do you use the CPI? And what level do you embrace? I happen to be one of the more hawkish members of the committee, and I am uncomfortable when I see inflation above 1.5% as measured by the PCE index. I would also be interested in how we would explain this to the public. The public may not understand core measurements or some of the more refined measurements. So short answer, yes, I am in favor of the principle. But what is the political reality and how practicably can inflation targeting be implemented? What we are doing at the Federal Reserve is using our longer-term forecasts. That should imply what we think we can achieve. It is short of embracing a specific inflation target—sort of a backdoor way. I am not uncomfortable with that, but over what time frame are you speaking? We went through a period this summer where
we had enormous inflationary pressure, and it looked like it could break either way. Then the economy imploded globally, and now we have, if anything, deflationary price pressures as measured by the market baskets. Discussing inflation targeting is in part to offset the baser instincts that may embrace deflationary behavior. If people think you are going to deflate, they postpone purchases, which dampens economic activity further, drives prices down, and postpones purchases again. So, it may make equal sense in an environment where we have reduced price pressures or downside price pressures as it would if we had upward price pressures. It is also not clear from the data whether countries who have embraced formal targeting are more successful than those who have not. Most countries adopted formal targeting because they were in trouble and were dealing with inflationary pressures. So the jury’s out on inflation targeting. But I am not uncomfortable saying that we will consider a target. Again, it is about how we can implement it. H –Interview by Natalie Bau and Anna Zhang. Transcription by Xiaoqi Zhu.
AHY<!Q(/P(7O3><OB(<7Q(THA7(-P(/</?H==H
)R0%#2;#+(7"8*9":9#96;:4 Insights from psychology and neurobiology inform a new approach to economic rationality
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ith the stock market descending to record lows, increasing numbers of banks and financial institutions failing, countries and businesses going bankrupt, and people losing their homes and their jobs, understanding economic decisions and economic policy has never been more important. Why do people take out loans they will not be able to repay? Why did banks make loans to people who cannot possibly pay them back? Why would a company insure risk without reasonable risk assessment? What can a government do to stimulate an economy to grow, making new jobs and credit available? It is striking that after decades of research in economics, our understanding of economic behavior of people and institutions is so impoverished that all of our explanations are ex post facto. Perhaps it is times like these, when scientists are confronted with the limits of their knowledge, that the need for new approaches and paradigm shifts becomes most acute. Unfortunately, new paradigms donâ&#x20AC;&#x2122;t emerge overnight and new insights are not generated on demand. But perhaps the recognition of the boundaries of our current knowledge can encourage greater interaction across disciplines. Neuroeconomics represents just this kind of interaction and, while not brand newâ&#x20AC;&#x201D;it is arguably only about a decade oldâ&#x20AC;&#x201D; it is young enough to offer the promise of new knowledge and insights (Egidi, Nusbaum, & Cacioppo, 2007). However, even
at its young age, there are glimmers of evidence that the current approach may need to expand its horizons beyond a focus on individual decisions to an emphasis on how social interaction and social contagion, social situations and context, and social emotions such as empathy, affect the individual making decisions. Neuroeconomics is the study of the neural mechanisms that mediate economic decisions and it has developed from the synthesis of behavioral and experimental economics and cognitive neuroscience. On one hand, behavioral and experimental economics have focused on understanding how individuals make economic decisions, seeking to explain the principles that govern such decisions under risk, reward, uncertainty, and relative wealth. This research generally uses experimental designs that incorporate fundamental properties of economic situations such as auctions and measures behavior in the context of these tasks. On the other hand, cognitive neuroscience has focused on understanding cognitive processes more generally such as decision making, learning, memory, perception and attention. Researchers in this field use experimental designs generally drawn from cognitive psychology, but generally measure brain activity using functional Magnetic Resonance Imaging (fMRI; see Cabeza & Kingstone, 2001) or electrophysiology using scalp electrodes rather than behavior (see Fabiani et al., 2007). Some
