Charles Krauthammer on "Iran's Emerging Empire"

   Charles Krauthammer is talking empire again, this time with regard to Iran. In a Washington Post column he argues that, in the US,  "...Iran’s march toward conventional domination of the Arab world has been largely overlooked." He goes on to criticizes the president and congresses lack of attention to the Iranian backed coup in Yemen in the context of what he sees as alarming actions by Iran in Syria. Essentially, Iran is building an empire in the Middle East while Washington does nothing to stop it.

   As is often the case,  Krauthammer exhibits a pseudo-Realist view of the world as a place where nations vie for dominance over one another. I call this view pseudo-Realist because Krauthammer's analysis has the state- and power-centric characteristics of Realism without the typical view that security maximization is the primary motivation of the state. Thus, his analysis lacks one of the key virtues of Realist theory which is to provide a model of state decision making that applies to all nations. In so doing, it gives us the means to reduce inscrutable and fearsome foreign boogie men to calculating and constrained rational actors that simply have opposing interests to ours given the zero-sum nature of security.

   Of course, there are Offensive Realists, like Mearsheimer, who assume that states are power maximizers instead of security maximizers. But even Offensive Realism invites a more dispassionate and less nationalist view than Krauthammer. Consider John Meirsheimer's 2012 comments on PBS about the effect of a nuclear armed Iran on the Middle East:

I think there’s no question that a nuclear-armed Iran would bring stability to the region, because nuclear weapons are weapons of peace. They’re weapons of deterrence.

They have hardly any offensive capability at all. And if Iran had a nuclear deterrent, there’s no way that the United States or Israel, for that matter, would be threatening to attack Iran now, in the same way that if Saddam had had nuclear weapons in 2003, the United States wouldn’t have invaded Iraq, and if Libya had nuclear weapons in 2011, the United States wouldn’t have gone to war against Libya.

So I think that if you had a Middle East where other states besides Israel — and this, of course, includes Iran — had a nuclear deterrent, it would be a more peaceful region. But the problem is that there is always some small possibility that there will be nuclear use.

And the most likely scenario is what’s oftentimes referred to as inadvertent escalation. And this is where you have a conventional war that starts off with no intention of turning into a nuclear war, but inadvertently escalates to the nuclear level.

   Note in the above quotation that Mearsheimer implicitly applies the same model of decision making to all states and considers the deterrent effect on the US and Israel to be just as valuable for stability as deterrence on Iran. In short, there are no good guys and bad guys, just states with security interests that are both driven and constrained by the relative power of other states. That's a Realist at work.

   But, of course, Krauthammer is talking about conventional "domination" not nuclear proliferation. I used quotation marks because domination is not, theoretically speaking, a clear cut term. I suppose he may means that Iran is seeking to achieve hegemony in the region and Krauthammer does characterize the situation as "Iran's growing hegemony in the region." However, by definition, hegemony is generally a "there can be only one" situation and, regionally, that one is Israel in the Levant and, arguably, the US in the Gulf. So, semantically, talking of Iran's "growing hegemony" is nonsense.

   Iran may be better characterized as challenging Israeli in the Levant and US hegemony in the gulf.  Indeed, it is hard to argue that they are not. It is generally what the Iranians say they are trying to do, and it is also what Realism predicts they will do.

   The question is what should the US being doing about it. From Realism and Krauthammer's state-centric point of view, the US should be trying to thwart Iran's efforts as a general rule. However, the specific situation is complicated by the rise of ISIS which is threatening to take over Syria in the Levant and Iraq in the Gulf region. To the extent that ISIS is a non-state actor, it hits Realist theory in its non-state blind spot.

  However, since ISIS is proclaiming itself to be a state and is taking over territory, it may be that it should be considered a new emerging state in theoretical terms. Furthermore, one might argue that its insurgent strategy is proving to be a surprisingly effective war fighting technology that is upsetting the balance of power in the region in an unexpected way with unpredictable future consequences.

  If you buy this, admittedly, ad hoc modification of Realism, then Realist theory would predict that the US and other powers would have to adjust their alliance structure to deal with the shift in power within the region. Arguably, that is what the US and Iran have done as they have become tacit allies in the fight against ISIS. If the US and Iran seem like strange bedfellows,  it is important to remember that Realism predicts that nations will make alliances based on considerations of power, not national amity or enmity.

   From this point, many of the things Krauthammer decries as US inaction against Iran are actually US actions against ISIS. That is, the US decision to drop demands for Assad's ouster in Syria is attempt to keep an ally in the fight against ISIS. The acquiescence to the presence of Hezbollah fighters and Iranian officers in Syria is acquiescence to the presence of a tacit ally's troops and proxy troops on the field against the common enemy, even if they may up to some other mischief. The administration's reluctance to impose more sanctions on Iran may reflect a reluctance to impose more costs on an ally that is already hurt by falling oil prices and/or a belief that a more conciliatory approach will be more successful in the presence of a new mutual enemy. (Welcome to the pitfalls of coalition warfare.)

   Overall, it appears that the US has made a decision to tolerate marginal gains in power by Iran in order to thwart potentially larger and more destabilizing gains by ISIS. This decision is akin  (albeit on a much smaller scale and without explicit official acknowledgment on either side) to the decision to ally with the Soviet Union in World War II. While that decision had distinct long term drawbacks, any systematic analysis of it would have to take into account the large short term benefits. Therefore, Krauthammer's arguments fall short because he is not considering the impact of the rise of ISIS on the region's distribution of power and the benefits of a tacit alliance between the US and Iran in mitigating that impact.

