Selling debt goes against everything the free market stands for

JDN 2457555

I don’t think most people—or even most economists—have any concept of just how fundamentally perverse and destructive our financial system has become, and a large chunk of it ultimately boils down to one thing: Selling debt.

Certainly collateralized debt obligations (CDOs), and their meta-form, CDO2s (pronounced “see-dee-oh squareds”), are nothing more than selling debt, and along with credit default swaps (CDS; they are basically insurance, but without those pesky regulations against things like fraud and conflicts of interest) they were directly responsible for the 2008 financial crisis and the ensuing Great Recession and Second Depression.

But selling debt continues in a more insidious way, underpinning the entire debt collection industry which raises tens of billions of dollars per year by harassment, intimidation and extortion, especially of the poor and helpless. Frankly, I think what’s most shocking is how little money they make, given the huge number of people they harass and intimidate.

John Oliver did a great segment on debt collections (with a very nice surprise at the end):

But perhaps most baffling to me is the number of people who defend the selling of debt on the grounds that it is a “free market” activity which must be protected from government “interference in personal liberty”. To show this is not a strawman, here’s the American Enterprise Institute saying exactly that.

So let me say this in no uncertain terms: Selling debt goes against everything the free market stands for.

One of the most basic principles of free markets, one of the founding precepts of capitalism laid down by no less than Adam Smith (and before him by great political philosophers like John Locke), is the freedom of contract. This is the good part of capitalism, the part that makes sense, the reason we shouldn’t tear it all down but should instead try to reform it around the edges.

Indeed, the freedom of contract is so fundamental to human liberty that laws can only be considered legitimate insofar as they do not infringe upon it without a compelling public interest. Freedom of contract is right up there with freedom of speech, freedom of the press, freedom of religion, and the right of due process.

The freedom of contract is the right to make agreements, including financial agreements, with anyone you please, and under conditions that you freely and rationally impose in a state of good faith and transparent discussion. Conversely, it is the right not to make agreements with those you choose not to, and to not be forced into agreements under conditions of fraud, intimidation, or impaired judgment.

Freedom of contract is the basis of my right to take on debt, provided that I am honest about my circumstances and I can find a lender who is willing to lend to me. So taking on debt is a fundamental part of freedom of contract.

But selling debt is something else entirely. Far from exercising the freedom of contract, it violates it. When I take out a loan from bank A, and then they turn around and sell that loan to bank B, I suddenly owe money to bank B, but I never agreed to do that. I had nothing to do with their decision to work with bank B as opposed to keeping the loan or selling it to bank C.

Current regulations prohibit banks from “changing the terms of the loan”, but in practice they change them all the time—they can’t change the principal balance, the loan term, or the interest rate, but they can change the late fees, the payment schedule, and lots of subtler things about the loan that can still make a very big difference. Indeed, as far as I’m concerned they have changed the terms of the loan—one of the terms of the loan was that I was to pay X amount to bank A, not that I was to pay X amount to bank B. I may or may not have good reasons not to want to pay bank B—they might be far less trustworthy than bank A, for instance, or have a far worse social responsibility record—and in any case it doesn’t matter; it is my choice whether or not I want anything to do with bank B, whatever my reasons might be.

I take this matter quite personally, for it is by the selling of debt that, in moral (albeit not legal) terms, a British bank stole my parents’ house. Indeed, not just any British bank; it was none other than HSBC, the money launderers for terrorists.

When they first obtained their mortgage, my parents did not actually know that HSBC was quite so evil as to literally launder money for terrorists, but they did already know that they were involved in a great many shady dealings, and even specifically told their lender that they did not want the loan sold, and if it was to be sold, it was absolutely never to be sold to HSBC in particular. Their mistake (which was rather like the “mistake” of someone who leaves their car unlocked and has it stolen, or forgets to arm the home alarm system and suffers a burglary) was not to get this written into the formal contract, rather than simply made as a verbal agreement with the bankers. Such verbal contracts are enforceable under the law, at least in theory; but that would require proof of the verbal contract (and what proof could we provide?), and also probably have cost as much as the house in litigation fees.

Oh, by the way, they were given a subprime interest rate of 8% despite being middle-class professionals with good credit, no doubt to maximize the broker’s closing commission. Most banks reserved such behavior for racial minorities, but apparently this one was equal-opportunity in the worst way.Perhaps my parents were naive to trust bankers any further than they could throw them.

As a result, I think you know what happened next: They sold the loan to HSBC.

Now, had it ended there, with my parents unwittingly forced into supporting a bank that launders money for terrorists, that would have been bad enough. But it assuredly did not.

By a series of subtle and manipulative practices that poked through one loophole after another, HSBC proceeded to raise my parents’ payments higher and higher. One particularly insidious tactic they used was to sit on the checks until just after the due date passed, so they could charge late fees on the payments, then they recapitalized the late fees. My parents caught on to this particular trick after a few months, and started mailing the checks certified so they would be date-stamped; and lo and behold, all the payments were suddenly on time! By several other similarly devious tactics, all of which were technically legal or at least not provable, they managed to raise my parents’ monthly mortgage payments by over 50%.

Note that it was a fixed-rate, fixed-term mortgage. The initial payments—what should have been always the payments, that’s the point of a fixed-rate fixed-term mortgage—were under $2000 per month. By the end they were paying over $3000 per month. HSBC forced my parents to overpay on a mortgage an amount equal to the US individual poverty line, or the per-capita GDP of Peru.

They tried to make the payments, but after being wildly over budget and hit by other unexpected expenses (including defects in the house’s foundation that they had to pay to fix, but because of the “small” amount at stake and the overwhelming legal might of the construction company, no lawyer was willing to sue over), they simply couldn’t do it anymore, and gave up. They gave the house to the bank with a deed in lieu of foreclosure.

And that is the story of how a bank that my parents never agreed to work with, never would have agreed to work with, indeed specifically said they would not work with, still ended up claiming their house—our house, the house I grew up in from the age of 12. Legally, I cannot prove they did anything against the law. (I mean, other than laundered money for terrorists.) But morally, how is this any less than theft? Would we not be victimized less had a burglar broken into our home, vandalized the walls and stolen our furniture?

Indeed, that would probably be covered under our insurance! Where can I buy insurance against the corrupt and predatory financial system? Where are my credit default swaps to pay me when everything goes wrong?

And all of this could have been prevented, if banks simply weren’t allowed to violate our freedom of contract by selling their loans to other banks.

Indeed, the Second Depression could probably have been likewise prevented. Without selling debt, there is no securitization. Without securitization, there is far less leverage. Without leverage, there are not bank failures. Without bank failures, there is no depression. A decade of global economic growth was lost because we allowed banks to sell debt whenever they please.

I have heard the counter-arguments many times:

“But what if banks need the liquidity?” Easy. They can take out their own loans with those other banks. If bank A finds they need more cashflow, they should absolutely feel free to take out a loan from bank B. They can even point to their projected revenues from the mortgage payments we owe them, as a means of repaying that loan. But they should not be able to involve us in that transaction. If you want to trust HSBC, that’s your business (you’re an idiot, but it’s a free country). But you have no right to force me to trust HSBC.

“But banks might not be willing to make those loans, if they knew they couldn’t sell or securitize them!” THAT’S THE POINT. Banks wouldn’t take on all these ridiculous risks in their lending practices that they did (“NINJA loans” and mortgages with payments larger than their buyers’ annual incomes), if they knew they couldn’t just foist the debt off on some Greater Fool later on. They would only make loans they actually expect to be repaid. Obviously any loan carries some risk, but banks would only take on risks they thought they could bear, as opposed to risks they thought they could convince someone else to bear—which is the definition of moral hazard.

“Homes would be unaffordable if people couldn’t take out large loans!” First of all, I’m not against mortgages—I’m against securitization of mortgages. Yes, of course, people need to be able to take out loans. But they shouldn’t be forced to pay those loans to whoever their bank sees fit. If indeed the loss of subprime securitized mortgages made it harder for people to get homes, that’s a problem; but the solution to that problem was never to make it easier for people to get loans they can’t afford—it is clearly either to reduce the price of homes or increase the incomes of buyers. Subsidized housing construction, public housing, changes in zoning regulation, a basic income, lower property taxes, an expanded earned-income tax credit—these are the sort of policies that one implements to make housing more affordable, not “go ahead and let banks exploit people however they want”.

Remember, a regulation against selling debt would protect the freedom of contract. It would remove a way for private individuals and corporations to violate that freedom, like regulations against fraud, intimidation, and coercion. It should be uncontroversial that no one has any right to force you to do business with someone you would not voluntarily do business with, certainly not in a private transaction between for-profit corporations. Maybe that sort of mandate makes sense in rare circumstances by the government, but even then it should really be implemented as a tax, not a mandate to do business with a particular entity. The right to buy what you choose is the foundation of a free market—and implicit in it is the right not to buy what you do not choose.

