Endless repositories of ad hoc explanations

Division of labour. It’s a thing. A big thing in economics.

But like many core economic concepts[1] it is mostly an endless repository of ad hoc explanations.

In my last post I showed how Adam Smith’s observations of production techniques in 19th century pin factories lead him to make many contradictory remarks about the division of labour. Yet the implicit argument of a single causal mechanism leading from more division labour to greater productivity has become gospel, filling pages of economics texts for a century.

Let’s take a recent example to show exactly why the division of labour is such a slippery concept.

@AlanHonick Interesting, but surely division of labour predates humans and is common to most species.

— Cameron Murray (@Rumplestatskin) June 13, 2015

The title, and indeed much of the text reporting the discovery of new stone tools from Jordan, implies that these tools are somehow evidence of the dawn of the division of labour.

These toolmakers appear to have achieved a division of labor that may have been part of an emerging pattern of more organized social structures
…
They were gearing up for a clearly defined division of labor, including firewood gathering, plant gathering, hunting and food foraging.

But the invention of these tools probably led to less division of labour rather than more!

Let me digress for a moment. To be clear about a division of labor story requires being clear about the counterfactual world of undivided labour. It should not involve counting up the labelled roles within organisations, as larger organisations will have more uniquely named roles for their employees purely due to size.

To really narrow down we need to think in terms of tasks, not labelled roles given to different people. And then think about all the tasks that need doing for basic production of life’s necessities, then make everyone do all necessary those tasks AT THE SAME TIME IN THE SAME ORDER.

That’s right. That is the counterfactual of undivided labour. A tribe of people who all wake up at the same time, collect berries from the same location at the same time, start a fire at the same time, hunt alone the same animal at the same time, cook the animal at the same time, build a hut at the same time. Also procreate at the same time.

The reason all of this has to occur at the same time is because if it doesn’t then we have naturally a division of labour already. I hunt animals while you collect fruit. Though tomorrow you may hunt and I may collect berries. Turn-taking is quite clearly not the fundamental idea behind the division of labour, yet I often get the feeling the fancy terminology is used to capture this childish idea.

More important is the question of complementarities in joint production, like hunting in groups. I track, you kill. Division of labour.

But if we invent the spear I am able to more effectively hunt AND kill myself than in a team of specialists. Two tasks by one person becomes more efficient. The hunter becomes an anti-specialist, accomplishing more tasks than before.

Even in the iconic pin factory, the story of specialisation can be seen in reverse. Modern pin factories require very few people to do all the 18 tasks required in Smith’s time and in far greater quantities. The specialist maker of a single pin production stage has been replaced by a generalist who controls the whole process, including, no doubt, more advanced packaging.

The division of labour story about productivity is mostly a story about naming conventions for roles in society rather than the tasks achieved in those roles. I am an engineer, you are an account. Mostly though we both use spreadsheets to add numbers, make phone calls, type sentences, maybe drive a car. In fact from a task perspective rather than a role-in-group perspective, there is almost no specialisation. The majority of tasks are the same. But with more people we define each other’s roles more precisely. The ‘division of labour’ story unravels into a ‘large groups can accommodate more named roles’ story.

In modern lives as a whole there are far more tasks we each undertake. Rather than each doing fewer tasks better, we are all doing more than ever thanks to technologically superior capital. The diversity of our own life experience is far higher than ever. More so, those countries with more diversity, rather than specialty, are routinely the most economically advanced.

Returning to the ancient stone tools of Jordan, the invention of those tools would allow the tribe as a whole, and each member within it, to achieve a greater variety of tasks than ever and expand their production possibilities. But if the number of tribe members was the same, no additional specialisation of tasks could take place. Each unit of labour would accomplish a more diverse variety of tasks than ever, which is what expands the production frontier.

To really make the point, imagine a tribe of 50 people can undertake 100 productive tasks. Then with the invention of new tools, the number of possible tasks the tribe can undertake expands to 125. Clearly, the means the average tribe member is doing 2.5 instead of 2 tasks each - the opposite of what you'd expect from a division of labour story.

So what exactly is this phenomena of divided labour about anyway? To me it is mostly a sign of our level of ignorance about human coordination in groups. When looking to why one company, one country, or one historical period was different from the others, the idea of a division of labour is a catch all term that means ‘something to do with cooperation in groups’, and without further refinement, is an endless repository of ad hoc explanations.

fn[1]. I’m thinking here of concepts like capital (including human), technology, utility/preferences. The phrase 'endless repository of ad hoc explanations' comes from this paper.

