Thing I wish economists never said

One thing I find surprising about economics is the misuse of models as tools for reasoning.

Think about the basic micro-models. What do they say? They say all markets are in equilibrium. Okay, if that’s the approach you want to take. So how did they get there? Tatonnement? A Walrasian auction. We get there via a central planner who facilitates the equilibrium price before trade is allowed to take place! 

This lack of substance in the fundamental model of markets should beg the question of why markets are preferred over alternative forms of planning? You actually need some other theory to support the assertion that markets are the best resource allocation tools - but such a theory does not exist. 

One problem you face trying to get economists to think deeply about the real life applications of their beloved models is that you have to pretend to take these nonsense models seriously. Don’t be surprised if you get arguments to the effect that real life commercial behaviours must be wrong because the model is right. 

With that short rant over, I want to share a list of phrases and terms that I wish economists never said. These terms illustrate that vacuous nature of economic reasoning, as as you will see, they test the patience of any thoughtful observer. 

Fundamentals

Probably top of the list of things you say when you have no idea what is happening in a market - “we need to look at the fundamentals”. Okay, WTF are they? Just your pet theory? You actually need a deep understanding of the institutional history, legal and regulatory structures of markets, and a decent technical understanding to even know what the fundamentals might be. Plucking an uninformed notion of supply and demand out of thin air is not understanding fundamentals.

Second best

Most people who use this term actually don’t understand its meaning. In the equilibrium model of markets if one market is not in equilibrium, then no other market can be in equilibrium - it’s all or none. The idea of second best is that if in reality there are some markets that aren’t in equilibrium, improving overall outcomes might mean implementing policies that make other markets diverge further from their theoretical equilibrium.

Basically it means that trying to make an outcome perfect in one market might lead to counteracting effects in other market that negate any beneficial effects.

For me this term implies that the equilibrium model of markets is a poor tool for analysis of the economy. However the term implies that market model is first best, and real life is second best - how truly odd to say that.

Bad equilibrium

A assume the economy is in equilibrium. When shit goes bad, assume that the economy is in a ‘bad equilibrium’. WTF does that even mean?

Free market

Really, the ‘free market’ is just a system of highly rigid social institutions that define rights and constrains activities. One frustrating alternative to this phrase is “let the market decide”, which doesn't actually means anything of interest, because markets are merely a product of alternative regulatory constraints. The term creates a diversion from important social issues because it reinforces the assumption that market allocations automatically fulfil social goals, and any interruption of their operation will have costly social repercussions.

The NBN is a great example of this. The social aim is to provide equitable access at a consistent high standard to fibre internet through cross-subsidies between city and country users. The market alternative is that few high value city location will get access to an almost identical service, possibly at lower prices. We decide whether markets are the appropriate tool to fulfil social aims - markets don't decide anything. 

Remember, we can create institutions to produce whatever social goals we have in mind. Market outcomes are great in many circumstances, but they too have social outcome that might justify alternative forms of allocation. 

Shock

As if the regular business cycle, the subject of now centuries of economic research, somehow arises from somewhere external to the commercial activities of society.

Malinvestment

This Austrian economics terminology is both subjective and confusing at the same time. A school of thought that has its own ideas of creative destruction (implying an unpredictable future and therefore lots of poorly allocated capital) somehow expects all capital to be perfectly allocated or this system will collapse? Unfortunately this term provides an excuse to points the finger for economic woes at whatever your pet hate is at the time (usually government involvement in setting nominal interest rates).

Reform

I will let Zac Gross have a go at this one.

‘Reform’ is very sexy word. It is often deployed to cloak policy in feel good vibes and to create an aura of leadership and vision. So everyone in the policy-sphere wants to think of themselves as reformers and many a complete bastard has appropriated this lovely, but overused, title.

Land and housing are durable goods (or why demand/supply framework fails)

The ‘standard’ urban economic model is based on Alonso, Muth and Mills combined work in the 1960s to fashion a mono-centric urban space into an economic equilibrium model. For some reason this model has gained traction in the literature despite it gross misrepresentation of housing markets.

I will let the reader enjoy the comments from David Pines’ 1987 review of the urban economics literature

The static approach in the Alonso-Mills-Muth model is useless in explaining many stylized facts regarding the urban structure and its evolution through time. In the static analysis... land is continuously utilized within the city boundaries and the city boundaries are continuously extended with income and population size.
...
The reason for the failure of the static model in explaining these ‘irregularities’ is that the housing stock is assumed to be perfectly malleable, which, of course, is highly unrealistic. 

What this means is that every time there is a marginal change in any of the parameters of the model - a new person moves to the city, the rental price of the second best land use increases, or the efficiency of construction methods change - the whole city is wiped clean of housing, and the land owners and people sit down around the camp fire and decide a new optimal allocation of housing under the new conditions, then the whole stock of housing is rebuilt in an instant to that new specification. There is never a vacant site or development opportunity. 

Yes, this bizarre model was used by RBA used just a few years ago to help them understand regulatory impacts on housing supply. 

However we have known since 1989, when Bagnoli, Salant and Swierzbinski explored the durable goods monopoly problem posed earlier by Ronald Coase, that the optimal revenue raising strategy of land owners is withhold new supply of housing to future periods to maintain price levels. 

Thus, the constraint on new supply is the number of buyers willing to pay current prices or above in a given time period. If the number of buyers dries up, the optimal solution for the land owner is not to develop until such demand arises. Thus speculative booms are likely to coincide with construction booms, as investors rush into housing markets allowing developers to sell larger volumes of new stock at current prices. 

