Wednesday, November 27, 2013

Defending the econ status quo

In post GFC naval-gazing discussions about the nature of the economics discipline important questions have arisen about the discipline’s general inability to put forth a coherent set of models explaining commercial behaviour in production and trade, particularly boom and bust cycles.

The revolution the discipline needs to have seems to be starting in the classroom rather than academic outlets such as journals. I have strong interest in the teaching of economics, having been involved with the development of Australian Learning Standards for university level economics. One thing I can say is that undergraduate economic students are spoon fed an unrealistic, often useless, outdated, and very narrow set of concepts and tools, rather than being introduced to the wider nature of economics as a moral science.

But is this teaching approach merely reflective of the discipline? Sadly, I believe it is. The neoclassical status quo is heavily entrenched.

I do see some light at the end of the tunnel. Economics now does have leaders in the revolution. While Krugman’s methods fall very neatly into the mainstream, he seems to be slowly writing more like a modern monetary theorist. Nick Rowe is as mainstream as they get, defending neoclassic models while still making the effort to understand Steve Keen’s path-breaking work in debt driven cycles.

At the student level change is being strongly advocated by the University of Manchester’s new Post Crash Economics Society. Unfortunately, this open letter by Peter Backus in response to their efforts reflects the challenge that lies ahead. Although it is one of the better defences of the economics discipline, in many ways it also reveals the flaws and ignorance of the profession I have so often noted.

Backus makes seven points in his defence of economics, which I paraphrase as headings for each following section. 

Many criticisms of economics are simply that economics is not the study of politics, history or philosophy 

This is a bugbear of mine; that somehow economics operates in a moral and political vacuum. As soon as you want to interpret some action, behaviour, rule or policy in terms of ‘welfare’ you are automatically making a moral judgement about what is in the interests of the people. While it might be on occasion correct that a very simply utility function can represent a common notion of welfare, this need not be the case in general. As such, all economic analysis of welfare is conditional upon a moral judgement about the desires, wishes, dreams and imaginations of all others.

This is important stuff. It gets to the heart of almost all the fundamental issues in economics - benefits of trade, incentives, information and so on. It is the departure point for many alternative schools of thought that do not profess to reduce all activity to a moral assumption about the nature of individuals in the economy. 

Economics can’t also be detached from history and politics. All regulation occurs via political processes and anyone worth their salt as an advisor to policy makers needs to acknowledge the intricacies and often conflicting incentives in the political sphere. As I learnt in my days in government, history matters. A policy might appear best on paper to some economic analyst, but it must be a coherent step forward for all the stakeholders involved and must not conflict with other current, or often historical, policy directions.

While many economists agree that increasing taxes on the wealthy has almost no effect on aggregate output, this is rarely acknowledged at undergraduate level. Learning even a little economic history would reveal that high tax rates on the extremely wealth were very common through much of the 20th century and by most estimates had no measurable impacts on output and growth. 

There is no monolithic neoclassical mainstream (and if there is it is not an ideology). Chris Auld, self proclaimed defender of this no-existent mainstream, also makes this point.

Yes there is. Seriously, as someone who has recently completed PhD level courses at one of Australia’s top economics schools, the neoclassical framework of utility maximising representative agent models appears to define the discipline. Whereas it simply defines one approach in a broad family of methodological approaches to economic analysis.

One commenter sums up the reality of the modern economics curriculum.

This is barely the case nowadays: it is normal in economics today that the average master’s degree student is not even able to tell in a few words what Post-Keynesian or marxist or institutionalist economics are about and what are their peculiar analytical tools compared to those of neoclassical economics. Do you know a lot of disciplines where the students are maintained in the complete ignorance of entire parts of their own discipline?

In my area of research I see sociologists embracing the tools of graph theory to analyse social interaction, while the econ crowd pay lip service and attempt to subsume social networks into their own framework, in the process negating the relevance of the concept (if a network is a powerful structure a network link must be more than a perfectly tradable commodity).

It is generally not the job of an economist to predict the future

I love this defence, only because it is a classic misrepresentation of the critique. The critique is not that economics didn’t predict this exact crisis, its timing, political response or international scope. The critique is that no mainstream economists where even analysing economic processes with models that even allowed for such an event to occur! Had the discipline been approaching economics using more dynamic modelling tools, and potentially through networked models that allow for cascading changes, there would have been a standing warning that the economy system is subject to large unexpected swings (yes, booms and busts) by the very nature of its structure.

