Tuesday, April 15, 2014

Robinson: An introduction to economic doctrine

Imagine a modern economics textbook in three parts, the last two being Analysis and Modern Problems. What do you think would the first part would be called?

I doubt your answer was Economic Doctrines. But that’s exactly how Joan Robinson began her textbook An Introduction to Modern Economics back in 1973.

For Robinson, rebuilding economics teaching meant starting with an understanding of evolving economic doctrines. As such, she begins her revolutionary textbook with a summary of the defining battles within economic philosophy, tracing the key players and their moral and logical arguments since the writings of Fan├žois Quesnay in the 18th century.

Robinson’s book, written with John Eatwell, was supposed to offer a fresh new way to teach economics that would replace the ‘Samuelson’ approach to economic teaching. It failed to do so. In fact, it failed so catastrophically that it never gained one-tenth the circulation of Samuelson’s principles text in its short publishing history, and has been all but forgotten in modern discussions about rewriting the economics curriculum. So unpopular is this book that it is deemed unworthy of shelf space at my university library, and instead resides in an off-site library storage facility.

But its popularity should definitely not be a guide to its quality.

For those who may never read the book I want to highlight some of the more interesting content that you won’t easily find elsewhere, and that is perhaps even more important and relevant today than forty years ago when the book was first published.

As a recently trained economist, one of the more shocking things about Robinson’s textbook is the way many core features of neoclassical economics are brushed away in a sentence or paragraph as mere metaphysical reasoning. She defines such reasoning as being “applied to a use of language that conveys no factual information, describes no logical relations nor gives precise instructions and yet is calculated to affect conduct.” One such concept is utility, which is described as follows when it is first introduced
Utility is the characteristic of commodities which makes individuals want to buy them, and individuals buy commodities to enjoy utility consuming them.
Another metaphysical concept is that of profit maximisation; which is purely defined in terms of itself. While it may seem a little smug of Robinson to dismiss these ideas, the unscientific nature of metaphysical concepts renders much of the economic approach to generating knowledge utterly useless. Not a week passes when I don’t see a new economics paper or seminar that makes appeals to unmeasurable and unknowable concepts, defined purely in terms of themselves, that exist only as story-telling devices. Just a few days ago I sat in a seminar where labour markets were being ‘modelled’ in terms of an unquantifiable concept of search efficiency, which could not be defined without circular reasoning and offered no testable predictions.

Another feature of Robinson’s book is that unlike our new Australian learning standards in economics, her text includes the following index items
Moral considerations, 2-3, 42, 313; see also Metaphysics, Politics and Social Justice.

Slogans, 1, 3, 9-10, 59
For anyone with a mainstream economics education, these terms would seem wildly out of place. Even the mere suggestion of morality in economics these days will cast you as an outsider and ruin your career prospects. Economists love to see themselves as value-free, and collectively ignore the reality that any welfare analysis is inherently a moral analysis.

When discussing the rise of the neoclassicists, Robinson writes critically of their core construct of the Walrasian equilibrium.
Walras himself realised that it is not practicable to reach the equilibrium position by trail and error, but he imagined that buyers and sellers could proceed by shouting out demands and offers, finding the equilibrium set of outputs and prices before production and trade took place.

His modern followers seem to have given up pretending that this is possible, and content themselves with finding conditions necessary to ensure that at least one position of equilibrium exists.
Oh my. She really did just say that a great bulk of academic economists have simply given up on reality to content themselves with mathematical game-playing. Which implies that much of neoclassical theory itself is unable to be reconciled with real processes in the economy.

Finally, we get a taste of the controversy that surrounds the definition of capital which is generally omitted from introductory texts. Robinson includes Thorstein Veblen’s view on the orthodoxy from his review of John Bates Clarks’s The Distribution of Wealth to make the point.
Here, as elsewhere in Mr Clark’s writings, much is made of the doctrine that the two facts of ‘capital’ and ‘capital goods’ are conceptually distinct, though substantially identical. The two terms cover virtually the same facts as would be covered by the terms ‘pecuniary capital’ and ‘industrial equipment’… 
This conception of capital, as a physically ‘abiding entity’ constituted by the succession of productive goods that make up the industrial equipment, breaks downs in Mr Clark’s own use of it when he comes to speak of the mobility of capital; that is to say, so soon as he makes use of it… 
The continuum in which the ‘abiding entity’ of capital resides is a continuity of ownership, not a physical fact. The continuity, in fact, is of an immaterial nature, a matter of legal rights, of contract, of purchase and sale.  
Just why this patent state of the case is overlooked, as it somewhat elaborately is, is not easily seen. But it is plain that, if the concept of capital were elaborated from observation of current business practice, it would be found that ‘capital’ is a pecuniary fact, not a mechanical one; that it is an outcome of a valuation, depending immediately on the state of mind of the valuers; and that the specific marks of capital, by which it is distinguishable from other facts, are of an immaterial character. 
What we see in this book is what I believe is an honest appraisal of economics. The myths and legends that are passed down as fact in most textbooks are shown to be anything but. Even Adam Smith’s pin factory and the lessons of the division of labour are challenged.

The book does leave the reader wondering exactly how economic research should proceed. I think Robinson would be impressed by the gains made by experimental economics researchers, particularly because their findings more often than not challenge some element of neoclassical doctrine.

