A solution to a big commodity price puzzle (super wonkish)

A long standing puzzle in the economics of commodity prices concerns the large amount of autocorrelation observed in most price series.  While most commodity prices appear to revert to historical means eventually, it typically takes a long time, so much so that, at least statistically, it's hard to reject the hypothesis that price shocks are permanent and historical reversions have simply been due to chance.

This "puzzle" was so articulated in a series of very influential papers by Angus Deaton and Guy Laroque.  They reasoned that commodity prices should be autocorrelated to some extent due to the buffering effects of storage.  In plentiful times some production is saved; in bad years, inventories are drawn down to supplement production.  Consumption is therefore smoother than production and prices are less volatile that they would be without storage, but are autocorrelated even though production shocks can appear random (like from the weather).   The puzzle came about from the formal modeling of this process and some sophisticated techniques they used to fit that model to observed commodity prices.  That model indicated a certain amount of autocorrelation but nowhere near as much as we observe in reality.

So, all this might sound very technical, and it is, but it is pretty fundamental for understanding why we occasionally have huge commodity price spikes like the one in 2008, which can cause starvation, malnutrition, and civil conflict in developing countries.  When staple food gets too expensive the world turns very ugly.

A new paper by Carlo Cafiero, Eugenio and Juan Bobenrieth, and Brian Wright (one of my professors at Berkeley) in the Journal of Econometrics (sorry, only a gated version)  have a pretty clear solution to this puzzle.  It turns out that Deaton and Laroque's puzzling findings stemmed mainly from imperfect calibration of their model that came from using approximation methods that were too coarse.  I'd guess computers simply weren't fast enough back then to make super fine approximations.  Cafiero et al. simply improved the resolution of the approximation, obtained better estimates of the few key parameters, and can now model commodity prices that look very much like the real world.

The crux, it seems, is that demand for commodities is extremely inelastic.  Thus, when inventories get very low, prices spike very high.  This creates a strong incentive to keep a lot of inventories in speculation for the day when prices do spike.  So we rarely get stock outs but when we do, or get close, prices can go very high.  That's pretty much what happened in 2008.  It may have been precipitated somewhat by the ethanol boom that increased grain demand more than expected.  In the initial years after the boom, inventories were probably too low for the new demand regime, which made the market particularly susceptible to inventory draw downs and a huge price spike.

To my mind, this is one of the best examples of a dynamic rational expectations economic model that actually works.

Update: Below is a picture of the solution and how a poor approximation missed what was critical.  The essential problem involves finding a function that relates price (p) to the available supply (z).  Available supply includes inventories carried over from the last period plus current production, which can vary randomly.  The 'kink' in the line is where storage reaches zero and the market consumes everything that's available.  So the upper part of the price function is just the consumption demand curve.  When prices are below that line, the amount stored is the horizontal difference between the price function and the dashed line that follows from the straight line above the kink.  So, this is the essential picture that tells when its optimal to sell high and buy low when it comes to commodities.  The kink is critical--that's where prices can really start to spike more in relation to small shocks.  The red line is Deaton and Laroque's approximation, which doesn't quite fit to correct (more finely callibrated) line.  It's especially far off near the kink, which is key. The incorrectly smooth price function suggested prices less autocorrelated that we observe.  But it was all just approximation error, not necessarily a fundamental flaw in the theory.

Rhee brings high-powered incentives to DC's schools

So Michelle Rhee, DC's controversial chancellor, just fired 241 teachers, most due to poor performance on new IMPACT evaluations.  That's about 6 percent of all teachers in the district.  Another 737 were rated "minimally effective" on IMPACT and could lose their jobs next year.

At least the recession, high unemployment and state cutbacks around the country have left plenty of jobless teachers to fill the new vacancies in DC.

So, should economists everywhere cheer a new high-powered incentive system for teachers?

I'm not so sure.  Incentives can be great.  But they have to be meaningful.

One encouraging sign is that a lot of thought and effort seemed to go into developing IMPACT (see here and here). The problem with IMPACT is that it hasn't yet been proven meaningful.  Why, I wonder, wasn't the evaluation system first tested experimentally to see if it actually differentiated effective teachers from ineffective teachers?

