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Time and interest are not so interesting

I wanted to add a quick follow-up to the previous post, inspired by its very excellent comment thread. (If you do not read the comments, I’ve no idea what you are doing at this site; I am always pwned by brilliant commenters.)

Cribbing Minsky, I defined the core of what a bank does as providing a guarantee. Bill Woolsey and Brito wonder whatever happened to maturity transformation, the traditional account of banks’ purpose? Nemo and Alex ask about interest, which I rather oddly left out of my story.

Banks do a great many things. They certainly do charge interest, as well as a wide variety of fees, both related and unrelated to time. Banks do borrow short and lend long, and so might be expected to bear and be compensated for liquidity, duration, and refinancing risk. Banks also purchase office supplies, manage real estate, and buy advertising spots. Banks do a lot of things.

But none of those are things that banks do uniquely. Banks compete with nonbank finance companies and bond markets for the business of lending at interest, and nearly every sort of firm can and occasionally does borrow short to finance long-lived assets. There is no obvious reason why any special sort of intermediary is needed to mediate exchanges across time of the right to use real resources. As Ashwin Parameswaran points out, there is no great mismatch between individuals’ willingness to save long-term and requirements by households and firms for long-term funds. Banks themselves largely hedge the maturity mismatch in their portfolios, outsourcing much of the whatever risks arise from any aggregate mismatch to other parties. Once upon a time, before we could swap interest rate exposures and sell bonds to pension funds, perhaps there was a special need for banks as maturity transformers. But if that was banks’ raison d’être, we should expect their obsolescence any time now.

But that is not and never was banks’ raison d’être, however conventional that story might be. Banks’ role in enabling transactions is and has always been much more fundamental than their role in lending at interest over long periods of time. It is not for nothing that we sometimes refer to cash money as “bank notes”. In some times and places, paper bills issued by private banks served as the primary means of commercial exchange. Here and now, the volume of exchange of bank IOUs to conduct transactions entirely dwarfs the scale of loans intended to survive for an extended length of time. When we buy and sell with credit and debit cards, merchants pay a fee for nothing more than a banks’ guarantee of a customers’ payment. Banks issue deposits to merchants with varying degrees of immediacy for these purchases, but charge no interest at all to debit and nonrevolving credit card customers.

Interest over time is, of course, at the center of how banks make money. But the question is why banks have any advantage over bond investors and nonbank finance companies in earning an interest spread. One traditional story has to do with relationship banking: local banks know local businesses (in part by having access to the history of their deposit accounts, in part because of social and community connections), and are able to lend profitably and consistently to firms whose creditworthiness other lenders could not evaluate, and can helpfully smooth over time variations in lending interest rates due to changes in the firm’s financial situation over time because the ongoing relationship prevents firms from jumping during periods when they are “overcharged”. I think there is something to this story historically, but fear it’s growing less and less relevant as the business consolidates into megabanks that require “hard” centrally verifiable statistics rather than “soft” local information to justify making credit decisions. In any case, if managing relationships actually is banks’ special advantage, note that it has nothing to do with maturity transformation and everything to do with evaluating creditworthiness and providing a guarantee.

Even if there’s something to the relationship banking story, it’s not sufficient to explain the resilient centrality of banks. Why can’t local nonbank finance companies couldn’t enter into persistent relationships with firms, evaluate creditworthiness, and earn the same smoothed interest rates as banks? Banks’ advantage in earning an interest rate spread comes ultimately not from anything special about their portfolio of assets, but from what is special about their liabilities. Banks pay no interest at all or very low interest rates on a significant fraction of their liabilities, low-balance checkable demand deposits. The class of bank creditors called “depositors” accepts these low rates because 1) they deem the bank to be highly creditworthy, and so don’t demand a credit spread; and 2) they gain an in-kind liquidity benefit because “bank deposits” serve as near perfect substitutes for money.

To me, a bank is any entity that can issue liabilities that are widely accepted as near-perfect substitutes for whatever trades as money despite being highly levered. Bill Gates can issue liabilities that will be accepted as near-perfect substitutes for money, but Gates is not a bank: his liabilities are viewed as creditworthy precisely because he is rich. The value of his assets far exceed his liabilities; he is not a highly levered entity. Goldman Sachs, on the other hand, was a bank even before it received its emergency bank charter from the Federal Reserve. Prior to the financial crisis, despite being exorbitantly levered and having no FDIC guarantee, market participants accepted Goldman Sachs’ liabilities as near substitutes for money and were willing to leave “cash” inexpensively in the firms care. The so-called “shadow banks”, the conduits and SIVs and asset-backed securities, were banks before the financial crisis, because their highly rated paper was treated and traded as a close substitute for cash despite the high leverage of the issuing entities. Shadow banks wrapped guarantees around a wide variety of promises that, after a while, we wished they hadn’t.

Maturity transformation, issuing inexpensive liquid promises today in exchange for promises that pay a high rate of interest over a period of time, is one strategy that banks use to exploit the advantages conferred by the resilient moneyness of their liabilities. Issuing guarantees for a fee — swapping their money-like liabilities in exchange for some other party’s less money-like IOUs — is another way that banks exploit their special advantage. These activities are not mutually exclusive: lending at interest over time and bundling the price of the guarantee into a “credit spread” embedded in the interest rate combines these two strategies.

But maturity transformation is really nothing special for banks: depositors’ willingness to hold the liabilities of highly levered banks at low interest means banks can invest at scale in almost anything and earn a better spread than other institutions. Whether that spread comes from bearing maturity risk or credit risk or currency risk or whatever doesn’t matter. What is uniquely the province of banks is their ability to issue, in very large quantities relative to their capital, money-like liabilities in exchange for the illiquid and decidedly unmoneylike promises of other parties, and thereby effectively guarantee those promises. It is this capability that makes banks special and so central in enabling commerce at scale among mistrustful strangers.

A final point about banks as I’ve defined them is that they simultaneously ought not exist and must exist. In financial theory, the interest demanded of an entity by its liability holders should increase in the leverage of the institution. There ought not to be entities that can “lever up” dramatically, often against opaque and illiquid assets, without creditors demanding a large premium to hold its deposits. Yet banks exist, and existed long before deposit insurance immunized some creditors from some of the risks of bank leverage. They existed in spite of financial theory, with the help of marble columns and good salesmanship and perhaps the small assurance that came from knowing that if depositors were ruined, the banker would be too. Under a wide range of political and institutional settings, banks come into the world and gain people’s trust despite their inherent fragility, because humans are susceptible to elevating gods, because commerce requires scalable and trustworthy guarantors. People require commerce enough to collectively hope for the best and overlook the inherent contradiction between leverage and trustworthiness. Nowadays, we mostly rely on the state to overcome this contradiction. But recall that no one thought that AAA tranches of structured vehicles had a state guarantee, yet they were often treated as near-money assets. It was just unthinkable that the rating agencies could be so wrong on so vast a scale. If you think about it, you’ll come up with other examples of entities that became able to act as banks, to issue near-money paper despite high leverage, because failure became conventionally unthinkable, even in the absence of any state guarantee or ability to extract one via the knock-on costs of failure. Our propensity to anoint banks is ultimately a social phenomenon, not a product of economic rationality.

Then the state itself is a special kind of bank. Like any bank, the state is perfectly creditworthy in its own banknotes. But unlike other banks, many states make no promise that their notes should be redeemable for anything in particular. “Currency-issuer” states (as the MMTers put it) are highly creditworthy because they don’t make clear promises they might be ostentatiously forced to break. That the failure of states is conventionally unthinkable lends another layer of resilience to the state-as-bank. Successful states use their capacity to intervene in economies — both gently through good stewardship and roughly via taxation — to ensure that the liabilities they issue remain valuable and liquid in commerce. This capacity to intervene renders states and state-guaranteed banks somewhat more resilient than private banks, although not infinitely so. Ultimately the value of any state’s irredeemable notes depends on its capacity to organize and tax valuable real production.

Addendum: Note that the subsidy to sellers described in the previous post depends specifically on the notion of banking systems organized and guaranteed by the state, rather than the more general definition of banks used in this piece. A person who surrendered some real good or service directly for the AAA paper of some CDO bore risk and probably got screwed. But if the same vendor surrendered a real resource for Citibank deposits which had been issued to the buyer against that same AAA paper as collateral, the seller was protected from the risk engendered by her semi-transaction. (“Semi”, because she surrendered something real, but received nothing real in return, creating a risk of nonreciprcation that did not exist before, see e.g. Graeber). It is the state guarantee of bank IOUs, whether explicit or tacit, that effectively socializes the risk of a sale, rather than merely obscuring it or rendering it conventionally unthinkable.

Update History:

  • 15-Jul-2012, 8:15 p.m. EEST: Added addendum re importance of state guarantee to the engineering of a subsidy to sellers.
  • 16-Jul-2012, 4:55 a.m. EEST: Fixed an ambiguously phrased sentence, many thanks to Ritwik for pointing out the issue: “requirements by households and firms for long-term savings funds.”
  • 16-Jul-2012, 5:05 a.m. EEST: “somewhat more resilient than more circumscribed private banks”, “against the that same AAA paper as collateral”

What is a bank loan?

When a bank makes a loan, does it create money “from thin air“? Are banks merely intermediaries, where “if people are borrowing, other people must be lending“? I consider these sorts of questions less and less helpful. Let’s just understand what a bank loan is, in terms of real resources and risk.

Suppose I go to my local bank and ask for a loan. The bank says yes, and suddenly there is “money in my account” where there was not before. Am I now a “borrower” and the bank a “creditor”?

No. Not at all. The transaction that has occurred is fully symmetrical. It is as accurate to say that the bank is in my debt as it is is to say that I am in debt to the bank. The most important thing one must understand about banking is that “money in the bank” also known as “deposits” are nothing more or less than bank IOUs. When a bank “makes a loan”, all it does is issue some IOUs to a borrower. The borrower, for her part, issues some IOUs to the bank, a promise to repay the loan. A “bank loan” is simply a liability swap: I promise something to you, you promise something of equal value to me. Neither party is in any meaningful sense a creditor or a borrower when a loan is initiated.

Now suppose that after accepting a loan, I “make a purchase” from someone who happens to hold an account at my bank. That person supplies to me some real good or service. In exchange, I transfer to her my “deposits”, my IOUs from the bank. Suddenly, it is meaningful to talk about creditors and debtors. I am surely in somebody’s debt: someone has transferred a real resource to me, and I have done nothing for anyone but mess around with financial accounts. Conversely, the seller is surely a creditor: they have supplied a real service and are owed some real service in exchange. It would be natural to say, therefore, that the seller is the creditor and I, the purchaser, am the debtor, and the bank is just a facilitating intermediary. That is one perspective, a real resources perspective.

