A random physicist takes on economics

Jason Smith, a random physicist, has a new book out where he takes aim at some of the core foundations of microeconomics. I encourage every economist out there to open their mind, read it, and genuinely consider the implications of this new approach.

Go get it now. It only costs a few bucks.

So what do I think? His approach is exactly what economics needs - a set of fresh eyes on the basics.[1]

The book is, fundamentally, an introduction to Smith's new view of what I would call ‘microeconomics as the emergent characteristic of random agents in constrained situations’. Or, more simply put, why you don’t need rational decision-makers for a useful economic theory that makes good predictions.

To get some sense of why this is important, economists are often criticised for getting the big picture stuff of macroeconomics wrong, like missing the financial crisis. But in reality, the economic micro-level stuff, about responding to relative prices, making choices based on incomes and preferences, is also a failure built on an elaborate, but highly questionable, theoretical structure.

Smith says that this theoretical structure is unnecessary. In fact, he says, people acting randomly within their budget will have the emergent property of behaving ‘as if’ they comply with the rational economic model. That is, humans are irrational at the individual level, but the fact that our choices are constrained by our incomes means that in aggregate, the average behaviour responds to external changes in a similar manner to that of the mythical rational person.

To get a feeling for this, consider the graph below from one of Smith's favourite economics paper by Gary Becker, which made similar points. For those who haven't guessed what it shows, the X and Y axes are the amount of consumption of two goods, and the lines C-D and A-B are the budget constraints (i.e. how much of each good, or combination of goods, can be bought) at two different sets of relative prices. The line C-D has a lower price of good Y, and a higher price of good X, than the line A-B.

The point C is the centre of the triangle A-B-0. So if people consume randomly within that budget constraint at those prices, the average person will consume a combination of goods near point C. When the budget constraint changes to C-D, the new centre point is C'. This shift, from C to C', is very similar to the shift p to p', which is what would be expected under the standard theory utility maximisation.

Just taking the average of random choices within the budget constraint predicts the same patterns as utility maximisation, without requiring any knowledge of individual behaviour. When the price of good Y declines, people consume more of it, and vice-versa for good X, whether people act randomly or as utility maximisers.

Smith's (and Becker's) simpler approach reframes traditional micro-level topics as the emergent behaviour they are, and leaves the quirky patterns within individual choices to the realm of psychology. This approach makes perfect sense to me.

However, I highly doubt that this idea will be picked up in a hurry by the economics profession for a couple of main reasons. First, it gives away the big prize of economics-- utility and social welfare. If people just behave randomly at an individual level, it breaks the important link between individual choices, higher utility, and social welfare, which forms the backbone of economic thinking, and gives the profession the claim to power in political debates. No longer will economists be the only ones to proclaim that they know the secrets to a better (or higher utility/welfare) society. In fact, they will have to admit that they don’t.

Second, it removes the ability to blame bad choices by individuals as the cause of their economic destiny. If our theory of microeconomics is that people behave randomly within constraints, then to improve outcomes for certain groups of people, we need to change the nature of their constraints, not their decisions. These constraints could be income, wealth, social status and relationships, etc. Solutions to inequality, to homelessness, and other social problems are immediately redirected by this theory back to society at large, and the rules and systems we put in place to create constraints on individuals.

I highly recommend the read. When I finished the book, however, my mind was racing with more ways in which this approach could be applied in more ways across economic topics.

Finally, if you want to read more, you can read Smith's more detailed and technical attempt at piecing together this new approach here.

fn.[1] As a brief disclaimer, I have followed the author's terrific blog for quite a while. I make a point of keeping an eye on original thinkers in general, and he certainly is one, though I’ve never met Smith in person.

Economic bandits

Get the book via gameofmates.com 

A string of successful Game of Mates speaking events has happened recently -- in Kuranda, Sydney, Canberra, and Melbourne. I can't take all the credit. But, James, our bandit in the Game of Mates, can. He has been extremely active all across the land and people are starting to notice.

One issue that has repeatedly come up at these events is the rise of 'strategic representation' of the economic benefits of major projects in planning applications. For example, a land subdivision proposal might include plans for a new university campus, eco-tourism facilities, and more, in order to be able to claim the project will generate billions of dollars of economic benefits to the region. But the reality is often that these additional facilities are completely infeasible and will never happen. They are just included in the application to beef up the claimed merits of the project, for there is no obligation from the approval to follow through with the full extent of the proposal.

