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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!

Competitiveness is about capital much more than labor

Besides justifying labor-hostile monetary policy, unit labor costs are often trotted out to blame unreasonable wage expectations for troubled economies’ “lack of competitiveness”. For example, here’s a chart published last year by Paul Mason (ht Paul Krugman):

It is a common trope that labor costs in the European periphery have grown to unsustainable levels, while in the prudent and virtuous North, costs have been contained.

But the chart is misleading. Let’s take a look at the same information presented a bit differently, from a wonderful Levy Institute working paper by Jesus Felipe and Utsav Kumar, “Unit Labor Costs in the Eurozone: The Competitiveness Debate Again”:

Rather than lazy Mediterraneans demanding high pay for little output, what has happened since 1980 is a convergence to prudent German norms. Workers in Southern europe are now paid roughly the same amount per unit of goods produced as their counterparts in Mitteleuropa. This is macroeconomics, so the meaning of a “unit of goods produced” is a fuzzy and contestable. But to the degree that unit labor cost statistics capture what they claim to capture, what they tell us is that European workers, North and South, have come to earn roughly equal pay for equal product.

Southern European workers do earn less overall, simply because they produce fewer or lower-value goods and services than their Northern neighbors. Unit labor costs are not the problem at all: it is the scale of aggregate output. And what determines the scale of aggregate output? Is it the laziness of workers? No, of course not. We all know that when residents of poor countries emigrate to rich ones, the same weak bodies and flawed characters that produce very little at home suddenly explode into economic vigor. The difference is “capital depth”, broadly construed to include all the physical equipment, business organization, public infrastructure, and governance that collude to enable two small hands and a broken mind to accomplish outsize things. Workers’ pay level is not the problem in Southern Europe. It is deficiencies in the arrangement of capital, again broadly construed, that have left Greece and Spain unable to produce value in sufficient quantity to compete with their neighbors.

One might argue that since “capital” is in some sense a scarcer factor in Southern Europe than in Northern Europe, unit labor costs “should” be lower in the South, as a “marginal unit of capital” adds more value than another hour of labor. I have to use the scare quotes though, because there really is no such things as a marginal unit of good institutions, and to the degree that’s even coherent as an idea, it has no relationship at all to financial returns on invested cash. If governance fairies came to Greece and demanded workers surrender some fraction of their per-unit wages in exchange for the institutional capital that enables German levels of productivity, that might be a good deal. (Perhaps Angela Merkel thinks of herself as just such a governance fairy. I don’t think a disinterested observer of her priorities and demands would agree.) In the real world, there is little consensus, with respect either to institutional development or deployment of physical capital, on how, in the context of a tradables glut from its neighbors, Southern Europe could increase its output of tradable goods and services. Looking backwards, with a converging European price level, restraint in unit labor costs relative to the European norm would have meant increased returns to financial capital, and financial capital was emphatically not a scarce factor in Southern Europe prior to the crisis. On the contrary, financial capital was abundant and enthusiastically misdeployed. That misdeployment, the tsunami of bank-mediated money that found its way into real estate and consumer loans rather than the production of competitive tradables, was the primary and proximate cause of Southern Europe’s diminished competitiveness.

In their role as borrowers, some Southern Europeans were complicit in this process. But, as always, it is creditors rather than borrowers who we must hold accountable for bad lending, if we want incentives consistent with good aggregate outcomes.

In their role as workers, Southern Europeans were victims rather than beneficiaries of the wave of malinvestment. Recall that unit labor costs can be decomposed into two factors, the price level and labor’s share of output. Let’s take a look at some more graphs, again from Jesus Felipe and Utsav Kumar:

In all countries other than Greece (including the rest of the “PIIGS”), labor’s share of output has been declining. Rather than winning unreasonable victories, workers have been receiving an ever smaller fraction of the output that they help to produce. The rise of unit labor costs in Portugal, Italy, Ireland and Spain have only partially compensated for the steeply rising prices that have attended European convergence.

Felipe and Kumar also estimate “unit capital costs” along the lines I described in the previous post. (See Table 1 of the paper.) For all countries other than Greece, payments to capital providers per unit output have been growing faster than payments to workers.

