derivatives

How not to do financial transaction tax

pnrj public policy , , , , , , , , , ,

JDN 2457520

I strongly support the implementation of a financial transaction tax; like a basic income, it’s one of those economic policy ideas that are so brilliantly simple it’s honestly a little hard to believe how incredibly effective they are at making the world a better place. You mean we might be able to end stock market crashes just by implementing this little tax that most people will never even notice, and it will raise enough revenue to pay for food stamps? Yes, a financial transaction tax is that good.

So, keep that in mind when I say this:

TruthOut’s proposal for a financial transaction tax is somewhere between completely economically illiterate and outright insane.

They propose a 10% transaction tax on stocks and a 1% transaction tax on notional value of derivatives, then offer a “compromise” of 5% on stocks and 0.5% on derivatives. They make a bunch of revenue projections based on these that clearly amount to nothing but multiplying the current amount of transactions by the tax rate, which is so completely wrong we now officially have a left-wing counterpart to trickle-down voodoo economics.

Their argument is basically like this (I’m paraphrasing): “If we have to pay 5% sales tax on groceries, why shouldn’t you have to pay 5% on stocks?”

But that’s not how any of this works.

Demand for most groceries is very inelastic, especially in the aggregate. While you might change which groceries you’ll buy depending on their respective prices, and you may buy in bulk or wait for sales, over a reasonably long period (say a year) across a large population (say all of Michigan or all of the US), total amount of spending on groceries is extremely stable. People only need a certain amount of food, and they generally buy that amount and then stop.

So, if you implement a 5% sales tax that applies to groceries (actually sales tax in most states doesn’t apply to most groceries, but honestly it probably should—offset the regressiveness by providing more social services), people would just… spend about 5% more on groceries. Probably a bit less than that, actually, since suppliers would absorb some of the tax; but demand is much less elastic for groceries than supply, so buyers would bear most of the incidence of the tax. (It does not matter how the tax is collected; see my tax incidence series for further explanation of why.)

Other goods like clothing and electronics are a bit more elastic, so you’d get some deadweight loss from the sales tax; but at a typical 5% to 10% in the US this is pretty minimal, and even the hefty 20% or 30% VATs in some European countries only have a moderate effect. (Denmark’s 180% sales tax on cars seems a bit excessive to me, but it is Pigovian to disincentivize driving, so it also has very little deadweight loss.)

But what would happen if you implemented a 5% transaction tax on stocks? The entire stock market would immediately collapse.

A typical return on stocks is between 5% and 15% per year. As a rule of thumb, let’s say about 10%.

If you pay 5% sales tax and trade once per year, tax just cut your return in half.

If you pay 5% sales tax and trade twice per year, tax destroyed your return completely.

Even if you only trade once every five years, a 5% sales tax means that instead of your stocks being worth 61% more after those 5 years they are only worth 53% more. Your annual return has been reduced from 10% to 8.9%.

But in fact there are many perfectly legitimate reasons to trade as often as monthly, and a 5% tax would make monthly trading completely unviable.

Even if you could somehow stop everyone from pulling out all their money just before the tax takes effect, you would still completely dry up the stock market as a source of funding for all but the most long-term projects. Corporations would either need to finance their entire operations out of cash or bonds, or collapse and trigger a global depression.

Derivatives are even more extreme. The notional value of derivatives is often ludicrously huge; we currently have over a quadrillion dollars in notional value of outstanding derivatives. Assume that say 10% of those are traded every year, and we’re talking $100 trillion in notional value of transactions. At 0.5% you’re trying to take in a tax of $500 billion. That sounds fantastic—so much money!—but in fact what you should be thinking about is that’s a really strong avoidance incentive. You don’t think banks will find a way to restructure their trading practices—or stop trading altogether—to avoid this tax?

Honestly, maybe a total end to derivatives trading would be tolerable. I certainly think we need to dramatically reduce the amount of derivatives trading, and much of what is being traded—credit default swaps, collateralized debt obligations, synthetic collateralized debt obligations, etc.—really should not exist and serves no real function except to obscure fraud and speculation. (Credit default swaps are basically insurance you can buy on other people’s companies. There’s a reason you’re not allowed to buy insurance on other people’s stuff!) Interest rate swaps aren’t terrible (when they’re not being used to perpetrate the largest white-collar crime in history), but they also aren’t necessary. You might be able to convince me that commodity futures and stock options are genuinely useful, though even these are clearly overrated. (Fun fact: Futures markets have been causing financial crises since at least Classical Rome.) Exchange-traded funds are technically derivatives, and they’re just fine (actually ETFs are very low-risk, because they are inherently diversified—which is why you should probably be buying them); but actually their returns are more like stocks, so the 0.5% might not be insanely high in that case.

But stocks? We kind of need those. Equity financing has been the foundation of capitalism since the very beginning. Maybe we could conceivably go to a fully debt-financed system, but it would be a radical overhaul of our entire financial system and is certainly not something to be done lightly.

Indeed, TruthOut even seems to think we could apply the same sales tax rate to bonds, which means that debt financing would also collapse, and now we’re definitely talking about global depression. How exactly is anyone supposed to finance new investments, if they can’t sell stock or bonds? And a 5% tax on the face value of stock or bonds, for all practical purposes, is saying that you can’t sell stock or bonds. It would make no one want to buy them.