Teaching effectiveness is an iellusive thing.  This recent paper in the Journal of Political Economy, for example, shows that teachers that provoke "deep learning," measured by performance of students in courses subsequent to the course being evaluated, tend to score relatively poorly on current evaluations.  This is the best metric for good teaching I've seen: not student performance in the current class, standardized tests, or current evaluations, but performance in subsequent classes that require or otherwise use or apply knowledge from the course being evaluated.  Granted, this JPE study was for college students and things might be different for kindergarten through 12th grade.

Still, I would have like to have seen IMPACT ratings carefully studied over time in relation to actual student performance before they started laying off teachers.  Yes, this kind of careful investigation takes time.  But without it efforts to improve DC education are a lot less likely to succeed.

Update: Speaking about the iellusiveness of teaching effectiveness, this study, as described by David Leonhardt, is kind of mind blowing.  But you know, it's what my mother (a child development expert who taught Kindergarten for 9 years) always told me.

Is subsidizing research a good substitute for pricing carbon?

So everyone who knows more about politics than I do (which is pretty much everyone) says that cap and trade, or any kind of carbon pricing, is dead.  That makes me, and I expect the vast majority of economists, very sad.  Republicans (and probably some Dems) are now pushing old command-and-control regulations, which make almost no sense in comparison to pricing carbon.

Another angle that makes at least some sense, and may be more politically feasible (I profess no insight), is to subsidize research and development of alternative energies.   Can we come up with energy sources that have no externalities and have private costs that are cheaper than current cheap but polluting energy sources?  Sitting from my armchair this seems dubious but possible.  

Here's Ezra Klein interviewing Michael Shellenberger:

Ezra Klein: It looks like a carbon-pricing bill is pretty much dead. What happened?
Michael Shellenberger: .... the green groups hired some of the best advertisers and lobbyists and spent $100 million. ... They had arguably the best mobilization environmental groups have ever done in the history of the environmental movement. It was the proposal itself that was impossible for this Congress, and any Congress in recent memory, to pass.

EK: Is there any near-term hope for the politics to change? Any reason to think that a future Congress will view this differently?
MS: I think that this is the end of cap-and-trade for a long time.....

EK: So then, what next?
MS: Our view is you need a price on carbon, but that it’s going to start very low..... So we need to be moving to a framework where at the center is technological innovation to close the gap between fossil fuels and clean energy. That might need to be funded with a small tax on carbon. But the center is the technological innovation.

EK: And to distinguish that from cap-and-trade, the idea here isn’t really that you’re pricing carbon, but that you’re funding research into alternatives.
MS: In the early years, that’s its primary purpose. .... A cost of $5 a ton is $30 billion a year. ... far below estimates of cap-and-trade. What conservatives and Republicans might find appealing is that this would be focused on technology innovation....everything from solar to nuclear, you should be able to appeal to some of them.

EK: And why put any faith in this? Why should we believe it’ll work?
MS: This isn’t something we think can succeed right away. .... We’re not going to do anything of consequence on reducing emissions without closing the price and technology gap between clean energy and fossil fuels, and we’re not going to make serious headway on technology innovation unless we fund innovation directly, .... The history of tech innovation in the U.S. is really a history of military procurement, R&D funding, science and engineering education, and demonstration projects.

EK: And how would this work, in practice? Won’t it just end up subsidizing a lot of waste?
MS:....Defense spends $80 billion a year on R&D. Is some of it wasted? Of course. Thomas Watson said, “If you want success, increase your failure rate.” ....We’re missing a demanding customer, which is what the Pentagon has been. You can point to waste there, but also amazing innovations in communications and rocketry. We look at Google and Apple and think the federal government had nothing to do with them, but without federal investment in computers there would be no Apple and without DARPA there would be no Google.

Given history, it seems likely to me that market failures on the innovation front may be as large as pollution externalities, which suggests subsidizing research and development may be a reasonable substitute for pricing carbon.  Of course, with two market failures the *best*  solution would involve at least two policy instruments--something like subsidize innovation and tax pollution.  That was the angle Waxman and Markey took.  But oh well...