There are many regulations on debt that do impose upon freedom of contract: As horrific as payday loans are, if someone really honestly knowingly wants to take on short-term debt at 400% APR I’m not sure it’s my business to stop them. And some people may really be in such dire circumstances that they need money that urgently and no one else will lend to them. Insofar as I want payday loans regulated, it is to ensure that they are really lending in good faith—as many surely are not—and ultimately I want to outcompete them by providing desperate people with more reasonable loan terms. But a ban on securitization is like a ban on fraud; it is the sort of law that protects our rights.

What is progress? How far have we really come?

JDN 2457534

It is a controversy that has lasted throughout the ages: Is the world getting better? Is it getting worse? Or is it more or less staying the same, changing in ways that don’t really constitute improvements or detriments?

The most obvious and indisputable change in human society over the course of history has been the advancement of technology. At one extreme there are techno-utopians, who believe that technology will solve all the world’s problems and bring about a glorious future; at the other extreme are anarcho-primitivists, who maintain that civilization, technology, and industrialization were all grave mistakes, removing us from our natural state of peace and harmony.

I am not a techno-utopian—I do not believe that technology will solve all our problems—but I am much closer to that end of the scale. Technology has solved a lot of our problems, and will continue to solve a lot more. My aim in this post is to convince you that progress is real, that things really are, on the whole, getting better.

One of the more baffling arguments against progress comes from none other than Jared Diamond, the social scientist most famous for Guns, Germs and Steel (which oddly enough is mainly about horses and goats). About seven months before I was born, Diamond wrote an essay for Discover magazine arguing quite literally that agriculture—and by extension, civilization—was a mistake.

Diamond fortunately avoids the usual argument based solely on modern hunter-gatherers, which is a selection bias if ever I heard one. Instead his main argument seems to be that paleontological evidence shows an overall decrease in health around the same time as agriculture emerged. But that’s still an endogeneity problem, albeit a subtler one. Maybe agriculture emerged as a response to famine and disease. Or maybe they were both triggered by rising populations; higher populations increase disease risk, and are also basically impossible to sustain without agriculture.

I am similarly dubious of the claim that hunter-gatherers are always peaceful and egalitarian. It does seem to be the case that herders are more violent than other cultures, as they tend to form honor cultures that punish all sleights with overwhelming violence. Even after the Industrial Revolution there were herder honor cultures—the Wild West. Yet as Steven Pinker keeps trying to tell people, the death rates due to homicide in all human cultures appear to have steadily declined for thousands of years.

I read an article just a few days ago on the Scientific American blog which included the following claim so astonishingly nonsensical it makes me wonder if the authors can even do arithmetic or read statistical tables correctly:

I keep reminding readers (see Further Reading), the evidence is overwhelming that war is a relatively recent cultural invention. War emerged toward the end of the Paleolithic era, and then only sporadically. A new study by Japanese researchers published in the Royal Society journal Biology Letters corroborates this view.

Six Japanese scholars led by Hisashi Nakao examined the remains of 2,582 hunter-gatherers who lived 12,000 to 2,800 years ago, during Japan’s so-called Jomon Period. The researchers found bashed-in skulls and other marks consistent with violent death on 23 skeletons, for a mortality rate of 0.89 percent.

That is supposed to be evidence that ancient hunter-gatherers were peaceful? The global homicide rate today is 62 homicides per million people per year. Using the worldwide life expectancy of 71 years (which is biasing against modern civilization because our life expectancy is longer), that means that the worldwide lifetime homicide rate is 4,400 homicides per million people, or 0.44%—that’s less than half the homicide rate of these “peaceful” hunter-gatherers. If you compare just against First World countries, the difference is even starker; let’s use the US, which has the highest homicide rate in the First World. Our homicide rate is 38 homicides per million people per year, which at our life expectancy of 79 years is 3,000 homicides per million people, or an overall homicide rate of 0.3%, slightly more than a third of this “peaceful” ancient culture. The most peaceful societies today—notably Japan, where these remains were found—have homicide rates as low as 3 per million people per year, which is a lifetime homicide rate of 0.02%, forty times smaller than their supposedly utopian ancestors. (Yes, all of Japan has fewer total homicides than Chicago. I’m sure it has nothing to do with their extremely strict gun control laws.) Indeed, to get a modern homicide rate as high as these hunter-gatherers, you need to go to a country like Congo, Myanmar, or the Central African Republic. To get a substantially higher homicide rate, you essentially have to be in Latin America. Honduras, the murder capital of the world, has a lifetime homicide rate of about 6.7%.

Again, how did I figure these things out? By reading basic information from publicly-available statistical tables and then doing some simple arithmetic. Apparently these paleoanthropologists couldn’t be bothered to do that, or didn’t know how to do it correctly, before they started proclaiming that human nature is peaceful and civilization is the source of violence. After an oversight as egregious as that, it feels almost petty to note that a sample size of a few thousand people from one particular region and culture isn’t sufficient data to draw such sweeping judgments or speak of “overwhelming” evidence.

Of course, in order to decide whether progress is a real phenomenon, we need a clearer idea of what we mean by progress. It would be presumptuous to use per-capita GDP, though there can be absolutely no doubt that technology and capitalism do in fact raise per-capita GDP. If we measure by inequality, modern society clearly fares much worse (our top 1% share and Gini coefficient may be higher than Classical Rome!), but that is clearly biased in the opposite direction, because the main way we have raised inequality is by raising the ceiling, not lowering the floor. Most of our really good measures (like the Human Development Index) only exist for the last few decades and can barely even be extrapolated back through the 20th century.

How about babies not dying? This is my preferred measure of a society’s value. It seems like something that should be totally uncontroversial: Babies dying is bad. All other things equal, a society is better if fewer babies die.

I suppose it doesn’t immediately follow that all things considered a society is better if fewer babies die; maybe the dying babies could be offset by some greater good. Perhaps a totalitarian society where no babies die is in fact worse than a free society in which a few babies die, or perhaps we should be prepared to accept some small amount of babies dying in order to save adults from poverty, or something like that. But without some really powerful overriding reason, babies not dying probably means your society is doing something right. (And since most ancient societies were in a state of universal poverty and quite frequently tyranny, these exceptions would only strengthen my case.)

Well, get ready for some high-yield truth bombs about infant mortality rates.

It’s hard to get good data for prehistoric cultures, but the best data we have says that infant mortality in ancient hunter-gatherer cultures was about 20-50%, with a best estimate around 30%. This is statistically indistinguishable from early agricultural societies.

Indeed, 30% seems to be the figure humanity had for most of history. Just shy of a third of all babies died for most of history.

In Medieval times, infant mortality was about 30%.

This same rate (fluctuating based on various plagues) persisted into the Enlightenment—Sweden has the best records, and their infant mortality rate in 1750 was about 30%.

The decline in infant mortality began slowly: During the Industrial Era, infant mortality was about 15% in isolated villages, but still as high as 40% in major cities due to high population densities with poor sanitation.

Even as recently as 1900, there were US cities with infant mortality rates as high as 30%, though the overall rate was more like 10%.

Most of the decline was recent and rapid: Just within the US since WW2, infant mortality fell from about 5.5% to 0.7%, though there remains a substantial disparity between White and Black people.

Globally, the infant mortality rate fell from 6.3% to 3.2% within my lifetime, and in Africa today, the region where it is worst, it is about 5.5%—or what it was in the US in the 1940s.

This precipitous decline in babies dying is the main reason ancient societies have such low life expectancies; actually once they reached adulthood they lived to be about 70 years old, not much worse than we do today. So my multiplying everything by 71 actually isn’t too far off even for ancient societies.

Let me make a graph for you here, of the approximate rate of babies dying over time from 10,000 BC to today:

Infant_mortality.png

Let’s zoom in on the last 250 years, where the data is much more solid:

Infant_mortality_recent.png

I think you may notice something in these graphs. There is quite literally a turning point for humanity, a kink in the curve where we suddenly begin a rapid decline from an otherwise constant mortality rate.

That point occurs around or shortly before 1800—that is, it occurs at industrial capitalism. Adam Smith (not to mention Thomas Jefferson) was writing at just about the point in time when humanity made a sudden and unprecedented shift toward saving the lives of millions of babies.

So now, think about that the next time you are tempted to say that capitalism is an evil system that destroys the world; the evidence points to capitalism quite literally saving babies from dying.

How would it do so? Well, there’s that rising per-capita GDP we previously ignored, for one thing. But more important seems to be the way that industrialization and free markets support technological innovation, and in this case especially medical innovation—antibiotics and vaccines. Our higher rates of literacy and better communication, also a result of raised standard of living and improved technology, surely didn’t hurt. I’m not often in agreement with the Cato Institute, but they’re right about this one: Industrial capitalism is the chief source of human progress.

Billions of babies would have died but we saved them. So yes, I’m going to call that progress. Civilization, and in particular industrialization and free markets, have dramatically improved human life over the last few hundred years.

In a future post I’ll address one of the common retorts to this basically indisputable fact: “You’re making excuses for colonialism and imperialism!” No, I’m not. Saying that modern capitalism is a better system (not least because it saves babies) is not at all the same thing as saying that our ancestors were justified in using murder, slavery, and tyranny to force people into it.

Free trade, fair trade, or what?

JDN 2457271 EDT 11:34.