The inferiority of renting

Debates about housing affordability in Australia are clouded by the belief that renting is an inferior substitute to home ownership. Renters are all just home owners who haven’t made it yet.

Sadly, this leads to the debate ignoring the very real and beneficial option of improving tenant’s rights in order to improving affordability for renting households as well.

Our collective ignorance leads to loud calls to cut stamp duties, the government fee on property transfers, because they are economically inefficient. They make it costly for homeowners to relocate via selling and buying in a new location.

But stamp duties are only inefficient in a world of homeownership, and even then there are alternatives.

1. Don’t sell your home, rent it out. Then rent a home in a new location. 
2. Just rent in any location if you have a highly mobile career.

For some reason these perfectly legitimate alternatives are considered inferior. Who would someone rent if they could buy? And shouldn’t we make it easier for homeowners to buy and sell as they please?

What we then ignore is that prices are being set not by the homeowner market, but by investors who time their purchase and sale decisions in order to capitalise on the land value cycle. Cut stamp duties, and we are also giving this group a free lunch, even though they are the ultimate beneficiaries of high prices, while future homeowners bear the costs.

But what if renting wasn’t inferior? What if tenants had greater rights and obligations? Maybe in a ‘renter society’ like Germany and Switzerland, where the majority of households rent, the debate about housing affordability and stamp duty would be very different.

Maybe the policy options would look at lot more like what we see in Germany - greater rights for tenants including limits on rental increases and higher capital gains taxes. Removing stamp duty in order to improve household mobility is a second best alternative to better tenant rights.

Adam Smith’s Pin Factory: Capital vs division of labour

Like many well-trained economists, I took Adam Smith’s argument about the productivity gains from the division of labour at face value. It wasn’t until I read Joan Robinson dismiss the argument in her 1973 textbook An Introduction to Modern Economics that I began to really put the effort into understanding the division of labour. I finally realised its incoherence as an explanation for productivity gains, but also that the pin factory story could provide valuable lessons about economics nonetheless.

Robinson dismisses Smith by suggesting that people can equally divide their own labour across different tasks through time. The 18 distinct operations Smith recounts could just as easily be conducted by the same labourer on 18 different days to generate the same output per person over an 18 day period as in the case where labour is divided between workers.

Further, the fact that relatively unskilled labour could perform any of these tasks adds to the case that it is not the division of labour at play in generating productivity gains. One-way causality from the division of labour to productivity gains is a highly problematic story.

But that leaves open the question about the actual mechanism that provided the enormous productivity gains in the pin factories of the mid-1700s.

Instead of Smith’s division of labour hypothesis, let me propose a capital investment hypothesis to explain the productivity of his pin factory. This hypothesis suggests that it is the technical nature of capital that determines the way labour will be divided across tasks to maximise output and that the division of labour responds to capital investment. The causality goes from capital investment to labour division.

To guide my inquiry I use the structured approach I have advocated for in the past, confronting economic issues by first asking questions about aggregation. For example, why are there 18 tasks to make a pin? Why are 18 workers in one pin factory and not 9 in one factory and 9 in another owned by a different entity? 

The answer to these questions is capital. The image above (source) shows the tools and equipment used in the pin factories described by Smith. Notice that the tools and machines in the picture have been designed to more efficiently perform distinct parts of the pin-making process. It is the way the tools have been designed to efficiently break down the task of making pins that leads to the labour division to ‘man the tools’.

Smith came close to instead presenting the capital investment hypothesis. He says

…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. [my emphasis]

He suggests that it is the division of labour that has probably given rise to the machines, rather than the machines themselves giving rise to the division of labour. But this logic comes undone later in the paragraph, even though he ignores the inconsistency in his argument.

…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. [my emphasis]

Even based on Smith’s own observations it is the tools and machines that generate the 18 tasks since people can perform more than one of them. So how exactly how did the division of labour give rise to the invention of the necessary machines that generate 18 tasks with only ten men?

If it was the division of labour that led to increased productivity, labour could just as easily be divided between firms. The fact that pin factories, even with only ten men, still performed all 18 tasks, instead of specialising in just 10 tasks, is clear evidence that there is something special and coordinated about the tasks themselves that arise from the particular capital investments. The tools and machines are designed to be compatible with each other, and if part of the process is done outside the firm, each of the two firms would inevitably be tied to the same compatible capital equipment, and would therefore find gains by merging into a single firm.

When we ask questions about the timing of investment in machines we can more sharply distinguish between the division of labour and capital hypotheses. If it was only after the machines were introduced that labour was divided in a particular way, then that is evidence for the capital hypothesis. If labour was divided into 18 tasks prior to the investment in machines, achieving the same tasks in the absence of tools, then the division of labour hypothesis holds.