So what’s does all this mean? Two things:

  1. There’s a common narrative of the European crisis that pins the blame on workers. It is said that during the “good times”, when rivers of money flowed from Northern Europe to the Mediterranean, workers in Southern Europe were able to extract exorbitant wage hikes, forcing prices up and rendering their products uncompetitive in global markets. To put it gently, there is no evidence to support this narrative except perhaps in Greece. In the other PIIGS, unit labor costs failed even to keep up with the rising price level. Workers received a smaller share of the value they helped produce in 2007 than they took in 1980. Southern Europe’s unit labor costs converged with Northern Europe’s because the price levels of the two regions converged, not because Mediterranean workers took a greater share. If Southern Europe lacks competitiveness, the part of the cost structure that needs to be reformed has to do with rents paid to capital rather than the sticky wages of workers.

  2. We should beware reductionist accounts that put the blame for the periphery’s misery on inflated relative prices. Though one can tell an alarmist story looking at relative rates of change of unit labor costs, in terms of levels, the periphery’s labor structure looks competitive. Nor can we blame the problems in the periphery on a mere absence of capital. Prior to the crisis, there was plenty of capital available. The European periphery was rendered uncompetitive by toxic patterns of capital allocation, for which both Northern Europe’s financial institutions and Southern Europe’s regulators ought to be held accountable. Altering the relative price of labor between Northern and Southern Europe would not fix these problems. Real devaluation might provide temporary relief in terms of domestic employment, and that might provide breathing room for developing better policy ideas than accepting capricious capital flows and hoping they sustain asset bubbles. But breathing room is all that devaluation can provide. It cannot substitute for better policy. Mediterranean Europe already had much lower relative labor costs than the European “core” prior to the recent convergence. Look how that worked out. The PIIGS should work to avoid falling into a kind of macroeconomic “Groundhog’s day”, cycling between low relative costs, convergence, and crisis.

    Even though devaluation is no panacea, the nations of peripheral Europe might still wish to consider dropping the Euro. But the case for that is not, ultimately, about relative prices, but about sovereignty and bargaining power. As the MMTers correctly emphasize, control over money is essential to the sovereign power of a state. For now, the nations of the Eurozone have ceded a significant part of their sovereignty to European institutions. That would be fine, if those institutions could be trusted to look out for, or at least give fair weight to, the interests of the states which have surrendered sovereign powers. If I were a citizen of Portugal or Greece, Spain, Ireland, or Italy, I would conclude that European institutions have unduly little concern for my interests and unduly much concern for a transnational financial system and Northern European taxpayers. If that continues, I’d want my government to retract the sovereignty it had ceded, so that it has the freedom to maximize the forward-looking welfare and growth of my nation without hobbling itself in the interests of claimants to past loans that ought never have been made.

An obvious corollary to all this is that “internal devaluation” is absolutely idiotic. It’s one thing to accept chemotherapy when the disease is cancer and the pain might do some good. But if the disease is not cancer, chemotherapy is just eating poison. Peripheral Europe’s problem is an incapacity to produce tradable goods and services in sufficient quantity to pay for its import bill. That is a structural deficiency. The wages workers are paid for the goods and services they do produce are in line with the rest of Europe’s. Lower wages might help create incentives for new investment to resolve the structural deficiency. But that hasn’t worked in the past when the periphery’s labor has been unusually cheap. The clear and present miseries of “internal devaluation” should not be allowed to rest on so slim a reed.

Update History:

  • 26-Feb-2012, 2:05 a.m. EST: Dropped superfluous sentence “Patterns matter.” Corrected “Norther Europe” to “Northern Europe”. Reorganized awkward and oververbose sentence beginning with “In the real world…” to a still awkward and oververbose sentence. No substantive changes.

Restraining unit labor costs is a right-wing conspiracy

In an otherwise excellent post, Matt Yglesias commits one of the deadly sins of monetary policy:

[M]y favorite indicator of inflation is “unit labor costs”… Unit labor costs are basically wages divided [by] productivity. It’s not the price of labor, in other words, but the price of labor output. If productivity is rising faster than wages, then even if wages themselves are rising unit labor costs are falling. Conversely, if wages rise faster than prodictivity than unit labor costs are going up. Clearly there’s nothing wrong with a little increase in unit labor costs here or there. But over the long term, growth in unit labor costs needs to be constrained or else it becomes impossible to employ anyone. And you can see that in the seventies it’s not just that gasoline got more expensive, we had an anomalous spate of high unit labor cost growth. That was inflation and it’s what led to the regime change that’s governed for the past thirty years.