researchers use behavioral tasks with patients with brain damage in particular areas of the brain to understand the contribution of specific neural regions (e.g., Koenigs et al, 2007). Other researchers intervene in brain function by stimulating the brain with electrical activity (e.g., Ojemann, 1991) or transcranial magnetic stimulation (TMS; Luber et al., 2007). The combination of the fields of behavioral and experimental economics with cognitive neuroscience has yielded an explosion of new research investigating the neural processes which underlie economic decisions (see Glimcher et al., 2009). Much of this research has investigated a wide range of questions from the neural basis of utility and value, choice, risk, and uncertainty. What does learning about these neural mechanisms tell us about economic decisions and economic theories? Behavioral and experimental economics has focused largely on understanding individual economic decisions. The apparent irrationality of the average economic decision maker has been well studied and documented as contrary to the assumptions of standard economics (e.g., Tversky & Kahneman, 1981). Rational choice theorists have continued to hew to the coldly rationalist model of the individual decision maker for several reasons. By questioning the generalizability of laboratory results to actual economical decision settings (e.g. Levitt & List, 2008),
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by reasoning that what appears to be irrational is in fact rational but reflective of utility functions that were incorrectly or incompletely specified, or by noting that economic theory makes predictions about aggregate, not individual behavior, and irrationality does not have an impact on aggregate human behavior, economists seek to justify overlooking these findings. For instance, if the irrationality describing individual behavior is unsystematic, then the departure from rationality will sum to zero as one aggregates over individuals, leaving the rational choice theory of economic behavior intact. Of course, behavioral economists and psychologists have contested the defense of rational choice. But perhaps it is more telling to remember that Federal Reserve Chairman Alan Greenspan used the term “irrational exuberance” in 1996 to describe what he viewed as an overvalued US stock market, acknowledging that irrationality was not confined to university experiments. Indeed, much of the current fiscal crisis could be viewed as a direct consequence of such irrational exuberance to incur debt without rational assessment of true cost or probable risk. Furthermore, in the resulting fiscal crisis, there is now a widespread risk aversion that affects financial institutions and people alike. In spite of the infusion of supporting funds from the government to banks to promote lending and ease the credit crisis, credit is not flowing into the economy. Moreover, consumers are not spending even though there are few financial benefits to saving given the huge losses in investments and
the nearly vanished interest rate on savings accounts. From the irrational exuberance demonstrated by ill considered investment and exorbitant amounts of incurred debt to the current, overly excessive risk aversion, overwrought responses to situations are not easily explained by the individual, isolated economic decision maker. The model of much of experimental economics and behavioral economics, as well as cognitive psychology and cognitive neuroscience, has focused on the individual and the comprehension of processes and mechanisms operating within an individual. This has produced substantial insights into the cognitive and neural processes that operate within each of us. In this respect, it is much like computer science which focuses on the architecture and processing within a single computer. This is a powerful model for understanding information processing and for developing new models and theories of human information processing. However, when computers are connected to each other in networks, there are emergent paradigms of information processing that are not predicted from studying the isolated system. Networks share information, distribute processing load, and parse problems into smaller components that can be attacked separately and thus handled more effectively and efficiently. The development of the Internet and new paradigms of commerce and social transaction directly reflect the power of networks that expand computing beyond the individual computer in ways that could not be anticipated from studying the isolated system. Moreover, the downside of such