If you want an introduction to economics that acknowledges the rather limited knowledge generated by the field and starts from fundamental moral foundations, then you could do worse than tracking down a copy of Robinson and Eatwell’s textbook from your local library's storage shed.

Thursday, April 3, 2014

Australian journalists wage war on cycling

Two recent traffic accidents involving cyclists and cars - one a ‘dooring’ and one a that can only be described as a driver flat-out running over a man on a bike with their car - provide a rather sobering backdrop to the introduction of Queensland’s new 1m law next week.

The law is described on the Queensland government website as follows [1]: 
From 7 April by law motorists must give:
- a minimum of 1 metre when passing cyclists in a 60km/h or less speed zone
- at least 1.5 metres where the speed limit is over 60km/h.
Motorists will be allowed to cross centre lines, including double unbroken centre lines, straddle lane-lines or drive on painted islands to pass cyclists provided the driver has a clear view of any approaching traffic and it is safe to do so.
There has been extensive media coverage of both the traffic accidents mentioned, and the implementation of this new law. As there should be.

But I simply cannot believe that the media coverage has been either honest or ethical. In fact, I would describe the media coverage as journalists promoting legal falsehoods and legitimising road-rage against cyclists.

In light of the media's abysmal efforts to cover these stories I have been pondering the following questions: Is it ethical to misrepresent the new law, or even current laws related to cycling? Is it ethical to promote a war between motorists and cyclists on the road?

Let me show you why ask such questions.

A recent editorial in The Australian following the 'oozing' incident seemed to serve the sole purpose of misleading and deceiving the public. It needs to be quoted here in full to be believed - I don’t want to be accused of a lack of context
THE arrogant sense of entitlement in our inner cities is also evident in the ever-growing number of cyclists snaking their way through pedestrians on overcrowded pathways, darting between cars and clogging-up lanes on our congested roadways.
The problem of city cyclists reached their apogee in Melbourne this week when a cyclist was “doored” on busy Collins Street, after a passenger opened a taxi door and a rider crashed into it. Neither the taxi nor its passenger could be deemed at fault because a narrow “bike lane” inhibited the taxi from stopping next to the kerb. The passenger was lucky to avoid serious injury.
What makes this incident even more absurd is that, although the lane was marked by a bicycle symbol, it was not actually a dedicated bicycle lane. Melbourne bike lanes must have signage, fixed to a pole, that shows the start and finish of a lane, as well as clear markings on the road itself. The state’s bicycle operations officer — yes, there is such a position — admits there is confusion for cyclists, pedestrians and motorists. Cyclists, including the one “doored” this week, are using cameras to film such incidents so they can make insurance claims. The Victorian government imposed even tougher on-the-spot fines in 2012 for people who opened car doors in the direct path of cyclists.
For too long, authorities have bowed to the demands of selfish cyclists and their lobby groups. Truth is, our cities are dominated by cars because they are sprawling. We have no equivalent of Amsterdam and should stop pretending we do.
In this article the law, in my view, is clearly misrepresented. The lane used by the cyclist in this incident was marked in a particular way with bike stencils (what are typically known as Bicycle Awareness Zones) indicating that drivers should be alert for cyclists and normal road rules apply. These normal road rules allow bicycles to pass vehicles on the left side.

The Australian’s editorial implies that a) it was inappropriate, if not illegal, to cycle in that road space because it was not a bike lane, and b) the taxi driver and passenger could not be at fault. Both these claims are false.

Such poor journalism probably goes some way to explaining why in a later article at The Age, their readers blamed the cyclist for the collision. 

Yesterday in Brisbane we had some coverage of the new 1m passing law. Madonna King calls it “a hostile and unworkable law”
That’s why there are so many spats even before the laws commence; sharing the road already requires motorists to cross the middle lane, to safely pass a cyclist. 
But despite the law being introduced to try and diffuse arguments, it’s only going to escalate tensions.
In this article it is implied that it is difficult to drive with cyclists on the road and that the rights of motorists are superior. Similarly, The Australian’s Michael Saunders and Robyn Wuth covered the law with an article about how the new 1m law will be unworkable, with a helpful link embedded to a Courier Mail article by Chris Bartlett entitled 14 reasons we hate cyclists, which is so bad I just can't tell whether it is satire (though the reader comments suggest not).

Returning to the question of ethics in journalism. How would these journalists feel if a driver who had killed a cyclist came forward and said

“It’s been in the newspapers everywhere. Cyclists bring it on themselves. The new law is unworkable. It wasn’t a real bike lane so I didn’t give them any room. Maddona King told me it is a war out there!”

I hope they would think twice about publishing fact-free misleading articles primarily aimed at provoking outrage and conflict. It is simply not that difficult to drive with other vehicles on the road - trucks, cars, buses AND bicycles - if we all just have a little courtesy.

fn.[1] For future reference, here are the links to summaries of relevant traffic laws in relation to cycling on public roads- Queensland,New South Wales,Victoria,South Australia,Western Australia,ACT, NT.

Wednesday, April 2, 2014

Four Corners: No logic on China

On Monday night Four Corners aired a segment about the post-GFC Chinese stimulus and its massive impact on levels of investment and debt. It was entitled How China Fooled the World, which is somewhat baffling, because there is no tricky involved in their very real investment binge. As you can tell, I have my reservations about the show’s analysis. 