Indeed, the prediction of the capital investment hypothesis is that labour task specialisation responds to capital investments in either direction - either with the division of labour, or consolidation of tasks by a single labourer.

A modern test of these predictions could be garbage collection. With rear-loading trucks, labour is divided between driving the truck and loading the bins. But with more advanced side-loading trucks with robotic arms, the labour is once again undivided between driving the truck and collecting the bins. The progression of capital technology determines the division of tasks.

Like many stories in economics, the division of labour as a productivity-enhancer has been approached far too narrowly. There are many economic lessons in the story of the pin factory, and if we probed deeper we could understand more about what considerations determine the boundaries of firms, and why firms are internally not-structured around market principles. But a structured approach to economic inquiry is required to turn Smith’s pin factory into a useful learning tool. The same applies to other stories, like economists favourite Robinson Crusoe story about specialisation and equilibrium. But that will have to wait for another time.

Will higher standards make apartment residents worse off?

No. 

Despite the fact that the principle lesson of economics is that there is no free lunch, for apartment residents this is a free lunch. To be more accurate, it is the landowners who are paying; they will now get less for their land because of the higher cost of converting it to apartments at the new higher minimum standard.

The usual arguments against such regulations are:

• Costs will be passed on to apartment prices and rents 
• Pro-choice, freedom and all that
• Regulations often do more harm than good 

All of these arguments are on display in an overly elaborate and ill-informed way in this piece by the usually sophisticated Alan Davies who argues that higher design standard for apartments will make residents worse off. My beef is with first of them.

This 'cost passed on' argument arises in the economics of housing all too often, particularly in regard to rental regulations. I expect the econ-blogosphere to be bubbling with such 'cost passed on' arguments forthwith after Berlin introduced maximum rental increase regulations. I have briefly had my say about this in the past, as has Matt Bruenig who makes the point that property ownership rights themselves are a form of rent control for property owners. If you believe that rent control is inefficient for standard economic reasons, you open yourself up to the problem that freehold title to property - apparently the building blocks of capitalism - are just as inefficient. 

For the pro-choice people, I’m happy for you to take your chances with a heart surgeon who hasn’t been screened through minimum standards regulation, or buy a house that doesn’t meet minimum building standards. Good luck [1].

But back to minimum design standards for apartments [2].

In standard economic analysis, the incidence of the cost of a tax or regulation does not always fall on the person who is obliged to pay it. What Davies argues is that the incidence of the additional regulatory cost falls predominantly on apartment buyers even though developers and builders pay such costs directly when constructing better buildings. In his view it is

Landowner	⇒	Developer	⇒	Apartment buyer
(no economic effect)		(pays the cost)		(economic incidence)

Why does Davies, and for that matter the much of the economics profession, believe this to be the case? Take the simplest of case of stamp duties on property sales. The economic incidence can clearly be shown to fall completely on the seller rather than the buyer, even though the buyer actually pays the cost. To be clear, if the stamp duty cost of purchasing a home is $5,000, buyers will factor that in and pay the seller $5,000 less for their house. Hence the incidence is on the seller who is $5,000 worse off, not the buyer. Economists routinely get this wrong.

In reality what happens in the case of apartment design standards is that the landowner bears the cost. In the short run that will also include developers who own land.

Landowner	⇒	Developer	⇒	Apartment buyer
(economic incidence)		(pays the cost)		(no economic effect)

Why can I be so confident that this the case and the economic incidence is not shared?

Land is a special case in terms of economic incidence because there is no substitute market for a plot of land. All buyers of any particular vacant plot are price-taking in their developed housing output, but price setting monopsony buyers of their land inputs. Although a development site can be sold in a market with many buyers competing on price, all those buyers will be working backwards from the highest and best use of the land, subtracting costs, and working out how much the site is worth. Add more costs into the development equation and each potential buyer will put these cost in their feasibility spreadsheet and reduce their bid for the land by the same amount. In terms of market power the situation is identical to having a single buyer (alternatively, think of the highest bidder the single buyer).

But how do we know developers can’t pass on costs to buyers through higher prices. Mainly because if they could sell at higher prices they would do so WITHOUT incurring any costs.

As a rule, you can tell where the economic incidence of a regulation is by the groups that oppose it, particularly if their logic makes no sense. The Property Council of Australia opposes stamp duties by arguing that they add to prices. But if developers can simply pass on these costs to the price of housing a) why do they oppose it, since they've admitted it costs them nothing, and b) why aren't they already charging higher prices? The Pharmacy Guild is another great example of lobby groups that proclaim that the economic incidence on regulation will be buyers rather than those who hold monopoly pharmacy licences. 