   To be sure, you could argue that the US is overestimating the threat posed by ISIS to US interests (primarily in Israel and Iraq). Indeed, it may be that, having first underestimated ISIS, US policymakers are irrationally over compensating. Or, you could argue that increased Iranian influence in Syria (and perhaps in Iraq) would be worse for the US than the emergence of a new state in Syria and parts of Iraq. If one is really worried about Iran, one could argue that having a new state to threaten Iran's western border would be a good thing.

   Ultimately, such arguments would be more palatable to Realists who would see ISIS as just another state seeking to maximize its security or power than to non-Realists who might take ISIS's ideology and brutality into account. But then, such non-Realists would also probably take Iran's ideology and brutality into account as well. This would then raise the thorny issue of which nation's ideology is more malignant and which nation is likely to be more brutal.

   Of course, one would only get into such comparisons if one puts the ISIS into the analysis in the first place. While attributing state status to ISIS is problematic in a Realist analysis, it is probably truer to the theory's emphasis (or, more precisely, Neo-Realism's emphasis) on the importance of considering the international system (i.e., the international distribution of power) as a whole. Such an emphasis encourages one not to make the mistake of selectively considering only part of the system as Krauthammer does.

Factoid: Percentage of Federal Income Tax Paid by the Top 1%

Mark Perry shares this graph of the percentage of Federal Income Taxes paid by the top 1% and bottom 95% of earners in the US.

This information comes from the Tax Foundation which provides the following histogram of the average tax rate paid by various income groups in the US:

It is interesting to note that the top 1/10 % pays a slightly lower tax rate than the top 1%. This may be due to capital gains (which are taxed at a lower rate than earned income) constituting a larger share of their income.

So, what's the point here? While I don't want to come off as too conservative, I think these graph do undercut the progressive argument that the rich are not paying their fair share, as far as Federal Income Tax goes. Of course, "fair" is a nebulous term (indeed, I sometimes call it the f-word), but when the top 1% are paying more in absolute terms and as a percentage of their income, it's hard to see what is unfair about this to anyone to the average middle-class American. I certainly can't see how one could justify raising taxes on the top 1% (or 5%) based on the current taxes being unfair.

However, this doesn't mean that we should not raise taxes on the top earners. If taxes need to be raised, the key question, to my mind, is where does it make the most fiscal and economic sense to raise them. Fiscally speaking, it used to be conventional wisdom that you had to raise tax rates on large numbers of people to realize significant revenue. But the top graph suggests that this is much less the case now than it was in the 1980s or early 1990s. If the top 1% and bottom 95% are paying about as much in taxes, adjusting the tax rates of either group by a given percentage will produce about as much revenue. Indeed, since then the top 5% are paying 59%, and adjusting their tax rates by any given percentage will produce more revenue than applying the same change to the bottom 95%.

As for the economic impact, the choice between raising tax rates on the rich versus raising them on the middle class is between discouraging investment or discouraging consumption. This is because the rich tend to save and invest more of their income than does the middle class. Given that interest rates and inflation are low, it appears that capital is relatively abundant in comparison to consumer demand, which suggests that raising taxes on the rich is the least bad option.

Furthermore, if you look at the second graph, there is kind of any obvious place to raise taxes since the top 1/10% are paying a lower tax rate than the top 1%. If this is because of the lower capital gains tax, then raising the capital gains tax seems like a logical place to start.

But hey wait! That's exactly what President Obama  suggested doing in his State of the Union speech, albeit based on an entirely different rationale. So while I reject the fairness based reasoning employed in the political rhetoric, I do support the specific policy (which is presumable rafted by less rhetorical economists).

Of course, this all begs the question of whether taxes need to be raised in the first place. The graph of federal expenditures below is why I lean towards saying that they do need to be raised. It shows that, for good or ill, the federal government has kept spending constant for the past few years. This suggests to me that we have gone about as far as we should go with cost cutting and so tax increases of some kind should be on the table. But, hey, that's just me (the blog is called thinking out loud).

Economic Impact of Freedom vs Changes in Freedom

One of the interesting trends in development thinking is the increasing importance attributed to freedom and democracy for economic growth. Acemoglu and Robinson talk about it in terms of inclusive versus exclusive and Selectorate Theory does so in terms of large versus small coalition regimes.

William Easterly talks about it in terms of the tyranny of experts which forms the better part of his 2014 book's title, The Tyranny of Experts: Economists, Dictators, and the Forgotten Rights of the Poor.  A long time critic of top down development assistance, Easterly has taken a broader and more abstract view of development economics in this latest work. The tyranny of which he speaks lies in the development community's prioritization of improvements in material well being over improvements in individual freedom and its embrace of benevolent autocrats as the most effective means of achieving this.

While there is a lot of meat on the bones of his book to chew on, one point he made seems particular relevant (at least to me). Easterly argues that changes in economic freedom can be more important in driving high economic growth than the absolute levels of freedom in a country. Therefore, a country may be less free than others but still experience higher economic growth than these freer nations if the less free country is freer than it used to be. After all an internal reform should unlock hitherto untapped economic opportunities and, thus, provide a new impetus to economic growth.

In Easterly's view, this sheds a new light on China's economic boom. While China is decidedly less free than many other countries, it has been undergoing a major liberalization of individual economic rights since 1978. So, while China may appear less free and more autocratic in cross-country comparisons, it is markedly more free and less autocratic in a cross-time comparison with itself. Therefore, rather than being a case in support of the idea that autocratic regimes are good for economic development, China is a case in support of the idea that increasing freedom and lessening autocratic control of the economy is good for economic development. (If that didn't strike you as significant, read it again.)