As I mentioned in an earlier post, almost all economists are opposed to protectionism. In a survey of 264 AEA economists, 87% opposed tariffs to protect US workers against foreign competition.

(By the way, 58% said they usually vote Democrat and only 23% said they usually vote Republican. Given that economists are overwhelmingly middle-age rich White males—only 12% of tenured faculty economists are women and the median income of economists is over $90,000—that’s saying something. Dare I suggest it’s saying that Democrat economic policy is usually better?)

There are a large number of published research papers showing large positive effects of free trade agreements, such as this paper, and this paper, and this paper, and this paper. It’s hard to find any good papers showing any significant negative effects. This is probably why the consensus is so strong; the empirical evidence is overwhelming.

Yet protectionism is very popular among the general public. The majority of both Democrat and Republican voters believe that free trade agreements have harmed the United States. For decades, protectionism has always been the politically popular answer.

To be fair, it’s actually possible to think that free trade harms the US but still support free trade; actually there are some economists who argue that free trade has harmed the US, but has benefited other countries like China and India so much more that it is worth it, making free trade an act of global altruism and good will (for the opposite view, here’s a pretty good article about how “free trade” in principle is often mercantilism in practice, and by no means altruistic). As Krugman talks about, there is some evidence that income inequality in the First World has been exacerbated by globalization—but it’s clearly not the primary reason for rising inequality.

What’s going on here? Are economists ignoring the negative impacts of free trade because it doesn’t fit their elegant mathematical models? Is the general public ignorant of how trade actually works? Does the way free trade works, or its interaction with human psychology, inherently obscure its benefits while emphasizing its harms?

Yes. All of the above.

One of the central mistakes of neoclassical economics is the tendency to over-aggregate. Instead of looking at the impact on individuals, it’s much easier to look at the impact on aggregated abstractions like trade flows and GDP. To some extent this is inevitable—there are simply too many people in the world to keep track of them all. But we need to be aware of what welose when we aggregate, and we need to test the robustness of our theories by applying different models of aggregation (such as comparing “how does this affect Americans” with “how does this affect the First World middle class”).

It is absolutely unambiguous that free trade increases trade flows and GDP, and for small countries these benefits can be mind-bogglingly huge. A key part of the amazing success story of economic development that is Korea is that they dramatically increased their openness to global trade.

The reason for this is absolutely fundamental to economics, and in grasping it in 1776 Adam Smith basically founded the field: Voluntary trade benefits both parties.

As most economists would put it today, comparative advantage leads to Pareto-improving gains from trade. Or as I’d tend to put it, more succinctly yet just as thoroughly based in modern game theory: Trade is nonzero-sum.

When you sell a product to someone, it is because the money they’re offering you is worth more to you than the product—and because the product is worth more to them than the money. You each lose something you value less and gain something you value more—so you are both better off.

This mutual benefit occurs whether you are individuals, corporations, or nations. It’s a fundamental principle of economics that underlies the operation of markets at every scale.

This is what I think most people don’t understand when they say they want to “stop sending jobs overseas”. If by that all you mean is ensuring that there aren’t incentives to offshore and outsource, that’s quite reasonable. Even some degree of incentive to keep businesses in the US might make sense, to avoid a race-to-the-bottom in global wages. But I get the sense that it is more than this, that people have a general notion that jobs are zero-sum and if we hire a million people in China that means a million people must lose their jobs in the US. This is not simply wrong, it is fundamentally wrong; it misses the entire point of economics. If there is one core principle that defines economics, I think it would be that the universe is nonzero-sum; gains for some can also be gains for others. There is not a fixed amount of stuff in the world that we distribute; we can make more stuff. Handled properly, a trade that results in a million people hired in China can mean an extra million people hired in the US.

Once you introduce a competitive market, things get more complicated, because there aren’t just winners—there are also losers. When you have competitors, someone can buy from them instead of you, and the two of them benefit, but you are harmed. By the standard methods of calculating benefits and harms (which admittedly leave much to be desired), we can show quite clearly that in general, on average, the benefits outweigh the harms.

But of course we don’t live “in general, on average”. Despite the overwhelming, unambiguous benefit to the economy as a whole, there is some evidence that free trade can produce a good deal of harm to specific individuals.

Suppose you live in the US and your job is to assemble iPads. You’re good at it, you like it, it pays pretty well. But now Apple says that they want to “reduce labor costs” (they are in fact doing nothing of the sort; to really reduce labor costs in a deep economic sense you’d have to make work easier, more productive, or more fun—the wage and the cost are fundamentally different things), so they outsource production to Foxconn in China, who pay wages 1/30 of what you were being paid.

The net result of this change to the economy as a whole is almost certainly positive—the price of iPads goes down, we all get to have iPads. (There’s a meme going around claiming that the price of an iPad would be almost $15,000 if it were made in the US; no, it would cost about $1000 even if our productivity were no higher and Apple could keep their current profit margin intact, both of which are clearly overestimates. But since it’s currently selling for about $500, that’s still a big difference.) Apple makes more profits, which is why they did it—and we do have to count that in our GDP. Most importantly, workers in China get employed in safe, high-skill jobs instead of working in coal mines, subsistence farming, or turning to drugs and prostitution. More stuff, more profits, better jobs for some of the world’s poorest workers. These are all good things, and overall they outweigh the harm of you losing your job.

Well, from a global perspective, anyway. I doubt they outweigh the harm from your perspective. You still lost a good job; you’re now unemployed, and may have skills so specific that they can’t be transferred to anything else. You’ll need to retrain, which means going back to school or else finding one of those rare far-sighted companies that actually trains their workers. Since the social welfare system in the US is such a quagmire of nonsensical programs, you may be ineligible for support, or eligible in theory and unable to actually get it in practice. (Recently I got a notice from Medicaid that I need to prove again that my income is sufficiently low. Apparently it’s because I got hired at a temporary web development gig, which paid me a whopping $700 over a few weeks—why, that’s almost the per-capita GDP of Ghana, so clearly I am a high-roller who doesn’t need help affording health insurance. I wonder how much they spend sending out these notices.)

If we had a basic income—I know I harp on this a lot, but seriously, it solves almost every economic problem you can think of—losing your job wouldn’t make you feel so desperate, and owning a share in GDP would mean that the rising tide actually would lift all boats. This might make free trade more popular.

But even with ideal policies (which we certainly do not have), the fact remains that human beings are loss-averse. We care more about losses than we do about gains. The pain you feel from losing $100 is about the same as the joy you feel from gaining $200. The pain you feel from losing your job is about twice as intense as the joy you feel from finding a new one.

Because of loss aversion, the constant churn of innovation and change, the “creative destruction” that Schumpeter considered the defining advantage of capitalism—well, it hurts. The constant change and uncertainty is painful, and we want to run away from it.

But the truth is, we can’t. There’s no way to stop the change in the global economy, and most of our attempts to insulate ourselves from it only end up hurting us more. This, I think, is the fundamental reason why protectionism is popular among the general public but not economists: The general public sees protectionism as a way of holding onto the past, while economists recognize that it is simply a way of damaging the future. That constant churning of people gaining and losing jobs isn’t a bug, it’s a feature—it’s the reason that capitalism is so efficient in the first place.

There are a few ways we can reduce the pain of this churning, but we need to focus on that—reducing the pain—rather than trying to stop the churning itself. We should provide social welfare programs that allow people to survive while they are unemployed. We should use active labor market policies to train new workers and match them with good jobs. We may even want to provide some sort of subsidy or incentive to companies that don’t outsource—a small one, to make sure they don’t do so needlessly, but not a large one, so they’ll still do it when it’s actually necessary.

But the one thing we must not do is stop creating jobs overseas. And yes, that is what we are doing, creating jobs. We are not sending jobs that already exist, we are creating new ones. In the short run we also destroy some jobs here, but if we do it right we can replace them—and usually we do okay.

If we stop creating jobs in India and China and around the world, millions of people will starve.

Yes, it is as stark as that. Millions of lives depend upon continued open trade. We in the United States are a manufacturing, technological and agricultural superpower—we could wall ourselves off from the world and only see a few percentage points shaved off of GDP. But a country like Nicaragua or Ghana or Vietnam doesn’t have that option; if they cut off trade, people start dying.

This is actually the main reason why our trade agreements are often so unfair; we are in by far the stronger bargaining position, so we can make them cut their tariffs on textiles even as we maintain our subsidies on agriculture. We are Mr. Bumble dishing out gruel and they are Oliver Twist begging for another bite.

We can’t afford to stop free trade. We can’t even afford to significantly slow it down. A global economy is the best hope we have for global peace and global prosperity.

That is not to say that we should leave trade completely unregulated; trade policy can and should be used to enforce human rights standards. That enormous asymmetry in bargaining power doesn’t have to be used to maximize profits; it can be used to advance human rights.

This is not as simple as saying we should never trade with nations that have bad human rights records, by the way. First of all that would require we cut off Saudi Arabia and China, which is totally unrealistic and would impoverish millions of people; second it doesn’t actually solve the problem. Instead we should use sanctions, tariffs, and trade agreements to provide incentives to improve human rights, rewarding governments that do and punishing governments that don’t. We could have a sliding tariff that decreases every time you show improvement in human rights standards. Think of it like behavioral reinforcement; reward good behavior and you’ll get more of it.