While I appreciate the effort to highlight just how dependent the world has become on Chinese investment, and indirectly on the policies of the Communist Party of China, the segment never made the point that the west has CHOSEN this path by refusing to independently support their local economies and employment by making tough political choices that involve reallocation of wealth and public investment. 

A far greater irony is that many in the west who fear a Chinese economic collapse usually end up pointing the finger at China’s political system and the lack of private enterprise or competition as the fundamental cause. Yet private enterprise and competition are fundamental features of the system that collapsed in the west during the financial crisis, and China’s non-competitive state-owned industry was apparently the only thing that saved the world from further destabilising impacts of capitalism!

By their very nature, complex systems, such as the socio-economic system, are prone to sudden collapse in activity following a period of extremely high activity. This applies in China just as it did in the west, although the system in China is characteristic more centralised choices and less emergence. It is highly unlikely that China will have investment at over 50% of GDP for decades to come in a perfectly smooth growing economy. 

But that doesn’t mean a collapse needs to be catastrophic or even costly in terms of the things that matter to those people within the system. For example, if the collapse in activity results in more years of schooling and education, fewer work hours per worker and more holidays, greater investment in environmental protection and restoration, and so on, this could just as equally be seen a beneficial period of transition; a collapse that forced radically beneficial social change. We shouldn’t underestimate the power of central control and need for the Communist Party to maintain improving living standards to support their legitimacy. 

That is of course, the optimistic view. There will certainly be many losers from a major economic contraction in China, and Australian consumers are part of that group. 

But back to the Four Corners story. I had a few other problems with the coverage, which like most economic reporting was quite superficial and lacked a rigorous foundation of analysis. Here are just a few.
1. Most funds for the Chinese stimulus came from borrowing. This is bad. 
Of course funds came from borrowing. This is neither good nor bad. The detrimental effects of debt that we now acknowledge are usually related to debt used for speculation rather than real investment, yet the whole segment was devoted to identifying just how much real investment there is in China
2. This rate of investment is unsustainable
Chinese investment share of GDP is around 50%, potentially 54%, up from around 43% of GDP in the period prior to the financial crisis. Many commentators saw the pre-crisis levels as unsustainable as well. Certainly this level is high, but remember that the longer this lasts, the wealthier China will be and the more easily it will be able to handle a large-scale economic transition. There was no consideration of what sort of transition the Communist Party might have in mind to edge down from these levels, just as there was no consideration of how the Party created such high levels of investment.
3. The rest of the world was unable to conduct stimulus on a similar scale 
This is another contradictory claim. For some reason, China, still a poor country in per capita terms and one with apparently gross political disfunction from the entrenched rent-seeking Communist party, was the only one who could save the world from the financial crisis. Similar levels of public investment could be made in Europe or the United States if the political will was there.
4. Shadow banking is a problem because debts are hidden 
What we didn’t really see is a view on what would be different if debts were not hidden? There seems to be no consensus on what it means in any case, and very little understanding of the political willingness of the Chinese Communist party to use their monetary system for their social, economic and political goals. The substance of this and other criticisms of China boiled down to ‘debt is bad’. Ignoring of course the international imbalances and the massive debts much of the west have with China.
5. Housing oversupply is 15%
This was strange. Surely more housing per person is a good thing. Some may be empty at the moment, but at some point there will be incentives for these home owners to occupy or rent these homes. And if you are thinking that they need lots of maintenance and might fall down before they are occupied, then you’ve identified another activity that can help in the transition to lower investment - maintaining current investments. 
Certainly China’s growth won’t be smooth sailing at these unprecedented investment shares of GDP for decades to come. There will be a transition, and it will be a bumpy ride.

But from my view most of the opinions in this documentary were blind repetition of contradictory views - that China was the only one who could save the west from the crisis, but now they will be unable to save themselves; that the Chinese political system was able to radically control production to maintain growth and employment, but now won’t be able to; that the answer to the problem that China does not yet have is to make the choices that the west has made, which didn’t stop them from having severe financial crises with lingering social impacts.

It is all so confusing.

Sunday, March 30, 2014

Uncertainty is not what you think it is

One strange claim in the economic debate that followed the financial crisis was the impact of uncertainty on the path of investment and subsequently the recovery in economic activity. Taking just one example, it was claimed here that “fiscal policy uncertainty has directly harmed the American economy by increasing the unemployment rate by 0.6%, or the equivalent of 900,000 jobs.”

Often the idea of uncertainty is captured in economic debates by labelling its inverse, a high degree of certainty, ‘confidence’, or when being a little more critical, the ‘confidence fairy’.

It was never particularly clear to me exactly what ‘high’ or ‘low’ uncertainty was supposed to mean, since the future is always uncertain and investment is always risky, and current policy decisions are not set for eternity. In this post I will dig down into the economic theory of real options that forms the basis for claims that uncertainty alone can greatly reduce investment activity. By doing so I hope the reader will develop a considered level of scepticism about such claims.

First, we should acknowledge just how widespread the idea that uncertainty hampers investment has become. There is a website devoted to providing national indices of policy uncertainty, which itself rests on two decades of effort in academic circles to endeavour to capture this mirage-like phenomena. Even now, India’s growth slowdown is being blamed on this mythical beast.

As a general observation, it seems there is no economic ill that cannot be blamed on government policy-induced high levels of uncertainty.

