Economic thoughts

1. Why is work virtuous?

I know many people who think it is. But at the same time, accumulating wealth and assets, giving the ability to generate passive income and not work, is also seen as virtuous by the same people!

Unfortunately, these hidden beliefs and biases are extremely common in economic thinking.

2. Why don’t we ever think about the opportunity cost of this spending?
It’s one of the privileges of living in a rich country to spend so much on the military will little public debate. Australia’s military budget this year is $32 billion. Over the next decade, we will spend around half a trillion on the military, much of it wastefully on expensive foreign-made hardware of questionable merit.

If we cut military spending in half over the next decade, spending only a quarter of a trillion dollars, rather than a half a trillion we could do these four things with our spare quarter trill:

1. Replace all electricity generation with renewables - $40 billion (16% of savings)
The basic calculation here is that large scale solar costs about $100MWh at the moment and the country uses 220 million MWh a year. Multiply these magic numbers together. Boom.

2. Fund wildlife conservation in all of Africa for the decade - $25 billion (10% of savings)
Total cost estimates are around $USD 1.9 billion a year to fund proper wildlife and national parks management in southern and eastern Africa. The continent has had a massive increase in poaching recently, and a breakdown in some of the governance structures that formerly were somewhat effective. Obviously flashing that kind of cash needs careful consideration, but if we can coordinate half a trillion of military spending, we could give it a shot.

3. Build a world’s-best fibre optical network - $60 billion (24% of savings)
This would cover all the capital costs, with users paying just for ongoing operational costs.

4. Give every household $1,400 a year in cash for the decade - (50% of savings)
We have to do something with the rest!

3. Does the market really allocate many resources in a "market" economy? 

Unlearning Economics asked it a few weeks back, noting a recollection of a study suggesting that markets only allocate 20% of resources.

Recall Ha-Joon Chang claiming Herbert Spencer found 80% of resource exchange is done outside markets. Anyone know where/if (roughly) true?

— Underworld Economics (@UnlearningEcon) September 9, 2016

A few years back I would have thought that estimate was reasonable. Now, I think it’s closer to zero.

Think about the fundamental ratio here. In the numerator are resources allocated by markets (which needs defining). On the denominator are all resources able to be potentially allocated by markets. In fact, all resources require some degree of allocation amongst humans. This is a massive “amount” even just sticking to earthly resources (ignoring the moon, Mars, other extra-planetary resources, the deep ocean, the upper atmosphere etc.).

In terms of land (or more precisely locations), we have the oceans, Antarctica, all public land in every country. Then on private land, we have resources allocated without markets. I don’t charge my kids for their bedrooms. But there is a market for renting rooms. I just choose not to use markets for this. So kids bedrooms are resources that should be on the denominator.

When you think about it, the denominator gets insanely massive very quickly. Take the labour market for instance.

Each person has 24hrs a day in which they choose what to do with their time. Lawyers charge their time in 6-minute increments, demonstrating that, in principle, we could each trade our labour in 6-minute blocks 24hrs a day from birth.

But we don’t. At most, we trade 20% of our time each working year in markets, and about 60% of a lifetime working, so that’s 12% of labour time in the market for a worker who works a full career.

Many people don’t work at all, so we can tweak that lower, and if we look globally, even less formal labour market participation exists, so perhaps we can halve that to 6% of potential labour market resources traded in markets.

But it is surely worse than that if, unlike lawyers, most labour time itself is allocated on the whim of the labourer because they are paid only each week, month, or year, for an agreed outcome. Thus, the allocation of time each day, even for your typical full-time employee, is not the outcome of market forces. It is instead allocated much more cheaply and efficiently through other hierarchal and bureaucratic mechanisms with a firm.

So in terms of the labour market, we must surely be down to some fraction of a percent of resource allocation done by markets.

Overall, the allocation of resources done by markets as we would strictly define them in economics, must round to zero.

* The image at the top of the post is from here. It is a reference to Herbert Simon's paper Organizations and Markets which asks what a "market" economy would look like to aliens.

Lobbyists own QLD planning

A draft of the new SEQ regional plan, a document that the State government uses to direct the development plans of local councils, is out this week.

Yeah for Queensland!