We do need to have sweatshops—but as Krugman has come around to realizing, we can make sweatshops safer. We can put pressure on other countries to treat their workers better, pay them more—and actually make the global economy more efficient, because right now their wages are held down below the efficient level by the power that corporations wield over them. We should not demand that they pay the same they would here in the First World—that’s totally unrealistic, given the difference in productivity—but we should demand that they pay what their workers actually deserve.

Similar incentives should apply to individual corporations, which these days are as powerful as some governments. For example, as part of a zero-tolerance program against forced labor, any company caught using or outsourcing to forced labor should have its profits garnished for damages and the executives who made the decision imprisoned. Sometimes #Scandinaviaisnotbetter; IKEA was involved in such outsourcing during the Cold War, and it is currently being litigated just how much they knew and what they could have done about it. If they knew and did nothing, some IKEA executive should be going to prison. If that seems extreme, let me remind you what they did: They used slaves.

My standard for penalizing human rights violations, whether by corporations or governments, is basically like this: Follow the decision-making up the chain of command, stopping only when the next-higher executive can clearly show to the preponderance of evidence that they were kept out of the loop. If no executive can provide sufficient evidence, the highest-ranking executive at the time the crime was committed will be held responsible. If you don’t want to be held responsible for crimes committed by people who work for you, it’s your responsibility to bring them to justice. Negligence in oversight will not be exonerating because you didn’t know; it will be incriminating because you should have. When your bank is caught laundering money for terrorists and drug lords, it isn’t enough to have your chief of compliance resign; he should be imprisoned—and if his superiors knew about it, so should they.

In fact maybe the focus should be on corporations, because we have the legal authority to do that. When dealing with other countries, there are United Nations rules and simply the de facto power of large trade flows and national standing armies. With Saudi Arabia or China, there’s a very real chance that they’ll simply tell us where we can shove it; but if we get that same kind of response from HSBC or Goldman Sachs (which, actually, we did), we can start taking out handcuffs (that, we did not do—but I think we should have).

We can also use consumer pressure to change the behavior of corporations, such as Fair Trade. There’s some debate about just how effective these things are, but the comparison that is often made between Fair Trade and tariffs is ridiculous; this is a change in consumer behavior, not a change in government policy. There is absolutely no loss of freedom. Choosing not to buy something does not constitute coercion against someone else. Maybe there are more efficient ways to spend money (like donating it directly to the best global development charities), but if you start going down that road you quickly turn into Peter Singer and start saying that wearing nicer shoes means you’re committing murder. By all means, let’s empirically study different methods of fighting poverty and focus on the ones that work best; but there’s a perverse smugness to criticisms of Fair Trade that says to me this isn’t actually about that at all. Instead, I think most people who criticize Fair Trade don’t support the idea of altruism at all—they’re far-right Randian libertarians who honestly believe that selfishness is the highest form of human morality. (It is in fact the second-lowest, according to Kohlberg.) Maybe it will turn out that Fair Trade is actually ineffective at fighting poverty, but it’s clear that an unregulated free market isn’t good at that either. Those aren’t the only options, and the best way to find out which methods work is to give them a try. Consumer pressure clearly can work in some cases, and it’s a low-cost zero-regulation solution. They say the road to Hell is paved with good intentions—but would you rather we have bad intentions instead?

By these two methods we could send a clear message to multinational corporations that if they want to do business in the US—and trust me, they do—they have to meet certain standards of human rights. This in turn will make those corporations put pressure on their suppliers, all the way down the supply chain, to uphold the standards lest they lose their contracts. With some companies upholding labor standards in Third World countries, others will be forced to, as workers refuse to work for companies that don’t. This could make life better for many millions of people.

But this whole plan only works on one condition: We need to have trade.

What is socialism?

JDN 2457265 EDT 10:47

Last night I was having a political discussion with some friends (as I am wont to do), and it became a little heated, though never uncongenial. A key point of contention was the fact that Bernie Sanders is a socialist, and what exactly that entails.

One of my friends was arguing that this makes him far-left, and thus it is fair when the news media often likes to make a comparison between Sanders on the left and Trump on the right. Donald Trump is actually oddly liberal on some issues, but his attitudes on racial purity, nativism, military unilateralism, and virtually unlimited executive power are literally fascist. Even his “liberal” views are more like the kind of populism that fascists have often used to win support in the past: Don’t you hate being disenfranchised? Give me absolute power and I’ll fix everything for you! Don’t like how our democracy has become corrupt? Don’t worry, I’ll get rid of it! (The democracy, that is.) While he certainly doesn’t align well with the Republican Party platform, I think it’s quite fair to say that Donald Trump is a far-right candidate.

Bernie Sanders, however, is not a far-left candidate. He is a center-left candidate. His views are basically consonant with the Labour Party of the UK and the Social Democratic Party of Germany. He has spoken often about the Scandinavian model (because, well, #Scandinaviaisbetter—Denmark, Sweden, and Norway are some of the happiest places on Earth). When we talk about Bernie Sanders we aren’t talking about following Cuba and the Soviet Union; we’re talking about following Norway and Sweden. As Jon Stewart put it, he isn’t a “crazy-pants cuckoo bird” as some would have you think.

But he’s a socialist, right? Well… sort of—we have to be very clear what that means.

The word “socialism” has been used to mean many things; it has been a cover for genocidal fascism (“National Socialism”) and tyrannical Communism (“Union of Soviet Socialist Republics”). It has become a pejorative thrown at Social Security, Medicare, banking regulations—basically any policy left of Milton Friedman. So apparently it means something between Medicare and the Holocaust.

Social democracy is often classified as a form of socialism—but one can actually make a pretty compelling case that social democracy is not socialism, but in fact a form of capitalism.

If we want a simple, consistent definition of “socialism”, I think I would put it thus: Socialism is a system in which the majority of economic activity is directly controlled by the government. Most, if not all, industries are nationalized; production and distribution are handled by centrally-planned quotas instead of market supply and demand. Under this definition, the USSR, Venezuela, Cuba, and (at least until recently) China are socialist—and under this definition, socialism is a very bad idea. The best-case scenario is inefficiency; the worst-case scenario is mass murder.

Social democracy, the position that Bernie Sanders espouses (and I basically agree wit), is as follows: Social democracy is a system in which markets are taxed and regulated by a democratically-elected government to ensure that they promote general welfare, public goods are provided by the government, and transfer programs are used to reduce poverty and inequality.

Let’s also try to define “capitalism”: Capitalism is a system in which the majority of economic activity is handled by private sector markets.

Under the Scandinavian model, the majority of economic activity is handled by private sector markets, which are in turn regulated and taxed to promote the general welfare—that is, at least on these definitions, Scandinavia is both capitalist and social democratic.

In fact, so is the United States; while our taxes are lower and our regulations weaker, we still have substantial taxes and regulations. We do have transfer programs like WIC, SNAP, and Social Security that attempt to redistribute wealth and reduce poverty.

We could define “socialism” more broadly to mean any government intervention in the economy, in which case Bernie Sander is a socialist and so is… almost everyone else, including most economists.

The majority of the most eminent American economists are in favor of social democracy. I don’t intend this as an argument from authority, but rather to give a sense of the scientific consensus. The consensus in economics is by no means as strong as that in biology or physics (or climatology, ahem), but there is still broad agreement on many issues.

In a survey of 264 members of the American Economics Association [pdf link], 77% opposed government ownership of enterprise (14% mixed feelings, 8% favor) but 71% favored redistribution of wealth in some form (7% mixed feelings, 20% opposed). That’s social democracy is a nutshell. 67% favored public schools (14% mixed feelings, 17% opposed); 75% favored Keynesian monetary policy (12% mixed feelings, 12% opposed); 51% favored Keynesian fiscal policy (19% mixed feelings, 30% opposed). 58% opposed tighter immigration restrictions (16% mixed feelings, 25% opposed). 79% support anti-discrimination laws. 68% favor gun control.

The major departure from left-wing views that the majority of economists make is a near-universal opposition to protectionism, with 86.8% opposed, 7.6% with mixed feelings, and only 5.3% in favor. It seems I am not the only economist to cringe when politicians say they want to “stop sending jobs overseas”, which they do left and right. This view is quite popular; but the evidence says that it is wrong. Protectionism is not the answer; you make your trading partners poorer, they retaliate with their own protections, and you both end up worse off. We need open trade. I’ll save the details on why open trade is so important for a later post.

One issue that economists are very divided on right now is minimum wage; 47.3% favor minimum wage, 38.3% oppose it, and 14.4% have mixed feelings. This division likely reflects the ambiguity of empirical results on the employment effect of minimum wage, which have a wide margin of error but effect sizes that cluster around zero. Economists are also somewhat divided on military aid, with 36.8% in favor, 33% opposed, and 29.9% with mixed feelings. This I attribute more to the fact that military aid, like most military action, can be justified in principle but is typically unjustified in practice. And indeed perhaps “mixed feelings” is the most reasonable view to have on war and its instruments.