Wealthy investors buying of stocks and bonds is essentially no different than average folks buying food, clothing or other real “goods and services.”

Yes it is. It is fundamentally different.

People buy goods to use them. People buy stocks to make money selling them.

This seems perfectly obvious, but it is a vital distinction that seems to be lost on TruthOut.

When you buy an apple or a shoe or a phone or a car, you care how much it costs relative to how useful it is to you; if we make it a bit more expensive, that will make you a bit less likely to buy it—but probably not even one-to-one so that a 5% tax would reduce purchases by 5%; it would probably be more like a 2% reduction. Demand for goods is inelastic. Taxing them will raise a lot of revenue and not reduce the quantity purchased very much.

But when you buy a stock or a bond or an interest rate swap, you care how much it costs relative to what you will be able to sell it for—you care about not its utility but its return. So a 5% tax will reduce the amount of buying and selling by substantially more than 5%—it could well be 50% or even 100%. Demand for financial assets is elastic. Taxing them will not raise much revenue but will substantially reduce the quantity purchased.

Now, for some financial assets, we want to reduce the quantity purchased—the derivatives market is clearly too big, and high-frequency trading that trades thousands of times per second can do nothing but destabilize the financial system. Joseph Stiglitz supports a small financial transaction tax precisely because it would substantially reduce high-frequency trading, and he’s a Nobel Laureate as you may recall. Naturally, he was excluded from the SEC hearings on the subject, because reasons. But the figures Stiglitz is talking about (and I agree with) are on the order of 0.1% for stocks and 0.01% for derivatives—50 times smaller than what TruthOut is advocating.

At the end, they offer another “compromise”:

Okay, half it again, to a 2.5 percent tax on stocks and bonds and a 0.25 percent on derivative trades. That certainly won’t discourage stock and bond trading by the rich (not that that is an all bad idea either).

Yes it will. By a lot. That’s the whole point.

A financial transaction tax is a great idea whose time has come; let’s not ruin its reputation by setting it at a preposterous value. Just as a $15 minimum wage is probably a good idea but a $250 minimum wage is definitely a terrible idea, a 0.1% financial transaction tax could be very beneficial but a 5% financial transaction tax would clearly be disastrous.

What really happened in Greece

pnrj critique of neoclassical economics, current events, market failure, public policy , , , , , , , , , , , , , , , , , , ,

JDN 2457506

I said I’d get back to this issue, so here goes.

Let’s start with what is uncontroversial: Greece is in trouble.

Their per-capita GDP PPP has fallen from a peak of over $32,000 in 2007 to a trough of just over $24,000 in 2013, and only just began to recover over the last 2 years. That’s a fall of 29 log points. Put another way, the average person in Greece has about the same real income now that they had in the year 2000—a decade and a half of economic growth disappeared.

Their unemployment rate surged from about 7% in 2007 to almost 28% in 2013. It remains over 24%. That is, almost one quarter of all adults in Greece are seeking jobs and not finding them. The US has not seen an unemployment rate that high since the Great Depression.

Most shocking of all, over 40% of the population in Greece is now below the national poverty line. They define poverty as 60% of the inflation-adjusted average income in 2009, which works out to 665 Euros per person ($756 at current exchange rates) per month, or about $9000 per year. They also have an absolute poverty line, which 14% of Greeks now fall below, but only 2% did before the crash.

So now, let’s talk about why.

There’s a standard narrative you’ve probably heard many times, which goes something like this:

The Greek government spent too profligately, heaping social services on the population without the tax base to support them. Unemployment insurance was too generous; pensions were too large; it was too hard to fire workers or cut wages. Thus, work incentives were too weak, and there was no way to sustain a high GDP. But they refused to cut back on these social services, and as a result went further and further into debt until it finally became unsustainable. Now they are cutting spending and raising taxes like they needed to, and it will eventually allow them to repay their debt.

Here’s a fellow of the Cato Institute spreading this narrative on the BBC. Here’s ABC with a five bullet-point list: Pension system, benefits, early retirement, “high unemployment and work culture issues” (yes, seriously), and tax evasion. Here the Telegraph says that Greece “went on a spending spree” and “stopped paying taxes”.

That story is almost completely wrong. Almost nothing about it is true. Cato and the Telegraph got basically everything wrong. The only one ABC got right was tax evasion.

Here’s someone else arguing that Greece has a problem with corruption and failed governance; there is something to be said for this, as Greece is fairly corrupt by European standards—though hardly by world standards. For being only a generation removed from an authoritarian military junta, they’re doing quite well actually. They’re about as corrupt as a typical upper-middle income country like Libya or Botswana; and Botswana is widely regarded as the shining city on a hill of transparency as far as Sub-Saharan Africa is concerned. So corruption may have made things worse, but it can’t be the whole story.

First of all, social services in Greece were not particularly extensive compared to the rest of Europe.

Before the crisis, Greece’s government spending was about 44% of GDP.

That was about the same as Germany. It was slightly more than the UK. It was less than Denmark and France, both of which have government spending of about 50% of GDP.

Greece even tried to cut spending to pay down their debt—it didn’t work, because they simply ended up worsening the economic collapse and undermining the tax base they needed to do that.

Europe has fairly extensive social services by world standards—but that’s a major part of why it’s the First World. Even the US, despite spending far less than Europe on social services, still spends a great deal more than most countries—about 36% of GDP.

