Futile rental-price competition

In his famous book, The Greatest Show on Earth, Richard Dawkins’ presents a Forest of Friendship story, which contains within it a powerful idea that has broad implications for how we develop important social, economic, and political institutions. I want to show how this idea provides clues about how to tackle excessively high home rental prices, and offer some suggestions about how to do just that.

Here is Dawkins.

Imagine the fate of a hypothetical forest - let's call it the Forest of Friendship - in which, by some mysterious concordat, all the trees have somehow managed to achieve the desirable aim of lowering the entire canopy to 10 feet. The canopy looks just like any other forest canopy except that it is only 10 feet high instead of 100 feet. From the point of view of a planned economy, the Forest of Friendship is more efficient as a forest than the tall forests with which we are familiar, because resources are not put into producing massive trunks that have no purpose apart from competing with other trees. 

But now, suppose one mutant tree were to spring up in the middle of the Forest of Friendship. This rogue tree grows marginally taller than the 'agreed' norm of 10 feet. Immediately, this mutant secures a competitive advantage. Admittedly, it has to pay the cost of the extra length of trunk. But it is more than compensated, as long as all other trees obey the self-denying ordinance, because the extra photons gathered more than pay the extra cost of lengthening the trunk. Natural selection therefore favours the genetic tendency to break out of the self-denying ordinance and grow a bit taller, say to 11 feet. As the generations go by, more and more trees break the embargo on height. When, finally, all the trees in the forest are 11 feet tall, they are all worse off than they were before: all are paying the cost of growing the extra foot. But they are not getting any extra photons for their trouble. And now natural selection favours any mutant tendency to grow to, say 12 feet. 

And so the trees go on getting taller and taller. Will this futile climb towards the sun ever come to an end? Why not trees a mile high, why not Jack's beanstalk? The limit is set at the height where the marginal cost of growing another foot outweighs the gain in photons from growing that extra foot.

The futile competition Dawkins describes is a natural instinct. Civilised society builds institutions to help avoid the negative consequences of such instincts, with rationing systems that foster genuine large scale cooperation.

One particularly important part of the economy where our institutions no longer prevent futile competition is in the housing market. I am not just referring to the house and land asset market, where speculation runs regularly runs rife. Rather than mutant trees, it is speculators who try to bid just a little more for each home, wasting resources by overpaying for land. These always end in spectacular crashes where the greatest fool - the last speculator - makes the greatest loss. But they also bring down the real economy as well!

I am talking of something more mundane. The rental market.

Here too there is a forest canopy. It is an invisible rental price curve, a rental canopy if you will, that expands across the world’s cities, supported not by heavy wooden trunks, but by the wasted resources used by tenants to pay to access the land. While Dawkins’ trees chased a bigger piece of sky, renters chase a better piece of the land.

The diagram below shows the basic idea. The green line is the current “rental canopy”, which is higher near city centres, and falls with distance. At half the height is an orange line, which is one possible height of the rental canopy, if a cooperative institution could be developed to stop the futile price competition amongst renters. The grey shading shows the economic gains for renters from an increase in cooperation.

So why don’t tenants cooperate like a Friendship Forest?

The benefits are clear. In Australia, there are around 2.7 million renting households paying $60 billion per year in rent or $22,000 per household. Halving the rental price saves $30 billion of previously wasted resources by renters, generating massive efficiency gains for them.

Large-scale cooperation could happen in practice in the following way. Each renter sends a copy of their lease that shows their current rent to a central organisation. The organisation tells each renter only to pay half the rental amount on the lease to their landlord, and that from now on it will set the rental prices. Because the organisation negotiates on behalf of all tenants, it is a monopoly supplier of tenants to the landlords and can set the rental price.

Let us call this organisation a Tenants’ Union.

If there are no “mutant”, or “rogue”, renters who opt out of the union and outbid rental prices by negotiating directly with landlords so they access a better home for themselves, the system will work. It is a genuine Friendship Forest. If this cooperative institution could drop the “rental canopy” by half it would save each renting household $11,000 per year.

This is great news. It is a perfectly possible and realistic thing that can be done.

But there is another side to the Tenants’ Union story. The landlords who own these 2.7 million homes would earn $30 billion less per year. In Dawkins’ story, the landlords are the animals who benefit from inhabiting the trunks, the loggers who cut them for timber, and others in the ecosystem who lose their benefits if not for the resources contributed by the futile competition amongst canopy trees.