But it is an incomplete perspective. Because in fact, the seller would not accept my debt in exchange for the goods and services she supplies. If I wrote her a promise to perform for her some service of equal value in the future (which might include surrendering crisp dollar bills), she would not accept that promise as a means of payment. I circumvent her fear by writing to the bank precisely the promise that the vendor would not accept and having the bank “wrap” my promise beneath its own. The bank’s job is not to “lend” anything in any meaningful sense. The bank is just a bunch of assholes with spreadsheets, it has nothing real that anyone wants to borrow. The bank’s role is to transform questionable promises into sound promises. It is a kind of adapter of promises, or alternatively, a guarantor. [*]

Let’s suppose for a moment that the bank’s promises are in fact ironclad. With 100% certainty, the bank will deliver to holders of its IOUs the capacity to purchase real goods and services as valuable as those that were surrendered to acquire the IOUs. Now, when I transfer to a seller IOUs the bank has issued to me in exchange for my somewhat sketchy promises, is it still meaningful to refer to the seller as a “creditor”? After all, she has already received something that is unquestionably as valuable as the goods and services she has surrendered. So her situation is flat, “even-steven”. In exchange for her real resources, she has “money in the bank” whose purchasing power is guaranteed. She bears no risk. But the bank still bears the risk that I will fail to honor my promise while it will be required to honor its own without fail. Which is the creditor then, the seller or the bank? It becomes a matter if definition.

So let’s define. A party that has supplied real goods and services in exchange for a promise of future reciprocation is a “creditor from a real resources perspective”. A “creditor from a risk perspective” is a party that bears the risk that a transfer of resources will fail to be reciprocated. When I have taken a bank loan and “spent the money”, the seller becomes a creditor from a real resources perspective, while the bank becomes a creditor from a risk perspective. The role of creditor becomes bifurcated.

More accurately, the role of creditor becomes “multifurcated”. It cannot be true that “the bank” is a creditor from a risk perspective. Remember: the bank is just a bunch of assholes with spreadsheets, it has nothing real that anyone wants. The risk that we claim sits with “the bank” must in fact fall on people who control or have controlled or might control real resources. We need to consider the “incidence” of the bank’s risk. It might be the case, for example, that the bank’s IOUs, its “deposits”, are in fact not solid at all, such that if I fail to repay the loan, the bank will fail to make good on its promises to people who supplied real goods and services in exchange for bank IOUs. In this case, the “creditors from a risk perspective” are the depositors, people who have delivered real goods and services in exchange for promises from the bank. When depositors are on the hook — and only when depositors are on the hook — there is no divergence of identity between creditors from a risk perspective and creditors from a real resources perspective. Only when depositors absorb losses it is fair to describe a bank as a mere intermediary between groups of borrowers and lenders, perhaps performing credit analysis and pooling risk to facilitate transactions, but otherwise just a pass-thru entity.

That is not how modern banking systems work. Bank depositors are almost entirely protected. The actual incidence of bank risk is, um, complicated. In theory, the risk of loan nonpayment falls first on bank shareholders, then on bank bondholders, then on uninsured depositors, and then on the complicated skein of taxpayers and other-bank stakeholders who back a deposit insurance fund, and then finally on holders of inflation-susceptible liabilities (which include bank depositors). In practice, we have learned that this not-so-simple account of the incidence of bank risk is inadequate, it cannot be relied upon, that the incidence of bank risk will in extremis be determined ex post and ad hoc by a political process which favors some claimants over others when the promises that a bank has guaranteed prove less than valuable.

This may all sound confusing, but one thing should be absolutely clear. Under existing institutions, there is little coincidence in the roles of creditor from a real resource perspective and creditor from a risk perspective. Our banks are machines that permit vendors to surrender real resources in exchange for promises the risks of which they do not bear. The risks associated with those promises do not go away. They may be mitigated to some degree by diversification and pooling. They might be modest, in the counterfactual that banks were devoted to careful credit analysis. But these risks must be borne by someone. The function and (I would argue) purpose of a banking system is to sever the socially useful practice of production-and-exchange-for-promises from the individually costly requirement of assuming the risk that promises will be broken, in order to encourage the former. The essence of modern banking is a redistribution of costs and risks away from people who disproportionately surrender real resources in exchange for promises. Under the most positive spin, modern banking systems engineer an opaque subsidy to those who produce and surrender more real resources than they acquire and consume by externalizing and ultimately socializing the costs and risks of holding questionable claims.

Unfortunately, there are a lot of ways of acquiring protected claims on banks besides producing and surrendering valuable real resources. This divergence of “creditor from a real resources perspective” and “creditor from a risk perspective”, between the party to whom real resources are owed and the party who bears the cost of nonperformance, creates incredible opportunities for those capable of encouraging loans that will be spent carelessly in their direction. Incautiously spent loans are unlikely to be repaid, but the recipients of the money never need to care. Industries like housing and education and of course finance depend heavily on this fact. When industries succeed at encouraging leverage that will be recklessly spent or gambled in their direction, they create certain gains for themselves while shifting risks and costs to borrowers and the general public.

Banks are not financial intermediaries in any simple sense of the word. When they “make a loan”, they serve as guarantors, not creditors. The borrower does not meaningfully become a debtor until the loan is spent. Only then do creditors emerge, but the role of creditor is bifurcated. The people to whom resources are owed are not the same as the people bearing the risk of nonperformance. The question of who actually bears the risk of nonperformance has grown difficult to answer, and concomitantly, incentives among bank decisionmakers for caution in creating that risk have weakened, especially relative to the benefits of cutting themselves in on some share of borrowers’ protected expenditures. This bifurcation of the role of creditor also explains why creditors as a political class are relatively indifferent to the upside of a good economy but extremely intolerant of inflation. A good economy means better higher values and better performance on outstanding loans, but creditors who are owed resources but are absolved from risk do not care about the performance of the loans that have become their assets. Those fluctuations, like fluctuations of the stock market, are somebody else’s problem or somebody else’s gain. Protected claimants, people who are owed money by banks or the state (which is itself a bank), can only lose via inflation. They understandably work within the political system to oppose inflation, which would force them to bear some of the cost of the bad loans whose misexpenditures were, in aggregate, the source of much of their wealth.


[*] Update: JW Mason of the remarkable Slack Wire gently chides that I ought to have attributed this point to Minsky. And indeed I should have! From Stabilizing an Unstable Economy (Nook edition, p. 227):

[E]veryone can create money; the problem is to get it accepted.

Banking is not money lending; to lend, a money lender must have money. The fundamental banking activity is accepting, that is, guaranteeing that some party is creditworthy. A bank, by accepting a debt instrument, agrees to make specified payments if the debtor will not or cannot. Such an accepted or endorsed note can then be sold in the open market.

Update History:

  • 8-Jul-2012, 8:10 p.m. EEST: Added update/footnote with attribution to Minsky, many thanks to JW Mason.

Stabilizing prices is immoral

The first thing to recognize is that a policy of enforced “price stability”, whether implemented in terms of levels or rates, is a form of goverment-provided social insurance, just like unemployment or disability benefits. For all of these programs, there are states of the world in which some individuals might suffer misfortune. The government acts to counteract that misfortune, imposing costs on other individuals in order to fund a transfer of resources. With unemployment insurance, business owners and employed workers pay unemployment premiums, which fund benefits for workers who lose their jobs. A similar dynamic holds for stabilizing prices.

Consider an adverse supply shock. Absent government action, the effect of a reduction of the supply of goods and services would be higher prices. The only way to prevent higher prices is to concomitantly reduce aggregate demand. The reduction might be implemented by raising interest rates or other monetary operations, or it might be effected via taxation. In either case, some people will pay a cost, which will show up as a reduction of demand. Other people will enjoy a benefit from the absence of price inflation.

Who are these people? Can we identify them? Sure. People who benefit from nonincreasing prices are people who hold nominal-dollar assets. That includes most obviously creditors — people with money in the bank, bondholders, etc. — but also people with stable employment but little bargaining power to pursue raises. These groups would see their purchasing power fall in an inflation. If the government restrains prices by reducing aggregate demand, it helps these groups by shifting costs to others. If prices are stabilized via monetary policy, debtors pay: both the increase in interest rates and the reduction of aggregate demand increase the burden of repaying debts. If prices are stabilized via increased taxation, then obviously whoever bears the incidence of the new tax pays. In both cases, marginal workers pay, by enduring an increased likelihood of becoming unemployed or a diminished likelihood of finding a job. [1]

It is fairly obvious, then, that restraining prices in the face of a supply shock effects a transfer from debtors, taxpayers, and marginal workers to creditors and secure workers. A policy of price restraint is a form of insurance for creditors and secure workers, who are absolved of the risk that the purchasing power of their nominal assets will suffer an unforeseen decay. It is financed with a guarantee written by debtors, taxpayers, and marginal workers, who are put at risk by the policy. [2]

So far, we have considered an asymmetric policy, price restraint. But suppose that the state targets a price level or an inflation rate symmetrically? Then don’t the losers from potential price restraint become the winners from potential price support when the state acts to prevent deflation? Absolutely! Under a symmetric price targeting regime, if by monetary policy, debtors enjoy the benefit of a positive supply shock in terms of lower interest rates and increased aggregate demand from which to draw income. If by fiscal policy, the benefit of the happy shock is distributed to whoever captures tax cuts and to recipients of government transfers and expenditures. Whether monetary or fiscal, an antideflationary response to a supply shock implies an increase in aggregate demand which helps keep marginal workers employed. Creditors and secure-but-stagnant job-holders lose out, as the increase in purchasing power they otherwise might have enjoyed via deflation is distributed to other parties.

So is a symmetric price targeting regime “fair”? Absolutely not. Sure, it involves an exchange of risk and benefits, rather than distributing only risks to some and benefits to others. But for this sort of swap to create value, benefits must be matched to losses. Risk-averse individuals seek insurance that pays off in bad times. All groups are at greater risk when an economy is poor following a supply shock. Under any policy of price restraint, creditors and the securely employed enjoy an insurance benefit. Under an asymmetrical policy, that insurance is free, the premiums are paid by other people. Under a symmetric policy, creditors and the securely employed purchase their insurance against bad times by foregoing some benefit during good times. That’s still a fine deal. Their overall risk is reduced.

But the opposite is true for debtors, taxpayers, and marginal workers. Just when these groups need a break, when the economy is bad due to an adverse supply shock, they are hit with additional costs in the name of price stability. Sure, when things are good all over, they get some frosting on their cake. Their highs are higher, but their lows are lower. Symmetrical price targeting turns debtors, taxpayers, and marginal workers into high-beta speculators on the state of the broad economy, while reducing the risk exposure of creditors and secure workers. It represents a vast subsidy, a transfer paid in risk-bearing, from debtors, taxpayers, and marginal workers to creditors and secure workers. A symmetric price target is a better deal than asymmetric price restraint for debtors, taxpayers, and marginal workers — better to have some benefit than no benefit for the burden of guaranteeing other peoples’ purchasing power! But a symmetric price target is still a raw deal. Debtors, taxpayers, and marginal workers are forced to bear costs when they are most burdensome and receive payoffs when they are least valuable.

