Four Corners: No logic on China

On Monday night Four Corners aired a segment about the post-GFC Chinese stimulus and its massive impact on levels of investment and debt. It was entitled How China Fooled the World, which is somewhat baffling, because there is no tricky involved in their very real investment binge. As you can tell, I have my reservations about the show’s analysis. 

While I appreciate the effort to highlight just how dependent the world has become on Chinese investment, and indirectly on the policies of the Communist Party of China, the segment never made the point that the west has CHOSEN this path by refusing to independently support their local economies and employment by making tough political choices that involve reallocation of wealth and public investment. 

A far greater irony is that many in the west who fear a Chinese economic collapse usually end up pointing the finger at China’s political system and the lack of private enterprise or competition as the fundamental cause. Yet private enterprise and competition are fundamental features of the system that collapsed in the west during the financial crisis, and China’s non-competitive state-owned industry was apparently the only thing that saved the world from further destabilising impacts of capitalism!

By their very nature, complex systems, such as the socio-economic system, are prone to sudden collapse in activity following a period of extremely high activity. This applies in China just as it did in the west, although the system in China is characteristic more centralised choices and less emergence. It is highly unlikely that China will have investment at over 50% of GDP for decades to come in a perfectly smooth growing economy. 

But that doesn’t mean a collapse needs to be catastrophic or even costly in terms of the things that matter to those people within the system. For example, if the collapse in activity results in more years of schooling and education, fewer work hours per worker and more holidays, greater investment in environmental protection and restoration, and so on, this could just as equally be seen a beneficial period of transition; a collapse that forced radically beneficial social change. We shouldn’t underestimate the power of central control and need for the Communist Party to maintain improving living standards to support their legitimacy. 

That is of course, the optimistic view. There will certainly be many losers from a major economic contraction in China, and Australian consumers are part of that group. 

But back to the Four Corners story. I had a few other problems with the coverage, which like most economic reporting was quite superficial and lacked a rigorous foundation of analysis. Here are just a few.

1. Most funds for the Chinese stimulus came from borrowing. This is bad. 
Of course funds came from borrowing. This is neither good nor bad. The detrimental effects of debt that we now acknowledge are usually related to debt used for speculation rather than real investment, yet the whole segment was devoted to identifying just how much real investment there is in China
2. This rate of investment is unsustainable
Chinese investment share of GDP is around 50%, potentially 54%, up from around 43% of GDP in the period prior to the financial crisis. Many commentators saw the pre-crisis levels as unsustainable as well. Certainly this level is high, but remember that the longer this lasts, the wealthier China will be and the more easily it will be able to handle a large-scale economic transition. There was no consideration of what sort of transition the Communist Party might have in mind to edge down from these levels, just as there was no consideration of how the Party created such high levels of investment.
3. The rest of the world was unable to conduct stimulus on a similar scale 
This is another contradictory claim. For some reason, China, still a poor country in per capita terms and one with apparently gross political disfunction from the entrenched rent-seeking Communist party, was the only one who could save the world from the financial crisis. Similar levels of public investment could be made in Europe or the United States if the political will was there.
4. Shadow banking is a problem because debts are hidden 
What we didn’t really see is a view on what would be different if debts were not hidden? There seems to be no consensus on what it means in any case, and very little understanding of the political willingness of the Chinese Communist party to use their monetary system for their social, economic and political goals. The substance of this and other criticisms of China boiled down to ‘debt is bad’. Ignoring of course the international imbalances and the massive debts much of the west have with China.
5. Housing oversupply is 15%
This was strange. Surely more housing per person is a good thing. Some may be empty at the moment, but at some point there will be incentives for these home owners to occupy or rent these homes. And if you are thinking that they need lots of maintenance and might fall down before they are occupied, then you’ve identified another activity that can help in the transition to lower investment - maintaining current investments. 

Certainly China’s growth won’t be smooth sailing at these unprecedented investment shares of GDP for decades to come. There will be a transition, and it will be a bumpy ride.

But from my view most of the opinions in this documentary were blind repetition of contradictory views - that China was the only one who could save the west from the crisis, but now they will be unable to save themselves; that the Chinese political system was able to radically control production to maintain growth and employment, but now won’t be able to; that the answer to the problem that China does not yet have is to make the choices that the west has made, which didn’t stop them from having severe financial crises with lingering social impacts.

It is all so confusing.

Uncertainty is not what you think it is

One strange claim in the economic debate that followed the financial crisis was the impact of uncertainty on the path of investment and subsequently the recovery in economic activity. Taking just one example, it was claimed here that “fiscal policy uncertainty has directly harmed the American economy by increasing the unemployment rate by 0.6%, or the equivalent of 900,000 jobs.”

Often the idea of uncertainty is captured in economic debates by labelling its inverse, a high degree of certainty, ‘confidence’, or when being a little more critical, the ‘confidence fairy’.

It was never particularly clear to me exactly what ‘high’ or ‘low’ uncertainty was supposed to mean, since the future is always uncertain and investment is always risky, and current policy decisions are not set for eternity. In this post I will dig down into the economic theory of real options that forms the basis for claims that uncertainty alone can greatly reduce investment activity. By doing so I hope the reader will develop a considered level of scepticism about such claims.

First, we should acknowledge just how widespread the idea that uncertainty hampers investment has become. There is a website devoted to providing national indices of policy uncertainty, which itself rests on two decades of effort in academic circles to endeavour to capture this mirage-like phenomena. Even now, India’s growth slowdown is being blamed on this mythical beast.

As a general observation, it seems there is no economic ill that cannot be blamed on government policy-induced high levels of uncertainty.

The economic origins of the idea start with Black-Scholes, and were more fully developed in the general sense in terms of capital investment by Dixit and Pindyck in what is generally known as real options theory. While I have concerns about how real options is applied (which I will get to in a moment), the fundamental principle embodied in real options theory is crucial to understanding economics.

The basic idea is this. If the future is uncertain, such that your future revenues and costs won’t be exactly what you expect, then you may choose to delay investment in order to get new information about the best investment choice.

Thus, when there is more uncertainty, or what would technically enter the real options model as a larger standard deviation on the expectations of price movements, then the value from delaying investment in order to better asses new information is greater.

Under these conditions firm value maximisation occurs not by profit maximising, but by maximising the rate of change of profit over time, or the rate of return on firm equity. The idea here is that investors choices based on expectation of both price levels and the rate of change in prices.

That’s whole idea right there. If you follow that through without thinking too much more about it, you can end up at the point of advising governments to ‘fix up certainty’ in order to bring forward investment decisions in order to reduce unemployment and increase economic growth.

But that ignores some very important points, which I haven’t seen properly addressed in the application of real options theory.