computing networks such as the contagion of viruses and worms was also unanticipated. In much the same way, while there is much to be gained by studying how individuals make decisions, knowledge about the isolated individual can neither predict nor explain the synergies that emerge from social networks and social interactions. Of course we can ask whether studying the brain helps in any respect of understanding economic decisions. How does the brain help us understand economic behavior? We can start by relating aspects of individual economic behavior to brain mechanisms directly. For example, the concept of utility is fundamental to economic theories. Is there a part of the brain that directly relates to aspects of perceived value? There are indeed networks in the brain that respond in relationship to the value of a good. It appears that the evaluation of utility is associated with activity in a neural network involving subortical regions projecting to the frontal cortical areas (see Sanfey, 2004; Knutson & Peterson, 2005 for reviews). The subcortical regions of this network involve part of the basal ganglia and limbic system that are important in a wide range of functions from motor control to emotional processes. Some of these areas are involved in a neural “hedonic” response to immediate rewards (e.g., McClure et al., 2004a). There is some evidence for a dissociation of neural responses between expected value and actual value (Knutson et al., 2001). The higher cortical areas include mostly the medial prefrontal cortex. One view of the medial prefrontal cortex (e.g., Knutson & Peterson, 2005) is that it is involved in calculating the probability of a positive reward. Indeed, research has indicated that prefrontal structures can be activated even in cases of evaluating abstract or symbolic gains or losses (e.g., O’Doherty et al., 2001). This is a slightly different interpretation than McClure et al.’s (2004b) view that these structures are part of the impulsive-passionate affective response system that drives the utility valuation of immediate rewards (see also Padoa-Schioppa & Assad, 2006; Plassmann et al., 2007) . The expectation of an outcome seems different from the impulsive hedonic drive for immediate reward. The notion of expectation of a reward may be very different from a simple probability. Patients with damage to these brain structures do not simply fail to anticipate a negative outcome in their choice behavior based on past probabilities—they also fail to
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show physiological evidence of an affective reaction (Bechara, et al., 1997). As a result, Bechara and colleagues argued that these prefrontal structures can serve a regulatory role in behavior. By recording past affective experiences along with the context of their occurrence, the prefrontal cortex can influence cognitive determinations in other cortical regions through projections to nuclei that regulate neurotransmitters which then modulate other cortical circuits such as dopamine. Perhaps it does not require brain damage to the prefrontal cortex to lose the regulatory control over choices that involve high risk or provide immediate payoff—perhaps it is simple to have strong expectations of reward. However, as described earlier in considering the computer science of individual computers and networks, there may be something important missing from a neuroeconomic model of utility, if the focus is limited to the individual. Across economic theories, utility is certainly critical to understanding economic decisions. In the studies just described, expectation can play a role in modulating choice behavior, perhaps by modulating experienced utility through cortical systems. But it is not clear why choice behavior would be affected if expectations are constant, if the face value of a reward is constant, and if other aspects of the received value are constant. Utility should not change. Sanfey et al. (2003) had participants play a two-person economic game. Sometimes offers were made by a human partner and sometimes offers were made by a computer partner. Brain activity was measured using fMRI to assess the neural activity accompanying the economic decisions. When participants were presented with unfair offers compared to fair ones, there was activity in the anterior insula and anterior cingulate, regions in which activation has been found to correlate with negative social emotions, such as the feeling of social rejection (Eisenberger et al., 2003). These are not brain regions associated with utility. In fact, activity in the insula was proportional to the unfairness of the offers. Across participants, there was higher insula activity for unfair offers that were rejected. Additionally, participants who rejected the highest number of unfair offers showed higher insula activation (Sanfey et al., 2003). In this game, rejection of an offer comes at a cost—participants were willing to pay to punish unfair offers. Other research has suggested that such altruistic