But I noticed something a little strange. It is this mysterious red shading with the word Undullah on it. From Map 24 (find it here). The red means “Draft Urban Footprint”. So no longer are uses on that land limited to rural or agricultural activities. Bring forth the bulldozers, there’s a residential subdivision to be made!

What an unusual shape though. I wonder how that decision was made?

Oh. Look what I’ve found. Here’s a map from planning application made to Logan City Council in 2015. In this map the urban footprint is only the blue hatched area, extending west only to the blue line. The yellow marks the land owned by the person making the planning application. This application did not comply with the planning rules when it was made.

Maybe I’m jumping to conclusions. Maybe there’s a legitimate reason to draw a new planning boundary around this one landowner's land, giving them a multi-million dollar windfall gain from this planning decision. My guess of the value this planning decision to this landowner is somewhere in the order of $80-150million. Give or take.

I’m sure if we had an investigative body look into this, there would be no evidence at all of misconduct or improper use of powers by anyone involved.

Or maybe just read the whole back story here and make up your own mind.

A private land titles office is bull$hit

The privatisation agenda knows no limits.

NSW has passed legislation to allow the sale of their land titles office. This is foolish. The land titles office serves as the record of property rights across the country. Its database has a government guaranteed final say on who owns what land and property in the state (under a Torrens Title system). Every sale is recorded there, and every mortgage or lien against any property is recorded there. The database forms the foundation for administering state land taxes and local rates.

How does the government thinks it can regulate a private owner of the titles office to ensure better public outcomes than when it is actually the owner and manager of the land titles office? What magic are they expecting to find? This is a pure gift to the private sector, and I would not be surprised to find whoever wins the bid for the sale will be repaying politicians for the next decades with cushy, high-paid jobs.

The financial logic makes no sense either. If it is worth buying for a private party because of the future returns, than it is worth the government owning it for these same high future returns. The financially logical thing is for the NSW government to borrow at its cheap 2-4% rate and buy it back!

My view is that the land titles database should be freely available to the public. Currently access is sold on a lot-by-lot basis, or in bulk through data-resellers such as CoreLogic (a likely bidder in the sale). It is expensive, and charging for access conflicts with the promoted views of both sides of politics about government transparency and accountability. Knowing who owns what property should be available to everyone, not just cashed-up interested parties. Like many other public record systems, it can be funded by those who benefit from its existence, in this case, property owners.

My questions about the planned sale are these.

1. Will the State Revenue Office be charged to access the register in order to administer land taxes?
2. Will there be regulation to limits price increases on access to bulk data to resellers?
3. Will the State government reman liable for compensation of loss caused by private fraud or by errors made on the registry? This includes, for example, from hacking, IT failure, natural disaster etc. 
4. Is there evidence that the titles registry is inefficient compared with similar systems globally?
5. Is there evidence that privatisation of titles registration generates either a) cost savings, and b) reduced costs of access to data for the public?
6. Given that the title office generates income for the government, would it be better to retain that income source to pay for other government investments?
7. What alternate options were considered to generate the revenue that would arise from the sale of the titles registry?
8. Will the sale of the titles registry restrict purchase of the titles registry by foreign entities?
9. Have any assessments been made of whether free public access to the land titles register provides a net economic and social benefit compared to the current system of paid access? Texas, for example, has such a system with free public access.
10. What are the total costs of the sale expected to be? Rumours of $4.5million for the sale costs of the NSW registry suggest they are high. 
11. What are the core regulations that will ensure reasonable and fair access to a privately owned land titles register, and who will enforce these regulations?'

I highly doubt that there are sensible answers to any of these questions. The NSW government is now firmly part of the corporate-mafia.

Future of health & retirement is public, not private

Despite the best efforts of the big end of town to get a free slice of the economic pie with subsidised private health and retirement insurance, this endeavour is a dead end. I say this because the core economic elements of each industry mean that the public systems will be forced to grow once again due to people selecting out of the private system over time, subsequently increasing political support for the public system.

Many readers have probably already noted just how difficult it is to keep these private insurance schemes propped up. Private health insurance requires taxation penalties for it to be taken up in large numbers, while the superannuation system has always relied on compulsion to get wage earners to pay into it, along with tax advantages, matching of savings by government, and periodic increases of compulsory rates of payment.