This point probably needs an example to really drive it home. Imagine you are subdividing a lot into three smaller housing lots. Your market research suggest that $300,000 per lot should be an achievable price. You put them on the market for that price. It takes 4 months to get the price you are after for one block. 

You get offered $280,000 for the second block after another 4 months. But you know that if you accept this price that you will most likely have to accept that price for the third block as well (especially given that sales prices are public records). 

The big question - the one that determines the rate of housing supply - is how long to wait for sales to maintain prices. Do you make a better return if you accept $280,000 and increase the supply now, or is it better to wait until you can get a price of $300,000 and defer new housing supply? 

The answer that Bagnoli found was that if the sellers are more patient than buyers on average (the have lower discount rates), than it is optimal to wait. It is better to sell one per year at $300,000, than 3 per year at $280,000. 

In the mainstream world of AMM’s economic model you shouldn’t have bothered waiting at all. You should have dropped the price immediately until you sold all three blocks on the first day. 

You might want introduce ‘competitive’ land developers at this point. Say my neighbour also subdivides their block into 3 smaller lots. With this less constrained supply surely now the rate of new housing construction will be higher? 

Actually it is not. 

The return maximising strategy is for each land owner to wait, and still sell just one of the now 6 potential lots each year. The land owners compete with each other for a sale, which encourages innovation in design to better appeal to buyers (to get the sale instead of their competitor), but it doesn’t bring forward supply.

Perhaps a little story from my time with a major residential property developer might help.  Remember the days when people would queue at sales offices for new subdivisions.  By sheer luck we were faced with this sort of crazy demand when we released sales of a new building at the Sunshine Coast.  Early that morning it seemed we would be able to sell the whole building within a day or two. So did we?

Of course not. We crossed all the prices out and wrote new ones 20% higher.  That certainly slowed the sales right down, and it took a couple of years to sell the whole building after that.  We simply did the profit maximising thing of withholding new supply. 

By understanding these fundamental processes at the heart of the housing supply debate it leads to very different conclusions about the types of policies that might trigger increasing housing investment - policies that focus on the discount rate of the land owners. 

This could include rent controls (decreasing future expected returns), incrementally ratcheting up land taxes (decreasing returns from not developing), announcing tighter building height restrictions in future periods (to encourage land owners to develop before the new restrictions are implemented), removing land tax exemptions for approved but undeveloped lots, and more. 

That last one is interesting.  In Queensland developers get a 40% discount on land taxes if they have subdivided a lot, but not sold it.  All this does is provide incentives to withhold land for longer, and the cost of doing so is reduced. Of course, developers will simply change the timing of the subdivision to be closer to the sales (getting approval, pre-sales, and then subdividing). But on average it must be a good move to remove this discount. 

The logic of durable goods means the extensive land banking by developers, which in Australia is currently around 19 years supply at current rates of sales, is actually a rent-seeking strategy - an attempt to buy land at a low price with one zoning, only to have it rezoned for more intensive uses before being developed.  It is not about anticipating supply needs and navigating regulations.

It means that developers stage developments in order to bring forward some construction and make the location more desirable for buyer of future stages.  Staging is about delaying development of new homes. 

Lastly, it means that reasoning of shortages or supply constraints due to land price differentials near zoning boundaries, such as by Grimes and Liang, is faulty at best. Of course differently zoned land at the same location is worth a different amount, because the value of that land is the capitalised income from its highest and best use minus the construction costs of that use. It has nothing to do with expectations of future rents or any such thing. 

I highly recommend reading my previous post in interpreting housing market indicators to fully grasp the potential misinterpretation of housing indicators from using the wrong model.

Thinking like RH Coase

I have often railed against the economic approach to social organisation problems which can be described as ‘assume first ask questions later’. There are too few good economists following more scientific methods of sound reasoning and the reliance on evidence in light of real world institutional structures.

The first approach is often called ‘thinking like an economist’. 

Ronald Coase, who passed away at age 102 earlier this week, was in many ways an outlier in the economics profession. He taught in the the University of Chicago’s Law School, rather than in economics, and was often misinterpreted by his economist peers on important and policy-relevant topics, such as what is known as the Coase Theorem. 

We can see his views in an article he wrote in 2012, at age 101, in the Harvard Business Review.

Economics as currently presented in textbooks and taught in the classroom does not have much to do with business management, and still less with entrepreneurship. The degree to which economics is isolated from the ordinary business of life is extraordinary and unfortunate. 

Coase’s scepticism is so important today, when the dominant ‘economic way of thinking’ is to apply marginalist equilibrium models to ever more obscure situations (a la Gary Becker). Unless one can be certain that the model is capturing the important characteristics of this particular market or social institution, the results of some manipulation to the model will have no relevance to the realities one is trying to understand.

One example of the original thinking that epitomised Coase’s career is his take on durable goods and the potential monopoly power of sellers in these markets. He raised these important questions a mere 41 years ago, yet almost none of the results from the research agenda that sprang up from it have entered the mainstream, and are certainly not found in most undergraduate textbooks. 

You will notice the strong links Coase makes to his descriptive model and ‘business practices’, a phrase you may never read in a whole economics degree. Nor do you much read the phrase “in the twinkling of an eye” to describe the rather arbitrary conceptual compression of time into a single period in economic models. 

One important feature of this and other work is that Coase did not make strong policy conclusions, but conditioned his results and explored reasons they may not hold in reality. 