So that political reality would need to be negotiated.

The rest of the story happens within the Tenants’ Union itself. To avoid futile competition, they must enforce a non-price way to ration the better (and worse) homes amongst potential renters. If they can’t do that, they simply shift the futile price-competition from outside the organisation to inside it.

I should be clear that any such system would not be perfect either. We are therefore comparing an imperfect system of rationing through futile price-competition, costing renters $30 billion, or an imperfect alternative system, that might make the choices of renters more limited, but will benefit tenants $30 billion every year.

So what sort of non-price rationing system could our Tenants’ Union employ? I can think of a few.

1. Queuing
A list is made of people who want to rent a home of a particular type, in a particular location, with new people added at the bottom. Each time a property becomes available, it is offered to the first person on the list. To retain a degree of choice, each person on the list might get 3 veto choices - homes that become available at their turn, but which they could choose not to take, and stay at the top of the queue and wait for the next home.

The more effective this system is at reducing prices, the longer the queues.

2. Lottery
Each time a home becomes available, a lottery is run, with a period of a few weeks in which potential tenants can get a ticket. The winning ticket gets the home. This can be expanded to run in batches at set intervals to overcome problems of having tickets in multiple lotteries at once.

The more effective this system is at reducing prices, the more people contesting each lottery.

3. Need
Homes would go to people based on an assessment of the household's needs. Criteria could include rental history, income, family status, age, other other metric deemed fair and reasonable. Such assessment can be used to determine qualification rules for lottery or queuing systems.

Other methods could, of course, be implemented. But to make any of them effective at undermining futile price-competition, secondary markets would need to be outlawed, and this rule rigorously enforced.

There are some final points to consider to counteract the likely arguments against this idea, all of which are inherently arguments in favour of futile price competition.

First, rationing without prices is itself futile, because "capitalism". Yet in the most important areas of society in all capitalist economies, price competition is strongly avoided. In the courts, we ration by queuing, and ration juries by lottery. In politics, we use elections to ration positions of power. In healthcare, we ration public services based on assessments of need. Spouses are allocated to each other through non-price rationing.

Second, non-price systems limit choices for tenants, and that is bad. Yet price-competition also limits choices for tenants. The bottom half of tenants by income already are excluded from choosing the top half of rental homes because of prices. These non-price systems provide much broader choices to the lower income households.

Overall, it should be clear that price competition over nature’s scarce resources - be it the sunlight in the forest, or access to the land in the housing market - is usually futile. Human societies overcome this by developing institutions that use non-price ways to ration resources. Taking a stand against price-rationing in the rental housing market by developing institutions like those discussed here could save tenants billions of dollars a year.  We should look into it.

Book review: The Econocracy

I have just read a fantastic economics book. In entertaining detail, it outlines many issues in the economics profession that I feel strongly about [1] Like the authors, I want my discipline to evolve into one that is much better than it is; more practical, humble, and diverse. So why did I finish the book feeling less than upbeat?

The book is called The Econocracy: The perils of leaving economics to the experts. It is about how the general population has been excluded from public policy debate by an inward-looking economics profession. More than this, the profession is fundamentally failing, having grown in the past three decades to become nothing more than ideology masquerading as science.

Econocracy is written for people with some economics training, or with a keen interest in economics. Or perhaps even someone who is simply concerned about public policy debates being hijacked by economists and their jargon would appreciate it, and I can imagine there are many such people!

I would summarise the main story of the book as follows

1. Economics is now the default method of analysis in serious social and political debate, undermining the legitimacy of other modes of analysis, making anyone who doesn’t understand economics and its jargon unable to participate in the major political debates of our time.
2. Despite the great power granted to economists, the discipline has become nothing more than a narrow ideology, with that last defining theoretical battles happening back in the 1970s, and little openness to criticism or new ideas since.
3. Changes in how economists and their discipline function could benefit democracy. These changes are 
a) economists training their next generation in a more pluralist way, giving them exposure to many methods of analysis to avoid the ideological indoctrination that is economics education and 
b) economists being less insular by reaching out to the public to promote a culture of “citizen economists”, who have sufficient understanding and confidence to bring their groups to the table and participate effectively in policy debate.

I will admit my bias upfront and say I needed no convincing of the first two points. Let me see which part doesn’t quite inspire me as much as I expected.