For the free market ideologue who hates big government, our current situation of small government using its powers of taxation and compulsion to force people into a situation of “private taxation” should be even crazier than the socialist view of big government funding and delivering health and retirement schemes. Not only is there no clear ideological reason for these markets, they suffer from a number of fundamental economic problems that make them rather unsuitable for provision in a private market.

The first fundamental economic problem in both of these sectors is that people remain implicitly insured by the government anyway. People with private health insurance are still able to treated at public hospitals, and those whose quickly burn through their private retirement savings will then rely on the public pension. The private systems simply add an extra layer of financial complexity (aka bullshit financialisation) to an ultimately public system.

The second fundamental problem is that the quality of the products sold in the private systems is impossible to judge. This means that there cannot be any genuine competition amongst players in the market. This is true for the financial insurance product itself, and in the healthcare sector, the health treatments as well. In superannuation, Australian’s pay annual fees of almost 1% more than other countries like Denmark or the Netherlands on their superannuation, or about $16 billion per year in fees that are pure economic losses to superannuation members. It's a rort.

Third, both schemes rely heavily on new members paying in more than what other members are receiving. Inflows to the superannuation system each year currently exceed outflows by about $50 billion (see graph below - red and pale blue inflows vs green outflows). This massive amount of money chasing the same pool of assets (predominantly domestic shares, bonds and property) has kept asset prices up. In about a decade’s time, when the retirement of baby boomers peaks, there will be net outflows from the system. The shift of superannuation from the demand side, to the supply side, of financial asset markets will depress prices, further undermining the ability of the system to fund the retirements of its members who will turn to the public pension.

The same baby boomers who will trigger the downfall of the superannuation will also undermine the private health insurance market. They will be the beneficiaries of far more healthcare after they retire simply because old people are more likely to die each year, and dying is expensive. This too will put pressure on the net cash-flow position of private health insurers.

Apart from these problems, the apparent economic rationale of having private insurance in these markets to reduce public debt makes no sense, even from an economic perspective. It is just an accounting trick. Economics teaches us that real resources are what constrains our productive output, not the balance sheet of different organisations. This is all the more obvious because the government is using its power to make contributions to these private insurance schemes compulsory, making them no different from taxation anyway.

As these economic problems become obvious in the next decade it will surprise many economists and policy analysts who have ignored them for too long.

Zoning nonsense: first Houston, now Japan

Advocates of the “zoning can fix housing bubbles” point of view seem to have two main examples in mind. Houston, Texas, and Japan as a whole.

I have absolutely no idea why these examples are supposed to support this point of view. There are two good reasons not to use them as examples. First, both areas have planning controls. Second, both areas have had real estate booms and busts of epic proportions.

1. There are planning controls in these areas

Houston development is controlled by an array of ordinances and codes that are very similar to those I am familiar with in Australia. The main difference being that areas are not partitioned by types of uses, or zones. Yet no one seems to have a story about why allowing other uses to outcompete housing on a particular plot of land is beneficial for housing supply.

In Japan, there is a similar system, whereby a “ladder” of zones allows all use types from that rung and below. Again, allowing other uses to outcompete residential never seems to bother anyone making claims about planning being a barrier to total quantity of new residential development.

Some people also cite Germany’s “right to build laws”, but these are little different from Australian planning laws that allow for “self-assessable” development. If you comply with the code, you just inform the authorities that your development fits within the code. Nothing different at all. It is just that because there are so many freebies up fro grabs by exceeding the code, just about everyone tries to do it!

2. These areas have had major bubbles

Japan had the worlds biggest real estate bubble in the 1980s; one that is credited with causing their three decade stagnation in asset values and persistent deflation. That sheer unbelievable scale of that bubble is shown in the figure below.

Houston had a similar 1980s price bubble, with prices rising and falling 40% in real terms from the 1982 peak. And Houston is at the peak of another boom that has seen prices double in the past four years. Exactly what effect are the zoning rules meant to have had in respect to avoiding speculative bubbles in housing markets if these are the best examples around?