The economic origins of the idea start with Black-Scholes, and were more fully developed in the general sense in terms of capital investment by Dixit and Pindyck in what is generally known as real options theory. While I have concerns about how real options is applied (which I will get to in a moment), the fundamental principle embodied in real options theory is crucial to understanding economics.

The basic idea is this. If the future is uncertain, such that your future revenues and costs won’t be exactly what you expect, then you may choose to delay investment in order to get new information about the best investment choice.

Thus, when there is more uncertainty, or what would technically enter the real options model as a larger standard deviation on the expectations of price movements, then the value from delaying investment in order to better asses new information is greater.

Under these conditions firm value maximisation occurs not by profit maximising, but by maximising the rate of change of profit over time, or the rate of return on firm equity. The idea here is that investors choices based on expectation of both price levels and the rate of change in prices.

That’s whole idea right there. If you follow that through without thinking too much more about it, you can end up at the point of advising governments to ‘fix up certainty’ in order to bring forward investment decisions in order to reduce unemployment and increase economic growth.

But that ignores some very important points, which I haven’t seen properly addressed in the application of real options theory.

First, why is a perfectly known probability distribution in any way uncertain? We have done the old trick of calling the distribution of expectations (or for that matter simply the distribution of past price movements) uncertainty instead of its usual label, risk. Unquantifiable Knightian uncertainty remains ignored. Which means that even if the distribution of price expectations narrows, and real option theory says that such a thing will encourage investment, there remains a value to delay at all times if there is even a trace of unquantifiable uncertainty.

For me, this lack of distinction removes the possibility for real options theory as it stands to provide insights into the business cycle, particularly in relation to the type of herding behaviour we see both in financial and real resource investments. My personal view is that ubiquitous unquantifiable uncertainty is fundamental to understanding why investors can appear irrational, and why our innate herding behaviour is often a more useful and actionable decision rule for investment.

Second, even accepting that risk appropriately captures the rationale for delaying investment, changing the average expectation doesn’t change uncertainty. Most commentators who argue that their policy proposals reduce uncertainty are actually more concerned with shifting the average expectation of price movements upwards. But if the whole distribution shifts, but doesn’t narrow, then uncertainty is unchanged and it remains equally rational to delay investment in the face of increasing prices.

Third, it is not at all clear what the implication for real options is when rather than shrinking the spread of the distribution, the complete nature of the distribution changes. What I mean by this is that if risk appears normally distributed at some point in time, but events occur that change expectations of future price outcomes to be exponentially distributed. Moreover, there is no real understanding of the emergent properties of agents interacting with different risk expectations - are these interactions already captured in perceptions of risk, or do they add an additional dimension which take risk perceptions into the territory of pure uncertainty?

Finally, it is well known that even in the absence of uncertainty there can still be a value to waiting to invest for current asset owners. For example, if I own a piece of land with scope for development, in the case where there is uncertainty about future prices it may be optimal to wait to see which direction prices move in order to determine the optimal building type and size to construct to maximise my land value. But even if I know exactly what prices and construction costs will be over the course of the next few years, I may still choose to delay if I expect (perfectly, with no uncertainty) the value of the land in its undeveloped state to increase at a faster rate than when it is developed. Or indeed, to not lose value as quickly if it were the case that prices are falling.

So while claims of policy uncertainty having large real impacts in investment may appear well-grounded in economic theory, the theory still has many problems when applied to real policy, real investment and a real world of fundamental Knightian uncertainty. However I do hold out some hope that the core elements of real options theory, which are substantial improvements on the usual equilibrium theory of mainstream economics, can be more successfully incorporated into our understanding of investment and the business cycle.

Tips, suggestions, comments and requests to rumplestatskin@gmail.com + follow me on Twitter @rumplestatskin

Thursday, March 27, 2014

Intuition in economics can't replace reason

One thing you will notice early on about economics is the overuse of the term intuition. Typically the term is used like this — “Let me give you the intuition behind this model”. Or something.

Let’s take a look at the common definition of intuition for starters. Google tells us that intuition is "the ability to understand something instinctively, without the need for conscious reasoning."

When you think about it—when you reason—you quickly see that intuition is a way to NOT reason. Instead, it is a way to latch onto ideas that support pre-existing beliefs.

When I hear a seminar presenter say “let me give you some intuition,” I now translate it in my mind as “let me align my theory with your beliefs so you will have trouble disagreeing with me regardless of the strength of my reasoning and the evidence I present."

I find the elevation of economic intuition to a skill in itself to be very unscientific.

In physics, for example, I see people discussing intuition as either experience with certain types of mathematics (you internalise the steps of mathematical logic), or as experience in the physical world—of taking one’s lived experiment and applying what are now intuitive results to problems. You know a lever works because you have used levers many times. The results do not contradict your lifetime of personal trial and error and therefore the result is intuitive. But from my experience, this is not what economists mean.

Duncan Watts describes much better how intuition pervades social sciences and stifles scientific advancement, particularly in economics.
Part of the problem is also that social scientists, like everyone else, participate in social life and so feel as if they can understand why people do what they do simply by thinking about it. It is not surprising, therefore, that many social scientific explanations suffer from the same weaknesses—ex post facto assertions of rationality, representative individuals, special people, and correlation substituting for causation—that pervade our commonsense explanations as well.
In many ways, intuition from experience should be irrelevant to individuals analysing complex systems from within them, especially since the properties of the whole are typically unrelated to the properties of individual parts. 