Second, if work incentives were a problem, you would not have high unemployment. People don’t seem to grasp what the word unemployment actually means, which is part of why I can’t stand it when news outlets just arbitrarily substitute “jobless” to save a couple of syllables. Unemployment does not mean simply that you don’t have a job. It means that you don’t have a job and are trying to get one.

The word you’re looking for to describe simply not having a job is nonemployment, and that’s such a rarely used term my spell-checker complains about it. Yet economists rarely use this term precisely because it doesn’t matter; a high nonemployment rate is not a symptom of a failing economy but a result of high productivity moving us toward the post-scarcity future (kicking and screaming, evidently). If the problem with Greece were that they were too lazy and they retire too early (which is basically what ABC was saying in slightly more polite language), there would be high nonemployment, but there would not be high unemployment. “High unemployment and work culture issues” is actually a contradiction.

Before the crisis, Greece had an employment-to-population ratio of 49%, meaning a nonemployment rate of 51%. If that sounds ludicrously high, you’re not accustomed to nonemployment figures. During the same time, the United States had an employment-to-population ratio of 52% and thus a nonemployment rate of 48%. So the number of people in Greece who were voluntarily choosing to drop out of work before the crisis was just slightly larger than the number in the US—and actually when you adjust for the fact that the US is full of young immigrants and Greece is full of old people (their median age is 10 years older than ours), it begins to look like it’s we Americans who are lazy. (Actually, it’s that we are studious—the US has an extremely high rate of college enrollment and the best colleges in the world. Full-time students are nonemployed, but they are certainly not unemployed.)

But Greece does have an enormously high debt, right? Yes—but it was actually not as bad before the crisis. Their government debt surged from 105% of GDP to almost 180% today. 105% of GDP is about what we have right now in the US; it’s less than what we had right after WW2. This is a little high, but really nothing to worry about, especially if you’ve incurred the debt for the right reasons. (The famous paper by Rogart and Reinhoff arguing that 90% of GDP is a horrible point of no return was literally based on math errors.)

Moreover, Ireland and Spain suffered much the same fate as Greece, despite running primary budget surpluses.

So… what did happen? If it wasn’t their profligate spending that put them in this mess, what was it?

Well, first of all, there was the Second Depression, a worldwide phenomenon triggered by the collapse of derivatives markets in the United States. (You want unsustainable debt? Try 20 to 1 leveraged CDO-squareds and one quadrillion dollars in notional value. Notional value isn’t everything, but it’s a lot.) So it’s mainly our fault, or rather the fault of our largest banks. As far as us voters, it’s “our fault” in the way that if your car gets stolen it’s “your fault” for not locking the doors and installing a LoJack. We could have regulated against this and enforced those regulations, but we didn’t. (Fortunately, Dodd-Frank looks like it might be working.)

Greece was hit particularly hard because they are highly dependent on trade, particularly in services like tourism that are highly sensitive to the business cycle. Before the crash they imported 36% of GDP and exported 23% of GDP. Now they import 35% of GDP and export 33% of GDP—but it’s a much smaller GDP. Their exports have only slightly increased while their imports have plummeted. (This has reduced their “trade deficit”, but that has always been a silly concept. I guess it’s less silly if you don’t control your own currency, but it’s still silly.)

Once the crash happened, the US had sovereign monetary policy and the wherewithal to actually use that monetary policy effectively, so we weathered the crash fairly well, all things considered. Our unemployment rate barely went over 10%. But Greece did not have sovereign monetary policy—they are tied to the Euro—and that severely limited their options for expanding the money supply as a result of the crisis. Raising spending and cutting taxes was the best thing they could do.

But the bank(st?)ers and their derivatives schemes caused the Greek debt crisis a good deal more directly than just that. Part of the condition of joining the Euro was that countries must limit their fiscal deficit to no more than 3% of GDP (which is a totally arbitrary figure with no economic basis in case you were wondering). Greece was unwilling or unable to do so, but wanted to look like they were following the rules—so they called up Goldman Sachs and got them to make some special derivatives that Greece could use to continue borrowing without looking like they were borrowing. The bank could have refused; they could have even reported it to the European Central Bank. But of course they didn’t; they got their brokerage fee, and they knew they’d sell it off to some other bank long before they had to worry about whether Greece could ever actually repay it. And then (as I said I’d get back to in a previous post) they paid off the credit rating agencies to get them to rate these newfangled securities as low-risk.

In other words, Greece is not broke; they are being robbed.

Like homeowners in the US, Greece was offered loans they couldn’t afford to pay, but the banks told them they could, because the banks had lost all incentive to actually bother with the question of whether loans can be repaid. They had “moved on”; their “financial innovation” of securitization and collateralized debt obligations meant that they could collect origination fees and brokerage fees on loans that could never possibly be repaid, then sell them off to some Greater Fool down the line who would end up actually bearing the default. As long as the system was complex enough and opaque enough, the buyers would never realize the garbage they were getting until it was too late. The entire concept of loans was thereby broken: The basic assumption that you only loan money you expect to be repaid no longer held.

And it worked, for awhile, until finally the unpayable loans tried to create more money than there was in the world, and people started demanding repayment that simply wasn’t possible. Then the whole scheme fell apart, and banks began to go under—but of course we saved them, because you’ve got to save the banks, how can you not save the banks?