That all sounds reasonable. But Yglesias has fallen into a trap. Unit labor costs are not “basically wages divided [by] productivity”. That’s not the right definition at all. [See update below.] Unit labor costs are nominal wages per unit of output. With a little bit of math [1], it’s easy to show that


An increase in unit labor costs can mean one of two things. It can reflect an increase in the price level — inflation — or it can reflect an increase in labor’s share of output. The Federal Reserve is properly in the business of restraining the price level. It has no business whatsoever tilting the scales in the division of income between labor and capital.

Yet throughout the Great Moderation, increases in unit labor costs were the standard alarm bell cited by Fed policy makers as an event that would call for more restrictive policy. And all through the Great Moderation, except for a brief surge during the tech boom, labor’s share of output was in secular decline. (More recently, the Great Recession has been accompanied by a stunning collapse in labor share. Record corporate profits!)

Correlation is not causation, and undoubtedly much of the decline in labor share can be attributed to factors unrelated to monetary policy, such as the integration of China into global labor markets. But even if the Fed didn’t “cause” the decline in labor’s share, Great Moderation monetary policy made it very difficult for labor’s share to grow. Consider a simple rearrangement of the equation above:


For labor’s share to expand, either the price level must fall, or unit labor costs must rise faster than the price level. But the Fed responds aggressively to rising unit labor costs, and is committed to preventing any decrease in the price level. Under this policy regime, expansions in labor’s share are pretty difficult to come by! There was that late 1990s surge in labor’s share. But that is the exception that proves the rule: The Fed, to its credit, tolerated an expansion in unit labor costs from 1997 through 1999 without raising interest rates.

In addition to its direct suppression of labor’s share of output, the Fed’s hawkish rhetorical hawkishness on unit labor costs had debilitating indirect effects. Politicians view contractionary monetary policy as a threat to reelection. George H.W. Bush famously blamed the Greenspan Fed for not easing sufficiently prior to his failed reelection bid. Bill Clinton famously chose Rubinomics over, say, Reichonomics, and he cultivated a cordial detente with the Fed. Far too much attention is given to keeping central banks independent of politicians, and far too little is given to keeping politicians independent of central banks.

Since the early 1990s, all actors in the US political system have understood that policies that increase unit labor costs risk a response by the “inflation fighting” central bank, whose “credibility” was swaggeringly defined as a willingness to provoke recession rather than risk inflation. In this environment, the decline of labor unions and their shift in focus from wage growth to working conditions was understandable. If workers won on wages, they would lose when the recession put them out of work. As long as wages were contained, monetary policy was “accommodative”, and workers could supplement their purchasing power with borrowings and asset appreciation. During the Great Moderation, wage growth was rendered obsolete. A superior means of middle class prosperity had been invented. Or so it seemed, until we experienced the toxic after-effects in 2008. Now we have grown skeptical of debt-fueled pseudoprosperity. But the covert hostility to wage growth that underpinned Great Moderation monetary policy remains unchallenged.

I imagine some readers saying to themselves, “But still. If the labor cost of ‘stuff’ is allowed to grow, how can that not be inflationary? It’s common sense.” And that’s true, as far as it goes. But if the capital cost of stuff grows, that must also be inflationary. Suppose we define the complement to unit labor costs, unit capital costs. Unit capital costs might be defined as “business profits per unit of output”. Would it be politically tolerable in the United States to have a central bank that prevented expansions of business profit per unit sold? Is restraining profitability of investment a proper role for a central bank? If suppressing returns to capital would be improper, why on Earth do we tolerate a central bank that opposes returns to labor?

There is an orthodox answer to this question. Wages, it is said, are sticky, while returns to capital are highly flexible. Elevated wage levels distort the economy, or force us to tolerate inflation in order to reduce real wages. Capital prices respond to market forces and find their efficient level. That might all be true at a micro level, but at a macro level our experience is opposite. The fraction of expenditures we pay into corporate profits has ratcheted upward pretty continuously since the mid-1980s, with a brief lull in the late 1990s and an even briefer one during the Great Recession. The share we pay as wages has fallen precipitously. In aggregate, labor has proven very flexible in its demands while the rentier class has been quite rigid. Economists like to be microfounded and all, but this is macroeconomics, and actual macroeconomic evidence has to count for something.