First, why is a perfectly known probability distribution in any way uncertain? We have done the old trick of calling the distribution of expectations (or for that matter simply the distribution of past price movements) uncertainty instead of its usual label, risk. Unquantifiable Knightian uncertainty remains ignored. Which means that even if the distribution of price expectations narrows, and real option theory says that such a thing will encourage investment, there remains a value to delay at all times if there is even a trace of unquantifiable uncertainty.

For me, this lack of distinction removes the possibility for real options theory as it stands to provide insights into the business cycle, particularly in relation to the type of herding behaviour we see both in financial and real resource investments. My personal view is that ubiquitous unquantifiable uncertainty is fundamental to understanding why investors can appear irrational, and why our innate herding behaviour is often a more useful and actionable decision rule for investment.

Second, even accepting that risk appropriately captures the rationale for delaying investment, changing the average expectation doesn’t change uncertainty. Most commentators who argue that their policy proposals reduce uncertainty are actually more concerned with shifting the average expectation of price movements upwards. But if the whole distribution shifts, but doesn’t narrow, then uncertainty is unchanged and it remains equally rational to delay investment in the face of increasing prices.

Third, it is not at all clear what the implication for real options is when rather than shrinking the spread of the distribution, the complete nature of the distribution changes. What I mean by this is that if risk appears normally distributed at some point in time, but events occur that change expectations of future price outcomes to be exponentially distributed. Moreover, there is no real understanding of the emergent properties of agents interacting with different risk expectations - are these interactions already captured in perceptions of risk, or do they add an additional dimension which take risk perceptions into the territory of pure uncertainty?

Finally, it is well known that even in the absence of uncertainty there can still be a value to waiting to invest for current asset owners. For example, if I own a piece of land with scope for development, in the case where there is uncertainty about future prices it may be optimal to wait to see which direction prices move in order to determine the optimal building type and size to construct to maximise my land value. But even if I know exactly what prices and construction costs will be over the course of the next few years, I may still choose to delay if I expect (perfectly, with no uncertainty) the value of the land in its undeveloped state to increase at a faster rate than when it is developed. Or indeed, to not lose value as quickly if it were the case that prices are falling.

So while claims of policy uncertainty having large real impacts in investment may appear well-grounded in economic theory, the theory still has many problems when applied to real policy, real investment and a real world of fundamental Knightian uncertainty. However I do hold out some hope that the core elements of real options theory, which are substantial improvements on the usual equilibrium theory of mainstream economics, can be more successfully incorporated into our understanding of investment and the business cycle.

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

Intuition in economics can't replace reason

One thing you will notice early on about economics is the overuse of the term intuition. Typically the term is used like this — “Let me give you the intuition behind this model”. Or something.

Let’s take a look at the common definition of intuition for starters. Google tells us that intuition is "the ability to understand something instinctively, without the need for conscious reasoning."

When you think about it—when you reason—you quickly see that intuition is a way to NOT reason. Instead, it is a way to latch onto ideas that support pre-existing beliefs.

When I hear a seminar presenter say “let me give you some intuition,” I now translate it in my mind as “let me align my theory with your beliefs so you will have trouble disagreeing with me regardless of the strength of my reasoning and the evidence I present."

I find the elevation of economic intuition to a skill in itself to be very unscientific.

In physics, for example, I see people discussing intuition as either experience with certain types of mathematics (you internalise the steps of mathematical logic), or as experience in the physical world—of taking one’s lived experiment and applying what are now intuitive results to problems. You know a lever works because you have used levers many times. The results do not contradict your lifetime of personal trial and error and therefore the result is intuitive. But from my experience, this is not what economists mean.

Duncan Watts describes much better how intuition pervades social sciences and stifles scientific advancement, particularly in economics.

Part of the problem is also that social scientists, like everyone else, participate in social life and so feel as if they can understand why people do what they do simply by thinking about it. It is not surprising, therefore, that many social scientific explanations suffer from the same weaknesses—ex post facto assertions of rationality, representative individuals, special people, and correlation substituting for causation—that pervade our commonsense explanations as well.

In many ways, intuition from experience should be irrelevant to individuals analysing complex systems from within them, especially since the properties of the whole are typically unrelated to the properties of individual parts. 

With so much emphasis on intuition over reason, it is no wonder that a fair portion of economic debate has not progressed in 140 years.

Spartan Morality

I want to show how the morality on display in the movie 300, in which babies are cast into a chasm for minor deformities or other weaknesses and illnesses, is easily compatible with utilitarian logic. In doing so I hope to show that utilitarianism provides completely insufficient scaffolding around moral reasoning to eliminate almost any policy, norm or cultural practice you desire.

I was motivated to write this post after discussions were stoked by my take on the moral foundations of economics, particularly in relation to health policy. Why it is optimal from a utilitarian point of view to allocate medical resources to the young rather than the old? While my personal view is that in our current social and political environment this is probably appropriate, it is by no means a superior position by utilitarian reasoning, and certainly there remains debate about such welfare foundations. 

To get this brief analysis started, here is a Wikipedia excerpt about life in Sparta.

Shortly after birth, a mother would bathe her child in wine to see whether the child was strong. If the child survived it was brought before the Gerousia by the child's father. The Gerousia then decided whether it was to be reared or not.
It is commonly stated that if they considered it "puny and deformed", the baby was thrown into a chasm on Mount Taygetos known euphemistically as the Apothetae. This was, in effect, a primitive form of eugenics.
Sparta is often portrayed as being unique in this matter, however there is considerable evidence that the killing of unwanted children was practiced in other Greek regions, including Athens.

Here’s some basic utilitarian rationale for the ‘Spartan morality’ of disposing of sick children. It could rely on any of the following propositions or assumptions.

1. People with life-long physical disabilities or other chronic illness have lower utility than those without.
2. Disposing of sick children brings forwards births of non-sick children because of replacement reproductive effort.
3. There is relatively low utility loss from mothers and family of disposing of their sick child.
4. The existence of ill people reduces the utility of their carers.
5. The reduced ability to contribute to productive activity of the disabled and their carers (and medical professionals) reduces the utility of others in society.

In fact, we need not even invoke propositions three to five in order for Spartan morality to be utilitarian, since the first two clearly show that infanticide of the sick, “puny and deformed”, would be a straight substitute of one lifetime of low utility for one lifetime of high utility, increasing aggregate welfare.

And that’s just about all you need. 

I hope that this challenges your faith in the objectiveness of economic reason. As Joan Robinson would say, utility is a meta-physical construct—its existence rests on circular reasoning, requiring it to be defined in terms of itself. 

Similar utilitarian reasoning could be applied to the subjects of gay marriage, slavery, or other such social practices to support any desired outcome.

We shouldn’t feel helpless in the absence of an objective method of social reasoning. We should feel freed from its shackles to debate our underlying moral values, and why they are appropriate for our societies, given our histories and culture. 

