Saturday, March 24, 2018

Seven questions economists can't answer

I’m not saying all economists can’t answer these questions. I’m saying that collectively these are core parts of what the discipline of economics should be about and yet are topics dealt with by fringe groups whose key insights have not penetrated the textbooks or been shared widely across the discipline.

1. What is money and where does it come from?
There is only one textbook that gets this right.[1] Despite the economics discipline being told directly by the world’s second oldest central bank that their textbooks are wrong nothing has changed. Students continue to learn the debunked money multiplier model.

It is puzzling how an intellectual discipline that doesn't understand money invented, advocated for, and implemented, monetary policy—a tool that most nations almost exclusively rely upon to improve economic stability and growth.

2. What do prices do?
Prices best perform the function of clearing markets in those markets that are not in core economic theories—financial markets. But this is clearly not the main function of prices in markets for real goods and services.

Many firms choose to have shortages, queues, or wastage, rather than change prices. I think Fieke van der Lecq got it right—prices are just one of many rules that help form a coordinating system and stable prices facilitate long-term coordination. Imagine if your local supermarket adopted surge pricing and increased prices when there were checkout queues? That would disrupt coordination and mean some people will leave their goods on the shelf potentially coming back later or going to a supermarket where the prices are predictable. The predictability of price helps all actors in the economy plan ahead.

If prices are really the super-flexible rationing tool economic theory assumes you would expect them to be changing frequently. Instead, most firms change prices once a year or less. 

3. What are opportunity costs?
The most insightful idea in economics is that resources are scarce and there is an opportunity cost for using labour time, land, labour and capital equipment for one purpose over another.

This is the core idea of economics, and yet when you survey a bunch of professional economists at their annual conference they can’t answer their own textbook questions on it. Then they take to the journals to say that ‘opportunity cost is whatever I want it to be!’ Crazy.

Confusion over opportunity cost is pervasive even in core models. For example, cost curves (in the theory of the firm) are opportunity cost curves but we drop the logic of opportunity cost in the model and compare profits at different output levels without considering the different opportunity costs arising from the different amount of resources needed at each output level. More on that conundrum here.

Out of interest, the question that stumped trained economists is this. 
You won a free ticket to see an Eric Clapton concert (which has no resale value). Bob Dylan is performing on the same night and is your next‐best alternative activity. Tickets to see Dylan cost $40. On any given day, you would be willing to pay up to $50 to see Dylan. There are no other costs of seeing either performer.
What is the opportunity cost of seeing Eric Clapton? A. 0, B. 10, C. 40, D. 50.
4. Why do firms exist?
It may surprise some readers but the core economic theories that show how markets create a socially optimal outcome rely on the existence of a central planner to do it (Walrasian auctioneer or some equivalent). The organising mechanism is assumed away rather than being the focus of analysis.

This approach is typical. The layers of organisation and non-price rule systems that exist in a society that coordinate production between and within firms are mostly neglected or assumed away. Firms themselves also come in many types.

Of course, there is a literature on this (like everything) but it is not ‘standard’ economics and most students will never hear much discussion about it in their classes beyond some simple transaction costs escape clause.

5. How can poor countries become rich?
You would think this would be a key insight of economists, but no, it remains a puzzle. For example, economists are divided on how to manage international trade to local advantage—specialise or protect industries to promote more diverse productive capabilities—and have little to say about workable ways for the public sector to productively set rules and administer them to guide development that brings widespread prosperity.

6. What is competition?
Economists have pointed the finger at a lack of competition as the cause of many of our social ills. And yet competition is clearly inefficient in markets where economies of scale exist and under a host of other well-known conditions.

We also know that for a fixed number of firms in a market for an identical product that naive price experimentation will lead to the monopoly outcome across the whole market (see here and here). Any economic value from competition must be a story more like that of monopolistic competition, and must be more about expanding the ‘product-space’ rather than under-bidding on price in well-defined markets with known competitors.

Many economists proclaim that more competition will help in just about every circumstance without really teasing out the details of how exactly that would happen. Because if you know the details of what investment would be made and what products and prices would be desirable under competition then the logical question is whether these outcomes can be achieved more efficiently in other ways. Competition is often just a convenient excuse to do nothing rather than make tough decisions as a community, and economists go along with it.