All of this is one more reason to prefer the NGDP path target promoted by Scott Sumner and his merry Market Monetarists. It might prove difficult in practice to target inflation without paying some especial attention to wage growth. But a central bank can target the path of aggregate expenditure without playing favorites about who pays what to whom. Simple neutrality by the central bank in the contest between capital and labor would be a huge improvement over the status quo.

Many thanks to Nick Rowe, who probably doesn’t agree with any of this, but helped me think these issues out in the comments here.

Update: It is easy to show that unit labor costs are not equal to total wages divided by labor productivity. But Nick Rowe points out in the comments that unit labor costs are equal to the average hourly wage divided by labor productivity. So, depending on how you want to interpret “wages”, I was too quick in tweaking Matt Yglesias for a misstatement. Sorry!

Thanks to Rowe, Dan Kervick, and JKH who work this out carefully in the (excellent) comment thread.

[1] Here’s the math. By definition…


But (NOMINAL_WAGES_PAID / TOTAL_NOMINAL_EXPENDITURES) is just labor’s share of GDP and (TOTAL_NOMINAL_EXPENDITURES / QUANTITY_OF_REAL_OUTPUT) is the price per unit of output, or the price level. So we have…


Update History:

  • 22-Feb-2012, 12:30 a.m. EST: Added update re alternative definition of “wages divided by productivity”. Added “[by]” where quote read “wages divided productivity”.

Starter Savings Accounts

So, here’s a thing I think we should do.

The Federal government should offer inflation-protected savings accounts to individual citizens, but with a strict size limit of, say, $200,000. These accounts would work like bank savings accounts, and might even be administered by banks. But deposits would be advanced directly to the government (reducing borrowing by the Treasury), and the government would be responsible for repayment. The accounts would promise a tax-free real interest rate of 0% on balances up to the limit. Each month, accounts would be credited with interest based on the most recent increase in the Consumer Price Index (adjusted for any revisions to estimates for previous months).

The purpose of this plan would be to offer a no-frills, low risk savings vehicle for middle-class workers. Ordinary bank savings accounts no longer do the job. They already pay negative real interest rates, and those rates might well get worse if we experience more inflation. TIPS don’t do the job. They expose savers to interest rate risk and liquidity risk. Small savers must compete with large savers for the same very limited pool of securities, resulting in negative yields. The option implicit in the floor on principal isn’t easy to price. It takes a degree of risk-tolerance and sophistication to manage a portfolio of TIPS that we ought not demand of waitresses and schoolteachers. They should be able to just open an inflation-protected savings account at their local bank.

Republicans should love this proposal. It would reward “virtuous” savers who are currently punished by negative real rates, and the benefit would be tilted upwards towards the relatively prudent and productive. People with substantial savings gain more from the tax and interest rate subsidy than people putting just a few dollars away. Democrats should love it too, as rewarding savers is a bipartisan trope, and the $200,000 limit keeps it a middle-class program, preventing a huge giveaway to the top 1%.

These “starter savings accounts” would be a popular vehicle for ordinary people who want convenience and safety with as little entanglement as possible in casino finance.

But the real benefit would be macroeconomic. “Market monetarists”, MMTers, and old-fashioned Keynesians love to squabble with one another, but they have a great deal in common. By whatever combination of monetary and fiscal policy, in a depression, all these groups agree that some manner of expansionary intervention should be pursued to maintain spending and effective demand. But any such policy increases the risk of inflation, and so is opposed by people holding debt or fixed-income securities. The people with the most to lose from inflation are the very wealthy, who hold a disproportionate share of financial claims. But middle-class savers value their small nest eggs just as dearly, and make common cause with multibillionaires to oppose inflation. By providing means for small savers to protect themselves from inflation when intervention is called for, we can stop the very wealthy from using middle-class retirees as human shields, and thereby create political space to adopt expansionary policy.

The existence of these accounts would be mildly contractionary, as smaller savers could no longer be scared into spending by the threat of inflation. But while pushing small savers to spend their way into precarity might contribute to short-term GDP, the overall costs of that approach probably exceed the benefits. Expansionary policy should encourage consumption and investment by people with the means to bear risk rather than threaten the savings of people who cannot afford to spend.