Applying utilitarianism means you can support mutually contradictory ends and means. You can end up at the repugnant conclusion, or justify slavery to a 'utility monster'. Or if you take an average  principle of utilitarianism, you can get to the point of justifying killing disabled children by appeal to Spartan morality. Or, as we deem currently acceptable, arrive at the point where we should allocate scarce medical resources to children above the elderly in accordance to ‘need’. 

There is no absolute reference point in utilitarianism. It is always applied with reference to current norms, customs and practices and can evolve to support different conclusions as society evolves.

17 million Reasons Rent Control is Efficient

The case of Herbert Sukenik being paid $17 million in 2005 to leave his rent-controlled NYC apartment has been receiving a great deal of attention online recently. 

At the risk of perpetuating the brilliant viral marketing campaign for Michael Gross’ new book, which is, in fact, the source of the story, I want to make a brief comment about it to counter some of the bizarre, emotional, and inconsistent reactions I have seen.

A short version of the story is that billionaire developers Arthur and William Zeckendorf paid $401million for the Mayflower Hotel adjacent to Central Park, planning to turn the site into 202 super-luxury apartments.

The building was occupied by many long-term tenants under New York’s rent-control laws. This meant that tenants could only be evicted upon mutual agreement, which in turn led to the new owners offering attractive lump-sum payments to tenants for them to leave the building. While most tenants accepted offers ranging from $650,000 to $1 million, the final tenant held out for an astonishing $17 million lump-sum payment, in addition to the developers offering him another apartment to live in for the rest of his life for a peppercorn rent of $1 per month.

To me the most astounding part of the story has been the reaction by the press and social media, which has been of outrage over the injustices of rent control - that for some reason poor old Sukendik didn’t deserve the money.

There have also been cries of rent-control hindering development - that somehow rent-control is ‘inefficient’.

This is absolutely wrong. Wrong, wrong wrong.

First, almost everyone has ignored the key fact that a developer buying the building knowing that rent-controlled tenants are occupying it should have expected these expenses and subtracted them from the purchase price. Thus, the tenants win at the expense of the previous building owner. The developer does not lose unless some unexpected legal loophole was exploited (which doesn't appear to be the case) - it is merely that the economic rent was shared between the previous owner and the previous tenant.

It is therefore not any less efficient than in the absence of rent control. No one sees the previous building owner holding out for $401million as inefficient, yet it is exactly the same dynamic at play. 

The second point routinely ignored is that rent control describes a general set of rules about renting. That the NY set of rules allows this to happen doesn't mean that another set of rent-control rules could be implemented that had mechanisms for relocation and prescribed methods for calculating compensation payments to tenants. After all, in the freehold world there are generally accepted methods for compensation for landowners upon compulsory acquisition by a government authority.

Third, if Sukenik owned his apartment in freehold he would have had the same power to hold out and extract this price from the developer. This happens routinely in Australia and elsewhere when strata-titled buildings are redeveloped. The last hold out seller extracts a massive payout. Yet we see nothing at all wrong with that because they have ‘the right’ to do it. Yet under a different set of laws, tenants could also have such rights, which they did in this case. 

What really surprises me is that almost everyone who has written a reaction to the incident seems to fall on the side of the developer. If the developer had kicked out the tenant for $10,000 it wouldn't be news, but it would have been equivalent to 'Developer screws tenant of their rightful $17million compensation’.

Wrong lesson from Adam Smith's pin factory

We commonly use stories to teach new ideas, but all too often end up taking the wrong lessons from them. My favourite example is the Coase theorem. Economics textbooks describe theorem as saying that it doesn’t matter where you place the liability for pollution, because in a world of zero transaction costs the right to pollute will end up in the hands that value is most. This is the exact opposite of the point Coase made. As Deidre McCloskey wrote,

Economists have gotten the “theorem” wrong; in fact, backwards
…
Coase’s actual point, the core of a Coasean economics, was to note what happens in the many important cases in which transactions costs cannot be neglected. If the situation does have high transactions costs, then it does matter where the liability for pollution is placed.

I was alerted to another example in Joan Robinson’s long forgotten textbook. In it she dismisses the division of labour as a primary factor in the great surge in productivity of the industrial revolution, noting that this is the wrong lesson to take from Adam Smith’s pin factory story.

First let me recount the relevant part of Smith’s writing where he describes the productivity boon enabled by the division of labour.

To take an example, therefore, from a very trifling manufacture; but one in which the division of labour has been very often taken notice of, the trade of the pin-maker; a workman not educated to this business (which the division of labour has rendered a distinct trade), nor acquainted with the use of the machinery employed in it (to the invention of which the same division of labour has probably given occasion), could scarce, perhaps, with his utmost industry, make one pin in a day, and certainly could not make twenty.  

But in the way in which this business is now carried on, not only the whole work is a peculiar trade, but it is divided into a number of branches, of which the greater part are likewise peculiar trades. One man draws out the wire, another straights it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head; to make the head requires two or three distinct operations; to put it on, is a peculiar business, to whiten the pins is another; it is even a trade by itself to put them into the paper; and the important business of making a pin is, in this manner, divided into about eighteen distinct operations, which, in some manufactories, are all performed by distinct hands, though in others the same man will sometimes perform two or three of them.  

I have seen a small manufactory of this kind where ten men only were employed, and where some of them consequently performed two or three distinct operations. But though they were very poor, and therefore but indifferently accommodated with the necessary machinery, they could, when they exerted themselves, make among them about twelve pounds of pins in a day.  

There are in a pound upwards of four thousand pins of a middling size. Those ten persons, therefore, could make among them upwards of forty-eight thousand pins in a day. Each person, therefore, making a tenth part of forty-eight thousand pins, might be considered as making four thousand eight hundred pins in a day.  

But if they had all wrought separately and independently, and without any of them having been educated to this peculiar business, they certainly could not each of them have made twenty, perhaps not one pin in a day; that is, certainly, not the two hundred and fortieth, perhaps not the four thousand eight hundredth part of what they are at present capable of performing, in consequence of a proper division and combination of their different operations.

This insight has attracted so many followers and is so embedded in economic thinking, that it was quite a shock for me to see it dismissed. Robinson merely states that people can equally divide their own labour across different tasks through time and thus Smith is incorrect in attributing the productivity of the pin factory to the division of labour.

The 18 distinct operations Smith recounts could just as easily be conducted by the same labourer on 18 different days to create the same output per person over an 18 day period as in the case where labour is divided between workers.

I’ll be honest. Dismissing one of the key elements of accepted economic theory in a single sentence is bold. But again, Robinson had a lot to get through in a short book.

So what is the real lesson? To me the lesson of productivity is not about division of labour, but of capital accumulation. 

Smith suggested it was the division of labour that had ‘given occasion’ to the invention of machinery. But this gets causality backwards; it is the new tools and production techniques that allowed both the division of labour and the great increase in efficiency. 