In sum, there is no free lunch by setting minimum apartment standards. But for residents, the lunch is being shouted by landowners and developers so it will make them better off.

fn.[1] The image above is from a recent fire in Melbourne that spread 15 storeys up the building in minutes due to the use of cladding that did not meet minimum fire standards.

fn.[2] Note that I am ignoring the macroeconomic cost in terms of resources potentially diverted from other uses in the construction sector from building these higher standard buildings. And why not. It’s not like Australia, nor most of the world right now is anywhere near full-employment growth rates. There is slack everywhere you look. Higher standards could even be stimulatory in this environment.

Renegade Economists interview on dodgy rezoning

I was interviewed recently about my research on political favouritism in land rezoning by Karl Fitzgerald from Prosper Australia, the country's leading land tax advocacy group. You can subscribe to Karl's podcast, the Renegade Economists, in iTunes.

Enjoy.

Clean Money, Dirty System by Renegadeeconomists on Mixcloud

Exposing political favouritism in land rezoning

Property development can be a dirty business, particularly when it comes to land-banking, which is the speciality of Australia’s largest developers.

Land-banking involves the speculative buying of large parcels of land that are currently unsuitable for development in the hope of future development potential. But hope alone is not a business strategy. How can land banking be so routinely successful for developers in Australia?

One argument is that successful land-banking comes from political favours in terms of rezoning and public provision of infrastructure. These favours provide substantial value gains to landowners at no cost to themselves. While in certain cases this account appears to have some merit, there has been no systematic evidence that rezoning favours the politically connected.

Until now.

I have a new working paper out with my co-author Professor Paul Frijters, that you can download here, in which we look systematically at land rezoning decisions in Queensland.

The basic result is this: How well-connected you are determines how successful you will be in getting your land rezoned for higher value uses. In Queensland $410million worth of additional development rights were given to mates in just our sample of decisions.

In the study we use sample of planning decisions and landowners involving a total area of 12,676Ha, made by one State authority, the Urban Land Development Authority (ULDA), which took planning powers away from local councils with the intention to increase the scale and speed of development in the rezoned areas. Throughout its time the ULDA was no stranger to accusations of bias, with the Local Government Association of Queensland arguing the government is “playing politics and favouring developers.”

In order to establish how well-connected both rezoned and non-rezoned landowners were, we trawled through a wide range of data on political donations, lobbyists and their clients, industry groups memberships, politicians and their former employers, relationships of ULDA board members, and landowner’s corporate records, in order to construct a relationship network.

We also compiled historical sales data to estimate that this series of rezoning decisions increased the value of the rezoned land by $710 million.

Our main finding however, is that well-connected landowners owned 75% of the rezoned land, but only 12% of comparable land immediately outside the rezoning boundaries, indicating that these decisions were primarily driven by the relationship networks of the landowners, rather than any technical assessment of efficient and appropriate locations for urban expansion.

Political favours in the property industry were found to be much more about being part of the entrenched well-connected political class, whose tight-knit mutual relationships support implicit favouritism, than about visible activities such as making political donations.

These well-connected landowners made $410 million in profit from the rezoning decision, at the expense of the public at large who had the option to instead sell those additional development rights. The data tells the story that connected property developers bought land unsuitable for development land on the urban fringe, then successfully lobbied State politicians and bureaucrats through their relationship networks to rezone areas where they had bought properties, wrong-footing both councils and other property developers. This process of influence took 7 years on average.

Scaling up our results suggests that the ‘back-scratching’ rezoning game has probably cost the general public many billions of dollars in Queensland in the last few decades.

We propose a number of technical solutions to this great game of political favouritism in land rezoning. The size of the gains to rezoning can be diminished by increasing land taxes. Development rights could instead be sold to land owners, perhaps through local auction processes, or the value gains recovered through a betterment tax. Even a local democratic system for voting on new areas for urban expansion would counterbalance vested interests with the interests of the public more broadly.

One unfortunate lesson however, is that the same relationship networks that allow favouritism to thrive in rezoning decisions will obstruct any systematic reform of rezoning processes.

UPDATE [1]: Please read the original study carefully to understand how we controlled for the fact that well-connected developers might be just better at anticipating where urban expansion will occur. Our control group of landowners are in almost identical locations.

UPDATE [2]: Seems that NSW is looking to one-up Queensland in the land development back-scratching game. Former Energy Minister for Chris Hartcher, who is under investigation by the corruption watchdog, is now lobbying on behalf of land developers.