With so much emphasis on intuition over reason, it is no wonder that a fair portion of economic debate has not progressed in 140 years.

Thursday, March 13, 2014

Spartan Morality

I want to show how the morality on display in the movie 300, in which babies are cast into a chasm for minor deformities or other weaknesses and illnesses, is easily compatible with utilitarian logic. In doing so I hope to show that utilitarianism provides completely insufficient scaffolding around moral reasoning to eliminate almost any policy, norm or cultural practice you desire.

I was motivated to write this post after discussions were stoked by my take on the moral foundations of economics, particularly in relation to health policy. Why it is optimal from a utilitarian point of view to allocate medical resources to the young rather than the old? While my personal view is that in our current social and political environment this is probably appropriate, it is by no means a superior position by utilitarian reasoning, and certainly there remains debate about such welfare foundations. 

To get this brief analysis started, here is a Wikipedia excerpt about life in Sparta.
Shortly after birth, a mother would bathe her child in wine to see whether the child was strong. If the child survived it was brought before the Gerousia by the child's father. The Gerousia then decided whether it was to be reared or not.
It is commonly stated that if they considered it "puny and deformed", the baby was thrown into a chasm on Mount Taygetos known euphemistically as the Apothetae. This was, in effect, a primitive form of eugenics.
Sparta is often portrayed as being unique in this matter, however there is considerable evidence that the killing of unwanted children was practiced in other Greek regions, including Athens.
Here’s some basic utilitarian rationale for the ‘Spartan morality’ of disposing of sick children. It could rely on any of the following propositions or assumptions.
  1. People with life-long physical disabilities or other chronic illness have lower utility than those without.
  2. Disposing of sick children brings forwards births of non-sick children because of replacement reproductive effort.
  3. There is relatively low utility loss from mothers and family of disposing of their sick child.
  4. The existence of ill people reduces the utility of their carers.
  5. The reduced ability to contribute to productive activity of the disabled and their carers (and medical professionals) reduces the utility of others in society.
In fact, we need not even invoke propositions three to five in order for Spartan morality to be utilitarian, since the first two clearly show that infanticide of the sick, “puny and deformed”, would be a straight substitute of one lifetime of low utility for one lifetime of high utility, increasing aggregate welfare.

And that’s just about all you need. 

I hope that this challenges your faith in the objectiveness of economic reason. As Joan Robinson would say, utility is a meta-physical construct—its existence rests on circular reasoning, requiring it to be defined in terms of itself. 

Similar utilitarian reasoning could be applied to the subjects of gay marriage, slavery, or other such social practices to support any desired outcome.

We shouldn’t feel helpless in the absence of an objective method of social reasoning. We should feel freed from its shackles to debate our underlying moral values, and why they are appropriate for our societies, given our histories and culture. 

Applying utilitarianism means you can support mutually contradictory ends and means. You can end up at the repugnant conclusion, or justify slavery to a 'utility monster'. Or if you take an average  principle of utilitarianism, you can get to the point of justifying killing disabled children by appeal to Spartan morality. Or, as we deem currently acceptable, arrive at the point where we should allocate scarce medical resources to children above the elderly in accordance to ‘need’. 

There is no absolute reference point in utilitarianism. It is always applied with reference to current norms, customs and practices and can evolve to support different conclusions as society evolves.

Sunday, March 9, 2014

17 million Reasons Rent Control is Efficient

The case of Herbert Sukenik being paid $17 million in 2005 to leave his rent-controlled NYC apartment has been receiving a great deal of attention online recently. 

At the risk of perpetuating the brilliant viral marketing campaign for Michael Gross’ new book, which is, in fact, the source of the story, I want to make a brief comment about it to counter some of the bizarre, emotional, and inconsistent reactions I have seen.

A short version of the story is that billionaire developers Arthur and William Zeckendorf paid $401million for the Mayflower Hotel adjacent to Central Park, planning to turn the site into 202 super-luxury apartments.

The building was occupied by many long-term tenants under New York’s rent-control laws. This meant that tenants could only be evicted upon mutual agreement, which in turn led to the new owners offering attractive lump-sum payments to tenants for them to leave the building. While most tenants accepted offers ranging from $650,000 to $1 million, the final tenant held out for an astonishing $17 million lump-sum payment, in addition to the developers offering him another apartment to live in for the rest of his life for a peppercorn rent of $1 per month.

To me the most astounding part of the story has been the reaction by the press and social media, which has been of outrage over the injustices of rent control - that for some reason poor old Sukendik didn’t deserve the money.

There have also been cries of rent-control hindering development - that somehow rent-control is ‘inefficient’.

This is absolutely wrong. Wrong, wrong wrong.

First, almost everyone has ignored the key fact that a developer buying the building knowing that rent-controlled tenants are occupying it should have expected these expenses and subtracted them from the purchase price. Thus, the tenants win at the expense of the previous building owner. The developer does not lose unless some unexpected legal loophole was exploited (which doesn't appear to be the case) - it is merely that the economic rent was shared between the previous owner and the previous tenant.

It is therefore not any less efficient than in the absence of rent control. No one sees the previous building owner holding out for $401million as inefficient, yet it is exactly the same dynamic at play. 