Imagine that each on the 18 separate tasks could be achieved more efficiently with 18 different new tools. Drawing the wire used a particular apparatus, straightening another, and cutting yet another, and so on.

For the individual labourer to be equally efficient as the factories of the time, each labourer would need 18 different tools that each sat idle for 17/18ths of the time. Thus it is the search for returns on the investment in new tools and equipment that allowed for both the observed division of labour and the radical increase in productivity.

You might interject that if 18 labourers joined together they could each buy a single different tool and simply share their own tools on the off days, that they would be equally efficient as a group. But in fact, they would simply be a factory, with the only difference to Smith’s example that workers owned all the capital.

Thus it is capital investment that leads to larger firms, internal coordination via division of labour, and increases in productivity. That is the real lesson of Smith’s pin factory.

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

Are Australian universities just not good enough?

The reserved and mild-mannered American Canadian law Professor James Allan, who works at an under-performing Australian university, has recently written a long tirade against the bureaucratisation of higher education in Australia.

While it contains a few home truths which need public acknowledgement - like the centralisation of decision-making and the power of university executives to make inappropriate rules, and also set their own pay - it also misses important context, and offers personal biases and anecdotes instead evidence and constructive suggestions for improvements.

I want to respond here to that article. First let me attempt to summarise Allan’s points about what is wrong with Australian universities.

• University administrators seem to value research grants as outputs rather than inputs
• Bureaucratic decisions at universities are quite centralised
• Students work and study, meaning they want lectures recorded and don’t want to do extra reading
• Students don’t travel to other cities to study
• University ranking tables are a sham, and Australian universities are not performing as well as these tables make out

However Allan doesn’t actually explain what a suitable output performance measure should be for a university. The most we get is this

In Canadian law schools (and US ones, and UK ones) you are expected to be working on your degree full-time. You are expected to do lots of reading. You are expected to think. You are expected to pursue things on your own. You are not expected to schedule classes all on two days of the week so you can work the other three. Or tell your professor that you can’t do something because it conflicts with work. Or be so tired that you do as little reading as you can get away with. 

Yet that is now standard practice in Australia. I can still, just, get away with refusing to record any of my lectures and so insist that students come (or not, since as adults it is up to them, but if not they are on their own). But the university administration detests that position and is making it harder and harder to take. As I came to Australia already with a chair I can ignore the students who get infuriated about this practice of mine in their course evaluations. But no junior academic wanting to be promoted can do so. It is no exaggeration to say that the incentives are slanted heavily in favour of caving in, of spoon-feeding students, of recording all lectures for viewing from home (with much reduced class attendance as a result)—anything to facilitate the job commitment of the supposedly full-time undergraduate. 

The flip-side of this situation is that the demands on students (even at our Group of Eight universities) are noticeably below what they are in good Canadian and UK and US universities. As for a serious Ivy League or Oxbridge undergraduate education, well, we are not in the same league as those institutions because we demand so little of our students.

Australian universities are not good enough, apparently, because students need to read more, and think, and pursue things on their own. 

He also makes a personal judgement that what you learn at university must be superior to the skills you learn at work, or that working and earning a living is not ‘pursuing things on your own’. That doesn’t really sound like a typical Australian attitude to me. My personal experience in economics is that a degree gets you in the door, then it is all down to experience. Working while studying, especially in your chosen field, is quite advantageous.

But he really doesn’t elaborate any further. Is university performance measured by research output? Is it measured by revenue? If so, he doesn’t have much of a case against the administrative bias towards academics who generate research grants.

Or is it the number of peer reviewed journal articles? If so, is it quantity or quality? Who will judge quality? Is it student numbers per academic? Or is it student quality? Who will assess that? Or do we judge performance on the gut feel of visiting academics with their own personal biases?

I don’t want to sound harsh, but for a senior academic writing about the underperformance of Australian universities, a little note about what underperformance really means, framed within the role of universities within society, would be nice. He signals that it should be research output, noting that people

…could see the difference between judging people based on what they wrote and produced versus one that judged them based largely on winning as many grants as possible.

but fails to return to how this measure fits into his picture of a competitive university system.

Whinging about the rules doesn’t really help. It is like an Apple employee coming into the company and saying they have a lot of centralised decision-making and that engineers were slugged with bureaucratic tasks, such as getting central approvals to spend money on new equipment. Whereas at their last job they could do as they please.

Sure, from the employee perspective this seems like a horrible system to work in. But any outsider assessing the performance of the company as a whole would feel it is worth it. That’s because we have an agreed measure of what company performance is. For universities we don’t, and that is usually the recipe for a growing bureaucracy.

Allan lays some of the blame at a lack of competition, perhaps due to some cultural norm of families not sending their sons and daughters interstate to the ‘best’ university in their field. Apparently this lack of competition means that universities can slack off and amuse themselves with ever more burdensome central rule-making and ever-greater executive pay.

Allan writes

In this sense, Australia and its universities are at a disadvantage. Imagine what would happen if parents were as likely to send their kids to Melbourne University as to Sydney University or the University of Queensland or Australian National University, and the deciding factors came down to what the universities had to offer, say in terms of class sizes or contact with professors or the “undergraduate experience”.

There are two problems with this point. First, is that the universities are full of international students. Outside of law especially. Surely these students are discerning about their university choice and hence provide a great deal of competitive pressure. According to the ABS 22% of students at university in Australia are international students, while at some universities that figure is over 40%. Monash and Melbourne universities seem to be competing quite fiercely, with Melbourne experimenting with student offerings at great risk.

Second, the central rules that Allan hates so much are just as much the result of competitive forces, than on the lack of such forces; of trying to attract students by ensuring the get the easiest path through their study. We’ve seen the gimmicks about giving new student iPads. Allan mentions the imposition of consistent marking systems, PhD criteria for lecturing positions, timing of student evaluations; all of these are about managing university-wide quality in order to assure new students of what they will be getting. Haven’t you seen advertisements?

This is what happens with competition for students (customers), and students mean revenue. If you want universities run competitively like private businesses, you must expect that they will measure their success in similar ways.

So where does research output fit into his competitive picture? It certainly doesn't raise revenues, and most undergraduates, the customers of universities, wouldn’t have a clue about their school’s research anyway.

Regarding the lack of travel to university, if I can sum up the Australian view very roughly, it is that university is more like advanced vocational training. Degrees that used to be provided by technical colleges are now integrated into universities. Students don’t travel because their local university usually maintains standards high enough to get them into their chosen field. Why travel if you can be assured of equally good local training? After all, once you are in the door, your experience counts much more than your degree in most fields.

He writes

When I try to point out the advantages of sending one’s kids away to university here in Australia I am generally met with blank stares of incredulity.