Since Bernie Sanders strongly supports raising minimum wage and some of his statements verge on protectionism, I do have to place him to the left of the economic consensus. A lot of economists would probably disagree on the particulars of his tax plans and such. But his core policies are entirely in line with that consensus, and being a social democrat is absolutely part of that. Compare this to the Republicans, who keep trying to out-crazy each other (apparently Scott Walker thinks we should not only build a wall against Mexico, but also against Canada?) and want policies that were abandoned decades ago by mainstream economists (like the gold standard, or a balanced-budget amendment), or simply would never be taken seriously by mainstream economists at all (the aforementioned border wall, eliminating all environmental regulation, or ending all transfer payments and social welfare programs). Even the things they supposedly agree on I’m not sure they do; when economists say they want “deregulation” Republicans seem to think that means “no rules at all” when in fact it’s supposed to mean “simple, transparent rules that can be tightly and fairly enforced”. (I think we need a new term for it, though there is a slogan I like: “Deregulate with a scalpel, not a chainsaw.”) Obama has done a very good job of deregulating in the sense that economists intend, and I think in general most economists view him positively as a leader who made the best of a bad situation.

In any case, the broad consensus of American economists (and I think most economists around the world) is that some form of capitalist social democracy is the best system we have so far. There is dispute about particular policies—how much should the tax rates be, should we tax income, consumption, real estate, capital, etc.; how large should the transfers be; what regulations should be added or removed—but the basic concept of a market economy with a government that taxes, transfers, and regulates is not in serious dispute.

Indeed, social democracy is the economic system of the free world.

Even using the conservative Heritage Foundation’s data, the correlation between tax burden and economic freedom—that’s economic freedom—is small but positive. (I’m excluding missing data, as well as Timor-Leste because it has a “tax burden” larger than its GDP due to weird accounting of its tourism-based economy, and North Korea because they lie to us and they theoretically have “zero taxes” but that’s clearly not true; the Heritage Foundation reports them as 100% taxes, but that’s also clearly not true either.) See for yourself:

Graph: Heritage Foundation Economic Freedom Index and tax burden

Why is this? Do taxes automatically make you more free? No, they make you less free, because you have to pay for things you didn’t choose to buy (which I admit and the Heritage Foundation includes in their index). But taxes are how you manage a free economy. You need to control monetary policy somehow, which means adding and removing money. The way that social democracies do this is by spending on public goods and transfers to add money, and taxing income, consumption, or assets to remove money. Even if you tie your money to the gold standard, you still need to pay for public goods like military and police; and with a fixed money supply that means spending must be matched by taxes.

There are other ways to do this. You could be like Zimbabwe and print as much money as you feel like. You could be like Venezuela, and have government-owned industries form the majority of your economy. Or, actually, you could not do it; you could fail to manage your country’s economy and leave it wallowing in poverty, like Ghana. All of the countries I just listed have lower tax burdens than the United States.

Within the framework of social democracy, there are higher taxes so that spending and transfers can be higher, which means that more public goods are provided and poverty is lower, which means that real equality of opportunity and thus, real economic freedom, are higher. It’s not that raising taxes automatically makes people more free; rather, the kind of policies that make people more free tend to be the kind of social-democratic policies that involve relatively high taxes.

Worldwide, US is 12th in terms of economic freedom and 62nd in terms of tax burden. We currently stand at 24%. That’s quite low for a First World country, but still relatively high by world standards. The highest tax burden is in Eritrea at 50%; the lowest is in Kuwait at an astonishing 0.7% (I don’t even know how that’s possible). Neither is a really wonderful place to live (though Kuwait is better).

Indeed, if you restrict the sample to North America and Europe, the correlation basically disappears; all the countries are fairly free, all the taxes are fairly high, and within that the two aren’t very much related. (It’s been a long time since I’ve seen a trendline that flat, actually!)

Graph: Heritage Foundation Economic Freedom Index and tax burden, Europe and North America

Switzerland, Canada, and Denmark all have higher economic freedom scores than the United States, as well as higher tax burdens; but on the other hand, Greece, Spain, and Austria have higher tax burdens but lower freedom scores. All of them are variations on social democracy.

Is that socialism? I’m really not sure. Why does it matter, really?

What are we celebrating today?

JDN 2457208 EDT 13:35 (July 4, 2015)

As all my American readers will know (and unsurprisingly 79% of my reader trackbacks come from the United States), today is Independence Day. I’m curious how my British readers feel about this day (and the United Kingdom is my second-largest source of reader trackbacks); we are in a sense celebrating the fact that we’re no longer ruled by you.

Every nation has some notion of patriotism; in the simplest sense we could say that patriotism is simply nationalism, yet another reflection of our innate tribal nature. As Obama said when asked about American exceptionalism, the British also believe in British exceptionalism. If that is all we are dealing with, then there is no particular reason to celebrate; Saudi Arabia or China could celebrate just as well (and very likely does). Independence Day then becomes something parochial, something that is at best a reflection of local community and culture, and at worst a reaffirmation of nationalistic divisiveness.

But in fact I think we are celebrating something more than that. The United States of America is not just any country. It is not just a richer Brazil or a more militaristic United Kingdom. There really is something exceptional about the United States, and it really did begin on July 4, 1776.

In fact we should probably celebrate June 21, 1789 and December 15, 1791, the ratification of the Constitution and the Bill of Rights respectively. But neither of these would have been possible without that Declaration of Independence on July 4, 1776. (In fact, even that date isn’t as clear-cut as commonly imagined.)

What makes the United States unique?

From the dawn of civilization around 5000 BC up to the mid-18th century AD, there were basically two ways to found a nation. The most common was to grow the nation organically, formulate an ethnic identity over untold generations and then make up an appealing backstory later. The second way, and not entirely mutually exclusive, was for a particular leader, usually a psychopathic king, to gather a superior army, conquer territory, and annex the people there, making them part of his nation whether they wanted it or not. Variations on these two themes were what happened in Rome, in Greece, in India, in China; they were done by the Sumerians, by the Egyptians, by the Aztecs, by the Maya. All the ancient civilizations have founding myths that are distorted so far from the real history that the real history has become basically unknowable. All the more recent powers were formed by warlords and usually ruled with iron fists.

The United States of America started with a war, make no mistake; and George Washington really was more a charismatic warlord than he ever was a competent statesman. But Washington was not a psychopath, and refused to rule with an iron fist. Instead he was instrumental in establishing a fundamentally new approach to the building of nations.
This is literally what happened—myths have grown around it, but it itself documented history. Washington and his compatriots gathered a group of some of the most intelligent and wise individuals they could find, sat them down in a room, and tasked them with answering the basic question: “What is the best possible country?” They argued and debated, considering absolutely the most cutting-edge economics (The Wealth of Nations was released in 1776) and political philosophy (Thomas Paine’s Common Sense also came out in 1776). And then, when they had reached some kind of consensus on what the best sort of country would be—they created that country. They were conscious of building a new tradition, of being the founders of the first nation built as part of the Enlightenment. Previously nations were built from immemorial tradition or the whims of warlords—the United States of America was the first nation in the world that was built on principle.

It would not be the last; in fact, with a terrible interlude that we call Napoleon, France would soon become the second nation of the Enlightenment. A slower process of reform would eventually bring the United Kingdom itself to a similar state (though the UK is still a monarchy and has no formal constitution, only an ever-growing mountain of common law). As the centuries passed and the United States became more and more powerful, its system of government attained global influence, with now almost every nation in the world nominally a “democracy” and about half actually recognizable as such. We now see it as unexceptional to have a democratically-elected government bound by a constitution, and even think of the United States as a relatively poor example compared to, say, Sweden or Norway (because #Scandinaviaisbetter), and this assessment is not entirely wrong; but it’s important to keep in mind that this was not always the case, and on July 4, 1776 the Founding Fathers truly were building something fundamentally new.

Of course, the Founding Fathers were not the demigods they are often imagined to be; Washington himself was a slaveholder, and not just any slaveholder, but in fact almost a billionaire in today’s terms—the wealthiest man in America by far and actually a rival to the King of England. Thomas Jefferson somehow managed to read Thomas Paine and write “all men are created equal” without thinking that this obligated him to release his own slaves. Benjamin Franklin was a misogynist and womanizer. James Madison’s concept of formalizing armed rebellion bordered on insanity (and ultimately resulted in our worst amendment, the Second). The system that they built disenfranchised women, enshrined the slavery of Black people into law, and consisted of dozens of awkward compromises (like the Senate) that would prove disastrous in the future. The Founding Fathers were human beings with human flaws and human hypocrisy, and they did many things wrong.

But they also did one thing very, very right: They created a new model for how nations should be built. In a very real sense they redefined what it means to be a nation. That is what we celebrate on Independence Day.

1200px-Flag_of_the_United_States.svg

What you need to know about tax incidence

JDN 2457152 EDT 14:54.