The same happens with applications for new mines. Miners often propose unrealistically high volumes of production to be able to exaggerate the scale and intensity of investment in the local area, along with inflated estimates of royalty revenues to State governments.

One solution to this problem is to make planning approvals an obligation, not an option. At present, miners are granted a right to mine up to a particular volume of minerals or energy resources, but with no obligation to do so. Instead, approvals could carry the obligation to deliver what was proposed within a reasonable timeframe or pay penalties and risk losing the option to ask for future approvals.

In the ACT, when land is sold to private developers for a particular purpose, like a residential apartment complex, they must deliver a development that complies within two years or face penalties, including the possibility of the land reverting back to public ownership.

In mining, to determine whether a proposal is exaggerated, rules that oblige application to pay their estimated royalties up front could be enacted, perhaps with a discount. If the project seems feasible, banks and other financiers would be willing to lend this amount to cover the royalties. If the project is unviable and exaggerated, no one will be will to be part of this financing effort.

The solutions are clear once we understand the core economic issues at play.

Bullshit economic assessments par for the course in Australia (more politely, it’s just “strategic assessment”) https://t.co/FuE2mlI5RI

— Cameron Murray (@DrCameronMurray) August 2, 2017

In other news, on 12th August I will be attending 'Love Your Bookshop Day' at Avid Reader in West End (Brisbane), so please come along to that event if you can.

Lastly, I will be a keynote speaker at The Australia Institute's Accountability and Law Conference in Canberra on 17th August. There is a group of very esteemed legal experts attending, as well as political representatives. All in all, it should be a very interesting event. The event website is here.

Long live food waste

One issue that occupies the minds of environmentalists from across the political spectrum is food waste. Around one-third of all food produced for human consumption is never eaten. To environmentalists, this is astonishing and terrible.

But, unfortunately, they are completely wrong. And I say that as a fervent environmentalist.

It is actually a world with zero food waste that is a terrible place to be. We absolutely do not want to be that world.

The reason is this.

Food waste is, in practice, a tremendously important global food insurance policy. In a world of zero food waste, if a natural disaster, such as a flood or drought, hits some of the most productive agricultural regions, both food production and food consumption will fall dramatically. There is no buffer. If production falls, food consumption falls by an equal amount.

If a flood, for example, wiped out a quarter of world food production one year, in a world with zero food waste the per person food intake must also fall on average by 25%. It would be an absolute humanitarian tragedy by any measure.

However, in a world where one-third of the food produced is wasted, either on the farm, during distribution, or in processing and cooking, that flood would have the same effect on food production, but a much smaller impact on overall food consumption. Reducing waste at each point in the food production chain could regain most of that 25% of food that was lost to flood.

The below table show this basic comparison. Country A is the idealised zero food waste utopia, producing 100 units of food, and consuming it all, in the Before scenario. Country B is the current world, consuming only two-thirds of the food produced, and ‘wasting’ the rest. Notice that in the situation before the natural disaster, Country B produces far more food, and this production requires vast swathes of land to be brought into production, something with considerable environmental cost.

But look at both countries in the After scenario, where an unforeseen disaster wipes out a quarter of food production, it is Country B that comes out on top. Country B is able to consume more than Country A, perhaps as much as before, by using the food waste as a type of insurance, able to be drawn on when needed.

This is important. As a world we can’t use traditional insurance for such situations. Being paid out financially by an insurance policy is useless if there is no food to buy. You still starve.

This is also why most countries heavily subsidise and incentivise agricultural production. Letting markets alone decide what to produce each year will not create the genuine over-supply needed to act as a buffer against bad times.

Indeed, countries with the most food waste are generally the most economically efficient. Europe and North America waste almost 300kg of food per person per year. In sub-Saharan Africa and southern Asia, food waste is around half of that. Yet it is Europe and North America that are overall the most economically efficient in terms of converting resource inputs to outputs.

The above scenario also abstracts away from the many distributional issues at play in our food system as well. But reducing food waste overall won’t solve these either. If the problem is distribution, focus on distribution.

Indeed, if land degradation from agriculture is the underlying concern that makes reducing food waste an attractive idea, we should focus directly on the problem by making rules that control land uses to ensure better environmental outcomes. Indirect approaches should be a last resort.