punishment provides a neural reward even while incurring a monetary cost (de Quervain et al, 2004). Moreover it is important to note that these results held only when participants were given unfair offers by human partners. When offers were known to be made by a computer, not only did participants accept unfair offers more often, but the activity in the insula and anterior cingulate did not significantly increase for unfair offers (Sanfey et al., 2003). Clearly a decision made in a social setting can strongly depend on assumptions made by the participants. Indeed, anthropological research has shown that, across cultures, the willingness to incur costs to punish inequitable behavior varies with the willingness to engage in altruistic behavior (Heinrich et al., 2006). Cultural norms about individual behavior and socially appropriate behavior interact in the regulation of fairness by society. Prosocial behavior may depend on how cultures tell us we should think about each other. The classic Frank Capra movie, “It’s a Wonderful Life,” portrays two clear stereotypes from a banking and finance system that is all but gone from the 21st Century. The protagonist, George Bailey, has the prosocial plan of establishing affordable housing for the people of his town. These are people he knows well, both in their strengths and weaknesses. The antagonist, Mr. Potter, is the epitome of homo economicus in his approach to man-
aging his financial affairs, with the concept of concern for his fellow townspeople entirely irrelevant to his economic decisions. However, both Bailey and Potter approach economic decision making in a way that has slowly vanished from our current financial system: both men know the people they are dealing with economically and, although coming to different assessments of the financial strengths and weaknesses of these people, social connection plays an important role in economic decisions, as does theory of mind (e.g., Rilling et al., 2004), perspective taking (Decety & Sommerville, 2003), and empathy (Decety & Jackson, 2006). The current mortgage and housing crisis, and perhaps much of the credit crisis in general, has emerged from a very different milieu of financial decision making than that of the Capra movie era. Isolated from real social information about borrowers, there is an assumption that certain kinds of economic data are sufficiently objective, diagnostic, and reliable to ground decisions about credit. However, the ability to transfer risk from the loan originator serves to decouple the decision process from the outcomes of those decisions. Asset appraisal gets short shrift because risk will get transferred. For example, real estate appraisals are often carried out on comparable sales without even a close inspection of the properties inside and out. Lip service to due diligence trumps real long-term knowledge about individuals
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and assets. Mortgage brokers act as dissociated financial agents, and institutions that make loans resell them to shed risk. This separates the loan decision process from the outcomes. The credit business is not the only aspect of economic decision making that has eliminated social knowledge from the process. Trading is no longer strictly a face-to-face business with known agents. Faceless artificial intelligence handles transactions so quickly that artificial restraints have been put in place. Investments are managed without much social knowledge. In short, the social brain no longer serves as a way of governance over the economic engine in spite of the development of social needs throughout the course of our evolution (Cacioppo & Patrick, 2008). Trust and cooperation are important elements of social interaction which take place in economic exchanges. Social cooperation produces increased activity in the basal ganglia and the medial prefrontal cortices (King-Casas et al., 2005; Rilling et al., 2004), consistent with increasing utility and bias for cooperation. However, with strong prior expectations about the trustworthiness a potential economic partner has, successive interactions have little impact on the basal ganglia (Delgado et al., 2005). Reputation and personal knowledge matter in economic decisions and in the brain activity that relates to the utility of successful economic transactions. Much of the research in neuroeconomics analyzes patterns of brain activity simply by searching for the reliable peak of activity. While this may characterize the strength of specific brain responses, it overlooks the fundamental nature of neural systems as networks of regions rather than individual isolated mechanisms. Just as behavioral and experimental economics has focused on the individual rather than the social network, much of cognitive and social neuroscience has focused on individual brain regions rather than dynamically coordinated neural systems. While some studies have begun to regress behavioral data onto brain activity (e.g., Plassmann et al., 2007) in order to understand brain-behavior relationships more directly, and others have examined the interaction between activity in one personâ&#x20AC;&#x2122;s brain and activity in another personâ&#x20AC;&#x2122;s brain (KingCasas et al., 2005) to understand joint neural changes in social interaction, it will be necessary to develop more sophisticated analytic models in neuroeconomics that consider the
covariance among brain regions rather than simple magnitude of activity. Neuroeconomics needs to find ways of understanding interaction between brains rather than the individual brain operating in isolation. Social psychology has long discussed the need for comprehending the power of social situations in shaping individual behavior. At the same time it is important to understand individual differences in the response to such