But of course, he didn’t mention any of those advantages in his article. Could it be that there really aren’t many? Or is he saying that Australians are just too stupid to see them?

Which leads to the more entrenched problem. The competition that drives student selection and travel for study in the US and the UK is the result of monopoly power of universities so that students must compete rather than universities. And this competition between students is also driven from a higher level. Reputation and insider connections within top universities to political and corporate elites means the payoff to getting into those universities is much higher. A degree at Princeton or Harvard is a meal ticket with a value far higher than cost of tuition itself. This not only means that students want to travel to get in to these universities, but that they (and their parents) are willing to pay through the nose for it as well. Here’s just one example of the political connections a degree at Oxford brings.

In Australia we don’t have that ‘boys club’ mentality to such an extent, especially not in most degrees. Having a teaching degree from QUT doesn’t open doors at Goldman Sachs, unlike a finance degree from MIT.

While I am sure Allan feels much better getting this all off his chest, I can’t help but think he has missed the important points to focus on his personal gripes. He overlooks exactly why Australian universities aren’t good enough, and then appeals to competition as some magical remedy to all organisational problems like some evangelical Chicago economist. Lastly, his suggestions for improving the situations include a bunch of central administrative tools!

One of his suggestions, the publication of remuneration of the highest paid employees, is generally already complied with in the annual financial accounts, where executive pay is itemised (here’s UQ, here’s QUT). But of course, executive pay exploding is not limited to universities. It is a general problem of power that competition alone does not solve.

Another suggestion is to publish the ratio of academic to non-academic staff, which is essentially a meaningless ratio because it absolutely depends on the tasks each staff is responsible for. If administrative staff are freeing up time for academics, then that is a good thing. I could imagine these suggestions being implemented and a future version of Professor Allan writing another article deriding them!

He suggests scrapping the ARC grant system, but makes no suggestion of alternative funding allocation mechanisms, as if by magic money will find worthy researchers. I agree the system is poor, but we need to be discussing better alternatives. Why didn’t Allan tell us a bit about the funding systems in those hot-shot universities he so reveres?

When push comes to shove Allan goes for the practical over the ideological, which is a good thing. But it leaves you wondering what the point of all those words really were. Will they merely be interpreted as at the ravings of a sheltered and entitled academic? We have quite enough of that already.

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Wages share and investment

Kieran Latty produced this chart on wages share and investment share in OECD countries. If we take this at face value it implies the existence of a wage share that maximises investment - which in the long run is what makes us wealthier. 

To me this seemed a little too neat. Economists love the inverted U-shape relationship, or concave relationships in general, because it implies the existence of some kind of equilibrium - just set labour share correctly and you will maximise investment. Or something like that.

It turns out to produce the ‘inverted U-shape’ curve Latty used a time fixed effect and a non-linear estimator on data from AMECO. While this may be somewhat normal in the literature on this topic - for such reasons as removing the effects of international business cycles and to control for any secular trend in international growth rates - ultimately these model choices fundamentally determine the results. Like most observational data from complex systems, we are applying models as mere plausible stories, with no objective criteria for assessing their validity.

Often the details (including the outliers) in these types of international comparisons reveal much more of the story than the general trends. To satisfy my curiosity I constructed a similar chart from OECD and World Bank data.

Below is the scatterplot of my sample (you will notice the chart is animated to show country data connected through time) . Eyeballing the data there seems to be no general time-independent inverted U-shape. This is confirmed by regressions on the sample without controls, and indeed, with a quadratic specification we find a positive coefficient on the squared term.

 

Notice that each country seems to occupy a distinct section of the chart. Such divergence between countries should be of great interest to macroeconomists. In my smaller sample below Japan has consistently high labour share and investment share, while New Zealand is consistently low on both measures. Then we have the US and UK with consistently low investment accompanying a rather high labour share. 

My expectation is that a high labour share of income would result in greater investment share, if only because owners of capital would have greater incentives to invest and innovate in order to gain a return, rather than simply hold existing assets. Who knows whether this is the case at all. But it’s my current speculation.

What is, for me, more fascinating in this data is the trend over time. We know that the labour share of national income has been falling in most countries since the 1970s. We can see that trend, along with short-term cycles, in the animated chart below that tracks my six country sample since 1970. 

In broad terms the maturing nature of these economies may mean that such a downward trend in labour share is naturally expected. Or it could be that policy choices for the past four decades have directed national income towards owners of capital, which resulted in lower investment in some cases but not others. The answer still seems completely unclear. If you want more analysis, you can read the Productivity Commissions recent work on the topic. 

Like many macroeconomic curiosities, the relationship between wage share and investment is a puzzle unlikely to find a satisfactory conclusion any time soon. 

What does affordable housing mean?

In my submission to the Senate Inquiry on Housing Affordability I wrote the following

Home ownership and reducing housing costs are not necessarily related policy goals. Housing can be cheap with extremely low rates of home ownership, and expensive with high rates of ownership. Clarity about what housing affordability means as a social policy goal is necessary.

There is usually an implicit stance in the housing affordability debate in Australia that a high rate of home ownership is a desirable policy goal. For some reason, a renting society is frowned upon. I put this down to tradition.

In Switzerland and Germany for example, around 60% of households rent. In Denmark and Austria it is around 50%. In Australia 30% of households rent.

We must remember that affordability of buying homes is not the same as making housing cheaper. Making housing cheaper means focussing on rental prices and their share of household income. If rents fell by 25% but prices didn’t, surely we would say housing has become more affordable. And vice-versa, if home prices increase 25% but rents were flat, we should say that housing has become less affordable.

A home is a financial asset that produces a place to live. Why do we care about owning the financial asset that produces our housing, but we don’t care about owning the assets used to produce our food, clothing and other goods? No one ever talks about a BHP share affordability problem!

The exact meaning of affordable housing is a crucial question to consider before any constructive housing policy can be developed.

Some may argue home ownership is about security. Home owners can put down roots because they know they won’t be evicted by a greedy landlord. But security of tenure can equally apply to rental housing, as it does in many countries. We just choose not enact the regulation to enable this to happen. Maybe readers have other reasons that home ownership is socially desirable.

For my part, I believe it is actually counterproductive to tackle housing affordability by encouraging greater home ownership.

Here’s why.

High home-ownership rates imply that most of the electorate has a financial interest in keeping prices high. This implies an interest in keeping rents high in order to maintain those prices. Thus, the interests of the home owner and the investor are aligned against the interests of the renter. 

When the bargaining power of renters is curtailed it merely enables investors to extract the full share of rents - that is, they are able to charge the maximum that renters are willing to pay. Any reduction in rents is merely a transfer of wealth from investors and home owners to renters.

With a higher proportion of rental households governments would be forced to improve conditions for tenants, and by doing so, increase their bargaining power.