Environment Minister sabotages environmental groups

Minister for the Environment, the Honourable Greg Hunt MP. What a title. Pity the guy doesn’t deserve it.

Hunt’s latest effort is to conduct a Parliamentary Inquiry into the Register of Environmental Organisations, which maintains records for eligible organisations and carries with it tax deductibility status, and annual reporting obligations. 

The Terms of Reference clearly reflect an intention to amend the qualifying rules to ensure environmental groups that aren’t directly involved in ‘on-ground activities’ like tree planting, will have a hard time staying on the Register. Groups whose primary interest is in political lobbying on behalf of people who value the environment, such as the Environmental Defenders Office, the Wilderness Society and others, may lose support deductibility status, leading to fewer donations and ultimately less political clout. 

What sort of crazy political system would it be if we facilitated and supported organisations that involve themselves in political decisions on behalf of people who care about the environment?

The Honourable Minister for the Environment better do something about that. 

Sarcasm aside, the sad story behind this Inquiry is one of an elite group of vested interests pulling the strings of both major parties in Australian politics. Hunt knows the game is about a trade in favours, and he is doing his utmost to signal to mining and other business interests that he is on their side, and that he is a willing participant in a game of quid pro quo. I have no doubt that our ‘environment minister’ will find himself on the payroll of a major mining interest, or more than one, when he retires from politics. 

While cleaning up our political system will just about require a revolution, there a couple of simple things you can do about this Inquiry if you are interested in having an Australia that has an active organisational sector representing environmental protection. 

You can sign this petition at change.org. 

Or you can write a submission to the Inquiry yourself.

My submission is here (pdf) if you would like to copy from it in part or in whole.

Back-scratching: Do what's best for your mates and screw the rest

Image source: Hungarian sociologists’ study on corruption voted best in world

tl;dr I have a new experiment demonstrating the sheer power of back-scratching, even when it imposes huge costs on others. 

These days it seems that just about every political decision is about doing favours for the connected few at the expense of the many. It is part of an implicit quid pro quo; trading of favours now for favours in the future. 

I call it back-scratching, and it is a topic I have been researching for three years.

While trading favours can lead to amazing levels of productive human cooperation, it can also generate a considerable amount of unproductive cooperation when the trades benefit the few at a cost to the many. More than that, back-scratching can come with substantial efficiency losses; the costs to outsiders can far outweigh the gains to favoured insiders.

The revolving door between regulators and the regulated is one clear mechanism sustaining back-scratching. Ben Bernanke is just the latest long list of powerful regulators swinging through this door.

But studying back-scratching in the wild faces a major problem. Favours are almost impossible to objectively observe. Not only is there a powerful incentive to conceal favours, determining the ‘no favour’ counterfactual is almost impossible. Was the government contract given to the most efficient firm? Or was it a favour to the winner because an alternative bidder could have delivered a better outcome for the price? More often than not we just don’t know.

I have a new working paper out reporting an experiment on the economics of back-scratching. Studying back-scratching in a controlled experiment, while sacrificing realism, allows a close examination of the fundamental cooperative processes at play. The ‘big new thing’ I was able to do, in light of the long history of cooperation games in social psychology and economics, was to measure costs of back-scratching against an efficient counterfactual, and test which institutional designs encourage or curtail back-scratching.

To be brief, the basic experiment has 4 players in a group (the minimal number for an in-group and out-group to form), with one player able to choose which of the others to receive a prize of $25 in a round (in experimental currency). The payer who receives the prize allocates a fresh $25 the next round to one of the other three.

Obviously the best thing to do is form a back-scratching alliance with one other player and trade the $25 favour back and forth. Over 25 rounds an alliance pair would make $625, while the other two would make nothing.  

What makes back-scratching costly is that each of the potential recipients is given a randomly shuffled ‘productivity number’ each round, either 1, 2 or 3, which determines a payoff for everyone in the group. Each player gets an amount equal to the receivers productivity number in a round. Give the prize to the player who is 1, the group gets $1 each. Give the prize to the player with 3, the group gets $3 each. Think of this productivity number as reflecting the efficiency firms competing for a government contract. 

To sustain a back-scratching alliance means not choosing the most productive player for the prize in two-thirds of the rounds. It earns the alliance $725, the outside group $100, and comes with an efficiency loss of $100 from the repeated non-productive choices.

It turns out that most players repeatedly formed alliances, even though they were young honest university students who didn’t know each other. In real money terms (rather than experimental currency) alliance pairs ‘stole’ $30 from the outsiders to increase their alliance earnings by $20.