social situations. Neuroeconomics needs to move beyond the paradigm of carrying out behavioral and experimental economics studies simply using brain imaging (cf. Cacioppo et al., 2003). It is important to explore broader notions of how individual differences and social situations interact to dynamically assemble the neural networks that mediate economic decisions. H
Howard C. Nusbaum and John T. Cacioppo are professors with the Center for Cognitive and Social Neuroscience in the Department of Psychology at the University of Chicago. Cabeza, R., & Kingstone, A. (Eds). (2001). Handbook of functional neuroimaging of cognition. MIT Press: Cambridge, MA. Cacioppo, J. T., & Patrick, B. (2008). Loneliness: human nature and the need for social connection. New York: W. W. Norton and Company. Cacioppo, J. T., Berntson, G. G., Lorig, T. S., Norris, C. J., Rickett, E., & Nusbaum, H. (2003). Just because you're imaging the brain doesn't mean you can stop using your head: A primer and set of first principles. Journal of Personality and Social Psychology, 85, 650-661. de Quervain, D. J.-F., Fischbacher, U., Treyer, V., Schellhammer, M., Schnyder, U., Buck, A., & Fehr, E. (2004). The neural basis of altruistic punishment. Science, 305, 1254-1258. Decety, J., & Jackson, P.L. (2006). A social neuroscience perspective on empathy. Current Directions in Psychological Science, 15, 54-58. Decety, J., and Sommerville, J.A. (2003). Shared representations between self and others: A social cognitive neuroscience view. Trends in Cognitive Science, 7, 527-533. Delgado, M. R., Frank, R. H., & Phelps, E. A. (2005). Perceptions of moral character modulate the neural systems of reward during the trust game. Nature Neuroscience, 8, 1611. Egidi, G., Nusbaum, H. C., & Cacioppo, J. T. (2007). Neuroeconomics: Foundational issues and consumer relevance. In C. Haugtvedt, P. Herr, & F. Kardes (Eds.), Handbook of Consumer Psychology, Psychology Press, 1177-1214. Eisenberger, N. I., Lieberman, M. D., & Williams, K. D. (2003). Does rejection hurt? An fMRI study of social exclusion. Science, 302, 290-292. Fabiani, M., Gratton, G., & Federmeier, K. D. (2007). Event-Related Brain Potentials: Methods, Theory, and Applications. In Cacioppo, J. T., Tassinary, L. G., & Berntson, G. G. (Eds). Handbook of psychophysiology, 3rd edition. New York: Cambridge University Press, 85-119. Glimcher, P. W., Camerer, C., Poldrack, R. A., & Fehr, E. (Eds.) (2009). Neuroeconomics: Decision making and the brain. Academic Press: London. Joseph Henrich, J., Richard McElreath, R., Abigail Barr, A., Jean Ensminger, J., Clark Barrett, C., Alexander Bolyanatz, A., Juan Camilo Cardenas, J. C., Michael Gurven, M., Edwins Gwako, E., Natalie Henrich, N., Carolyn Lesorogol, C., Frank Marlowe, F., David Tracer, D., & Ziker, J. (2006). Costly punishment across human societies Science, 312, 1767-1770. King-Casas, B., Tomlin, D., Anen, C., Camerer, C. F., Quartz, S. R., & Montague, P. R. (2005). Getting to know you: Reputation and trust in a two-person economic exchange. Science, 308, 78-83. Knutson, B. & Peterson, R. (2005). Neurally reconstructing expected utility. Games and Economic Behavior, 52, 305-315. Knutson, B., Fong, G. W., Adams, C. M., Varner, J. L., Hommer, D. (2001). Dissociation of reward anticipation and outcome with event-related fMRI. NeuroReport, 12, 3683-3687. Koenigs, M., Tranel, D. T., & Damasio, A. R. (2007). The lesion method in cognitive neuroscience. In Cacioppo, J. T., Tassinary, L. G., & Berntson, G. G. (Eds). Handbook of psychophysiology, 3rd edition. New York: Cambridge University Press, 139-157. Levitt, S. D., & List, J. A. (2008). Homo economicus evolves. Science. 319, 909-910. Luber, B., Peterchev, A. V., Nguyen, T., Sporn, A., & Lisanby, S. H. (2007). Application of Transcranial Magnetic Stimulation (TMS) in psychophysiology In Cacioppo, J. T., Tassinary, L. G., & Berntson, G. G. (Eds). Handbook of psychophysiology, 3rd edition. New York: Cambridge University Press, 120-138. McClure, S. M., Laibson, D. I., Loewenstein, G., & Cohen, J. D. (2004). Separate neural systems value immediate and delayed monetary rewards. Science, 306, 503-507. Ojemann, G.A. (1991). Cortical organization of language. Journal of Neuroscience, 11, 2281-2287. Plassmann, H., Oâ&#x20AC;&#x2122;Doherty, J., & Rangel, A. (2007). Orbitofrontal cortex encodes willingness to pay in everyday economic transactions. Journal of Neuroscience, 27, 9984-9988. Rilling JK, Sanfey AG, Aronson JA, Nystrom LE, & Cohen JD. (2004). The neural correlates of theory of mind within interpersonal interactions. NeuroImage, 22, 1694-1703. Sanfey, A. G. (2004). Neural computations of decision utility. Trends in cognitive sciences, 8, 519-521. Sanfey, A. G., Rilling, J. K., Aronson, J. A., Nystrom, L. E., & Cohen, J. D. (2003). The neural basis of economic decisionmaking in the ultimatum game. Science, 300, 1755-1758. Tversky, A., & Kahneman, D. (1981). The framing of decisions and the psychology of choice. Science, 211, 1124-1131.
