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

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

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

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

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

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

The article deserves fisking. Here we go.

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

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

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

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

This is a poor attempt at defences 2 and 3.

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

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

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

 

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

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

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

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

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

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

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

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

No it wouldn’t. See above.

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

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

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

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

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

Put your cane down Landsburg and take your medicine.

The preference whisperer

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

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

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

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

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

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

Seeking housing supply logic

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

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

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

Response dynamic

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

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

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

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

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

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

Expectation dynamic

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

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

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

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

Corner the market

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

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

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

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

Squeeze

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

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

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

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

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

Conclusion

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

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

Australia outbuilds Texas, but will the shortage myth die?

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

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

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

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

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

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



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

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

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



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

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

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

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

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



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

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

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



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

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

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

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

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

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

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

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

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

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

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

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

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

Land taxes, rent-seeking, boom and bust

I came across this video today. It's a fairly concise argument about the rent-seeking activities and incentives that perpetuate bad economic policy. Some great comments in there by Mason Gaffney, Ed Dodson and of all people Milton Freidman.

Friedman explains how a tax on the unimproved value of land is economically the best tax, but politically the worst, and he also takes some blame for personal income taxes which he helped introduce during his time in the US treasury in 1941. He says

The question is, which are the least bad taxes. And in my opinion, and this may come as a shock to some of you, the least bad tax is the property tax on the unimproved value of land - the Henry George argument from many many years ago. 

It's an interesting thing if you're talking about taxes about why it is that the property tax is so unpopular. It's not unpopular for good economics reasons. It's unpopular in my opinion for one good reason.  It's the only tax left on the books for which people have to write a big cheque. 

The income tax is a far worse tax. But, and I have to admit that I have some part of the guilt in this process, because during World War Two I worked at the Treasury and helped to design the withholding system (my wife has never forgiven me for it).  But with respect to the income tax we've arranged it so it's taken off bit by bit and it's almost painless. With respect to the sales tax we pay a little bit of it each time. With respect to the corporate tax and excise taxes, they're hidden in the price of things we buy - we don't even know we're paying them. 

But with respect to property tax that remains a tax that we as individuals have to pay, and then we have to write a big cheque for it. That's the fundamental reason in my opinion why it's so unpopular. 

But if you wanted to reduce the unpopularity of the property tax the way to do it would simply be to provide for an effective method whereby it could be withheld at source in small payments. 

For me Friedman's last comment could be the key to unlocking land taxes as the primary source of government revenue in many jurisdictions. People in general have intense loss-aversion - they hate getting something and having it taken away much more than never having it in the first place. The practicalities of implementing a withholding system for land taxes should be seriously considered by land tax advocates.

I could suggest that for residential property, each State's rental authority (the authority that holds rental bonds in trust) also operate as a rent intermediary, deducting estimated land taxes from periodic rental payments in the same way that income taxes are withheld. This would allow landlords to see only rents net of land tax, and make investment decisions on the basis of this new net rental amount.

But rentals are only about 30% of the housing stock. For owner occupiers, vacant and non-residential land owners, I currently see no practical alternative but collect State-level land taxes in the same manner as the already are.

In truth, this loss-aversion problem with land taxes might reflect Friedman's world view more than the real political problem. After all, in Australia most State's already have land taxes, but with extensive exceptions, particular for owner-occupied housing. Incrementing the tax rate is a costless exercise politically, as only a tiny fraction of voters pay it, compared with alternative sources of taxation. It seems to me the hinderance here is more a case of the political power of the wealthy, who would be on the hook for most land taxes, regardless of how they are disguised.

In any case, a good video.

Next Australian housing boom in progress

I hate high house prices but I am a realist, and I trust the numbers. While history doesn’t always repeat, right now I can hear it rhyme.

Three years ago I decided that using the mortgage rate divided by the gross rental yield did a fairly good job of catching the main cyclical patterns in the Australian housing market. The basic investment rule from this indicator (blue line) is to buy when it goes below 1.5, and sell when it goes above 2.25.

Unfortunately in practice Australian capital cities don’t always have coordinated booms, so you must augment this knowledge with an understanding of the ripple effects that begin in Sydney and later flow through other housing markets.

