Improving 'Neoclassical man' with a gaze heuristic

The gaze heuristic describes the behaviour of people trying to catch ball and is useful when attempting to program robots that mimic human behaviour. Gigerenzer explains that:

The gaze heuristic is the simplest one and works if the ball is already high up in the air: Fix your gaze on the ball, start running, and adjust your running speed so that the angle of gaze remains constant. A player who relies on the gaze heuristic can ignore all causal variables necessary to compute the trajectory of the ball––the initial distance, velocity, angle, air resistance, speed and direction of wind, and spin, among others. By paying attention to only one variable, the player will end up where the ball comes down without computing the exact spot.

We know that dogs follow similar dynamic heuristics when catching frisbees. In more technical terms, dogs follow a 'linear optical trajectory' gaze heuristic. While I thoroughly recommend reading the full paper on frisbee-catching dogs, we can examine the most basic gaze heuristic described by Gigerenzer to show the logic of behaving according to these heuristics in a dynamic world of uncertainty. In essence, I want to show that due to uncertainty human behaviour is dynamic and differs radically from the homo economicus behavioural assumptions almost universally applied in economic analysis. Further, such behaviour can be identified as the mechanism which connects price and investment dynamics in economic systems.

Below I summarise the basic difference in behaviour between neoclassical man, who makes a choice at a particular point in time based on expected probabilities, and dynamic uncertainty women, whose behaviour responds to the dynamics in her environment.

Neoclassical man observes the ball, develops a probabilistic expectation of where it will land, and instantaneously positions himself at the most probable position. Dynamic uncertainty women observes the ball and begins running from her current position towards the ball, linking her run to the ball’s trajectory by fixing her angle of gaze.

We can think about the ball as the environment our catchers respond to. Neoclassical man sees the ball’s position and generates expectations, ignoring its dynamics of velocity and acceleration, or merely developing some expectation about them. In economic models, such behaviour is reflected in static optimising on price levels based on expectations. But to dynamic uncertainty woman, the position of the ball has no effect on her behaviour. Her own velocity is tied to the ball’s velocity through the fixed gaze angle, no matter what her starting positions or progress in her run. Only as the ball accelerates does her action change, and she will accelerate her run as the ball accelerates towards the ground (including changing directions when the ball drifts). In economic terms, the ball is the business environment and each individual catcher is making their running investment decisions in response to that dynamic environment. Using a gaze heuristic this implies matching running speed (investment rate) with the balls speed (rate of change in real demand).

So what happens when the business environment changes? In our analogy, this implies an acceleration of the ball (a change in velocity). We know from experiments on dogs chasing frisbees thrown in order to swing severely that the reaction of a dynamically uncertain dog will be to change paths at the current relative position by adopting a new gaze angle linkage with the ball.

Below we see dogs reacting to a swing in a frisbee throw by updating their gaze heuristic and following a new path in relation to the frisbee’s new velocity. 

Under dynamic uncertainty a change occurs via an acceleration in environmental conditions. In economic systems these environmental conditions could be asset prices, product demand, or some another indicator guiding investment decisions. Remembering of course that investment decisions by businesses in one part of the economy generate the economic conditions that other firms respond to, meaning that economic cycles are emergent phenomena of interacting uncertain agents, be they firms, governments, consumers, banks and other actors in the economy.

Applying the gaze heuristic to investment decisions, where asset prices are the environment to which investment responds, results in an incentive to bring forward investment when the acceleration of asset prices is positive, and an incentive to delay investment when the acceleration of prices is negative.

The 'micro-foundations' for this behaviour requires some explanation. In essence asset owners, be it land, or some other scarce monopoly right, face the decision of when to exercise their option to invest in irreversible capital equipment that takes advantage of those rights – construct a building to package with property rights, build a transmission tower to package with spectrum rights, and so forth. Since the option has a value growth over time without needing to be exercised, the optimal time to exercise will be when its value is increasing at an increasing rate (accelerating).

The cyclical link between asset prices and investment arises because when investment is brought forward it slows the acceleration of asset prices, providing a feedback in the system.

To be clear I show below a stylised cycle that results if people behaved like Dynamic Uncertainty Woman in an economic environment; monitoring the dynamics of asset prices and adjusting the rate at which they invest in new capital in response. We end up with an out-of-sync cycle of asset prices and investment activity.

There is also a very tight link between this behaviour under uncertainty and the numerous empirical relationships observed by Steve Keen between the acceleration of debt, the growth rate of asset prices, and the employment level.

Keen observes that the acceleration of the debt level approximates the rate of change in the price level of relevant asset classes, while my additional input is that investment growth responds to acceleration of prices.

This analysis implies the following relationships: Debt acceleration creates price growth, which creates investment (and employment), but that investment also requires debt funding, leading to more growth, and a cyclical feedback. If price acceleration is a key factor determining investment growth, then perhaps even the third derivative off debt, the jerk, is leading to tangible behavioural results and implying the potential for high degrees of instability in the system. 

To me, it makes perfect sense to first look at human behaviour in dynamic settings before conjecturing about what is or is not optimal by introspection. The widely observed gaze heuristic in humans and other animals provides a clear case where dynamic behavioural rules lead to effective actions in other settings. But the same logic applies in social and economic environments as well. Too often the introspection approach to economic theory overlooks our easily observed biological instincts which evolved in a dynamic and uncertain world.

Economics of how Triple J makes music better

Brendan Markey-Towler

19 January 2015

As I was driving to work today I was treated to the dulcet tones of Peter Garrett’s radio voice as a guest on Triple J – the ABC’s “youth-oriented” radio station. Aside from musing about how much better I like the former contortionist and Midnight Oil front man now that he is no longer a political contortionist (also known as a federal minister – apologies to Mr Garrett, being an Australian I have an instinctive, possibly pathological, definitely worrying prejudice against politicians), I also got thinking about what economics has to say about the quirky little offshoot of Australia’s much loved “Auntie”.

For those who don’t know, the station is a little as if the pirate radio stations in the North Sea during the 1960s had been run by the BBC, funded and sanctioned by the British government. It is deliberately designed with the teenage-to-late-30s demographic in mind and seeks out artists who wouldn’t be in the mainstream of the music industry. The music is almost always that which would be classed as “alternative” – at least until it’s picked up by a major station. The artists are often Australians, Kiwis, and Brits, and less often American than one would expect. It is not uncommon for the guest artists of the station to be doing interviews on their day off work – jobs they hold to survive whilst playing the underground music scene in Australia’s capital and major cities.

The station does not host advertisements, and would be unlikely to attract them anyway if it did, given the size and demographic makeup of its listener base compared to other major radio stations. It does host ABC-quality news and current affairs programs (such as Hack) of a quality rarely available to the bulk of Australians, let alone the listeners of Triple J (who, often being the disaffected youth of our age, are probably the most likely to need its information). With this profile, in the modern commercialised age, the station would not survive on a commercial basis. So why have it? Why should the government continue to take the taxes of everyone to provide a service for the few?

It can be difficult to rationalise the ongoing support of the Australian government for Triple J using standard economic analysis, in which markets are made up of perfectly informed individuals with computational skills that would make your typical Australian blush (and then reach for their tall poppy clipper). As my teacher’s teacher Frank Hahn used to say “we’ll pretend that people know exactly what they want and exactly how to get it”. If everyone knows exactly what they want and exactly how to get it, the justification for Triple J’s basis must rest on market failures – deviations from the perfect competition model.

One failure Triple J might remedy is a lack of information – people don’t know exactly what they want, or exactly how to get it, so Triple J needs to make this information available. This argument is a little weak, given that Triple J has a niche position in the market, such that we would be able to make the case that the vast bulk of the market finds this information not particularly valuable. At least, not to the extent it is economically worthwhile to make the whole population pay for the improvement of information with their taxes.

A second argument is a much stronger, if rather vague one, about “externalities”. Triple J could be argued to have a “positive externality” – a benefit which does not accrue directly to the listeners of Triple J, but rather “spills over” to the rest of the economy – for instance, by supporting a “creative” environment for entrepreneurs in the music and other industries. This argument for Triple J’s existence is a stronger one than remedying information problems, but it is notoriously difficult to identify and measure these benefits using standard economic analysis.