Buying a home in Australia currently costs between 1.5 and 2 times more than renting, meaning that few rental households have an outside option of buying. They rent because they have to.

We can improve the bargaining power of renters either though changes to rental regulations, or through improving the home-buying outside option. This means that the very act of reducing prices, via LVR restrictions, removing the FHOG, and limiting CGT discounts and negative gearing, means that home buying will reduce in cost compared to renting, allowing buying to be a financially viable alternative to more currently renting households.

For more discussion on the issue I recommend this paper, which contains a wealth of data on rental housing in the OECD, and reasonable discussion about these important issues, including rent controls and the need to shift bargaining power towards tenants to reduce housing costs.

Once we focus on the rental price of housing, and not the price of the financial asset of residential property, we get a very different picture of the housing affordability debate. In fact, we get a picture where housing affordability has remained relatively stable in Australia over the past 20 years. And one where home ownership may even be a policy goal at odds with the goal of affordable rental housing.

But that doesn’t mean we can’t change the situation if we wanted to. We just have to accept that doing so involves a massive transfer of wealth.

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Inequality is a capital vs labour story

I was in a seminar recently where the presenter explored some trends in income inequality in Australia, Canada and the US over the past century. While there was much to like about economists trying to unravel this issue, including the repeated reminders that representative agent models cannot deal with this problem, I had some niggling doubts that the whole story was being considered. I thought this presenter was sticking to only the issues deemed acceptable to discuss in the economics community, while ignoring the more important political issues.

First the good parts. Education is not a solution to income inequality. Canada and the US in particular are very highly educated countries, whose average educational attainments have soared for the past 30 years - the exact period that also saw huge growth in inequality. 

It was acknowledged that the greater the degree of inequality, the easier it is to buy favours within political processes, further entrenching the income divide. It was nice to see economists raise these political points, but equally it highlighted how much of a disgrace it is that economists (and economic theory) play such a key role in capturing political processes for the 1%. 

Now to the issue I believe is the crux of the income equality debate.

I was informed in the presentation that the inequality story of the past 20 years is not about the division of income between capital and labour. Labour incomes in the top 1% are increasing very rapidly too. Sure. But we know that CEO and executive pay is more closely linked to capital returns than ever before, following the wide acceptance of the principle of incentive pay and aligning executive pay to share market performance. 

When I look at the data from the Henry tax review, I find that in fact that the distribution of income from capital is far more distorted towards the upper end than income alone. 

I’ve borrowed the chart below from the Henry Review website. What we see is that the top 5% of income earners in Australia get half of total national income from owning capital assets. While they only get 15% of the wages. 

We can even see that the bottom 20% are making capital losses (capital gains and dividends), highlighting the process by which the poor are becoming more dependent on labour income. 

Many researchers do in fact note that decreasing labour share, and therefore increasing capital share, of national income has been a global trend since the 1970s. What few say however is that this is trend is a result of policy choices informed by neoliberal ideology. We certainly could have avoided this trend if we desired. It was simply a matter of different policy choices. And to reverse the trend is also very simple, should be desire to do so. 

There is no 'natural' outcome when it comes to inequality.

In a mere technical sense, reversing the trend couldn’t be easier. Off hand I can think of dozens of policies; from inheritance taxes, greater public transparency of personal income data (including trusts), land taxes, improving the power of shareholders in the determination of executive pay, grants of land or capital for public service, and more. The options are limitless. 

The barrier to change is modern realpolitik. Those at the top have captured the political process, partly by capturing the media. Any change will entail a massive redistribution of wealth from those who bankroll the political parties, to those with the least resources, the least education and the least interest. 

This is the heart of the matter, and one we repeatedly avoid discussing.

Pretending to care about housing affordability

Australia is embarking on another Inquiry into housing affordability. In the past decade almost every government body, at every level of government, that has any function related to any aspect of housing policy, has conducted similar inquiries. With zero results.

Is it time we stopped pretending to care?

I made a submission (pdf here) to the inquiry, not because I think things will change, but to highlight the 'big picture' considerations in any housing policy. You know, the ones we don't talk about because the Overton window has been slammed shut by decades of well-funded propaganda by wealthy interest groups. Just look at the content of other submissions to see how they miss the big picture, either simply promoting their own financial interests or preserving their reputation by reiterating arguments deemed acceptable in polite company.

My main point is this - any policy that successfully reduces housing rents, and subsequently home prices, entails a massive redistribution of wealth from the richest to the poorest. I wrote the following in my submission.

At current prices Australia’s total housing stock is valued at around $5 trillion. If a policy successfully reduced rents and prices by 20% it would wipe $1 trillion of value from this market. Purchasing power of around $40 billion per year would be redistributed from the almost 6 million current home owning households and 1.8 million residential property investors, to the 2.8 million renters, along with future home buyers and owners of other non-residential domestic assets. 

There is no win-win scenario. Housing affordability is almost completely a question about the distribution of wealth in society. 

To understand the magnitude of potential redistribution from successful policy to improve housing affordability, a reduction in housing rents by even as little as 10%, would lead to possibly the largest redistribution of wealth from the richest to the poorest in Australia's recent history.

Politically it makes sense to pander to the majority. And while the majority of households still own their own home, absolutely nothing will be done to reduce rents and home prices. Even the ridiculous fig leaf of the First Home Owners Grant is actually a subsidy to existing home owners. It's the most fantastical piece of doublespeak to not call it what it really is - the Current Home Owners Grant.

This is the elephant in the room on housing policy. Here. Right here. I'm pointing at it.

Watch me be ignored.

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The 140 year cycle in macroeconomic thought

I am reading Progress and Poverty: An Inquiry into the Cause of Industrial Depressions and of Increase of Want with Increase of Wealth: The Remedy by Henry George (free ebook available here).

I’ve been fascinated so far that the economic debates that occurred during the long recession of the 1870s are almost identical to those still occurring during the great recession. I would have expected more progress in macroeconomic thought in 140 years.

Here’s George describing the utter disarray of the economic elite of that time in explaining how the depression had arisen, and where to look for a remedy.

This is shown by the widely-varying attempts to account for the prevailing depression. They exhibit not merely a divergence between vulgar notions and scientific theories, but also show that the concurrence which should exist between those who avow the same general theories breaks up upon practical questions into an anarchy of opinion.

Upon high economic authority we have been told that the prevailing depression is due to over-consumption; upon equally high authority that it is due to over-production; while the wastes of war, the extension of railroads, the attempts of workmen to keep up wages, the demonetisation of silver, the issues of paper money, the increase of labour-saving machinery, the opening of shorter avenues to trade, etc., etc., are separately pointed out as the cause by writers of reputation.