What is an econocracy?
In the words of authors - Joe Earle, Cahal Moran and Zach Ward-Perkins (EMW) - an econocracy is

A society in which political goals are defined in terms of their effect on the economy, which believed to be a distinct system with its own logic that requires experts to manage it.

I am totally on board here. Making policy in order to nurture a thing called an economy is bizarre, bordering on meaningless. The slightest scrutiny reveals that the economy is whatever economists assume it to be.

When we think of Gross Domestic Product, probably the main measure of the ethereal thing we call the economy, we are actually thinking of a measure whose definition has changed dozens of times. The latest change of note is the inclusion of illegal drugs and prostitution in the European Union official GDP statistics. So is crime now part of the economy? And if so, is it good or bad to have more of it?

Examples like this are common, yet routinely ignored. They reveal that when you define an economy, you are making moral judgements about what is good or bad for society. Economic growth is only good if you agree with the hidden moral judgements that sneak in when you define the economy.

Bringing insights like this to the surface can connect economics to a broader audience. Many people want to put forward their views in political debates about what constitutes a good, and just, society, but are bamboozled by economics jargon, which seems to leave no place for them. Cloaking policy debates in economic jargon limits participation from those who simply want to express their valid moral judgements about how society should be run.

Not only is the economy now the exclusive subject matter for experts who hide their moral judgements, these experts often hide their financial interests as well. If you have seen the 2010 film Inside Job, you would know how prevalent this is, particularly in the economics profession. I can personally attest to the troubles of even getting economists to recognise that they may have ethical obligations. But perhaps that is because their training was so narrow and uncritical.

Fixing a failing discipline
The decline of critical thinking in economics is beautifully told in the chapter entitled Economics as Indoctrination. For anyone considering studying economics, and for its many of teachers, this chapter will resonate.

EMW make their case that economics courses are best described as indoctrination by presenting the results of a curriculum review they conducted covering 174 economics modules at seven Russell Group universities. Their data is revealing and provides indisputable evidence that the discipline trains its newcomers in a narrow, uncritical, and unrealistic way.

As a teacher of economics, their survey results were fascinating, but not surprising. Multi-choice questions and lack of critical thinking seem to dominate assessment at the two universities I have taught at, while neoclassical methods of optimising representative agent models are the default, and sometimes only, approach taught. If anything, this chapter is a call-to-arms for teachers of economics everywhere.

EMW propose that teaching in a more pluralist and critical way is the answer. Many of the core parts of an economics course would be kept, and some replaced with a more diverse set of ideas and methods. No longer would material be presented uncritically as religious icons to be believed, not challenged, but each idea would be pulled apart and rigorously scrutinised.

However, the battle for change in teaching cannot be underestimated. Just look at the profession’s reaction to the efforts of EMW and their allies at the Post-Crash Economics student group.

The main reaction as has been “change without change”. A group of alternative reformers agree with EMW that the teaching of economics is poor (though in the quality of the teaching, not the content), and have endeavoured to fix it with better teaching materials, producing an updated textbook for the 21st century called Core Economics. Unfortunately, this group missed EMW’s central critique - the content should also change!

EMW respond to the Core Economics project in their book. But I don’t think they quite see it as the defensive strategy of a powerful group that it is in reality. To me, this reaction is a signal of the political and financial power of the status quo in economics, and the enormous challenge ahead.

There are other problems I see with their pluralist solution. Teaching a pluralist curriculum requires teachers who actually understand alternative non-neoclassical approaches to economics in all their nitty-gritty detail, so they can be equally taught in a thoughtful and critical manner. There are very few of them.

And to make space for this type of pluralist teaching means dropping parts of the current core economics modules. Which ones should go? Egos will be damaged in this process.

I have personally tried to improve my teaching multiple times, only to find that dropping particular materials and including other new material, combined with more critical and reflective assessment pieces, has been frowned upon by others in the school. Particularly if they are teaching modules later in the course that build on the material that I chose to drop. Some kind of collective choice needs to be made about what topics to drop, and what to keep. And it is inescapable that such a choice will signal to many professors in positions of power that their careers have been wasted on things the discipline now considers to be nonsense, and not worth teaching.

Having an academic tribe that conforms to the same approach gives that tribe power. Notice the book is not called “sociologocracy” or “political science-ocracy”. Disciplines that do teach a variety of methods in a pluralist way typically end up losing credibility to outsiders because of the infighting within the discipline about fundamental issues.