I would offer another rationalisation for the ongoing support of Triple J from evolutionary economics, one which supports the standard economic analysis of Triple J as a source of positive externalities. The existence of Triple J in the Australian music industry generates variety without which the market would not have as high a quality provided to consumers as it does.

Evolutionary economics sees the market economy as an evolutionary system similar, but not identical, to an evolutionary biological system [1]. A market system, of which the music industry is one, consists of ordinary (neither rational nor irrational) human beings within production organisations (bands) trying to compete for the custom of consumers (listeners, via radio stations and album sales).

All evolutionary systems are characterised by the same three step process. In the first stage, a variety of “selection units” (genetic characteristics in biological systems, different products in a market system) is generated, before that variety is subjected to “selection” (by natural selection in biological systems, by consumer choice in market systems), and from this process emerges a set of “retained” selection units (genes which survive in biological systems, products which continue to be sold in market systems). The improvement of “fitness” in the market system comes from the selection by the system amongst the variety of different goods and services (songs in the music industry), some of which are deemed of better quality than others by consumers.

Without variety, the market cannot act to improve quality, and the more variety generated within the market, the better (with some caveats) the overall average quality within the market will be. This is actually a mathematical fact [2], which holds true of all evolutionary systems, including economic systems [3]. In general, the greater the variety within an evolutionary system, the greater will be the rate of increase in its average “fitness”, or quality. The greater the variety generated within a market system therefore, the greater will be the quality of the alternatives on offer to the customers. Many products for consumption, including artistic products, will fail to be selected, and their producers will not succeed, but without the competitive pressure generated by their existence in the first place, we would not have a basis for selection of the highest quality anyway. In evolutionary systems, it is a mathematical fact that strength comes through diversity.

What differentiates the economic system that is the music industry from a biological one is also that the generation of variety in an economic system is purposeful [4], where in biology it is taken to be random [5] or at least well beyond human control. We can ourselves choose to generate variety which helps to drive the evolutionary process. This is why there is a solid economic case for the government’s ongoing support of Triple J.

Triple J acts as a generator of variety for the music market in a manner in which commercial stations simply cannot. Commercial stations, for perfectly legitimate reasons, must be driven by the profit motive. They need advertisers to pay for airtime, which requires that they have a significant listener base, which requires that they play music they understand to be popular to a broad audience. This naturally limits what they can air, and indeed, means they will in all likelihood offers very similar listening to each other (this is very similar to the median voter theorem in economics). They literally cannot afford to air a wide variety of “alternative” music. Triple J, being funded by the government has no such concerns, and is in fact mandated, in effect if not in law, to seek out alternative, and particularly Australian content, and has a forty year history of doing so.

If it were not for Triple J expanding the variety of material in the market, we would find that the overall average quality in the market for music would be lowered, as dictated by evolutionary mathematics. Being unencumbered by commercial concerns, Triple J serves an economic purpose by bringing to the market music which people would otherwise not have known they enjoyed, and which would have been too alternative, and, Catch-22 like, unestablished for a commercial station to take a risk on bringing to the market first.

This means not only that it by itself will provide greater variety, and hence enhance the quality of the overall market, it means that the commercial stations also have a source for new artistic material which they would not otherwise have. It will often be the case that one will hear an artist on Triple J, and a few months later the same artist will be given some airtime on commercial stations, at which point they can become quite successful commercially as well as artistically. I seem to remember that the New Zealand born artist Lorde was noticed by Triple J after filling in at a festival in Australia the station had been covering. Her music, spare and trancelike with more or less only percussion, a bass and vocals is quite unlike anything else in the music industry, certainly the mainstream thereof, and one could make the case it would not have become so well-known had not Triple J been able to establish her music in the market relatively unencumbered by concerns about appealing to a broad segment of the population.

Of course, much of the material aired on Triple J will not become commercially viable, but this is simply a manifestation of the selection processes of the market. What does survive in the market place due to Triple J will enhance the overall quality of the offerings of the music industry.

This is one source of the externalities of the radio station, upon which standard economics builds its strongest case for government intervention in the music industry. Triple J and its listeners do not acquire all the benefit of their activities, some of it spills over into the commercial sphere when the commercial stations pick up an artist who is actually appealing to a broad cross-section of society, but would have been a risky proposition to give airtime to. But also, by providing a variety of music free to air which is alternative, cutting edge, pushing the boundaries and all of these too much so for airing on a commercial station, Triple J provides a platform whereby artists (not always individuals with the greatest access to material resources) can access and influence each other. The station in this manner provides a platform where the variety of miners at the coalface of music can be made available to the public, and learn new ways of advancing along and exploring their own vein.

Triple J is a (comparatively) very cheap [6], somewhat unusual and quite successful example what evolutionary economists call a “national innovation system”. National innovation systems typically involve large scale schemes for providing financial backing to many small projects which would be unable to obtain finance from responsible banks in spite of their promise and potential importance. Often these projects will go on to constitute significant advances in the quality and function of items produced by an economic system, as the mathematics of evolutionary markets dictates. Mariana Mazzucato (2011) has provided a wealth of examples where national innovation systems provided financial means for innovators to obtain the critical mass necessary for many innovations which simply would not have got funding otherwise - such as almost all technology within the iPhone. In the Australian music industry, all Triple J needs to do the same is to give airtime to some songs, at the cost of the wages of the people who run the station, the cost of broadcasting equipment, and the other incidental costs of operating a radio station. It is an excellent example of just how little the government need to intervene in the market sometimes to create a significantly improved market outcome, while leaving the positive aspects of the market process more or less unaltered.

So, on this the 40th anniversary of the foundation of Auntie’s eclectic offshoot, we can reflect once again that Australia is the “lucky country”. I am no expert on Australian political history, but the Whitlam Labor government likely instituted Triple J (Double J as it was then known) in 1974 for reasons other than promoting the generation of variety for evolutionary market processes to create a higher quality market. Much more likely, it was part of the Whitlam government’s vision for a more progressive Australia, to differentiate it in the eyes of the youth from the staid, conservative Menzies era government by reaching out to them with their music. But in trying to give the youth the music their parents disapproved of, the government also (probably inadvertently) instituted one of the most important institutions for the health and strength of the music industry in Australia.

Three cheers for Triple J.

[1]. Pioneers in this field were Nelson, R., Winter, S., 1982, An Evolutionary Theory of Economic Change. Harvard University Press, Cambridge, Massachussetts., while a more modern and generally accepted statement of the framework can be found in Dopfer, K., Foster, J., Potts, J., 2004. Micro-meso-macro. Journal of Evolutionary Economics, 14(3), 263-279.

[2]. Price, G.R., 1970. Selection and Covariance. Nature, 227, 520-521, Price, G.R., 1972a. Extension of covariance selection mathematics. Annals of Human Genetics, 35, 485-490, Price, G.R., 1972b. Fisher's "fundamental theorem" made clear. Annals of Human Genetics, 36, 129-140.

[3]. For instance, Metcalfe, J.S., 1998, Evolutionary Economics and Creative Destruction. Routledge, London., Metcalfe, J.S., 2008. Accounting for economic evolution: Fitness and the population method. Journal of Bioeconomics, 2008(10), 23-49. and Markey-Towler, B., 2014, Law of the Jungle: Firm Survival and Price Dynamics in Evolutionary Markets.

[4].  On this, one would do worse than consult Foster, J., 1997. The analytical foundations of evolutionary economics: From biological analogy to economic self-organization. Structural Change and Economic Dynamics, 8, 427-451. and Witt, U., 1999. Bioeconomics as economics from a Darwinian perspective. Journal of Bioeconomics, 1, 19-34.

[5].  For an emphatic, almost dogmatic defence of this idea, also known as the “central dogma of biology”, see Dawkins, R., 1976, The Selfish Gene. Oxford University Press, Oxford. 

