Sunday, June 26, 2016

Lessons from Brexit

I didn’t predict this outcome. Few did. I thought it was too soon. But I wasn’t naive about the politics of the situation. One of my main concerns was that the Remain campaigners seemed overly attached to unrealistic models of economic doom, while simultaneously accusing the other side of spreading lies.

Almost nobody I asked could give me an economic reason to be in the EU. I read nothing that made any sense from this outsider’s perspective. No one could point to a particular policy change and clearly say exactly how the economic ramifications would play out. They couldn’t really. Because nobody knew, or even knows now, what the word of UK trade and immigration policy will look like post-EU.

The whole question is political.

Let me briefly note some of the main lessons I see from this experience. This post is as much a record of my thinking as it is a commentary on politics.

1. Facts don’t matter and politics rewards lies
Anyone able to make an objective assessment of the day-to-day behaviour of successful politicians in any country knows this. Lying is the main ingredient in political success. Yet the Remain campaign seemed to somehow think that stating facts could change people’s minds. For apparently scientifically-minded technocrats, that is absurdly naive.

2. Economic effects will be serious
This is the big lie that the Remain campaign couldn’t bring itself to admit was a lie. If they could admit this, they would have seen the campaign period as a battle of lies, and get over their foolish attachment to their own truth.

That the pound dropped a touch in a short period after the referendum result is economically meaningless. All it says is that currency traders were surprised. We also live in a world embroiled in a currency war, each country looking to deflate to stimulate its export sector. Yet somehow the weak pound is a bad thing for UK.

When other countries observe how economical benign it was for the UK to leave, others will follow, and this lie will become all too obvious even to those who believe it now. As James Galbraith said “such warnings will be even less credible when heard the next time.”

3. Technocrats underestimated peoples willingness to blame outsiders
War is the nature of civilisation. People are tribal animals. Yet somehow the mental model of Remain-side technocrats was too full of ideology over observation. People always blame outsiders for their problems. Always have. Always will. There doesn’t have to be truth in it and telling them ‘facts’ can actually strengthen their beliefs.

4. Naive support for the EU rent-seekers
Many people don't actually benefit from the free movement of labour across the EU. Highly educated professionals do. But your average labourer doesn’t. For most people they see only costs to political integration with Europe. And indeed, any benefits come at the cost of an enormous layer of bureaucracy and rent-seeking.

In many minds, the question is whether you want your political rent-seekers locally raised, or part of the outsider group you are inclined to blame for your troubles. The answer here is obvious.

5. High immigration is disruptive
Take a look at Germany. The refugee crisis really gave them no choice but to accept a huge influx of new immigrants. To maintain internal cohesion will require a massive propaganda effort, coupled with a massive intervention effort to teach the language and culture to the new immigrants.

It’s something that the left doesn’t like to speak about, but the evidence is pretty clear. High rates of immigration are disruptive to social institutions that share a group’s wealth. This is a fact of human nature.

Be honest now. I’m sure you can think of some person, or some group, that you perceive as an outsider and genuinely don’t want to lend a hand to, perhaps you even want to punish them. Absolute humanism, utilitarianism, or whatever you call it, where all lives are equally important, is pure fantasy. We are tribal, and the veil of equality is always a within-group phenomenon.

Last word
In all, the political ramifications of Brexit are far less interesting than the volumes of words spilt about it suggest. Some leaders will come and go as the internal transition is navigated. It’s no big deal. One will stick eventually.

And I think the one who sticks in the UK will have a surprisingly social agenda. A pro-UK agenda. If history is a guide, this is what people want once you've choked off immigration.

Other rich countries in the EU will see how “surprisingly” successful the transition has been and also leave. The EU in its current form is over. Without direct democratic input and fiscal unification it lasted longer than could be expected. We can only hope that what comes out of the EU rubble are the peaceful nation states that it helped create, and decades on we can say that the EU served its purpose of bringing widespread peace across Europe.

Or am I too naive?

In all honesty, if I was voting I would have voted Remain. But not for any rational reason. I just would have conformed to the expectations of my social group. And because of the social reinforcement, I probably would have become very passionate about my position. As a remote observer with no particular interests, it is much easier to see the underlying logic of the situation.