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william milberg
Keynes’s Stimulus, Polanyi’s Moment The economic foundations of Keynes and the political economy principles of Polanyi offer insight into crafting a new American economy
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anuary 2009 marked not only the inauguration of a new President of the United States, but also a virtual coronation of John Maynard Keynes as the king of modern economics. For decades, the economics profession attacked Keynesianism, first for lacking a theory of inflation and then for an insufficient appreciation of individual rationality in decisions by investors and employers. But in the past year, Keynesianism has served as the inspiration for the ideas of today’s most celebrated economists. From Martin Feldstein to Joseph Stiglitz, from Glen Hubbard to Paul Krugman, all major economists supported the adoption of a massive Keynesian stimulus to reverse our economic decline. Most of them support a second round of fiscal stimulus. Keynes taught us that a fully decentralized, free market economy does not naturally gravitate to full employment. This radical conclusion comes not from the assumption of rigid labor markets, a high minimum wage, excessive union bargaining power, or the presence of distortionary taxes. It is the result of inadequate aggregate demand. Keynes detailed (and Hyman Minsky, 1986, elaborated) how endogenous and speculative financial market bubbles can bust with disastrous consequence for investment, employment, and output. And Keynes understood (as emphasized by followers like Paul Davidson, 1996) why the efficient market hypothesis so central to today’s macro and financial models is of limited relevance given the non-ergodic nature (that is, unpredictable in statistical or stochastic terms) of many 2 economic processe. Keynesianism is, thus, a useful and tested backdrop for policy making today, and Keynes himself, were he alive today, might not have been surprised at the resurgence of his ideas in policy circles. “Practical men who believe themselves to be quite exempt from any intellectual influences,” Keynes wrote in the last paragraphs of his 1936 book, The General Theory of Employment, Interest, and Money, “are usually the slaves of some defunct economist.”
Keynes is, by any account, more than just “some defunct economist,” but the current economic challenges require a creativity of economic theory and policy making that extends beyond Keynes. Free markets have led to unprecedented and unacceptable inequality of income and wealth, imbalances in international payments, and a misallocation of resources that overemphasizes financial speculation and underemphasizes entrepreneurship, innovation and economic security. Today we face the challenge of creating a society that provides a more productive and sustainable use of resources at the same time that it should generate a greater degree of economic security for its citizens. In short, America is searching for a new social contract. New and creative thinking will be required to build true economic security— starting with universal access to good quality education, health care, and adequate and secure retirement income—while encouraging private innovation and job creation; to re-regulate the financial markets with the aim of channeling financial institutions to do what they are designed to do in capitalism: allocate resources efficiently by providing credit for production, innovation and long-term growth; and to redesign the architecture for the management of international finance so it promotes economic growth and stability globally. What may be required is a new way of thinking, in short, a new theory of political economy. If Keynesianism is not enough, what will constitute the next great paradigm of political economy? To begin to understand the challenges, economists and policy makers might be well advised to take advice from another mid-20th century thinker, Karl Polanyi. Polanyi’s 1942 book The Great Transformation: The Political and Economic Origins of Our Time shows that industrial capitalism has exhibited a series of swings in economic and social policy from free market fundamentalism to a more regulated system in response to the excesses and detrimental social consequences of