These reasons were picked up and explored later by Mark Bagnoli and others, who found that certain critical implicit assumptions in Coase’s model were leading to its conclusions. 

Thus the assumption of a continuum of consumers-so innocuous and useful a simplification in other contexts-has proved misleading in the context of durable-goods monopoly. 

They explain that the optimal seller of an infinitely durable good (land) will exercise full market power and perfectly price-discriminate, holding back new sales to the market till future time periods to maintain price levels. They label this strategy for sellers the Pacman Strategy “since the monopolist attempts to eat his way down the demand curve.” 

This improvement and development of theory in the market for durable goods is still detached from empirical testing, but is at least an attempt to maintain links to “business practices” actually employed by land owners. 

Unfortunately, like his work on The Problem of Social Cost, Coase has been repeatedly misinterpreted by other economists. When you read about the Coase Theorem, you are probably reading about George Stigler’s interpretation of Coase’s discussions around social costs (externalities). 

As Coase explains in this interview (at the 0.50) -

It’s not about my work at all. George Stigler, who is a very nice man, wanted to pay me a compliment. So he invented the Coase Theorem, but he named it the Coase Theorem and not the Stigler Theorem.
The reason I don’t like it is that it is a proposition about a system in which transaction costs are zero. Well, that isn’t the way the system actually is. Therefore it is a theoretical proposition. I don’t like that.  

He later laments the difficultly in getting economists to understand reason during the now infamous meeting where he convince some Chicago colleagues of the merits of auctioning radio spectrum. 

All I said that the FCC should award the right to transmit on a given frequency to the person who paid the highest amount for it. To my astonishment this room, which one would of thought would be welcomed it in Chicago, was rejected by them. We went on for, I don’t know how long, and hour or something like that. At the end that time they all thought I was right.

They were very impressed by the fact the I had changed their views. But I wasn’t particularly impressed because all I was doing was stating the obvious. 

Coase relies extensively on real court cases and judgements to describe the apparent arbitrariness of property rights, when examining the judges ruling on Bryant v. Lefever he notes that 

The smoke nuisance was caused both by the man who built the wall and by the man who lit the fires. Given the fires, there would have been no smoke nuisance without the wall; given the wall, there would have been no smoke nuisance without the fires. Eliminate the wall or the fires and the smoke nuisance would disappear.On the marginal principle it is clear that both were responsible and both should be forced to include the loss of amenity due to the smoke as a cost in deciding whether to continue the activity which gives rise to the smoke. (original emphasis) 

Led by Stigler, many economists took this logic and ran with it, turning it into the Coase Theorem, while not fully comprehending that the real contribution of this article is to consider the case where bargaining is costly. 

The key point is that “In these conditions [costly bargaining] the initial delimitation of legal rights does have an effect on the efficiency with which the economic system operates”. He goes on to note that every type of social arrangement, including regulation by means of the “special kind” of “super-firm” that is government, has costs and we should seek social arrangements that minimise costs of cooperation relative to the gains. 

He explicitly says the perfect market model is irrelevant to almost all real social costs. The main message being that property rights are arbitrary constructions and we should consider the social costs and benefits of any changes from a given starting point. Its message was very relevant for legal scholars considering rights for damage claims.

On his work about the Nature of the Firm, he recently noted that firm organisation is really a sociological problem, not an economic problem. Which seems so obvious since internal firm decisions are rarely priced, nor do they take place within an environment of market-style contracts.

Rarely now do we see the type of common sense thinking that the ‘accidental economist’ Ronald Coase showed throughout his long career. In fact, I would be surprised if a Coase was beginning his career today that he would be able to break into the profession at all, given it’s obsession with formalisation of mathematical models, and disdain for verbal reason informed by real world conditions. He joked recently that he made his career stating the obvious.

Morality in economics, paid parental leave edition

Aussie econ blogs are all having a go at deciphering the debate about government sponsored paid parental leave in the lead up to the the Federal election. And they mostly miss the moral foundations of the debate, leaving us with a whole lot of economics wigs on the opinion pig.

Joshua Gans had a go at framing the debate in terms of productivity instead of fairness, but seems oblivious to the moral foundations of productivity itself and the ambiguity surrounding the aggregated macro-economic productivity outcomes from such policy decisions.

Matt Cowgill seemed to hold back in what is a rather respectful comment

You say a productivity claim is more ‘relevant’ than a fairness claim when it comes to assessing competing policies. Fine, that’s a reasonable point of view. But it is a point of view! That’s a normative, values-based, even ideological claim you’re making (that fairness is a low-order priority), yet you assert it here as if it is incontrovertible truth and that anyone emphasising fairness in policy debates is some kind of moron.

So Gans followed up with some nonsense quotes from a cartoonist that proved he is just being idiotic to impress the neoclassical econ club. Despite, as one commenter noted, his moral arguments in favour of science investment.

Rex Ringschott had a go at Club Troppo. His view is pretty clear from his final paragraph

Whatever the justification – the message to the scullery maid couldn’t be clearer. The sooner you get that Marketing degree and join the smart set the sooner your little fetus gets an even break.

Paul Frijters rehashed a post from the lead up to the 2007 election, essentially revealing how economic reasoning can be used to justify just about anything.

Over at the Guardian, Andi Fox does a good job of identifying the motivation for paid parental leave policies, and assesses the two major party’s policies against it.