Many of the underlying causes of the financial crash were political and regulatory and structural, not the fault of sloppy Economic thinking 

Backus makes the point here that government failed to properly regulated financial markets. Fair enough. But where were the voices in the economics profession calling for greater regulation? Even talking about central bank intervention in the currency is a taboo topic with most mainstream economists I’ve met. I doubt there is a single non-trivial financial regulation that the economics profession would agree would improve the operation of financial markets.

It is usually the case that the mainstream profess a belief that markets are virtuous and always correct, and therefore deviations from perfection are typically the result of meddling governments or some other market failure.

As an example of this more common ideological thinking, Justin Wolfers recently tweeted about the dodgy practices of car salesman as an example of how regulation could improve ‘free market’ outcomes. Mainstream poster-boy Tyler Cowen replied that in fact car sales are regulated, and hence it is likely the regulation at fault. 

Having worked under the Queensland version of car sales regulation (the Property Agents and Motor Dealers Act) I can tell you that the whole purpose of the regulation is improve outcomes for consumers who were constantly being ripped off in an unregulated market! Why the hell does Cowen think such regulations even exist? Because everything was fine and dandy and consumers felt they were being treated fairly in a market we know functions under massive information failures?

You often see affirmations of the belief in markets in other writings, with phrases such as “I believe in the power of markets to aggregate information”. Which is of course nonsense, since if there exist conditions for markets to aggregate information, then there exist conditions for some other non-price mechanism to do the same. 

A LOT of what you guys learn as undergraduates is based on Keynes

Not true. I’ll let others expand on this, but for anyone who has read Keynes’ work there is almost nothing identifiable in any undergraduate textbook that represents his ideas.

I am happy to discuss and debate Marx and variants of Marxism with you (but be warned, I’ve been to Cuba and North Korea is bad)

The comments at the original article do more than address this. Especially this “Marx’s writings are about capitalism, NOT about command economies.”

Economists are always trying to do better! We are always revising theories, debating alternatives 

Actually, as a young researcher I find that in fact the econ crowd to be very much a closed shop. Any analytical method that falls outside the utility maximising representative agent optimal control model solved with to some quirky modification is essentially rejected with comments such as “in what way is that a model?” Yet if it conforms to their methods it doesn’t matter how nasty the assumptions, or how irrelevant the model, it is revered and worshipped as some kind of all seeing totem.

Some might say the rise of experimental and behavioural economics is evidence of the openness of the profession to new ideas. Unfortunately the behavioural revolution has been hijacked by the mainstream who now treat such irreconcilable evidence as mere modification to an individual’s utility function.

One final point. 

Backus links to a paper about taxing the wealthy, saying “you need a lot of maths under your belt to understand it”. I have said before, maths is often used in economics to disguise the conceptual links between variables and the real life objects and actions the represent. Here’s just one example of teaching economics where you learn nothing at all about the link between mathematical representations and reality. In Backus’s linked paper the whole idea is explained in two paragraphs starting on the bottom of page 4, while the maths that follows is mere intellectual obfuscation. Indeed  I find the whole 'maths thing' in economics strange. All the maths does is demonstrate that a set of concepts can be internally consistent with each other, and occasionally is helpful to communicate and compare ideas. The maths can't be used to discover anything new that was not implicitly already assumed. Every proof stems directly from an assumption made. 

The challenge of reforming economics, to break down the narrow and unrealistic analytical frameworks, to update teaching to reflect improvements in theory and the rapid expansion of empirical research, is daunting. While I do have some hope, and am relieved to see some true believers softening their positions and broadening their perspective, one can’t underestimate the determination with which vested interests in maintaining the status quo will defend their territory. Good luck to the Manchester students.

Tuesday, November 26, 2013

Three long term housing metrics

Philip Soos does an excellent job of compiling and sharing long term Australian housing data. I don’t want to replicate that sort of comprehensive work here, but simply share a few interesting graphs that come from Nigel Stapledon’s latest work on long term housing metrics.

First we have a metric that I call ‘Excess housing share’, which is the ratio of total dwellings to occupied dwellings. Notice the massive construction boom during the ‘golden years’ of the post- WWII boom until the 1970s. We can even see the blip of the naughties construction boom.