The limited size of “starter savings accounts” would leave the wealth of large savers at risk, and with fewer places to hide. That is as it should be. The risk of the aggregate investment must be borne by someone. Patterns of aggregate investment are determined by the behaviors of savers, or the people to whom they directly or indirectly delegate investment decisions. If we want a high quality of investment, we have to ensure that these investors bear the cost when aggregate investment disappoints. All savers would enjoy protection of their “starter savings”, but people trying to push large sums of wealth into the future would have to take responsibility for directing the use of their capital, and for monitoring the quality of the institutions through which capital is allocated generally. When the process fails, when capital allocation goes badly awry, large savers would bear the costs directly via writedowns or indirectly via inflation. It will be hard to push for bail-outs when middle-class nest eggs are insulated from the vagaries of capital markets and banks. It will be hard to push for austerity when middle-class nest eggs are immune from inflation. Wealthier savers would still be protected from penury, if they wisely max out their starter savings accounts before piling into CDOs and auction-rate securities.

The program proposed would, for now, be a subsidy to small savers, since real risk-free interest rates are negative. In better times, the program would impose a small “tax”, because the government would pay less to depositors than the positive real rates it pays on other borrowings when the economy is growing. But this would not actually be a tax, because participation would be optional. When times are good, banks and brokers will relentlessly encourage savers to migrate into higher yielding assets. Savers may choose to buy whatever Wall Street is selling, or to stick with what is simple and safe. Even in good times, a guaranteed, perfectly liquid, inflation-protected savings vehicle would be popular with many savers. Starter savings accounts would be a useful and voluntary program with a negative fiscal cost.

Some practical considerations:

  • Limiting the size of the accounts is absolutely crucial. Failing to do so could put the finances of the state into dangerous jeopardy. A currency-issuing government’s nominal “debt” is best classified as equity. Inflation-protected debt is much more debt-like, and can put the solvency of the state into question. Nominal debts can always be repayed in extremis by printing money. But that is not true of inflation-protected debt, on which a government may be forced to default, overtly or tacitly (by corrupting the inflation indices). The US government, very wisely, keeps its TIPS issuance very small. It should keep the aggregate size of the starter savings program small as well. At $200,000 per person, the program could succeed catastrophically if the relatively well-off take to it en masse. To manage this, the government might set a ceiling on the aggregate size of the program (perhaps 25% of GDP), and adjust the limit of inflation protection as necessary to remain beneath the ceiling. (The government would announce periodic adjustments, up or down, to the limit. The government would pay the ordinary 30-day Treasury bill rate on balances above the inflation protection ceiling.)

    Alternatively, the government could discourage overuse by publishing a diminishing real-interest rate schedule, so that the first few thousand dollars in an account would accrue interest at a sharply positive real rate while “late” dollars are punished with ever more negative real rates.

  • The accounts would have to be nonhypothecable. To put that in English, loans and other contracts that pledge the contents of these accounts as security should be prohibited and unenforceable. Otherwise, when real interest rates are negative, financial engineers will bundle loans secured against many poorer individuals’ accounts into unlimited sized accounts for rich people. This sort of indirect use of the accounts is impractical if the loans are unsecured and their repayment is at the discretion of the borrower. (Every sort of contractual encumbrance or automatic withdrawal should be prohibited, to prevent schemes where administering banks enforce security arrangements that the law would not.)

Often my proposals are pie-in-the-sky, after-the-revolution sort of affairs. But this one strikes me as practical, achievable within the present political context. “Starter savings accounts” would represent a form of middle class social insurance that I think a lot of people are thirsting for. They would have a small near-term fiscal cost, and would likely pay for themselves over the long-term. Since the program would be structured as personal savings, it flatters the American policy establishment’s devotion to “bourgeois virtues“. I think the existence of these accounts would open up a great deal of political space for better macroeconomic policy. They would reduce resistance to expansionary monetary/fiscal intervention. They would reduce the press for bailouts and corrupt reflations when the stock market swoons or some megabank coughs blood. Shouldn’t we do this?

Haitao Zhang’s macro stabilization proposal

I first “met” Haitao Zhang seven or eight ago, when we were both frequent commenters at Brad Setser’s remarkable blog. After I wrote about NGDP targeting, Zhang forwarded to me a paper he composed and sent around several years ago. He has graciously given me permission to republish it.

It’s an interesting piece, in the spirit of a several proposals (Abbott, Parameswaran, TradersCrucible, me) that try to combine the benefits of fiscal policy with the institutional agility and rule-orientation associated with monetary policy. Zhang’s proposal is a particularly creative and ambitious contribution.