Surprisingly alliance players were happy about their actions. They thought they had been very cooperative by doing their mate a favour, and didn’t feel guilty about the costs they imposed on others. They also rationalised their behaviour, saying that forming an alliance is a justifiable strategy, while also concealing it by lying when explicitly asked in a later survey if they had formed an alliance.

I tested two institutional changes in the experiment. Staff rotation, a common anti-collusion policy, and a low-rent policy mimicking bureaucratic procedures to limit the size of prize able to be allocated with discretion. Neither was particularly effective at stopping back-scratching. I also manipulated the strength of relationships between players.

For me the take-home lessons are:

• Loyalty is strong. Rotation policies are good, unless those people being rotated in have existing loyalties. This means there is a trade-off for regulators; staff with more industry experience are also likely to come with stronger prior alliances and hence be more prone to back-scratching. In politics it means voting in a different political party brings with it the alliances of that party.

• Bureaucracy can work. The array of procedures emerging in our large organisations could simply be the result of seeking internal fairness over favouritism. But back-scratching can still arise even with minimal amounts of discretion.

• Social norms are strong. In organisations or groups where some people are observed ‘doing the right thing for the group’, this quickly becomes the norm. Whereas where favouritism is observed, the group descends into counterproductive back-scratching.

• Be loyal, but not too loyal. If your alliance partner fails to come through with favours when expected it pays to look for someone else whose back needs scratching.

None of this is really rocket science. If this sounds obvious to you then you’ve probably learnt a lot about human behaviour through life experience. It also means the experiment is capturing some elements of real phenomena.

After spending three years researching this topic, of which this experiment is a small part, I have come to the conclusion that group formation through favouritism is probably the primary determinant of political outcomes. Countries themselves can even be seen as a loose alliance of insiders looking to do what’s best for themselves even when it comes at a cost to other countries.

And if you look deep enough there is an evolutionary foundation for this behaviour. As Joshua Green explains:

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

This. Fundamentally. Is why corrupt back-scratching is so hard to eradicate, and why it will continue to be the main game in politics.

Self-censoring on superannuation

When applying for a job recently I was asked to write a 500 word opinion piece about using superannuation funds for home deposits. I didn’t get the job so there is no reason to waste 500 good words; I’ve published the piece at the bottom of this post.

But that’s not what this post is really about.

I am writing this post to reveal that I severely self-censored in that opinion piece. Those are not my genuine views about superannuation. Like many before me I twisted my words to fit within the Overton Window of acceptable public discourse. Maybe it was the wrong thing to do. But I did.

I want to say what I really think, even if some find it too far outside the range of acceptable conversation.

My view is this: Australia’s superannuation system will not survive another 30 years in its current form, or anything like it.

The reason for that view is that there was never an economic logic for a compulsory superannuation system in the first place.

The modern superannuation system was introduced in 1992 to relieve pressure on the age pension system by forcing all workers to save for retirement reduce wages and has since been reinterpreted as a retirement funding system. But forced saving does nothing to address the fundamental problem of a shrinking workforce - all the income streams drawn down from superannuation upon retirement rely on purchases of assets from those currently working. The net effect is exactly the same as if the working population simply gave retirees money through the tax system. Any problems with the age pension system due to demographic change also affect the superannuation system.

Furthermore, the problem of a shrinking workforce has been dramatically overblown. While the age-dependency ratio will increase when baby-boomers retire, this effect will be balanced out by relatively fewer births and a declining youth-dependency ratio. On balance, the share of the population out of the workforce under the worst-case population growth scenarios (yes, higher population growth makes the dependency ratio worse), will peak around 70% - exactly the same as the 1960s and 1970s.

To be clear about how the same demographic patterns affect the superannuation system just as they do a public pension system we must think in terms of goods and services produced in aggregate, and assets and their prices in aggregate.

In aggregate, the total goods and services produced depends on the size of the workforce and installed capital. Whether boomers retire in pensions or superannuation incomes, the rate of growth of this total production will be lower as the growth rate of the workforce decreases.

This lower rate of growth of goods and services must still be shared amongst all workers and retirees. Who gets what out of the economic pie depends on who has which rights - which claims on incomes streams in any form, either assets, public pensions, or wages. Under a public pension system workers give up some of their rights to wages by paying taxes which would go directly to the pensions of the retired. Under a private superannuation system, workers give up some of the rights to wages to buy assets, which would be sold by retirees who had previously accumulated them, in order to provide a retirement income. The net effect of both of these schemes, shown below, is identical.


