Economics – Page 5 – Gavinsblog.com

Monkey business-sense

I rather liked this story from last week’s Economist. It concerns risk aversion in humans and monkeys.

When buying things in a straight exchange of money for goods, people often respond to changes in price in exactly the way that theoretical economics predicts. But when faced with an exchange whose outcome is predictable only on average, most people prefer to avoid the risk of making a loss than to take the chance of making a gain in circumstances when the average expected outcome of the two actions would be the same.

…Keith Chen, of the Yale School of Management, and his colleagues decided to investigate its evolutionary past. They reasoned that if they could find similar behaviour in another species of primate (none of which has yet invented a cash economy) this would suggest that loss-aversion evolved in a common ancestor. They chose the capuchin monkey, Cebus apella, a South American species often used for behavioural experiments.

So the experiment was carried out as follows:

First, the researchers had to introduce their monkeys to the idea of a cash economy. They did this by giving them small metal discs while showing them food. The monkeys quickly learned that humans valued these inedible discs so much that they were willing to trade them for scrumptious pieces of apple, grapes and jelly.

Preliminary experiments established the amount of apple that was valued as much as either a grape or a cube of jelly, and set the price accordingly, at one disc per food item. The monkeys were then given 12 discs and allowed to trade them one at a time for whichever foodstuff they preferred.

Once the price had been established, though, it was changed. The size of the apple portions was doubled, effectively halving the price of apple. At the same time, the number of discs a monkey was given to spend fell from 12 to nine. The result was that apple consumption went up in exactly the way that price theory (as applied to humans) would predict. Indeed, averaged over the course of ten sessions it was within 1% of the theory’s prediction. One up to Cebus economicus.

The experimenters then began to test their animals’ risk aversion. They did this by offering them three different trading regimes in succession. Each required choosing between the wares of two experimental âsalesmenâ?. In the first regime one salesman offered one piece of apple for a disc, while the other offered two. However, half the time the second salesman only handed over one piece. Despite this deception, the monkeys quickly worked out that the second salesman offered the better overall deal, and came to prefer him.

In the second trading regime, the salesman offering one piece of apple would, half the time, add a free bonus piece once the disc had been handed over. The salesman offering two pieces would, as in the first regime, actually hand over only one of them half the time. In this case, the average outcome was identical, but the monkeys quickly reversed their behaviour from the first regime and came to prefer trading with the first salesman.

In the third regime, the second salesman always took the second piece of apple away before handing over the goods, while the first never gave freebies. So, once again, the outcomes were identical. In this case, however, the monkeys preferred the first salesman even more strongly than in the second regime.

What the responses to the second and third regimes seem to have in common is a preference for avoiding apparent loss, even though that loss does not, in strictly economic terms, exist. That such behaviour occurs in two primates suggests a common evolutionary origin. It must, therefore, have an adaptive explanation.

What that explanation is has yet to be worked out. One possibility is that in nature, with a food supply that is often barely adequate, losses that lead to the pangs of hunger are felt more keenly than gains that lead to the comfort of satiety. Agriculture has changed that calculus, but people still have the attitudes of the hunter-gatherer wired into them. Economists take note.

And yes I would be much more pro-nature as oppose to nurture.

Oil in troubled waters

The Economist has oil as its cover story this week, a subject oft-covered on this blog. Vijay Vaitheeswaran is writing this story in the Economist. Here’s a nice graph:

Vijay notes, and I will highlight the bits I like:

More worryingly, Mr Morse believes the problem extends well beyond just spare production capacity. He points to the tightness in markets for oil rigs, tankers, petroleum engineers, refinery capacity and various other bits of the oil value chain, and concludes that the problem is systemic: âThe illusion that oil is in perennial oversupply has led to two decades of underinvestment in the oil industry. The world has been living off the legacy spare capacity built up many years ago.â?

Given today’s high prices, surely the market will soon enough provide the necessary new infrastructure? Probably not, for two reasons. The first is that the world seems to be coping rather well with today’s shockingly high prices, so perhaps they have to persist for longer or rise higher still before investors are stirred into action. The second reason is the bitter memory of oil at $10 a barrel.

OPEC countries are unlikely to rush to build lots of spare capacity because they are worried that another price collapse may follow. PFC Energy observes that when the oil price hit $55 late last year, spare capacity was less than 15% of the 8.7m bpd peak reached in 1985, and notes: âOPEC national interests do not lie in creating large capacity surpluses that have existed for most of the history of oil.â?