The modern equivalents are

1870s excuses		2000s excuses
over-consumption	→	excess household debt
over-production	→	excess housing construction
wastes of war	→	government waste or regulation
high wages	→	high wages
currency debasement	→	currency debasement
labour-saving machinery	→	robots

I found even more interesting the debates about the nature of capital and wealth that occurred at the time. George criticised the writers of common textbooks for not being specific in their definitions which caused much confusion when applying economic reasoning to the problems of the day. It seems an awful lot like the Cambridge Capital debates of the 1970s and reminded me of debates (or indeed lack of debate) around foreign investment that appear to have subsided in the past few decades. 

Here’s a snippet, which shows George would firmly be on the side of Cambridge, England, in the capital debates, and would be firmly of the position that foreign investment is merely a transfer and is not wealth-creating. 

As commonly used, the word " wealth " is applied to anything having an exchange value. But when used as a term of political economy it must be limited to a much more definite meaning, because many things are commonly spoken of as wealth which in taking account of collective or general wealth cannot be considered as wealth at all.
...
Increase in the amount of bonds, mortgages, notes, or bank bills cannot increase the wealth of the community, that includes as well those who promise to pay as those who are entitled to receive.

The enslavement of a part of their number could not increase the wealth of a people, for what the enslavers gained the enslaved would lose. Increase in land values does not represent increase in the common wealth, for what land owners gain by higher prices, the tenants or purchasers, who must pay them, will lose. 

And all this relative wealth, which, in common thought and speech, in legislation and law, is undistinguished from actual wealth, could, without the destruction or consumption of anything more than a few drops of ink and a piece of paper, be utterly annihilated. 

By enactment of the sovereign political power debts might be cancelled, slaves emancipated, and land resumed as the common property of the whole people, without the aggregate wealth being diminished by the value of a pinch of snuff, for what some would lose others would gain. 

There would be no more destruction of wealth than there was creation of wealth when Elizabeth Tudor enriched her favourite courtiers by the grant of monopolies, or when Boris Godoonof made Russian peasants merchantable property. 

All things which have an exchange value are, therefore, not wealth in the only sense in which the term can be used in political economy. 

Only such things can be wealth the production of which increases and the destruction of which decreases the aggregate of wealth. If we consider what these things are, and what their nature is, we shall have no difficulty in defining wealth.

What amused me is that George looked for answers in political economy

It must be within the province of political economy to give such an answer. For political economy is not a set of dogmas. It is the explanation of a certain set of facts. It is the science which, in the sequence of certain phenomena, seeks to trace mutual relations and to identify cause and effect, just as the physical sciences seek to do in other sets of phenomena.Maybe it’s time to follow his lead, again, and look outside of sterile economic theory to resolve problems of macroeconomic instability.

Open borders: A morality play by the 1%

Alex Tabarrok, who I rarely agree with, has recently argued his moral position on open borders here. There is no doubt that most moral frameworks also support his position. As do I in the mere theoretical sense. As Tabarrok argues

How can it be moral that through the mere accident of birth some people are imprisoned in countries where their political or geographic institutions prevent them from making a living?

I have argued before that redistribution of wealth from the world’s richest to the world’s poorest should be at the top of the policy agenda for any economist who believes in the utilitarian foundations of their discipline. Open borders is an indirect method for pursuing similar goals of increasing wellbeing for the poorest, and usually promoted by those who fall on Mankiw’s side of the political spectrum; by those who typically argue that the rich ‘deserve’ their wealth (counterargument here).

Open borders is merely the logical outcome of any type of ‘natural rights’ approach to moral reasoning. People should have the opportunity to flourish irrespective of the patch of Earth they were born. Yet the idea boils down to being the policy you support when you want to help the world’s poor but don’t support actually giving them money. Tabarrok’s argument equally applies within borders between the rich and poor, and I paraphrase his comment to make this point. 

“How can it be moral that through the mere accident of birth some people are imprisoned in towns and suburbs where their financial and geographic constraints prevent them from making a living?”.

That open borders within countries does not automatically eliminate poverty reminds us be skeptical of claims that opening borders between them will reduce poverty automatically.

It helps to identify the potential winners and losers from opening borders in order to better understand the motivations of its proponents. If open borders works, and large scale migration occurs, the net effect is that the poorest in the world’s richest countries would have their wages reduced due to competition for unskilled jobs. By contrast, the richest individuals in rich countries, whose incomes are derived mostly from owning capital, would increase due to the greater demand for their domestic assets (such as land) following high levels of immigration. 

Even the wildest proponents of open borders agree that

…open borders could not on its own eliminate poverty and that international migration could only help the relatively better off among the global poor

The rich get richer; that we know with some degree of confidence. The poor get, well, we don’t know. Probably poorer in relative terms, maybe richer in absolute terms. We just don’t know. But we can be fairly certain that the poorest in the world are unlikely to walk away from their homes and straight into the most exclusive enclaves of New York and London. Indeed, one suspects that the most highly educated from the poorest countries will be the first to leave (as they often are now).

Open borders in a global sense is therefore likely to be a game that benefits the richest from the poorest countries and still leaves the poorest with few options to improve their economic fortunes.

Putting this raw economic analysis to one side for a moment, one question seems completely overlooked by proponents of open borders. Why do borders exist in the first place? If we can’t satisfactorily answer that question we won’t get far understanding the many important social issues that would accompany open borders.

A very brief and abstract story of borders is as follows. National borders typically exist as a result of previous wars, or the negotiations that took place between competing interests under the threat of war. These borders now serve as moral boundaries, whereby we see those within our border as part of our tribe. Tribes reinforce their internal cohesion through social signals, customs and rituals which foster stability. This process, however, can distance them from other tribes (countries).

It is these tribal and moral values of borders that make integrating tribes quite difficult. Immigration is always contentious not because of the existence of a line on a map, but because of these deeper social customs, norms and rituals are often in conflict. It takes a mighty will for immigrants to adapt to their new countries, and for citizens of destination countries to patiently accept new people with often conflicting customs and beliefs in their towns and suburbs. I generalise here probably a little too much, but the point I hope to make is that social integration is not automatic and is an extremely complex issue that needs to be properly considered in arguments for open borders.

While I don’t have a disagreement with open borders on moral principles, I disagree on practical grounds that they should be promoted as a first-best way to improve the lives of the world’s poorest. Any economic success from such a fantastical global open borders policy would come at cost of social challenges arising from what I’ve described as ‘tribal integration’. The greater the economic benefits to the, the higher the social costs at both source and destination countries. 

In many ways open borders is the type of policy you support to display street cred in the company of the economically rational, particularly when discussions turn to inequality and, god forbid, redistribution. Making the poor richer is as simple as giving them money and therefore access to resources, whether they are fellow citizens of your country, or your planet.

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Economics is applied morality

The ignorance of many highly experienced economists to the moral foundations of their work is quite alarming. As a group, economists typically internalise the utilitarian morality embedded in their methodology to such a degree that they are happy to promote economic theory and practice as an objective scientific approach.