Whereas with public pensions it is clear that more retirees in the population requires larger contributions by workers to support them, the superannuation system disguises this element. It does this through incremental changes to the minimum contribution requirement - from 4% of wages in 1992 to soon 12%, along with increases in the preservation age, from 55 as of this year, to 60 in 2024. This means that new contributors to the super system pay more and get less - exactly as would occur under a public pension system when increasing pension funds come from direct transfers from the workforce.

What’s more, the net effect of superannuation as a mere transfer between workers and retirees will become all too obvious when the ever-growing rate of new money pouring into the asset classes held in superannuation accounts begins to fall as the rate of superannuation drawdowns grows faster than the rate of new contributions. In the chart below the benefit payments in green will increase faster than the contributions (the red, blue and purple) as boomers begin to retire en masse.





When this occurs, the asset classes that dominate the super system, like Australian shares, will see fewer buyers and more sellers, depressing currently inflated prices and reducing the investment income of superannuation account holders. With lower account balances more funding will be needed from public pensions anyway. To be clear about this asset price effect, does anyone think the share market, or even the property market, would be at its current value without the massive inflow of funds from the compulsory super system?

Depressed incomes from super accounts will again see the need to increase contributions, or increase public pension funding, or otherwise rejig the rules to inflate asset prices at the expense of wages.

At the moment the music is still playing. But in the next 20 years there will be a generation who puts more than 12% of their wages into the super system for half their working life only to find the system requires a complete rethink. They will lose out due to their demographic destiny with the superannuation system, just as they would with a public pension system only. But the super system allows us to pretend that this is not happening by disguising transfers as investment.

This is the big issue with Australia’s superannuation system, and one that is till now outside the range of acceptable discourse. In any case, here’s my self-censored opinion piece.

...

Hockey’s housing ideas are anything but super

If you think home ownership is out of reach for the average family in Australia today, you ain’t seen nothing yet.

If Federal Treasurer Joe Hockey has his way, superannuation funds could be used by first-time buyers as a home deposit.

Taken at face value, Hockey’s idea reveals a deep misunderstanding about not only the role of superannuation in the welfare system but of the housing market itself.

Worse still, allowing access to super accounts will increase prices above even their current astronomical levels.

Compulsory superannuation was introduced in 1992 to anticipate and counteract the age pension tidal wave as baby boomers entered retirement.

Yet one big issue we are seeing as this demographic tidal wave approaches, is that many retirees have low superannuation savings, but very high home values, yet they are unable to tap into their home value to generate a retirement income.

The great majority of retirees prefer the stability of their own home within their local community, and are unwilling or unable to use their home as a source of income during retirement.

Directing more retirement savings into home ownership will only amplify this problem, rather than amplify retirement incomes as superannuation was designed to do.

While reforms could improve the ability for retirees to utilise their home values to generate retirement incomes, one thing that cannot change is the economics of the housing market.

Hockey’s proposal would produce a massive boost in buyer activity and turn superannuation funds into subsidised quasi-home deposit accounts, with associate tax savings advantaging the highest income earners.

Like many home buyer initiatives, such as the First Home Buyers Grant (FHBG), increasing buyer purchasing power has a clear and definite effect of increasing home prices, negating its supposed benefit and passing it directly to the home seller.

To see how this works, imagine you are at a home auction, and after great excitement and fanfare, the bidding has stopped at $500,000. The final two potential buyers are now on edge as they decide whether to tip their hats one more time.

In one scenario the second buyer stays quiet and the home is sold at that price.

But in another, the government steps in and allows the last two bidders to use their super accounts to help buy the home, or alternatively give them a FHBG. What do they do?

The extra funds allow the auction to continue as the losing bidder sees value in outbidding the previous winning price, and the previous winner is able to also outbid that new price.

This only stops when the extra buying power from the new regulations is completely absorbed into the price. If it was a $7,000 FHBG, the sale price would be $507,000.

It is clear then that Hockey’s proposal is at odds with the intention of using superannuation to provide retirement incomes, and by making the housing market more expensive, will completely contradict its intentions of facilitating home ownership and saving.

Macroeconomics = Fallacy of Composition

I am teaching an introductory macroeconomics course for graduates this semester at the University of Queensland. Coming up is soon is the AD-AS model and I must say, I’m having a hard time generating useful tutorial questions for my students.

The illogical contrivances required to interpret any real economic events in terms of the model are almost laughable. I've asked a number of experienced macro teachers in the school to explain the model to me in an internally consistent way. It turns out that most economic professors don’t have a clear grasp of what aspects of the macroeconomy the model is meant to be capturing. None could explain what the concept of the price level in the aggregate even is, nor what mechanism was meant to be at play in generating the relationship between price level and output. If anything I learnt that I should use the curves to support some kind of Keynesian story-telling exercise.