Today Sydney is again booming, with a near 15% price increase in the past year. Here’s a capital city price breakdown from the RBA. Notice that Sydney and Melbourne are roughly moving in sync, but that Brisbane and Adelaide are yet to move. If this boom does rhyme with the last boom, Brisbane and Adelaide prices will really hit their stride late next year, while Sydney prices will peak. Perth prices will peak a little sooner.

To be more clear about the dynamic at play in my property cycle indicator, here an alternative view. When the mortgage payment per dollar at the prevailing interest rate is relatively lower than the gross rental yield we should expect prices to be rising. 

I can’t say I like it, but the pattern is there. Tax advantages for investment property will waltz through the current Senate Inquiry unscathed, and tax bracket creep will continue, further enhancing negative gearing benefits from buying investment property. Interest rates are staying low indefinitely, and mortgage interest rates are getting down near 5% flat, and banks will lend to anyone with a pulse. It's a crazy world out there. 

Why has the public service become impotent?

Guest post

Sydney Morning Herald’s economics editor Ross Gittins recently wrote a scathing article about the quality of policy advice coming from the upper echelons of the public service. Treasury, and particularly Finance, copped a fair whack.

While the article touches on some valid points and criticisms, I believe it misses some vital points as well. Far be it for me to leap to the defence of the public service, but I think Ross has been a little too indiscriminate in his criticism.

There exists a disturbing lack of vibrant thinking in the policy formulation space in government in this country, and it seems that governments of all persuasions are only too willing to outsource policy development to various interest groups and (erroneously named) think tanks.

These developments, as well as the seemingly unbridled growth in the number of staffers and advisors in ministers’ offices, has meant that the role of the departments in policy formulation and advice has been diminished.

This may not necessarily be a bad thing, particularly if the onus of formulating policy shifts towards more expert sources, however I doubt this is the case, even allowing for any diminished expertise in the public service.

Which brings me to the point of this post – why has the public service been effectively sidelined, or what has made it so impotent?

The internal incentive structures of the public service are to blame for a large part of this and are dooming the public service to an existence on the sidelines of policy formulation.

It remains true that there are some very capable, highly intelligent thinkers in the public service. However the nature of the beast is that the people who think outside the box, who come up with creative and radical reform options, are marginalised.

Despite the plethora of ex senior public servants now running ‘training’ sessions about how to think creatively and influence people (whilst conveniently collecting exorbitant fees made available through previously cultivated networks), the public service culture prizes the ability to sit down, shut up and row in unison above all.

Promotions in the public service do not go to those who propose the best policies to address a given issue, or show the greatest ability to think analytically about something, but rather to those who can convince the bloated HR departments of their ability to recite buzzwords, or attend the relevant afternoon teas.

This results in the senior levels of the public service being filled by people who are very good at reading what people want to hear, and feeding that directly to them – whether that be the relevant minister or higher levels of their department. There is no way this will lead to optimal policy outcomes, even if the public service had the ear of ministers as it may have had back in the mythical “golden age” where government may have trusted public servants to be more than sycophantic rent-seekers.

Frank and fearless advice be damned.

This phenomenon has gone hand in hand with the rise of generalists in the public service. As best I can tell from statements about wanting people to be ‘all-rounders’ and ‘flexible’ there appears to be some kind of false premise that technical and deeper analysis skills are mutually exclusive from communication and organisation skills. This perverse scenario results in people in high places in large government departments who are little better than innumerate, but presumably can cook a great sponge cake.

Incentives once at the very top of departments are no better. Departmental secretaries still tailor their responses to issues in such a manner as to present ministers with what they want to hear. Most policy advice is coming from a public service severely lacking in fearlessness, or ministerial staffers who are largely sourced from fresh-out-of-uni Young zealots, who are possibly even more likely to be telling ministers what they think they want to hear.

In response to Ross Gittins – yes, some blame is rightfully directed toward the public service. But isn’t it time we looked at the way it is managed, and what incentives exist? Where is the public pressure for a more trusted and fearless public service?

Whilst economists inside the public service seem to have been increasingly marginalised, there is no reason those on the outside need to remain muzzled about it.

Structural vs individual poverty theories: A comment

Matt Bruenig has stirred up Noah Smith by laying out why life-coaching is a foolish way to address poverty, since most people churn into and out of poverty during their lives, meaning that most people already achieve what the life coaches are intended to achieve.