The second point routinely ignored is that rent control describes a general set of rules about renting. That the NY set of rules allows this to happen doesn't mean that another set of rent-control rules could be implemented that had mechanisms for relocation and prescribed methods for calculating compensation payments to tenants. After all, in the freehold world there are generally accepted methods for compensation for landowners upon compulsory acquisition by a government authority.

Third, if Sukenik owned his apartment in freehold he would have had the same power to hold out and extract this price from the developer. This happens routinely in Australia and elsewhere when strata-titled buildings are redeveloped. The last hold out seller extracts a massive payout. Yet we see nothing at all wrong with that because they have ‘the right’ to do it. Yet under a different set of laws, tenants could also have such rights, which they did in this case. 

What really surprises me is that almost everyone who has written a reaction to the incident seems to fall on the side of the developer. If the developer had kicked out the tenant for $10,000 it wouldn't be news, but it would have been equivalent to 'Developer screws tenant of their rightful $17million compensation’.

Friday, March 7, 2014

Wrong lesson from Adam Smith's pin factory

We commonly use stories to teach new ideas, but all too often end up taking the wrong lessons from them. My favourite example is the Coase theorem. Economics textbooks describe theorem as saying that it doesn’t matter where you place the liability for pollution, because in a world of zero transaction costs the right to pollute will end up in the hands that value is most. This is the exact opposite of the point Coase made. As Deidre McCloskey wrote,
Economists have gotten the “theorem” wrong; in fact, backwards

Coase’s actual point, the core of a Coasean economics, was to note what happens in the many important cases in which transactions costs cannot be neglected. If the situation does have high transactions costs, then it does matter where the liability for pollution is placed.
I was alerted to another example in Joan Robinson’s long forgotten textbook. In it she dismisses the division of labour as a primary factor in the great surge in productivity of the industrial revolution, noting that this is the wrong lesson to take from Adam Smith’s pin factory story.

First let me recount the relevant part of Smith’s writing where he describes the productivity boon enabled by the division of labour.

To take an example, therefore, from a very trifling manufacture; but one in which the division of labour has been very often taken notice of, the trade of the pin-maker; a workman not educated to this business (which the division of labour has rendered a distinct trade), nor acquainted with the use of the machinery employed in it (to the invention of which the same division of labour has probably given occasion), could scarce, perhaps, with his utmost industry, make one pin in a day, and certainly could not make twenty.  
But in the way in which this business is now carried on, not only the whole work is a peculiar trade, but it is divided into a number of branches, of which the greater part are likewise peculiar trades. One man draws out the wire, another straights it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head; to make the head requires two or three distinct operations; to put it on, is a peculiar business, to whiten the pins is another; it is even a trade by itself to put them into the paper; and the important business of making a pin is, in this manner, divided into about eighteen distinct operations, which, in some manufactories, are all performed by distinct hands, though in others the same man will sometimes perform two or three of them.  
I have seen a small manufactory of this kind where ten men only were employed, and where some of them consequently performed two or three distinct operations. But though they were very poor, and therefore but indifferently accommodated with the necessary machinery, they could, when they exerted themselves, make among them about twelve pounds of pins in a day.  
There are in a pound upwards of four thousand pins of a middling size. Those ten persons, therefore, could make among them upwards of forty-eight thousand pins in a day. Each person, therefore, making a tenth part of forty-eight thousand pins, might be considered as making four thousand eight hundred pins in a day.  
But if they had all wrought separately and independently, and without any of them having been educated to this peculiar business, they certainly could not each of them have made twenty, perhaps not one pin in a day; that is, certainly, not the two hundred and fortieth, perhaps not the four thousand eight hundredth part of what they are at present capable of performing, in consequence of a proper division and combination of their different operations.

This insight has attracted so many followers and is so embedded in economic thinking, that it was quite a shock for me to see it dismissed. Robinson merely states that people can equally divide their own labour across different tasks through time and thus Smith is incorrect in attributing the productivity of the pin factory to the division of labour.

The 18 distinct operations Smith recounts could just as easily be conducted by the same labourer on 18 different days to create the same output per person over an 18 day period as in the case where labour is divided between workers.

I’ll be honest. Dismissing one of the key elements of accepted economic theory in a single sentence is bold. But again, Robinson had a lot to get through in a short book.

So what is the real lesson? To me the lesson of productivity is not about division of labour, but of capital accumulation. 

Smith suggested it was the division of labour that had ‘given occasion’ to the invention of machinery. But this gets causality backwards; it is the new tools and production techniques that allowed both the division of labour and the great increase in efficiency. 

Imagine that each on the 18 separate tasks could be achieved more efficiently with 18 different new tools. Drawing the wire used a particular apparatus, straightening another, and cutting yet another, and so on.

For the individual labourer to be equally efficient as the factories of the time, each labourer would need 18 different tools that each sat idle for 17/18ths of the time. Thus it is the search for returns on the investment in new tools and equipment that allowed for both the observed division of labour and the radical increase in productivity.

You might interject that if 18 labourers joined together they could each buy a single different tool and simply share their own tools on the off days, that they would be equally efficient as a group. But in fact, they would simply be a factory, with the only difference to Smith’s example that workers owned all the capital.

Thus it is capital investment that leads to larger firms, internal coordination via division of labour, and increases in productivity. That is the real lesson of Smith’s pin factory.

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Wednesday, March 5, 2014

Are Australian universities just not good enough?