Honestly I don’t even disagree with saving the banks, actually. It was probably necessary. What bothers me is that we did nothing to save everyone else. We did nothing to keep people in their homes, nothing to stop businesses from collapsing and workers losing their jobs. Precisely because of the absurd over-leveraging of the financial system, the cost to simply refinance every mortgage in America would have been less than the amount we loaned out in bank bailouts. The banks probably would have done fine anyway, but if they didn’t, so what? The banks exist to serve the people—not the other way around.

We can stop this from happening again—here in the US, in Greece, in the rest of Europe, everywhere. But in order to do that we must first understand what actually happened; we must stop blaming the victims and start blaming the perpetrators.

The terrible, horrible, no-good very-bad budget bill

pnrj public policy , , , , , , , , , , ,

JDN 2457005 PST 11:52.

I would have preferred to write about something a bit cheerier (like the fact that by the time I write my next post I expect to be finished with my master’s degree!), but this is obviously the big news in economic policy today. The new House budget bill was unveiled Tuesday, and then passed in the House on Thursday by a narrow vote. It has stalled in the Senate thanks in part to fierce—and entirely justified—opposition by Elizabeth Warren, and so today it has been delayed in the Senate. Obama has actually urged his fellow Democrats to pass it, in order to avoid another government shutdown. Here’s why Warren is right and Obama is wrong.

You know the saying “You can’t negotiate with terrorists!”? Well, in practice that’s not actually true—we negotiate with terrorists all the time; the FBI has special hostage negotiators for this purpose, because sometimes it really is the best option. But the saying has an underlying kernel of truth, which is that once someone is willing to hold hostages and commit murder, they have crossed a line, a Rubicon from which it is impossible to return; negotiations with them can never again be good-faith honest argumentation, but must always be a strategic action to minimize collateral damage. Everyone knows that if you had the chance you’d just as soon put bullets through all their heads—because everyone knows they’d do the same to you.

Well, right now, the Republicans are acting like terrorists. Emotionally a fair comparison would be with two-year-olds throwing tantrums, but two-year-olds do not control policy on which thousands of lives hang in the balance. This budget bill is designed—quite intentionally, I’m sure—in order to ensure that Democrats are left with only two options: Give up on every major policy issue and abandon all the principles they stand for, or fail to pass a budget and allow the government to shut down, canceling vital services and costing billions of dollars. They are holding the American people hostage.

But here is why you must not give in: They’re going to shoot the hostages anyway. This so-called “compromise” would not only add $479 million in spending on fighter jets that don’t work and the Pentagon hasn’t even asked for, not only cut $93 million from WIC, a 3.5% budget cut adjusted for inflation—literally denying food to starving mothers and children—and dramatically increase the amount of money that can be given by individuals in campaign donations (because apparently the unlimited corporate money of Citizens United wasn’t enough!), but would also remove two of the central provisions of Dodd-Frank financial regulation that are the only thing that stands between us and a full reprise of the Great Recession. And even if the Democrats in the Senate cave to the demands just as the spineless cowards in the House already did, there is nothing to stop Republicans from using the same scorched-earth tactics next year.

I wouldn’t literally say we should put bullets through their heads, but we definitely need to get these Republicans out of office immediately at the next election—and that means that all the left-wing people who insist they don’t vote “on principle” need to grow some spines of their own and vote. Vote Green if you want—the benefits of having a substantial Green coalition in Congress would be enormous, because the Greens favor three really good things in particular: Stricter regulation of carbon emissions, nationalization of the financial system, and a basic income. Or vote for some other obscure party that you like even better. But for the love of all that is good in the world, vote.

The two most obscure—and yet most important—measures in the bill are the elimination of the swaps pushout rule and the margin requirements on derivatives. Compared to these, the cuts in WIC are small potatoes (literally, they include a stupid provision about potatoes). They also really aren’t that complicated, once you boil them down to their core principles. This is however something Wall Street desperately wants you to never, ever do, for otherwise their global crime syndicate will be exposed.

The swaps pushout rule says quite simply that if you’re going to place bets on the failure of other companies—these are called credit default swaps, but they are really quite literally a bet that a given company will go bankrupt—you can’t do so with deposits that are insured by the FDIC. This is the absolute bare minimum regulatory standard that any reasonable economist (or for that matter sane human being!) would demand. Honestly I think credit default swaps should be banned outright. If you want insurance, you should have to buy insurance—and yes, deal with the regulations involved in buying insurance, because those regulations are there for a reason. There’s a reason you can’t buy fire insurance on other people’s houses, and that exact same reason applies a thousandfold for why you shouldn’t be able to buy credit default swaps on other people’s companies. Most people are not psychopaths who would burn down their neighbor’s house for the insurance money—but even when their executives aren’t psychopaths (as many are), most companies are specifically structured so as to behave as if they were psychopaths, as if no interests in the world mattered but their own profit.

But the swaps pushout rule does not by any means ban credit default swaps. Honestly, it doesn’t even really regulate them in any real sense. All it does is require that these bets have to be made with the banks’ own money and not with everyone else’s. You see, bank deposits—the regular kind, “commercial banking”, where you have your checking and savings accounts—are secured by government funds in the event a bank should fail. This makes sense, at least insofar as it makes sense to have private banks in the first place (if we’re going to insure with government funds, why not just use government funds?). But if you allow banks to place whatever bets they feel like using that money, they have basically no downside; heads they win, tails we lose. That’s why the swaps pushout rule is absolutely indispensable; without it, you are allowing banks to gamble with other people’s money.