Reducing food waste, like many pro-environment ideas, seems plausible and obvious on the surface but ignores crucial systemic issues.

First published at Renegade Inc.

Population debate now mainstream

After years of being an 'off-limits' topic, a debate has finally emerged in the mainstream media about an appropriate level of immigration to Australia.

As a background, immigration levels have been rising steadily since the late 1990s, with record inflows after the financial crisis of 2008, as the below ABS chart shows. The break in the data series is a change in the measurement, now applying a "12/16 month rule" of residency that captures immigrants who travel to their home country periodically, but reside in Australia for 12 out of the past 16 months. This brings the data in line with many other countries, like Canada.

The latest mainstream media attention has been at The Guardian, in an article by Tom Westlake, responding to ongoing discussions at MacroBusiness, which has led to some back and forth (here, here, and now here).

No doubt the media will prefer to avoid the main issue, instead attracting clicks with racist rants and name-calling, all the while presenting the debate as a choice between two extremes (open borders vs zero immigration). The debate is not about immigrants being bad people for coming to Australia. After all, they almost always jump the hoops and follow the rules our politicians made. The debate is about setting up an immigration system that delivers a lower overall rate while delivering better humanitarian and social outcomes.

Below is what I hope is a sensible contribution, which I originally posted at Medium in response to Tom Westlake.

~~~***~~~

I’m pretty sure the arguments boil down to you each having two different points of view, then both sides finding evidence to support it (which is totally normal, by the way). As you said:

I am not going to try to address the implied moral logic of van Onselen: that the criterion upon which we ought to judge immigration policy is the welfare of incumbent residents. As it happens, I think this is a deeply unethical social welfare function.

This is the crux. I know enough economics now to know that you can get just about any answer from technical assessments of marginal welfare effects. So let’s leave that to the side. Let’s stop pretending technical assessments will provide an answer or change minds.

I personally think this ideological different is strange, and am curious as to your ethical viewpoint. For example, if you think nations are a useful organisational institution, and democracy is a useful way to offer some checks on power structures in a nation, surely you imply support for judging national policy based on the welfare of residents, as that is the underlying rationale of the democratic nation-state.

If you don’t, then you open up some puzzles. For example, if you are instead a global welfare maximiser, start sending ships to collect the neediest people from Bangladesh, or the drought-affected regions of Somalia, South Sudan, Tanzania, Mozambique etc., and bring them over. It’s the easiest way to do it. Or just send them free food and equipment. Our policy settings, and most individual choices, are completely unlike the choices of a global welfare maximiser.

In any case, any policy position apart from complete open borders is a de facto population policy. The question is whether the benefits outweigh the costs (to whoever, based on your ethical view) at an immigration rate of 200,000+ per year, or whether the net benefits are higher with a rate less than 100,000 per year. Judging by the comments and my experience talking to people from all across the country, the common view is that the benefits are more apparent with lower rates.

If we take some counterfactuals for a moment, consider if this debate was happening in the early 2000s when the immigration rate was about half what it is now. I assume you would argue that higher is better. I have no idea what Leith would argue, since I don’t think he thought it was an issue back then.

Then immigration doubles. You, I assume, would still be happier with a higher rate. Leith now sees it as a problem.

Let’s double the rate again (to half a million a year). Would your position change? I suspect not. I suspect, again, that this argument is really about conflicting underlying moral and philosophical viewpoints.

Anyway, my feeling is many of the policy failures you discuss are also much easier to remedy with lower rates of immigration.

Lastly, if you genuinely want higher immigration you should be ignoring this debate and not fuelling the fire, since there is massive popular support for lowering immigration back to pre-2006 levels, and the more it is in the media, the more politicians will have to respond to this groundswell.

Billionaire Industrial Policy

Elon Musk has lost billions of dollars for nearly a decade trying to make electric vehicles at Tesla in a way that has never been done before.

In the new tech-billionaire space-race, where Musk has also been active with his Space X company, his competitor Blue Origin, run by Amazon CEO Jeff Bezos, has been running at an enormous financial loss, requiring Bezos to sell over a billion dollars of Amazon stock a year to fund his space venture.

In both of these sectors, electric vehicles and space transport, there is no guarantee of any long term profit – there are threats from multiple new entrants as well as incumbents in both sectors. Yet billions of dollars are being poured into these experimental investments.