I would recommend the book Economists and the Powerful: Convenient Theories, Distorted Facts, Ample Rewards, by Norbert Häring, which explains how neoclassical economists and their methods become powerful because of a feedback loop between the theories they created, and the support of the political classes who benefited from those theories. Economics as a discipline is now very powerful, and its uniformity maintains its power.

These incentives mean that change needs a grand coalition, rather than a slow evolution of improving the curriculum one module at a time. Past efforts of student groups have sought similar reforms in economics for nearly thirty years without success. I don't think EMW see the sheer size of the political challenge their proposed reforms face. I do. And that's probably why it is hard for me to get too excited.

Reaching out
To shift society away from an econocracy to a democracy, EMW also see benefits from economists as a group reaching out to the public to make accessible the technocratic analysis of themselves and their peers. A survey the authors conducted of 1,500 adults across the UK found very low levels of economic literacy in the general public, meaning the economic jargon being sprouted by politicians and the media each day is not actually communication useful information to voters.

I agree wholeheartedly with this proposal. It only takes a few economists to reach out and teach active community groups to be savvy about, rather than intimidated by, economic analysis. And if such efforts result in greater participation from community groups in all spheres of life, it may undermine the demand for bogus economic analysis by vested interests who use it as a shield against criticism.

This idea has promise because it generates change outside the discipline. I simply do not see a way for economics to reform itself from the inside. The only way to change, that I see, is for the rebels and reformers to form a new discipline. Perhaps reaching out to the public is the start of that, which will develop a network of ‘citizen economists’ who are able to share knowledge, and through their networks and organisations, create a demand for work of people trained in this new discipline.

Call this new disciple something catchy, then agree broadly on its scope, some guiding philosophies, then add in some ethical standards. Get the major institutions of the country involved, like the Bank of England, to give it credibility. With some luck, this rebel group will soon develop a reputation as being the superior discipline to economics, or what would soon become known “out-dated economics”.

Anyone who has studied powerful informal groups and networks knows that radical change usually comes from outside, while insiders go down clinging to their old beliefs and denying that reform is necessary. The book itself the work of three outsiders; students from Manchester who were able to see the tribe with clear eyes, and a clear head.

I can only hope that with such bright and critical minds as theirs entering the discipline, that the time may be ripe for change, either from within the discipline, or with new leaders rising up to change it from outside. Whatever the case, while I finished the book a little glum, I have finished this review much more upbeat, ready to push for change wherever I can.

fn [1]. I have a PhD in economics, teach graduate economics courses at The University of Queensland, and consult widely for non-profit groups to help them participate in policy development. An important disclaimer is that I have also been peripherally involved with Rethinking Economics, a group very much aligned with the reform efforts of the authors and their student group Post-Crash Economics. The authors provided me a complimentary copy of the book.

Value capture now a serious debate in Australia

The Department of Infrastructure and Regional Development has released a discussion paper about value capture; an idea that the incremental gains to land values that arise from new public investment can be captured n some way to fund that investment.

I have made a very brief submission to this policy development process (reproduced below).

What is surprising is how far the debate about land value taxation has moved in the past 5 -10 years. Just a decade ago any talk of taxing land values was dismissed by 'very serious people' as the crazy idea of 19th century eccentric (yes, I'm referring to Henry George), and also argued to not be technically possible in reality (which was a bald-faced lie).

To capitalise on this new political climate of acceptance of taxing land, I have made the absolutely crucial point in this submission that we already have well-functioning system of land value taxes in every state, which automatically perform the function of capturing land value gains from public investment! However, these systems are clogged up with politically expedient exemptions. These exemptions could simply be closed in order to get a system that is a near perfect implementation of the idea of value capture.

So here's my submission, which responds to 13 question raised in the discussion paper in order.

How can we make better use of Value Capture?
Submission 

Dr Cameron K. Murray
The University of Queensland
Tuesday, 24 January 2017

1. What factors would cause beneficiaries, in particular property owners, to see a value
capture charge as ‘just another tax?’ How can these factors be overcome?

Every loser from a tax change will whinge. The trick is perhaps to simply remove exemptions from existing land taxes and then sell it as ‘fixing loopholes’. There is no obvious reason why a special “value capture” tax should exist, when a tax on land values, which already exists in all States (with far too many exemptions) will automatically provide the funding mechanism sought by arbitrarily drawn “value capture districts” or other measures.