The introduction of a universal scheme in this country was about helping those women and their babies catch up to the rest of us

Richard T. Green is the only economist I’ve seen actually properly frame the debate in terms of moral motivations, and the potential success of policies in addressing the moral arguments.

• The Rights Motivation Having a baby is a universal right and if people cannot afford to take the time off work that is necessary to have a baby, the state should enable them to do so.
• The Pro-Natalist Motivation We need more babies.
• The Equality Motivation The time taken off will inevitably fall partially on women (since she has to give birth) and then almost always the period of extreme infancy through the choices of the parents (conditioned by culture and economics). It is unfair that a mother cannot earn money by selling her labour in this period whilst a father can, so the state should compensate her for the unfairness of biology and cultural norms.

I'd assumed that the current round of policies were motivated by some blend of all three of Green's potential moral motivations, with a little more weighting perhaps on the Equality Motivation. Essentially the fact that women rather than men bear children is hugely detrimental for their careers. We have a moral stance that women should have equal opportunities in the workplace, so a paid parental leave policy will take some of the burden away from employers who hire more women. Of course, being financially more able to take leave from jobs without any maternity benefits also satisfies the Rights Motivation, as well as the Pro-Natalist Motivation.

Both policies will satisfy these moral motivations to some degree, and perhaps there are other moral considerations about fairness and economic equality that are required to adequately compare the two.

Given the moral ambiguity, and the unwillingness of politicians to actually put forward a coherent moral justification for their preferred policy, social scientists shouldn’t be rushing to calculate the efficiency of one policy choice over another against their own moral benchmark. They should be seeking clarification about what sort of moral position society at large supports, and assessing the degree to which alternative policies support those moral positions.

Which brings me to the much broader point. In practice economics is not some objective scientific endeavour. Anytime costs or benefits are calculated, recommendations are made, policies are assessed, there are moral judgements underlying these calculations. This is not to say that economics does have a scientific part to it. Positive analysis that seeks to understand empirical regularities of the world as it is certainly is scientific. But as soon as we apply this understanding to the world we must make a value judgement about what is desirable.

Simply ask yourself, why is productivity ‘good’ or desirable, and then keep asking why to your answer (yes, just like kids do). At some point you will hit the moral judgement that says more is better, which conflicts with the empirical literature that reveals happiness is mostly about relative status and reference groups, not about total consumption.

The moral foundations of economics are so clear to those outside the profession, yet so hidden as part of the economics indoctrination process. This leads to all sorts of nonsense debates about economics as a science.

To combat this problem not only am I writing about is, I have made a point of including in the new Australian Economics Learning Standards the requirement that economics student learn about the implicit value judgements within economic analysis.

Let’s hope the next generation of economists take their lead from Green and future policy debates are provided with much more substance from the economics profession.

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Musings...

Random things that have been on my mind

Security theatre 
...and to be honest, theatrical displays more generally in society. By this I mean doing something just to give the impression of doing it rather than for the outcome. Maybe it is something to do with David Graeber’s idea of bull$#it jobs. Or maybe it had more to do with Erving Goffman convincing me we are mere actors in our own world.

Think about this idea more generally. In any human institution we find procedures and processes, habits and social norms, that appear to be for a particular purpose, but in reality are mostly for the appearance of that purpose rather than the purpose itself.

To take one recent example, finance approvals. But of course receipts can be easily doctored by computer, and the very fact we rely on this process will decrease suspicion. If someone wanted to scam they system it would be an easy target.

Thinking like an economist
You hear this phrase a lot. I am on a committee to develop national learning standards in economics for Australian universities, and during our philosophical debates about what is economics and what comprises and economics degree, I have been confronted with the idea that “aren’t we just trying to teach students how to think like an economist?”

Unlearning Economics has a brilliant post about this concept. But I would like to add my 2 cents. 

For me thinking like an economist is about starting with the idea of a perfect market and rational choice as a starting point in any analysis and noting that anything that deviates from your newly constructed model to be a ‘market failure’. 

There are two main problems with this.

1. If you start with some kind of rational choice model, there is strictly never a justification to deviate if you accept the foundation premise. If people rationally make their own choices, and you deviate from this, the there is no guidance to how people behave - what sort of irrationality is there? 
2. If you start with a perfect market model, there is strictly no reason to prefer markets over government allocation of resources. As Robert H Nelson writes in his book Economics as Religion, from Samuelson to Chicago and Beyond, “...if transaction costs were reduced to zero, government and market would be equally (indeed perfectly) efficient.” In a more general sense, if prices can convey all information, then there must also exist an alternative non-price method to convey that information which governments could use for an alternative allocation system. 

For economists' preferred role as policy advisors this is absurd. Furthermore, you won’t find these ideas in any undergraduate economic textbook, and if you do, they are squirrelled away so that no graduates will leave with this fundamental understanding. As I have said before, economics education is far too much like indoctrination.

Take one recent example of this approach in action when discussing obesity . Here Frijters starts with the rational choice model and perfect markets for food, and struggles to find a reason to deviate from his ‘real obesity cycle theory’ of the opesity epidemic. Now I know Frijters well enough that he thinks far differently about these cultural phenomena, but the fact he feels compelled to ‘think like an economist’ and start from this point is absolutely absurd.

Another more relevant in this current economic period is blog superstar Noah Smith, who tries to wrap his mind around the notion that public deficits equal private surpluses in the national accounts. And at a deeper level, he struggles with the idea of ‘saving’ at a macro-economic level.