In the real world, of course, we usually see something between a policy of pure price restraint and a symmetrical price targeting regime. And usually, price stabilization is implemented via monetary policy. We assiduously provide insurance to creditors and the securely employed, but haphazardly reward debtors and the marginally employed when they least need help. Price stabilization is social insurance we provide to the most secure members of our society, while the bill is paid in lost purchasing power and increased risk by the least secure. Further, the benefits of price stabilization accrue disproportionately to the largest creditors and to holders of high-salary secure jobs. Preserving the purchasing power of a billion dollar stash is a lot more valuable than preserving the value of fifty bucks in a bank account. Price stabilization is an incredibly regressive form of social insurance, a program whose distributional ghastliness would be abhorrent to most people if it were not conveniently submerged. But the transfers engendered by price stabilization are invisible, obscured by the money veil. Since they benefit the most influential and harm the most marginal in our society, this ghastly policy is politically untouchable.

It is certainly true that there are groups in our society whose purchasing power we ought to collectively insure: retirees on fixed incomes, savers with moderate nest eggs. It is great that Social Security payouts are indexed, so that retirees enjoy some protection of purchasing power. But indexing is a visible, and visibly costly, form of social insurance. Because it is visible, we transparently ration its provision and allocate its costs. I do not argue that purchasing power insurance is immoral. On the contrary, we need purchasing power insurance and the state should invent explicit means to provide it. What is immoral is to hide what is arguably the government’s largest social insurance program behind the technocratic phrase “price stability”. This a scheme that forces the most precarious members of our society to insure the purchasing power of the most secure, without any limit or even any accounting of the scale of the transfer.


Addenda:

  1. In the argument above, I have considered only the effect of supply shocks, not of shocks to aggregate demand. Price stabilization, in the counterfactual that it were fully symmetric, would seem less awful if we considered demand shocks. But it is silly to do so. The tools that we use to stabilize the price level all work through aggregate demand. To the degree that it is possible to stabilize prices, it is possible to stabilize aggregate demand directly. I am not opposed to macro stabilization in general. Aggregate demand stabilization is a great idea, although I have preferences with respect to means that might differ from those of the market monetarists who most famously advocate the policy. But since aggregate demand manipulation is our instrument, it is simpler to stabilize that variable than to stabilize prices. Causing aggregate demand to deviate from a planned growth path in order to stabilize prices is what is immoral. The price level should have no weight whatsoever in macro policy, which should simply target an NGDP path.

  2. I’m aware of New Keynesian models that predict “divine coincidence”, where stabilizing prices would stabilize real production as if by an invisible hand. The conditions under which we might rely on “divine coincidence” even in theory are unlikely to hold in practice. The models that predict divine coincidence posit one “representative household”, and so are blind by construction to the distributional concerns discussed here. I consider “divine coincidence”, in almost any forward-looking context, to be another name for “error”.

  3. I’ve neglected term effects when discussing the effect of interest rate changes on creditors. For creditors holding long-maturity debt, raising interests rates to restrain prices helps by supporting the purchasing power of the principal lent and by increasing the interest they might earn on reinvestment. But it also harms by provoking a capital loss should they need to liquidate and spend their term debt prior to maturity. For long-term savers, the reinvestment effect compensates the capital loss. Creditors as a group are clearly made better off by a policy of price restraint, but some long-term creditors do get burned by rising interest rates.


Notes:

[1] Unemployment contributes to price restraint by reducing worker bargaining power and therefore the cost of a major factor of production, and by diminishing consumption of goods that might be in scarce supply, as people without jobs sharply curtail consumption. In theory, unemployment might also lead to price increases due to a reduction in supply from goods and services not produced by idle workers. But if the unemployment is caused by restraint of aggregate demand (rather than, say, destruction of a productive factory), the effect of reduced consumption will dominate, as the people fired will be people who provide more exchange value by refraining to consume than by producing, after consumption baskets shift under tighter budget constraints. What the unemployed do not eat is the basis of everyday low prices for the rest of us. Note that these workers are “zero marginal product“, but only in a narrow and artificial sense. The marginal product of workers as reflected in hiring and firing patterns is clearly sensitive to aggregate demand policy, demonstrably over the short-term and almost certainly over the long-term. Those who appear to offer “zero marginal product” when nominal income is scarce and prices stable might provide a high marginal product when income is plentiful and prices are flexible. Ones marginal product today is a function of policy as well as intrinsic qualities, and economic activity is very path dependent.

[2] Of course, these various groups are not exclusive. One can be both a debtor and have a stable job, both a creditor and a taxpayer. Each individual enjoys some benefit, and bears some burden, from a policy of enforced price stability. But on net, there are winners and losers from such a policy. If price restraint will be implemented via monetary policy, large creditors and secure non-indebted workers enjoy the largest net benefit while marginally employed debtors bear the largest risk. Securely employed debtors would experience a mix of risk and benefit, depending on the scale of their salaries and debts.

Update History:

  • 24-Jun-2012, 12:40 a.m. EEST: Shifted what was originally the last paragraph of the piece into the Addenda section; it is now the first addendum — makes for a punchier ending.
  • 24-Jun-2012, 1:00 a.m. EEST: The ending is too punchy now. Removed last sentence, “It is detestable.” I think my disdain comes through well enough without so artlessly overpunctuating it.
  • 24-Jun-2012, 1:20 a.m. EEST: “are politically invisible”

Great Britain as a case study: which sticky price?

Richard Williamson offers a report from the UK. Combining bits via Tyler Cowen and Williamson’s own excellent blog:

I think there has been a lot missing from the discussion of the UK in the blogosphere. We are a bit of a puzzle on a purely AD-based explanation of the recession.

  1. We didn’t have deflation (on annual basis at least), and even stripping out the effect of the VAT rise in 2011 should still show persistent inflation over 3% since 2010 http://www.tradingeconomics.com/united-kingdom/inflation-cpi

  2. UK inflation expectations seem to be significantly higher here (if falling away a little recently) http://www.bondvigilantes.com/2012/03/19/markets-start-to-think-about-inflation-again/ http://uk.finance.yahoo.com/news/uk-inflation-expectations-drop-1-093038319.html

I’m not really sure what is going on… If we were to just look at inflation (at expectations thereof), the country that ought to be having an AD-driven double-dip recession would appear to be the US…

I am becoming steadily less convinced that [an aggregate demand deficiency] is the whole story, at least for the UK. Back in November, Karl Smith made the clearest statement I have ever read of the New Keynesian explanation of a recession:

I can’t hammer this home enough. A recession is not when something bad happens. A recession is not when people are poor.

A recession is when markets fail to clear. We have workers without factories and factories without workers. We have cars without drivers and drivers without cars. We have homes without families and families without their own home.

Prices clear markets. If there is a recession, something is wrong with prices.

Right now, unemployment remains at over 8% in the UK while real wages are lower than they were 7 years ago and are continuing to fall. Yes, you read that correctly. Which immediately leads one to ask: on this explanation of a recession as expounded by Karl, how much further do real wages have to fall to eliminate disequilibrium unemployment?

There are two broad stories having to do with “sticky prices”. One, the mainstream New Keynesian story, emphasizes rigidity in the price of goods and services, most especially “sticky wages”. The other, emphasized by post-Keynesians and sometimes by monetarists, has to do with the sticky price of satisfying debts.

In the standard New Keynesian story, a depression is caused by the relative prices of goods and services falling out of whack. This is the basis for much of the mainstream policy consensus. The source of macroeconomic problems is sluggish adjustment of some goods and service prices, and stabilizing the price level should diminish the need for such adjustments. Macro policy can’t prevent relative prices in the real economy from needing to change sometimes. But it can prevent difficult-to-adjust prices from requiring frequent updates due to fluctuations in the overall price level. Because some important prices — the price of labor especially — are thought to be “sticky downward” (meaning they can “ratchet” upwards but can’t adjust down), targeting a positive inflation rate is recommended. The gradual, predictable movement of prices allows slow updates, preventing misalignments due to sluggish adjustment. The upward-slope permits “sticky downward” prices to fall in real terms relative to other goods and services by simply not rising with other prices. A recession, in the New Keynesian telling, occurs when this stabilization policy is not sufficient. If changes in supply and demand are so great that “sticky downward” prices must fall faster than the targeted rise in the price level, markets won’t clear. If the “sticky downward” price is workers’ wages, then it is employment markets that won’t clear, and we will experience mass joblessness. If this occurs, a cure would be to increase the targeted rate of inflation until real wages fall relative to other goods and services. When real wages fall enough, employment markets will clear again and the recession will end.

In the post-Keynesian story, a depression is driven by an decrease in agents’ willingness or ability to carry debt. Agents “pay for” decreased indebtedness by devoting their income to the purchase of safe assets (including especially their own outstanding debt) rather than spending on real goods and services. Unfortunately, money spent on financial asset purchases does not create income (they are asset swaps), and may not be cycled back into income for producers of real goods and services. So, in aggregate the attempt to reduce indebtedness can lead to a reduction of income that sabotages the attempt to pay down debt. This is the famous “paradox of thrift”. We simultaneously experience unemployment (reduced spending and income to real goods and service providers plus sticky wages means that people get canned) and financial distress (reduced income and fixed debt makes prior debt ever more burdensome). In this story, reducing real wages is not a solution. Real wage reductions might mitigate unemployment temporarily, but they also engender financial distress. Financial distress then causes agents to redouble their efforts to satisfy debts, reducing aggregate income and requiring further reductions in real wages ad infinitum. The only way out of a post-Keynesian depression is to increase real wages relative to the real burden of debt. In the post-Keynesian story, inflation is helpful only if real incomes hold steady, or, at very least, fall more slowly than the real value of prior debt.

One data point is not dispositive. But Williamson’s account of the UK experience is not consistent with the New Keynesian story, while it is perfectly consistent with the post-Keynesian account. There has been inflation in the UK. The real price of labor has not been sticky. The real burden of debt has fallen, sure, but real wages and incomes have fallen even farther, leaving people less able than ever to satisfy debts they’ve contracted and so purchase financial security.

There is a lesson here. If we mean to pursue reflationary policy, the goal should not be to reduce real wages, but to reduce the real value of debt relative to incomes. One way to do this, which the post-Keynesians’ closest frenemies suggest, is to stabilize the nominal income path at its prior trend while tolerating whatever inflation that engenders. This implies a large increase in nominal income from current levels. Going forward, if we hold nominal income to a gently rising path, the burden of aggregate debt relative to income will never unexpectedly rise. (Unfortunately, predictable distress may not prevent debtors in aggregate from taking on more debt than they can service, due to the competitive dynamic of a boom. I think NGDP targeting would be a big improvement, but not sufficient: We must always be mindful of leverage and debt.)

Pace the very brilliant Chris Dillow, the UK has not stabilized the path of NGDP:

Even if, as Dillow suggests, policymakers could not have held NGDP on path in 2009 due to forecast error, after the collapse they certainly could have restored total income to its prior trend with some combination of monetary and fiscal policy. They have not, and so the burden of debt relative to incomes in the UK has increased.

The UK has just entered a “double-dip” recession, and remains, in my view, in a depression, despite occasional thaws and recoveries. That this has happened, despite the plummeting real wages that Williamson reports, tells a tale. It is not “sticky wages” that should concern us, but the sticky burden of precontracted nominal debt.


Afterward: David Andolfatto wonders whether debt dynamics could play so large a role more than three years after a collapse in nominal income. Yes it can, I argue in his comments.

Karl Smith responds to Williamson here.