Sunday, June 12, 2016

Robinson Crusoe’s real economic choices

The Robinson Crusoe economy is widely used as a teaching aid in economics to explain concepts such as comparative advantage and equilibrium in an exchange economy.

In my view, the use of the Crusoe economy as a teaching aide often trains students to focus only on a few very narrow ideas, and ignore many of the fundamentally important elements involved in economic production and coordination in Crusoe's world.

This will be obvious to you when you watch the latest “stranded on an island” reality television show. The lessons of economics simply don’t correspond to the type of production and coordination I see in them.

In this post I want to show how Crusoe’s story can be an effective teaching aide, and demonstrate a structured, yet pluralist, approach to economic inquiry, in the way I have previously proposed. This structure breaks down an economic problem into various domains of interest, along with a number of guiding questions about aggregation timing, and prediction, in order to assess the types of concepts, models and analysis being applied in each domain.
Rather than use Crusoe's story to justify a concept - “This is specialisation, remember it by the story of Crusoe”, the reverse approach could be taken. “Here is the story of Crusoe, how would we understand that economics of the story?” Having a structured method of economic inquiry then allows students to ‘discover’ the economic concepts you really want to teach them.

Where would such a method of inquiry lead us in Crusoe’s story?

First, here is the standard use of Crusoe, which typically focuses on specialisation when Crusoe is joined by Friday. For some reason he has an absolute advantage in producing fish and coconuts, as each day he can produce more both than his companion Friday. But his relative advantage is in coconuts. The graph such as the one below is then used to demonstrate the gains to specialisation. The dashed light blue line is their combined output without specialisation, and the green line is with each producing the product in which they have a relative advantage, and the gap between these lines near the kink of the green line is the gain from specialisation.
This lesson is simple, and true enough on its face. But it is very incomplete.

So what about my alternative use of the Crusoe economy for teaching economics?

Social and political environment
We first inquire about how Crusoe and Friday came to understand what their social arrangements should look like, noting that any subsequent economic activity will be embedded within these social relationships. In the actual story Crusoe rescues Friday and ‘employs’ him as a servant, teaches him Christianity, and generally creates a hierarchal social relationship. Under this condition the idea that Crusoe and Friday will equally and jointly make decisions about their production activities and trade is a little strange. What will happen is that Crusoe will use the social arrangement to dictate their joint activities in order to fulfil his wishes, which are themselves a product of his previous social environment.

What other social structures could there be in a two-person economy? One case might be that the two are parent and child. In this case the parent will likely have power to dictate the activities of the child, but will also have an incentive to invest in the relationship in order for the child to reciprocate in the future.

The story can be used to open lines of enquiry about social and political structures and their analysis, revisiting this simple case to enforce the basic concepts later introduced.

Money and legal rights
Moving on from social and political environment, we can then interrogate the related economic domains of money and property rights. We can ask questions about who owns what, and how accounts will be kept. Unless we understand the rights of our two gents, we aren’t going to make much progress in understanding the situation.

For example, if Crusoe is a more productive fisherman because he excludes Friday from the most fertile fishing areas by claiming property rights over these areas, this opens up a new puzzle. Would the productivity of Crusoe and Friday be different if they had a different system of property rights? Maybe if Friday could access those parts of the island Crusoe set aside for himself, total output could be much higher. Hence this story can be used to show how understanding the distribution of property rights can help answer questions about whether there are more efficient alternative allocative institutions. For example, maybe cooperative production by fishing together one day, and then collecting coconuts together the next, is even better than any outcome from specialisation.

In the money domain we can ask how Crusoe and Friday plan to keep accounts if they specialise, as per the standard economic account, yet some days the fishing is better than others, and some seasons the coconut palms are not fruiting so prolifically. If their daily output of fish and coconuts fluctuates, we create an inter-temporal problem of smoothing production and consumption via accounting.

What would these accounts look like? Would Crusoe credit Friday some fish when coconuts are slim pickings, and vice versa? At what price could a debt in fish be repaid with coconuts. These questions about how accounts are kept and how they evolve through time really matter for how Crusoe and Friday coordinate their production.

We can use the story as a stepping stone to another story, of the Capitol Hill babysitting coop, and its monetary system, before leaping off to study large-scale monetary systems and central banking.