While Easterly does not explicitly argue the opposite point, that a decrease in freedom may harm economic growth even if a country is still relatively free in comparison to other nations, it may be that this opposite is also true.  This brings to mind the case of Venezuela, which touts itself as a socialist nation and looks to China for inspiration and support. Venezuela rates a freedom rating of 5 (Partly Free) on Freedom House's Freedom in the World Index, which is slightly better than China's 6.5 (Not Free) rating. However, ten years ago, Venezuela had a rating of 3.5, and so has been on a downward trajectory. Indeed a rating of 5 is on the cusp of being in Freedom House's Not Free category.

Of course,  China has been consistently at 6.5 on Freedom House's 7 point scale since the think tank started publishing the index in 1998. This is not surprising since China's major reforms predate this period and Freedom House looks primarily at political, not economic freedoms.

For a measure of economic freedom, we can turn to the Heritage Foundation's Index of Economic Freedom. The Heritage Foundation provides a graph of China's vs Venezuela's rating on economic freedom from 1995 to 2014 (which has resisted my attempts at embedding here, so you need to follow the link). The graph shows that economic freedom in China has been largely flat lined at between 51 and 56 point on Heritage's 100 point scale (though there was a small uptick from 1997-2000) while economic freedom in Venezuela has been trending downward since 2003, dropping from 55 to 36 points. Again this data set does not encompass China's reforms from 1978 to 1995 and is not capturing the biggest reforms in their economy. However, the lack of improvement in China's rating may explain the slowdown in Chinese economic growth and support a prediction of lower growth in the future.

With regard to Venezuela, we see that economic freedoms (as measured by the Heritage Foundation) have been deteriorating over the past decade, both in comparison with the country itself and it's supposed role model, China. Indeed, it is interesting to note that when we switch from an index of political freedom to one of economic freedom, Venezuela goes from the middle of the pack on the former index to fourth from the bottom on the latter (only Cuba, Zimbabwe and North Korea rate lower on Heritage's index). Since the point here is to emphasize cross time comparisons, Venezuela went from the Mostly Unfree category (which included no fewer than 60 out of 175 nations in 2014) on Heritage's index to the Repressed category (a more exclusive club of 27 nations in 2014).

It should be said that we need to avoid relying too much on Heritage Foundation's overall  index as it aggregates no less than 10 separate sub-indexes of what the Heritage Foundation considers to be freedoms. Some of these sub-indexes may be more valid than others in capturing what Easterly means by freedom (such as Business Freedom, Property Rights and Labor Freedom) than others (such as Government Spending, Monetary Freedom and Investment Freedom), again as defined by the Heritage Foundation.

Furthermore, to the extent that the Heritage Foundation espouses what is pejoratively referred to as Neo-Liberal ideology, we need to be doubly careful in our use of their data. Indeed, if one subscribes to the notion that the embrace of Neo-Liberalism (or what Dani Rodrik calls Hyperglobalization) was harmful to economies (especially in Latin America) , we might expect to see increases in the Heritage Foundation's index preceding decreases in economic growth in those cases.

With these caveats in mind, I think that Easterly's idea survives first contact with data and is useful for evaluating development efforts. Of course, there are many more ideas from Easterly to come.

Oil Price Break-even Points

The Oil and Gas Financial Journal posted an article by Abhishek Deshpande and Nic Brown last April that estimated the fiscal break even points for various OPEC nation. The break even points are based on the government budgets of the nations and represent the minimum price of oil that will allow the government to realize the revenue anticipated in those budgets. These points are as follow for 2014:

Saudi Arabia: $97/barrel
Iran: $126/barrel
Iraq: $103/barrel
Kuwait: $61/barrel
UAE: $88/barrel

It is important to keep in mind these are fiscal break evens not industry break even (or zero profit) points. That is to say that the countries' oil industries can still make a profit at lower prices than these. It is just that they will not make as much profit as anticipated in the government budgets and the government will not have as much revenue as it was planning to spend. Therefore, at oil prices below the fiscal break even point governments must cut spending, spend cash reserves, and/or borrow money to keep going. Because these break even points are driven by the governments plans for spending more than the actual costs of production, they can change dramatically from budget year to budget year. As a result, one has to be careful when talking about these points as they are fuzzy and changeable.

Update on Oil Prices

In last week's post Fears of an Oil Glut, there was a small but significant amount of interpretation of Saudi/OPEC motives. Therefore, it is gratifying to see that the Energy Minister of the UAE, Suhail al-Mazrouei,  has flat out said it for himself and OPEC in a news conference reported by AFP. He clearly lays out OPEC concerns about North America shale oil producers and OPEC market share.

The only thing left open to interpretation/speculation is whether this is the death knell of OPEC as an effective cartel. After all, al-Mazrouei is admitting that there is enough non-OPEC oil production to prevent the cartel from acting to raise prices, which is its primary reason for existing. Moreover, the production logic he lays out is based on the direct costs of production (known as upstream costs),  which consist of the costs of finding oil (finding costs) and the costs of extracting it (lifting costs). Since these are the factors one would expect to influence production decisions in the absence of a price setting cartel, it is hard to see what role OPEC would play.

Of course the Iranian president had a different interpretation, at least in public. President Hassan Rouhani claimed that Iran will weather the price decrease and that Saudi Arabia and Kuwait will suffer more than Iran. Furthermore, he portrayed the price slump as a plot against Iran (presumably by the gulf kingdoms) and said, "Those who have planned the oil price reduction against some countries should know that they will regret it."

To be sure, the gulf kingdoms will take comfort in any economic distress this causes Iran, but whether they view Iran or the shale oil producers as the biggest threat is an open question.

Factoid: Federal Reserves acquisition of US Debt

The subject of the Federal Reserves purchase of US T-bills came up in my IPE class in Columbus, GA. I mentioned that the Federal Reserve had really gone to war in the Great Recession by purchasing US government debt (i.e., T-bills) and Mark Perry posted a graph illustrating this, The red line in the graph below (which corresponds to the red axis on the left) shows the securities held by the Federal Reserve from 2003 to 2014.