2. Are there examples of mechanisms currently being used in Australia or internationally which provide a clear nexus between payments and the benefits provided by the infrastructure?

The Gold Coast Infrastructure Levy is supposed to do that. But there is no good policy reason to do so, because the factors that determine land prices in an area are much more broad than the type of things that get categorised as infrastructure. And it is also the case that some infrastructure will have negative effects on nearby land prices due to noise and other externalities.

There is also no ability, even if governments promise it, to isolate and earmark certain revenues for certain expenses, given politicking and accounting trickery. Forget about it. Use it as a selling tool if you must, but don’t pretend it is the reality.

3. Which mechanisms are currently being used which have weak links between payments and benefits?

Promises.

4. In providing funding to projects, should the Commonwealth set a condition that any contributions levied by state or local government on surrounding landowners are dedicated to the project?

Forcing the states to choose catchments affected by infrastructure is going to open up political battles that don’t need to be fought. There is no clear accepted method for determining catchment boundaries, and catchments are likely to vary project by project, depending on the pre-existing infrastructure, and type of activities occurring in the local area.

Certainly a less politically sensitive way to do this is to add a charge on new development only within an arbitrarily defined catchment, avoiding much of the blow-back from existing owners and residents.

5. How can governments accurately estimate the incremental value uplift generated by infrastructure projects as compared to uplift due to ordinary market growth?

Highly detailed data on property sales or land values is necessary. Even then, it is still very difficult to isolate the marginal value gains statistically, given the challenges of properly identifying the timing of value effects. I have recently undertaken such an analysis on the Gold Coast Light Rail.

6. When identifying beneficiaries, how should governments determine the geographical boundaries around new infrastructure assets? Should governments focus on all properties directly around the new assets, within the wider region or at a city-level?
 
Every time a boundary is drawn it will generate conflict near the boundary as some landowners win, and some miss out, financially. A better way is a city-wide levy, which makes sense for network-style infrastructure, such as rail, where expanding the network benefits people not only at the new station, but on the rest of the network who now have access to that new station.

7. How can governments design processes which cause beneficiaries to reveal their
willingness to pay?

This is unnecessary. Simply incrementing up the rate of land value taxes in general, and removing exemptions, will automatically capture incomes from land value gains which arise from public infrastructure investment of all types, and at levels which are perfectly in proportion to the willingness to pay of land market participants.

Additionally, there is an interaction on some modes, like rail, between ticket prices and the effect on land value. If trains were made free to ride, land values nearby would rise to reflect the reduced cost of living in that locations (and vice-versa).

A general recurring tax on land values automatically responds in both directions to any such effect, reducing tax burdens on those suffering negative effects, and increasing it on those who gains positive economic benefits.

8. Could we adopt an approach in Australia of holding popular votes in relation to large
infrastructure projects and their funding mechanism?

That would be possible only if there was already a system in place to generate a shortlist of viable candidate projects that could then be voted on.

9. Who would be best placed to organise such votes? Local councils? Transport
authorities? Others?

Given the large size of many new infrastructure projects, these seem a task for the States, though some large councils could independently conduct such a voting system. Although if it was a decision on funding by the Commonwealth to choose between alternatives generated by the State, the Commonwealth could run votes locally.

10. Would the Commonwealth be justified in linking funding to evidence of popular
support and willingness to pay?

This is difficult. Many people can’t think about how they will behave in the future, especially when infrastructure is a new mode that they are not yet familiar with. You are asking for trouble to justify funding on this basis of elicited willingness to pay from survey data based only on early proposals.

11. Are there examples of other successful approaches to seeking community
acceptance for value capture mechanisms?

Not sure.

12. Should there be different approaches to obtaining proof for different beneficiaries?

No. As above, broadly applied land value taxes automatically identify landowning beneficiaries. Obviously users benefit as well, and user changing is widely accepted in rail (tickets), road (tolls), and other transit infrastructure. However, it is a social and political choice as to whether users, or external beneficiaries, such as landowners, should pay more.

13. Are there examples where re-zoning, integrated planning and value capture funding have been well implemented? Are there examples of missed opportunities?