the free market phase. This “double movement” captures what capitalism today is undergoing, and, amidst the frenzy of bailouts, stimulus plans, TARPs and TALFs emerging these days, Polanyi’s warnings about the nature of this “countermovement” are useful to revisit and consider as the basis for an alternative theory of political economy to replace the failed market fundamentalism espoused by economists 3 for decades. Polanyi describes how industrial capitalism has consistently fluctuated between free-market fundamentalism and considerable government intervention. When free markets create social conditions that threaten social cohesion—massive unemployment or dangerous working conditions, for example—governments respond with a “countermovement” like the one we’re witnessing today: they expand regulation of markets, strengthen social protections like anti-poverty programs and work safety regulations, and bail out failing businesses and households. Whether it was wage subsidies to avert mass poverty in England at the end of the 18th century, or the late 19th century British laws on coal mine safety and the expansion of public access to vaccinations, or 20th century America’s invention of Social Security, legislators supported government intervention because the effect of free markets was unacceptable and threatened social cohesion. In this context, Keynesianism is the easy part. Economists can faithfully rely on Keynes’s 1936 text for scientific foundations and politicians can readily support more spending for unemployment and health insurance, and for the construction of roads, schools, solar panels and wireless internet access. The harder part involves the Polanyian pendulum swing we find ourselves in, since it signals the need for a new social contract and a new way of thinking about the economy. Polanyi’s insights give a sense of how complex and contested this countermovement is and how much creativity and diligence its success will require. Here’s a very brief synopsis:
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1. Markets work best when embedded in a legitimate institutional context. Polanyi insisted that markets function because they are embedded in social and political institutions which create trust and provide norms and limits. Institutions, in Polanyi’s view, extend well beyond questions of property rights and legal contracts that are the main focus of institutional economics today. Market-based freedoms (consumer choice and business investment) must be balanced with attention to other freedoms, including the provision of such basic needs as adequate food, housing, healthcare, education, and income security. Our inability to adequately address many of these social freedoms could be said to have contributed to the current economic collapse: A study by my colleagues at the Schwartz Center for Economic Policy Analysis found that the U.S. current account deficit, sometimes attributed to Americans’ consumer spending binge, was best tracked by increases in healthcare spending by Americans (Barbosa et al. 2005). To ignore these social freedoms is to reduce the likely success of market-based reforms. 2. Ad hoc solutions are often unsustainable. While the move to laissez-faire often occurs as a result of careful deregulation and political change (for example the adoption of the gold standard in 1870 or the deregulation of industry and decline of unions in the U.S. in the 1970s and 1980s), the re-regulation of capitalism often occurs under emergency conditions and in an ad hoc manner. The passage of the $700 billion TARP without clear guidelines or sufficient oversight is a perfect example of the chaotic nature of the countermove. Polanyi argues for a solution that is sustainable in order to avoid a drastic reverse counter swing of the social pendulum. Providing universal health insurance coverage that also lowers costs to business would be an example of a sustainable response to today’s crisis. 3. The social contract requires democracy, accountability and justice. Despite the inaccurate but oft-trumpeted description of Obama as a socialist, today we simply don’t face the deadlock between the economic and political realms that confronted many countries in the 1930s, when Polanyi eschewed the “idealist” extremes of both communism and fascism for a pragmatic approach. Polanyi insisted that democracy, accountability and justice are crucial for government legitimacy in the eyes of its