The reserved and mild-mannered American Canadian law Professor James Allan, who works at an under-performing Australian university, has recently written a long tirade against the bureaucratisation of higher education in Australia.

While it contains a few home truths which need public acknowledgement - like the centralisation of decision-making and the power of university executives to make inappropriate rules, and also set their own pay - it also misses important context, and offers personal biases and anecdotes instead evidence and constructive suggestions for improvements.

I want to respond here to that article. First let me attempt to summarise Allan’s points about what is wrong with Australian universities.
  • University administrators seem to value research grants as outputs rather than inputs
  • Bureaucratic decisions at universities are quite centralised
  • Students work and study, meaning they want lectures recorded and don’t want to do extra reading
  • Students don’t travel to other cities to study
  • University ranking tables are a sham, and Australian universities are not performing as well as these tables make out
However Allan doesn’t actually explain what a suitable output performance measure should be for a university. The most we get is this
In Canadian law schools (and US ones, and UK ones) you are expected to be working on your degree full-time. You are expected to do lots of reading. You are expected to think. You are expected to pursue things on your own. You are not expected to schedule classes all on two days of the week so you can work the other three. Or tell your professor that you can’t do something because it conflicts with work. Or be so tired that you do as little reading as you can get away with. 
Yet that is now standard practice in Australia. I can still, just, get away with refusing to record any of my lectures and so insist that students come (or not, since as adults it is up to them, but if not they are on their own). But the university administration detests that position and is making it harder and harder to take. As I came to Australia already with a chair I can ignore the students who get infuriated about this practice of mine in their course evaluations. But no junior academic wanting to be promoted can do so. It is no exaggeration to say that the incentives are slanted heavily in favour of caving in, of spoon-feeding students, of recording all lectures for viewing from home (with much reduced class attendance as a result)—anything to facilitate the job commitment of the supposedly full-time undergraduate. 
The flip-side of this situation is that the demands on students (even at our Group of Eight universities) are noticeably below what they are in good Canadian and UK and US universities. As for a serious Ivy League or Oxbridge undergraduate education, well, we are not in the same league as those institutions because we demand so little of our students.
Australian universities are not good enough, apparently, because students need to read more, and think, and pursue things on their own. 

He also makes a personal judgement that what you learn at university must be superior to the skills you learn at work, or that working and earning a living is not ‘pursuing things on your own’. That doesn’t really sound like a typical Australian attitude to me. My personal experience in economics is that a degree gets you in the door, then it is all down to experience. Working while studying, especially in your chosen field, is quite advantageous.

But he really doesn’t elaborate any further. Is university performance measured by research output? Is it measured by revenue? If so, he doesn’t have much of a case against the administrative bias towards academics who generate research grants.

Or is it the number of peer reviewed journal articles? If so, is it quantity or quality? Who will judge quality? Is it student numbers per academic? Or is it student quality? Who will assess that? Or do we judge performance on the gut feel of visiting academics with their own personal biases?

I don’t want to sound harsh, but for a senior academic writing about the underperformance of Australian universities, a little note about what underperformance really means, framed within the role of universities within society, would be nice. He signals that it should be research output, noting that people
…could see the difference between judging people based on what they wrote and produced versus one that judged them based largely on winning as many grants as possible.
but fails to return to how this measure fits into his picture of a competitive university system.

Whinging about the rules doesn’t really help. It is like an Apple employee coming into the company and saying they have a lot of centralised decision-making and that engineers were slugged with bureaucratic tasks, such as getting central approvals to spend money on new equipment. Whereas at their last job they could do as they please.

Sure, from the employee perspective this seems like a horrible system to work in. But any outsider assessing the performance of the company as a whole would feel it is worth it. That’s because we have an agreed measure of what company performance is. For universities we don’t, and that is usually the recipe for a growing bureaucracy.

Allan lays some of the blame at a lack of competition, perhaps due to some cultural norm of families not sending their sons and daughters interstate to the ‘best’ university in their field. Apparently this lack of competition means that universities can slack off and amuse themselves with ever more burdensome central rule-making and ever-greater executive pay.

Allan writes
In this sense, Australia and its universities are at a disadvantage. Imagine what would happen if parents were as likely to send their kids to Melbourne University as to Sydney University or the University of Queensland or Australian National University, and the deciding factors came down to what the universities had to offer, say in terms of class sizes or contact with professors or the “undergraduate experience”.
There are two problems with this point. First, is that the universities are full of international students. Outside of law especially. Surely these students are discerning about their university choice and hence provide a great deal of competitive pressure. According to the ABS 22% of students at university in Australia are international students, while at some universities that figure is over 40%. Monash and Melbourne universities seem to be competing quite fiercely, with Melbourne experimenting with student offerings at great risk.

Second, the central rules that Allan hates so much are just as much the result of competitive forces, than on the lack of such forces; of trying to attract students by ensuring the get the easiest path through their study. We’ve seen the gimmicks about giving new student iPads. Allan mentions the imposition of consistent marking systems, PhD criteria for lecturing positions, timing of student evaluations; all of these are about managing university-wide quality in order to assure new students of what they will be getting. Haven’t you seen advertisements?

This is what happens with competition for students (customers), and students mean revenue. If you want universities run competitively like private businesses, you must expect that they will measure their success in similar ways.