[6].  National innovation systems in the Australian context have been discussed at length by Dodgson, M., Hughes, A., Foster, J., Metcalfe, J., 2011. Systems thinking, market failure, and the development of innovation policy: The case of Australia. Research Policy, 40, 1145-1156.

References

Dawkins, R., 1976, The Selfish Gene. Oxford University Press, Oxford.

Dodgson, M., Hughes, A., Foster, J., Metcalfe, J., 2011. Systems thinking, market failure, and the development of innovation policy: The case of Australia. Research Policy, 40, 1145-1156.

Dopfer, K., Foster, J., Potts, J., 2004. Micro-meso-macro. Journal of Evolutionary Economics, 14(3), 263-279.

Foster, J., 1997. The analytical foundations of evolutionary economics: From biological analogy to economic self-organization. Structural Change and Economic Dynamics, 8, 427-451.

Markey-Towler, B., 2014, Law of the Jungle: Firm Survival and Price Dynamics in Evolutionary Markets.

Mazzucato, M., 2011, The Entrepreneurial State. Demos, London.

Metcalfe, J.S., 1998, Evolutionary Economics and Creative Destruction. Routledge, London.

Metcalfe, J.S., 2008. Accounting for economic evolution: Fitness and the population method. Journal of Bioeconomics, 2008(10), 23-49.

Nelson, R., Winter, S., 1982, An Evolutionary Theory of Economic Change. Harvard University Press, Cambridge, Massachussetts.

Price, G.R., 1970. Selection and Covariance. Nature, 227, 520-521.

Price, G.R., 1972a. Extension of covariance selection mathematics. Annals of Human Genetics, 35, 485-490.

Price, G.R., 1972b. Fisher's "fundamental theorem" made clear. Annals of Human Genetics, 36, 129-140.

Witt, U., 1999. Bioeconomics as economics from a Darwinian perspective. Journal of Bioeconomics, 1, 19-34.

Why is terrorism so frightening?

Brendan Markey-Towler

Yes, it is the bullets, the bombs, the blood. Yes, it is that it could happen any time and to anyone. But these things are somewhat held in common with gangland violence. Yes, it is that the terrorist is indiscriminate, human life is incidental to their cause, and is sacrificed to the end of terrorising a population for a political purpose. But nuclear weapons have similar properties. It is my contention that terrorists are so frightening, in part, because they are madmen.

Madmen are frightening not because they are irrational, quite the opposite. It is the hallmark of madness that the most insane acts are defended and supported by the most rock-solid logic. This logic is based on a most distorted – to “us” the terrorised – interpretation of the facts, but it follows the rules of logic nonetheless. Their argument therefore cannot be fully defeated by reason.

I suggest that the terrorist is so frightening because of this; that at least in part they frighten us because we can’t reason with them. The terrorist shows us that reason has limits, that those limits mean reason can become, to slightly misuse David Hume’s immortal phrase “the slave of the passions”, and that reason can justify the most insane acts. We feel frustrated by the terrorist in much the same way we feel frustrated because we struggle to find an answer to Isaiah Berlin’s question “is the idiot who thinks he is an egg to be condemned solely because he is in the minority?”

The individual who brought terror to our nation recently may have been mad, but he would not have been irrational (in the old-fashioned sense of being “without reason”), and that is why he is so frightening. If the negotiators asked – as I suppose they must have – “why are you doing this?” he would have likely given them many reasons for his actions which could easily have been honed into a logically solid argument. It is possible that no amount of counter-argument, presenting another logically solid argument arrived at by a different interpretation of the facts, could have persuaded him to abandon the reasons for his actions.

We all know what they might have been. While he may not have been claimed as one of their own by the group to whom he pledged his allegiance, the individual deliberately made his act a political one, justified by what he saw as the oppression of Muslims in this country. He would have pointed to the innocents who have been killed by bombs dropped and bullets fired by Australian soldiers in the Middle East, to the recent anti-terrorism laws passed within Australia, the minority status of the Muslim community in Australia as evidence of oppression of Muslims by our government. Since he could not achieve his aims of freeing those he claimed as his brethren by the establishment of an Islamic caliphate via the ballot box and since Australia and its allies have overwhelming military might in a conventional battlefield, to further his aims he had to resort to engaging in what we call terrorism.

Logic on its own cannot defeat his argument, because what differentiates this madness from sanity is not reason, but a different perception of the facts of the world, about which reasoning is all but impossible. We cannot reason with individuals such as these because no logical argument will persuade them to see the world in the way in which we see it.

We could not force him to see by logical argument to see that, yes, Australian bullets and bombs may kill innocent civilians, but the Australian military tries to avoid this where possible, and ultimately it must act because as a nation with the ability to act Australia has the responsibility to act to stop more innocent civilians and children from being killed by extremists’ bullets and bombs, let alone prevent them from growing up in a society where their freedom is severely constrained in the name of God. We could not force him to see that anti-terrorism laws are necessary to prevent harm being brought to civilians within our country, and that there is in fact a great deal of debate even within parliament about the extent to which we as a society can trade off security against our ideals with respect to these laws.

We could not force him to see that our elites understand the glories of the Muslim civilisation without which St Thomas Aquinas would likely never have discovered Plato and Aristotle (burned and buried by early Christians), or European mathematicians the Hindu-Arabic number system which we use to this day, or the stunning design from which our architects draw. We could not force him to see the kindness and inherent decency - which one only really appreciates in comparison with the rest of the world - with which the bulk of the Australian population treat each other irrespective of colour or creed. We could not force him to see that while Muslims suffer as a minority in Australia at the hands of some of our zealots, our nation as a whole, painfully aware of the more shameful aspects of its history of racism and bigotry, is doing credit to the better parts of its history by trying to combat these forces in modern society.

What we see in the terrorist is the most severe and devastating manifestation of an increasingly common phenomenon across our world – the submission of reason to passion, and the resulting construction of logically solid cases for insane views and acts which categorically contradict our humanity. The terrorist perceives the world in a manner consistent with their passionate adherence to an ideology, and uses reason to construct a disturbingly logical interpretation of the world which justifies murder in the name of something supposedly higher than human life.

The terrorist is a more extreme version of the Marxist who takes a refutation of their ideology to in fact be a support thereof - “the soviet economy could not provide bread for its people because western imperialist powers sabotaged the plans of the central planners”. The terrorist is a more extreme version of the creationist or the radical evangelical who argues “dinosaur fossils were put there by god to test our faith”. The terrorist is a far, far, more extreme version of the right wing extremist who sees an Aboriginal community in poverty and feels only that “this community deserves their poverty because they are unwilling to work”. The terrorist is a far, far, far, more extreme version of the most extremist climate change denier – “of course we see evidence of global warming, because climate scientists are paid to find that evidence”. None of these arguments can be refuted on logical grounds alone, because they follow logically from a particular interpretation of the facts of the world, which isn’t completely without foundation, and about which it is extremely difficult to argue. For the terrorist, as with any political fanatic, logic becomes the servant of an ideology, reason is placed categorically above humanity, and only a different perception of the world reveals the madness of the logical system constructed by the extremist.

The problem presented by logic needing to be based on subjectively perceived facts is well known to philosophers, as it presents significant problems for science. The great philosopher of science Imre Lakatos characterised the advance of science by the interaction of “research programs”, systems of logic such as general relativity, quantum mechanics and Newtonian physics, connecting together bits of information in a logical fashion but which, ultimately, are the outcome of assumptions about the world which cannot be tested, and which cannot be reasoned about. A good example of such assumptions is the Leibnitzean principle of sufficient reason – that everything must have a cause. Another is raw materialism - the assumption that all which exists must be something we can see or touch. Science progresses only because (and if) scientists recognise the limits of reason and distance themselves from their identification with a particular research program, in a sense not taking it too seriously, and allowing their ideas to grow or fade according with how well they explain the world. Those who do take the reasoning contained within a particular research program too seriously, and who explain refutations solely on the basis of a particular interpretation of the facts are no longer scientists.