He characterises the debate about poverty as falling into two theoretical camps, individual or structural, and presents some data to make the case that poverty is a structural problem, concluding that 

Since the problem is structural, the solution must be structural as well 

Bruenig outlines the two theories as follows.

Theory One: Poverty Is Individual
The right-wing view is that poverty is an individual phenomenon. On this view, people are in poverty because they are lazy, uneducated, ignorant, or otherwise inferior in some manner. If this theory were true, it would follow that impoverished people are basically the same people every year. And if that were true, we could whip poverty by helping that particular 15% of the population to figure things out and climb out of poverty. Thus, a program of heavy paternalistic life contracts to help this discrete underclass get things together might conceivably end or dramatically reduce poverty. 

Theory Two: Poverty Is Structural
The left-wing view is that poverty is a structural phenomenon. On this view, people are in poverty because they find themselves in holes in the economic system that deliver them inadequate income. Because individual lives are dynamic, people don't sit in those holes forever. One year they are in a low-income hole, but the next year they've found a job or gotten a promotion, and aren't anymore. But that hole that they were in last year doesn't go away. Others inevitably find themselves in that hole because it is a persistent defect in the economic structure. It follows from this that impoverished people are not the same people every year. It follows further that the only way to reduce poverty is to alter the economic structure so as to reduce the number of low-income holes in it.

Smith doesn’t like this for some reason. He responds with a bunch of reasons why it bugs him, which I summarise as

1. The theories are not mutually exclusive and the dividing line is a bit arbitrary (his points 1, 2 and 5) 
2. We might not care about structural poverty because people can borrow to smooth consumption during periods they are in poverty 
3. There are measurement issues 

Bruening then responds.

My contribution to this discussion is to offer an analogy that might be useful in both explaining the problem to a broader audience, and narrowing down where the line between the two competing theories lies.

Imagine a highway full of potholes (structural holes on the road of life). At one end of the highway, people start their lives with certain endowments of vehicles (wealth), certain starting points, either near lots of potholes, or near smooth parts of the road (social capital), and certain levels of driver training (education). This is the structure, or the setup, of the situation in which individuals then make decisions about how to navigate the highway without falling into a pothole of poverty.

Even if it is technically possible that everybody could get along the highway without falling into potholes (which it may not be), it may require a great deal of effort not only for those with disadvantageous starting points and clunky vehicles, but a great deal of effort for those zooming along the fast lane in their Porsches, who may need to make space, give way, or lend a hand to make it happen for everyone.

Getting people out of potholes is not as simple, as many like to think, as telling the drivers of clunky old VW Beetles to stop hitting potholes. Some are really stuck; many get themselves out only to fall in the next one. No one wants to be in a pothole. 

So the trade-off is this. Either we

1. just keep yelling at people to drive around potholes, 
2. rely on passers-by to devote resources to getting everyone along the road by digging them out, giving way, towing if needed, 
3. or we systematically change the structure of the highway by filling in the potholes. 

Taking the last choice allows each individual more freedom to do as they please along the road of life without fear of landing in a pothole.

We might even start the race with more evenly matched vehicles, say, through inheritance taxes on those who start life with a Ferrari.

If we change the structure of the road, individual behaviour doesn’t matter in terms of potholes and poverty anymore. That's the approach we take to running actual highways. We don't pretend that having a road network full of potholes is fine, because people can make choices to steer around them. But when it comes to poverty such reasoning is all too common.

To borrow from the handbook of Bruenig reasoning we can think of the possible poverty solutions in terms of individual or structural changes as follows.

• Changed individual behaviour, no structural change - maybe 
• No changed individual behaviour, no structural change - no 
• Changed individual behaviour, structural change - yes 
• No changed individual behaviour, structural change - Yes 

Looks like the common factor that solves the poverty problem is structural change. Sure, we could technically say that it is a little bit of both, but that doesn’t help guide any policy solutions. Once you start along the road of blaming the individual, you can justify just about any economic and institutional structure. Why not make it even harder for people to get out of poverty? It is still their choice, and there is still technically a set of individual choices they could make to get out of poverty. But that's not at all helpful in solving the problem.

Most important chart in human history - debunked

Exponential growth is one of those things that confuses many people. Here's probably the best example getting traction in social media at the moment.