Some people want to argue that despite these bubbles the price to income ratio is relatively low. But this is a foolish measure; prices do not reflect the full cost of ownership, which includes interest rates on mortgages, property taxes, and even expectations of price growth. Any city can bring down this ratio by increasing taxes on residential land or increasing mortgage interest rates.

For a while I was tempted by the view that perhaps there are some effects from zoning on the overall market that I was missing, but the more I dig, the more the evidence is piling up against this view.

Give us a child at 10 and we will show you the debt

The article quoted below, by editors of The Australian, was shared on Facebook, to which I responded rather pointedly:

It's an absolute nonsense article, and a bullshit cover story for a blatant agenda to get public assets into the hands of "mates of Murdoch".

In the economic circles I travel it can be socially risky to be so blunt about points of economics that have divergent and strongly held views.

So I want to pick apart the story, piece by piece, to show how the words are spin and misdirection dressed up as hard economic truths. The title of this post is the title of that piece. Threatening? A little.

Here we go:

A child born in Australia 10 years ago began life in a country whose national government had zero net debt. These children had the great good fortune of starting their lives with the unlimited opportunities of our diverse economy, the freedoms of our liberal democracy and the advantages of our universal education, health and welfare systems. With no net debt, Australians of just a decade ago owed nothing to their forebears but gratitude and nothing to future generations but their diligence.

It’s not true that have no net federal government debt means what they say - a virtuous social timeline of perfect opportunity. Because federal government debt is owned by someone as well. And the next generation will inherit both the liability and the asset side of the debt. It also ignores the many other gross liabilities the next generation inherits in terms of, for example, having to buy housing from the past generations at exorbitant prices. And lastly, the education, health and welfare systems will survive regardless of the debt picture, so to announce them to be implicitly at risk because of debt is pure scaremongering.

But each child born this year bears the burden of a net federal government debt of about $13,000 per capita. With any luck these children will aspire to the same opportunities — but, apart from paying for the education, health and welfare systems, they will have to find a way to service and repay a $300 billion debt. This is their generational burden and this is the inequity we grapple with: do we have the right to fund our own comforts through deficit budgets and extended borrowings that merely pass on the burden to future generations?

This is absolute nonsense. It’s “time travel” economics to pretend that a resource burden can be passed through time to a future point. Debts simply facilitate a transfers of resources at one point in time between lender and borrower, and another transfer at a future point in time between borrower and lender. The next generation inherits not only the $300billion debt, but the $300billion asset in the form of government bonds as well! There are certainly major distributional questions about who owns these bonds, and many are owned by foreign entities - something which this article ignores entirely.

On the surface, we are going about our business happily enough. The unemployment rate is lower than in most developed economies, interest rates are at historic lows, our dollar is defiantly strong, petrol is relatively cheap and travel has never been more affordable. Despite the GFC, sluggish global growth and the end of the mining investment boom, real estate prices remain buoyant, underpinning personal wealth as the nation notches 25 unbroken years of economic growth. Government services and payments such as the National Broadband Network, National Disability Insurance Scheme, paid parental leave scheme and subsidised childcare have been expanded across the decade while additional funds have been poured into health and education. It may all seem a little too good to be true.

It’s not too good to be true. These are the types of social benefits all countries invest in as they get wealthier. And you could say the same thing at any point in history. Also, suspiciously absent is the spending in submarines and other “wasteful” schemes.

If we dig beneath the surface we can see that our economic and budgetary situation is perilous. Investment levels have plunged from extraordinary highs and in the past year wages growth was 2.1 per cent, the lowest since the last recession. The federal government’s net debt position has deteriorated from zero a decade ago to more than $290bn and will rise to almost $350bn within three years. The interest costs on the debt, even at historically low rates, already total more than $1bn a month. Household debt is at record levels. When state public debt is included, government debt amounts to more than 36 per cent of gross domestic product. The debt situation is not out of control but it will be if it is not arrested.

Investment levels have nothing to do with government debt. Indeed, the rush to pay off debt could arise because many public investments are trimmed back. It is actually much easier and cheaper for the government to borrow for investment than the private sector. At exactly what level, besides zero, do they think would be “out of control” debt? They sneak in a cab at household debt, but I am quite sure none of the writers think that household debt should be zero.