Real resources and welfare
In the domain of real resources we can ask questions about whether Crusoe has always been more productive, and look at how he came to be; a question of timing. Perhaps he has a fishing net that Friday cannot access. If this is that case were again need to ask the question of why it is Crusoe’s net in the first place it it washed up on the beach.

Putting this to the side, if Crusoe did specialise in coconuts while possessing a fishing net, there will be a loss in potential joint production because of the idle capital of the net. We know that the existence of fixed capital can break down the logic specialisation, undermining the clear-cut beneficial outcome that is presented in textbook economics. And even if Crusoe is somehow innately better skilled at the two activities, it merely begs the question of how he learnt to be better and what is stopping Friday from learning the skills and even surpassing Crusoe’s productivity. These lines of inquiry can lead into the study of trade, and arguments about managerial economics and learning, infant industries, trade protection, and so forth.

We can even build on the standard specialisation story. In the earlier graph I have also plotted a dotted orange line showing a 50:50 split of the output from Crusoe and Friday specialising. Notice that this line sits fully below Crusoe’s own production frontier. What this means is that while there is a gain from trade, it is not clear how it should be split. Obviously, given the existing legal situation and capital stock, Crusoe is more productive and will be able to extract a greater than half share of the resulting larger combined economic pie. But how much?

If we deal just with the kink in the combined production frontier for a moment, if Friday receives a 37.5% share of combined output he is just as well off as going it alone and not trading. At that same kink point, Crusoe is just as well off if he receives 53.9% of the combined production of fish and coconuts.

Here we have a problem. This trade produces a surplus that needs to be shared. Somewhere between 37.5 and 46.1% of combined output to Friday and the rest to Crusoe will make them both better off in pure output terms. How this surplus gets divided is a defining issue of economic distribution and welfare which is fundamentally ignored by most economists. It is a question of who gets the rights to surpluses generated by trade. If Crusoe captures all the surplus, inequality on the island will start increasing, but if Friday can capture most of it, their wealth will become more equal.

Because Crusoe and Friday now face the problem of how to allocate their economic surplus, the story allows us to introduce ideas of utilitarianism, including how welfare can be assessed or improved.

The story also provides scope to lead into questions about whether the standard story of specialisation makes useful predictions applicable to the modern world. On this account, some of the basic predictions of the standard story of specialisation and trade fail, as Hill and Myatt explain
…since the industrialized nations are so similar – similar economic structures, resources and technology – they likely have similar opportunity costs in production. Thus, they would not be expected to trade much with one another. But in fact industrialized countries trade extensively with one another. He says: ‘Over 70 per cent of the exports of industrialized countries go to other industrialized countries … These facts appear to be inconsistent with comparative advantage theory’
We should be asking why that it, and looking at what else may be happening. 

Indeed, we can take the next step after discussing specialisation to ask how the scale and diversity of Crusoe and Friday’s economic output can be increased once they have learnt to optimally collect coconuts and go fishing. We then talk about capital investment, innovation, and so forth.

So what?
The story of Crusoe is usually seen as a memorable simplification for teaching a couple of basic economic concepts. But I argue that it can instead be used to teach a structured and coherent pluralist approach to economic inquiry. In doing so, this approach makes clear the many hidden assumptions necessary to concentrate on the economic analysis of specific domains of the Crusoe economy, and ensure students understand from the very beginning that this is the norm in economic analysis, and to remain critical.

Wednesday, June 8, 2016

Time to revisit how we calculate expectations?

The below presentation by Dr Ole Peters opened my mind. If there was one thing I believed was a reasonable implicit assumption of economics, it was determining the expectation value upon which agents base their decisions as the “ensemble mean” of a large number of draws from a distribution. Surely there is nothing about this simple method that could undermine the main conclusions about rational expectations, whether humans act that way or not? Surely this is a logical benchmark, regardless of whether actual human behaviour deviates from it.

But now I’m not so sure. Below is a video of Dr Peters making the case that non-ergodicity (according to the physics interpretation of the word) of many economic processes means that taking the ensemble mean as an expectation for an individual is probably not a good, or rational, expectation upon which to base your decisions.

I encourage you to watch it all.

Let me first be very clear about the terminology he is using. He uses the term ergodic to describe a process where the average across the time dimension is the same as the average across another dimension.