Update History:

  • 28-Apr-2012, 6:00 a.m. EDT: Had mistakenly used a FRED graph that I thought was NGDP, but was really RGDP. I’ve replaced it with a proper NGDP graph. Removed the word “remotely”, as the proper graph shows a less dramatic picture: “the UK has not remotely stabilized the path of NGDP.

Two quick responses on choosing depression

  • Scott Sumner and Marcus Nunes suggest that our policy failures are in some sense just an “oops!”, that they result from a mix of mistaken theory, institutional frictions, personal quirks, and political forces rather than being, as I argue, a choice. I’d be more sympathetic if these “mistakes” were unique to the United States. Broadly similar choices have been made in Europe, and Japan.

    You can tell idiosyncratic stories of political and institutional failure for each of these countries individually. But ex ante, you’d not have expected similar policy responses. From an international balance perspective, for example, it’s not surprising that Japan did not inflate, but you might expect the United States to jump at a policy response that would reduce the burden of its considerable debt to foreigners. Yet the US and Japan seem to be on broadly parallel tracks.

    There is supposed to be a constituency for stimulative policy. The conventional story is that, during a downturn, election-seeking politicians will be recklessly pro-expansion, in conflict with and checked by an independent central bank. But, at least in the United States and Europe, there is surprisingly little appetite among politicians from “mainstream” parties to emphasize either fiscal or monetary expansion. On the contrary, the political conversation revolves around restraining deficits and “being responsible”, which is code for ensuring that the demands of creditors (public and private) are fully satisfied. This may change. In Greece, Portugal, Ireland, and Spain, parties now viewed as “fringe” may gain influence. But despite a years-long downturn of Great Depression severity, so far elected politicians in all these countries have emphasized a narrative of necessary adjustment and responsibility, and have almost never agitated for monetary policy better tailored to Southern Europe or threatened disorderly default. The behavior of politicians, in Europe as in the United States, suggests that the people to which they are accountable are not primarily the fraction of their labor force that is out of work. This is different from the 1970s, when elected officials did seem to behave as though they were accountable to unemployed people, and put central bankers under intense pressure to be accommodative. Something has changed. In status quo democracies, politicians tend to respond to groups that are numerous, rich, or organized. Since the 1970s, in all the depression democracies, retirees and near-retirees have grown both more numerous (as a fraction of voters) and more rich, while workers have grown less organized. Emerging markets like China have responded to the downturn quite differently. I think this pattern is too systematic to chalk up to idiosyncratic mistakes. [1]

  • Kevin Drum writes:

    [The problem is] Steve’s claim that the median influencer — whoever it is — “is panicked by the prospect of becoming poorer,” which explains our financial system’s rabid opposition to inflation higher than 2%. This claim might have made sense 50 years ago, when many of the affluent elderly were coupon clippers. But today it doesn’t make sense even for them, and it certainly doesn’t make sense for anyone else. Hardly anybody literally lives on a fixed income these days. The elderly middle class lives on Social Security, which is indexed to inflation. The broad middle class has its retirement savings invested in 401(k) funds, which do better when the economy does better. The wealthy have their money invested in a variety of sophisticated vehicles, all of which are hedged against inflation in one way or another. We simply don’t live in a world of fixed returns anymore. Unless you’re a hedge fund quant making some specific kind of inflation play, there are very few people today who have any reason to fear higher inflation, especially of the moderate, temporary sort that the Paul Krugmans and Scott Sumners of the world advocate.

    Drum is right that there are no more coupon clippers. There is very little coupon to clip, because interest rates have been in secular decline for the last 30 years. But he is wrong to jump from that to imagine that upper-middle-class retirees and near retirees are immune to inflation. Affluent retirees depend heavily on asset wealth; Social Security cannot cover the lifestyles to which they’ve grown accustomed, and the expenses and commitments they’ve accumulated.

    Affluent older Americans hold a large proportion of their wealth in bonds and cash-like instruments (bank CDs, money market accounts). They also maintain significant positions in stock funds that might “do better when the economy does better”. But, unsurprisingly, retirees keep the wealth they most depend upon in safer, fixed income vehicles. The proportion they keep in stock funds tends to increase with wealth. [2] Since they can’t clip coupons, retirees rely upon asset sales and redemptions for income. They try to manage the pace of sales so they don’t outlive their capacity to maintain their lifestyles.

    Retirees living on asset wealth are very exposed to inflation. It’s an error, a fallacy of composition, to assume that the existence of hedges and “sophisticated vehicles” means that somehow everybody can be protected. Every debt contract imposes inflation risk that some party must bear. Stock markets get the press, but most financial claims on capital are structured as debt, all of which must be held, directly or indirectly, by some human (usually an old or rich human). [3] Any individual retiree can shed inflation risk by switching from, say, municipal bonds or bank CDs into TIPS. But retirees and near-retirees in aggregate can’t do this: there aren’t enough TIPS to go ’round, and somebody has to be persuaded to hold the unprotected bonds. TIPS already pay negative yields. If creditors grow nervous and try to herd into protected assets, TIPS yields would be driven even more sharply negative and prices of ordinary bonds would collapse. Somebody, some creditor, will bear the loss of value imposed on bondholders by inflation. It’s a game of musical chairs. No matter how sophisticated your vehicle, evading inflation risk is and must be costly if markets are remotely efficient. (If markets are not efficient and it is cheap to slough off inflation risk, then someone — quite possibly a gullible retiree — has been made a patsy and persuaded to offer underpriced insurance. “Sophisticated vehicles” tend to benefit those who structure them more reliably than those who purchase them.) [4]

    Affluent retirees do hold some of their wealth in corporate stock, and it is obviously true that the US political system and the Federal Reserve are extremely loss-averse when it comes to the stock market. Note that some equity claims (think banks) are indirect claims on debt, and so are themselves conduits for inflation risk. And there is no necessary relationship between asset inflation and goods inflation. The interests of affluent retirees are best served when financial assets in general (both stocks and bonds) are inflating but goods prices are not. And for the most part, that is what the US political system works to deliver. [5] If you could promise that stimulating the economy would lead to a stock boom, much of the opposition to expansionary macro policy would dissolve. But you can’t promise that. Even if the policy “works” from an employment perspective, stocks may fall. Corporate profits are near all-time highs as a fraction of GDP, and stock markets are priced with optimistic growth assumptions already. Sharing more of the wealth with wage earners may cost more than the benefit to shareholders of incremental sales. Today’s affluent retirees lived through the most stock-market-focused era in human history. They remember the 1970s stagflation, during which the influx of women into the labor force was successfully absorbed but stocks languished. They know that stock wealth is fickle.

    So people who intend to live off their nest eggs rely first and foremost on the “safety” of bonds. Expansionary policy is a hazard for them.

    Consider NGDP targeting. Under this policy rule, Treasury securities would become risk assets, whose real return would be geared to the health of the economy. (NGDP path targeting implies that shortfalls in real growth must be matched by increases in inflation.) Treasuries become low-beta index funds, diversified claims on the real production. Nominal yields would be more stable, but the real value of a future payment becomes as uncertain and volatile as the business cycle.

    More conventionally, an increase of the de facto inflation target from 2% to 4% would be a “tax” on whoever holds fixed income securities at the moment the change is announced. Holders of long-term bonds would lose no matter what. If the inflation target is raised in order to enable steeper negative real yields (and that is the point), then people holding short-term bills and deposits would also face a new 2% per year cost, for as long as the low rates persist. And that’s not the worst of it. Ben Bernanke is speaking in the voice of older affluent Americans when he argues that adjusting the inflation target is bad because it might disturb “anchored” expectations. What people who rely upon asset wealth really fear is a sharp, unexpected increase in inflation. And much as that may not be what dovish economists have in mind, there is no guarantee that higher inflation and lower real rates will succeed at reviving growth and employment. If the new target fails, will the Fed double down and try 6% inflation? Even if the Fed says it won’t, will nervous markets require the bank to prove its credibility at 4%? Will the Fed be willing to hike interest rates into a still depressed economy, to prove it will hold its new 4% inflation target? Should it? All bets are off.

    Affluent retirees and near-retirees have very good reason to fear inflation.


Notes

[1] In Japan, Germany, and France, more than 50% of the total population is over 40 years old. (56.5%, 57.2%, and 50.2% respectively.) They do have children in these countries, so there are many more retirees and working-age people over 40 than there are younger workers. In the US, “only” 45.5% of the population is over 40, but I think as a polity, the United States behaves as though it is substantially older, because its unusual fecundity (for a developed economy) comes from relatively poor and disenfranchised immigrants. By comparison, China’s over-40 share is 40.3%, Brazil’s is 32.8%, and India’s is 27.1%. In the 1970s, when the US policy was, um, plainly inflationary, the over-40 share of the population was 36.1%.

Using 40-years-old as a cut-off age is arbitrary. “Retirees and near-retirees” is a vague formulation, and 40+ is admittedly a stretch. But people do not turn suddenly into zombie-like asset hoarders. As cohorts of workers age, they accumulate financial assets and become less likely to face unemployment. When they retire, their fear of unemployment disappears entirely, and their dependence upon saved assets increases. There is a continuum between the young and poor, who should prefer the risk of stimulus, and the old and rich who should not. It’d probably be best to modify my story to declare “affluent retirees and older workers” the “median influencer”.

By the way, I am guilty of data mining the cutoff age to support my case. (I examined the population pyramids.) Add whatever grain of salt you like, but I think the point stands. The data are via Wolfram Alpha, e.g. “age distribution US 1975“, then “Show Details”.

[2] As of 2001, people over 65 with assets of $1M or less held substantially more in cash and bonds than stock. Richer people held a greater share in stock. See Curcuru et al, Table 6.

[3] Remember Karl Smith’s point that capital is mostly stuff like buildings and cars. In the US, the bond market is roughly twice as large as the public equity market, and that excludes debt held indirectly via ordinary bank deposits.

[4] Throughout this piece, I’m using “inflation risk” to encompass both the risk that inflation will diminish the real value of precontracted payments from long-term, fixed coupon securities and the risk that inflation will enable sharply negative real yields, affecting the real value of floating rate debt and short-term claims.

[5] This lends credence to Matt Yglesias’ view that central banks would use negative nominal rates where they do not use inflation to generate negative real yields. Negative nominal yields would deliver windfall gains to people holding stock and longer-term bonds, while negative yields engineered via inflation would have uncertain effects on stock and reduce the real value of longer term bonds (with or without capital losses, depending on whether yields follow inflation). If the American political system is geared to paying off asset holders, it’s no wonder that reducing nominal yields became “conventional” monetary stimulus.

Depression is a choice

I enjoyed Matt Yglesias’ suggestion that depressions are merely a technical problem that will go away once the obsolescence of cash eliminates the zero lower bound on interest rates, and Ryan Avent’s rejoinder. Although I’ve toyed with Yglesias’ view myself, I think that Avent has the better of the argument when he characterizes our current policy impotence as reflecting behavioral rather than technical constraints. We don’t lack for technical means to counter people’s self-defeating impulse to hoard cash and safe financial assets. On the contrary, we have a whole cornucopia of options! The squabbling that has preoccupied me lately, between market monetarists and post-Keynesians and mainstream saltwater economists, is an argument over which of many not-necessarily-mutually-exclusive options would most perfectly address address this not-really-challenging problem.