So, my academic question of the day is, suppose there are two market failures, say a pollution externality and a public goods problem that stifles innovation for renewable energy, but suppose you can use just one instrument to deal with that problem, say, a tax on pollution or a subsidy on innovation.  Which would be best under what circumstances?  Can a toy model be combined with some stylized facts to suggest whether a pollution tax beats an innovation subsidy or vice versa?  Is it possible that the big policy push should have been (and should be) on innovation subsidies rather than carbon taxes even though both are theoretically optimal?

Robert Solow on Dynamic Stochastic General Equilibrium Models (DSGE)

Robert Solow:

...Economic theory is always and inevitably too simple; that can not be helped. But it is all the more important to keep pointing out foolishness wherever it appears. Especially when it comes to matters as important as macroeconomics, a mainstream economist like me insists that every proposition must pass the smell test: does this really make sense? I do not think that the currently popular DSGE models pass the smell test. They take it for granted that the whole economy can be thought about as if it were a single, consistent person or dynasty carrying out a rationally designed, long-term plan, occasionally disturbed by unexpected shocks, but adapting to them in a rational, consistent way. I do not think that this picture passes the smell test. The protagonists of this idea make a claim to respectability by asserting that it is founded on what we know about microeconomic behavior, but I think that this claim is generally phony. The advocates no doubt believe what they say, but they seem to have stopped sniffing or to have lost their sense of smell altogether.

Ouch.  I'd like to think these tools are useful in many applications.  Actually, I think among the first applications of the Bellman equation and stochastic dynamic programming were in agricultural economics by Oscar Burt.  I'm doing some stuff with crop rotations right now that I think is useful, interesting, and relevant to the real world.  But I think I have to agree with Solow here: I really don't see how these models have been useful in helping us to understand any of the important questions in macroeconomics.  But then I'm not a macroeconomist.  Can anyone briefly explain a key insight about the macro economy that DSGEs have helped to teach us?

I agree with Leonard and Stavins: A price on carbon is the only honest way of dealing with climate change

David Leonard:

....The most efficient way to begin attacking the global swelter is no mystery. It involves raising the price of carbon emissions, which are warming the planet, and then letting the private sector find innovative ways to use less dirty energy. Conservative economists, like Gregory Mankiw, support this approach. So do liberals, like Joseph Stiglitz.

But taxing carbon has never had much of a political chance. It’s too honest. 

....Robert Stavins, the Harvard economist, told me he would actually prefer a bill that cut emissions less in the short term but created a template for much bigger cuts in the future. “Success, to me, would be the beginning of political acceptance of carbon pricing,” he said.

Read the whole article.

If you're worried about distributional issues associated with a carbon tax (and I might be too), then deal with those separately with appropriate transfers and safety nets.

This isn't that hard.  It's not that costly.

John Quiggin thinks academic economists look good on the issue of climate change

John Quiggin:

Ross Gittins repeats the criticism he, Ken Henry and Martin Parkinson, have put forward previously, that economists were either missing in action or actively unhelpful in the climate change debate. I disagree – I think academic economists as a group look a lot better on this issue than do economic columnists, and (on the limited available evidence) at least as good as public servants.

The views of the profession were stated pretty clearly back in 2002, when Clive Hamilton and I organized a statement calling for ratification of Kyoto which got 250 signatures (about 40 per cent of the entire academic economics profession at the time, which is huge given that many people never sign anything, or don’t get round to answering their email). A second pro-Kyoto statement in 2007 got 270 signatures, including 70 professors.

Against that, there are a handful of rightwingers who accept the delusional anti-science line that is required as a totem of tribal loyalty on the right. Not only is this group numerically small but, AFAIK, it doesn’t include anyone with substantial standing in the profession[1]. That’s certainly what the public record suggests. In 2002, John Humphreys and some others announced a counter-statement, but it never appeared, presumably because of the embarrassing quantity and quality of those willing to sign.

The footnote [1] presumably refers to this issue.

Anyway, I do think most academic economists believe it makes sense to price carbon emissions either via a tax (see Greg Mankiw's Pigou Club) or a cap and trade system (as advocated by Robert Stavins).  Differences between these two approaches are small in economic terms.  Political differences may be large but I just don't get the politics here.  I do believe arguments against any form of policy are from a considerably smaller group of economists that typically have less standing and tend to be closely tied to some right-wing ideological faction.  There is also serious debate about the correct carbon price and whether it is best to start with a high price for carbon or start with low price and gradually ramp up.