The scientists get around the problem that one can find reason for any view if one interprets the facts in a certain way by standing somewhat aloof to and recognising the bounds of reason, and recognising that it can only be based on assumptions which cannot ultimately be reasoned about. What is true of science, is true of reason in general. The terrorist, as the fanatics and the madmen do, places their perception of the world and the reasoning based upon it above everything else.

The difference between the terrorist who kills to further the cause of setting up a utopian society, and the “Western” government which kills in the name of their citizens lies in the perception they have of the facts of the world and their willingness to hear alternative points of view. We can reason with the “Western” government, we cannot reason with the terrorist, we can only isolate them from the rest of humanity. This, I think, is a special property of the terrorist which makes them so frightening, they kill on the basis of reasoned argument like our governments do, but while we can see their argument is mad and justifies insane acts which are devoid of humanity, we cannot ultimately articulate why other than “we see the world differently to them”.

I think, however, that this realisation offers us a means of fighting the terrorist and thwarting their aims. In cases such as these where no logical argument will persuade an individual to see the world in the way in which we do, we must withdraw from logical arguments and instead affirm the place of humanity above reason fed by ideology in our speech and our deeds.

The difference between the terrorist, or indeed any fanatic, or any madman who believes god or some Fuhrer calls them to some greater purpose, and the sane individual is that the latter admits the limits to reason and places humanity above a reasoned, logical, argument which goes against it. The difference between our nation and the terrorist is that our government does terrible things in our name, but our nation - or at least parts of it - attempts to conduct a reasoned debate about whether these terrible things prevent a total descent into savagery and are the path of lesser evil.

The most disturbing thing about any ideology is that it asserts the primacy of reasoning from a particular ideology over this common humanity. It goes against what Adam Smith called “sympathy”, (more accurately “empathy”) which human beings feel for each other, an ability to understand and feel another’s suffering which drives us to care for each other and minimise the suffering we cause. Smith’s contention was that this feeling of common humanity was the basis of civilisation. We can find evolutionary reasons why this is the case, game theoretical notions of reciprocity, but many individuals in the world feel empathy for one another “just because”. There is no reason, it is simply human.

We can easily find reasons why we should separate ourselves from the Muslims in our community, and to hate them for the fear we feel of them because of what madmen do in their name. The terrorist succeeds when their acts drive us into division, cause us to act against our humanity, so that the terrorist can point and say “look, I told you so, they hate us” and add another stone to their logical fortress. In holding to and affirming our humanity, in treating each other with decency, understanding and kindness and allowing ourselves to let go of ideologies and rationality in favour of empathy and fraternity where the former goes against the latter, we show the insanity of the terrorist for what it is. We show that reason easily becomes the slave of passions and that the idiot who thinks God or some Fuhrer has given him a divine mission to bring about a better world by acts of indiscriminate destruction has such a warped view of the current one that they have left humanity behind. Isolating these individuals from humanity and removing them from a position in which they can do harm comes at a cost, but we show we are different from the terrorist if we fully acknowledge and feel this cost, even if it prevents a descent into barbarity.

What does this mean in practice? It means that in the immediate aftermath of the recent events, the way in which we show as a nation that the individual who perpetrated it was a madman is not by reason. It is by standing up to the individual who understandably launches into an Islamophobic rant and say quite simply, “no, Muslims are welcome here, this was a madman”. We show this individual was a madman by individuals across the nation offering to walk with our fellow citizens who are Muslim and defend them against attacks by frightened individuals in our society who in their terror lash out against anyone who holds to the creed the terrorist claims to hold to. We show the madness of the terrorist by our politicians and our elite standing up and saying “this individual was to Islam what a Provisional IRA bomber is to Christianity and what a Nazi is to German patriotism”. After the immediate hurt and shock has passed, we show our humanity and the madness of the ideological rationalist by those of us who aren’t Muslim treating our Muslim compatriots as we would any other Australian who does not have our colour or creed.

Napoleon paid the British nation its greatest compliment when he called it “a nation of shopkeepers”. That nation, respectful of reason (being the home of Isaac Newton, Charles Darwin, Cambridge and Oxford) but sceptical of its supremacy and committed to a “small” life defeated Napoleonic France with all its heritage of science and rationality. Australia, typically, was paid its greatest compliment when Sam Kekovich said “who cares where they come from, as long as they can handle a pair of barbeque tongs”, and a majority of Australians across the country felt exactly the same way. It may seem simple, perhaps simplistic to say that we can defeat the terrorist by simply being nice to each other. George Orwell felt this way about Charles Dickens’ writings, but realised at the end of his famous essay on the great writer that Dickens deserved his plot in Westminster abbey for his moral leadership. Dickens realised that the best way to show the madness of the miser was to contrast in A Christmas Carol and Hard Times the kindness and simple reasoning of ordinary people against the cold inhuman rationality of Ebenezer Scrooge and Thomas Gradgrind which destroys the people around them.

We can never force the terrorist to acknowledge the value of our way of life, we can never persuade them that their view of reality is warped, all their reasoning is therefore worthless, and their acts disgusting and criminal but we can through affirming our common humanity and rejecting fear and hate – no matter how reasonable it may seem - draw our nation together and isolate the madmen on the fringes who would divide and destroy it.

National hindsight bias day

For balance I follow a few people on Twitter at the opposite end of the political spectrum. I consciously try to avoid confirmation bias, and regularly find there is much agreement across what are often imaginary political divides.

One thing I’ve noticed today, in the aftermath of the Sydney siege, is that the right-wing - the conservatives and nationalists - seem more likely to be suffering a serious dose of hindsight bias, which is

… the inclination, after an event has occurred, to see the event as having been predictable, despite there having been little or no objective basis for predicting it, prior to its occurrence

Many on the right are arguing that because the perpetrator had a criminal history it should have been obvious that he was a risk of committing this sort of insanity.

But this is almost never the case. Almost everyone with a criminal history does not do this. The sheer rarity of such an event is what is causing the media fanfare, and the sheer rarity is why such things cannot be easily foreseen in advance, despite our retrospective justification.

The gunman could have been just about anyone and we would have latched on to some feature of his life that in retrospect appears to offer a prediction of future radical behaviour. Any strange hobby, personality quirk, or previous emotional breakdown would appear to be a reliable signal after the fact.

The world is full of nut-jobs.

I’m quite pleased to see religious leaders joining together, and the community coming to support each other. We should all be thankful that such events are so rare.

In any case, given some of the reactions I want to declare today National Hindsight Bias day.

The case for 7% stamp duty on property

In the spirit of turning ideas on their head, let me put forward the case in favour of stamp duties on housing transactions. To be honest, it is pretty compelling to me. If I had to rank taxes from best to worst in terms of efficiency and equality, land value taxes would be first best, but stamp duties would be not far behind, huddled together with Tobin taxes and capital gains taxes to make up a top four.

There are three mains arguments in favour of stamp duties - improved price stability, no affordability effects, limited mobility effects.

Price stability
The first point is that stamp duties are not a tax on relocating, but a tax on asset market churn. We know that property bubbles have the characteristic of high transaction volumes arising from speculative buying and selling. Eliminating some of this activity because of its increased costliness will have an indirect effect of stabilising prices to some degree. Additionally, fewer transactions means less waste of resources on the real estate sales industry. Essentially it is a Tobin tax for property markets. If reducing resources devoted to the zero-sum game of trading share markets is a good thing, then the same is true for property markets.

From the perspective of macro stability stamp duties are a massive automatic stabiliser - raising plenty of revenue during the boom, and much less during the bust.

No affordability effects
Valuation theory and practice support the view that stamp duties, although paid for by the buyer, actually come off the price of housing. That is, buyers determine their total willingness to pay a the house, and subtract any transaction costs from that total to arrive at a residual that they can pay to the seller. Empirical studies also support this view.

In terms of effects on home prices, the cost of stamp duty is subtracted from prices, leaving the total purchases costs unchanged. If they also deter speculative sales as I suggest in the previous section, then the net effect of stamp duties on property prices is to reduce them. That’s about the best side-effect from a tax you could hope for.

