(Stockbyte)
Did President Obama get the economics wrong earlier this month when he abandoned stricter air-quality rules, wagering environmentalist loyalty in a bid to avoid job losses from strict new ozone standards? Paul Krugman thinks so, calling the decision to wave off the EPA a “lousy decision all around.” But is Krugman right?
The short-run job-creating move, Krugman contends, would have been for Obama to promulgate the new ozone regulations, which would have forced firms in hundreds of counties across the country to replace and upgrade capital in order to comply with new, stringent pollution abatement requirements. He asserts that because the U.S. economy is in a liquidity trap, wherein conventional monetary policy is insufficient to induce firms to spend, the regulations could have accomplished what the Fed cannot. In such a “world of topsy-turvy,” as Krugman says, the usual rules of economics are thrown out, and even the “Broken Window Fallacy” ceases to hold.
The 19th century French theorist Frederic Bastiat cautioned against concluding that a shopkeeper’s broken window is a good thing because it induces him to employ a glazier to repair the window. Such a conclusion ignores that which is unseen: that the shopkeeper would have employed the shoemaker to replace his worn out shoes had the window not been broken. Hence, the broken window doesn’t increase employment or grow wealth. In fact, it shrinks wealth, leaving the shopkeeper worse off than if he had been able to replace his worn out shoes for the cost of the new window. The deliberate destruction of windows, then, would assuredly be poor economic policy in normal times because it trades wealth-creating spending for wealth-replacing spending.
But what happens in unusual times, like those of a liquidity trap? Krugman contends that shopkeepers are sitting on stockpiles of cash and not spending. So the shopkeeper’s expenditures to replace broken windows won’t crowd out expenditures on shoes since he wasn’t going to purchase shoes in the short run anyway. So, too, Krugman reasons, forced investments on pollution abatement won’t crowd out other investments since they’re not happening anyway. Thus a policy of capital destruction to spur economic activity, like breaking windows or using regulatory fiat to mothball functional equipment, may never make more sense than during a liquidity trap. But that doesn’t mean it makes sense even then.
Let us consider the employment and wealth impacts of new pollution abatement requirements on three classes of businesses: those with savings, those without savings, and those who are considering new entry or expansion. Let us assume, as a liquidity trap story does, that absent new pollution abatement requirements, businesses with savings would not spend down their savings in the short run to buy new equipment or hire new workers. In order to comply with the new regulations, these businesses draw down their savings and make expenditures to meet the new standards. There is seemingly no crowding out of other investments in the short run, though future spending would decline.
But, cash reserves are not “idle” for most businesses; they are providing a hedge during uncertain economic times. If owners of such businesses have decided that their current reserve is optimal, then surely they will seek to maintain that hedge even with the requirement of new pollution-abatement expenditures. In that case, they must reduce other expenditures today in order to retain the hedge. The new expenditures and jobs for pollution abatement, then, are partially or fully offset by reduced expenditures and job losses elsewhere.
What about the business that does not have savings but must spend to comply with the new regulations? Unless these businesses can take on debt, which is doubtful if they are cash constrained, then the new regulations force them to either shutter their businesses or make one-for-one reductions in other expenditures. Among those without savings, then, the broken window fallacy holds strong. In essence, creating a job for a pollution “abater” comes at the cost of a job for a shoemaker or for the shopkeeper, himself.
Finally, what do the pollution abatement requirements do to the shopkeeper who was planning to open a new shop? The compliance costs lower his return on investment from opening a new shop and may cause him to forego opening the shop altogether.
When one considers that which is unseen—the loss of expenditures and jobs by businesses without substantial cash reserves and the loss of jobs among potential entrants—it becomes clear that Krugman’s prescription for job growth may not be the antidote to an ailing economy. And even among those businesses sitting on cash reserves, it is likely that regulatory compliance costs would crowd out other expenditures (and thus other employment) as those firms sought to maintain the cash reserves they deemed optimal in the first place as a hedge against an uncertain economic future.
Even in a world of topsy-turvy, the laws of economics still hold: shopkeepers, glaziers and shoemakers are still utility maximizing agents. And imposing higher regulatory costs on firms still deters job creation and growth. President Obama may not succeed in creating enough jobs to save his job, but, a priori, it’s certainly not clear that his decision to walk back costly new ozone regulations in uncertain economic times was a bad idea.
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To play on the broken window fallacy a bit, it strictly applies only if the shopkeeper replaces the broken windows with identical ones. Suppose instead that breaking the old window with its small panes of bubbly, distorting glass causes the shopkeeper to invest in new double-paned, thermal insulating glass. His goods are now more visible from outside, so he attracts more business from passers-by. The shop is lighter and better insulated, so is more pleasant for customers, he spends less on light & heat, etc. And as a result he makes enough extra profit to pay for the new windows, and buy two new pairs of shoes.