citizens. Bailouts and stimulus plans must be transparent and regulations enforced. Our voting system must instill confidence. Executive compensation schemes must be more fair, especially when supported by taxpayers. International economic institutions too must be even-handed and democratic, not promoting austere monetarism for poor countries in crisis and expansionary Keynesianism in the rich ones, for ex4 ample. 4. Economics combines science, politics and ethics. Economists too can learn from Polanyi that models of the optimality of free markets often ignore broader social consequences of market forces. There are a series of much-heralded, new developments in economic thought today: experimental economics, behavioral economics, complexity theory and agent-based modeling, to name a few. These are all impressive technical developments. But there is very little of substance about the economy in any of these, much less a coherent vision about social relations, and in particular the connections among states, markets, firms and households—that is, about capitalism. Capitalism is a word that had until the last few months disappeared from the lexicon of economics—it is not mentioned in Gregory Mankiw’s bestselling, 500-page economics principles textbook.5 The previously unmentionable word has now resurfaced in legitimate academic and policy circles, an indication precisely of the broad questioning and rethinking currently underway. 6 The recent return to Keynesianism is perhaps just a step on the path to a new theory of political economy that will be
more rooted in institutional detail and more modest in its predictions. Economists have already begun a debate over the failure of existing economic models and 7 the likelihood of a new paradigm. Most indications are that change will be resisted. But without a new Keynes in the wings, it is hard to know exactly how the countermove will manifest itself in economic thought. The Obama administration has shown a strong allegiance to Keynesianism as a means of creating a real “21st century economy.” But the Polanyian challenge demands unparalleled imagination and accountability as we seek a legitimate renegotiation of the social contract. We must reverse decades-long trends of rising economic insecurity and income inequality, of speculative bubbles and their inevitable collapse, and of growing rewards for unprofitable and especially unethical corporate behavior. And all this must be accomplished while we encourage business to be the driver of innovation, investment, and economic growth. Only by meeting this grander challenge are we likely to approach Polanyi’s pragmatic goal of “freedom in a H complex society.” William Milberg is an Associate Professor with the Department of Economics at the New School for Social Research in New York. Endnotes 1. I am grateful to Jeff Goldfarb and Peter Spiegler for comments on an early draft of this essay. 2. See Buiter (2009) for a similar critique of the most recent macro and financial models. 3. See Kozul-Wright and Rayment (2007). 4. See Chang (2007). 5. This omission was noted by Heilbroner (1999) in a prescient essay entitled “The End of The Worldly Philosophy?” 6. See, for example, Posner (2009), Barbera (2009) and Akerloff and Shiller (2009).
7. See, for example, Kobayashi (2009) and recent articles in The Financial Times by De Grauwe (2009) and Skidelsky (2009). References Akerloff, G. and R. Shiller (2009) Animal Spirits: How Human Psychology Drives the Economy and Why it Matters for Global Capitalism, Prineton: Princeton University Press. Barbera, R. (2009) The Cost of Capitalism: Understanding Market Mayhem and Stabilizing Our Economic Future, New York: The McGraw-Hill Companies. Barbosa-Filho, N. et al. (2005) “U.S. Macro Imbalances: Trends, Cycles and Policy Implications,” Policy Brief, Schwartz Center for Economic Policy Analysis, New School for Social Research, December. Buiter, W. (2009) “The unfortunate uselessness of most ‘state of the art’ academic monetary economics,” downloaded at http://www. voxeu.org/index.php?q=node/3210, March 6. Chang, Ha-Joon (2007) Bad Samaritans: Rich Nations, Poor Policies and the Threat to the Developing World, London: Random House Business Books. Davidson, P. (1996) “Reality and Economic Theory,” Journal of Post Keynesian Economics, V. 18, No. 4, pp. 479-508. Heilbroner, R. (1999) The Worldly Philosophers: The Lives, Times and Ideas of the Great Economic Thinkers, 7th edition, New York: Simon and Schuster. Kobayashi, K. (2009) “Why this crisis needs a new paradigm of economic thought,” Vox, August 24, downloaded at VoxEu.org. Kozul-Wright, R. and P. Rayment (2007) The Resistible Rise of Market Fundamentalism: Rethinking Development Policy in an Unbalanced World, London, Zed Books and Third World Network. Krugman, P. (2009) “A thought about macroeconomics,” June 26, downloaded at http://krugman.blogs.nytimes.com/2009/06/26/athought-about-macroeconomics/?apage=3. Minsky, H. (1986) Stabilizing an Unstable Economy, New Haven: Yale University Press. Posner, R. (2009) A Failure of Capitalism: The Crisis of ’08 and the Descent into Depression, Cambridge: Harvard University Press.