Rolling a dice is a good example. The expected distribution of outcomes from rolling a single dice in a 10,000 roll sequence is the same as the expected distribution of rolling 10,000 dice once each. That process is ergodic [1].

But many processes are not like this. You cannot just keep playing over time and expect to converge to the mean.

Peter’s example is this. You start with a $100 balance. You flip a coin. Heads means you win 50% of your current balance. Tails means you lose 40%. Then repeat.

Taking the ensemble mean entails reasoning by way of imagining a large number coin flips at each time period and taking the mean of these fictitious flips. That means the expectation value based on the ensemble mean of the first coin toss is (0.5x$50 + 0.5*$-40) = $5, or a 5% gain. Using this reasoning, the expectation for the second sequential coin toss is (0.5*52.5 + 0.5 * $-42) = $5.25 (another 5% gain).

The ensemble expectation is that this process will generate a 5% compound growth rate over time.

But if I start this process and keep playing long enough over time, I will never converge to that 5% expectation. The process is non-ergodic.

In the left graph above I show in blue the ensemble mean at each period of a simulation of 20,000 runs of this process for 100 time periods (on a log scale). It looks just like our 5% compound growth rate (as it should).

The dashed orange lines are a sample of runs of the simulation. Notably the distribution of those runs is heavily biased towards final balances of around $1 (remembering the starting balance was $100).

In fact, out of the 20,000 runs in my simulation, 17,000 lost money over the 100 time periods, having a final balance less than their $100 starting balance. Even more starkly, more than half the runs had less than $1 after 100 time periods. The right hand graph shows the final round balances of the 20,000 simulations on a log scale. You can read more about the mathematics here.

So if almost everybody losses from this process, how can the ensemble mean of 5% compound growth be a reasonable expectation value? It cannot. For someone who is only going to experience a single path through a non-ergodic process, basing your behaviour on an expectation using the ensemble mean probably won’t be an effective way to navigate economic variations.

I see two areas of economics where we may have been mislead by thinking of the ensemble mean as reasonable expectation.

First is a very micro level concern: behavioural biases. The whole idea of endowment effects and loses aversion make sense in a world dominated by non-ergodic processes. We hate losing what we have because it very often decreases our ability to make future gains. And we should certainly avoid being on one of the losing trajectories of a non-ergodic process.

The second is a macro level concern: insurance and retirement. Insurance pools resources at a given point in time across individuals in the insurance scheme in order that those who are lucky enough to be winners at that point in time, make a transfer to those who are losers. By doing this, risk is shared amongst the pool of insurance scheme participants [2].

Retirement and disability support schemes are social insurance schemes. They pool the resources of those lucky enough to be able to earn money at each point in time, and transfer it to those that are unable to.

But there has been a big trend towards self-insurance for retirement. In the US they are 401k plans, and in Australia superannuation schemes. Here the idea is that rather than pooling with others at each point in time (as in a public pensions systems), why not pool with your past and future self to smooth out your income?

You can immediately see the problem here. If the process of earning and saving non-ergodic and similar in character to the example here, such a system won’t be able to replace public pensions, as many individuals earning and saving paths will never recover during their working life to support their retirement. Unless you want the poor elderly living on the street, some public retirement insurance will be necessary.

Undoubtedly there are many more areas of economics where this subtle shift in thinning can help improve out understanding of the world (I’m thinking especially about Gigerenzer’s ideas of heuristics approach as being ways humans have evolved to navigate non-ergodic processes).

I will leave the last word to Robert Solow, who has had similar misgivings (for over 30 years!) about our assumptions of ergodicity (a stationary stochastic process) which undermine rational expectations.
I ask myself what I could legitimately assume a person to have rational expectations about, the technical answer would be, I think, about the realization of a stationary stochastic process, such as the outcome of the toss of a coin or anything that can be modeled as the outcome of a random process that is stationary. If I don’t think that the economic implications of the outbreak of World war II were regarded by most people as the realization of a stationary stochastic process. In that case, the concept of rational expectations does not make any sense. Similarly, the major innovations cannot be thought of as the outcome of a random process. In that case the probability calculus does not apply.
fn[1]. He does not use the term as it is often used in economics as describing what often falls under the term Lucas critique, or in sociology is called performativity. Basically, it is the idea that the introducing a model of the world creates a reaction to that modal. Take a sports example. As a basketball coach I look at the past data and see that three point shots should be take more because they aren’t defended well. I then create plays (models) that capitalise on this. But because my opponents respond to the model, the success of the model is fleeting.

fn[2]. Peters himself has a paper on The Insurance Puzzle. The puzzle is that if it is profitable to offer insurance, it is not profitable to get insurance. The typical solution invokes non-linear utility to solve it. Peters offers an alternative. My take is on the economic implications of this - if people can smooth through time for retirement than there is not logic to social insurance.