From the abstract:

In this essay I propose that the central bank be freed from its role of using interest rate policy to support aggregate demand. Instead, a truly variable public spending program is suggested to regulate aggregate demand. The program should be running constantly in order to minimize the time delay of fiscal responses. The amount of spending is variable and can be automatically computed from the realized nominal GDP so as to target a fixed growth rate for the nominal GDP. In order to gain popular support and avoid the pitfalls of traditional Keynesian stimulus programs, I propose that an electronic national market be set up to give voters direct control over where such stimulus spending is applied.

Read the whole thing!

P.S. Scott Sumner, the Timothy Leary of NGDP targeting, seems to have endorsed the Abbott paper. If so, there is a lot less daylight than I thought between his views and my own. Which is a shame — he’s fun to argue with!

Update History:

  • 2-Feb-2012, 7:00 p.m. EST: Added TradersCrucible’s TC rule to the list of rule-oriented fiscal policy proposals.

Bad rhetoric

I’ve had a fair amount of feedback and correspondence following my recent posts on “opaque finance” (1, 2, 3). Much of that has been positive, though certainly many readers disagree and dispute my points. That’s par for the course. But I’ve had several letters outraged in a way that I haven’t so much encountered before, from correspondents who felt mistreated, like their ideas and concerns had been bulldozed by my rhetoric.

Looking back at the posts, especially the second in the series, I think that those correspondents have a point. I try to keep interfluidity mostly pretty civil, and hope to be respectful of readers who disagree with me. I think I failed to do so in this series.

As a blogger and a polemicist, I do a lot of thinking aloud. I try to liven things up in voices, hyperbolic, outraged, absurd, gruff, petulant. I mean to present ideas that I think matter, and to do so in ways that are fun to read and write. I intentionally allow my moods and passions to flow into the tone. My moods and passions have been dark recently, and I let that excuse a degree of license that I should not have taken.

Although I’m entirely done blogging the subject, I think the ideas I presented on “opaque finance” are interesting and important. But I regret my categorical use of the word “true”. I should have listened to this guy:

The quality of mind I value in other people and strive for in myself is a kind of nimbleness, a fluidity of mind. The world is too complex for any particular narrative to be perfect. Good judgment, I think, comes from the ability to slip between and among stories, to understand the ways different accounts might be true, to marshall evidence and reasoning on both sides and then assign weights to a superposition of competing, sometimes contradictory ideas, all of which play a role in ones choices.

Wait. That was me. But you’d never know it reading this.

I certainly reserve the right to vigorously defend my ideas, and not to walk on eggshells when I do so. I think the perspective I presented captures something very real about the role that finance plays in human affairs. But it isn’t the one true story, there are lots of other important narratives, and I apologize to readers who, with some justice, felt as though I shouted them down.

Is opacity an excuse?

I’ve been getting a lot of concerned feedback from people I respect on my claim that status quo finance requires opacity and some degree of trickery in order to function. (See previous posts.) If prosperity is connected to “opaque, faintly fraudulent, financial systems”, is that an excuse for looting and predation by financial intermediaries? Won’t it be used as one?

Though it may be counterintuitive, rather than excusing misbehavior, opacity in finance implies that misbehavior of intermediaries must be policed more vigorously and punished more punitively than in a world that could be made transparent. If finance were as transparent as baseline neoclassical models suggest, there would have been no “flaw” in Alan Greenspan’s ideology, and no need to regulate markets or root out fraud. Creditors would themselves vet and monitor their financial arrangements, would assume risks in full knowledge of all potential mishaps ex ante, and could therefore be required to accept responsibility for losses ex post. There would be no need for any heavy-handed meddling by the state or vitriolic second-guessing by nasty bloggers. The harms of malinvestment would be internalized by investors who were capable of bearing the risks. When things go wrong, it would be none of the rest of our business.

It is when the relationship between capital provision and investment choice becomes intermediated and opaque that we must impose institutions of accountability. If we permit you to invest other people’s money behind closed doors, if, even worse, we institute society-wide cons (deposit insurance, rating agencies) to trick people into bearing the risk of your schemes, then it is absolutely essential that you perform your duties to a very high ethical standard, and that you have strong incentives to deploy the pilfered capital well rather than to squander or expropriate it.