I said in my previous post that I consider tax incidence to be one of the top ten things you should know about economics. If I actually try to make a top ten list, I think it goes something like this:

  1. Supply and demand
  2. Monopoly and oligopoly
  3. Externalities
  4. Tax incidence
  5. Utility, especially marginal utility of wealth
  6. Pareto-efficiency
  7. Risk and loss aversion
  8. Biases and heuristics, including sunk-cost fallacy, scope neglect, herd behavior, anchoring and representative heuristic
  9. Asymmetric information
  10. Winner-takes-all effect

So really tax incidence is in my top five things you should know about economics, and yet I still haven’t talked about it very much. Well, today I will. The basic principles of supply and demand I’m basically assuming you know, but I really should spend some more time on monopoly and externalities at some point.

Why is tax incidence so important? Because of one central fact: The person who pays the tax is not the person who writes the check.

It doesn’t matter whether a tax is paid by the buyer or the seller; it matters what the buyer and seller can do to avoid the tax. If you can change your behavior in order to avoid paying the tax—buy less stuff, or buy somewhere else, or deduct something—you will not bear the tax as much as someone else who can’t do anything to avoid the tax, even if you are the one who writes the check. If you can avoid it and they can’t, other parties in the transaction will adjust their prices in order to eat the tax on your behalf.

Thus, if you have a good that you absolutely must buy no matter what—like, say, table saltand then we make everyone who sells that good pay an extra $5 per kilogram, I can guarantee you that you will pay an extra $5 per kilogram, and the suppliers will make just as much money as they did before. (A salt tax would be an excellent way to redistribute wealth from ordinary people to corporations, if you’re into that sort of thing. Not that we have any trouble doing that in America.)

On the other hand, if you have a good that you’ll only buy at a very specific price—like, say, fast food—then we can make you write the check for a tax of an extra $5 per kilogram you use, and in real terms you’ll pay hardly any tax at all, because the sellers will either eat the cost themselves by lowering the prices or stop selling the product entirely. (A fast food tax might actually be a good idea as a public health measure, because it would reduce production and consumption of fast food—remember, heart disease is one of the leading causes of death in the United States, making cheeseburgers a good deal more dangerous than terrorists—but it’s a bad idea as a revenue measure, because rather than pay it, people are just going to buy and sell less.)

In the limit in which supply and demand are both completely fixed (perfectly inelastic), you can tax however you want and it’s just free redistribution of wealth however you like. In the limit in which supply and demand are both locked into a single price (perfectly elastic), you literally cannot tax that good—you’ll just eliminate production entirely. There aren’t a lot of perfectly elastic goods in the real world, but the closest I can think of is cash. If you instituted a 2% tax on all cash withdrawn, most people would stop using cash basically overnight. If you want a simple way to make all transactions digital, find a way to enforce a cash tax. When you have a perfect substitute available, taxation eliminates production entirely.

To really make sense out of tax incidence, I’m going to need a lot of a neoclassical economists’ favorite thing: Supply and demand curves. These things pop up everywhere in economics; and they’re quite useful. I’m not so sure about their application to things like aggregate demand and the business cycle, for example, but today I’m going to use them for the sort of microeconomic small-market stuff that they were originally designed for; and what I say here is going to be basically completely orthodox, right out of what you’d find in an ECON 301 textbook.

Let’s assume that things are linear, just to make the math easier. You’d get basically the same answers with nonlinear demand and supply functions, but it would be a lot more work. Likewise, I’m going to assume a unit tax on goods—like $2890 per hectare—as opposed to a proportional tax on sales—like 6% property tax—again, for mathematical simplicity.

The next concept I’m going to have to talk about is elasticitywhich is the proportional amount that quantity sold changes relative to price. If price increases 2% and you buy 4% less, you have a demand elasticity of -2. If price increases 2% and you buy 1% less, you have a demand elasticity of -1/2. If price increases 3% and you sell 6% more, you have a supply elasticity of 2. If price decreases 5% and you sell 1% less, you have a supply elasticity of 1/5.

Elasticity doesn’t have any units of measurement, it’s just a number—which is part of why we like to use it. It also has some very nice mathematical properties involving logarithms, but we won’t be needing those today.

The price that renters are willing and able to pay, the demand price PD will start at their maximum price, the reserve price PR, and then it will decrease linearly according to the quantity of land rented Q, according to a linear function (simply because we assumed that) which will vary according to a parameter e that represents the elasticity of demand (it isn’t strictly equal to it, but it’s sort of a linearization).

We’re interested in what is called the consumer surplus; it is equal to the total amount of value that buyers get from their purchases, converted into dollars, minus the amount they had to pay for those purchases. This we add to the producer surplus, which is the amount paid for those purchases minus the cost of producing themwhich is basically just the same thing as profit. Togerther the consumer surplus and producer surplus make the total economic surplus, which economists generally try to maximize. Because different people have different marginal utility of wealth, this is actually a really terrible idea for deep and fundamental reasons—taking a house from Mitt Romney and giving it to a homeless person would most definitely reduce economic surplus, even though it would obviously make the world a better place. Indeed, I think that many of the problems in the world, particularly those related to inequality, can be traced to the fact that markets maximize economic surplus rather than actual utility. But for now I’m going to ignore all that, and pretend that maximizing economic surplus is what we want to do.

You can read off the economic surplus straight from the supply and demand curves; it’s the area between the lines. (Mathematically, it’s an integral; but that’s equivalent to the area under a curve, and with straight lines they’re just triangles.) I’m going to call the consumer surplus just “surplus”, and producer surplus I’ll call “profit”.

Below the demand curve and above the price is the surplus, and below the price and above the supply curve is the profit:

elastic_supply_competitive_labeled

I’m going to be bold here and actually use equations! Hopefully this won’t turn off too many readers. I will give each equation in both a simple text format and in proper LaTeX. Remember, you can render LaTeX here.

PD = PR – 1/e * Q

P_D = P_R – \frac{1}{e} Q \\

The marginal cost that landlords have to pay, the supply price PS, is a bit weirder, as I’ll talk about more in a moment. For now let’s say that it is a linear function, starting at zero cost for some quantity Q0 and then increases linearly according to a parameter n that similarly represents the elasticity of supply.

PS = 1/n * (Q – Q0)

P_S = \frac{1}{n} \left( Q – Q_0 \right) \\

Now, if you introduce a tax, there will be a difference between the price that renters pay and the price that landlords receive—namely, the tax, which we’ll call T. I’m going to assume that, on paper, the landlord pays the whole tax. As I said above, this literally does not matter. I could assume that on paper the renter pays the whole tax, and the real effect on the distribution of wealth would be identical. All we’d have to do is set PD = P and PS = P – T; the consumer and producer surplus would end up exactly the same. Or we could do something in between, with P’D = P + rT and P’S = P – (1 – r) T.

Then, if the market is competitive, we just set the prices equal, taking the tax into account:

P = PD – T = PR – 1/e * Q – T = PS = 1/n * (Q – Q0)

P= P_D – T = P_R – \frac{1}{e} Q – T= P_S = \frac{1}{n} \left(Q – Q_0 \right) \\

P_R – 1/e * Q – T = 1/n * (Q – Q0)

P_R – \frac{1}{e} Q – T = \frac{1}{n} \left(Q – Q_0 \right) \\

Notice the equivalency here; if we set P’D = P + rT and P’S = P – (1 – r) T, so that the consumer now pays a fraction of the tax r.

P = P’D – rT = P_r – 1/e*Q = P’S + (1 – r) T + 1/n * (Q – Q0) + (1 – r) T

P^\prime_D – r T = P = P_R – \frac{1}{e} Q = P^\prime_S = \frac{1}{n} \left(Q – Q_0 \right) + (1 – r) T\\

The result is exactly the same:

P_R – 1/e * Q – T = 1/n * (Q – Q0)

P_R – \frac{1}{e} Q – T = \frac{1}{n} \left(Q – Q_0 \right) \\

I’ll spare you the algebra, but this comes out to:

Q = (PR – T)/(1/n + 1/e) + (Q0)/(1 + n/e)

Q = \frac{P_R – T}{\frac{1}{n} + \frac{1}{e}} + \frac{Q_0}{1 + \frac{n}{e}}

P = (PR – T)/(1+ n/e) – (Q0)/(e + n)

P = \frac{P_R – T}}{1 + \frac{n}{e}} – \frac{Q_0}{e+n} \\

That’s if the market is competitive.

If the market is a monopoly, instead of setting the prices equal, we set the price the landlord receives equal to the marginal revenue—which takes into account the fact that increasing the amount they sell forces them to reduce the price they charge everyone else. Thus, the marginal revenue drops faster than the price as the quantity sold increases.

After a bunch of algebra (and just a dash of calculus), that comes out to these very similar, but not quite identical, equations:

Q = (PR – T)/(1/n + 2/e) + (Q0)/(1+ 2n/e)

Q = \frac{P_R – T}{\frac{1}{n} + \frac{2}{e}} + \frac{Q_0}{1 + \frac{2n}{e}} \\

P = (PR – T)*((1/n + 1/e)/(1/n + 2/e) – (Q0)/(e + 2n)

P = \left( P_R – T\right)\frac{\frac{1}{n} + \frac{1}{e}}{\frac{1}{n} + \frac{2}{e}} – \frac{Q_0}{e+2n} \\

Yes, it changes some 1s into 2s. That by itself accounts for the full effect of monopoly. That’s why I think it’s worthwhile to use the equations; they are deeply elegant and express in a compact form all of the different cases. They look really intimidating right now, but for most of the cases we’ll consider these general equations simplify quite dramatically.