But as always in the style of Economist articles – on the other hand…

Still, the crunch may ease if the Saudis rebuild their buffer. It may be in their interest to do so. For most of the OPEC countries, it makes sense to try to maximise prices in the short term because their reserves of oil are relatively small. The Saudis, by contrast, are sitting atop at least 260 billion barrels of proven oil reserves, far more than Libya, Venezuela, Indonesia and Nigeria combined. Even at current production levels of around 10m bpd, which make them the world’s top exporters, they have enough oil to pump for most of this century. They will not want prices to stay too high for too long, or else investors will put money into non-OPEC oil or alternative fuels.

The desert kingdom’s rulers also remember the lessons of the 1970s oil shocks, when the biggest losers were not consuming economies (which eventually adapted to higher prices) but the petro-economies of OPEC. Ali Naimi, the Saudi oil minister, rejects the idea that his country wants prices to rise ever higher: âWe are misunderstood: we thrive on the economic growth of others, which is concomitant with energy demand.â? That is why the Saudis have long acted as the voice of moderation within OPEC, resisting calls from price hawks such as Libya, Iran and, since the rise of Mr Chavez, Venezuela to squeeze consumers.

Indeed, at the most recent formal OPEC meeting, held in Iran on March 16th, the Saudis in effect bullied reluctant cartel members into trying to calm prices down. They won agreement for a rise in oil production quotas to boost global oil inventories that looked like a reversal of the cartel’s established policy of keeping OECD inventories tight and prices high.

Developments within Saudi Arabia seem to confirm that the buffer is being rebuilt. Saudi Aramco, the state-run oil giant (and the world’s largest oil company), has recently launched its biggest expansion programme in many years. Outside contractors report a surge in rig counts and drilling activity as the country increases spare capacity to its stated goal of 1.5m-2m bpd. But even if Saudi Arabia is willing to re-establish an adequate buffer, this could take years. Will prices stay high until then?

Well will they? In short, yes. But there is a ‘but’ attached. Here’s why.

OPEC ministers and Wall Street analysts talk of a new âprice paradigmâ?. At first sight, there seems to be something in that. In the past, contracts for delivery of crude months or years ahead (what Alan Greenspan, the chairman of the Federal Reserve, has poetically called âdistant futuresâ?) usually stayed low and stable even if the spot price shot up because of some short-term disruption. But for the past couple of years the distant futures have tended to shoot up too. The markets clearly expect that higher prices are here to stay.

Political scientists point to the bloated welfare states in most OPEC countries which will require higher oil prices to balance budgets and avoid social unrest. Some industry analysts see a new âfloorâ? price of $30-40, if only to persuade oil firms to splash out on necessary investments upstream. Matt Simmons, a prominent energy investment banker, thinks that in view of rising input costs (for such things as oil rigs, steel pipes, tankers and so on) the oil price âneeds to go way, way upâ?.

But…(and what was Bush saying about China’s demand for oil recently?)

One factor is potential weakness in demand. There is much talk about Chinese demand changing all the rules, but that is just plain wrong. China’s share of world oil consumption is still under 8%, far smaller than America’s at 25%. Goldman Sachs, an investment bank, estimates that even assuming robust growth, China will remain a smaller oil consumer than America for decades to come.

And the growth in China’s oil demand of nearly 16% last year is unsustainable. For one thing, there are simply not enough cars in all of China to guzzle that much oil. Much of the 2004 rise was related to the country’s overheating economy and is unlikely to be repeated. For example, shortages of cheap coal led to the use of pricey fuel oil or dirty diesel for electricity generation; as bottlenecks in the coal system ease, that oil use will disappear. Over the past two years, as the country has developed its oil infrastructure, it has needed to fill pipelines, storage tanks and the like, but these were one-off purchases. The International Energy Agency (IEA) says that in January and February 2005, Chinese oil demand rose by only 5.4% on the same period in 2004, less than a quarter of the rate a year earlier. And if China’s banking sector or its overall economy takes a knock, oil consumption is bound to be hit too.

And to conclude:

Aramco’s boss [Saudi’s and indeed the world’s largest oil company] Abdallah Jumah, sums it up: âWhere the oil price goes, nobody knows.â? He wishes it were otherwise. âThe key is stability so we can plan. Oil investments take a long time to come to fruition.â? His boss, Mr Naimi, argues that âoil is simply too vital a commodity to be left to the vagaries of the marketplace.â? But even Saudi Arabia cannot guarantee oil-market stability, especially with its buffer so depleted. Indeed, the only sensible thing anyone can say about oil prices today is that they are unlikely to remain stable.