Opacity creates a very serious technical problem: as we allow finance to be opaque and complex, it may become difficult to police and impose good incentives. So we may, as a society, face an unpleasant tradeoff. Tolerating more opacity may help mobilize capital for useful purposes, but any benefit may be offset by a diminishment of our capacity to regulate and police. At one extreme of opacity, financial intermediaries simply steal everybody else’s wealth. That’s no good. At the other extreme, if we insist on perfect transparency (without big changes in how we organize our affairs), the result will be extreme underinvestment. Which is no good either.

There are some issues that we’ll need to unpack. When we talk about “transparency”, a core question is transparent to whom? My thesis is that status quo finance must be opaque to beneficial investors, that is to the innumerable people who must be persuaded to bear some portion of the risk of aggregate investment when their informed preference would be to defensively hoard. That does not mean that finance must be opaque to, say, regulators, who themselves participate in the con by assuring people it is “safe to get in the water”. (Ultimately it cannot be made safe.) In theory, we could design a system that is opaque to the broad public, but transparent to regulators who police the intermediaries. That is the architecture that our present system strives for. But the many practical problems of this architecture are widely known: the capital allocators are more numerous than the regulators, and as a matter of practice, they tend to be much better remunerated (a fact which itself is a kind of regulatory failure). If bankers wish to invest recklessly (or simply to loot) and it boils down to a cat-and-mouse competition, the bankers are likely to win. The potential spoils from looting are very large, large enough that bankers can offer to share the spoils with regulators or the politicians who control them, leading to revolving doors and see-no-evil regulation. Regulators are supposed to stand in as agents of people who’ve ceded control of capital to opaque intermediaries, ultimately the broad public. But it is difficult to prevent them from being “captured” — socially, ideologically, and financially — by the groups that they are supposed to regulate. Regulators themselves often prefer opacity and complexity for reasons analogous to those that sucker end-investors. Regulators don’t like to fight with their friends and future benefactors, and they fear the operational and political headaches that would come with reorganizing large banks. But they don’t like to be put in a position where misbehavior is plainly before them, so inaction would be unmistakably corrupt. They find it a great relief to be persuaded that “sophisticated risk management” models, rating agencies, and “market discipline” mean they don’t have to look very hard or see very much. It seems better for everyone. Everyone gets along and feels fine. Until, oops.

All that said, to the degree that we can maintain high quality supervision, regulators who pierce the veil of opacity, prevent looting, and ensure high quality capital allocation are a clear positive. If we posit very good regulators, there is no tradeoff at all between supervision and effective capital mobilization. On the contrary, opaque finance is unlikely to deploy capital effectively without it, since, with actual capital providers blind, there is no one else to provide intermediaries with incentives to invest carefully rather than steal. An opaque financial system is an argument for vigilant regulation, not deregulation. If regulators allow themselves to be blinded by complexity and opacity, if financial intermediaries are permitted to arrange themselves so that legitimate practices and looting are difficult for regulators to distinguish, that becomes an argument for very punitive regulation whenever plain misbehavior is discovered, because as the probability of detection diminishes the cost must increase to maintain any hope of effective deterrence.

I am pretty pessimistic about this architecture. I think that high quality financial regulation is very, very difficult to provide and maintain. But for as long as we are stuck with opaque finance, we have to work at it. There are some pretty obvious things we should be doing. It is much easier for regulators to supervise and hold to account smaller, simpler banks than huge, interconnected behemoths. Banks should not be permitted to arrange themselves in ways that are opaque to regulators, and where the boundary between legitimate and illegitimate behavior is fuzzy, regulators should err on the side of conservatism. “Shadow banking” must either be made regulable, or else prohibited. Outright fraud should be aggressively sought, and when found aggressively pursued. Opaque finance is by its nature “criminogenic”, to use Bill Black’s appropriate term. We need some disinfectant to stand-in for the missing sunlight. But it’s hard to get right. If regulation will be very intensive, we need regulators who are themselves good capital allocators, who are capable of designing incentives that discriminate between high-quality investment and cost-shifting gambles. If all we get is “tough” regulation that makes it frightening for intermediaries to accept even productive risks, the whole purpose of opaque finance will be thwarted. Capital mobilized in bulk from the general public will be stalled one level up, and we won’t get the continuous investment-at-scale that opaque finance is supposed to engender. “Good” opaque finance is fragile and difficult to maintain, but we haven’t invented an alternative.