"Banks are ripping us off, what can you do?"

"Housing is too expensive, what can you do?"

"Schools aren't well resourced, what can you do?"

"The public transit system is failing, what can you do?"

In practice, the word has lost all meaning. It is a feel-good religious mantra.

Indeed, I would argue the ‘peril of monopoly' is more a failure of politicians and law-makers to operate in the interests of the broader public. Often the prevalence of monopolies and cartels correlates with high rates of economic growth.

Here’s an interesting take from Richard Werner.
Considering therefore the half-century from 1950 to 2000, we would expect the best performance in those economies that are more market-oriented, and the worst performance in economies that have chosen to practice intervention, ‘guidance’ and the use of production cartels. 
By the late 1960s, Japan was effectively not a market economy, but a ‘guided economy’ in which over 1000 cartels (official exemptions to the anti-monopoly law) had been established, in which tens of thousands of economic regulations allowed the bureaucrats to intervene in the economy, in which the stock and bond markets were largely irrelevant (as most funding came from banks), and in which the labour market was famously full of ‘rigidities’ and ‘inflexibilities’, with life-time employment, seniority pay and company unions.

7. What is capital?
Lastly, a big one. Capital is either machines, or it is property rights. If it is machines and equipment it seems strange that these machines need to earn a rate of return for themselves. If capital is property rights then we have just exploded all economic theories that rely on the 'cost of capital’ since we can make this cost whatever we want through the legal system governing these property rights which can change their value, and hence the cost of capital.

This is a massive unresolved debate that economists no longer seem to have an interest in, and yet incorrect conceptions of capital still underpin theoretical reasoning in just about every aspect of economics.
fn. [1] The new CORE Econ textbook is the only one I am aware of that gets it right. I picked up 10 random economics textbooks off the library shelf recently all of them present the money multiplier story.

** Some people on Twitter seem to take issue with What Do Prices Do and Why Do Firms Exist as being well-established questions dealt with satisfactorily so that your average trained economist would have a decent insight. After all, sticky pricing is an old problem and there are many theories about firm behaviour, agency problems, team production etc.

To be more clear, economists think that the thing prices do (which was my question) is clear markets. Sticky prices come from a growing ad hoc list of restrictions on this primary function. Alan Blinder also had concerns about this approach, many of which apply to questions about firm existence.
It is not that economists have ignored these questions. One could literally fill many volumes with good empirical studies of wage and price stickiness, and many more with clever theories purporting to explain these phenomena. Yet, despite all this work, the range of admissible theories is wider than ever, and new theories continue to crop up faster than old ones are rejected. (The study I am about to describe, for example, tests 12 theories; and my list is not exhaustive.) This lack of scientific progress makes one wonder about the basic research strategy that economists have been pursuing. 

Thursday, March 15, 2018

Replicating the RBA's housing analysis

Last week the RBA released a research paper which sought to unravel the potential effect of planning controls, like zoning, on home prices in Australia. I think the results of their analysis are wrongly interpreted to be due to zoning, and I quickly made my views known on Twitter.
But, like the good researcher I am, I wanted to check their method. So I put together a sample of land sales from my area and replicated the method, just be 100% certain I understood. Lo and behold, I get the same result. Using twenty-nine neighbouring land sales and estimating ln(p) = A + B ln(area) + e, I get the following result.

The coefficient of 0.54 for ln(area) indicates that a 1% increase in land area only increases the total land price by 0.54%. So if the average price was $100/sqm for a 1,000sqm block (total price of $100,000), an extra 10sqm (1%) would cost just $540, or only $54/sqm.

This indicates that indeed, because of zoning constraints, people are unable to assemble marginal pieces of land at $54/sqm and thus must pay on average $100/sqm instead. The zoning effect clearly accounts for 46% of land value. Quite a stark result.

In my data the actual average land price of a lot was 0.1 pence per square metre while the marginal price was just 0.052 pence.


Yes, my average lot size was 4 acres, 1 rood, and 34 perches and sold at 19 pounds, 6 shillings and 9 pence. My randomly selected sample of sales occurred in December 1851 in South Brisbane. Zoning was still nearly a century away from being invented, and the population of the whole state of Queensland was less than 17,000 people or about half the normal attendance at a Broncos football match.