Second is the dwelling occupancy rate in persons per dwelling. There appears to be both and inter-war decline in occupancy, as well as a post-WWII long boom all the way till 2006. 

The last metric I call ‘Excess rental growth’ which is the CPI divided by the rental price index, which is a cumulative measure of the increase in average residential rents over CPI. Since the 1970s rents have outpaced CPI, with a stable period from the 1970s to early 2000s. We are currently at an historically unprecedented level of ‘excess rents’. Luckily I didn’t start this graph in 1955 because it would have been one hell of a shock, with rents growing 60% faster than CPI since that time on average. 

If my gut is correct, the emerging trend of below-CPI rental growth will be with us for a few more years till this measure drops back. 

I must note that some of this recent increase, and indeed some of the dramatic post-WWII increase might be attributable to the ever-changing measurement practices and techniques for both the CPI and rental index themselves. We can really only trust the short-term directions, and not the long-term magnitudes. 

Sunday, November 24, 2013

You can’t borrow from the future!

“We are borrowing from the future” is a common phrase you might hear from economists musing about the state of the economy; about the behaviour of individuals, businesses and especially of government.

These statements arise in discussions about ageing, stimulus, social security, public investment, public debts, health, education and almost every other public policy topics in which economists self-declare some degree of expertise. To really drive home the entrenched nature of such thinking in economics, here’s Satyajit Das saying “Debt allows society to borrow from the future” and here’s something purporting to be an economics text saying the same thing.

Oh, and it’s a favourite line the double-speak repertoire of Tony Abbott and Joe Hockey.

All of this is truly odd. It’s nonsense really. Perhaps expected from politicians, but not from a profession that usually ‘looks through’ the veil of money to the utilisation of real resources in the economy.

The confusion rests on a conflation of money with resources; if money equals a claim on resources then borrowed money, or debts in general, therefore equates to resources borrowed from the future. Will Ricardian Equivalence ever die?

All debts are transfers of purchasing power for current resources, despite new bank-issued debts not requiring current funding from a third party (as in the loanable funds model). In a direct credit transaction (peer to peer lending or credit channels including loanable funds) one party gives up their current purchasing power to another, with repayments and interest being a reversing of the transaction over time. No borrowing from the future there.

When new money is created through lending from the banking system, the same thing occurs, except that the society as a whole transfers resources to the entity spending the new money through inflation via their newly available purchasing power. This is usually known as by the concept of seniorage, though rarely is new lending discussed in these terms.

The whole point is that future resources don’t exist yet, so they can’t be consumed in the present! There is no transfer of resources - no hover boards are removed from the future and brought into the present via lending.

Which brings us back to often hotly debated idea of counter-cyclical fiscal policy, which is fundamentally used to increase demand for current production outputs, increase labour demand and employment and inflation, and invest in capital goods to be used in future period to produce those as yet uncertain future products.

Luckily there are some common sense economists out there. At least there was back in 1961 when Abba Lerner wrote this note about the impossibility of shifting burdens onto the future for society as a whole in response to a rather confusing article attempting to say the opposite in the American Economics Association’s most prestigious journal in 1960. Some of the ‘new generation’ are feeling the need to repeat this mantra in blog form.

If all of this isn’t enough, here’s the clincher - if today’s debt is borrowing from future generations, can’t we simply use tomorrow’s debt to borrow from later future generations indefinitely for the infinite future? Yes, yes we can.

Money and debt are mere tools of social goals. They are not the real resources of the economy but records of transaction and ownership claims. We can change the rules at any point to suit our social desires - debts can be forgiven, defaulted on, inflated away, or they can be used to justify war.

Please share this article. Tips, suggestions, comments and requests + follow me on Twitter @rumplestatskin

Wednesday, November 20, 2013

Everything I was afraid to ask about Bitcoin but did

The econ-blogosphere has been Bitcoin crazy for a while now. I haven’t quite understood what all the fuss is about, and knowing the personalities involved in much of the hype, I was afraid to ask too many detailed questions.

But I did anyway.

I finally put together my views following Rabee Tourky’s post at Core Economics, and a recent note by CommSec’s Craig James earlier in the week.

So what are the big questions about Bitcoin that need answering? There are two: What is its purpose? And, how will it maintain value and avoid volatility?

To answer the first question it is worth starting with Bitcoin founder Satoshi Nakamoto’s paper about a peer-to-peer electronic cash system. He repeatedly remarks that the benefit of electronic cash is being able to avoid intermediary financial institutions, thus cutting down transaction costs, and that the reversibility of such facilitated transitions is an inherent weakness. I quote from the paper at length.