There are several cases to consider.

Land has an extremely high cost to create—for practical purposes, we can consider its supply fixed, that is, perfectly inelastic. If the market is competitive, so that landlords have no market power, then they will simply rent out all the land they have at whatever price the market will bear:

Inelastic_supply_competitive_labeled

This is like setting n = 0 and T = 0 in the above equations, the competitive ones.

Q = Q0

Q = Q_0 \\

P = PR – Q0/e

P = P_R – \frac{Q_0}{e} \\

If we now introduce a tax, it will fall completely on the landlords, because they have little choice but to rent out all the land they have, and they can only rent it at a price—including tax—that the market will bear.

inelastic_supply_competitive_tax_labeled

Now we still have n = 0 but not T = 0.

Q = Q0

Q = Q_0 \\

P = PR – T – Q0/e

P = P_R – T – \frac{Q_0}{e} \\

The consumer surplus will be:

½ (Q)(PR – P – T) = 1/(2e)* Q02

\frac{1}{2}Q(P_R – P – T) = \frac{1}{2e}Q_0^2 \\

Notice how T isn’t in the result. The consumer surplus is unaffected by the tax.

The producer surplus, on the other hand, will be reduced by the tax:

(Q)(P) = (PR – T – Q0/e) Q0 = PR Q0 – 1/e Q02 – TQ0

(Q)(P) = (P_R – T – \frac{Q_0}{e})Q_0 = P_R Q_0 – \frac{1}{e} Q_0^2 – T Q_0 \\

T appears linearly as TQ0, which is the same as the tax revenue. All the money goes directly from the landlord to the government, as we want if our goal is to redistribute wealth without raising rent.

But now suppose that the market is not competitive, and by tacit collusion or regulatory capture the landlords can exert some market power; this is quite likely the case in reality. Actually in reality we’re probably somewhere in between monopoly and competition, either oligopoly or monopolistic competitionwhich I will talk about a good deal more in a later post, I promise.

It could be that demand is still sufficiently high that even with their market power, landlords have an incentive to rent out all their available land, in which case the result will be the same as in the competitive market.

inelastic_supply_monopolistic_labeled

A tax will then fall completely on the landlords as before:

inelastic_supply_monopolistic_tax_labeled

Indeed, in this case it doesn’t really matter that the market is monopolistic; everything is the same as it would be under a competitive market. Notice how if you set n = 0, the monopolistic equations and the competitive equations come out exactly the same. The good news is, this is quite likely our actual situation! So even in the presence of significant market power the land tax can redistribute wealth in just the way we want.

But there are a few other possibilities. One is that demand is not sufficiently high, so that the landlords’ market power causes them to actually hold back some land in order to raise the price:

zerobound_supply_monopolistic_labeled

This will create some of what we call deadweight loss, in which some economic value is wasted. By restricting the land they rent out, the landlords make more profit, but the harm they cause to tenant is created than the profit they gain, so there is value wasted.

Now instead of setting n = 0, we actually set n = infinity. Why? Because the reason that the landlords restrict the land they sell is that their marginal revenue is actually negative beyond that point—they would actually get less money in total if they sold more land. Instead of being bounded by their cost of production (because they have none, the land is there whether they sell it or not), they are bounded by zero. (Once again we’ve hit upon a fundamental concept in economics, particularly macroeconomics, that I don’t have time to talk about today: the zero lower bound.) Thus, they can change quantity all they want (within a certain range) without changing the price, which is equivalent to a supply elasticity of infinity.

Introducing a tax will then exacerbate this deadweight loss (adding DWL2 to the original DWL1), because it provides even more incentive for the landlords to restrict the supply of land:

zerobound_supply_monopolistic_tax_labeled

Q = e/2*(PR – T)

Q = \frac{e}{2} \left(P_R – T\right)\\

P = 1/2*(PR – T)

P = \frac{1}{2} \left(P_R – T\right) \\

The quantity Q0 completely drops out, because it doesn’t matter how much land is available (as long as it’s enough); it only matters how much land it is profitable to rent out.

We can then find the consumer and producer surplus, and see that they are both reduced by the tax. The consumer surplus is as follows:

½ (Q)(PR – 1/2(PR – T)) = e/4*(PR2 – T2)

\frac{1}{2}Q \left( P_R – \frac{1}{2}left( P – T \right) \right) = \frac{e}{4}\left( P_R^2 – T^2 \right) \\

This time, the tax does have an effect on reducing the consumer surplus.

The producer surplus, on the other hand, will be:

(Q)(P) = 1/2*(PR – T)*e/2*(PR – T) = e/4*(PR – T)2

(Q)(P) = \frac{1}{2}\left(P_R – T \right) \frac{e}{2} \left(P_R – T\right) = \frac{e}{4} \left(P_R – T)^2 \\

Notice how it is also reduced by the tax—and no longer in a simple linear way.

The tax revenue is now a function of the demand:

TQ = e/2*T(PR – T)

T Q = \frac{e}{2} T (P_R – T) \\

If you add all these up, you’ll find that the sum is this:

e/2 * (PR^2 – T^2)

\frac{e}{2} \left(P_R^2 – T^2 \right) \\

The sum is actually reduced by an amount equal to e/2*T^2, which is the deadweight loss.

Finally there is an even worse scenario, in which the tax is so large that it actually creates an incentive to restrict land where none previously existed:

zerobound_supply_monopolistic_hugetax_labeled

Notice, however, that because the supply of land is inelastic the deadweight loss is still relatively small compared to the huge amount of tax revenue.

But actually this isn’t the whole story, because a land tax provides an incentive to get rid of land that you’re not profiting from. If this incentive is strong enough, the monopolistic power of landlords will disappear, as the unused land gets sold to more landholders or to the government. This is a way of avoiding the tax, but it’s one that actually benefits society, so we don’t mind incentivizing it.

Now, let’s compare this to our current system of property taxes, which include the value of buildings. Buildings are expensive to create, but we build them all the time; the supply of buildings is strongly dependent upon the price at which those buildings will sell. This makes for a supply curve that is somewhat elastic.

If the market were competitive and we had no taxes, it would be optimally efficient:

elastic_supply_competitive_labeled

Property taxes create an incentive to produce fewer buildings, and this creates deadweight loss. Notice that this happens even if the market is perfectly competitive:

elastic_supply_competitive_tax_labeled

Since both n and e are finite and nonzero, we’d need to use the whole equations: Since the algebra is such a mess, I don’t see any reason to subject you to it; but suffice it to say, the T does not drop out. Tenants do see their consumer surplus reduced, and the larger the tax the more this is so.

Now, suppose that the market for buildings is monopolistic, as it most likely is. This would create deadweight loss even in the absence of a tax:

elastic_supply_monopolistic_labeled

But a tax will add even more deadweight loss:

elastic_supply_monopolistic_tax_labeled

Once again, we’d need the full equations, and once again it’s a mess; but the result is, as before, that the tax gets passed on to the tenants in the form of more restricted sales and therefore higher rents.

Because of the finite supply elasticity, there’s no way that the tax can avoid raising the rent. As long as landlords have to pay more taxes when they build more or better buildings, they are going to raise the rent in those buildings accordingly—whether the market is competitive or not.

If the market is indeed monopolistic, there may be ways to bring the rent down: suppose we know what the competitive market price of rent should be, and we can establish rent control to that effect. If we are truly correct about the price to set, this rent control can not only reduce rent, it can actually reduce the deadweight loss:

effective_rent_control_tax_labeled

But if we set the rent control too low, or don’t properly account for the varying cost of different buildings, we can instead introduce a new kind of deadweight loss, by making it too expensive to make new buildings.

ineffective_rent_control_tax_labeled

In fact, what actually seems to happen is more complicated than that—because otherwise the number of buildings is obviously far too small, rent control is usually set to affect some buildings and not others. So what seems to happen is that the rent market fragments into two markets: One, which is too small, but very good for those few who get the chance to use it; and the other, which is unaffected by the rent control but is more monopolistic and therefore raises prices even further. This is why almost all economists are opposed to rent control (PDF); it doesn’t solve the problem of high rent and simply causes a whole new set of problems.

A land tax with a basic income, on the other hand, would help poor people at least as much as rent control presently does—probably a good deal more—without discouraging the production and maintenance of new apartment buildings.

But now we come to a key point: The land tax must be uniform per hectare.

If it is instead based on the value of the land, then this acts like a finite elasticity of supply; it provides an incentive to reduce the value of your own land in order to avoid the tax. As I showed above, this is particularly pernicious if the market is monopolistic, but even if it is competitive the effect is still there.