So what does a freshly trained economics PhD do? Thinks like an economist and undertakes a little bit of introspection based on Robinson Crusoe style analogies of the macro-economy. Such analogies are dodgy at the best of time in economics, but are totally absurd in macroeconomics and national accounting.

Libertarians
They bug me. So self-righteous. It might have been my own stupid choice to watch Sh&t$ville Express, or ever look at Catallaxy Files, but I did. Please read anything by Matt Bruenig and escape your fantasy world before it’s too late.

History, free trade and more
A big plug for Unlearning Economics who is now writing with some other fantastic people at Pieria (including John Aziz). One of my favourites on making history is here , and a beauty on ‘free‘ trade is here.

Expectations, norms and cooperation I’ve been running experiments in the lab on group cooperation - particularly on alliance formation by means of trust (which I interpret as the level of accuracy of predicting responses by others to your behaviour). I also attended a workshop in experimental and behavioural economics last week.

The main thing that struck me is that explaining deviations from rationality in almost any cooperative game relies on trust, or more specifically, accurate expectations of others. Moreover, when we repeat games we provide the opportunity to generate trust (expectations) in the lab to levels that might be reflective of reality.

The big puzzle then is how we ensure continued trust in society - a general pattern of behaviour and social norms that facilitates trade and investment and ultimate a fair distribution of the economic surplus.

I guess my thinking on this idea has moved into the realm of path dependency, and ultimately some kind of chaos. The norms we have a result of previous norms, which constantly evolve (are selected) by contemporary conditions. There are no right or wrong norms, but some are more conducive to economic investment than others, some are more conducive to equality than others.

A real puzzle for policy makers is to enhance these ‘free’ norms for social gain.

Capital - still controversial
I honestly can’t believe that the economic profession has not fully grasped the importance of the Cambridge capital debates, nor is it a prime feature of economics degrees.

One particular problem here is the way most economists still believe that the interest rate is somehow the ‘price’ of capital, while completely ignoring the capital value itself. It’s like saying that housing gets cheaper when interest rates fall, yet we use that exact policy to increase the value of capital relative to its nominal income stream.

Arbitrary
If aliens landed during a war, how would they decide which side of the war was 'in the right'.  There is never a moral right and wrong by any objective standard.

Lastly, statistics are an arbitrary human construct. Be wary.

Indoctrination...

Mankiw's Principles of Economics, the most widely used introductory economics textbook, can be held high as an iconic symbol of what is wrong with the economics profession.

His books complements nicely the symbolism surrounding Mankiw's class protest, where Harvard students walked out in protest of the narrow and one-sided curriculum of economics, funnelling the spirit of the Occupy Movement. The student's protest letter concludes-

...We are walking out today to join a Boston-wide march protesting the corporatization of higher education as part of the global Occupy movement. Since the biased nature of Economics 10 contributes to and symbolizes the increasing economic inequality in America, we are walking out of your class today both to protest your inadequate discussion of basic economic theory and to lend our support to a movement that is changing American discourse on economic injustice. Professor Mankiw, we ask that you take our concerns and our walk-out seriously.

The full video is here


The Mankiw symbol gained more power this week from his recent attempt to defend the 1% in the Journal of Economic Perspectives.  The article has been given the treatment it deserves by Unlearning Economics.

Add to these facts that Mankiw is a known Republican, acting in advisory positions for Bush and now Romney, who does not disclose these interests in his teaching or mainstream press articles, we get a man who epitomises all that is wrong with the profession.

It won't be long before the name Mankiw becomes an verb to describe an argument that uses simplistic reasoning unrelated to the real world situations to advance one's own financial interests.

To get down into a little more detail, in what should be an important chapter in Mankiw's textbook on the effects of taxes on markets, he simply rehashes a handful of nonsense myths about taxation - the Laffer curve, the French being taxed into low work hours, land taxes being unable to raise enough revenue for government and so forth.

One interesting point is his statement that taxing land values are impractical because the value of land is inseparable from building improvements therefore such taxes will be distortionary. This might seem a minor issue in the much bigger issues covered in the almost 900 page tome, but it concerns the most fundamental issues economists are meant to understand - where value comes from, and how best to raise taxes.

Here's the full treatment of Henry George

Why pick on this minor issue? Because it reveals the detachment of the theories taught to students from reality.  In reality many countries already value land without building improvements for tax purposes. It is a very common way to raise revenue and the valuation methodologies are well accepted and defendable in courts of law.  In fact this process in intimately linked with compulsory acquisition rules that are the real practical mechanisms for public investment that Mankiw seems to ignore.

This type of indoctrination into economics is powerful stuff.  Next time an economist argues by appealing to ECON101, you can say "don't bloody mankiw me".

Interpreting housing market indicators

I was motivated by this article in The Economist about housing costs in London to really dig down to how most economists think about housing supply and land markets. Today I want to share a toy version of the model I use to understand land and housing markets, and potential supply issues within them.

The model 
At time=0 a city has 20 people in 10 homes owned by out-of-town investors. 1 person from each home earns $52,000 per year, the other is a dependent. Rent for each home is $250 per week and each home is 100sqm in size. In sum, per capita income is $26,000, rent to income ratio is 25%, and floor space is 50sqm per person.

Say supply is perfectly restricted. No new homes can be built at all but population increases 10%. Now there are 11 income earners supporting 11 dependents. Average occupancy must rise from 2 to 2.2 people per home. 

Household income rises from $1,000 to $1,100 per week. Rents will stay around 25% of incomes so now rent is $275 per week. Floor space is down from 50sqm to 45.5sqm per person. Rent paid per capita is the same. 