As you can see the Fed bought about $3,5 trillion insecurities (mainly treasury bonds or T-bills) since 2008. Since, according to Federal Reserve data, US federal debt increased by $8,3 trillion in the same period, this means that the Fed absorbed about 42% of the increase in federal debt.

In his post, Perry makes a big deal about this being a transfer of wealth from the private sector to the public sector, but I think that interpretation is colored by ideology and borders on rhetoric. That is to say, we are supposed to be outraged that a private-t- public transfer has occurred on general principle (in particular one of the general principles of libertarianism). Maybe this principle is right, but it needs more discussion.

To more fully evaluate the impact of the Fed's purchase of T-bills, we need to consider what occasioned the purchases and what would have happened if the Fed had not made them.  The recession put the government into deep deficit and it issued lots of debt to pay the bills. Had the Fed not purchased the T-bills it did, the whole debt would have been dumped on the private capital markets and would have forced up interest rates. This would have drawn private funds away from other investments and consumption, not to mention driving up the cost of servicing the debt.

Instead, the Fed used its "magic checkbook" (meaning, it just declares the dollars involved to be in existence) to buy the T-bills, thus keeping interest rates lower and flooding the market with more dollars. This is what they mean by "Quantitative Easing." Of course, the danger of "printing money " like this is that the dollar will lose its value and the society will experience inflation. However, as the FRED graph below shows, inflation has been kept under control and actually has been lower since the recession than in the years before it:

Of course, the above graph just shows that the Fed avoided the mistakes of the Weimar Republic, not that everything is rosy. By intervening in the markets, the Fed has kept interest rates low which has been to the detriment of the value of people's savings and investments. In many ways, Fed policy has amounted to an indirect tax on creditors that benefits debtors.

But then, that was the point. As demand in the economy crashed in 2009 (as can be seen by the drop in inflation to actual 2% deflation) the desire was to stimulate spending not savings in the society. By keeping interest rates low, they discouraged people from savings and encouraged spending. At the same time it facilitated deficit spending by the government so that it could keep paying benefits (claims for which naturally rise during a recession) without increasing taxes (the returns from which tends to go down during a recession). Again, this kept up spending in the society.

Of course, this sort of macroeconomic intervention is something that many libertarian economists think is ineffectual and undesirable. By talking about a transfer from the private to public sector, Perry is alluding to this though ideological code words, but this obscures the argument in play. To my mind, Perry needs to make the argument that it would have been better for the Fed to let interest rates rise in the recession and recovery than to intervene as they did.

Low Oil Prices and Conflict

Last week, I wrote about the drop in oil prices from purely an economic point of view and, in October, I briefly commented on the effect lower prices would have on Putin's regime in Russia; but what about oil prices from a more purely IR point of view? What effect, if any, can we expect on the behavior of states in the international system?

Rob Nikolewski  at Watchdog.org raises this concern in an article entitled Will crashing oil prices make Russia, Iran and Venezuela more dangerous? The gist of this article is that low oil prices are hurting Russia, Iran, and Venezuela and, therefore, their leaders may lash out at the world. However, most of the substantive analysis is an assessment of how much these countries are hurt by lower oil prices, and very little analysis focuses on the motives and strategic calculations of their leadership that would support concerns about them "lashing out."

Indeed, one is left with the impression that Nikolewski thinks the proposition that one can expect aggression from these leaders when they are under pressure needs little more examination than a quote from an expert or two. This might fly with the conservative readership of Watchdog.org but, as IR scholars (and here I am addressing my students), we should be more critical in our reading. We should look at Nikolewski's piece and note that he spends too much time on the suppositional part of his argument (i.e., that lower oil prices are hurting Russia, Iran, and Venezuela) and far too little on the more causal part of his argument (i.e., that this economic pain will encourage more aggression internationally).

This is turn should get us thinking about what the price reaction of the Russian, Iranian, and Venezuelan leadership may actually be. With apologies for another Rex Stout reference, Nero Wolfe frequently tells his assistant, Archie Goodwin to proceed based on "intelligence guided by experience." For our purposes, these twin pillars of intelligence and experience can be interpreted to mean theory (which is logical inference and deduction based on a model of underlying causal relationships) and empirical research (which is the study of past behavior of states).

Taking the second one first,Cullen Hendrix shares some results from his empirical research in a Monkey Cage post entitled Falling oil prices, more peace?  As is typical of scholarly (read, with admitted bias, as "good") empirical research, Cullen starts with some theory, specifically Thomas Friedman's First Law of Petropolitics, which Friedman defines as follows:

The price of oil and the pace of freedom always move in opposite directions in oil-rich petrolist states. According to the First Law of Petropolitics, the higher the average global crude oil price rises, the more free speech, free press, free and fair elections, an independent judiciary, the rule of law, and independent political parties are eroded. And these negative trends are reinforced by the fact that the higher the price goes, the less petrolist leaders are sensitive to what the world thinks or says about them. Conversely, according to the First Law of Petropolitics, the lower the price of oil, the more petrolist countries are forced to move toward a political system and a society that is more transparent, more sensitive to opposition voices, and more focused on building the legal and educational structures that will maximize their people’s ability, both men’s and women’s, to compete, start new companies, and attract investments from abroad. The lower the price of crude oil falls, the more petrolist leaders are sensitive to what outside forces think of them.

The last line of the preceding passage is most suggestive in that it suggests that, when oil prices are low, the leaders of oil exporting states will actually be more constrained by international pressure than when oil prices are high. In other words, contrary to what Nikolweski implies, the leadership of Russian, Iran, and Venezuela may be less likely to lash out due to the current low oil prices.