Wednesday, June 1, 2016

The great Australian town planning give-away

It is the gift that keeps on giving for the Australian property developer lobby. Planning gains. Betterment. Whatever you call it, it is a multi-billion dollar give-away to the politically connected happening every year.

It works like this. Property developers buy land with the accompanying right to use it for a certain purpose, which is typically prescribed in the local council planning documents. They then lobby their mates in power to change the prescribed uses in the plan, in the process giving them a new property right which they did not pay the previous owner for. Nor did they pay the government for that new right. It was a gift.

But in Australia’s beloved capital city this game of giving planning gifts to your mates doesn’t work. There is no gift. In the Australian Capital Territory, if you want more property rights, you pay the government for them.

The ACT government achieves this in two ways. First, it has a public body that plays the role of land developer, the Land Development Agency, which converts land into urban uses, invests in infrastructure, and sells the new plots of land at market prices. When it sells this land it comes with the requirement to build on that land within two years in accordance with the purpose clause of the land title. By acting as the developer, 100% of the windfall planning gains goes to the government in manner that is economically efficient.

Second, if you have land that can be developed to higher uses within relevant zoning rules of the town plan, you must pay the government a Lease Variation Charge (formerly a Change of Use Charge) of 75% of the value gains to the land from allowing the higher value use.

These two schemes earned the ACT government $164 million and $19 million in 2014-15 respectively. That’s $183 million in revenue that would be given away to land developers in other states.

So how big is the great betterment give-away occurring in other states? We can scale up the ACT data to get a good estimate of the size of this give-away happening in the rest of the country.

There are two main adjustments necessary to do this. First is to adjust for the dwelling price differences across states. While the two schemes apply to all types of land, including residential and commercial, the residential values dominate. I therefore adjust the figure by the ratio of state median dwelling prices to ACT median prices to get the price ratio. I then adjust for the number of new dwellings in other states completed in that year to get the dwelling ratio. I then calculate the total scaling factor as price ratio times the dwelling ratio. Then I multiply this by the ACT betterment revenue and sum across states.

The result is summarised below. And the answer is $11 billion.

Median price
(May 2015)
Trend new private
dwellings (ABS, year
to June 2015, State)
Price ratio Dwelling ratio Scaling factor Scaled
Sydney $ 691,000 51,368 1.39 14.13 19.57 3,582
Melbourne $ 502,000 64,529 1.01 17.75 17.86 3,267
Brisbane $ 424,000 42,055 0.85 11.57 9.83 1,799
Adelaide $ 383,000 10,079 0.77 2.77 2.13 389
Perth $ 528,000 30,343 1.06 8.35 8.83 1,616
Hobart $ 299,000 2,734 0.60 0.75 0.45 83
Darwin $ 510,000 1,648 1.02 0.45 0.46 85
Canberra $ 499,000 3,636 1.00 1.00 1.00 183
Total 10,821

That sounds right to me. $11 billion is what the Australian states gave away to landowners and property developers in 2014-15, that they could have recouped had they had the system of betterment taxes that the ACT has had since 1971.

As a final point, you might think that the degree to which the ACT government controls land uses might have some effect on slowing new investment in dwellings. This is not the case. The ACT has the largest homes in the country, and has the same bedrooms/person ratio (a measure of dwelling stock per capita) as Queensland, slightly behind Tasmania, but in front of NSW and Victoria. While I remain cautious about the ability for such systems to be taken advantage of, I see the current system of private landowners taking planning gains and determining the new supply even more prone to political corruption and favouritism. Rezoning gifts don't even come with obligations on developers in other states to actually build what they promise. They can sell the land with the new rights the following day and cash in their gains.