I do, however, think economists as a group are generally biased toward the idea that adaptation to climate change will be relatively easy while adaptation to a low-carbon economy will be difficult.  I cannot carefully document that impression (well, maybe I could with a lot more work than a quick blog post). While I regard both kinds of adaptation as highly uncertain, my own take on the evidence thus far is that adapting to a low-carbon economy will be less costly than adaptation to a significantly warmer climate.

More misleading reports of "smaller farms"

Here we go again.

Last time it was the New York Times. (See this old post.  And this one and this one.)

Now Emmeline Zhao at the Wall Street Journal:

FARMS GET SMALLER, LESS GOVERNMENT SUPPORT 

More — but smaller — farms across the country generated greater national net income in times of drastically less government support. National net farm income in 2008 was $87.3 billion, up from $50.7 billion in 2000, the Census Bureau said last week. Net income was greatest in California, Iowa, Minnesota and Illinois.

The latest agriculture census data also reveals a greater number of farms in the U.S. — just over 2.2 million in 2007, up from more than 2.1 million in 2002 — and about a 52% increase in overall property value, but the average size of farms has fallen to 418 acres from 441 acres over the same period....

This is a mirage.  And average farm size is a utterly meaningless statistic. This goes back to an utterly ridiculous definition of a farm that is intended to maximize farm counts and keep counts increasing over time.  But it's the definition that's changing, not the actual management of farms or land.

Here's a great USDA-ERS report that spells out these issues carefully.  Here's a brief report  about how this matters for tracking changes in farm size.

At least the article explains that less government support is coming mainly from the fact that commodity prices are higher today than they were in 2005 and earlier.  What the article shamefully does not mention is the implicit support coming from ethanol subsidies.  These get passed to farmers in the form of higher commodity prices, not checks from the government.  Instead those checks get passed to ethanol producers who then buy the grain from farmers.

Is it too much to ask the Wall Street Journal to inform rather than misinform readers?

If Teach for America cannot accept Harvard graduates accepted to UVA law school then I know a good use for stimulus dollars

Michael Winerip at the New York Times:

Alneada Biggers, Harvard class of 2010, was amazed this past year when she discovered that getting into the nation’s top law schools and grad programs could be easier than being accepted for a starting teaching job with Teach for America.

Ms. Biggers says that of 15 to 20 Harvard friends who applied to Teach for America, only three or four got in. “This wasn’t last minute — a lot applied in August 2009, they’d been student leaders and volunteered,” Ms. Biggers said. She says one of her closest friends wanted to do Teach for America, but was rejected and had to “settle” for University of Virginia Law School.

So.  Here's the question:  If as a society we could borrow money at zero percent interest to fund states so they could hire a lot more Teach for America Students from Harvard, and thus increase the quality of education in inner cities currently struggling amid savage budget cuts, do you think it would be worth it?  Do you think the rewards for society would be worth the expense?

Before you answer, please note that a lot of economics research suggests (a) there are very few investments that pay as well as education does, just in terms of the wages paid (see the review by David Card); and (b) a lot more recent economics research (much of it by Enrico Moretti) that shows additional benefits to society from higher education, including (i) reduced crime; and (ii) knowledge spillovers in the workplace that increase wages for everyone; (iii) intergenerational effects that cause the children of educated parents more likely to become more educated themselves, all of which could easily double the already high private returns to education.   Now consider that today we can buy higher quality teachers cheaper than probably any time since World War II.  And we can borrow the money to do this at [almost] ZERO PERCENT.

This is something we can do right now.  But unfortunately it is currently politically unacceptable to do it because people seem to think that government deficit spending on public goods like education is equivalent to a feckless household who over spent during the boom times maxing out another credit card on frivolities at 20 percent interest.

Okay.  So you know how I feel about this.  But if you have a coherent argument for why the government should not further increase the debt to hire a lot more Teach for America (and other) teachers, then please explain in the comments section.