What about margin requirements? This one is even worse. Margin requirements are literally the only thing that keeps banks from printing unlimited money. If there was one single cause of the Great Recession, it was the fact that there were no margin requirements on over-the-counter derivatives. Because there were no margin requirements, there was no limit to how much money banks could print, and so print they did; the result was a still mind-blowing quadrillion dollars in nominal value of outstanding derivatives. Not million, not billion, not even trillion; quadrillion. $1e15. $1,000,000,000,000,000. That’s how much money they printed. The total world money supply is about $70 trillion, which is 1/14 of that. (If you read that blog post, he makes a rather telling statement: “They demonstrate quite clearly that those who have been lending the money that we owe can’t possibly have had the money they lent.” No, of course they didn’t! They created it by lending it. That is what our system allows them to do.)

And yes, at its core, it was printing money. A lot of economists will tell you otherwise, about how that’s not really what’s happening, because it’s only “nominal” value, and nobody ever expects to cash them in—yeah, but what if they do? (These are largely the same people who will tell you that quantitative easing isn’t printing money, because, uh… er… squirrel!) A tiny fraction of these derivatives were cashed in in 2007, and I think you know what happened next. They printed this money and now they are holding onto it; but woe betide us all if they ever decide to spend it. Honestly we should invalidate all of these derivatives and force them to start over with strict margin requirements, but short of that we must at least, again at the bare minimum, have margin requirements.

Why are margin requirements so important? There’s actually a very simple equation that explains it. If the margin requirement is m, meaning that you must retain a portion m between 0 and 1 of the loans you make as reserves, the total amount of money supply that can be created from the current amount of money M is just M/m. So if margin requirements were 100%—full-reserve banking—then the total money supply is M, and therefore in full control of the central bank. This is how it should be, in my opinion. But usually m is set around 10%, so the total money supply is 10M, meaning that 90% of the money in the system was created by banks. But if you ever let that margin requirement go to zero, you end up dividing by zero—and the total amount of money that can be created is infinite.

To see how this works, suppose we start with $1000 and put it in bank A. Bank A then creates a loan; how big they can make the loan depends on the margin requirement. Let’s say it’s 10%. They can make a loan of $900, because they must keep $100 (10% of $1000) in reserve. So they do that, and then it gets placed in bank B. Then bank B can make a loan of $810, keeping $90. The $810 gets deposited in bank C, which can make a loan of $729, and so on. The total amount of money in the system is the sum of all these: $1000 in bank A (remember, that deposit doesn’t disappear when it’s loaned out!), plus the $900 in bank B, plus $810 in bank C, plus $729 in bank D. After 4 steps we are at $3,439. As we go through more and more steps, the money supply gets larger at an exponentially decaying rate and we converge toward the maximum at $10,000.

The original amount is M, and then we add M(1-m), M(1-m)^2, M(1-m)^3, and so on. That produces the following sum up to n terms (below is LaTeX, which I can’t render for you without a plugin, which requires me to pay for a WordPress subscription I cannot presently afford; you can copy-paste and render it yourself here):

\sum_{k=0}^{n} M (1-m)^k = M \frac{1 – (1-m)^{n+1}}{m}

And then as you let the number of terms grow arbitrarily large, it converges toward a limit at infinity:

\sum_{k=0}^{\infty} M (1-m)^k = \frac{M}{m}

To be fair, we never actually go through infinitely many steps, so even with a margin requirement of zero we don’t literally end up with infinite money. Instead, we just end up with n M, the number of steps times the initial money supply. Start with $1000 and go through 4 steps: $4000. Go through 10 steps: $10,000. Go through 100 steps: $100,000. It just keeps getting bigger and bigger, until that money has nowhere to go and the whole house of cards falls down.

Honestly, I’m not even sure why Wall Street banks would want to get rid of margin requirements. It’s basically putting your entire economy on the counterfeiting standard. Fiat money is often accused of this, but the government has both (a) the legitimate authority empowered by the electorate and (b) incentives to maintain macroeconomic stability, neither of which private banks have. There is no reason other than altruism (and we all know how much altruism Citibank and HSBC have—it is approximately equal to the margin requirement they are trying to get passed—and yes, they wrote the bill) that would prevent them from simply printing as much money as they possibly can, thus maximizing their profits; and they can even excuse the behavior by saying that everyone else is doing it, so it’s not like they could prevent the collapse all by themselves. But by lobbying for a regulation to specifically allow this, they no longer have that excuse; no, everyone won’t be doing it, not unless you pass this law to let them. Despite the global economic collapse that was just caused by this sort of behavior only seven years ago, they now want to return to doing it. At this point I’m beginning to wonder if calling them an international crime syndicate is actually unfair to international crime syndicates. These guys are so totally evil it actually goes beyond the bounds of rational behavior; they’re turning into cartoon supervillains. I would honestly not be that surprised if there were a video of one of these CEOs caught on camera cackling maniacally, “Muahahahaha! The world shall burn!” (Then again, I was pleasantly surprised to see the CEO of Goldman Sachs talking about the harms of income inequality, though it’s not clear he appreciated his own contribution to that inequality.)