So where does research output fit into his competitive picture? It certainly doesn't raise revenues, and most undergraduates, the customers of universities, wouldn’t have a clue about their school’s research anyway.

Regarding the lack of travel to university, if I can sum up the Australian view very roughly, it is that university is more like advanced vocational training. Degrees that used to be provided by technical colleges are now integrated into universities. Students don’t travel because their local university usually maintains standards high enough to get them into their chosen field. Why travel if you can be assured of equally good local training? After all, once you are in the door, your experience counts much more than your degree in most fields.
He writes
When I try to point out the advantages of sending one’s kids away to university here in Australia I am generally met with blank stares of incredulity.
But of course, he didn’t mention any of those advantages in his article. Could it be that there really aren’t many? Or is he saying that Australians are just too stupid to see them?

Which leads to the more entrenched problem. The competition that drives student selection and travel for study in the US and the UK is the result of monopoly power of universities so that students must compete rather than universities. And this competition between students is also driven from a higher level. Reputation and insider connections within top universities to political and corporate elites means the payoff to getting into those universities is much higher. A degree at Princeton or Harvard is a meal ticket with a value far higher than cost of tuition itself. This not only means that students want to travel to get in to these universities, but that they (and their parents) are willing to pay through the nose for it as well. Here’s just one example of the political connections a degree at Oxford brings.

In Australia we don’t have that ‘boys club’ mentality to such an extent, especially not in most degrees. Having a teaching degree from QUT doesn’t open doors at Goldman Sachs, unlike a finance degree from MIT.

While I am sure Allan feels much better getting this all off his chest, I can’t help but think he has missed the important points to focus on his personal gripes. He overlooks exactly why Australian universities aren’t good enough, and then appeals to competition as some magical remedy to all organisational problems like some evangelical Chicago economist. Lastly, his suggestions for improving the situations include a bunch of central administrative tools!

One of his suggestions, the publication of remuneration of the highest paid employees, is generally already complied with in the annual financial accounts, where executive pay is itemised (here’s UQ, here’s QUT). But of course, executive pay exploding is not limited to universities. It is a general problem of power that competition alone does not solve.

Another suggestion is to publish the ratio of academic to non-academic staff, which is essentially a meaningless ratio because it absolutely depends on the tasks each staff is responsible for. If administrative staff are freeing up time for academics, then that is a good thing. I could imagine these suggestions being implemented and a future version of Professor Allan writing another article deriding them!

He suggests scrapping the ARC grant system, but makes no suggestion of alternative funding allocation mechanisms, as if by magic money will find worthy researchers. I agree the system is poor, but we need to be discussing better alternatives. Why didn’t Allan tell us a bit about the funding systems in those hot-shot universities he so reveres?

When push comes to shove Allan goes for the practical over the ideological, which is a good thing. But it leaves you wondering what the point of all those words really were. Will they merely be interpreted as at the ravings of a sheltered and entitled academic? We have quite enough of that already.

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Monday, March 3, 2014

Wages share and investment

Kieran Latty produced this chart on wages share and investment share in OECD countries. If we take this at face value it implies the existence of a wage share that maximises investment - which in the long run is what makes us wealthier. 

To me this seemed a little too neat. Economists love the inverted U-shape relationship, or concave relationships in general, because it implies the existence of some kind of equilibrium - just set labour share correctly and you will maximise investment. Or something like that.

It turns out to produce the ‘inverted U-shape’ curve Latty used a time fixed effect and a non-linear estimator on data from AMECO. While this may be somewhat normal in the literature on this topic - for such reasons as removing the effects of international business cycles and to control for any secular trend in international growth rates - ultimately these model choices fundamentally determine the results. Like most observational data from complex systems, we are applying models as mere plausible stories, with no objective criteria for assessing their validity.

Often the details (including the outliers) in these types of international comparisons reveal much more of the story than the general trends. To satisfy my curiosity I constructed a similar chart from OECD and World Bank data.

Below is the scatterplot of my sample (you will notice the chart is animated to show country data connected through time) . Eyeballing the data there seems to be no general time-independent inverted U-shape. This is confirmed by regressions on the sample without controls, and indeed, with a quadratic specification we find a positive coefficient on the squared term.

Notice that each country seems to occupy a distinct section of the chart. Such divergence between countries should be of great interest to macroeconomists. In my smaller sample below Japan has consistently high labour share and investment share, while New Zealand is consistently low on both measures. Then we have the US and UK with consistently low investment accompanying a rather high labour share. 

My expectation is that a high labour share of income would result in greater investment share, if only because owners of capital would have greater incentives to invest and innovate in order to gain a return, rather than simply hold existing assets. Who knows whether this is the case at all. But it’s my current speculation.

What is, for me, more fascinating in this data is the trend over time. We know that the labour share of national income has been falling in most countries since the 1970s. We can see that trend, along with short-term cycles, in the animated chart below that tracks my six country sample since 1970. 

In broad terms the maturing nature of these economies may mean that such a downward trend in labour share is naturally expected. Or it could be that policy choices for the past four decades have directed national income towards owners of capital, which resulted in lower investment in some cases but not others. The answer still seems completely unclear. If you want more analysis, you can read the Productivity Commissions recent work on the topic. 

Like many macroeconomic curiosities, the relationship between wage share and investment is a puzzle unlikely to find a satisfactory conclusion any time soon.