Limited mobility effects
Some people call stamp duty a tax on mobility. It’s not. There is a whole group of people called renters who are quite a mobile part of the population and avoid the tax entirely. While the evidence suggests that fewer relocations are made by owners (perhaps 8% fewer in a year for a 1% increase in the stamp duty rate), disentangling the speculative motive of such sales from the actual labour force relocation motive has never been attempted, though they must be entwined.

Already a house sale has a combined cost to buyers and sellers of probably close to 8-9% of the house price; from removal costs, lawyers, agents, inspections, loan fees etc. Why not make it 10% by raising stamp duty ? After all, the seller gets a lower price and the buyer pays the same total of house price plus stamp duty. It’s a transfer from current home owners.

In all it stamp duties seem like a pretty reasonable tax in terms of economic efficiency. Perhaps rather than promoting land value taxes as a replacement for stamp duty, a better position is to use land tax revenues to replace more distortionary State taxes such as payroll tax.

While I’m at it
Many economists in tune with the role of land rights in economics have criticised Piketty's book for being a bit loose in the way he aggregates capital. They say that because he conflates improvements and property rights, such as land, a tax on all wealth to reduce inequality, as he proposes, will act like a tax on improvements and land value.

But what they forget is that this is about the second best tax. If a tax on property rights of all sorts (minerals rights, patents, land and so forth) is a first best tax, an incremental tax on wealth is second best. Having this argument is completely counterproductive from a policy perspective.

Four books and one film to understand the world

Money, Coordination and Prices (1998)
Fieke van der Lecq

Van der Lecq asks the question 'Why does money exist?' After an extensive review of the many approaches to understanding money, she ultimately argues that the very reason for money may be the same reason that there is often little incentive to change nominal prices. Money provides a broad look at the role of norms, conventions and institutions in coordination - the macro-foundations of micro behaviour, if you will. The point is made clear when she looks at the necessity of meta-assumption in  game theory, the meta-assumptions in game theory that we ignore but are the key reasons there is so little practical application, and so on. It is probably a book for those with a fair bit of economics training.

One stand out section for me was the way coordination requires clues about the behaviour of others. In game theory it is merely assumed, almost always without question, that there is a common knowledge of instrumental rationality. What that assumption is also rational is never quite made clear. But in any case, the way Van der Lecq describes the role of 'focus points', or clues we use to infer the likely behaviour of others. She quotes Schelling

People can often concert their intentions or expectation with others if each knows the other is trying to do the same. Most situations (...) provide some clue for coordinating behavior, some focal point for each person's expectation of what the other expects him to be expected to do (Schelling 1960, p57)

To be the approach in this book to money sits very cleanly with Erving Goffman's approach to coordination, in that we present ourselves in particular ways in different circumstances in order to present the necessary signals for coordination. While I don't have a separate entry for his book The Presentation of Self in Everyday Life, I highly recommend it.


Moral Tribes: Emotion, Reason and the Gap Between Us and Them (2013)
Joshua Greene

A brilliant look at what morality is, how people respond differently to seemingly different framing of the same utilitarian dilemma (mostly centred on the trolley problem). The big message from this book for me is summarised in the passage below.

Morality evolved to enable cooperation, but this conclusion comes with an important caveat. Biologically speaking, humans were designed for cooperation, but only with some people. Our moral brains evolved for cooperation within groups, and perhaps only within the context of personal relationships. Out moral brains did not evolve for cooperation between groups (at least not all groups). How do we know this? Because universal cooperation is inconsistent with the principles of natural selection. I wish it were otherwise, but there's no escaping this conclusion

Economic Indeterminacy (2013)
Yanis Varoufakis

A terrific book focussing on the rather technical aspects of game theory and the hidden assumptions that no one wants to talk about. The big message for me was that all economists, when they truly dig down into the depths of their theory, hit a wall of indeterminacy. Most then do the dance of the meta-axioms to step back from the wall with additional hidden assumptions. To make a career you must continue to dance away from that wall - confronting it casts you as an outsider.

Another important piece in Varoufakis's work is the nature of human conflict, and how it can fit into the picture of rationality. Put simply it can't. And that the puzzle that led Varoufakis down the garden path.

The following passages are insightful.

…young graduates, who spent countless months and years mastering this analysis, they will, indeed, require an heroic disposition to ‘come clean’; to admit that all this investment has led them to the conclusion that conflict is … indeterminate. Those of them who do say this courageously will never get tenure, as their papers will remain unpublished – their models will not have achieved the requisite ‘closure’. And those who maintain silence of the faulty foundations of their analysis, continuing to produce models of greater complexity along the same lines (and on the basis of the same denial of indeterminacy’s actual hold), will become the new blood that keeps neoclassicism fresh and forever dominant within the economics departments of the best universities. 

In this sense, economists do not mind it when other social scientists disparage their model of men and women as unrealistic, as unrepresentative of how people actually think and act, even as downright misleading about the people around us. Their defence is simple: while homo economicus, the instrumentally hyper-rational ideal type, may not exist, it is an excellent benchmark against which to ‘measure’ the rationality of living and breathing humans and, moreover, it represents a very helpful model of the type of behaviour toward which real humans tend the greater their immersion in market competition.   

And when critics of the economists’ theories point out systematic differences between actual behaviour (e.g. in the laboratory) and the behaviour economists predict, the latter resort to the explanation that these differences are the result of the fact that people are not as rational as they, the economists, assume. That if they were truly rational, economic theory would predict perfectly their behaviour. Thus, economists interpret the chasm between observed human behaviour and the behaviour their models predict as a reflection of the divergence between actual and ideal human rationality.

Debt: The first 5000 years (2011)
David Graeber

There are hundreds of reviews of Debt online. This is not a review, but merely a recommendation. The book is long and wonders a little, but you will be rewarded by reading with an open mind. Debt focuses on recasting the nature of financial debt as fundamentally a human relationship - something we all too quickly forget when discussing the modern world of high finance (or should I say modern world of relationships). The following passages make this ‘relationship calculation’ role of debt and money quite clear.

Freuchen tells how one day, after coming home hungry from an unsuccessful walrus-hunting expedition, he found one of the successful hunters dropping off several hundred pounds of meat. He thanked him profusely. The man objected indignantly: 

"Up in our country we are human!" said the hunter. "And since we are human we help each other. We don't like to hear anybody say thanks for that. What I get today you may get tomorrow. Up here we say that by gifts one makes slaves and by whips one makes dogs. 

... The refusal to calculate credits and debits can be found throughout the anthropological literature on egalitarian hunting societies. Rather than seeing himself as human because he could make economic calculations, the hunter insisted that being truly human meant refusing to make such calculations, refusing to measure or remember who had given what to whom, for the precise reason that doing so would inevitably create a world where we began "comparing power with power, measuring, calculating" and reducing each other to slaves or dogs through debt. 

It's not that he, like untold millions of similar egalitarian spirits throughout history, was unaware that humans have a propensity to calculate. If he wasn't aware of it, he could not have said what he did. Of course we have a propensity to calculate. We have all sorts of propensities. In any real-life situation, we have propensities that drive us in several different contradictory directions simultaneously. No one is more real than any other. The real question is which we take as the foundation of our humanity, and therefore, make the basis of our civilization.

Here is another

This is a great trap of the twentieth century: on one side is the logic of the market, where we like to imagine we all start out as individuals who don't owe each other anything. On the other is the logic of the state, where we all begin with a debt we can never truly pay. We are constantly told that they are opposites, and that between them they contain the only real human possibilities. But it's a false dichotomy. States created markets. Markets require states. Neither could continue without the other, at least, in anything like the forms we would rec­ognize today.

The Fog of War (2003)
Errol Morris

Lastly, a documentary that really opened my mind to recent US war history - The Fog of War. It is based on the life of Robert Strange McNamara, and centred on a lengthly interview of him at age 85 reflecting on the nature of war. McNamara was the US Secretary of Defence from 1961-1968, following a period as the President of the Ford Motor Company, and overall was a very influential decision maker in key aspects of US military actions. It is a little scary the way he explains just how close the US was to other wars, including the invasion of Cuba, and how often mistakes are made that cost the lives of millions.