And that is why Democrats must not give in. The Senate should vote it down. Failing that, Obama should veto. I wish he still had the line-item veto so he could just remove the egregious riders without allowing a government shutdown, but no, the Senate blocked it. And honestly their reasoning makes sense; there is supposed to be a balance of power between Congress and the President. I just wish we had a Congress that would use its power responsibly, instead of holding the American people hostage to the villainous whims of Wall Street banks.

The Rent is Too Damn High

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Housing prices are on the rise again, but they’re still well below what they were at the peak of the 2008 bubble. It may be that we have not learned from our mistakes and another bubble is coming, but I don’t think it has hit us just yet. Meanwhile, rent prices have barely budged, and the portion of our population who pay more than 35% of their income on rent has risen to 44%.

Economists typically assess the “fair market value” of a house based upon its rental rate for so-called “housing services”—the actual benefits of living in a house. But to use the rental rate is to do what Larry Summers called “ketchup economics”; 40-ounce bottles of ketchup sell for exactly twice what 20-ounce bottles do, therefore the ketchup market is fair and efficient. (In fact even this is not true, since ketchup is sold under bulk pricing. This reminds me of a rather amusing situation I recently encountered at the grocery store: The price of individual 12-packs of Coke was $3, but you could buy sets of five for $10 each. This meant that buying five was cheaper in total—not just per unit—than buying four. The only way to draw that budget constraint is with a periodic discontinuity; it makes a sawtooth across your graph. We never talk about that sort of budget constraint in neoclassical economics, yet there it was in front of me.)

When we value houses by their rental rate, we’re doing ketchup economics. We’re ignoring the fact that the rent is too damn high—people should not have to pay as much as they do in order to get housing in this country, particularly housing in or near major cities. When 44% of Americans are forced to spend over a third of their income just fulfilling the basic need of shelter, something is wrong. Only 60% of the price of a house is the actual cost to build it; another 20% is just the land. If that sounds reasonable to you, you’ve just become inured to our absurd land prices. The US has over 3 hectares per person of land; that’s 7.7 acres. A family of 3 should be able to claim—on average—9 hectares, or 23 acres. The price of a typical 0.5-acre lot for a family home should be negligible; it’s only 2% of your portion of America’s land.

And as for the argument that land near major cities should be more expensive? No, it shouldn’t; it’s land. What should be more expensive near major cities are buildings, and only then because they’re bigger buildings—even per unit it probably is about equal or even an economy of scale. There’s a classic argument that you’re paying to have infrastructure and be near places of work: The former is ignoring the fact that we pay taxes and utilities for that infrastructure; and the latter is implicitly assuming that it’s normal for our land ownership to be so monopolistic. In a competitive market, the price is driven by the cost, not by the value; the extra value you get from living near a city is supposed to go into your consumer surplus (the personal equivalent of profit—but in utility, not in dollars), not into the owner’s profit. And actually that marginal benefit is supposed to be driven to zero by the effect of overcrowding—though Krugman’s Nobel-winning work was about why that doesn’t necessarily happen and therefore we get Shanghai.

There’s also a more technical argument to be had here about the elasticity of land supply and demand; since both are so inelastic, we actually end up in the very disturbing scenario in which even a small shift in either one can throw prices all over the place, even if we are at market-clearing equilibrium. Markets just don’t work very well for inelastic goods; and if right now you’re thinking “Doesn’t that mean markets won’t work well for things like water, food, and medicine?” you’re exactly right and have learned well, Grasshopper.

So, the rent is too damn high. This naturally raises three questions:

  1. Why is the rent so high?
  2. What happens to our economy as a result?
  3. What can we do about it?

Let’s start with 1. Naturally, conservatives are going to blame regulation; here’s Business Insider doing exactly that in San Francisco and New York City respectively. Actually, they have a point here. Zoning laws are supposed to keep industrial pollution away from our homes, not keep people from building bigger buildings to fit more residents. All these arguments about the “feel” of the city or “visual appeal” should be immediately compared to the fact that they are making people homeless. So 200 people should live on the street so you can have the skyline look the way you always remember it? I won’t say what I’d really like to; I’m trying to keep this blog rated PG.

Similarly, rent-control is a terrible way to solve the homelessness problem; you’re created a segregated market with a price ceiling, and that’s going to create a shortage and raise prices in the other part of the market. The result is good for anyone who can get the rent-control and bad for everyone else. (The Cato study Business Insider cites does make one rather aggravating error; the distribution in a non-rent-controlled market isn’t normal, it’s lognormal. You can see that at a glance by the presence of those extremely high rents on the right side of the graph.)

Most people respond by saying, “Okay, but what do we do for people who can’t afford the regular rent? Do we just make them homeless!?” I wouldn’t be surprised if the Cato Institute or Business Insider were okay with that—but I’m definitely not. So what would I do? Give them money. The solution to poverty has been staring us in the face for centuries, but we refuse to accept it. Poor people don’t have enough money, so give them money. Skeptical? Here are some direct experimental studies showing that unconditional cash transfers are one of the most effective anti-poverty measures. The only kind of anti-poverty program I’ve seen that has a better track record is medical aid. People are sick? Give them medicine. People are poor? Give them money. Yes, it’s that simple. People just don’t want to believe it; they might have to pay a bit more in taxes.