With these mounting problems we seem to be living in something of a fool’s paradise. While GDP growth remains comparatively encouraging, with expectations it can be sustained at 2.5 per cent, much of the economic activity is in the deficit-funded public sector. As we report today, annual public sector wages growth has outstripped increases in the private sector and hours worked have grown by almost 2 per cent in the non-market economy while they have barely risen in the productive sectors. In the past eight years, the non-market industries have boosted hours worked by almost 25 per cent while elsewhere the growth has been below 5 per cent. The states are leading this process, with state public employee numbers growing by 10 per cent from 2008 to last year to total almost 1.5 million while the federal public service headcount remained static. These trends, combined with diminished terms of trade, demonstrate an unsustainable position.

Pubic sector wages have seen recent increases, but if we look just a few years back, the opposite was the case. Strangely enough, State government employees have risen 10% since 2008, which is exactly in line with population growth.

None other than the outgoing Reserve Bank governor, Glenn Stevens, issued a warning last week. He spoke about the “difficult choices” required to get the federal budget back to balance and to foster growth. He noted how the debate had become predictable after agreement was reached on the need for fiscal repair. “When specific ideas are proposed that will actually make a difference over the medium to long term,” he said, “the conversation quickly shifts to rather narrow notions of ‘fairness’, people look to their own positions, the interest groups all come out and the specific proposals often run into the sand.” Mr Stevens warns that unless this challenge is overcome public debt will become a “material” problem.

What Glenn Stevens said “Well, actually it matters how you got the surplus; it matters what you did with it. And even if you're reducing debt, it matters how you do that, and what the debt is for. A country with no debt but no public assets, is that actually good?”

Malcolm Turnbull tackled all this in a speech this week. He dared the opposition to work “constructively, co-operatively” on the economic and budget task, and warned that failure would hurt the most disadvantaged. “Unless we deal sensibly with the challenge of living within our means,” the Prime Minister said, “Australians, and our children and grandchildren, will be facing a future of higher taxes, higher public debt and, ultimately, a reduction in the quality of services our society wants and expects.” This is where the clear and present economic and fiscal danger runs hard up against political risk. Bill Shorten has declared “Labor’s up for budget repair which is fair”. But he is demanding Labor’s agenda rather than recognising the government’s mandate, and throwing in a good dose of anti-business, class-warfare rhetoric. “Mr Turnbull could improve the budget bottom line dramatically by not going ahead with the $50bn of tax giveaways that he wants to give large companies,” the Opposition Leader said.

This is just quoting professional liars arguing.

As a nation we need to think about what benefits and liabilities may confront children born a decade from now. Politicians from both major parties, and Senate crossbenchers, need to consider whether fiscal decline and mounting debt can be left for another generation to tackle. Because nothing is surer than the simple fact this nation will eventually be forced to live within its means. The question now is whether we will roll up our sleeves and make this a national project of considerable priority so we can manage the task sensibly over time, or if we will kid ourselves that all is well enough until we are confronted by calamity, forcing a sudden and ugly reckoning.

Doom. Fear. Reiterating the nonsense that come before. Exactly how can we live beyond our means. We can’t bring resources forward from the future - taxes and debts are just alternative mechanisms for making current redistributions.

Even if you buy into the fear, there are many easy ways to fix government budgets: inheritance taxes, betterment taxes, and more. And there are bad ways to do it, like privatising assets, which in the hands of the public would have generated future incomes. But you can be certain that the authors of this article will spin this fear in the direction that support the economic interests of their mates, even if it makes less economic sense than what they have already argued.

RBA wants one-sided coin on foreign capital

The below excerpt is from an interview with RBA Governor Glenn Stevens on 15th August 2016, on the topic of foreign capital. It made the front page of the nation’s most popular newspaper. Read it closely, particularly the bold part.

That’s not something that the Reserve Bank can wave a wand and make go away. Australia wants to be open to foreign capital. That’s our national philosophy. I think in that discussion, it would be helpful to think about the kind of foreign capital we want. 

 

Foreign capital that builds new assets, like some of the capital that funded the mining boom. That’s one thing. Foreign capital that buys up the existing assets, I’m not saying that we should be closed to that, but that’s not creating new capital for the country, that’s just altering the allocation of who owns the capital that’s here now. 

