Why Paul Krugman’s “Regulate to Stimulate” Argument Doesn’t Work

Many influential opinion-makers, including former Vice President Al Gore, contend that President Barack Obama last week rolled back the Environmental Protection Agency’s proposed ozone regulation due to reasons of political expediency.

To me, this mainstream thinking makes sense. The rule likely would have put virtually the whole of the country into non-attainment of the National Ambient Air Quality Standard for ozone, and compliance costs would have been obscene. This being the campaign silly season, it stands to reason that the President didn’t want to be perceived by voters as kicking a down economy

At the New York Times website, Nobel Prize winning economist Paul Krugman has challenged this conventional wisdom. According to Krugman, Al Gore and his ilk are way off-base, because the ozone rule, far from being an economic depressant, is actually an economic stimulus.

Here’s Krugman’s post, “Broken Windows, Ozone, and Jobs,” in its entirety:

I’ve actually been avoiding thinking about the latest Obama cave-in, on ozone regulation; these repeated retreats are getting painful to watch. For what it’s worth, I think it’s bad politics. The Obama political people seem to think that their route to victory is to avoid doing anything that the GOP might attack — but the GOP will call Obama a socialist job-killer no matter what they do. Meanwhile, they just keep reinforcing the perception of mush from the wimp, of a president who doesn’t stand for anything.

Whatever. Let’s talk about the economics. Because the ozone decision is definitely a mistake on that front.

As some of us keep trying to point out, the United States is in a liquidity trap: private spending is inadequate to achieve full employment, and with short-term interest rates close to zero, conventional monetary policy is exhausted.

This puts us in a world of topsy-turvy, in which many of the usual rules of economics cease to hold. Thrift leads to lower investment; wage cuts reduce employment; even higher productivity can be a bad thing. And the broken windows fallacy ceases to be a fallacy: something that forces firms to replace capital, even if that something seemingly makes them poorer, can stimulate spending and raise employment. Indeed, in the absence of effective policy, that’s how recovery eventually happens: as Keynes put it, a slump goes on until “the shortage of capital through use, decay and obsolescence” gets firms spending again to replace their plant and equipment.

And now you can see why tighter ozone regulation would actually have created jobs: it would have forced firms to spend on upgrading or replacing equipment, helping to boost demand. Yes, it would have cost money — but that’s the point! And with corporations sitting on lots of idle cash, the money spent would not, to any significant extent, come at the expense of other investment.

More broadly, if you’re going to do environmental investments — things that are worth doing even in flush times — it’s hard to think of a better time to do them than when the resources needed to make those investments would otherwise have been idle.

So, a lousy decision all around. Are you surprised?

There are three major problems with Krugman’s reasoning.

Krugman’s Timing Is Way off

Krugman seems to misunderstand the nature of the regulatory process set forth by the Clean Air Act, which renders incorrect his theory’s timing.

Krugman is talking about economic defibrillation, but the ozone rule isn’t a short-term policy. State implementation plans to achieve the new ozone standard wouldn’t be due for three years. Moreover, the ozone regulations wouldn’t be EPA-enforceable for six to seven years—this was the administration’s idea of regulatory “flexibility.”  So it’s not like we’re talking about “timely, targeted, temporary” stimulus spending.  Rather, these regulation-induced investments are years off. This nuance would seem to undercut his thesis that the ozone regulation would stimulate the economy. Otherwise, he’s assuming that there will be a “world of topsy-turvy, in which many of the usual rules of economics cease to hold,” years down the road. This would be presumptuous.

Krugman Misidentifies Primary Target of Regulation

Krugman claims that “tighter ozone regulation would actually have created jobs” because “it would have forced firms to spend on upgrading or replacing equipment, helping to boost demand…And with corporations sitting on lots of idle cash, the money spent would not, to any significant extent, come at the expense of other investment.”