Thank you industrial revolution(s). Most important chart in human history right here. pic.twitter.com/xMbWpALiW4
— Michael Dearing (@mcgd) July 21, 2014

Notice that at this scale we know nothing apart from the general exponential shape of the curve, which is all that is communicated by representing the data in this way.

Similar exponential graphs have been used to support many ideas and predictions. Mostly these have to do with some kind of impending doom, or sometimes it is to do with an observation about the how unusual the period of recent history has been.

But the existence of an exponential trend tells us nothing about whether an imminent limit is about to be reached, or how a trend may progress into the future. It certainly doesn't tell us that recent rates of growth of a particular measure are unusual, because an exponential curve has the same rate of growth at all points.

To make my point I have a series of charts to show. Below I have plotted the exponential function 2^x/25 over different ranges of 1000 on the x-axis . Think of x as years AD to match this with the image in the tweet.

What do you notice?

Looking at the same function at different points in time produces the same shape. In fact the ‘hockey-stick’ effect, that suggests the recent period is unusual, is just as prominent 1000 years ago as it is today. Here we merely have a doubling of the indicator every 25 years, and that's what it looks like.

The lesson here is that at any point in history this same graph could be produced because the rate of growth is constant. It tells us nothing special about the current period.

But what about the likelihood of reaching a limit? Doesn't the exponential growth approach any limit more rapidly each period?

Sure, but we don't know whether this pattern is actually a logistic function rather than an exponential one. Notice in the graphs below that a logistic function can look very much like the exponential growth charts in the tweet. But rather than hit some catastrophic limit, the rate of growth slows as the limit gets closer. This type of function is commonly used to describe population dynamics, and with recently falling global population growth, it seems that such a pattern for human population growth is also likely.

Remember this next time you see an exponential graph that is argued to support an argument that there is something unusual about recent history, or that a sudden rapid collapse is imminent. 

Review: Bubble Economics (Soos and Egan)

Paul Egan and Philip Soos [1] have a new book out. It available for free here (pdf), and it’s called Bubble Economics: Australian Land Speculation 1830-2013.

Some reviews and reactions have started to flow in - locally, internationally, and even some critical reactions. This post gives my take on this very detailed and topical book.

A short review would go something like this: Read this book if you want a very rich long term view of Australia’s economic history, particularly regarding land use and land cycles, mining booms, taxation, banking and finance. Think of it as a reference book that brings together historical data, institutional context, and economic analysis in manageable sections that can be easily referred back to.

As an example of the scope of topics covered, Soos and Egan conclude with 57 (yes, 57) recommendations about tax reform, financial regulation, public policy, and economic practice which are derived from the analysis in earlier chapters. As expected, the no-brainer reforms are all in there - transition to land and resource taxation, improve macro-prudential regulations, consciously plan for counter-cyclical government spending, and adopt more secure rental tenancy controls. But they also take hints from a broad range of perspectives, suggesting, for example, the possibility of a job-guarantee style scheme popularised by modern monetary theorists.

The book consists of three sections - Australia’s Three Depressions, Understanding How Asset Bubbles Form, and Modern Australian Economic and Financial Settings.

Part 1 introduces the reader to a long term perspective of Australia’s economy and the asset cycles that dominate the long run trends. As its heading suggests, this section details the economic situation prior to, and during the depressions of the 1840s, 1890s, and 1930s. This is important historical context that we often ignore in modern debates about the business cycle.

I was particularly impressed with their research on the 19th century Australian economy. Since land was such a major component of economic activity in that era, the role of land prices and impacts of land speculation were even more pronounced.

One element dominating that process, which is not a feature of the modern cycle, was the privatisation of public lands by State governors, which, prior to the 1830s, involved discretionary gifts of land to private individuals. Later, lands were sold at auction into private possession. Although there was an effectively endless supply of land to the private sector by government through this auction process, there was still a massive land boom and bust cycle during that period. The chart below, taken from p14, shows the land bust of that era quite clearly.

You notice many similarities across Australia’s three depressions - an asset price boom, followed inexplicably by a bust where asset prices fall at the same time as turnover plummets. In the latter two depressions we can see a clear pattern of deflating prices across the whole economy (chart below), with retail prices falling around 35% in the 1890s, and around 20% in the 1930s. It makes you appreciate the automatic stabilisers that come with a larger government sector and the willingness to conduct counter-cyclical policy (including guaranteeing bank deposits). 