 

And I think when we all talk about – you know, we want capital inflow, we can probably have a bit of nuance and subtlety over what kind of inflow we mean and ask ourselves whether we’re attractive enough to the kind of capital that actually builds new assets.

I think the Governor is confused here. He appears to be reiterating some all-too-common economic nonsense by using the word capital with two different meanings in the same breath. By doing so he seems to want an outcome that is beyond the realm of accounting reality.

He says that capital, in its strict economic meaning of machines and equipment, is good to have foreigners invest in. These help create new productive “assets” [1]. Then he says that capital, with its financial meaning of non-current assets (like bonds, equities, and property), is not good to have foreigners invest in, because it is just a transfer of ownership of existing assets.

This is weird, for two reasons.

First, economic capital is just a type of good. Foreign economic capital is therefore just the importation of machines and equipment from abroad. To be clear, in this analysis I will use the term Good Foreign Capital to mean imports of machines and equipment. But mining booms aren’t funded by gifts of machinery. They are built with them, but these machines need to be paid for.

Second, if you import more Good Foreign Capital than you export, the gap must necessarily be made up by sales of assets to foreigners, or “altering the allocation of who owns the capital that’s here now”, in the words of the Governor. You can begin to see the problem. I will call selling existing assets to foreigners Bad Foreign Capital.

In the above table, showing Australia’s 2010/11 external accounts, Good Foreign Capital is an import, with a negative sign. Because all accounts balance, this import of mining machinery can either be balanced by exports, or Bad Foreign Capital (labelled Direct and Portfolio investment abroad), both of which have positive signs [2].

If Good Foreign Capital is balanced by exports of other goods and services, we are in a world with a zero foreign investment on balance. Inwards Bad Capital equal outwards Bad Capital. Overall, there is no Bad Foreign Capital. But there is also no net Good Foreign Capital either. If Glenn Stevens wants to balance trade, he should just say it.

However, if Good Foreign Capital is paid for with Bad Foreign Capital, we are in a world of with a positive capital account balance (and a negative trade balance), as Australia has been for all but a handful of the last 150 years. Economists have mostly seen this as a good thing, by justifying the Bad by its offsetting Good. You cannot have a trade deficit, or net Good Foreign Capital, without paying for it with Bad Foreign Capital.

A simple example could help clarify.

Imagine a local miner who has the rights to extract coal in an area, but not the local funding to build  up the mine with the necessary equipment. They enter into a joint venture with a foreign company. That company supplies the foreign-made mining equipment for a share of the equity in the project.

This could be the type of example Glenn Stevens has in mind when he talks about Good Foreign Capital. But in fact, it is an example of using Bad Foreign Capital funding Good Foreign Capital. The imported machines are funded by the sale of the equity stake by the local miner, which is totally non-productive and a mere “allocation of who owns the capital that’s here now”. The two types of capital are two sides of the same coin in this example. And they are also two sides of the same coin at a macro level, given the entrenched nature of Australia’s foreign position as a net seller of assets which funds its trade deficit.

What Glenn Stevens seems to be saying is that he wants to increase exports to pay for Good Foreign Capital, which would bring the capital and current accounts closer to each balancing on their own. This requires the Aussie dollar to be substantially lower in order for our producers to compete internationally, particularly when many of the world’s central banks are already involved in depressing the value of their currencies. This outcome can be achieved by directly limiting asset sales foreign entities, or by intervening in foreign exchange markets. Yet neither of these two main options, which are used by other countries to great effect to manage their external position, seem to even be in the discussion.

The big mystery to me is why Glenn Stevens mentions these things now when he has had the power to intervene in currency markets in the interests of long-term Australian growth for a whole decade. Instead, he seems to be promoting a public debate that instead focusses on a magical, “one-sided coin solution” that is an accounting impossibility.

fn [1]. I also believe he uses the word asset to mean each of the two different types of capital.
fn [2]. I avoid incomes for the moment, as these are the result of previous international asset trades.