Yet anthropogenic emissions of the precursor pollutants that create ozone—namely, nitrogen oxides and volatile organic compounds—come primarily from the auto fleet, not “corporations sitting on lots of idle cash.” (See here and here.) States have regulatory authority under the ozone rule, and they use inspection\maintenance regimes to control automobile emissions of nitrogen oxides and volatile organic compounds emissions. The upshot is that the car owner, and not “firms” or “corporations,” would bear much of the regulatory burden. It’s the motorist (i.e., you and me) that has to take the time to visit an auto-body shop every year, and it’s the motorist that has to pay to upgrade his or her car when it fails an emissions test.

Evidence Contradicts Krugman

So, the ozone rule doesn’t fit Krugman’s thesis. There is, however, a recent, major EPA regulation that must be implemented in short order, along the lines of what Krugman wants: the Cross-State Air Pollution Rule. But this regulation’s expected impacts do not support Krugman’s reasoning.

When the EPA issued the Cross-State Air Pollution Rule in July, it could have been the least objectionable component of the President’s regulatory assault on energy production, as it was directly mandated by the Congress (unlike, say, the EPA’s greenhouse gas power grab; or, its Clean Water Act power grab). But the EPA rendered the Cross-State Air Pollution Rule very objectionable by slipping into the final regulation a uniquely harsh regime for Texas, in what appears to have been an act of political payback.

Specifically, the final Cross-State Air Pollution Rule mandates that Texas reduce sulfur-dioxide emissions 47 % within 5 months, despite the fact that it takes 3 years to install sulfur “scrubber” retrofits on coal-fired power plants. EPA asserts that the emissions reductions can be achieved immediately through fuel-switching; Texas power companies argue that the only way to meet the EPA’s “unprecedented” and “impossible” timeline is to shut down power plants. Of course, this would lead to lost jobs. Jonathan Gardner, a vice president of the International Brotherhood of Electrical Workers, warns that the rule directly threatens 1,500 employees at six different power plants across Texas.

Worse still, the Cross-State Air Pollution Rule threatens to turn out the lights. At the request of the Texas Public Utilities Commission, ERCOT, the independent operator of the State’s electricity infrastructure, conducted a study on the reliability ramifications of the Cross-State Air Pollution Rule. In the resultant report published last week, the reliability watchdog warned that, “had the [Cross-State Air Pollution Rule] taken effect in 2011 instead of 2012, ERCOT would have experienced rotating outages during days in August.” It concluded,

The implementation timeline [for the Cross State Air Pollution Rule] provides ERCOT an extremely truncated period in which to assess the reliability impacts of the rule, and no realistic opportunity to take steps that could even partially mitigate the substantial losses of available operating capacity described in the scenarios examined in this report. In short the [Cross-State Air Pollution Rule] implementation date does not provide ERCOT and its resource owners a meaningful window for taking steps to avoid the loss of thousands of megawatts of capacity and the attendant risks of outages for Texas power users.

The Cross-State Air Pollution Rule is exactly the sort of speedy environmental regulation that Krugman posits to be a stimulus, but the rule’s expected impacts–jobs losses and blackouts–suggest he’s mistaken.

Conclusion

I’m not an economist, so I can’t comment intelligently on the economic theory that underpins Krugman’s thesis that costly environmental regulation can be a stimulus in our current “world of topsy-turvy.” But I do know how environmental regulations work, and the example he chooses—the ozone National Ambient Air Quality Standard—doesn’t comport with the tenets of his thesis. He thinks the regulation would be a short term boost; in fact, it plays out over the medium to long term. He thinks the regulation would target “corporations sitting on idle cash”; in fact, it targets everyday Americans. Finally, another major recent environmental regulation, the Cross-State Air Pollution Rule, which seems to be exactly what Krugman has in mind, belies his theory.

Background

• For more on the economic reasoning in support of the mainstream belief that environmental regulation necessarily harms the economy, see this testimony by AEI’s Ken Green.

• For more on the economics and health effects of the EPA’s proposed ozone NAAQS, see this Open Market post by my colleague Marlo Lewis.

• For more on the sketchy science behind the EPA’s proposed ozone NAAQS, see this Washington Times opinion piece by Steve Milloy.