The whole film is on YouTube here, and below is the trailer. It is worth your time.

 

Grandpa Landsburg, the Rocking-Chair Economist, defends econ tribe

My friend Unlearning Economics has a series of seven posts that pour cold water over the economics profession’s ridiculous defences of their demonstrated incompetence surrounding the financial crisis.

For those who haven’t read them, here’s the seven arguments linked to their respective posts.

1. But we did a great job during the boom
2. The Efficient Markets Hypothesis (EMH) claims that crises are unpredictable, so the fact that economists didn’t predict the crisis is not a problem for economics at all
3. Economists aren’t oracles. Just as seismologists don’t predict earthquakes and meteorologists don’t predict the weather, we can’t be expected to predict recessions
4. Mainstream economics cannot be blamed for politicians inflating housing bubbles/pursuing austerity/deregulating the financial sector; our models generally go against this. Clearly, we do not have that much influence over policy
5. We got this one wrong, sure, but we’ve made (or are making) progress in macroeconomics, so there’s no need for a fundamental rethink
6. Sure, modern macroeconomics is pretty weak. But most economists don’t even work on macro, so they are unaffected
7. Economists had the tools in place, but we overspecialised and systemic problems caught us off guard

Yesterday I came across an article that includes quite a few of these defences, and displays the strange ways economists often argue. It’s by Steven Landsburg, an economics professor at University of Rochester, and self-proclaimed ‘armchair economist' who is part of the ‘freakonomics’ bandwagon, writing books presenting quirky but shaky results in economics as surprising insights into reality. 

He argues in a senile ‘grandpa’ style - a label used by Matt Bruenig to describe his opponents illogical ramblings over inequality in the ‘Grandpa Sumner debates’. It’s argumentation as you’d expect from uninformed grandpa yelling from his rocking chair and shaking his cane in the air. Maybe I'll call him the 'rocking chair economist' from now on.

The article deserves fisking. Here we go.

As recently as a few months ago, doctors were held in high esteem and educated people believed that medicine could be useful. All that changed, of course, with the medical profession’s stunning failure to prevent or even predict the breakout of ebola in West Africa. Worse yet, many doctors to this very day cling to their old ways of thinking, writing prescriptions, setting broken bones, and performing surgery in bull-headed defiance of the urgent need to jettison everything we know about medical practice and start over from scratch.

Nobody, of course, writes such nonsense about medicine. Why, then, do so many write equivalent nonsense about economics?

This is nonsense attempting to be humour. Maybe Landsburg is unaware of epidemiology, which is entirely devoted to the spread of disease in the population. Governments have guidelines, programs and procedures in place for epidemics, and universities even have whole departments dedicated to this research.

Did economists have a standing warning about economic crises? Or standing plans and programs in place? Did they develop guidelines on how to react and monitor certain types of financial crisis? Did the lobby for ‘economic vaccinations’?

This is a poor attempt at defences 2 and 3.

Most economists failed to predict the 2008 financial crisis and ensuing recession for pretty much the same reason most doctors failed to predict the 2014 ebola epidemic — their attention was, quite reasonably, directed elsewhere. It’s easy to say in hindsight that if economists had paid more attention to the shadow banking system, they’d have seen what was coming. But attention is finite, and if economists had paid more attention to the shadow banking system, they’d have paid less attention to something else.

More nonsense. It is not that economists didn’t predict this particular crisis, but they didn’t even predict the possibility of the crisis. This is completely unlike in medicine, or seismology or any other study of complex systems. Seismologists do predict the chance of earthquakes, and epidemiologists do predict the likely structure of epidemics and study how to contain them.

For a little perspective, have a look at this chart showing U.S.~per capita income in fixed (2005) dollars: 

 

That little downward blip you see near the top is the recent crisis. The somewhat bigger downward blip in the 1930s is the Great Depression. The moral is that in the overall scheme of things, recessions don’t matter very much. At the trough of the Great Depression, people lived at a level of material comfort that would have seemed unimaginably luxurious to their grandparents. Today, while Paul Krugman continues to lament “the mess we’re in”, Americans at every income level live far better than Americans of, say, 1980. If you doubt that, you surely don’t remember what life was like in 1980. Here’s how to fix that: Pick a movie from 1980 — pretty much any movie will do — and count the “insurmountable” problems that the protagonist could have solved in an instant with the technology of 2014. Or reread any of the old posts on this page.

If you care about human well-being, recession-fighting is small potatoes. It’s that long-term upward trend that matters. And economists, fortunately, understand a lot about what it takes to nourish that trend — things like well-enforced property rights, the rule of law, free trade, sound money, limited regulation and low marginal tax rates. Even more fortunately, economists have managed, however imperfectly and with fits and starts, to impress that understanding on the minds of policymakers. As a result (and going back, at least, to the repeal of the Corn Laws), we’ve had better policies and greater prosperity.

This is an attempt at defence 1: We did great job during the boom. But I still have some bones to pick. First, stating that living standards are higher now that some arbitrary time in the past could have been made at any point in history, regardless of the state of economic knowledge. This is not a defence of economic understanding.

Moreover, saying recessions don’t matter much is like the medical profession saying that cancer doesn’t matter much. After all, every dies, we should be grateful that we are living longer than ever. Aren’t we glad doctors were out there studying other things while taking credit for the fact that people are born at all?

Importantly, Landsburg seems to think that economists can take credit for the development of human society for the last 230 years or so. That’s sheer nonsense.

Even the specific policies that economists believe ‘nourish’ the long run growth trend - well-enforced property rights, the rule of law, free trade, sound money, limited regulation and low marginal tax rates - are pretty debatable, and often wrong.

Is Landsburg suggesting that China would have even more rapid growth if it followed his prescriptions? Or is he just reciting the biblical passages from the mainstream bible.

To throw out all that hard-won knowledge because we failed to prevent a financial crisis would be like closing all the hospitals because doctors failed to prevent an epidemic.

No it wouldn’t. See above.

Moreover, it’s entirely possible that some of the best policies for fighting recessions are inimical to long-term growth. It could easily follow that even if you knew exactly how to fight recessions, you might prefer not to.

Sure. It could be possible. But no one knows this. It is just like saying we could send people to Mars, but then aliens might invade us, so if that’s the case we wouldn’t want to go to Mars. It’s internally logical, but externally pretty stupid.

It’s a very good thing that some economists are trying to understand recessions, and a very good thing that they’re accounting for the lessons of the past few years. It’s also a very good thing that most economists are working in the myriad of other areas where we’re capable of doing good. Another very good thing is historical perspective. The current so-called “mess” that economists have (partly) gotten us into is not just the most prosperous era in human history; it is prosperous beyond the wildest imaginings of your parents’ generation. And yes, economists helped get us here.

I would respond by asking, do economists know more about recessions today than they did a century ago? Not really would be my answer.

Again, he suggest economists should take some credit for the boom, as if they made it happen.

Put your cane down Landsburg and take your medicine.

The preference whisperer

I had a chat today with a freshly minted PhD from an elite US economic school about rationality and utility maximisation. As you do.

There was simply no phenomena he could not explain with his beloved utility theory. But if the theory explains everything imaginable, then it predicts nothing. I resolved that the theory as it stands, in the revealed preference form, was not falsifiable, though he didn’t seem to understand why that would matter.

I’ve since dubbed him the preference whisperer - someone who can observe any apparently illogical combination of behaviour and reverse out a utility function that is consistent with that behaviour. Insurance, check, Gambling, check. Addiction, check, Suicide, check. 

Of course, I could develop a theory of space monkeys controlling the universe that fits will all observable phenomena. I could add a sense of mathematical rigour to it by demonstrating that our space monkey is optimising confusion in human society to amuse himself through the infinity of time his poor immortal soul is cursed with. 

You would laugh it off of course. But for some reason, you are not laughing off utility theory just yet. Over the decades an air of credibility has sprung up around the idea. Economists who believe it to represent reality sometimes wear suits, have fancy degrees, and jobs in the respected halls of academia.