Stock-flow confusion (wonkish)

In his latest article, Noah Smith repeats a claim that has long bothered me: that mainstream economic models are “stock-flow consistent”. Which is to imply that the very popular research agenda in monetary economics using stock-flow consistent (SFC) methods has little new to add to the mainstream. Because. You know. We got that.

I want to respond with two points about this, which also relate to Smith's general views on maths, theory, and economics. First, a theory is a concept. An idea. Theories can therefore be modelled mathematically in many ways. Second, the stocks and flows of the mainstream are different, theoretically, to those of the monetary economists.

Theories are concepts
Evolution is a theory. It requires absolutely no maths to explain it. Cell theory, is, well, a theory. Again, no maths required. Plate tectonics. Heliocentirsm. All concepts or ideas. Not equations.

Or closer to home, game theory is a concept that has many, many, mathematical representations.

I don’t see the problem with an “economics without maths” if we are engaged in debate about which ideas have merit, and can on their face, provide useful predictions. Smith cites Minksy as an economist who explains his theory of “stability is destabilising” in words. To me that’s a great example of the usefulness of theories, even without mathematical models to accompany them. After all, many mathematical methods could be used to capture the core elements of this theory.

So to say frame “broad idea-sketching” as an alternative to “formal models” is rather naive in my view. You can’t have a formal model without big ideas underneath it. After all, every variable and parameter in a mathematical equation is meant to capture some piece of reality, and you need a theory to say that such a thing even exists.

And there are still many debates about whether measured, mathematical, things have theoretical foundations that allow them to be interpreted in particular ways. Think of the capital debates. You can have many formal models with K in them, but you need a theory to say what K is in reality.

Or more recently, there has been a debate around the meaning of the number we get when we measure multi-factor productivity. Just because we measured it, and had a formal model underpinning it, doesn’t allow for an interpretation without a theory to accompany it.

SFC models use different concepts
With that in mind, we can now compare the SFC approach of monetary economics with the apparent stock-flow consistency of mainstream models. As you might have guessed, the consistency is not really there once we account for the underlying theoretical concepts.

Again I will use my mud-map of economic domains to make this point. I find this a useful way to structure economic inquiry as it makes clear the point that there are different conceptual and theoretical domains in which economic analysis takes place.

The fundamental difference is this. Standard models capture a theory about real goods and services, and real capital (the physical buildings and machines). SFC models capture transactions and balances (assets and liabilities) in money, regardless of the underlying physical attributes of the goods and capital. This means that SFC models allow for credit balances between entities, which can’t be captured in the standard economics of real goods, since credits are not physical goods or services. The image below tries to show that although standard models are consistent in their treatment of stocks of physical capital and flows of investment in that physical capital, the very concept of physical capital is different to the items accounted for in money-based SFC models.

I also try to show that the way each approach deals with aggregation can be quite different. Standard models typically pick an arbitrary level and aggregate under the assumption of a representative agent, often to the level of a whole country. But SFC models are only useful when they aggregate at the levels of economic sectors, or even more finely than that. Because after all, once you have aggregated the whole economy to a single agent, the credit balances between agents within the group all cancel out, yet the whole point of SFC models it to observe the dynamics of these balances between different parts of the economy.

The table below is from Lavoie and Godley’s Monetary Economics, which details the monetary transactions that can be accounted for in this approach, which simply cannot exist in a world of real goods and services only.

I have long held the view that many of the conflicts in economics stem from theoretical confusions. After all, once a bunch of equations are written down, it is very easy to see if the “solution” is correct.

Noah could use his unique position as a facilitator of economic debate in the blogosphere to help economists with different approaches begin to talk to each other, rather than past each other. But confusing formal models with theory, and holding alternative approaches to a higher standard to mainstream approaches, is not a great start.

UPDATE:
To make clear the idea of analysing different domains, I think a motor-racing analogy is useful. One racing "school of thought" measures stocks and flows in terms of the weight of each car each lap. They show that the flows of weight lost in fuel is consistently captured in declining stock of weight of the car. Another school of thought measures the length travelled by each car and its speed, noting how their stocks and flows of distance are also consistent.

Yet the two aren't directly comparable, even though they may both be independently, and jointly, useful approaches for understanding motor-racing. In economics we get confused because we use words like capital to mean multiple things. This problem is all too obvious if consider what sort of understanding of racing we would have if the two schools of thought used the name capital to mean both distance and weight. 