One exception I can see is if there are different tiers based on broad classes of land that it’s difficult to switch between, such as “land in Manhattan” versus “land in Brooklyn” or “desert land” versus “forest land”. But even this policy would have to be done very carefully, because any opportunity to substitute can create an opportunity to pass on the tax to someone else—for instance if land taxes are lower in Brooklyn developers are going to move to Brooklyn. Maybe we want that, in which case that is a good policy; but we should be aware of these sorts of additional consequences. The simplest way to avoid all these problems is to simply make the land tax uniform. And given the quantities we’re talking about—less than $3000 per hectare per year—it should be affordable for anyone except the very large landholders we’re trying to distribute wealth from in the first place.

The good news is, most economists would probably be on board with this proposal. After all, the neoclassical models themselves say it would be more efficient than our current system of rent control and property taxes—and the idea is at least as old as Adam Smith. Perhaps we can finally change the fact that the rent is too damn high.

What if you couldn’t own land?

JDN 2457145 EDT 20:49.

Today’s post we’re on the socialism scale somewhere near the The Guess Who, but not quite all the way to John Lennon. I’d like to questions one of the fundamental tenets of modern capitalism, but not the basic concept of private ownership itself:

What if you couldn’t own land?

Many things that you can own were more-or-less straightforwardly created by someone. A car, a computer, a television, a pair of shoes; for today let’s even take for granted intellectual property like books, movies, and songs; at least those things (“things”) were actually made by someone.

But land? We’re talking about chunks of the Earth here. They were here billions of years before us, and in all probability will be here billions of years after we’re gone. There’s no need to incentivize its creation; the vast majority of land was already here and did not need to be created. (I do have to say “the vast majority”, because in places like Japan, Hong Kong, and the Netherlands real estate has become so scarce that people do literally build land out into the sea. But this is something like 0.0001% of the world’s land.)

What we want to incentivize is land development; we want it to be profitable to build buildings and irrigate deserts, and yes, even cut down forests sometimes (though then there should be a carbon tax with credits for forested land to ensure that there isn’t too much incentive). Yet our current property tax system doesn’t do this very well; if you build bigger buildings, you end up paying more property taxes. Yes, you may also make some profit on the buildings—but it’s risky, and you may not get enough benefit to justify the added property taxes.

Moreover, we want to allocate land—we want some way of deciding who is allowed to use what land where and when (and perhaps why). Allowing land to be bought and sold is one way to do that, but it is not the only way.

Indeed, land ownership suffers from a couple of truly glaring flaws as an allocation system:

      1. It creates self-perpetuating inequality. Because land grows in value over time (due to population growth and urbanization, among other things), those who currently own land end up getting an ever-growing quantity of wealth while those who do not own land do not, and very likely end up having to pay ever-growing rents to the landlords. (I like calling them “landlords”; it really drives home the fact that our landholding system is still basically the same as it was under feudalism.) In fact, the recent rise in the share of income that goes to owners of capital rather than workers is almost entirely attributable to the rise in the price of real estate. As that post rightly recognizes, this does nothing to undermine Piketty’s central message of rising inequality due to capital income (pace The Washington Post); it merely tells us to focus on real estate instead of other forms of capital.
      2. It has no non-arbitrary allocation. If we want to decide who owns a car, we can ask questions like, “Who built it? Did someone buy it from them? Did they pay a fair price?”; if we want to decide who owns a book, we can ask questions like, “Who wrote it? Did they sell it to a publisher? What was the royalty rate?” That is, there is a clear original owner, and there is a sense of whether the transfer of ownership can be considered fair. But if we want to decide who owns a chunk of land, basically all we can ask is, “What does the deed say?” The owner is the owner because they are the owner; there’s no sense in which that ownership is fair. We certainly can’t go back to the original creation of the land, because that was due to natural forces gigayears ago. If we keep tracing the ownership backward, we will eventually end up with some guy (almost certainly a man, a White man in fact) with a gun who pointed that gun at other people and said, “This is mine.” This is true of basically all the land in the world (aside from those little bits of Japan and such); it was already there, and the only reason someone got to own it was because they said so and had a bigger gun. And a flag, perhaps: “Do you have a flag?” I suppose, in theory at least, there are a few ways of allocating land which seem less arbitrary: One would be to give everyone an equal amount. But this is practically very difficult: What do you do when the population changes? If you have 2% annual population growth, do you carve off 2% of everybody’s lot each year? Another would be to let people squat land, and automatically own the land that they live on—but again practical difficulties quickly become enormous. In any case, these two methods bear about as much resemblance to our actual allocation of land as a squirrel does to a Tyrannosaurus.

So, what else might we use? The system that makes the most sense to me is that we would own all land as a society. In practical terms this would mean that all land is Federal land, and if you want to use it for something, you need to pay rent to the government. There are many different ways the government could set the rent, but the most sensible might be to charge a flat rate per hectare regardless of where the land is or what it’s being used for, because that would maximize the incentive to develop the land. It would also make the rent fall entirely on the landowner, because the rent would be perfectly inelasticmeaning that you can’t change the quantity you make based on the price, because you aren’t making it; it’s just already sitting there.

Of course, this idea is obviously politically impossible in our current environment—or indeed any foreseeable political environment. I’m just fantasizing here, right?

Well, not quite. There is one thing we could do that would be economically quite similar to government-only land ownership; it’s called a land tax. The idea is incredibly simple: you just collect a flat tax per hectare of land. Economists have known that a land tax is efficient at providing revenue and reducing inequality since at least Adam Smith. So maybe ownership of land isn’t actually foundational to capitalism, after all; maybe we’ve just never fully gotten over feudalism. (I basically agree with Adam Smith, and for doing so I am often called a socialist.) The beautiful thing about a land tax is that it has a tax incidence in which the owners of the land end up bearing the full brunt of the tax.

Tax incidence is something it’s very important to understand; it would be on my list of the top ten economic principles that people should learn. We often have fierce political debates over who will actually write the check: Should employers pay the health insurance premium, or should employees? Will buyers pay sales tax, or sellers? Should we tax corporate profits or personal capital gains?

Please understand that I am not exaggerating when I say that these sorts of questions are totally irrelevant. It simply does not matter who actually writes the check; what matters is who bears the cost. Making the employer pay the health insurance premium doesn’t make the slightest difference if all they’re going to do is cut wages by the exact same amount. You can see the irrelevance of the fact that sellers pay sales tax every time you walk into a store—you always end up paying the price plus the tax, don’t you? (I found that the base price of most items was the same between Long Beach and Ann Arbor, but my total expenditure was always 3% more because of the 9% sales tax versus the 6%.) How do we determine who actually pays the tax? It depends on the elasticity—how easily can you change your behavior in order to avoid the tax? Can you find a different job because the health insurance premiums are too high? No? Then you’re probably paying that premium, even if your employer writes the check. If you can find a new job whenever you want, your employer might have to pay it for you even if you write the check.

The incidence of corporate taxes and taxes on capital gains are even more complicated, because it could affect the behavior of corporations in many different ways; indeed, many economists argue that the corporate tax simply results in higher unemployment or lower wages for workers. I don’t think that’s actually true, but I honestly can’t rule it out completely, precisely because corporate taxes are so complicated. You need to know all sorts of things about the structure of stock markets, and the freedom of trade, and the mobility of immigration… it’s a complete and total mess.

It’s because of tax incidence that a land tax makes so much sense; there’s no way for the landowner to escape it, other than giving up the land entirely. In particular, they can’t charge more for rent without being out-competed (unless landowners are really good at colluding—which might be true for large developers, but not individual landlords). Their elasticity is so low that they’re forced to bear the full cost of the tax.

If the land tax were high enough, it could eliminate the automatic growth in wealth that comes from holding land, and thereby reducing long-run inequality dramatically. The revenue could be used for my other favorite fiscal policy, the basic income—and real estate is a big enough part of our nation’s wealth that it’s actually entirely realistic to fund an $8,000 per person per year basic income entirely on land tax revenue. The total value of US land is about $14 trillion, and an $8,000 basic income for 320 million people would cost about $2.6 trillion; that’s only 19%. You’d actually want to make it a flat tax per hectare, so how much would that be? Well, 60% of US land is privately owned at present (no sense taxing the land the government already owns), and total US land area is about 9 million square kilometers, so to raise $2.5 trillion you’d need a tax of $289,000 per square kilometer, or $2,890 per hectare. If you own a hectare—which is bigger than most single-family lots—you’d only pay $2,890 per year in land tax, well within what most middle-class families could handle. But if you own 290,000 acres like Jeff Bezos, (that’s 117,000 hectares) you’re paying $338 million per year. Since Jeff Bezos has about $38 billion in net wealth, he can actually afford to pay that ($338 million per year is about one-tenth of what Jeff Bezos makes automatically on dividends), though he might consider selling off some of the land to avoid the taxes, which is exactly the sort of incentive we wanted to create.

Indeed, when I contemplate this policy I’m struck by the fact that it has basically no downside—usually in public policy you’re forced to make hard compromises and tradeoffs, but a land tax plus basic income is a system that carries almost no downsides at all. It won’t disincentivize investment, it won’t disincentivize working, it will dramatically reduce inequality, it will save the government a great deal of money on social welfare spending, and best of all it will eliminate poverty immediately and forever. The only people it would hurt at all are extremely rich, and they wouldn’t even be hurt very much, while it would benefit millions of people including some of the most needy.

Why aren’t we doing this already!?