When governments fund similar decades-long loss-making ventures that expand the economy’s production capabilities, we call it industrial policy. When a billionaire does it, we say it is markets at work.

But there is nothing “market like” about long-term, long-shot, gambles like these. This behaviour falls outside any core economic theory about the efficiency of markets in allocating resources. After all, most billionaires don’t spend their fortunes on privately-funded industrial policy with only a fleeting chance of any future payoff.

...

Read the rest of this post at Renegade Inc

Game Of Mates: Nepotism Is Costing The Economy Billions

It is no secret that increasingly, workers are no longer enjoying the fruits of their labour as a smaller and smaller group of people and companies come to share the returns of (slowing) economic growth across developed nations such as the US, the UK and Australia.

The ‘jobs for the boys’ model is having a tangible and outsized impact on inequality and it is killing the economy.

It is so tangible you can measure it. And measure we did.

In our book, Game of Mates, I and my colleague, Professor Paul Frijters explore insights from the science of human cooperation and raw metrics of economic costs and benefits, melding this information together to paint a picture of how a nation’s wealth can become siphoned off by a well-connected network of powerful individuals.

Drawing on our own research and that of others, we find that those outside the game are being bled dry, with hundreds of billions of dollars a year of hidden theft taking place.

The book helps to frame a discussion on ‘grey corruption’ – the type of unethical political favouritism that is economically costly to the unfavoured, but that is not necessarily illegal – that is brutally honest about human nature. We look at how the Game of grey corruption in played, how much it costs, and what to do about it.

What is a grey gift and when do I know I am getting one?
A grey gift is a way to pick a winner and loser without great, (or any) personal cost. Often the cost is instead passed on to another person or group. This phenomenon exists at many levels in almost all organisations, including government bureaucracies.

When a city council decides a plot of land can be now used for urban development instead of farming, it adds millions in value to the land which goes into the pockets of landowners.

In our study of just six rezoned areas in Queensland, Australia, we found that $410 million worth of property rights were given to a small group of well-connected landowners.

Or when the government insures bank deposits to secure the financial system, the free insurance is a gift to bank owners that should have instead been sold, costing the public billions in forgone revenue. In Australia, this gift of insurance is worth about $4 billion per year, which goes straight into the pockets of bank shareholders.

And when the transport department closes road lanes to funnel cars onto a private toll road it provides a gift to the toll road owner that costs motorists, but not themselves. If just 1,000 vehicles per day are forced onto a $4 toll road, that is an $18 million grey gift from a small routine bureaucratic decision.

It is important to make clear that a network of people trading favours is not inherently a bad thing and is an innately natural way to cooperate. The problem is when gifting occurs at an enormous cost of the financial, social, legal, or physical, security of other people.

Read the rest of this post at Renegade Inc

Why does a basic income need to be universal?

Image credit: WNYC

A Universal Basic Income is a wolf in sheep’s clothing. Even Australia’s opposition party has rejected the policy proposal on the grounds it is free money for millionaires. So why does this idea continue to be so popular?

Robots are a foolish reason to consider a universal basic income (UBI). And yet so many still want to indulge in such nonsense. The link between technological disruption, income security, and UBI, is weak at best. And existing targeted welfare systems already achieve income support from any type of workplace disruption, robotic or otherwise.

The fundamental idea behind a UBI is that all members of society should get an equal share of that society’s income prior to even attempting to earn a market income, and regardless of what their market income is. It is a worthy principle.

In contrast, a targeted welfare system phases in income support when individual or family income falls below particular thresholds, and phases it out again when market incomes rise. This is in effect a national income insurance scheme, and again, a worthy idea.

So why all the buzz about the less progressive UBI welfare system that will have to raise additional taxes from the wealthy, only to give it right back? Wasn’t less administrative cost one of the big selling points of a UBI in the first place?

...

Read the full article at Renegade Inc.

The bank competition myth

Australian banks are upset. Their $30 billion per year gravy train of profits from the Australian people is finally being slowed down.

A levy on bank liabilities of 0.06% annually was announced as part of the 2017 Federal government budget, and is expected to raise about $1.5 billion per year, or 5% of bank profits.

To be clear, the banking system is a regulated cartel. Its primary function is to provide a public good in the form of the money supply of the country. As such, we would expect it to be uncompetitive, and use tight regulatory controls to ensure that the privileged position of private banks is not being abused.