While the system works well enough for most transactions, it still suffers from the inherent weaknesses of the trust based model. Completely non-reversible transactions are not really possible, since financial institutions cannot avoid mediating disputes. The cost of mediation increases transaction costs, limiting the minimum practical transaction size and cutting off the possibility for small casual transactions, and there is a broader cost in the loss of ability to make non-reversible payments for non- reversible services. With the possibility of reversal, the need for trust spreads. Merchants must be wary of their customers, hassling them for more information than they would otherwise need. A certain percentage of fraud is accepted as unavoidable. These costs and payment uncertainties can be avoided in person by using physical currency, but no mechanism exists to make payments over a communications channel without a trusted party. 
What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party. Transactions that are computationally impractical to reverse would protect sellers from fraud, and routine escrow mechanisms could easily be implemented to protect buyers. In this paper, we propose a solution to the double-spending problem using a peer-to-peer distributed timestamp server to generate computational proof of the chronological order of transactions. The system is secure as long as honest nodes collectively control more CPU power than any cooperating group of attacker nodes.

Here’s where the circularity of arguments about trust comes in, and where my first question about the purpose of Bitcoin becomes rather confusing. What sort of transaction would buyers be willing to undertake without a trusted intermediary? Twitter was not much help either…

But even in the case of ‘dodgy anonymous transaction’ as one of my mates suggested on Facebook, the whole point of Bitcoin is a record of transactions or ‘money as memory’. A court could order Bitcoin's miners, online waller suppliers or others involved in the network to disclose knowledge of transaction details and wallet identities in any case. Not only that, US officials have shut down digital currency operations in the past.

Authorities have also been looking into the criminal aspects of virtual currencies. Wolf Richter’s exposition of Bitcoin examines some of their discussions.

Officials from the Secret Service, the Treasury’s Financial Crimes Enforcement Network, and the Justice Department bragged to the committee about successful investigations of crimes where bitcoin or other virtual currencies were used, including the busts of Silk Road, eGold, and Liberty Reserve. They were confident that they knew how to tamp down on criminal use of virtual currencies. No one expressed outright alarm about the new world of bit coin.
Since every transaction of every bitcoin is forever recorded and part of the system, Mythili Raman, acting assistant attorney general at the Justice Department’s criminal division, pointed out that “cash is still probably the best medium for laundering money.” And she admitted that “many virtual currency systems offer legitimate financial services and have the potential to promote more efficient global commerce.” 
At the word legitimate, bitcoin soared. And I mean, SOARED.

My line of thinking about potential benefits of Bitcoins is to consider what sort of transaction I would like to be unable to reverse. Would I ever purchase items on eBay with irreversible electronic cash, assuming that eBay itself did not provide any other intermediary role apart from advertising? Nakamoto seems to suggest that the cost of financial intermediaries excludes very small transactions, yet facilities like Flatter seems to overcome this problem through batching transactions.

The success of Paypal as an online payment system is partly due to the insurance it buys for both buyer and seller for the transaction. Anyone who refused payment from Paypal would be signalling their untrustworthiness or unwillingness to meet conditions of any mediated dispute. The point being, rather than creating a payment system that doesn’t rely on trust, using Bitcoin over other payment methods will itself signal a lack of trust. All transactions require some trust. There is no escaping that. Online that is even more important. For example, you pay me with Bitcoins, then I don't post your goods, what recourse do you have?

So far there is no reasonable answer to my first question about the purpose of Bitcoins. 

My second question unfortunately reveals similar unsatisfactory answers. If Bitcoins really are limited by constraints on ‘mining’, then that will mean that in a situation where they are in demand as a medium of exchange, they will also be increasing in value and be a means of investment. As more people prefer to hold Bitcoins as investments rather than exchange them, this will push their value higher still. If you can’t see it coming, the end result is a massive bubble followed by a crash when the herd realises that their investment value was purely based on herd mentality, without any fundamental resources backing it, and that the system is no longer being used as a medium of exchange. This view has been put forward previously by Eric Posner.

It’s not like alternative payment methods have not been tried many times before. Bartercard springs to mind as one system that survives in its business-to-business niche. 