In his working paper for the Peterson Institute, Hendrix puts this idea to the test, as his abstract very succinctly describes:

Anecdotal evidence suggests high oil prices embolden leaders in oil-rich states to pursue more aggressive foreign policies.This article tests the conjecture in a sample of 153 countries for the time period 1947–2001. It finds strong evidence of a contingent effect of oil prices on interstate disputes, with high oil prices associated with significant increases in dispute behavior among oil-exporting states, while having either a negative or null effect on dispute behavior in nonexporting states.

 Thus, Hendrix's research suggests that high, not low, prices encourage more aggressive behavior (the lashing out that Nikolewski is concerned about) on the part of oil exporting states. It should be pointed out that Hendrix finds only weak evidence to suggest that low prices (below $33/barrel) make oil exporting states more pacific than non-exporting states, so we have to see this as a somewhat one-way relationship. That is, high prices promote more aggressive behavior among oil exporting states and lower prices will not promote such particular behavior.

So, empirical research (the systematic study of experience, if you will) not only casts doubt on Nikolewski's concerns, but paints an entirely different picture of the effect of low oil prices on state behavior. We could leave it there but, sometimes, when confronted with an article that tweak's one critical thinking as Nikolewski's does, there may not be an empirical study so on point as Hedrix's at hand. In such a case, one needs to resort to theory to examine the question in mind.

Hendrix started with Thomas Friedman's First Law of Petropolitics and I generously categorized this as theory. However, a law is technically not a theory but rather an observed empirical regularity, and Friedman is not a theorist but rather a journalist. Indeed, nothing marks the difference between a journalist and scholar so much as Friedman's inexact use of the term "law" in that the term should be used only after an exhaustive empirical study (as opposed to the more anecdotal evidence Friedman depends upon) has established it

Perhaps a better theoretical foundation would have been to use a theory that explains the conflict behavior of  national leaders based on political economy factors. Obviously, Realism is out here as it focuses on system level variables, but my old stand-by of Selectorate Theory clearly applies (and I never miss a chance to pass out the Kool-aid). While Selectorate Theory focuses on the differences in behavior of large versus small coalition regime leaders, it can be applied here since oil exporting states are typicaly small coalition, or non-democratic, regimes.

Back in July, I wrote about Selectorate Theory's predictions about the war making decisions of democratic versus non-democratic leaders (dictators for short). I described the prediction of Selectorate Theory about the war making decisions of dictators as follows:

 In a small coalition regime, the leader (call him a dictator) survives in office with the support of a small coalition of supporters. Because they are small in number, the dictator can best ensure their loyalty by providing them with private benefits. As a result, the leader's survival depends not on his job performance as a national leader, but on his ability to keep the flow of private benefits to supporters going. As long as the private benefits flow to the leader's essential supporters, the leader is free to do whatever he wants with regard to policy, including the prosecution of a war. However, the leader will have only the resources he has left over after paying off his supporters to devote to the war effort.

I have added emphasis to the last sentence because it points to an important consideration for dictators who depend on oil revenue to pay private benefits to supporters. When the price of oil is high, the dictator will have more money left over after paying off his/her supporters than when prices are low. Therefore, the leader will have more resources with which to conduct wars, or any other policy, when oil prices are high than when they are low. Therefore, we should see more aggression when the leader has excess resources to carry it out than when the leader is scrambling to find enough money to pay off supporters. More importantly, even if a leader may be more inclined to be internationally aggressive when oil prices are low, the leader will have less resources to act on the inclination.

Indeed, to the extent that the leaders of Russia, Iran, and Venezuela depend on smaller rather than larger coalitions of supporters, they can be expected to focus on keeping the private benefits flowing to key supporters more than on international adventurism. This is because the leader's domestic political survival is at stake and the theory assumes that this overrides other considerations. Of course, this assumption is supported by the argument that, if leaders don't act to ensure their survival, then they will be far less likely to survive in office.

In short, we shouldn't theoretically expect low oil prices to make the leaders of oil exporting, small- coalition regimes lash out internationally. Given that most oil exporting states have small coalition regimes, this lines up well with Hendrix's empirical finding that oil exporters are less dispute oriented when oil prices are low than when they are high. As Nero Wolfe would say, this reveals Nikolewski's concerns to be fatuous.

Fears of Oil Glut

Seems like we hardly get used to cheaper gasoline before the talk turns to jitters over a global oil supply glut (any excuse to re-use a Ron Burgundy meme).

So what's going on with oil prices? I think it is important to keep in mind that prices are driven by the balance between supply and demand. Therefore, to understand changes in prices, one needs to consider both supply side and demand side influences.

Demand Side:  I am putting this first because this is the side that most people overlook and which has been increasingly important over the past decades or so. In general, higher oil prices have been driven by increased demand for oil (and energy in general) in the developing world. The overarching story is that demand for oil has grown faster than the supply of it and that factors influencing global demand have become more important in driving prices than they were in, say, the 1990s.

At the risk of oversimplifying, for the last decade, oil producers have basically produced as much as they can (making the supply of oil somewhat fixed) and more fluid factors influencing demand (such as the economic strength of oil consuming markets) have driven price changes. Of course, with supply so tight, any shock to supply, like the Libyan uprising, resulted in a spike in prices. However, in general, good economic forecasts and strong growth in US, Europe, Japan, and China have tended to raise the price of oil while bad economic forecasts and recessions in any of those market have tended to lower prices.

For instance, oil prices dropped precipitously in the end of 2008 as the US entered the Great Recession. Oil had been selling a over $130/barrel in June and was below $40 by January 2009 all do to the economic misfortune of the largest consumer of oil in the world.