We are in a depression, but not because we don’t know how to remedy the problem. We are in a depression because it is our revealed preference, as a polity, not to remedy the problem. We are choosing continued depression because we prefer it to the alternatives.

Usually, economists are admirably catholic about the preferences of the objects they study. They infer desire by observing behavior, listening to what people do more than to what they say. But with respect to national polities, macroeconomists presume the existence of an overwhelming preference for GDP growth and full employment that simply does not exist. They act as though any other set of preferences would be unreasonable, unthinkable.

But the preferences of developed, aging polities — first Japan, now the United States and Europe — are obvious to a dispassionate observer. Their overwhelming priority is to protect the purchasing power of incumbent creditors. That’s it. That’s everything. All other considerations are secondary. These preferences are reflected in what the polities do, how they behave. They swoop in with incredible speed and force to bail out the financial sectors in which creditors are invested, trampling over prior norms and laws as necessary. The same preferences are reflected in what the polities omit to do. They do not pursue monetary policy with sufficient force to ensure expenditure growth even at risk of inflation. They do not purse fiscal policy with sufficient force to ensure employment even at risk of inflation. They remain forever vigilant that neither monetary ease nor fiscal profligacy engender inflation. The tepid policy experiments that are occasionally embarked upon they sabotage at the very first hint of inflation. The purchasing power of holders of nominal debt must not be put at risk. That is the overriding preference, in context of which observed behavior is rational.

I am often told that this is absurd because, after all, wouldn’t creditors be better off in a booming economy than in a depressed one? In a depression, creditors may not face unexpected inflation, sure. But they also earn next to nothing on their money, sometimes even a bit less than nothing in real terms. “Financial repression! Savers are being squeezed!” In a boom, they would enjoy positive interest rates.

That’s true. But the revealed preference of the polity is not balanced. It is not some cartoonish capitalist-class conspiracy story, where the goal is to maximize the wealth of exploiters. The revealed preference of the polity is to resist losses for incumbent creditors much more than it is to seek gains. In a world of perfect certainty, given a choice between recession and boom, the polity would choose boom. But in the real world, the polity faces great uncertainty. The policies that might engender a boom are not guaranteed to succeed. They carry with them a short-to-medium-term risk of inflation, perhaps even a significant inflation if things don’t go as planned. The polity prefers inaction to bearing this risk.

This preference is not at all difficult to understand. The ailing developed economies are plutocratic democracies. “The people” do have power, but influence is weighted in a manner correlated with wealth. The median influencer in these economies is not a billionaire, but an older citizen of some affluence who has mostly endowed her own future consumption. She would like to be richer, of course. But she is content with her present wealth, and is panicked by the prospect of becoming poorer. For such a person, the depression status quo is unfortunate but tolerable. The risks associated with expansionary policy, on the other hand, are absolutely terrifying.

The revealed preference of my polity is not my personal preference. Perhaps that is because I’m an idealist, and I actually care about the misery provoked by precarity and unemployment. Perhaps it’s simply because I’ve not yet endowed my own future consumption, and I’m scared. Regardless, I object. Although I understand where it comes from, I detest the preference for depression revealed by my polity. Perhaps you do too.

But if we want to change the behavior of the polity, it’s not enough to argue over clever policies that, if implemented, might do the trick. We’ve got to change its preferences, which means either buying off the median influencer, or changing her identity via political struggle. Alternatively, we can wait until what are now problems of aggregate demand morph into supply problems (after people become unemployable and capital decays), or into threats of political and social unrest. The median influencer may change her views if tight supply makes goods costly despite fiscomonetary conservatism. Or if her neighborhood is on fire. But I’d prefer we avoid all that, and take a more proactive route.

In the meantime, we have to recognize that what we are experiencing is not a technical failure. It is not “magneto trouble”. We, collectively, are making a choice. The task before us is to change our mind.

Update History:

  • 17-Apr-2012, 9:20 p.m. EDT: Small edits to eliminate wordiness and word repetition: “In the meantime, what we have to recognize is that what we are experiencing is not a technical failure.”; “and is terrified frightened of becoming poorer”
  • 17-Apr-2012, 11:50 p.m. EDT: Changed my change above; “frightened” is too weak: “and is frightened panicked by the prospect of becoming poorer”

A note on model risk, policy design, and political alliances

My previous post advocating a collaborative detente between post-Keynesians, market monetarists, and mainstream saltwater economists, has drawn smart and often skeptical comments. Some critics suggest I understate the dissimilarities between the three schools, and argue that any sort of fusion would amount to a muddled middle, centrism only for its own sake. (I like this: “The centrist position on building a bridge would end up with a bridge halfway across the river.”)

If I were advocating some kind of Grand Unified Theory, I might concede the point. But I’m not advocating a theoretical fusion at all. I’m advocating a policy compromise. Quarreling schools may not find very much common ground in arguments over theory. Theory and its inseparable twin, ideology, are too pervasive to admit much compromise. They are indistinguishable from reality. Our eyes form the world before the world forms our vision. When truth itself is at stake, we will not easily give ground.

But it is not the truth that we are after here. We should strive for something far less grand: to do actual good in the world. It just so happens that the theoretical disputes which divide the disciples and apostates of Keynes do not prevent overlap in the solution space. We can work together even when the stories that we tell ourselves are worlds apart.

And since it is at least possible that my side might be wrong, the existence of others who are almost certainly mistaken is actually helpful. We can build insurance policies out of their errors and make resilient analogues of Pascal’s wager. The point is not to take the best a priori position. The point is to avoid going to hell.

I am not neutral between the economic schools I’ve identified for a love-fest. Although I dislike binding myself with labels, I lean post-Keynesian. I agree with many critics that monetary policy alone is unlikely to be effective, and my gut inclination is not at all favorable to monetary policy as an instrument. I think overreliance on monetary policy, especially during the so-called Great Moderation, played a key role in the development of socially destructive inequality and economically catastrophic patterns of aggregate investment.

But, as the finance types like to say, that’s a sunk cost. We are in a global depression. Despite periods of respite, I think we are likely to remain in a depression until we sort out the immense social conflict embedded in the financial and political claims we’ve accumulated against against one another. This is a bad situation. Last time, it took a catastrophic global war before we put our squabbles into perspective and found ways to engineer a reset. That kind of thing is still not off the table.

The incremental cost of trying a bit more monetary policy seems small to me by comparison. I don’t think it’s likely to work, but I am heartened at least that the variant proposed by the market monetarists is much less toxic than the mainstream dogma that, de jure or de facto, prizes price stability above all things. I’m still skeptical, but NGDP path targeting represents a huge improvement over inflation targeting as a monetary policy rule. I’d be willing to give it a try. In exchange, I’d like to try to persuade monetarists of good will to agree to limits on what constitutes legitimate monetary policy, and to assent to a coherent and non-corrupt fiscal lever as a backstop.

This sets up a wager that both sides should smugly accept. The market monetarists should be glad to accept the fiscal backstop, despite theoretical objections, because they should be sure that it will not need to be used. I can put up with one last big monetary push. I expect it won’t work, but it will automatically open the door to policy that I’m pretty sure will work. In either case, whichever side is wrong will be glad to have taken the bet. There are devils in the details, obviously. There are some forms of monetary policy that I’d consider too destructive to try, that might “work” in terms of restoring growth in macro aggregates but that would threaten social values I hold dear. The “fiscal lever” is unlikely to be a decentralized job guarantee engineered by Pavlina Tcherneva and Randy Wray, which in a more perfect world I’d like to see given a try. But the world is as it is, and time is of the essence.

One of the worst unintended consequences of the Obama administration is that it has discredited compromise. We can argue about whether Obama was hapless and naive, or whether he was cynical and canny, using compromise as a fig leaf to promote the center-right outcomes that he actually favors. But to the progressive left, “compromise” has come to mean sacrificing core ideals and values as the starting position in negotiations that only gets worse.

But compromise is not always a bad idea. Sometimes there are people with whom one can find common ground despite important, even fundamental, differences. That doesn’t mean we smudge away the disagreements, that we cease to argue the merits and demerits of conflicting models and worldviews. But we shouldn’t let our debates in the seminar room prevent or delay finding a practical consensus. If we are not, all of us, just a constellation of egos engaged in a masturbatory pissing match to establish our place in academic or journalistic hierarchies, then we need to find ways to leaven our disputes with provisional compromises and coordinated efforts to improve the real world. In real time.

Because the stakes are so small?

People I admire were calling each other nasty names last week, so I cowered in the corner, put my hands to my ears, and hummed very loudly. I’m talking about the debate over money and banking that involved Steve Keen (1, 2, 3, 4, 5), Paul Krugman (1, 2, 3, 4, 5, 6, 7), Nick Rowe (1, 2, 3), Scott Fullwiler, and Randy Wray among others. Here are some summaries by Edward Harrison, John Carney, and Unlearning Economics. Anyway, although there were some good moments, this debate just made me unhappy. The mechanics of banking are straightforward and uncontroversial, although they are widely misunderstood. [1] Yes, some misunderstandings were expressed and then glossed over rather than acknowledged when corrected. But that is to be expected in a very public conversation in which people are not behaving cordially, but are instead playing “gotcha” with one another. When a conversation is framed with one group calling the other mystics and the other shouting “Ptolemy!”, that is not a good sign.

I don’t mean this as criticism of anybody. Humans have egos, and I’ve certainly behaved worse. But it is terribly frustrating to me. The protagonists in this debate have much more in common than they have apart, and I think some progress could be made intellectually, and perhaps in the governance of the real world, if they’d communicate with an eye toward finding where they agree. Though I get in trouble for saying so, I think that the heterodox post-Keynesians, mainstream saltwater economists, and uncategorizable market monetarists actually agree on a lot. I think they unnecessarily pick fights with one another for reasons that are more sociological than intellectual. I don’t mean to pretend that they don’t have important theoretical differences. They do. They will probably never agree on what sort of policy would be “optimal”. But if we move the goal posts from perfection to better-than-the-status-quo, they’d find a lot of room to join forces. I do my best to understand all of their models, and as imperfectly as I may have done so, I think I’ve learned from them all.

I’m going to switch gears a bit from the banking debate and talk about the fault lines over “fiscal” vs “monetary” policy, however you wish to define those words. We have identifiable groups of thinkers who agree on the most fundamental question — should the state act to stabilize “aggregate demand”? — but who have strong preferences over whether macro policy should be implemented via fiscal or monetary channels. If we frame this as a binary choice, all we have is a fight. But if we realize that we live in a “mixed economy” and are likely to do so for the foreseeable future, there is lots of room for conversation.

  • Market monetarists make excellent points about how cumbersome and unsuitable a legislature is to the task of managing high-frequency macro policy. They point out that fiscal interventions may have limited or even paradoxical effect if they are offset with countermoves or diminished activism by the central bank. They emphasize the nimbleness of monetary operations, their inexhaustibility and fast reversibility, and how those characteristics combine to make central banks extremely credible expectation-setters. They suggest that we rely upon consistent rule-oriented monetary policy, and argue that this can be implemented more by anchoring expectations (which become self-fulfilling) than by direct market intervention.