Let me be clear. Either it is true that the method used by the RBA does identify zoning effects, and therefore also identifies zoning effects of a similar scale 167 years ago in a remote and deserted convict colony that we know did not have planning controls. Or, it is true that the method does not identify zoning effects.

You decide.

*Here is a look at some of the data used for this post.

Tuesday, March 13, 2018

Who really owns Antarctica?

I have often argued with libertarians (and anarchists) that the existence of property rights first requires the existence of a government with a monopoly on coercive force (ie. government requires the largest armed force). If such an entity didn’t exist, then the largest armed force would simply take control and become the government. Many voices in these debates suggested that I need only look to international treaties to show how cooperative we can be without the need for world police.

Putting aside the obvious point that the US is the current world police, with their military budget making up 43% of the world total military spend, and that their international military presence often conflicting with international treaties, we can examine whether libertarian views are vindicated by one of the shining examples of international cooperation – Antarctica.

Back in 1959, twelve countries active in the Antarctic signed the Antarctic Treaty (implemented in 1961), which led to further treaties and conventions to manage activities and resource use (especially fisheries) in the whole Antarctic region south of 60% latitude. Collectively these treaties are known as the Antarctic Treaty System. With the shadow of the Second World War still looming large, the top priority of the original treaty was to ensure that the area remained conflict-free by outlawing a military presence – prescribed in Article I of the treaty. Other peace-inspired provisions include Article V, prohibiting nuclear explosions and the disposal of radioactive material. Who knew that the dominant ideologies of 1960s youth originated in Antarctica?

Since that time the Montreal Protocol was adopted as part of the Antarctic Treaty System with the explicit intention of preserving the Antarctic as a natural reserve devoted to peace and science. Critically, Article 7 of the Protocol prohibited all non-scientific mineral resource activities.

The Antarctic Treaty was a bold and lasting agreement, recently celebrating its 50th year. The treaty’s anniversary gave rise to some optimistic claims
The lesson of fifty years of the Antarctic Treaty System is that the nations of the world can set aside their political and territorial aspirations to share in the management of a vast region of the planet, says Paul Berkman, chair of the International Board for the Antarctic Treaty Summit.
But I wouldn’t make such strong claims so fast.

Geopolitics was not cast aside by the free love of the original Antarctic Treaty. The US does not recognise the territorial claims of other governments and reserves the right to assert claims. The USSR, and later Russia, made the same non-commitment to the Treaty. The success of the Antarctic treaties over the past fifty years was perhaps more the result of the low value of any commercial or strategic military operations in the Antarctic.

While the US has no current claim over territory, it has positioned its Amundsen-Scott research base at the South Pole so as to maintain a presence in all claimed territories (shown in the map below). The US may very well have secured a right to claim territory that existing claimants leave unoccupied.

We also know Australia does not have the capacity to visit the inland areas of its territorial claim. This may be problematic as the original Antarctic Treaty has a provision in Article XII allowing a contracting party to call a review of the operation of the treaty after thirty years. One could expect that our absence, or lack of presence, in our claimed territory puts us in a poor position for any future treaty negotiations that may establish new claims based on current activities.

The rise of new entrants into Antarctica is also concerning for existing territorial claimants.
Russia has seven stations in the AAT; China opened its second station last year; India will start construction on its first over summer; and South Korea is planning to set up a new station near the Easter sector by 2014.
With renewed interest from emerging global economic powers, and the ice sheets receding in some areas, mining the Antarctic is attraction a lot of attention (and here).

So it seems that the ingredients for conflict are slowly being added to the spicy Antarctic political stew (these concerns have been noted elsewhere). How one resolves these new interests in the mineral rights of Antarctica, with the interests of the existing parties to the Antarctic Treaty System, I am not sure. But let’s be clear. The US will not lose out in any future negotiations that allow further exploitation of the Antarctic. In a hypothetical future scenario where mining becomes allowable under the treaty system, does anyone really expect the US to respect the rights established by existing territorial claims? I don’t.

In the end, current Antarctic territorial claims are only valid as long as they are not challenged. So I ask the anarchists and libertarians, exactly how does one negotiate a territorial claim (or defend their property right) with an unmatchable armed force that happens to be a necessary military ally?