Update:  It may not have been clear in my post, but I'm not saying Harvard grads make better teachers than others or that TFA teachers are better than standard credentialed teachers.  I'm merely saying that if Harvard grads are having a tough time getting into TFA it suggests that schools can buy good recent grads cheap.  It wasn't like this just a few years ago.  When the job market was tight and teacher pay was poor schools were begging for teachers.  Now the creme de la creme, or close to it, are begging to become teachers.  Given that, and the tremendous public good provided by a more educated public, I'd say the cost-benefit calculation here is pretty clear: more stimulus dollars for more and better teachers, please.  The easy way to do this is for the Feds to provide money to states and let the states spend it.

Who really benefits from agricultural subsidies?

I've mentioned this paper by Barrett Kirwan before on this blog.  Here's the title and abstract:

The Incidence of U.S. Agricultural Subsidies on Farmland Rental Rates

Who benefits from agricultural subsidies is an open question. Economic theory predicts that the entire subsidy incidence should be on the farmland owners. Using a complementary set of policy quasi experiments, I find that farmers who rent the land they cultivate capture 75 percent of the subsidy, leaving just 25 percent for landowners. This finding contradicts the prediction from neoclassical models. The standard prediction may not hold because of less than perfect competition in the farmland rental market; the share captured by landowners increases with local measures of competitiveness in the farmland rental market.

This paper is one of very few in recent history on the topic of US agricultural policy published in a first-tier economics journal.  I like this paper a lot, but I'm less than fully objective. Barrett is a colleague and good friend. And I worked with Barrett during the incipient stages of this work (a much earlier and less thorough version that I was involved with is published here).

We are working on a joint follow piece now that I'll present at the AAEA meetings in Denver this summer.

Some senior economists in the field of agricultural economics who are far more experienced than Barrett or I, do not agree with these results.  They are convinced that payments are fully capitalized into land values and that land owners are the main beneficiaries.  I am trying hard to understand what they think they see in the data that I don't see.

On one level, I don't see how the incidence question matters all that much.  It looks like about 60 percent of subsidized cropland acres are owned by non-operating landlords, so the incidence question does matter, to an extent, for discerning who gains most from subsidies.  But whether we're talking about landowners or farmers, both are relatively wealthy these days, so the idea of transferring wealth to either of these groups seems like a hard thing to justify.  Neither are farmers or landlords, as a group, absurdly wealthy--this doesn't seem at all like CEO corporate welfare.  My point is that no side of this playing implicit advocate here--my impression is that this debate is purely an intellectual one.

In other ways I think less than full incidence of subsidies on land rents could have much broader implications.

One aspect of this that matters for policy is the fact that strong incidence of payments on land rents and values might engender an argument for subsidies as an established entitlement.  Agricultural subsidies have been around a long time, so if today's landowners bought the land with the idea that it embodied future subsidies, then taking the subsidies away only punishes those who invested with the mistaken idea that subsidies would endure.  This argument, of course, makes it more difficult (or costly) to end subsidies.  So, the lower the incidence of subsidies on land rents and land values, the less politically difficult it may be to reduce subsidies going forward.  No doubt it would be hard to end subsidies even if incidence were zero.

Other aspects of this that are even more interesting have to do with (a) what less than full incidence implies about the functioning of agricultural land rental markets and (b) what it may imply about the broader effects of subsidies.

With regard to (a), it seems agricultural rental markets are far from perfectly competitive.  It's not entirely clear why that might be the case.  But it appears most rented cropland is rented by large farms from multiple relatively small landowners.  The landowners class is fairly diverse, ranging from retired farmers, extended families of former farmers that often live far from the land, and investors.  For information and transactions-costs reasons, it seems to make sense that farmers would often hold more bargaining power than landlords in these arrangements, which may explain the incidence issue.  Barrett has done some work in this vein.  It needs a lot more study.

With regard to (b), it seems that imperfect competition in the rental market might lead to indirect effects subsidies that heretofore have not really been explored.  If farmers can extract 75 cents on the dollar of subsidies attached to land rented then, all else the same, it is going to pay to make your farm bigger.  And that's what we see, bigger and faster growing crop farms in places with higher subsidies--  I've shown this in earlier research with Nigel Key. Presumably this process  would drive up rents toward full incidence.  But if that's not happening for some reason, we get fewer bigger farms.  I think the same incidence issue could explain our research showing that subsidies keep farmers farming longer.  If retiring means giving up 75 cents of every subsidy dollar on rented land, plus 75 cents of every dollar on land owned that the owner may then rent out, then maybe it's worthwhile to farm for a few more years.