  • Mainstream saltwater economists are accustomed to operationalizing monetary policy as interest-rate policy, and pay great attention to the zero lower bound on nominal interest rates. They point out that regardless of your theories of central bank “ammunition”, as a matter of practice or politics, expansionary monetary policy seems to become difficult once the zero lower bound of conventional interest rate management has been hit. They suggest we rely upon monetary policy in “ordinary” times, but that we supplement it with fiscal policy at the zero bound. Conventional “neoclassical synthesis” models did not do a great job of foreseeing or predicting the crisis, but they have done a good job of explaining and predicting macro behavior during the crisis, in the context of “depression economics” or a “liquidity trap”.

  • Post-Keynesians did predict a crisis, on broadly the terms that we actually experienced. They argue that there are adverse side effects to using monetary policy to manage aggregate demand. Although in theory this might be avoidable, post-Keynesians point out that in practice monetary stabilization, even above the zero bound, seems to engender increasing indebtedness and financial fragility, and to distort activity towards overspecialization in finance and real estate. They pay much more attention to the details of financing arrangements than the other schools, and emphasize that vertiginous collapses of aggregate demand are nearly always accompanied by malfunctions in these arrangements. Aggregate demand, post-Keynesians argue, cannot be managed without concrete attention to the operation of financial institutions and the conditions that lead to their fragility. Post-Keynesians make the deep and underappreciated point that fiscal policy, even if it is conventionally tax-financed, can deleverage the private sector and reduce financial fragility in a way that monetary operations cannot. Monetary operations, if you follow the cash flows, amount to debt finance of the private sector by the public sector. The central bank advances funds today, in exchange for diverting precommitted streams of future cash from private sector entities to the central bank. Fiscal expansion is more like equity finance of the private sector by the public sector. Public funds are advanced, and captured by parties with weak balance sheets as well as strong. But taxes are not withdrawn on a fixed schedule. They are recouped “countercyclically”, in good times, when private sector agents are most capable of paying them without financial distress. Further, the private sector’s tax liability is distributed according to ex post cash flows realized by individuals and firms, while debt obligations are distributed according to ex ante hopes, expectations, and errors. So tax-financed fiscal policy acts as a kind of balance-sheet insurance. Both by virtue of timing and distribution, taxation is less likely than monetary-policy induced debt service to provoke disruptive insolvency in the private sector. Plus, during a depression, fiscal expansions may never need to be offset by increased taxation. [2] Never-to-be-taxed-back fiscal expenditures, if they are not inflationary, shore up weak private-sector balance sheets without putting even a dent into the financial position of the strong. They represent a free lunch both in real and financial terms.

When I think about these three groups, I don’t think, HIghlander-style, “There can be only one!”. I think “Cool! Let’s put these ideas together.”

The market monetarists are right. Having different agencies conduct fiscal and monetary policy without coordinating or setting expectations is a bad idea, it invites inconsistent and ineffective policy. If we can, as the market monetarists suggest, overcome the status quo inadequacy of monetary stabilization with more aggressive policy or by inventing better tools — new techniques for expectation setting, targeting NGDP futures, negative IOR, etc. — we should do those things! [3] But, the mainstream saltwater types may be right too. Monetary policy at the zero bound seems difficult to do in practice, even if it need not be in theory. So, to avoid having the central bank and fiscal policymakers work at cross-purposes, we can give the central bank fiscal levers it can use as part of its overall policy regime. Some post-Keynesians and market monetarists seem to like the idea of using payroll taxes as a fiscal lever (albeit with different rationales). The monetarist Scott Sumner has endorsed a proposal to use sales-tax surcharges and rebates as a supplement to monetary policy. We might find common ground even on more ambitious fiscal policy ideas, provided they are implemented in an expectations-consistent, rule-oriented way and integrated with monetary policy, rather than reliant upon ad hoc moves by a legislature in real-time. (We may have a harder time finding common ground on the MMT job guarantee, but once we get talking to one another on friendlier terms, who knows?)

There are lots of issues and controversies, but they strike me as far from insurmountable. A lot of people (like me!) distrust status quo central banks. I think central banks tilt the economic scales in favor of rentiers in general and financial industry cronies in particular. But central-bank cronyism is a governance issue. No one is particularly attached to the current governance structure of, say, the US Federal Reserve, which keeps the public and elected officials at a remove but gives the financial industry great influence (via formal ownership and enfranchisement but also via operational interdependence and “dependency corruption“, ht Matt Yglesias). It’s not just the leftish post-Keynesians who are upset about how central banks behave. Market monetarists like Scott Sumner and saltwater Keynesians like Paul Krugman constantly lament the bureaucratic caution of the real-world Fed, when the economic theory advanced by the guy who runs the place demands flamboyant commitment in order to anchor expectations. If there is a correct policy, if the managers of the central bank are competent and understand the correct policy, but it is politically or institutionally impossible to implement the correct policy, then we do not have an “independent central bank”. We have a governance problem that we should remedy. [4]

One nice thing about a monetarist / saltwater / post-Keynesian synthesis, the thing that has me most excited, is that it would be perfectly possible to give our nouveau central bank a mandate that explicitly includes restraint of private-sector leverage in addition to an NGDP target. I think that the post-Keynesians are right to identify financial fragility as a first-order macro concern. On its own, NGDP path targeting would help “mop up” after financial fragility and collapse, because it weds depressions to inflations, engineering wealth transfers from creditors to debtors when things go wrong. But we’d rather avoid the whole cycle of fragility, insolvency, and inflation, if we can. Monetarist David Beckworth has pointed out that stimulative monetary policy need not expand bank-mediated imbalances between creditors and debtors. Proper expectations could encourage creditors to spend (and, implicitly, debtors to save), reducing overall indebtedness. That could happen! But it has not been our experience with expansionary monetary policy in the recent past. Over the Great Moderation, wealth inequality and the indebtedness continually expanded while interest rates were pushed towards zero in order to sustain the pace of debt-funded expenditure. Under an NGDP-targeting regime, however, Beckworth’s view might be vindicated. NGDP-targeting would dramatically increase the vulnerability of creditors to inflation compared to the status quo price-stability commitment. Creditors might become less willing to accumulate large stocks of fixed-income assets, especially as indebtedness and perceived financial instability grows, for fear that a “Minsky moment” will require a path-targeting central bank to engineer a burst of inflation. In my view, nothing has distorted financial market behavior more egregiously than taking inflation risk off the table, which has guaranteed real rents to default-free debt holders, financed if necessary by the taxation of workers and the nonconsumption of the unemployed. Restoring inflation risk to its proper place (a bad economy means crappy real returns even to fixed-coupon debt) may be enough to shift private sector incentives and prevent unwanted accumulations of financial leverage. The market monetarists could be right, full stop.

But the post-Keynesians might be right that treating financial fragility as an afterthought is never sufficient, that the dynamics of endogenous instability identified by Minsky will not be thwarted by vague fears of inflation among creditors. If macro policy were to include a leverage cap as well as an NGDP path target, and if the central bank were empowered with a broadly targeted fiscal instrument, an unwelcome expansion in private sector leverage could be opposed with a shift towards tighter money but looser fiscal. This would reduce the pace of new borrowing, and accelerate repayment of existing private-sector debt, shifting creditors’ claims from fragile private-sector balance sheets to an expanded public sector debt stock. The NGDP path (with the occasional inflations it imposes) and the leverage cap (with the occasional deficits it engenders) would combine to shape the budget constraint faced by the political branches of government. Loose bank regulation would be paid for with automatic fiscal outflows to constrain leverage rather than via occasional crises and bailouts. The cost of borrowing would be related to the level of aggregate leverage and the government’s consolidated fiscal stance, and would be set reactively rather than actively by the central bank to maintain the NGDP path subject to an aggregate leverage constraint.

Maybe this is a terrible idea. I’m intrigued, but I’m kind of an idiot. The rest of you are very nice and smart and reasonable. You should talk with one another and stop picking fights over how many straw men can dance on the head of a DSGE model. Please.


[1] As Henry Ford famously noted, “It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.”

[2] Many post-Keynesians would object to the phrase “tax-financed” as an incoherent descriptor for any government expenditure. But the claim that government expenditures sometimes need never be offset with tax increases is perfectly orthodox, when the cost of interest service is below the long-term growth rate of the economy, or when the present value of incremental growth in tax receipts engendered by the spending (under existing law) exceeds the cost of servicing the debt. Depressions are a time when government paper is sought after by the private sector, driving real debt service costs towards or below zero. If there are unutilized resources in the economy that would have generated no tax revenues absent government expenditure, or that would have elicited real transfers — negative tax revenues — via unemployment or other transfer payments, the incremental growth in real tax revenues engendered by government investment of fallow resources may be large, even if the investment is inefficient. In ordinary times, government expenditures do not “pay for themselves”, but in a depression, they very well might. Note there is no substantive symmetry here with “dynamic scoring” of tax cuts. In a depression, the private sector is leaving resources unutilized, foregoing potential consumption and investment in order to acquire government paper. Cutting taxes only generates incremental tax revenue if the distribution of tax cuts is to people who will invest by putting unutilized resources to work rather than bid-up the price of resources already in use or expand their holdings government paper. That’s a hard kind of tax cut to engineer. In good times, tax cuts may generate some incremental revenues by substituting efficient private-sector resource use for less efficient public-sector use and by sharpening incentives for private-sector production. But incremental revenue will be modest, as we’ve merely replaced a less efficient use with a more efficient use rather than bringing an entirely unutilized resource into service. And the cost of financing the tax cuts that generate this incremental revenue will be burdensome, as real interest rates are high and positive when the economy is booming. It is unlikely that tax cuts ever “pay for themselves”, but expenditures can when the economy is in depression. None of this conflicts with the market monetarists’ view that fiscal policy is unhelpful because depressions can be avoided with sensible monetary policy. If they are right that monetary policy is enough, then there never need to be unpleasant depressions where fiscal policy pays for itself because of inefficient nonutilization of resources by the private sector.

[3] There is some unconventional monetary policy to which we absolutely should object, “credit easing” targeted towards particular institutions or sectors, which is a form of directed subsidy. Fortunately, the market monetarists agree that this is a bad idea.

[4] Perhaps there is less of a tension between technocratic competence and democratic accountability than we once imagined.

Update History:

  • 9-Apr-2012, 12:25 a.m. EDT: Fixed broken link in Footnote #3; “future cash from the private sector entities to the central bank”
  • 9-Apr-2012, 3:10 a.m. EDT: Adopted consistent (non)hyphenation of “zero lower bound”.
  • 11-Apr-2012, 2:30 a.m. EDT: Fixed broken link to Tcherneva job guarantee paper.