In my book, Game of Mates, I explain that the result of this uncompetitiveness and lack of adequate regulation in Australia is that over half of the banks' profits can be considered economic rents, which could be taken back with better regulation and shared with the public at large.

I want to use this blog post to explain in detail the underlying administrative mechanics of why any modern banking system is necessarily uncompetitive.

The first thing to know is that banks do two things. They make money by extending loans, which expands the money supply; a function that is an essential public service in a growing economy. Second, they settle obligations between parties both within their own bank, and between banks, which is another essential public service.

But letting private entities simply make money is risky. So our central banking system constrains the private banking system by making the banks settle payments between each other with a different currency held in accounts at the central bank. In Australia these are called Exchange Settlement Accounts. Every private bank in the system must have an account at the central bank so that they can perform this second function of settling payments.

By controlling the second function of banks by making them use a currency controlled by the central bank, it indirectly controls the former function of money creation. No one bank can rapidly create new money by writing loans faster than the rest of the banks. If they do, when the borrower deposits the money created into an account at a different bank, like when they use the loan to buy a house from someone who banks with another bank, it will require the originating bank to settle this payment flowing from their bank to a different bank with their central bank money.

This process reduces their net asset position and increases their costs. They can’t continue to do this. What limits their rate of money creation through new loans is how fast other banks are creating money and transferring central bank money to them. Each individual bank is constrained in their money creation function by their settlement function.

Keynes wrote as such in his 1930 Treatise on Money:

…it is evident that there is no limit to the amount of bank money which the banks can safely create provided they move forward in step.

The words italicised are the clue to the behaviour of the system. Every movement forward by an individual bank weakens it, but every such movement by one of its neighbour banks strengthens it; so that if all move forward together, no one is weakened on balance.

The Australian bank data shows this process in action. Below are two graphs. On the left is the size of the loan book of Australian banks. There is a clear concentration here and a surprising regularity to the trends at all banks. To show these trends more clearly, on the right is the monthly growth of the loans made by the four major Australian banks. As you can see, there is no sustained deviation by any banks from the core growth trend. All banks are moving lock step, as they should.

The whole point of a central banking system is that the growth rate of loans for all banks in the system will quickly equalise. If you are a small bank, this means you can never grow abnormally fast in order to gain market share by competing for loans with the larger banks.

Any central banking system is therefore, by definition, unable to be competitive.

In Game of Mates, the solution proposed to stop the economic losses from the abnormal profits of the protected private banking cartel is to let the central bank itself offer basic low-risk lending and deposit functions directly to the public. Because it has the ability to create for itself its own central bank money, it is the only entity that can grow faster than the existing banks in the system.

Of course, the reality is that the solution would be a far greater hit to bank profits than the small levy proposed. In fact it would likely take back over $20 billion per year in profits from the private banks, which would be shared with the government through its profits on banking operations, and with its bank customers through lower costs. If the banks are upset about a levy of just $1.5 billion a year, they are going to really crack it when they hear this proposal!

*This proposal is actually widely called for by economists, and the idea can be mostly attributed to Nicholas Gruen. See here for example. 

The impossible home deposit

After reading today about how home buyers need to save over $500 per month for 10 years for a deposit in NSW and Victoria, I thought I would republish the below post of mine from January 2010 about the impossibility of saving a deposit in a market with rising prices. 

Baby boomers and older generations often cite high expectations, and the inability to save, as the main hindrance to the younger generations’ ability to buy their own home. They go into great detail about how much it has always been a struggle to buy a home, and that if young people decreased their expectations and bought something small they could work their way up the property ladder.

I am one of those generation Ys looking to buy my own home, and from this perspective, it is not quite that simple.

The mythical property ladder
The argument that if younger generations decreased their expectations, and maybe bought a small apartment now, so that they could somehow work their way up the ‘property ladder’, is entirely misleading.