In this scenario what measures can signal a supply-side squeeze? Clearly we need to be looking at an increase in the rent to individual income and a decline in the sqm per person as evidence of a supply side squeeze. 

But once you introduce two more critical features to the model - geography and income distribution - things get very interesting.

Geography
We can add geography to our toy model very easily by having the 10 identical homes on a single road heading away from the city centre. They are equally spaced, and the marginal travel cost is $20 per week for each home as distance increases from the city. 

In the base case we have 2 people per house willing to spend 34% of their income on a home with zero travel cost (the 1st home on the road). 

The first house would rent for $340pw, the next $320, then the third at $300 etc up until the 10th house is rented for $170pw. Remember, the housing cost (including commuting time) is $340per week for each household. The average and median rent is still $250pw or 25% of household income. 

The left graph below summarises this simple linear geographic set up, where a single home is at each point heading away from the city centre, and price a household is willing to pay for each location is falling with distance.

In the situation where all supply is constrained and the population grows by 10%, as in the first example we see that that prices simply increase in accordance with the increased income of the average household. 

But what if supply is only constrained over the first half of the road? No new homes can be built in the area occupied by the current 5 closest homes (as stylistically shown in the middle graph above). 

The outcome is that the density of the second half of the road increases by 20%. 

Prices at each location are identical, but there are now 1.2 homes on average at every position on the road from house 5 onwards. The mean rent has fallen from $250 to $245 per home because the new homes are only in the inferior locations (the same rent-to-income ratios and same floorspace per capita would exist). 

Had there been a ‘greenbelt’ style constraint, in that no new homes could be built in the furthest half of the road (where homes 6 to 10 are located), the number of dwellings in the inner half would have increased by 20% to accommodate the new people. In this case the new average rent would be $255 per dwelling in average. This is because all the new homes are in superior positions. Every single household is still spending 34% of their income, or $340 per week on housing and commuting, and each resident has the same size home. 

In either of these cases supply could not be said to be constrained in the city as a whole, despite half of the city being unable to expand dwelling numbers. Yet we see by virtue of location of growth that mean rents will change substantially. To summarise the impacts of geographically constrained supply we can observe the following metrics. 

The critical difference between local constraints and absolute city wide constraints is that the sqm of housing per person does not fall. However, this doesn’t mean that some households might be willing to trade household size for location, in which case the housing space per person may shrink in areas close to the city despite the city itself not being supply constrained and the fringes being able to be easily developed.

Income distribution 
We can add another dimension to this toy model in the form of a stylised income distribution. Income differences allow wealthier individuals to use their income to outbid for superior locations. 

Say the average individual still earns $52,000 per year ($1000pw), but that the wealthiest individual earns $125,000 and the poorest $13,400. Each household in between earns 80% of the previous household, starting at the wealthiest. 

We also convert the $20/week incremental commute cost to a commute-time cost based on the wage rate of each household. Thus the commute cost to the first home costs $20 for the average income earner, but $48 of time for the high income earner, and just $5.17 for the lowest income earner. 

What happens in this situation is that households sort themselves into inferior/superior locations based on incomes. But it also means that the rental gradient is much steeper than the income gradient. 

Let’s see how this works. 

Imagine that only the worst located home is vacant, and only the poorest household is in need of a home. How does the bargain over rent occur? Clearly the poor household has no alternative option but to rent an existing home - they can’t buy a piece of land and built their own. Another land owner could build a home for them and rent it, but they would have legitimate worries about being underbid by the current owner of the vacant home. 

This home owner also has the outside option to attract higher income earners away from other homes by lowering the price a little. Essentially, the owner of this last home has all the negotiating power to extract the full willingness to pay from the renter. In this case willingness to pay from the poorest household is 35% of their income minus commuting costs, or $112 per week. 

The same logic applies to any of the homes that are vacant at any point in time. Thus the home owners are able to extract rents because of their monopoly bargaining position. We end up with the following situation. 

The critical indicators from our three types of supply constraint in this model are summarised below. Note that while the mean of the income distribution is still $52,000 or $1,000 per week, the presence of very high incomes skews the rent distribution by a large degree. The income distribution of the new population (after growth) is assumed to be identical to the existing residents.

We learn that increasing income inequality actually increases the mean and median measures of rents, despite affordability being identical (34% of income on housing and commuting). The most important measure is the sqm per person if one wants to discuss housing supply constraints. Any other measure needs to control for income and geographical distributions. 

Concluding remarks 

What we realise from this simple toy model is that rents are a function of incomes, willingness to pay for superior locations, commute time and city structure, and ultimately the institutional bargaining power of land owners. 

Think about it. If all tenants could collectively bargain by agreeing to only pay half the rent they currently pay, and no one would outbid that new halved price in order to move to a better location, then rents fall by half. Real wages would rise dramatically, and real land prices would plummet. 

We also learn that most aggregate measures of housing affordability suffer from biases due to geographical and income distributions. Thus to make any solid claims about the affordability of the market household level data is required. If we measure housing within a city boundary, yet the urban area extends beyond that boundary, we will always find worrying measures because we haven't monitored the price of homes at the actual urban fringe (Yes it is still possible to buy a 3 bedroom home on the urban fringe and within commuting distance to Brisbane for less than $300 per week).