So yes, regulations are actually part of the problem. But they are clearly not the whole problem, and in my opinion not even the most important part. The most important part is monopolization. There’s a map that Occupy Wall Street likes to send around saying “What if our land were as unequal as our money?” But here’s the thing: IT IS. Indeed, the correlation between land ownership and wealth is astonishingly high; to a first approximation, your wealth is a constant factor times the land you own.

Remember how I said that the average American holds 7.7 acres or 3 hectares? (Especially in economics, averages can be quite deceiving. Bill Gates and I are on average billionaires. In fact, I guarantee that Bill Gates and you are on average billionaires; it doesn’t even matter how much wealth you have, it’ll still be true.)

Well, here are some decidedly above-average landowners:

  1. John Malone, 2.2 million acres or 9,000 km^2
  2. Ted Turner, 2 million acres or 8,100 km^2
  3. The Emmerson Family, 1.9 million acres or 7,700 km^2
  4. Brad Kelley, 1.5 million acres or 6,100 km^2
  1. The Pingree Family, 800,000 acres or 3,200 km^2
  1. The Ford Family, 600,000 acres or 2,400 km^2
  1. The Briscoe Family, 560,000 acres or 2,270 km^2
  2. W.T. Wagonner Estate, 535,000 acres or 2,170 km^2

I think you get the idea. Here are two more of particular note:

  1. Jeff Bezos, 290,000 acres or 1,170 km^2
  1. Koch Family, 239,000 acres or 970 km^2

Yes, that is the Jeff Bezos of Amazon.com and the Koch Family who are trying to purchase control of our political system.

Interpolating the ones I couldn’t easily find data on, I estimate that these 102 landowners (there were ties in the top 100) hold a total of 30 million acres, of the 940 million acres in the United States. This means that 3% of the land is owned by—wait for it—0.000,03% of the population. To put it another way, if we confiscated the land of 102 people and split it all up into 0.5-acre family home lots, we could house 60 million households—roughly half the number of households in the nation. To be fair, some of it isn’t suitable for housing; but a good portion of it is. Figure even 1% is usable; that’s still enough for 600,000 households—which is to say every homeless person in America.

One thing you may also have noticed is how often the word “family” comes up. Using Openoffice Calc (it’s like Excel, but free!) I went through the whole top 100 list and counted the number of times “family” comes up; it’s 49 out of 100. Include “heirs” and “estate” and the number goes up to 66. That doesn’t mean they share with their immediate family; it says “family” when it’s been handed down for at least one generation. This means that almost two-thirds of these super-wealthy landowners inherited their holdings. This isn’t the American Dream of self-made millionaires; this is a landed gentry. We claim to be a capitalist society; but if you look at who owns our land and how it’s passed down, it doesn’t look like capitalism. It looks like feudalism.

Indeed, the very concept of rent is basically feudalist. Instead of owning the land we live on, we have to constantly pay someone else—usually someone quite rich—for the right to live there. Stop paying, and they can call the government to have us forced out. We are serfs by another name. In a truly efficient capitalist market with the kind of frictionless credit system neoclassicists imagine, you wouldn’t pay rent, you’d always pay a mortgage. The only time you’d be paying for housing without building equity would be when you stay at a hotel. If you’re going to live there more than a month, you should be building equity. And if you do want to move before your mortgage ends? No problem; sell it to the next tenant, paying off your mortgage and giving you that equity back—instead of all that rent, which is now in someone else’s pocket.

Because of this extreme inequality in land distribution, the top landholders can charge the rest of us monopolistic prices—thus making even more profits and buying even more land—and we have little choice but to pay what they demand. Because shelter is such a fundamental need, we are willing to pay just about whatever we have in order to secure it; so that’s what they charge us.

On to question 2. What happens to our economy as a result of this high rent?

In a word: 2009. Because our real estate market is so completely out of whack with any notion of efficient and fair pricing, it has become a free-for-all of speculation by so-called “investors”. (I hate that term; real investment is roads paved, factories built, children taught. What “investors” do is actually arbitrage. We are the investors, not them.)

A big part of this was also the deregulation of derivatives, particularly the baffling and insane “Commodity Futures Modernization Act of 2000” that basically banned regulation of derivatives—it was a law against making laws. Because of this bankers—or should I say banksters—were able to create ludicrously huge amounts of derivatives, as well as structure and repackage them in ways that would deceive their buyers into underestimating the risks. As a result there are now over a quadrillion dollars—yes, with a Q, sounds like a made-up number, $2e15—in nominal value of outstanding derivatives.

Because this is of course about 20 times as much as there is actual money in the entire world, sustaining this nominal value requires enormous amounts of what’s called leverage—which is to say, debt. When you “leverage” a stock purchase, for example, what you’re doing is buying the stock on a loan (a generally rather low-interest loan called “margin”), then when you sell the stock you pay back the loan. The “leverage” is the ratio between the size of the loan and the amount of actual capital you have to spend. This can theoretically give you quite large returns; for instance if you have $2000 in your stock account and you leverage 10 to 1, you can buy $20,000 worth of stock. If that stock then rises to $21,000—that’s only 5%, so it’s pretty likely this will happen—then you sell it and pay back the loan. For this example I’ll assume you pay 1% interest on your margin. In that case you would start with $2000 and end up with $2800; that’s a 40% return. A typical return from buying stock in cash is more like 7%, so even with interest you’re making almost 6 times as much. It sounds like such a deal!