Today, the US economy is doing well but Germany is going into a recession (which will have ripple effects in Europe) and China (the second largest consumer of oil) just had the slowest economic growth in years. Meanwhile, India (never forget India) is having lackluster growth. So, at a global level, forecasts for demand are somewhat uncertain and bleak. A side effect of this is that the dollar has gained in value against currencies like the Euro, which has driven down the dollar dominated price of oil even further (though we are talking about a 10%-ish change here).

Supply Side: Meanwhile, back at the ranch (as in in North Dakota and Texas) hydraulic fracking has allowed the US to dramatically increase domestic production of crude oil. This chart from Mark Perry shows the impact of shale oil on US production:

As you can see above, since 2012, the US has increased crude oil production by about 3 1/2 million barrels a day.  US crude oil production now rivals that of Saudi Arabia, leading Perry (among others) to label the US as "Saudi America. Indeed, if one adds natural gas to the category of petroleum production, the US has exceeded Saudi Arabia as an energy producer for close to two years as shown in the chart from Perry below:

As a result of this increased domestic production, US imports of crude have dropped to their lowest levels (as a % of total US consumption) since the 1970s. This has left China in the position of being the largest global importer of liquid fuels and put the US (or rather US oil producers) in the position of rivals to Saudi Arabia (and other oil producers) for the US oil market.

This is significant because it means that the Saudis are competing for market share and, if they cut production to raise the price of oil (or at least put a floor under the price), they will also be keeping US shale oil producers in business. This is probably the reason they are blocking moves by OPEC to reduce production quotas. Of course there are conspiracy theories out there suggesting that the US and Saudi Arabia are colluding to drive oil prices down to weaken oil producers like Russia, Venezuela, ISIS, and Syria. While these theories are sexier than talk of market positions, they seem to elevate secondary considerations to a level of primacy.

Furthermore, theories of collusion between the US and Saudi Arabia posit a commonality of interest between the nations that ignores the fundamental change in both the US-Saudi economic relationship. Until recently, the US and Saudi Arabia had a basic consumer-producer relationship. While issues affecting the price of oil were inherently zero-sum in nature (and increase in price was good for the Saudis and bad for the US), the overall relationship was one of mutual benefit. That is, both sides gained from having a stable pattern of exchange and the Saudis (US) had a vested interest in maintaining the economic health of the largest consumer (producer) of oil in the world.

The rise of US shale oil producers as rivals to Saudi production complicates the relationship. In general, the competition for market share between producers is entirely zero sum and, potentially, a fight for survival. Therefore, the US is now less of a monolithic entity to the Saudis as it encompasses both a large set of consumers and a growing set of rival producers. However, in the current situation, the Saudis have the option to do something that simultaneously benefits US consumers and hurts rival producers, i.e., keep pumping oil despite the drop in prices. If you add to that the fact that, at any given price, curtailing production cuts Saudi income, then one hardly needs to suppose political collusion with the US to explain their decision to keep producing.

If you want a sexy narrative, though it maybe a bit fantastical,  one might try thinking of the current situation as being in part a contest between the Saudis and US shale oil producers. Hydraulic fracking was initially a high cost way of extracting oil that depended on prices above $50 or $60 per barrel. The question is whether US shale producers can cut costs to stay in business at lower prices.

While having the price of your product drop is never good for an industry, it is often an impetus for productivity increasing innovation. So far, US oil producers have been protected by financial hedges they purchased to insure themselves against a drop in prices. It will be interesting to see if they can use that financial cushion to fund innovations that allow them to survive lower oil prices. However, there is almost certainly no way that they can achieve the low costs of Middle East oil, so something will have to give somewhere else.

Back to Demand: As Nick Cunningham comments in his article on the top five factors affecting oil prices, the cure for low prices is low prices. Lower prices spur greater consumption, which then raises prices.  So a direct effect of lower prices may be an increase in global oil consumption that puts a floor on prices. Cunningham notes that US gasoline consumption has risen, when you look at the data to which he refers, it is hard to see a big change, especially in terms of global usage.

Of course low oil may have a secondary effect by spurring faster economic growth. While lower oil prices are a somewhat mixed blessing for the US economy, they should be a more unmitigated boon for China which doesn't produce much oil of its own. Also, lower oil prices might help India beat its projected growth rates in 2015. However, one of the reason we have lower prices is that the forecasts for these countries economies are generally poor. While those forecasts probably didn't include $50/barrel oil, the information available to investors suggested weak demand in the immediate future and so we are left to hope for (or against) something surprising.


Effect on US: All this begs the question of whether low oil prices are good for the US economy. At first blush, it seems obvious that low prices are good for the US consumers (and I am certainly one to argue that the interests of consumers are the primary interests of the society).  However, the fly in the ointment is that growth of the US oil industry has been a big part of the economic recovery, as Mark Perry illustrates in the following graph:

The graph above shows that grow in employment in Texas (largely driven by the growth in shale oil production) has been a significant part of employment growth in the US. Add that to the more obvious hit to the bottom line of oil giants like Exxon and BP and we can't easily dismiss the impact of a hit to that industry. Indeed, this is why Wall Street has jitters.

Even so, at a secondary effect level, the US economy (especially the so-called Main Street, as opposed to Wall Street) might gain more from a boost in consumer spending and confidence driven by lower gas prices than it loses in the oil producing industry. Indeed, if Congress takes advantage of low gas prices to raise the gas tax and fund more highway construction, that alone would have a positive impact on the economy. It is important to keep in mind that US government expenditures have been flat for the past 4 years (see FRED graph below) and so some additional spending that doesn't add to debt may be called for.

Tax Rates as Disincentives

This past year, I have indulged in reading Rex Stout's Nero Wolfe mysteries. The books were set in the time in which they were written and they span the 1930s through the early 1970s. As such they provide a glimpse of life in those times. Because Wolfe is running a business (and is a penny pincher) one also gets a lot of insight into the economics of the time. It is amusing to see people happy to get a quarter for a tip and to spend $4 on a 3 minute phone call from New York to Nebraska.