If we are seriously about housing affordability, we need to shift the bargaining power towards tenants. A transition period to higher land taxes would provide incentives to construct housing rather than hold out for increasing future values of development sites. Better standard contract conditions on regulated residential rental contracts (for example the inclusion of limits to rent increases) would also tilt the bargaining power in favour of tenants. 

Please share this article. Tips, suggestions, comments and requests to rumplestatskin@gmail.com + follow me on Twitter @rumplestatskin

Ford closes... along with common sense

Now that Ford has finally closed its assembly plant we have a reason for the economics crowd to reveal the biases in their ‘model thinking’.

Take Possum Comitatus, aka Scott Steel, who seems to think that if Australia had a few more people we would make more stuff (is that more per capita Poss?).

The lesson that shan't speak it's name - if we'd like to keep making stuff in Australia, we need more people in Australia
— Possum Comitatus (@Pollytics) May 23, 2013

Which is a bit of nonsense really.

A Twitter argument broke out between Possum, Nicholas Gruen, and our own The Prince. 

Nick - Nonsense, we’ll always make things in Australia, just less than some other countries.

Prince - Sorry, that’s BS. Switzerland, Norway, Finland. All manufacturing giants but minnows in population. It’s how you structure econ.

Possum - That utilise the EU population as a local population with common consumption demands. Ahem.

Possum - The Australian market isn’t large enough to sustain many goods specifically customised for Australia. Cars are the perfect example

Possum - Volume matters for stuff like this

Nick - So we’d export - like Volvo. Alas we woke up to that issue too late and too lethargically

Possum - We’d export to where? What other country in the world, using cars as an example - has a similar spectrum of conditions?

Prince - Population is not a cure for structural imbalances - makes house prices higher.. is that the real goal here?

Possum - Go and stick Finland, Switzerland and Norway in the middle of the Indian ocean. Reckon they’d be a manufacturing base?

Possum - Population is scale. Want cheaper house prices, build more houses.

Sorry Possum. Population is population. Scale is scale. The conflation of domestic population and industry scale, and therefore competitiveness, is one that regularly occurs. It is number two on my population myths list.

That large scale manufacturing is shifting to low cost countries is a product of globalisation - the multi-decade process of reducing barriers to international trade. It is a sign of our wealth relative wealth, but also a product of the management of our foreign account balances.

Switzerland protected its local trade-exposed industries by protecting its currency. German manufacturers are benefiting from the weak Euro, while Japan’s attempts at stimulating economy activity revolve around containing the value of the Yen.

Richard Tsukamasa Green actually has a very nice reply, outlining how in a situation of protected local markets being opened up to international trade.  He deserves quoting at length

In short, companies that produce for a market in their own country have an advantage when exporting. If we have increasing returns to scale, that is it keeps getting cheaper to produce more once you’re already producing, then the efficient, cheap producers are those who are already producing.
...
If so, then when it comes to trade, the countries who were producing widgets for their own market are those that provide it cheapest to everyone else. The home market has become part of the country’s comparative advantage.
...
Most importantly there aren’t too many cases I can think of where this advantage has been maintained without government props. Other elements of comparative advantage, like wages levels or training, seem to outweigh lingering home market effects – the massive amounts of computer hardware out of South East Asia isn’t due to their love of PCs, nor do Chinese consumers exhibit a love for…everything manufactured. The most valuable thing seems to be know how, and that is the most mobile of production factors.
The other is hat it makes the most sense when countries have been operating as autarchies and then BAM, international trade. That possibly made sense in the world of 1985 following five odd decades of global protectionism, but not now. Any developing industry will start with many countries as potential locations, regardless of where the consumer lies. The home market effect would only hold if transport costs are high so manufacturing close to customers is cheaper, but then that the lowering of costs once things get going are so great they more than offset the cost of transport.

I fully concur that this myth persists because in the period of reducing trade barriers larger domestic markets did provide a 'home market' advantage.  But this is not the world of 2013.

Let me respond to Possum point by point.

[Finland, Norway, Switzerland] “utilise the EU population as a local population with common consumption demands.”

I’m not sure what to make of this. Is he saying that foreign populations that demand the same goods generate a larger potential market? If so, that is my argument.

The Australian market isn’t large enough to sustain many goods specifically customised for Australia. Cars are the perfect example

Which is an astounding fact considering the number of different cars available from Japanese, European and US manufacturers. There must be at least 20 major brands in the Australian market, and over a hundred different models of car available. Whatever customisation they require seems a simple enough task.

After all, if Japan, Germany and Sweden can export a completed car suitably customised to Australian conditions to us, why can’t we do the same in reverse?

We’d export to where? What other country in the world, using cars as an example - has a similar spectrum of conditions?

I have no idea what ‘spectrum of conditions’ means, but the answer to the first part is easy - anywhere. If we are going to be an exporter we manufacture to the conditions of the destination countries regardless of whether they are identical to our own.

I find it funny because in Melbourne we have Boeing’s largest manufacturing base outside of North America. We assemble Volvo trucks. In fact over at Manufacturer’s Monthly there is a whole list of the companies ‘making stuff’ in Australia. It seems we can make stuff after all.

The problem of course is that the relative size of our natural resource production. Coal, iron ore and gold make up 40% of our exports. We then have education, tourism, and a whole bunch of other primary resources (gas, wheat, alumina, copper ore, beef). 

The big long term economic questions that the Ford decision reminds us about are

1. Do we value diversity of economic production?
2. How do we want to manage our external position given the volatility of the resources cycle?