Australia has a great working example of land value taxation in the ACT, specifically a transition towards much higher rates of land value tax. The ACT also capture land value gains from rezoning in its lease variation charge, getting around 75% of the value gains from rezoning (in addition to 100% of the value gains from rezoning rural to urban uses through the functions of the Land Development Authority. See this paper for analysis of the ACT example

Sau Paulo, Brazil, also has regular auctions of rezoning rights used to fund local infrastructure, and has raised over $USD 2 billion in the past decade (see here).

Company tax confuses economists

Basics

To think about company tax, we have to first understand it. These taxes apply to a type of entity run by humans with its own set of accounts called a company. That entity typically aims to make a profit each year, by making sure its revenues are above its costs, with some costs able to be amortised (or smoothed) across time in an accounting sense through depreciation, and in a financial sense, through borrowing and repaying debts. 

Across Australia, company profits were about $230 billion in 2015-16, and company tax revenue was $65 billion.

Companies in Australia pay tax on their profits at 30%. If these profits are then transferred to the company owners, through a dividend, the owners of the company are credited for the tax already paid by the company and pay the difference between the company tax and their marginal rate.

So we have two important situations to consider if we want to know the effect of a company tax. First, the situation where a company pays all profits to its owner in a year. In this case, because the tax is credited against the tax payable by the person (or people) who own the company, the effective company tax rate is zero. It ceases to be of any relevance to any decision making internally (profits, or whatever objective, are still maximised) or externally (owners of companies can compare company performance before tax).

If this was the case all the time, company tax would be a none issue. With it or without it the net effects are the same, and if we err on the side of simplicity, we would get rid of it. There are no distributional or efficiency effects to worry about.

But the second case, where the company retains their profits on their own accounts, gets really interesting. And confusing for economists. Because it all happens in their big blind spot - financial assets.

An example
Let's simplify some more. In this second case, the company makes a $100 profits, they pay the company tax rate of 30% on it each year, then simply accumulate the remaining 70% of profits (the after-tax profits) in their own bank account.

The table below compares the with and without company tax scenarios where one year's profits are saved as assets on the company books and are therefore assets on the owner’s books.

Notice what happens when we remove the company tax. It makes it easier for companies to accumulated assets with tax-free incomes, and thereby increase the wealth of their owners. Company tax is simply another way to tax wealth accumulation but on unrealised capital gains.

The "economic" logic
Now hold on there, says the little economist floating over my shoulder. Why would anyone want to own a company that increases in value without ever getting a dividend? What crazy economics is that?

It’s the type of economics that acknowledges that financial and asset markets even exist! After all, what purpose is there to run a business, or own a financial asset, except to accumulate wealth? If people weren’t interested in such things, there would be no super-rich people, they would have cashed out all their assets and spent the cash on faster cars, better aeroplanes, or bigger houses.

It’s the type of economics that acknowledges that people will own vacant land without building on it because it is an asset whose value rises over time.

It’s reality.

But things get crazier still

The economic consensus is that taxing companies is bad because it reduces investment in new machines, buildings, vehicles, ships, and other capital equipment, thereby reducing the rate of growth of the economy. After all, it means it costs companies more to save a year’s income in their own accounts before spending it on new machines next year.

It’s one of those ideas that seems plausible on the surface. But in fact, one great way to avoid company tax is to make less profit by investing now in new machines and equipment—the exact economic incentive most economists claim comes from removing the tax!

A company that is not investing like crazy is likely to have more profits—they are probably lazy monopolists. I can think of a few, like Telstra, the banks, and some of the big miners.

I’m serious. Here’s a plot of Amazon’s profits. Notice the period of low and negative profits. That’s what you get when you are investing heavily in warehouses, robots, servers, IT, and other large capital projects that are the things that make us more productive in the future. It’s an example of avoiding company taxes by investing!

Source: Business Insider

And yet, cutting company taxes is a love-in. Treasury likes it. Many think-tanks like it. Here’s Nick Gruen liking it. But they are all wrong. And they are wrong because their model conflates physical capital—machines, vehicles, buildings and equipment—with financial arrangements. You can’t tax a tractor. You tax only the profits of an entity that may own a tractor to help earn its revenue. The new tractor is a cost that reduces taxable profits!

If the company buys too few tractors, its profits will be lower because it couldn’t earn the revenue. If it buys too many, its profit will be lower because its costs are higher. The optimal investment in tractors that maximises profit is the same, whether you keep all the profit, or just a share of the profit because the rest is taxed.

The reason that so many economic models show efficiency gains from company tax cuts is… because they assume it in the first place! They assume that any additional profits kept by the company will all be used to invest in new machines and equipment.