When the novels hit the post war era, the subject of income taxes comes up quite frequently and it is interesting to see how they effected behavior, albeit in a fictional setting. For instance, in Trouble in Triplicate, a prospective client thinks that his business associate (Mr. Blaney) is planning to kill him and he wants to hire Nero Wolfe to solve his murder if it occurs. He offers Wolfe $5,000 to do the job but Wolfe refuses. The client then asks:

"What's the matter, don't you want five thousand dollars?"

Wolfe said gruffly, "I wouldn't get five thousand dollars. This is October. As my nineteen forty-five income now stands, I'll keep about ten percent of any additional receipts after paying taxes. Out of five thousand, five hundred would be mine. If Mr. Blaney is as clever as you think he is, I wouldn't consider trying to uncover him for five hundred dollars."

 Indeed, the marginal tax rate in 1945 was 90% for people making between $90k and $100k. At $100k it went up to 92% and maxed out at 94% at $200k. Of course, $90,000 in 1945 was worth over $1 million in 2013 dollars (according to the Tax Foundations historical tables), so it was a high threshold.  (Note: Someone making the equivalent of $440,000 in 2013 dollars, which is the 2013 threshold for the highest bracket, would have paid a marginal tax rate of 68% in 1945.)

This issue of taxes comes up repeatedly in the Nero Wolfe novels over the following decades. On several occasion people over to pay Wolfe in cash, with the implication that he might avoid reporting it on his incomes tax. Wolfe generally refuses to do so, though it is strongly implied that his assistant Archie Goodwin (who is the narrator of the stories) finesses the accounts to a large degree.

In the 1961 novel, The Final Deduction (which refers to a logical deduction, not a tax one),  Archie also uses his knowledge of Wolfe's proclivities and finances to talk him into helping a client retrieve a $500,000 ransom that has been paid for a one fifth share in whatever is recovered. Knowing that Wolfe will be reluctant to take on the case, Archie puts it to him this way:

"You might take a minute to look at it this way. It would be satisfactory to find something that ten thousand cops and FBI men will be looking for. And each year when you top the eighty-per-cent bracket you relax. I admit it's a big if, but if you raked this in and added it to what you already collected this year, you could relax until winter, and it's not May yet..."

In 1961, the 80% bracket for a single person (actually 81%) started at $70,000. Archie knows that Wolfe just earned a $60,000 fee, so this $100,000 would put him well over the top, even after deductions.  If he earns it,  than he can devote the rest of his year to tending his orchids, reading books and eating his gourmet meals. Wolfe's reaction to this is:

He closed his eyes, probably to contemplate the rosy possibility of months and months with no work to do and no would-be customers admitted. In a minute, he opened them and muttered, "Very well, bring him in."

The point here is that the "rosy possibility" of months without work is a very artificial one created by the tax structure. If Wolfe gets the $100k, in addition to the $60k mentioned and any other money he made  in the year to date, he will probably be in the 89% tax bracket ($100,000 to $150,000) even after deductions for things like Archie's salary. Therefore, if someone offers him $10,000 to do a job, he will only get $1,100. As we saw above, Wolfe won't do much for that little. Of course, Wolfe might get his mind going for a net gain of $10,000, but a client would have to offer him a gross over  $90,000 to do it. Even in Wolfe's world, that is an unusually high fee (which is part of why he is taking on the ransom money case in question).

The point here is that the high tax rate is creating a huge gap between what someone pays Wolfe to work and what he receives from doing so. Essentially, a client would have to be willing to pay nine times what Wolfe actually receives for doing a job. The "rosy possibility" of months of leisure is the result of the probability that no one would be willing to pay $9 for what Wolfe would be willing to do for $1.

While Wolfe might enjoy the enforced respite from work,  this is a loss from a social point of view. After all, Wolfe would be sitting on his fat butt (literally both in terms of sitting and fat) for most of the year, turning away clients that would otherwise benefit from his services. Of course, there is a Keynesian upside to this situation in that, since Archie's salary is a business expense, Wolfe has little incentive to lay him off since doing so would decrease his deductions and probably push him into a higher tax bracket. But even then, the society would have Archie, supposedly the second best private detective in New York City, sitting on his butt too (though, admittedly a much smaller one).

Now, of course, Nero Wolfe is a fictional character and accepts this situation because he is written as being moderately scrupulous about his taxes and limited in his means of being creative with expenses. Were he less scrupulous, he might accept cash under the table but, more importantly, were he in a corporate setting, he might find other ways of  getting paid that can't be taxed.

Indeed, in corporations during the days of 50+% tax brackets, non-monetary benefits were an important part of executive compensation. Things like company cars, executive dining rooms, memberships at clubs, and business trips with little business in them were part of the perks offered to higher paid executives. This was because just about anything that could be justified as a business expense to the IRS was an efficient way to compensate people in a high tax bracket.

For instance, a 1961 Cadillac sold for about $6,000. If it could be justified as a business expense it would cost the company about that much to offer it to an executive as part of the compensation package. If the company wanted to offer enough money to buy the car to an employee in the 81% tax bracket, it would have to pay over $54,000.  The same logic (or illogic if you prefer) applies to everything else.

Fast forward to today when the top tax rate is 39.6%. A company could offer someone a car worth $40,000, but the cash value (factoring in taxes) to a highly paid executive would only be about $67,000. In some cases, this might work out to their mutual advantage (if current IRS rules would allow it), but it may be that the executive would rather just have the $40K ($24k after taxes) to do whatever he/she wants with it. In technical terms, the tax benefit may be offset by the deadweight loss associated with not being able to spend the money as the executive wants.