Government debt hysteria

It’s budget time.  That means it’s time to switch off from the mainstream business news for a couple of weeks.  To help get you through I have a couple of notes about the ridiculous government debt hysteria that has broken out in this country in the past decade, and in many troubled nations (save Japan) since the financial crisis.

1. Nonsensical comparisons 
First cab off the rank, debt to GDP. GDP is a measure of the volume of all transactions in the economy.  How is it related to the debt held by an institution that forms a minor fraction of the economy.  Why not compare BHP debt to Australia GDP?  The very fact that this nonsense ratio is considered important by macroeconomists as a determinant of anything is quite bizarre.

In any case, Australia is a world leader in low government debt.

Source: Wikipedia

Moreover, shouldn’t we consider the assets of an entity when considering its debts? Mmm.  What would the assets of the the Australian government be worth? This is a trick question.   There is basically no way of estimating the value of the nation’s shared public assets despite some valiant attempts.  These attempts put Australia’s wealth at over $6 trillion in 2008.  That’s around $300,000 per person.

But isn’t a better measure of the ‘sustainability of debt’ the interest cost to government revenue ratio? For example, here is a nice comparison of interest expense as a percentage of central government revenue.  Australia barely makes a showing.

Should we not also consider that the same entity, in effect, sets the interest rate on those debts. As Dean Baker points out, this power really negates the ‘future burden’ of debt that the ‘household view’ of government budgets suggest.

And with all this focus on the crazy debt to GDP ratio, somehow the debts of the private sector are ignored.

2. Money is a human creation 
Humans made every rule there is, and every rule can be changed. Keep this in mind.

But we also need to think about what interest payments actually are.  They are transfers from the debtor to creditors.  So when government pays interest on its debt, it is simply creating a transfer payment from taxpayers to holders of government bonds.  In many cases, these will be the same people or entities. Sometimes the owners of bonds will be foreign, but they only get paid interest in Australia dollars, which need to be spent within Australia, circulating through the economy.

Furthermore, the government can allow inflation to reduce the real size of the transfer involved with servicing its debt, and it can set the interest rate it pays.

We also need to fully comprehend Paul Krugman’s analysis of the Capitol HIll Babysitting Co-op Crisis. Put simple, the baby-sitting co-op created their own monetary system which fell into recession for lack of money.  Those who were running low on ‘baby sitting money’ because they had redeemed their vouchers over short period were worried about their shortage of remaining vouchers and stopped going out.  Those who had accumulated vouchers were worried about being unable to earn back their wealth should they start spending.

Notice that the money issued actually facilitated wealth inequality in the co-op.  Some families had very few vouchers left while the others were accumulating voucher wealth. We shouldn’t be surprised about this relationship between widening wealth gaps and business cycles.  And we shouldn’t be surprised that ancient remedies involved resetting debt periodically though jubilees - which would have worked perfectly well in the babysitting coop.

Ultimately we make the rules and can deal with the social and economics outcomes that arise from our economic system however we choose.  Fundamentally these choices are moral ones.

3. Equilibrium analysis does not apply
Most detractors of government debt seem to have a model of the economy in mind where the economy is in its magical equilibrium.  Then the government spends money, and since the model is always in equilibrium, the extra spending crowds out other spending exactly.  You might think I’m simplifying the argument.  I’m not.  There is not even money in the model at all.

The scope for adjustment to monetary policy, tax policy, inflation, all of which can reduce the debt interest size over time, are never discussed.

Remember debt and money are human inventions. Look at Japan to see what is possible and why we need considered analysis based on a proper understanding of money.

I hope, given the horrid state of quantitative macro that the RBA’s conference at the end of this year attracts some more robust analysis.

Why Mathematica for economics?

Readers would have noticed that some of my previous posts containing interactive graphs that require Mathematica CDF Player to view. Which might leave you wondering why I choose to use Mathematica as my computational tool for ‘doing economics’.

So I thought I might outline here why I do. 

Image source

And the answer is, mostly, because it was easy to learn. 

1. The documentation in Mathematica is very comprehensive and delivered in a notebook format (Mathematica’s ‘front end’ interface), so you can modify the examples and test what your modification does to the output. 

Many useful functions are built in, and even better, functions are typically named by their real mathematical name. 

For me, I need a tool that can handle analysis of graphs and networks, can do symbolic manipulation, produce charts, handle diverse file types, analyse textual data (for matching names and other strings in large data sets). I have scraped data from websites using Mathematica, analysed social networks, and more.

Now, Mathematica is surely not the only tool for these jobs. Many like the open source R, others like Matlab, and for basic regressions Stata is a common tool. I don’t want to start a debate about which tool is better for which job - ultimately it is a user choice about investing their time to learn one or the other, and about the ongoing usability. 

2. I like the integration of different functionality. There are real and electronic books written completely in Mathematica. It has built-in slide show options to have live and interactive calculations and charts in presentations. Easy interactive tools and web deployment (but viewers do need the free CDF player). 

3. One thing that Mathematica users seem to emphasise is functional programming. Rather than writing loops to build up calculations, you simply write the function and it can automatically map across lists and various other data structures. Once you get used to this, you won’t want to write out loops again. This also means it is easy to get quite complex calculations coded up quickly. 

4. A very helpful user group, especially at StackExchange. 

Lastly the RBA produces their charts and does a lot of analysis with Mathematica (although using custom packages). Some useful Mathematica tips from the RBA’s Luci Ellis are here, and here is a useful blog on how the dynamic graphing capabilities make good teaching tools.