But there is a catch: If that stock goes down and you have to sell it before it goes back up, you need to come up with the money to pay back your loan. Say it went down 5% instead of up; you now have $19,000 from selling it, but you owe $20,200 in debt with interest. Your $2000 is already gone, so you now have to come up with an additional $1,200 just to pay back your margin. Your return on $2000 is now negative—and huge: -160%. If you had bought the stock in cash, your return would only have been -5% and you’d still have $1900.

My example is for a 10 to 1 leverage, which is considered conservative. More typical leverages are 15 or 20; and some have gotten as high as 50 or even 70. This can lead to huge returns—or huge losses.

But okay, suppose we rein in the derivatives market and leverage gets back down to more reasonable levels. What damage is done by high real estate prices per se?

Well, basically it means that too much of our economy’s effort is going toward real estate. There is what we call deadweight loss, the loss of value that results from an inefficiency in the market. Money that people should be spending on other things—like cars, or clothes, or TVs—is instead being spent on real estate. Those products aren’t getting sold. People who would have had jobs making those products aren’t getting hired. Even when it’s not triggering global financial crises, a market distortion as large as our real estate system is a drain on the economy.

The distorted real estate market in particular also has another effect: It keeps the middle class from building wealth. We have to spend so much on our homes that we don’t have any left for stocks or bonds; as a result we earn a very low return on investment—inflation-adjusted it’s only about 0.2%. So meanwhile the rich are getting 4% on bonds, or 7% on stocks, or even 50% or 100% on highly-leveraged derivatives. In fact, it’s worse than that, because we’re also paying those rich people 20% on our credit cards. (Or even worse, 400% on payday loans. Four hundred percent. You typically pay a similar rate on overdraft fees—that $17.5 billion has to come from somewhere—but fortunately it’s usually not for long.)

Most people aren’t numerate enough to really appreciate how compound interest works—and banks are counting on that. 7%, 20%, what’s the difference really? 3 times as much? And if you had 50%, that would be about 7 times as much? Not exactly, no. Say you start with $1000 in each of these accounts. After 20 years, how much do you have in the 7% account? $3,869.68. Not too shabby, but what about that 20% account? $38,337.60—almost ten times as much. And if you managed to maintain a 50% return, how much would you have? $3,325,256.73—over $3.3 million, almost one thousand times as much.

The problem, I think, is people tend to think linearly; it’s hard to think exponentially. But there’s a really nice heuristic you can use, which is actually quite accurate: Divide the percentage into 69, and that is the time it will take to double. So 3% would take 69/3 = 23 years to double. 7% would take 69/7 = 10 years to double. 35% would take 69/35 = 2 years to double. And 400% would take 69/400 = 0.17 years (about 1/6, so 2 months) to double. These doublings are cumulative: If you double twice you’ve gone up 4 times; if you double 10 times you’ve gone up 1000 times. (For those who are a bit more numerate, this heuristic comes from the fact that 69 ~ 100*ln(2).)

Since returns are so much higher on other forms of wealth (not gold, by the way; don’t be fooled) than on homes, and those returns get compounded over time, this differential translates into ever-increasing inequality of wealth. This is what Piketty is talking about when he says r > g; r is the return on capital, and g is the growth rate of the economy. Stocks are at r, but homes are near g (actually less). By forcing you to spend your wealth on a house, they are also preventing you from increasing that wealth.

Finally, time for question 3. What should we do to fix this? Again, it’s simple: Take the land from the rich. (See how I love simple solutions?) Institute a 99% property tax on all land holdings over, say, 1000 acres. No real family farmer of the pastoral sort (as opposed to heir of an international agribusiness) would be affected.

I’m sure a lot of people will think this sounds unfair: “How dare you just… just… take people’s stuff! You… socialist!” But I ask you: On what basis was it theirs to begin with? Remember, we’re talking about land. We’re not talking about a product like a car, something they actually made (or rather administrated the manufacturing of). We’re not even talking about ideas or services, which raise their own quite complicated issues. These are chunks of the Earth; they were there a billion years before you and they will probably still be there a billion years hence.

That land was probably bought with money that they obtained through monopolistic pricing. Even worse, whom was it bought from? Ultimately it had to be bought from the people who stole it—literally stole, at the point of a gun—from the indigenous population. On what basis was it theirs to sell? And even the indigenous population may not have obtained it fairly; they weren’t the noble savages many imagine them to be, but had complex societies with equally complex political alliances and histories of intertribal warfare. A good portion of the land that any given tribe claims as their own was likely stolen from some other tribe long ago.

It’s honestly pretty bizarre that we buy and sell land; I think it would be valuable to think about how else we might distribute land that didn’t involve the absurdity of owning chunks of the planet. I can’t think of a good alternative system right now, so okay, maybe as a pragmatic matter the economy just works most efficiently if people can buy and sell land. But since it is a pragmatic justification—and not some kind of “fundamental natural right” ala Robert Nozick—then we are free as a society—particularly a democratic society—to make ad hoc adjustments in that pragmatic system as is necessary to make people’s lives better. So let’s take all the land, because the rent is too damn high.