This logic seems to carry over to these environmental regulations. Outmoded, inefficient equipment, the cost of which is largely born by the general public in the form of dirty air &c, is replaced with new equipment, to the net profit of all concerned.
Hot debate. What do you think?
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Yes, but in that scenario he could have invested in that new window at any time, but the marginal value of other goods was deemed to be greater. That is the point of the article, not that the regulations have no value, but that other things have greater value.
Well-loved. Like or Dislike:
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Certainly the shopkeeper COULD HAVE invested in the new windows, but through a choice of ignorance & inertia, he didn’t. (Which of course would be fine if we’re considering just his shop, but here we’re considering “windows” that have deleterious effects on the general public.)
The US auto industry could serve as a textbook case. It spent decades (and untold amounts in lobbying fees) arguing that it couldn’t possibly replace its “windows” – that is, comply with air quality & efficiency standards. Meanwhile the Japanese automakers just went ahead and replaced theirs, with resulting gain in market share.
Hot debate. What do you think?
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This is sounding a lot like Monty Python’s dead parrot sketch.
He’s not dead!
The author missed, I think, an important point, the businesses are also going to increase the selling price of their product in order to get back the cost of this capital expenditure. If the item is electricity then everyone is going to be effected by higher prices. If he can not increase prices in the short run he may also look to reduce expenses, that will probably be labor. Either way who wins?
Well-loved. Like or Dislike:
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Fair question: is cleaner air worth a small increase in the price of electricity? (And tiny increases in the prices of stuff that is manufactured using electicity.) For me, the answer’s an emphatic yes. What could I buy with a couple of extra dollars a month that would give me more pleasure? And maybe save me money by reducing spending on health care for all the health problems caused by the dirty air?
It seems you may be embelishing the benefits. You are assuming that the marginal benefit in air quality will be markedly improved that instances of respiratory illnesses will demonstrably decrease. You are also assuming that the cost to you is only a few dollars to you a month. What you are not addressing are the potential hidden costs. Did the regulation cause someone to lose their job, could that person find another job, if not, will that person be collecting unemployment benefits, will that person be collecting any government sponsored welfare. How much does that government sponsored welfare cost you? What if the benefits of the regulation has no demonstrable impact on the general populations health?
I think the answer lies somewhere between Krugman and Sexton here. Krugman argues that the spending will not be offset, because it will come from idle cash. Sexton argues that the spending will be offset as some companies are constrained and others will want to build up their reserves again. It seems to me that some will be offset and some won’t and it will be impossible to know it the net effect is positive or negative without knowing the specifics of each industry and business affected.
If you’re judging the Overall effect, you do need to include the fact that these new rules were meant to curb substantial negative externalities, (they were essentially smog reducing rules and only tangentially, if at all related to climate change) so there would be a broad benefit in reduced asthma attacks and lung disease and all the sick days and medical bills that come with them.
Hot debate. What do you think?
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Presumably tighter air-quality rules have economic benefits in terms of human health. Or, in other words, lax environmental regulation has costs. If eliminating regulations always “maximized utility”, then crafting policy would be simple – no more regulations! Obviously, that does not maximize utility, which is why we have regulations to begin with. That doesn’t seem to get consideration here.
Hot debate. What do you think?
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Sure, lower ozone standards would make companies spend money on new air pollution controll equipment. However, the standards take several years to become fully effective even if there are no lawsuits (and there always is). Industry wont be purchasing new equipment or making upgrades for several years. Additionally, the type of control equipment for ozone is very expensive to operate. An expense that will persit well after the slug of initail orders are filled and, hopefully, the economy is back on its feet.
Also, the cost of control equipment can typically be passed on the to rate payer.
Not to mention the questions behind the stadards themselves. In many areas of the country, the natural ozone level (ie no human influence) is above the current standard.
Based on your argument, the important data here should be what kind of firms would be effected by the environmental regulation, and are they holding large savings? Assuming its industrial polluters, are they holding a disproportionate amount of the $2 trillion the private sector is sitting on? The answer to that question should tell whether you or Krugman has this particular case right.
A key assumption that you make is that the saver firms are actually optimizing their savings by storing away huge piles of cash reserve. It is not clear to me that your assumption accurately describes reality. Many firms found cutting jobs during the downturn to be very good for the bottom line. However, because so many firms cut jobs at once, they collectively damaged the consumer base, thus leaving firms with lots of cash but dim prospects for future demand growth. If someone (the government) could help firms solve the coordination problem by forcing many firms to spend the excess money they have stockpiled away all at once, firms would take a short-run hit to profits but could be more than compensated by having a healthier future consumer outlook. If the government forces this spending using worthwhile regulations that save lives by protecting air quality, that’s great!
Hot debate. What do you think?
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You seem not to have factored in the cost of pollution.