To set a more honest course for the discipline I pushed hard during the development of Australian Learning Standards in Economics to include criteria for the teaching of moral foundations, in addition to professional ethics. Indeed, I have argued previously for adopting standards of professional ethics in economics. You know, to cover the usual expected standards of professionalism such as not making comments in public forums without disclosing financial interests. 

I couldn’t get the actual words morals and ethics into the new learning standard. But the result was very good I think, with the fifth learning standard being called Reflection, and containing the following. 

Bachelor graduates will be able to reflect on the:

• nature and implications of assumptions and value judgments in economic analysis and policy
• interactions between economic thinking and economic events, both historical and contemporary
• responsibilities of economists and their role in society.

You wouldn’t believe it, but one concern was that there may be insufficient expertise within the cohort of university professors to achieve this standard. So in the interests of raising awareness, I want to provide a very brief comment on the moral foundations of economics.

Utilitarianism is the moral foundation of economics. The idea of the greatest good for the greatest number is intuitively appealing. But applying a utilitarian framework relies on value judgments about the desires, and a comparable measure of their intensity, of every individual. Some of the defining debates in economics over the past century have centred around the measurement and comparability of utility between individuals.

Thus any application of economics requiring estimation of costs or benefits is applying a judgment about the worthiness of competing desires of the population at large. That judgment is necessarily a moral one.

Further, most economic analysis applies utilitarianism in an ad hoc manner, by considering only the population within national borders. Unless you are a ‘national utilitarian’ (a distinct moral position), it can never be appropriate to consider domestic policy in terms of the utility of local residents while ignoring effects on the utility of those abroad. 

A truly utilitarian analysis must always and everywhere adopt a global perspective, which would make it exceeding difficult to justify any domestic policy in the developed world that didn't entail a massive redistribution from that country’s wealthiest to the world’s poorest. 

Then there’s the moral position that only the utility of humans counts.

Other times economic analysis is more clearly a case of applied morality. In analysis of public health economists usually appeal explicitly to the idea of utils, or some metric of quality-adjusted life years. The adoption of this metric relies on a moral judgement, for it implies that the elderly are less deserving of health resources than the young. But an equally valid moral position is that the elderly are more deserving as a repayment for their lifetime of work contributed to the community. Another moral position is that the young are easily and cheaply replaced, while the wisdom held in those elderly bodies has a high value and is costly to replace.

In more general terms we face the morality problem when measuring progress. Economists prefer GDP because their utilitarian framework implies that more consumption leads to greater utility. Apart from the obvious problem that GDP only includes goods traded in markets, ignores household production and externalities, it also contains a compositional problem.

What I mean is that many of the ‘goods’ that people trade are actually what we would call precautionary spending and increase utility only because they compensate for a loss of utility arising from outside of the market. Home security is one example.

Isn’t it better to not need to have home security, than for people to feel the need to spend 5% of their income on security, including locks, alarms, surveillance, insurance and so forth?

Other measures of progress have been proposed to overcome these issues. Each of these simply reflects and alternative moral judgment.

Lastly, there are the moral positions surrounding the degree of wealth distribution, the degree of community support to offer the unemployed, the elderly, and so forth that are perennially topical. These are all moral judgements, which are easy enough to see when we get down to the nitty-gritty debate and words such as worthy come out.

There is of course much more to the story of morality in economics than can be covered in this short post. One important thing to remember is that in practice utilitarianism can be, and has been, applied to justify almost every policy position.

What we need to remember is that you can’t escape morality in economics. But understanding the moral foundations of economics is the best way to properly grasp the limits of economic reasoning. It is my hope that the next generation of economists will learn to discuss and criticise the moral foundations of economics, and by doing so see policy debates as far more complex than is typically realised when alternative moral perspectives are ignored.

Organ markets and the problem of real options

The fanfare surrounding organ markets within the economics community is often extreme. For many it is the last frontier of market fundamentalism, with some even promoting a futures market in organs.

For others however, organ markets are so obviously ethically and morally questionable that these ‘non-economic’ concerns override their otherwise vigorous support for market solutions.

One purely practical consideration is whether markets for organs will fulfil their promise of increasing supply at all, especially from living donors. Will the ‘intrinsic’ motive of one’s moral commitment be crowded-out by the ‘extrinsic’ incentive of financial compensation?

The crowding-out hypothesis is supported by evidence of reduced blood donations in areas that pay for blood compared to those that don’t. In a classic study on conflicting motivations between financial incentives and social incentives, the introduction of a fine for late pick-ups at a selection of Israeli day-care centres actually increased the number of late pickups. The social motive to do the right thing by the centre was replaced with a financial relationship, where the fine became a fee for longer day care.

Medical professionals are much more cautious in their approach to organ markets. This survey of 739 individuals from the transplant-related medical community found that while 70% support indirect compensation for organ donation, 66% opposed direct compensation, while 84% approved of the role of next-of-kin in this decision. Other studies have found that 85% of families of donors reject any payment at all. Clearly there is more to the story that financial incentives.

I offer here a more standard economic reason why most estimates of increased organ supply from establishing a market for organs, especially by live donors, are massively overestimated. Typically organs are treated as commodities in the abstract sense used by neoclassical models of demand and supply. But in reality, organ donation is a once off irreversible and costly event for each individual, and therefore has the characteristics of a real options problem. 

Potential donors have a real option to delay donation for a better price in the future. Yep, the same constraint that determines the rate of housing development occurs in this situation, where donors face decision of when to exercise their one-shot option to donate. 

If the price of organs is rising rapidly, it will pay for potential donors to withhold their organs till a future time. Perhaps ultimately till their death, at which time they may exercise their option and bequeath the earnings to their heirs. Or they may not, since there is no financial motivation any longer (apart from bequeath motives, which are actually similar to the ‘intrinsic’ motives discussed earlier).

How such financial dynamics will effect the market for organs (including from live donors) is a concern for policy makers seeking stable reliable supply. There is clearly scope for organ price bubbles to occur, which will compromise the medical intentions of the policy in the first place.

Attempted legal markets for organs are generally compromised by unscrupulous behaviour and high levels of donations by the poorest in society, meaning potential organ donation success typically comes with associated social costs.

Non-market organ donation policies have proven to have great benefits. Setting the national default to opt-in to organ donation, rather than opt-out, seems to generate significant (usually 20-30%) increases in donations, although raising its own moral and ethical dilemmas.

My personal view is that the default option appears worthwhile and should be on the table for public discussion. But the moral controversy surrounding organ donation seems to suggest that developments in lab-grown organs will be a more attractive, potentially medically and morally. This a complex area of social policy and I am no expert. Simply offer yet another argument to quell the enthusiasm of the market zealots, and point interested readers to the variety of challenges, both moral and practical, in this area of policy.