What kind of serious intellectual could be happy with this situation? Is this the way we pass on our discipline’s knowledge to the next generation?

So far my tutorials are looking quite different from your typical introduction to the AD-AS model. More like an introduction to defending oneself against the claptrap sprouted by many economists.

Perhaps we may soon leave this nonsense out of economic teaching altogether. Here's my compromise for the time being.

Question 1

What is the fallacy of composition?

Create a list of phrases, sentences or paragraphs from the description of the AD-AS model in Chapter 10 of the textbook that commit the fallacy of composition.

Additional reading material is here, here, here, and here.

Discussion

A common definition for the Fallacy of Composition is

the fallacy of inferring that a property of parts or members of a whole is also a property of the whole

In terms of the study of macroeconomics this is of particular interest, since we are trying to take lessons from the behaviours of individuals and determine the likely aggregate response in the economy as a whole.

Here are some examples from Chapter 10, though many others may be included.


1. The aggregate demand curve shows the relationship between the price level and the quantity of real GDP demanded by households (p268). 



The AD curve is downward sloping because a fall in the price level increases the quantity of real GDP demanded (p268)



The fallacy at play here is that there is an aggregate price level. As we saw in Chapter 8 on Inflation, price levels are not absolute but relative to some base year. In the economy as a whole there is no external price from which to determine a price level. Hence the idea of an economy-wide price level is in a given time period is a fallacy. 

Often the AD-AS model is interpreted as showing Real GDP related to the rate of inflation in a period (not the level, but the rate of change of price levels relative to a base year). This overcomes the fallacy of composition because it compares the price level with last year’s price level, but contradicts earlier discussions about anticipated vs unanticipated inflation. If inflation is anticipated at any reasonable level then there should be no economic effect, and hence no relationship (no curve, or a vertical line at best).


2. As income rises consumption will rise, and as income falls, consumption will fall (p269)



In aggregate the total consumption (or demand) in the economy is equal to the total incomes in the economy be definition, since someone’s consumption is somebody else’s income. This sentence, allowing from proper aggregation that avoids the fallacy of composition, merely says that aggregate incomes and consumption just rise and fall together since they are equal at any point in time by definition. 



3. When prices rise, households and firms need more funds to finance buying and selling. Therefore when the price level rises, household and firms try to increase the amount of funds they hold by withdrawing from banks, borrowing from banks or selling financial assets, such as bonds. These actions tend to drive up the interest rate charged on bank loans and the interest rate on bonds. (p269)



First, if all prices rise then households and firms also have more income, since wages and profits are also prices in the economy. 



Second, as we discussed in Chapter 4, Measuring GDP, transfers of financial assets are not included in gross value added because they are mere transfers between on individual and another. Hence, a household selling financial assets requires another household to buy those financial assets leading to no net change in the aggregate ability of households to spend on current consumption. 



Third, if these actions have no aggregate affect by their own definitions it seems implausible that there will be aggregate affects on interest-rates (another price) set in the economy.



The end of the paragraph goes on to admit that it just committed the fallacy of composition when it says



The impact of the price level on investment is known as the interest-rate effect, and is a second reason why the AD curve is downward sloping. However there is caveat to this explanation. Lenders to banks and other financial institutions - people with savings are lenders - will have their wealth increased as the interest rate rises, and will increase their consumption spending. 



Essentially this contradicts all that went before it. In addition, the wealth effect on savers is incorrect in general (higher interest rates decrease the value of financial assets, not increase it).


4. Table 10.1, government purchases and tax effect on AD curve (p272).



The second and third rows in Table 10.1 show; 1) the effect of an increase in government purchases on, 2) the effect of an increase in government taxation. If the economy is at equilibrium prior to and after either of these changes then by definition one effect must counteract the other - the shift of the AD curve from an increase in government purchases must be accompanied by an equal and opposite shift from an increase in taxation. 


5. Because changes in the price level do not affect the number of workers, the capital stock or technology, in the long run changes in the price level do not affect the level of real GDP (p275).



This contradicts all that went before it, and relies on an undefined notion of the short and long run. How can there simultaneously be both an effect and no effect?


6. The main reason firms are willing to supply more goods and services as the price level rises is that, as prices of final goods and services rise, prices of inputs - such as wages of workers to the price of natural resources - rise more slowly. Profits rise when the prices of the goods and services firms sell rise more rapidly than the prices they pay for inputs (p276).



Here we see the fallacy of composition result in many confusing comments. First, the inputs of one firm are the outputs of another firm, hence in aggregate input and output prices cannot differ systematically.