More importantly, the old system of providing perks to executives hid many of the costs of employing them not just from the IRS but also from stockholders. Therefore, it was doubly in the interests of management to hide non-monetary compensation in their business expenses and, ultimately, it was in the interest of stockholders to move their corporations away from it, especially after the top marginal tax rate dropped from 70% in 1981 to 50% in 1982-1986, to 38.9% in 1987, and to 28% in 1988.

Of course, IRS rules, and the stringency with which they are applied, are a big part of the story. However, the IRS is susceptible to political pressure and, though I can't say for certain, there was probably a lot of pressure applied by businesses to allow expenses to be more loosely interpreted when perks were so important to corporations.

The point here is that high tax rates can distort the incentives of individuals. At the simplest level they can enforce lethargy on people like Nero Wolfe or they can encourage tax avoiding behavior on people who refuse to sit on their butts. At a more complex level, they can encourage institutionalized patterns of behavior that are far from optimal. In all cases it threatens to lead to less efficient outcomes from a purely Neo-classical point of view.

That being said, I have to add that today's tax rates in the US are far less distorting than in the past. I have listed the top marginal tax rates from 1918-2013 below. You can see a marked difference in the top rates that prevailed from 1932-1981 and those that have been in place since 1987. It is also interesting to note that most of the Reagan years saw a 50% top rate that bridges the two eras.

Here are the top marginal tax rates from 1918-2013 (again from taxfoundation.org)

1917-1918      77%*
1919-1921      73%*      
1922-1923      58%
1924               46% 
1925-1929      25%
1930 -1931     25%
1932-1935      63%*
1936-1940      79% **
1941                81%**
1942-1943      88%
1944-1945      94%
1946 -1951     91%
1952-1953      92%
1954 -1963     91%
1964               77%
1965-1981     70%
1982-1986     50%
1987              38.9%
1988-1990     28.0%
1991-1992     31%
1993-2001     39.6%
2002              38.6%
2003-2012     35%
2013              38.6%

* The top rate in these years only applied to people making $1 million or more.
** The top rate in these years only applied to people making $5 million or more.

A Substantive "Happy New Year"

One of my pet peeves is the ubiquity of gloomy evaluations about the state of the world and its prospects for the future. This is because there is actually a great deal of evidence to the contrary that seems to be consistently overlooked.

For instance, there is the Human Security Report Project that collects data on global death by violence over time. Their primary finding is that the incidence of war and deaths from war has declined dramatically over the past few decades. In the project's intro to their latest (2013) report, they put it this way:

 During 2012—the most recent year for which there are data—the number of conflicts being waged around the world dropped sharply, from 37 to 32. High–intensity conflicts have declined by more than half since the end of the Cold War, while terrorism, genocide and homicide numbers are also down.

And this is not simply a recent phenomenon. According to a major 2011 study by Harvard University's Steven Pinker, violence of all kinds has been declining for thousands of years. Indeed Pinker claims that, "we may be living in the most peaceful era in our species' existence."

  (The full text 2013 report is available here, but you may find the summary in the press release more manageable.)

Of course, one of the key factors in this conclusion is that the HSR researchers look at the number of deaths per million people in the population, rather than absolute numbers of deaths. If one looks simply at the number of people killed, the 20th century was the bloodiest century in history. However, if one takes into account the changing size of the world's population, even the carnage of WWII is not unprecedented (and  in fact is dwarfed by some previous conflicts). So how one measures the key variable is important.

This is very much the case with global poverty. If you google global poverty, you will find a large number of sites providing data that paints a gloomy picture. However, you have to dig down a bit to find out that extreme poverty has, in fact, been significantly decreasing over the past few decades. According to the World Bank's Global Monitoring Report, from 1981 to 2011, the number of people living in extreme poverty (i.e., on less that $1.25 a day in 2005 dollars) dropped from 1.94 billion to 1.01 billion. As a percentage of the global population, the extreme poverty rate dropped from 43% to 15%. Indeed, if one digs deeper into their report to find their forecasts, one finds that the WB predicts that the number of extreme poor will drop to 696 million (or 9% of the population) in 2020 and 412 million (or 5% of the population) in 2030. So, while one might well say that there are too many people living in extreme poverty (even at the projected 2030 levels), one can hardly say that things aren't getting better, much less worse.

In August 2014, Matt Ridley, the self-styled Rational Optimist, wrote an article for The Times (UK not New York) that expounded on this theme. After noting all the extremely bad news then in the  headlines Ridley argues:

All true and all horrible. But the world is always full of atrocity, violence, death and debt. Are things really worse this year or are we journalists just reporting the clouds in every silver lining? Remember the media does not give a fair summary of what happens in the world. It tells you disproportionately about the things that go badly wrong. If it bleeds, it leads, as they say in newspapers. Good news is no news.

So let’s tot up instead what is going, and could go, right. Actually it is a pretty long list, just not a very newsworthy one. Compared with any time in the past half century, the world as a whole is today wealthier, healthier, happier, cleverer, cleaner, kinder, freer, safer, more peaceful and more equal.

He then goes on to provide data to support these claims (I'll leave you to review it on his blog). Ridley ends by noting that his upbeat predictions in his 2010 book The Rational Optimist: How Prosperity Evolves have proven to be too cuatious as the world has bounced back from the Great Recession faster than he predicted. Yet he ends the article with a warning:

Be warned that being cheerful guarantees you will never be taken seriously. The philosopher John Stuart Mill said: “Not the man who hopes when others despair, but the man who despairs when others hope, is admired by a large class of persons as a sage.”

 Since I write this blog for my students, I guess the big take away is that your professor is not a member of that "large class of persons" and hope you won't be either.