Part 2 of the book provides a number of perspectives on asset bubble formation. Soos and Egan detail a decent range of ideas from different schools of economic thought - from Minsky’s description of an economy with increasingly speculative uses of debt during stable periods which later stifle investment, to the many micro-economic behavioural explanations that result in speculative herding in the aggregate.

In this part I was impressed by the effort to clarify the role of economic rent, both as part of the economic cycle, but also as a permanent feature of political machinations. If one is to believe that the use of debt for speculation is an inherent driver of booms and busts, then one must consider the political situation that allows, or sometimes encourages, this to occur. Obviously speculative asset price booms are in the interests of the rentiers who gain immense value from the risks taken by new speculative entrants in their respective asset markets. I don’t think we can really understand why certain countries seem able to stabilise their economies so well, while others do not, unless we understand this political element.

For example, in the section about debt dynamics and asset price cycles Soos and Egan test the simple correlation between housing debt acceleration and changes in housing asset prices. For most countries where it is well known that housing bubbles formed during the 2000s boom, the correlation is very significant (see table below). But then we have a number of outliers - Italy, Austria, Germany and Portugal. This analysis, to me, generated more questions than it answered. For example, where can we look for explanations of the apparent asset price stability of these outliers. 

We know that Portugal suffered a housing boom and bust while Germany has seen prices a flat as a pancake. Could it be foreign euro buyers herding into Portugal’s housing market, which disguise the domestic relationship between housing debt and pries?

And what of Germany? Which part of the political or institutional structure can we emulate if we want stable prices? Does it matter that German housing is 60% rental, and there is a major institutional sector operating in the rental market? Is it their tax incentives that promote long term investment over speculation? Or all of the above?

At the end of the second part of the book Soos and Egan settle on their preferred model of asset price cycles that they call a synthesis of ‘post-Keynesianism, Georgism and behavioural finance’, which they present as a summary to this section. I find this synthesis compelling. Indeed, it seems quite obvious when you think about it (though I don’t know why Minsky was not acknowledged in the title).

But their treatment of this synthesis is a little vague for my liking; then again, I enjoy the nerdy technical details maybe a little too much. The reason I still like their attempt at reconciliation of theories is that it seems obvious to me that people are irrational in the pure sense used in economics, hence the behavioural element, and that if we are not in a static equilibrium, then we are in the dynamic world of the Post-Keynesians, and if debt can be used for speculation instead of productive new capital, a la Minsky, then we are in a Georgist world with economic rents as well as competitive markets in capital goods.

Lastly, Part 3 begins with 40 pages of detailed historical Australian housing metrics, some of which have been published in various articles around the web by the authors. This is followed by a similarly detailed treatment of Australian banks, where I took the main message to be that banks have become much more housing focussed in their lending operations than ever before.

In this part of the book Soos and Egan delve into trends in modern lending standards and cases of fraud. We get a brief introduction to the US situation of subprime lending and securitisation, then move back to Australia, with very balanced overview of the alleged widespread fraud of loan application forms by banks and brokers, which contributed to the rise of no-doc lending.

Soos and Egan’s refute the ‘urban containment hypothesis’ at the end of this part of the book, which does not come as a surprise. After all, once you have read a detailed account of the three Australian depressions that occurred prior to any town planning, one of which occurred in an era of essentially unlimited supply of land from government to the private sector through the land auction process, then it would seem strange to turn around and invoke planning as a key factor in the current cycle. Indeed, after reading this book you can’t help but see the current land cycle as one of the least volatile in our history. Soos and Egan make their point here very clearly, and bring very compelling evidence and logic to support their position.

While Bubble Economics deals mostly with events that occurred over a century ago, it is nevertheless a timely contribution to the public debate around land, banking and the business cycle in Australia. The book is very detailed and you may find the style a little dry, but as I said, best thought of as a reference book. Again, Bubble Economics is free and available here.

fn. [1] Readers may recognise Philip from his work assembling long term data on the Australian housing market. I’ll also disclose that I provided feedback on some draft sections from Part 3 of the book.