I think we need to pay a great deal more attention to culture and ideology. Part of what has made opaque finance particularly destructive is a culture, in banking and other elite professions, that conflates self-interest and virtue. “What the market will bear” is not a sufficient statistic for ones social contribution. Sometimes virtue and pay are inversely correlated. Really! People have always been greedy, but bankers have sometimes understood that they are entrusted with other people’s wealth, and that this fact imposes obligations as well as opportunities. That this wealth is coaxed deceptively into their care ought increase the standard to which they hold themselves. If stolen resources are placed into your hands, you have a duty to steward those resources carefully until they can be returned to their owners, even if there are other uses you would find more remunerative. Bankers’ adversarial view of regulation, their clear delight in treating legal constraint as an obstacle to overcome rather than a standard to aspire to, is perverse. Yes, bankers are in the business of mobilizing capital, but they are also in the business of regulating the allocation of capital. That’s right: bankers themselves are regulators, it is a core part of their job that should be central to their culture. Obviously, one cannot create culture by fiat. The big meanie in me can’t help but point out that what you can do by fiat is dismember organizations with clearly deficient cultures.

But don’t my paeans to the role of opacity in finance place arrows in the quiver of those seeking to preserve and justify financial predation? Perhaps. People who benefit from corrupt arrangements will make every possible argument to rationalize and preserve their positions. But the fact that ones views might be misused doesn’t mean we should self-censor. I was rude, in the previous post, to assert categorically that my argument “is true”, but I do think that it is. My tone was sardonic and bleak, and perhaps it ought not to have been, but these ideas have always been “out there”, and it’s best we acknowledge and deal with them. Nearly every proposed financial regulation is greeted with stern warnings that it will cause “credit to contract”. It is worth trying to understand the mechanics of real-world capital mobilization, and its role in underwriting prosperity (or perhaps militarism). I don’t think we have to fear talking about this stuff. The proposition that looting and misdeployment of capital serve the public good is easy to debunk. The proposition that there are arrangements which serve useful purposes but also create space for corruption is not controversial. We need to understand how institutions actually function and how they are abused if we are to have any hope of minimizing their pathologies while preserving their benefits. And we have to understand the purposes our institutions actually serve if we are to have any hope of replacing very problematic arrangements with something better.

P.S. I should define what I mean by “transparent” and “opaque” investment. An investment is transparent if the investor is well informed ex ante of the potential risks of the use to which her capital will be deployed, and fully assents to bear those risks, such that there is little question or controversy ex post over who must bear losses should the investment not work out. An investment is “opaque” if the apportionment of potential losses is not well specified and clearly assumed by capable parties ex ante, so that in a bad outcome, allocation of losses would foreseeably become a subject of conflict and controversy ex post. Investments in which losses will “clearly” be borne by the state are opaque, because the actual incidence of those losses (in terms of taxation, inflation, or foregone government spending elsewhere) are unknowable ex ante and a matter of political conflict ex post. Transparency is ultimately about the quality of loss allocation.

Opacity and transparency are matters of degree, not binary categories. Questions of transparency cannot be resolved by legal formalism, but are matters of practice and expectation. Fannie Mae securities may have specified in big, bold text that they were not obligations of the United States government, but expectations of purchasers of those securities were not consistent with the formal disavowal, and those investors did not fully assent to bear the credit risk. The allocation of losses from Fannie Mae securities was determined ex post by a political process, not ex ante by informed acceptance of risk. So Fannie Mae securities were opaque investments. The degree to which an investment is transparent is contestable, a matter of judgment not a matter of fact. In the previous piece I argue that index funds are now opaque investments in the United States. I’m sure there are others who would dispute the point.

I think the degree to which investment in aggregate is mediated transparently vs opaquely is an important characteristic of a society.

P.P.S. It’s worth noting that, for now, in the US, savers are enthusiastically entrusting their resources to the state and opaque intermediaries. Deposit insurance and modest inflation expectations have been sufficient to prevent commodity hoarding and other nonintermediated, low return means of preserving wealth. For the moment, the bottlenecks to capital mobilization are at the interface of bankers, borrowers, and entrepreneurs, and in the reluctance of government to invest directly. (More fundamentally, perhaps the bottleneck is an absence of the security and demand that might inspire borrowers and entrepreneurs.)