So let’s summarise. Bitcoins have been severely hyped online yet almost no one can suggest scenarios for both buyers and sellers in which they are actually a more useful medium of exchange than current costly reversible transactions. Furthermore, the ability for Bitcoins to hold there value is severely hampered by the nature of their technically limited supply. To top it off the only people I know of who have owned Bitcoins were speculating and never used them to transact. I can only conclude that this episode will go down in history as a lesson about the nature of money and trust in facilitating trade.

Please share this article. Tips, suggestions, comments and requests to + follow me on Twitter @rumplestatskin

Tuesday, November 19, 2013

What limits housing supply… one more time

My long term view, based on experience in the property development industry and in planning regulations for water and infrastructure, is that zoning is not a binding constraint on the rate of supply of new housing.

There is no doubt that zoning and other planning measures limit the type and scale of use on any particular site, as they are intended, but in aggregate they do not constrain the rate of new housing. For zoning to truly hamper housing supply there must be no undeveloped lots available within a zoned area. Indeed, all land must currently be at its highest value use, meaning these would cease to be a development industry altogether, and land banking would be the stuff of imagination.

One reason for the confusion around housing supply is the simplification inherent in almost all economic models of markets whereby the free entry condition means that any positive NPV project is instantly produced. There is no time in the model, and therefore no ability to delay investment.

To deal with the realities of the irreversibility of investments and the ability to delay, Black, Scholes and Merton in the 1970s developed methods for valuing the option to invest in irreversible capital at some point in the future. Merton and Scholes were even awarded an Economics Nobel for their trouble in 1997.

Following these methods a large body of work has emerged that addresses firm choices with real options - that is, when the firm faces genuine options to delay irreversible investments. Firms then face compound investment decisions; what to invest in, and when to invest in it. 

Why is this important for housing supply? Well, only in a world where real options exist can land remain undeveloped or in low value uses when higher value uses exist. Thus any analysis of land markets that is able to account for the large volume of undeveloped land must be based on the real options of land owners.

I have written about research into the nature of durable goods markets in the past, particularly the debate over the Coase Conjecture of how a monopoly land owner would drip feed supply to maximise the value of their land, since by building more homes now they will compete with the home they build in the future.

Yet real options is far more general, embedding these ideas into a much more robust theory. So what happens to land models when you account for real options?

Strangely enough in 1985 Sheridan Titman asked this exact question and published his results in a little journal called the American Economic Review, in an article entitled Land Prices under Uncertainty.

Titman constructs a model based on the idea of options to reveal the types of fundamental characteristics the drive the choice by a land owner to develop, which include the expectations of future changes to the optimal density of development, as well as future rental price paths. 

Under his model of real options in land (and indeed any model derived from this proposition) the land owners response to external conditions is quite different that in the basic model of perfect markets. He writes

It is shown that the initiation of height restrictions, perhaps for the purpose of limiting growth in an area, may lead to an increase in building activity in the area because of the consequent decrease in uncertainty regarding the optimal height of the buildings, and thus has the immediate affect of increase in the number of building units in an area.

This is something I’ve said before, and it is worth repeating. Increasing zoning in an area provides an incentive for land owners to delay development and hold out for further changes in zoning. The reverse is also true, and I’m sure everyone would agree that if you announced a reduced maximum density in an area that there would be a rush of development prior to the loss of the ‘option’ to develop greater densities.

A similar situation will happen with changes to developer costs. Infrastructure charges are often blamed for the high cost of development, but in any theoretical picture involving real options, reductions in infrastructure charges will delay rather than accelerate development. Similar problems arise with stamp duty. Calls to reduce stamp duty arise due to equity concerns, yet they have been shown not to increase housing prices, and in other markets such transaction taxes, or Tobin taxes, are being proposed to reduce volatility.

Sure I’m all for land taxes, but replacing a rather good tax in the form of stamp duty, rather than highly distortionary taxes such as payroll and income tax, provides a much smaller social gain. 

Given that rental prices in most Australian capital cities are falling relative to incomes, land markets must be functioning as roughly intended. My earlier ideas on rental controls may also reduce the rate of growth of housing prices, leading to increases in housing investment as the payoff from withholding undeveloped land decreases.

For all the talk of ‘elastifying supply’, there if very little in the way of considered logical thought about exactly what factors generate the current rate of new housing supply. Only by acknowledging the real options for future development held by land owners can we begin to understand the true fundamentals driving housing supply patterns.