The difference between economists and political scientists

Dan Drezner has a lenghty post concerning a debate he’s having with Matthew Yglesias and Brad DeLong. It surrounds the US request for China to “immediately introduce a flexible currency” which the FT reports is “a marked shift in tactics after several years of patient diplomacy aimed at nudging China towards allowing the renminbi to float”.

Drezner notes:

Brad’s assertion is that political scientists think that “getting serious” about something is dispatching an ambassador — as opposed to the economists who want to fix the problem. Actually, to a political scientist — more specifically, one who studies international relations — you “get serious” about an issue like the currency when you engage in tactical issue linkage to change other government’s policies in such a way as to change the balance of returns and risks facing those buying and selling in foreign exchange markets. If one can arrange for other countries to bear a greater portion of the costs of adjustment from the current set of macroeconomic imbalances, then political scientists will predict that governments will prefer this policy option ten times out of ten — even if the long-term economic picture would be improved by listening to economists. [Yes, but doesn’t this still leave the U.S. with some long-term macroeconomic problems?–ed. I believe it was an economist who pointed out what happens in the long run.]

This leads to Matthew’s appropriate question about leverage — what does the U.S. have to offer? What is the tactical issue linkage that could be put in play here?

Running out of puff?

The Economist presents a pretty stark view of the world economy with such gems as:

Unemployment in the euro area is 8.9%; in Germany, France and Spain it is in double digits. Manufacturing in the single-currency zone has stalled. In its latest World Economic Outlook, published this week, the IMF, like other forecasters before it, slashed its forecast for euro-area GDP growth this year, to 1.6%. The world economy’s other weak link, Japan, faltered half-way through 2004 and despite the odd spark has not yet sputtered into life again. Rising oil prices have helped neither of these giant weaklings.

Even in America, where the strength of the expansion has consistently surprised economists, there are nascent signs of slowdown and worries about oil. With job growth scarcely topping 100,000, the March employment report was much weaker than expected. Retail sales grew by only 0.3% (month-on-month) in March, less than half of what analysts had expected, suggesting that record petrol prices were wearing holes in consumers’ pockets.

Or even:

According to statistics released on April 12th, America’s monthly trade deficit reached a record $61 billion in February (see chart). The climb in oil prices may mean another record in March—although much of February’s increase reflected sharp growth in non-oil imports, which were 16% higher than in February 2004.

Brad Setser, a former Treasury official who is now at Roubini Global Economics, an economic-analysis firm, reckons that if non-oil import growth continues at its recent pace and the oil price stays over $50 a barrel, America’s annual trade deficit would reach nearly $800 billion by the end of the year. That said, the figure may not get that high, because $50 oil ought to dampen American consumer demand and hence import growth.

But they conclude:

It is possible to be sanguine about America’s ever more colossal deficits, just as it is about oil. Certainly, the doomsday scenarios of a dollar crash or a hard landing for the American economy are not in sight. America has had little trouble attracting the necessary capital to fund its soaring deficits. Though Asia’s central banks are still big purchasers, they are not the only ones. Thanks to soaring prices, oil exporters have been building up their surpluses. Russia’s foreign-exchange reserves, for instance, are now over $130 billion. Many of these oil exporters are choosing dollar assets. The dollar has strengthened since the beginning of 2005 and long-term interest rates remain remarkably low.

This calm may explain why the world’s finance ministers have done so little to wean themselves off their addiction to American-led growth and why they will spend most of their time in Washington fretting about oil. That is a pity, for while the oil price seems to be the most imminent risk, the size and rate of growth of the global imbalances are the real reason to worry. If the world economy continues on autopilot, those imbalances are set to increase. And you do not need to be a Cassandra to predict that, eventually, they will create a nasty problem.

I guess we will have to see how things pan out in the coming months.

Free trade may have finished off Neanderthals

This one for all the free-market lovers out there:

Modern humans may have driven Neanderthals to extinction 30,000 years ago because Homo sapiens unlocked the secrets of free trade, say a group of US and Dutch economists. The theory could shed new light on the mysterious and sudden demise of the Neanderthals after over 260,000 years of healthy survival.

Dress down to save Japan, PM says

I have to hand it to them, it is a good idea.