So the efficiency gains all but evaporate if you don’t assume them and actually look at how company taxes actually work.

Gifts from the people
Lastly, what about the distributional effects? I have shown in the table above how company owners will be able to accumulate wealth in the company entity and avoid taxes altogether. But The Australia Institute has gone further and shown that the major beneficiaries are the big banks, who get $7.4 billion over the next ten years, as well as the US government through its tax system, because of offsetting arrangements used for companies who have already paid tax in other countries, like Australia!

Cutting the company tax will be a multi-billion dollar gift from with working class to the super-wealthy. If it goes ahead, prepare for Australia to catch up to the world in our political backlash against the establishment!

UPDATE:
The below meme came across my screen on Facebook. Don't know if it an real quote but the argument is true.

Quick views on Trump (did we forget Brexit already)

When the Brexit vote stunned the world’s elite (obviously it didn’t stun the millions who voted for it) I wrote about some simple lessons that are too easily ignored in “normal” times. 

With Trump winning the US election, perhaps it is again worth reflecting on how the world’s elites misread the public mood so badly.

1. Elites seem to believe the public will eat up their lies, but then they deludedly thought that exposing Trump’s lies would bring him down. Facts Don’t Matter. To either side!
 Look at the lies from celebrities promising to leave the country. Anyone could see through it!
2. Again, technocrats underestimated human tendencies to blame outsiders for their woes. Despite being a believer in multiculturalism, the basic reality is that high levels of immigration reduce labour’s bargaining power.

3. This disconnect is clearly seen in the way the media “looks to the markets” as a way to gauge views on political decisions like this (see top image). That’s total crap. No one gives two hoots about the financial markets unless they are part of the wealthy elite. In fact, this is a victory for his supporters who see, quite legitimately, that the worship of financial markets has distracted politicians from the needs of the vast majority people who have not a cent at risk in those markets.
4. The Australian media portrayed the land down under as a country of moderates who were disappointed about Trump’s win. That’s complete nonsense. While it may reflect the reaction in my social circles, and maybe yours, just remember that Australia already has a more inhumane immigration policy than what Trump proposes, and already has whole bunch of nut cases elected to government at all levels. Trump would be amongst like-minded friends in the halls of most Australian governments. 

5. It’s almost like the elites were speaking Latin, and the masses speaking english. The elites simply couldn’t understand Trump’s appeal, and their lack of appeal. He lies. He objectifies women. That signals he is a normal human being. Unlike the faux outrage, most common people realise humans, god forbid, pursue each other for sex. He talks about a wall along the Mexican border and everyone goes crazy. Almost as if they forget there is already a bloody wall! There are about 1,000km of barriers, fences and walls on that border!

6. The US is already a country taking political prisoners, torturing whistle-blowers, invading countries on false pretences and against the will of international organisations, and conducting mass surveillance on its own citizens. They already deport illegal immigrants and have a border wall. The political classes failed to punish anyone on Wall Street after the financial crisis, yet also then failed to take on public investment programs to support the wage-earning classes. They already have police killing black people routinely. What exactly is Trump going to do?

Economic thoughts

1. Why is work virtuous?

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

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

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

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

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

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

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

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

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

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

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

— Underworld Economics (@UnlearningEcon) September 9, 2016

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

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

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

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

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

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

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

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

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

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

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

Lobbyists own QLD planning

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

Yeah for Queensland!

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

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

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

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

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

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

A private land titles office is bull$hit

The privatisation agenda knows no limits.

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

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

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

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

My questions about the planned sale are these.

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

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

Future of health & retirement is public, not private

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

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

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

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

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

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

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

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

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

Zoning nonsense: first Houston, now Japan

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

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

1. There are planning controls in these areas

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

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

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

2. These areas have had major bubbles

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

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

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

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

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

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

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

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

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

Here we go:

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

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

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

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

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

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

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

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

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

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

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

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

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

This is just quoting professional liars arguing.

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

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

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

RBA wants one-sided coin on foreign capital

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

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

 

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

 

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

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

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

This is weird, for two reasons.

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

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

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

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

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

A simple example could help clarify.

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

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

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

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

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

Stock-flow confusion (wonkish)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Econ-media gets fresh

A quick update on two interviews from the past week.

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

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

Here’s the podcast

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

Economics of favours and karma

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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