For example, a young couple buys an apartment for $200,000 in lieu of a $400,000 house they really want based on the contemptuous advice of older generations. They imagine that in 10 years they might be able to sell for $350,000, netting a profit of around $100,000 to spend on a larger home (after transfer costs). The problem is that larger homes have also increased in price by 75% so that the $400,000 house is now $700,000. Buying that dream home has gone from a $400,000 prospect to a $600,000 prospect even with the apparent advantage of being on the property ladder.

The way to benefit from increasing property prices is to buy multiple investment properties so that you leverage the benefits beyond your single dwelling needs.

No more avocados
Next, we can look into the arguments about spending a little less on luxuries to get a person into a home-buying financial position. Dining out, gadgets, and holidays all seem to get mentioned. But if we look into it, these relatively small expenses are not the main factor – the main factor is income.

A hypothetical future home buyer might spend $200 per week on dining out, ‘gadgets’ (mobile phones etc), and travel. That’s $10,400 per year – maybe $3,000 on a trip to SE Asia, $2,000 on gadgets, $2,000 on dining out, and the balance for other luxury items. Let’s see what that money could have done if it were funnelled into a property-buying strategy.

Assuming a starting point with no savings, this hypothetical person (or couple, or family) can save about $58,000 in 5 years assuming they receive 6% on their savings. If they thought they might one day want to live in a home that currently costs $300,000, by the time they save their $58,000 the home is worth $400,000 (at a 6% price growth rate). They now need $80,000 for their deposit. They continue saving instead of splurging and in another 5 years they have $137,000 saved. The home is now worth $535,000. They have enough for a deposit, but the repayments on their home and associated ownership costs are now around $900/week.

So after ten years of saving, living life without those luxuries that make it so much more enjoyable, they are in no better a position than before.

I’ll leave you with a question. If you bought a home for $100,000 in 1990, and the market his risen so that it is now worth $600,000, how much better off are you?

Would a loan-to-rent limit for home investment work?

What if the rules about lending for housing investment limited the size of a loan to an amount based on the rental income of the property rather than its market value? Could such rules constrain wasteful lending growth that simply fuels speculation, and instead encourage lending that fosters long run investment in housing?

Let me take you through one possible version of such rule that I think could ensure that the enormous economic power of new money creation that lies at the heart of our banking system is used for productive purposes.

My proposed loan-to-rent-ratio (LRR) rule is this:

Loans can be made at 80% of the amount where the gross rent of a property covers the interest repayments at an interest rate 2% points above the offered rate.

How would this work?
Imagine a home that rents for $400 per week, or, say $20,000 per year. Mortgage interest rates are 4.5%.

The loan limit calculation starts by asking what size loan can be serviced with $20,000 a year at a 6.5% interest rate (4.5% plus the 2% buffer). This is $308,000. Using this as a benchmark value, 80% of this value can be created as a new loan, which is $246,000.

It is possible to beef up this rule further with a requirement that any remaining payment for the home must come from savings accrued from incomes, not from home equity lending secured against another property asset.

With this rule in mind, we can look at its effect through the property market cycle compared to a rule that restricts lending to a proportion of home values, say 80%, rather than tying it to rental income.

Now
For simplicity, let us start at a point where the market value of our example home is $308,000. Here, an 80% loan-to-value-ratio (LVR) limit would allow lending of $246,000 against this property, which is the same as my proposed LRR rule.

But then the market begins to rise in the property up-cycle.

A year later
Now, the property's market value has increased 15% to $354,000, but the rent is unchanged. Under an LVR limit, a new buyer could now borrow $283,000 (or 15% more). But since the rent has not grown, under the LRR rule, a new buyer could still only borrow the same $246,000. The LRR rule would thus reduce the amount of new funding available during a speculative upswing, where the rise in market value is not matched by a rise in rental income, and therefore dampen the price swing by not increased borrowing and new demand.

During a downturn
The reverse effect happens during a property market downturn. If the 15% price gains reverse, the LVR rule effectively restricts new lending by the same 15% during this market downturn. The LRR rule does not. Again, a dampening effect.

Any downsides to this plan?
The main one is that benefit of lower demand for housing mainly comes in the form of lower prices, which most current homeowners won’t be especially happy about. Banks won’t be happy that their cash cow of new lending is brought under control. Nor will the vested interests of the land-banking property development lobby be happy that their massive stocks of empty land will become worth far less than they thought.

But these are the downsides of any reforms that make housing more affordable. That’s why no effective reforms have been enacted in the past 20 years.