Econ-media gets fresh

A quick update on two interviews from the past week.

First, is an hour long chat with Frank Conway who hosts the Economic Rockstar podcast. We chat about many things. One big topic is teaching economics better by using the Robinson Crusoe economy as an example that opens up very broad lines of economic inquiry, rather than as a very narrow story to help learn comparative advantage. Another is how blogging has influenced by studies and career. There is also some discussion of environmental economics and rebound effects.

I also mix up my Alan’s near the end - attributing to Alan Blinder the work of Alan Kirman as well.

Here’s the podcast

Second, is a shorter interview with Colin Hesse, who hosts Radio Skid Row in Sydney. We chat about my research on relationship networks and favourable land rezoning (article here). I also talk more positively about how to crack the game of exchanging political favours, by using the carrot of the revenue that governments could raise if they charged for the new property rights they create with zoning decisions.

Economics of favours and karma

Giving gifts is often seen as a selfless act, but this is only one side of the story. The act of giving generates implicit obligations, whether we like it or not. When political donors say they are supporting a party out of a selfless respect for democracy, we know it is a lie. We implicitly understand the role of gifts in creating obligations.

At a personal level this leads to situations that seem paradoxical on the surface. For example, if you ask someone for a favour, they are more likely to give you a favour in the future.

Such findings are only interesting because they conflict with our baseline view about the rationality of giving and receiving favours. Why is this so?

I want to try and answer this question by making explicit the “favour-accounting” system between individuals that is fundamentally implicit. Such a system captures the core human desire to reciprocate.

When we do that, it becomes clear that because of our desire to reciprocate, giving a favour generates an asset in the form of being owed a favour, while receiving one creates a liability in the form of owing a favour. That is, the “favour balance sheet” looks good for those who give favours, but bad for those who receive them and are on the hook for future favours.

Think about it. Why power does a political donor really have? He has a bunch of assets in the form of politicians who owe him favours. In the table below I try to capture this situation in table form.

So you would expect that people seeking to accumulate assets and wealth would be in the business of giving favours to those with the ability to reciprocate. This is especially the case when there is a large subjective value difference between the cost of the favour given, and the value of the favour received, i.e. the cost is low for those giving the favour compares to the value of the benefit to those receiving it.

After you’ve asked for one favour, and while your credit is good, you can expect that the same person is willing to give you another favour to boost their exposure to your “favour credit”. It is common, for example, for politicians to seek extra funding from donors already contributing, rather than find new donors.

If you come through and reciprocate favours when required, you can participate as a giver and receiver in as ongoing game of favour exchange necessary to participate in social life. Maybe you can think of it as karma.

We can also see that giving favours to strangers won't always make them feel good about you, because you are creating liabilities for them. People often don't want to accept large gifts because of this.

But when we instead use money to settle “favour accounts” we are essentially saying “you gave me a favour, but I don’t want to owe you anything, so here is this money instead to cancel my obligation to you”. I don’t feel any particular need to reciprocate with my supermarket for the food I get there, but when my neighbours give me food its does end up on the social accounts.

That is why we there is such a big difference between doing something as a hobby, and doing something commercially - when you settle you accounts with money, your future cooperation can’t be assured, yet when you keep open the favour accounts, reciprocity ensures ongoing cooperation.

It stands to reason that you shouldn’t expect karma from counter-parties where you cancel obligation with money. But you should for your non-market interactions that rely on networks of ongoing exchanges of favours and implicit obligations.

Now to answer the question I posed of why our baseline intuition about favours is wrong. The reason is, I believe, that when we are implicitly thinking of favours that do not require reciprocation. We are thinking of a world were it is possible to give a favour and for the receiver to behave like a pure robot and feel not desire to reciprocate. The t-table of this situation is below.

But if this is truly the case, then there is no rational basis for ever giving a favour either, as it is a pure loss every time. Where the logic of rationality is failing is that we only look at the receiver of the favour through the lens of a perfectly rational world where no reciprocity exists. We forget that is such a world a giver of a favour with no reciprocal obligation wouldn’t exist either.