Japan’s prime minister plans to dress down this summer, and wants millions of Japanese office workers to do the same. Junichiro Koizumi is asking workers to cast off their collars and ties in a national effort to use less energy on air conditioning. To show how serious he is, Mr Koizumi has ordered government ministers to shed their suits to set an example. Japan often endures hot, humid summers, forcing offices and bars to ramp up air-conditioning systems.

A Pain in the Walnuts

Diana has a stinging rebuke for the Freedom Institute in the ongoing debate concerning minimum wage and that girl being pade €1.08 an hour on Irish Ferries. The entire debate, including all the comments, is a very enjoyable read.

Coal in a nice shade of green

Thomas Homer-Dixon and S. Julio Friedmann suggest using a new-type energy source known as gasification. What is it?

Here’s how it works: In a type of power plant called an integrated gasification combined-cycle facility, we change any fossil fuel, including coal, into a superhot gas that is rich in hydrogen – and in the process strip out pollutants like sulfur and mercury. As in a traditional combustion power plant, the heat generates large amounts of electricity; but in this case, the gas byproducts can be pure streams of hydrogen and carbon dioxide.

This matters for several reasons. The hydrogen produced could be used as a transportation fuel. Equally important, the harmful carbon dioxide waste is in a form that can be pumped deep underground and stored, theoretically for millions of years, in old oil and gas fields or saline aquifers. This process is called geologic storage, or carbon sequestration, and recent field demonstrations in Canada and Norway have shown it can work and work safely.

The marriage of gasified coal plants and geologic storage could allow us to build power plants that produce vast amounts of energy with virtually no carbon dioxide emissions in the air. Moreover, these plants are very flexible: Although coal is the most obvious fuel source, they could burn almost any organic material, including waste cornhusks and woodchips.

There are hurdles. For example, we need a crash program of research to find out which geological formations best lock up the carbon dioxide for the longest time.

On balance, though, this combination of technologies is probably among the best ways to provide the energy needed by modern societies – including populous, energy-hungry and coal-rich societies like China and India – without wrecking the global climate. The combination of gasified coal plants and geologic storage can be our bridge to the clean energy of the 22nd century and beyond.

The Overstretch Myth

David H. Levey and Stuart S. Brown write in the latest issue of Foreign Affairs on the US deficit. A riveting read, for those interested in US economics, I know some of you out there enjoy it at least. In their conclusion they look at some precedents:

At the peak of its global power the United Kingdom was a net creditor, but as it entered the twentieth century, it started losing its economic dominance to Germany and the United States. In contrast, the United States is a large net debtor. But in its case, no plausible challenger to its economic leadership exists, and its share of the global economy will not decline. Focusing exclusively on the NIIP obscures the United States’ institutional, technological, and demographic advantages. Such advantages are further bolstered by the underlying complementarities between the U.S. economy and the economies of the developing world — especially those in Asia. The United States continues to reap major gains from what Charles de Gaulle called its “exorbitant privilege,” its unique role in providing global liquidity by running chronic external imbalances. The resulting inflow of productivity-enhancing capital has strengthened its underlying economic position. Only one development could upset this optimistic prognosis: an end to the technological dynamism, openness to trade, and flexibility that have powered the U.S. economy. The biggest threat to U.S. hegemony, accordingly, stems not from the sentiments of foreign investors, but from protectionism and isolationism at home.

Pouring oil on the East China Sea

Some ongoing tensions between Japan and China are detailed here.

Japan has begun planning for the worst. A conflict with China over rich gas deposits in the East China Sea has escalated since late January when two Chinese destroyers entered the area, which has been in dispute for decades. Japan warned China that it would defend its resources there.

But conflict is not inevitable. China’s June 2004 proposal to jointly develop a large gas field that straddles a boundary claimed by Japan is an opportunity to cap rising tension, and at long last harvest the resources in the disputed area.

The East China Sea is thought to contain up to 100 billion barrels of oil – it is one of the last unexplored high-potential resource areas located near large markets. The development of oil and gas in much of the area has been prevented for decades by the boundary dispute. The Japanese government has refused to let companies explore and develop the resources in the area because it says that it could adversely affect relations and negotiations with China on the boundary.

But now China is drilling near the boundary claimed by Japan. Tokyo has officially protested the drilling and is now considering allowing some companies to drill on Japan’s side of its claimed boundary. Just the possibility has been protested by Beijing.