Yet the theory remains as unfalsifiable as my theory of space monkeys pulling the strings of the universe. And it makes the same predictions. In my view, a theory without falsifiability or predictability is no theory at all.

Seeking housing supply logic

A four year long debate over the potential role of town planning regulations in determining the price of housing has occurred at MacroBusiness. The latest instalments are here, here, and here, and my model of understanding price effects of locational distributions of housing is here.

I want to briefly look at the logic of those who argue that planning controls strongly influence housing prices, and ultimately the affordability of housing in all forms (including rental affordability).

So far it seems there are multiple conflicting views being simultaneously held by the shortage protagonists, which I call the response dynamic, the expectation dynamic, corner the market, and the squeeze. Each of these suffers from the problem of invoking an implicit baseline for comparison which simply can not exist.

Response dynamic

In this argument there exist regulatory barriers, such as the need for a development approval, that delay housing supply in the short run while prices are rising, amplifying any resulting cycle.

While intuitively appealing, this argument suffers from a similar logical problem that most supply arguments do - the implicit invoking of a baseline that doesn’t exist.

You see, implicit in this argument is the idea that there exists a world of no constraints in which an unlimited supply of some asset could exist (as asset, by the way, is by definition a share of a finite bundle of property rights, which if could be infinitely supplied, would have a zero price). This baseline arises in economic theory of perfect competition under the implicit, but poorly understood, assumption of free entry. Yet free entry invalidates positive prices in general. So the logic of this baseline relies on the same faulty logic hidden in the economic model of perfect competition.

So if this fantasy world is not a relevant baseline, then what is? At best it is a world of monopolistic competition, where all land owners compete in slightly different markets, as there are no perfect substitutes to each location. Here, each land owner faces an independent choice of when to develop for housing given current market conditions. Essentially, is it better to develop today, or will I make more money developing later?

In this case a land owner, or even a developer who has approvals and is ready to build, will delay sales if the present value of the revenue from delaying sales and achieving a higher price later exceeds the cost of delaying. In practice this means that when prices are rising rapidly and sales are occurring quickly, it usually pays to delay sales by increasing prices. This is a simple matter of logic, and is supported by a large literature on real options theory that takes into consideration the one-shot nature of development, and the optimal timing of investment and sales decisions.

What this means for the response dynamic argument is that regardless of the nature of the town planning system, and even if the development approvals process was removed entirely, land owners and developers would still delay sales and construction of new dwellings during the price cycle. They would not, as is argued, somehow ignore their independently available option to delay sales for higher prices.

Expectation dynamic

Another argument goes as follows - a housing bubble can occur in an oversupplied or undersupplied market, but what determines the long run average price level is the potential abundance of future supply.

This ignores a number of things, the main one being that current supply should, and does, matter for housing affordability because rental prices arise from competition for the current stock of dwellings. What we are discussing in this argument is how the expected growth rate of rents and prices is capitalised into current prices. If potential future supply enters the price equation through an expectation of future growth in prices and rents, then this expectation can of course increase prices.

The flaw in this argument is that expectations of growth in prices can, and do, arise in markets where future supply is essentially infinite, both in experimental settings, and in many real life examples, such as the public land auctions of the 1830s. So invoking expectations of future supply as the specific mechanism for the formation of price growth expectations is completely arbitrary.

By the logic of this argument I could promise to flood a city’s housing market with new dwellings in 50 years time, and by backwards induction, current home buyers would reduce their willingness to pay and overall prices would fall. If you believe this would work, I’m happy for you to believe the expectation dynamic argument on housing supply.

Corner the market

This argument says that because there are finite locations for future housing supply, large developers are able to corner the market by acquiring sites and drip-feeding new supply in order to maximise their prices.

Holding such a view relies on the same implied baseline as the response dynamic argument, in that a world of free entry and unlimited supply is assumed to be a possible alternative but for town planning controls. Of course a world that has no town planning control, but merely divides the land in bundles of private ownership, will also have limited supply, and will suffer the same problem.

What this argument boils down to is a claim that even with many thousands of developers operating in our housing markets, and even with many millions of potential development sites whose owners will seek development in the future, somehow adding additional potential development sites will increase competition.

It is fantasy to imagine that if competition between 1,000 developers does not exist, that when there are 2,000 some kind of magical competitive pressure arises.

Squeeze

Lastly, there is the basic squeeze argument that says that because planning constraints are binding, in terms of setting an effective quota system (which they don’t, more on that in a moment), that we can think of their effect in terms of basic constraints in supply and demand equilibrium approach. This is the approach the RBA has used before to attempt to understand housing supply.

But controlling what is allowed to be built where does not also control that rate at which new development of any type is constructed. Local councils approve developments at the rate they are sought, and in my home town the rate of approvals increased by a factor of five during the early 2000s property price boom. Clearly there was no quota system on quantity, only location restrictions on where different type of development would be allowed.

The separation of location controls and quotas can be clearly seen with an example. Think of road space. We have a ‘road planning system’ that says cars driving east can only use half the road space, and cars riving west can only use half. Therefore this should create, by the same logic that location regulations restrict housing supply, a shortage of commuting.

But it doesn’t. It facilitates better commuting because conflicting uses are segregated. Imagine then a city that says one side of the river can only be used for residential development, while the other side can only be used for non-residential uses. Does that automatically create a shortage and a housing squeeze? Only if you assume it does.

Taken to the extreme, this argument again invokes the free entry assumption and the backwards induction logic of the expectation dynamic. If segregating housing to one half of the city creates a squeeze, so do does ANY geographic restriction, including the mere finite size of the world. If only the world was bigger, housing would be cheaper!

Conclusion

Even you edge to the middle ground and argue that it is some combination of these arguments, this doesn't address the fact that they independently ignore the basic realities of property markets. It is not to say that at some point there could be a supply side effects on prices, such as following natural disasters and so forth. But we must realise just how small the new supply of housing is compared to the whole housing stock to understand that any effect of the rate of new supply on prices can only be miniscule. The real problem with these arguments (apart from their inability to make sense of rental prices) is that invoking a baseline of perfect competition is absolutely a wrong assumption.

Update
Even if you still want to ignore the logic of the arguments at hand, and insist that the evidence shows that, for example, houses are cheap in Houston, Texas, therefore their planning system is the reason why, you need to a) ignore that they have a strict planning system, which just does not have zoning as it is usually used, b) ignore that at the fringe of all Australian cities there are also cheap houses (eg. I found 121 houses for sale under $300,000 with over 3 bed, 2 bath, 600sqm of land, in Ipswich, west of Brisbane),  c) ignore the price effect of state property taxes in Texas, and d) ignore commuting costs from sprawling cities, which are avoided in more compact cities and get capitalised into prices.

Australia outbuilds Texas, but will the shortage myth die?

The claim of an Australian land and housing shortage is a myth of epic proportions, perpetuated by vested interests across the media landscape. An Internet search for the phrase ‘Australian land shortage’ produces a deluge of pronouncements confirming this view.

Those with an intimate knowledge of property-related data, or with experience in the development industry, can tell you that the alleged housing shortage is fiction. It is in the developers’ best interests, however, to remain quiet and reap windfall gains from beneficial rezoning (surely betterment taxes should be imposed on that?). The imagined scarcity of housing is promoted by think-tanks and other vested interests, and follows a familiar script:

Australia is not producing enough new land for housing due to policies pursued by state and local governments that prevent land supply and land use from responding to price signals. In fact, the supply of new land for housing has declined over the last decade, with the average number of lots produced in the five largest capital cities declining by 21%. The decrease in the supply of new land has not surprisingly seen an increase in land prices.