Zoning laws and property rights

A couple of weeks ago, I sat down and read Matt Yglesias’ The Rent Is Too Damned High and Ryan Avent’s The Gated City back to back. Both were a pleasure to read, for their content, and for the opportunity to kick a couple of bucks to two of my fave bloggers behind an ennobling veil of commerce. As an avid reader of both authors’ online work, there were no huge surprises, but reading the ebooks took me deeper and inspired some more considered thought on their ideas. Ryan Avent and Matt Yglesias (and Ed Glaeser too!) are separate humans with their own identities and ideas. But these “econourbanists” share a core view, and I hope they will forgive me if I consider their work together. Although they arrive at a similar place, the two books take very different roads: Avent’s book is a bit wonkier and more economistic, focusing on the macro role of cities in enhancing productivity through economies of scale and agglomeration; Yglesias treats the same set of issues more polemically and with an emphasis on the personal, thinking about how individuals should expect to make a living in an increasingly service-oriented economy, the importance of accessible cities to the kind of prosperity he envisions, and the perils of any obstacle that makes urban life inaccessible (“the rent is too damned high!”). Read both!

In a nutshell, the econourbanists’ case is pretty simple: Cities are really important, as engines of the broad economy via industrial clustering, as enablers of efficiency-enhancing specialization and trade, as sources of customers to whom each of us might sell services. Contrary to many predictions, technological change seems to be making human density more rather than less important to prosperity in the developed world. Commerce intermediated at a distance via material goods has become the province of cheap workers in distant lands, and will very soon be delegated to robots. The value of human work is increasingly in collaborative information production and direct personal services, all of which benefit from the proximity of diverse multitudes. Unfortunately, in the United States at least, actual patterns of demographic change have involved people moving away from high density, high productivity cities and towards the suburbanized sunbelt, where the weather is nice and the housing is cheap. This “moving to stagnation”, in Avent’s memorable phrase, constitutes a macroeconomic problem whose microeconomic cause can be found in regulatory barriers that keep dense and productive cities prohibitively expensive for most people to live in. It is not that people are “voting with their feet” because they dislike New York living. If people didn’t want to live in New York, housing would be cheap there. It isn’t cheap. Housing costs are stratospheric, despite the chilly winters. People are voting with their pocketbooks when they flee to the sun. (“The rent is too damned high!”) Exurban refugees would rush back, and our general prosperity would increase, if the clear demand for high-density urban living could be met with an inexpensive supply of housing and transportation. The technology to provide inexpensive, high quality urban housing is readily available. If “the market” were not frustrated by regulatory barriers and “NIMBY” politics, profit-seeking housing developers would build to sell into expensive markets, and this problem would solve itself.

Before going on, I should confess that I am not neutral. I was on-board with the econourbanists’ project before I’d read a word they’d written. I have always loved cities, and the problem at the center of Yglesias’ book has been a pressing problem in my own life. (I enjoy very dense and cosmopolitan cities, but am too risk averse to accept the steady burden of a high rent given the uncertain and irregular clumps by which I’ve earned my living.) Ultimately, I think that Avent and Yglesias and Glaeser have the right vision of the world that we need to move towards.

I’m skeptical, however, of the path that they’ve outlined to get us there. The econourbanists’ deregulatory ideas might win some victories at the margin, and might lead to important and useful reforms of regulatory “best practices”, for example regarding parking. But as a political matter, I don’t think it will be possible to diminish neighborly veto power over new development enough to put a dent in housing undersupply. As a matter of fairness, I think they underestimate the degree to which what they are after amounts to a “taking” from incumbent homeowners, not all of whom are unsympathetic rich bastards. And even if they could “win”, though it is clear that untrammeled developers would deliver housing supply, I don’t think they’ve made the case that a deregulated market would deliver high quality density. The econourbanists make a good case that density may be necessary to their vision of prosperity, but density is obviously not sufficient. The world has its Manhattans and San Franciscos, but it also has plenty of dense slums in poor cities. I’d like to see more attention to the circumstances that actually conjured the places we now recognize as dense, prosperous, and desirable. Was it the sort of libertarianism they prescribe?

One should always be careful of claims that problems could be solved if only we “let the market do its work”. I don’t mean to go all PoMo, but to the degree that there exists an institution we might refer to as “the market”, it is doing its work and it is not doing the work Ygesias and Avent ask of it. There is the market as it is, and then there is an infinite range of markets that might exist if the institutional arrangements and property rights that govern market transactions were different. Given the political obeisance still compelled in the United States by “market outcomes”, it is a common trick to claim that outcomes one would prefer are the outcomes that would occur if only institutions and property rights were redefined “appropriately”. That may be useful rhetorically, but it is always a bit disingenuous. In reality, what Yglesias and Avent propose is a redefinition of the rights surrounding urban property. If you redefine the institution of property, you reshape market outcomes. But persuading people to liberalize zoning restrictions in the name of “free markets” will be hard. Because the reform that Avent and Yglesias want — along with the developers who would love to build in expensive cities, and the people like me who would love to live in expensive cities but can’t afford to — amounts to an expropriation, a confiscation of property rights, from one of the best organized and most politically enfranchised groups in the United States.

A property right is first and foremost a right to exclude uses other than those desired by its owner. My car is mine because you can only do with it what I want, or else you can’t use it at all. When a person purchases “real estate”, they are buying a bundle of rights to exclude. You cannot trespass on my land without my permission, you can not be sheltered by my roof without my permission. But dirt and roofs are commodity items. If exclusive use of some dirt and a roof are all I am after, then, well, they are cheap in the sunbelt. If I purchase a home in an expensive city, in a “nice, stable neighborhood with good schools”, I’m paying for a lot more than dirt. Yes, I am paying for proximity to my prosperous city’s opportunities and amenities, but that is not all. I am also paying for the fact that not only my home, but my neighbor’s home, is being put to a use that pleases me and to which I would consent. I am paying for the fact that my neighbors themselves are the kind of people I would be pleased to live next door to. I’m paying for the fact that, as parents, the people whom I am moving in with send well-raised children to the local public school and devote some fraction of their attention to the management of that school. I’m paying for the fact that the streets, the architecture, the trees and public parks, are arranged in a way that pleases me. These are all reasons why, if I had the kind of money I do not have, I might pay up to live in a “nice neighborhood” located near the heart of a thriving city.

You might say this is idiotic. Narrowly, my deed to a certain property doesn’t entitle me to exclude bad parents from moving in next door or to prevent a high rise from replacing charming brownstones across my street. If the weather is nice on the day I purchase my home, does that grant me a legal right to perpetual sunshine?

But property rights arise in practice before they are written on paper. Even if they are never codified, the law, whether through courts or through legislatures, is loathe to disturb customary rights (unless the holders of evolved property belong to politically marginal classes). When people spend small fortunes on a “charming brownstone”, they do so with the understanding that the neighborhood is in fact “stable”. At some level, these affluent, educated buyers know that with their deed to the property comes an ability to exclude alternative uses of the neighborhood. That is part of what they are purchasing, a substantial part of the value for which they are laying out hundreds of thousands of dollars.

The mechanism by which that right is enforced is the thicket of zoning laws and permitting requirements that allow activist property owners exclude uses of the neighborhood to which they do not consent. It is this mechanism that invites the framing adopted by Avent, Yglesias, and Glaeser. Since the right to exclude is enforced by the operation of regulatory bureaucracies rather than by the criminal law of theft and trespass, we can claim that it is “government” that is enforcing policies whose outcomes we dislike in opposition to the “rights” of individual sellers, potential new residents, and property developers, to do as they please. But in substance, the enforcement mechanism is secondary. Purchasers of properties in “nice, stable” neighborhoods paid up for a right to exclude uses of their neighbors’ property to which they would not consent, and potential sellers who might enjoy a windfall if they could sell out to a high-rise developer understood when they purchased their properties that neighbors would likely prevent them from exploiting this sort of opportunity. Ex ante, most property owners are glad to cede the right to sell to a developer in exchange for the right to prevent their neighbors from doing the same. Retaining that right would create a prisoner’s dilemma whereby the threat of a neighbor’s defection (she sells to a developer at an attractive price for a use that impairs my property’s value) would leave each owner in a poor bargaining position, and guarantee that the character of the neighborhood could not be preserved. The value of neighborhood properties could not be justified or sustained without protection from this dynamic.

The private-property-like quality of zoning law is evident in the fact that where municipal regulations don’t enforce the right to exclude alternative uses of a neighborhood, property owners invent contractual means of doing the same. Developers, whether of high-rise condominiums or sprawled out “golf communities”, cobble together with a mix of contract and corporation law obligatory “community associations” that control and restrict the use of privately-owned properties (along with managing common spaces and other purposes). Developers don’t abridge the rights of their customers out of some inexplicable, cruel perversion. They form these associations, and grant them restrictive powers, because customers demand it, because doing so maximizes the market value of the properties they wish to sell. As buyers, developers hate zoning law, but as sellers they promulgate it. It is “the market” that demands some mechanism of overcoming potential coordination problems among neighbors, not the acommercial mix of identity politics, misplaced environmentalism, and “NIMBY”-ism that Yglesias and Avent emphasize. The only reason city neighborhoods don’t have restrictive covenants and powerful community associations is because they have city governments that serve the same function.

The definition of and proper scope of property rights is always contestable. As a matter of sheer interest politics — both my interest in finding an affordable home in a great city, and my interest in a productive and vibrant macroeconomy — I want to be on-board with Avent and Yglesias, and simply argue that the historical ability of urban property owners to exclude undesired development should not be construed as a property right. There are lots of purported property rights that I consider illegitimate and am perfectly willing to contest. For example, I agree enthusiastically with Yglesias that we have overextended rights to exclude on a variety of issues: so-called “intellectual property”, immigration law, and occupational licensing. All of these controversies pit the short-to-medium term interests of organized incumbents against those of unseen and less organized new entrants, and arguably against the long-term interests of the polity as a whole. But I am a bit more hesitant on the zoning question.

If we reform away urban zoning restrictions, are we going to invalidate the restrictive covenants of suburban developments? Affluent urban property owners would have almost certainly evolved institutions that perform the functions of community associations if they were not able to rely upon the good offices of municipal government for the same. If restrictions on higher-density development are illegitimate, then should the state refuse to enforce such restrictions when they are embedded in private contracts? Perhaps the answer is an enthuastic “Yes!” After all, over the last 60 years, the state intervened very nobly to eliminate a “property right” enshrined in restrictive covenants and designed to exclude people of certain races from their neighborhoods. Three-thousand cheers for that! But state refusal to enforce previously legal contracts sounds a lot less like “letting the market work” and a lot more like deliberate government action. It would be short-sighted to reform away municipal residents’ ability to exclude commercial and high-density development while leaving contractual restrictions negotiated between property owners enforceable. That would create a window for some high-density development against the wishes of affluent incumbents, but over time the result would be the privatization of affluent neighborhoods. Property owners would form restrictive community associations and purchase potential development sites as common property. There is already a de facto stratification of tacit property rights within cities. Very affluent communities have nearly automatic veto power over unwanted development while poorer homeowners sometime fight very hard to preserve the status quo. A regime that liberalized zoning restrictions without invalidating contractual restrictions would increase this block-level stratification, and perhaps move us from “gated cities” to a brave new world of gated neighborhoods.