I've said before that, excepting ethanol and perhaps some cotton subsidies, it's hard to see how subsidies might have large-scale effects on agricultural production in the U.S.  (You may be skeptical about this if you don't know a lot about the way subsidies work or historical land use in the U.S. The general point is that the nature and size of most subsidies are unlikely to keep the Midwestern corn belt from growing corn and beans.  After all, if they weren't growing corn and beans, what would they do with the land?)  But I do think it's highly plausible that subsidies help to make farm sizes bigger faster.

Bigger farms also tend to be more efficient farms, so it's really not clear whether all this is a good or bad thing in terms of production efficiency.  We still have a lot more work to do to connect the dots.  Then maybe we can say something confident about the bigger picture.

Deflation and Investment

The semester finally ended, which freed up time, some of which I had hoped to use for blogging.

No dice.  Now I'm back into the research grind.  Priorities...

Here are a few thoughts on a few recent developments:

Deflation:  For all the handwringing about inflation, deflation has been and will be the far greater threat.  I didn't think it would actually get this bad because I felt, especially with B.B. as Fed Chair, that they'd never never let deflation happen again.  But it seems history is repeating itself.  Paul Krugman is merciless on his intellectual enemies.  I can't blame him.  He's making a lot of sense.  And when John Makin from the extremely conservative AEI is essentially saying the same thing, and is equally clear and persuasive as Krugman, well... these guys are not your usual fluffy pundits that don't know what they're talking about.  I'm wondering and wishing I could know what Milton Friedman would say if he were still alive.

Investing:  Austerity measures and timid policy by the fed has put my plans for real estate investing on a temporary hold.  I'm shifting my portfolio toward long-run government bonds.  We're looking too much like Japan.   That means our long-run rates are probably headed toward levels similar to theirs, which means despite our record low rates, they're likely to go lower.  Since the stock market seems to be showing bizarre mean reversion, I'm shifting gradually, selling stocks on boom days and buying just a little back when the market crashes.  I'll reconsider real estate at a later time after more of the foreclosures come online and rates fall further.

Soda taxes

Karl Smith takes on researchers at USDA-ERS (the USDA agency where I used to work) who investigated soda demand and what their estimated elasticities implied about the effect a soda tax would have obesity.  I skimmed the study and have some issues with it.  My main issues differ a lot from Karl's.  Karl is right, of course, but I think the adjustments he has in mind require some heroic assumptions.  Given the results, others could easily make those assumptions and derive adjusted implications.  USDA-ERS is usually good about including lots of caveats and they probably should have discussed the issues Karl raised.

My problem with the study is that there is no explicit accounting for what drives price fluctuations in the demand study.  Prices don't vary randomly across consumers with consumers then deciding how much to buy at the given the price.  Prices tend to be higher in places where retailers know consumers are willing to pay more.  Put another way, it it's not clear that demand is held constant when looking at price variations.  This would generally cause bias toward a less responsive demand than would be seen in reality.

While one may think this would lend support for the idea of a soda tax, this is not so.  The reason prices vary with demand also has a lot to do with the nature of the market.  The soda market is oligopsonistic (Coke and Pepsi and all that), and perhaps monopolistically competitive at the retail level.  A 20 percent tax on soda is likely to lead to a much smaller increase in price.  After all, the marginal cost of a soda is the tiniest fraction of price.  (You don't really need to google that, do you?) This means soda producers and retailers will absorb a lot of the tax burden.

I do, however, think this is an interesting question.  If you've got a good idea for finding exogenous (ie., as if random) variation in soda prices then maybe you could write an interesting paper on how soda quantity demanded actually varies with price.  A more interesting and more ambitious study would find a clever way to model the whole oligopsonistic (and/or monopolistically competitive) soda market, and use that model to estimate the effect of soda taxes on actual consumption.

Update:  Via Catherine Rampell at NYTimes Economix (by the way, love her links), this study by Courtemanche and Carden, of genre similar to the USDA-ERS study, at least attempts a clear identification strategy.

A free textbook on real analysis

This book by William Trench looks to be about the right level for first-year PhD students.

Free is always nice.

Highly recommended for incoming graduate students.