Everyone is familiar with varying forms of this argument that are ceaselessly promoted by think-tanks and housing lobby organisations. Unfortunately for the vested interests, it is nonsense. For an abnormal surge in housing prices to be attributed to supply constraints that arise from town planning regulations, the following events must have occurred:

• Rents must rise relative to household income (the rent to income ratio), for if fewer homes are built, tenant bidding wars for scarce shelter must result in a higher ratio. 
• Real rents must increase (the nominal rent to inflation ratio), as supply is squeezed by regulations that restrict the number of new dwellings. 
• The occupancy rate must rise, as a lower dwelling construction rate results in more people per property. 
• The council approval rate for new dwellings must fall. 
• The rate of new construction must decrease. If government meddling prevents developers from building, the ratio of new housing construction to recent arrivals in a town, city, state, region and/or country must rise. 

The following data tests these assumptions taken for granted by most economists. In the figure below, the top panel shows the mean housing rents and prices in five of the larger Australian states, while the bottom panel displays mean housing rents and prices relative to incomes. In these states, the rent to income ratio during the 2000s is approximately the same as throughout the 1990s, but the price to income ratio has risen.



RBA statistics reveal the rent to income ratio actually fell during the late 1990s through to the mid-2000s, despite the unprecedented inflation in housing prices. After 2007, the ratio increased, but has remained under the peak established in 1999. Furthermore, the rent to income ratios for all income quintiles has remained steady during the housing price boom, except for a slight increase in the lowest income quintile.

Regarding the second criterion, real rents were trending close to zero during the late 1990s, and even turned negative during the early to mid-2000s as housing prices boomed, invalidating the assertion that supply shortages were squeezing the number of new dwellings.

The third criterion of the mainstream account also withers under scrutiny, for the occupancy rate (persons per household) has continued to fall during the boom, hitting a record low in 2007 at 2.72 before flattening out. This trend is in line with similar developed nations and has persisted, despite the average size of residential dwellings increasing to a record high.



The ratio can only fall so far, constrained by the social dynamics that affect family households and shared housing arrangements. The ratio of dwellings to people will never approach a one to one ratio, even when considering the surplus housing stock comprised of long-term vacant properties, second homes and holiday houses, and the extremely large size of the average Australian home.

Available data to assess the fourth criterion (housing approvals) also paints an interesting picture. For instance, South East Queensland provides an excellent measure – ‘Stock of lots approved by Council’ – that covers the early 2000s boom. Between 2000 and 2004, annual approvals increased from around 10,000 to 24,000, while the stock of approved but undeveloped lots surged from 25,000 to 46,000. If councils and planning controls really constrained development, the pattern should in fact be inverted.

Finally, in relation to the fifth criterion, the methodology often employed by economists when examining dwelling construction is faulty. New dwellings are sometimes compared to the existing population base, resulting in a downwards sloping trend. One could just as easily generate a rising trend by comparing the flow of new population against the existing dwelling stock (see here for an example). Further, measurement of the absolute and relative change in the number of dwellings constructed is pointless, for it says nothing about the change in population.

Flow to stock comparisons are occasionally valid, but it is nonsensical in the case of new supply. The existing (housed) population cares little about the availability of new dwellings, whereas it matters a great deal to the new net inflow of persons migrating into a city, town, region, state, or country. Australia has a relatively high home ownership rate of 68 per cent, with owners moving every decade on average.

Contrary to common perception, Australia has experienced a blistering rate of dwelling construction. From 1981 to 2013, Australia produced an average of one new dwelling per 1.76 new persons. Over the course of the housing price boom (1996 to 2013), the ratio is still a remarkable 1.93 - still way below the average 2.7 persons per existing household.



Due to moderate volatility a 2-period moving average trend line has been applied to smooth the series. The ratio is actually overstated, because it compares the new estimated residential population to new construction. A more appropriate measure would only include adults because children don’t purchase homes, make mortgage payments or pay rent, and it ignores increasing size of existing housing true to renovations and extensions.

Over the long-term, the post-WW2 ratio exhibits less volatility as a consequence of implementing stringent town planning regulations, perhaps by reducing uncertainty (a ratio of 2.0 between 1946 and 2012 compared to 3.8 between 1881 and 1945). This era also has a lower average ratio than pre-WW2, though this may be partially explained by more accurate data post-WW2. The supply of new housing has improved dramatically and remained responsive in the post-WW2 era in defiance of stricter planning regulations.

In contrast to the conventional supply argument, Australia has even out-built Texas, typically advocated as the ideal of supply-side efficiency. Between 1990 and 2012, where comparable data are available, the Australian and Texan ratios averaged 1.85 and 2.86, respectively. Over the course of both housing booms between 1996 and 2006 (the peak of the US bubble), the Australian and Texan ratios averaged 1.88 and 2.20, respectively.



When Australia and Texas experienced downturns during the GFC, the ratios in both countries increased, though more significantly in Australia’s case, leading to a sharp peak in 2009. Australia’s housing bubble failed to burst, following banking and housing interventions by the Rudd government. Consequently, the rate of construction has resumed its long-term average.

The comparison of the ratio of new population arrivals to new dwellings has some interesting implications for those blaming developer land-banking and other non-competitive practices on restrictive supply-side regulations. If the supply of new housing is being artificially constricted in Australia, how many new dwellings should developers be constructing? Should it be one new dwelling per new person? Ten new dwellings?

Fortunately, developers are run by businesspersons who are finely attuned to the real world functioning of property markets. Quaint notions of neoclassical equilibrium theory are discarded; such as the assumption the real estate market should operate in a perfectly competitive manner, with plots of land and dwellings modeled as if they come off a factory assembly line like candy.

In reality, developers carefully assess market conditions and make future trend estimates in an environment of uncertainty. They will certainly not imperil their future profits by constructing an absurd amount of dwellings in response to high prices. Rather, land banks are used strategically, in spite of the clamor against these practices.

The totality of the data discredits the mainstream housing shortage argument. In particular, the rent to inflation and rent to income ratios provide compelling evidence, alongside the occupancy rate. Apart from a few years during the GFC, both ratios have remained steady and/or even fallen for the most part during the housing price boom between 1996 and 2013. The data reveals the supply of dwellings has remained responsive and generally fulfilled the needs of a growing population, even as regulatory burdens have increased.

Conventional economic theory makes no allowances for private debt, land rent, speculation, bubbles, irrationality, instability and uncertainty – the characteristics of real world property markets. Yet, this has not prevented a number of economists from claiming that accelerating private debt results in greater volatility in restricted land markets.

This schizophrenic approach is inherently contradictory: on the one hand accepting that markets operate (correctly) according to disequilibrium price dynamics, but simultaneously modelling real estate markets as if they operate according to equilibrium price statics. Markets must be modelled with one or the other, not mixed and matched when convenient.

As equilibrium econometric modelling does not account for the role of accelerating private debt on asset (land) prices, a causative relationship cannot be established between supply factors and prices, only a tentative correlation. Even then, a thorough analysis of the data leads to misgivings about the role of restricted supply, with a strong rate of dwelling construction over the long-term in the midst of a supposedly strict town planning system.

The same cyclical pattern is found in the stock market, evidenced by the recent Dot-Com bubble which was the largest of its kind. What supply-side factors generated that enormous bubble in the virtual world? For centuries, developed nations have experienced recurring stock market bubbles irrespective of the regulatory environment. Thus, in a manner analogous to the real estate market, it would be absurd to blame high share prices on regulation, for instance, the government curbing the supply of new stock via IPOs.

Australia suffers not from a lack of supply, but high housing prices – seemingly contradictory if one abides by conventional economy theory and the standard account of town planning. Housing prices are abnormally high due to a bubble generated by financial deregulation and generous tax expenditures.

Even with plentiful supply, concerns over affordable housing, however, are still valid. The bottom 40 per cent of households by income has always struggled; it is not a recent phenomenon. Higher social welfare payments, rent controls and a greater supply of public housing would help to ameliorate affordability issues for the poor.

In conclusion, Australia has built a persistently responsive supply of new dwellings, relative to the flow of new net population. There has neither been a housing construction boom nor crash, but a healthy rate of supply at around one new dwelling for every 1.8 persons in recent decades. Assertions of a housing shortage and/or restricted supply are not supported by long-term data and a host of metrics.

Comments and data provided by Paul D. Egan and Philip Soos