I feel like a sourpuss in all of this, or at best a devil’s advocate. I like Matt Yglesias and Ryan Avent very much. I’m an ardent fan of their work, and I’m likely to be on their side in most actual controversies. I’ll enthusiastically support public or private action that promotes dense urban growth and transit-oriented development. But I think that’s going to require deliberate action, public and private, not just “getting government out of the way” and letting markets work. Dense cities exist to generate economies of scale. But markets cannot be relied upon to discover and exploit economies of scale “on their own”. Capturing economies of scale requires a leap across a chasm, the allocation of resources away from uses that are plainly productive towards uses that seem at first to be less valuable. The eventual benefits start off uncertain and hypothetical, so capturing economies of scale requires that someone bear very large risks of failure. Usually this requires coordination among many actors to divide costs and benefits. The econourbanists’ deregulatory scheme amounts to funding the initial costs of densification with value expropriated from incumbent homeowners, who are asked to cede the status quo pleasantness and exclusivity of their neighborhoods in the service of a hypothetical long-term abundance. That doesn’t strike me as a particularly fair way to finance what I agree is a very worthy project. Given the disproportionate political power of incumbent homeowners, it doesn’t strike me as a tactic very likely to succeed.


Update: I was flipping through The Rent Is Too High this afternoon (3/29), and noticed that Yglesias makes the very same connection that I felt very clever to make in this post, that zoning laws are really a form of property right. Yglesias writes

One way to think about the story I’ve been telling here is as a tale of big government run amok, an out-of-control abridgment of private property rights. A better way to think about it is that over the past several decades, there’s been a revolution in our understanding of what property rights entail. We’ve switched from a system in which owning a piece of real estate means you’re entitled to do what you want with it, to one in which owning a piece of real estate means you get wide-ranging powers to veto activities on your neighbors’ land.

Yglesias supports undoing zoning restrictions despite their property-like character.

He has my apologies for not acknowledging his description of zoning laws as an extension of property. I wrote this post several weeks after reading his book, and have made an unintentional plagiarist of myself by not recalling that he made this point.

Update History:

  • 26-Mar-2012, 1:10 a.m. EDT: “a “nice neighborhood” conveniently located near the heart of a thriving city.”; “cobble together with a mix of contract and corporation law obligatory and perpetual ‘community associations’ “; “Usually that this requires coordination among many actors to divide costs and benefits.”
  • 30-Mar-2012, 1:10 a.m. CDT: Added bold update re Yglesias’ prior characterization of zoning restrictions as property rights.

Partial equilibrium intuitions about choice

I think it’s fair to say that economists, in general, are disposed to favor “choice”. It is easy to understand why. If you model the world as being composed of rational and well-informed optimizers of their own welfare, giving a person a new alternative cannot possibly harm her, and may well make her better off. In the financial world, the value of an option (which is nothing more than a choice, the right but not the obligation to take some action) is never negative. On the contrary, when they are priced, options often turn out to be very expensive. An extra choice can’t hurt, and may turn out to help quite a lot.

There are behavioral and psychological critiques of this intuition. If people are not well-informed and rational, the availability of poor alternatives can increase the likelihood of costly mistakes. A bewildering array of alternatives may impose a cognitive burden on the chooser, the “cost” of which may outweigh the benefit of a marginally better result. Outcomes that are objectively identical may be subjectively worse when they are the result of open choice than when they result from compulsion or acts of God. Human beings may unpleasantly second-guess or hold themselves accountable for choices whose outcomes are less than perfect, but stoically reconcile themselves to imperfections they could not have prevented.

I want to put those critiques aside though, and stick to the world of conventional economics with its rational, well-informed agents. It is true, in this world, that giving any one person a choice never makes her worse off. But it does not follow, unfortunately, that giving everyone an extra choice will make everyone, or even anyone, better off. That is, to use one of the stylized insults of economists, “partial equilibrium thinking”. If you give me an extra choice, I will only pursue it if it benefits me. But if you give my customer an extra choice, that may very well harm me. If you give everyone a new choice, where the benefits conferred by our own freedom and the costs imposed by the choices of others take us is anybody’s guess.

This fact should be elementary to economists, but somehow it isn’t, at least not when it comes to policy debates. All economists encounter the “prisoner’s dilemma” prenatally. In a prisoner’s dilemma, what is clearly the best “partial equilibrium” choice for every participant — the best choice holding everybody else’s behavior constant — leads to a poor “general equilibrium” outcome when everybody does it. The prisoner’s dilemma is a situation in which all parties would be made better off if everybody involved had an attractive option taken off the table. Another common example is the “tragedy of the commons“. These situations are not at all rare in real life.

It never, ever, follows that creating a new option for people in an economy must make everyone, or even anyone, better off. Economists who worship at the alter of the first welfare theorem and sloppily equate more choice with “more complete” markets need to recall the Theory of the Second Best (ht Yves Smith, long ago). Markets are either complete or they are not. If they are not complete, the kind of intervention often described as “completing markets” (creating new choices, inventing new contracts) might help, but might also lead to very poor outcomes. For example, “more complete” financial markets have recently served to enable banks and institutional investors to customize payoff distributions in order to extract maximum value from government guarantees and foreseeable bailouts.

Partial equilibrium intuitions about choice are particularly destructive in circumstances where there are economies of scale to participation. The Prisoner’s Dilemma is a simple example of that: the benefits of not ratting out accomplices to a crime increase dramatically if everybody stays quiet than if only some people do. But there are many other examples where restricting choice can be Pareto improving when economies of scale obtain.

This rant was most immediately inspired by a lazy style of libertarian argument. The availability of sweatshop work must be a good thing, because workers must find the conditions, however abysmal, to be better than their next best alternative. Open borders are a great way to help the people of poor countries, because working in rich countries confers huge benefits on migrants. Complaints about the effect of “brain drains” are immoral, because they amount to forcing individuals who would benefit from migration to suffer for the questionable benefit of their compatriots.

In practice, I often agree with the lazy libertarians on these issues. I think China has done well for itself and improved the welfare of its people in part by tolerating “sweatshop” labor. My strong prejudice is to support open borders as much as possible. But we can’t think about these questions without considering counterfactuals, weighing the equilibria that would obtain if choice were restricted against the immediate benefits that those given an extra option are able to reap. What is seen and what is unseen, and all of that.

I’m sure that some anti-sweatshop sentiment is more about the narcissistic self-regard of the liberal rich than improving the welfare of the global poor. But the better hippies have thought these issues through and are not idiotically trying to remove workers’ best available option in the name of guilt-free lattes. Organized sweatshop labor displaces other arrangements, some of which may not be as miserable as stereotypes of “subsistence farming” suggest. If there are economies of scale to participation in traditional ways of life (and there almost certainly are), then the fact that people are willing to abandon their villages for sweatshop work tells us very little about whether welfare has been improved or harmed by its introduction. Further, the crappiness of the alternatives faced by potential workers is not independent of the existence of sweatshop work. In countries whose elites do well by arranging the provision of “flexible” labor, the awfulness of alternatives to sweatshop work might be contrived. The notion of an “oil curse” leading to corrupt political arrangements is uncontroversial. Surely a “labor curse” is just as plausible, and the details of its operation would be more pernicious. Arguably, China has done well with sweatshop labor because its elites have perceived “social stability” to be fragile, and have worked to deliver economic development rapidly and broadly to keep the revolutionaries at bay. The sweatshop model might not deliver the goods so well in countries whose leaders are less wary of their publics.

It is not incoherent to argue that a country might benefit from retaining talented people, and it is not even incoherent to argue that individuals who would choose to emigrate might in fact be better off themselves if they as well as all their compatriots could be persuaded to stay and contribute to development at home. Most of us view freedom as a per se good, and for myself, I’d have a very hard time arguing for emigration restrictions anywhere. Model risk is a bitch. That you can tell a story doesn’t mean the story is true, and when the cost of error is uselessly confining people, we should subject our fairy tales to pretty strict scrutiny. Fortunately, the existence of choice is not binary. We can think of “no choice” as a choice where one alternative is accompanied by either an infinite cost or infinite payoff. (That is, I have “no choice” but to stay in-country if the cost of migration or the benefit of staying is infinite.) A state that forbids emigration at pain of jail or death attaches a large negative payoff to trying to leave. But a country might attach a modest cost to emigration, or perhaps subsidize the retention of talented people. This sort of “nudge” does much less damage to norms of personal freedom, and may well contribute to the welfare of both the people affected and the polity as a whole. Indeed, in the US, the same sort of people (like me!) who support open borders are enthusiastic about interventions intended to retain foreign-born entrepreneurs and graduate students by offering them valuable immigrant visas. Whether you want to call this proposal a subsidy or elimination of a cost, it amounts to using the instruments of the state to reshape people’s choice space in ways that are arguably good for them and good for the polity. And ultimately, that is something a state ought to strive to do.

Does this sort of policy translate to “more” freedom or “less”? You can’t say. Freedom is not a scalar quantity. Sometimes actions of the state render one alternative overwhelmingly preferable to any other, and so clearly restrict choice. But the opposite tactic — having the state reshape people’s choice space so that alternatives that become evenly matched and force people to make agonizing tradeoffs, hardly serves the cause of freedom. And in a world of prisoner’s dilemmas, laissez faire policy, leaving the “natural” choice space undisturbed, just turns notional freedom into a figleaf for predictably bad choices and outcomes. People often can and do develop means of cooperating and coordinating to avoid prisoner’s dilemmas without the assistance of states at all, or with forms of assistance that libertarians find unobjectionable, like enforcement of contract. That’s awesome. But the world is full of hard problems with very serious consequences not all of which resolve themselves. It is reasonable that ones enthusiasm for state intervention into the choice space of individuals is conditioned by how prone to corruption and error one thinks the state to be. But it is either simpleminded or cynical to rule out such intervention based on economistic arguments about how choice always improves welfare. That’s simply untrue.

I’m going to end this with a bit from the always wise Nick Rowe:

[P]eople can solve partial equilibrium problems a lot more easily than they can solve general equilibrium problems. When a shock hits, each individual can solve for how his own reaction function should shift in response to that shock. But he can’t easily solve for the new Nash equilibrium point, because that requires him to figure out how every individual’s reaction function has shifted, solve for the new intersection point of all those reaction functions, assume everyone else will do the same, and expect everyone else will move to the new Nash equilibrium too. That’s hard.

If its hard for people to solve general equilibrium experiments, monetary policy should try to ensure they don’t have to solve general equilibrium experiments. Instead, monetary policy should try to ensure that the general equilibrium solution is as close as possible to the partial equilibrium solution, which individuals have a better chance of solving.

Rowe is writing about monetary policy in particular, from (I think) a New Keynesian perspective that assumes the existence of a unique stable long-term equilibrium that is where we want to be. But let’s generalize his ideas to policy in general and a world with a great multiplicity of potential equilibria. Rowe suggests that policymakers should look to the general equilibrium they hope will obtain, and shape the choice space so that decisions made by individuals holding the rest of the world constant move the world towards that equilibrium. In a world with many potential general equilibria (let’s call them “visions of the future”), policymakers must first understand the space of feasible equilibria and choose the one towards which the choice space should be shaped to grope. Choosing a vision of the future and designing policy that moves the polity towards a not-inevitable but intentional and hopefully positive state of affairs? I think that Rowe may have done the impossible and translated the concept of “leadership” into terms that economists can understand. Somebody ring up Sweden!