Bad Investment

I kind of understand the reasons behind the dot-com bubble. The emergence of new, paradigm-shifting technology suggested that untold fortunes might be made by the fearless who got in on the ground floor. The real estate bubble is more mysterious.

Who really thought that housing prices were accurately reflecting a balance between the number of available units (supply) and the ability of consumers to pay (demand), circa January 2006? Or even a year earlier, for that matter. Even casual attention to the loan-making process during this time would suggest a problem with the direction of the investments that were being made. Hindsight is 20/20, but at the time I did decline to take on such a loan myself because it just all seemed so ridiculous (though I should have taken it, had I been a more rational actor). 

I'm clearly no economist, but I think that the bubbles during the last halves of the last two decades must have a common cause. In both cases enormous investment was made on a basis of careless speculation bordering on willful self-injury. Why?

Some people talk about interest rates being artificially low and blame Greenspan and Bernanke. I'm no expert on that one, but I do wonder whether interest rates were low only because of the actions of the Fed. My suspicion is that low interest rates alone didn't cause all that bad investment, but that both the low interest rates and the bad investment were caused by a third factor.

I'm not quite sure how to phrase it, but doesn't it seem like there was an awful lot of capital that needed someplace to go during both of these booms? I've heard the phrase global savings glut bandied about, but I'm not sure exactly how to evaluate that. One thing seems sure: typical due diligence prior to investing was not being practiced in 1996 or in 2006. Is it simply that there were not enough quality investment opportunities available during these periods? Too much money chasing too few opportunities? That story seems to fit the facts, but I can't quite make sense of it.

Under what circumstance is there too much money ready to be invested? It's not the kind of thing I've heard debated, but I can imagine a world where saving is happening at a higher rate than is consumption. In that world, each saved dollar 'wishes' to be put to use producing, but most production is giving slim returns because demand is weak (e.g. most needs are already satisfied, so there's not a strong incentive to buy more). That doesn't sound like the USA we know and love, and whose savings rate has been negative in very recent memory. But it might be a description of the world when evaluated on net. 

Don't look at me like I have data to support that argument, because I don't. But imagine how a world like the one I've described might behave. Because many, many people are choosing to postpone spending until a later date, there are many dollars available for investment. But they can't be profitably put to work building factories to make gadgets to sell to people, because people are saving instead of buying gadgets. So investment dollars are available cheap, chasing every opportunity to earn some kind of return. Consequently, interest rates fall (with or without Bernanke's say so). In such an environment risky investments that pay well look much more attractive than they usually do because investors are desperate. Investment schemes based on the promise of unproven new technology or the faulty hope of perennially rising home values almost make sense. Eventually this kind of bad investment gains a certain amount of respectability and even becomes an indispensable part of every portfolio, because no one wants to be left earning pennies on securities that give Treasury Bill-like returns while the stupid money (other banks, municipalities, and private investors) make relatively good returns and don't seem to be blowing up.

This story is so simple that it must be wrong. Please tell me how it's wrong.

But if we assume that it's right, what policy can fix it? Or should it be fixed?

What if the solution is for governments to tax and spend in order to forcibly lower the savings rate?

What if we believe that taxing and spending is the solution, but it turns out that taxing and spending in the US doesn't fix the problem because we don't save much anyway, and that the real savers are in China and India?

Discouraging Effort and Success

Why do we tax labor? We know that any tax on an activity discourages people from engaging in that activity by reducing the rewards for doing it. So why do we tax hard work, production, and wise investment? Do we really want less of those things?

We need to fund our government (some claim), so we need to tax something. Why not tax behaviors that we want less of? Wouldn't that be killing two birds with one stone?

What would happen if we ditched all income taxes (including capital gains, and corporate income taxes) in favor of taxation levied exclusively against consumption? How would our society change?

I imagine a system wherein my income is not monitored by the government, but the total amount of my consumptive spending is instead. It's easy enough to do - just give up cash and require banks to report the amount of spending. As long as my consumptive spending total for the tax period stays below a legally established minimum, I pay no tax. But when my total rises above that level, I begin to pay tax out of each additional dollar spent. So if I don't spend much beyond the limit, the taxation I experience will be very low.

There are many advantages to such a system. For one, we'd stop punishing smart and hardworking people for being so productive. Every dollar they earn would be theirs to keep. This would include dollars earned for good investments (capital gains). Similarly, we'd stop punishing businesses for competence in producing and selling products and services to people who need them. When a highly successful business has to pay a large amount of income tax while its less successful competitor pays no tax (due to writing off business losses) the playing field is being unfairly tipped to reward poor performance! Not only that, but why tax production at all when production is what gives us the things we need and desire?

Also very important is the fact that taxing consumption, instead of labor, production, and investment, allows individuals to adjust their tax liability to fit their circumstances and desires. If I don't want to pay so much in taxes this year, I can reduce my consumption and pay less. And, I bear no penalty for working extra hard to earn additional money to fund my future, or my children's future.

Under this kind of system saving would be strongly incentivized. For those who wished to avoid taxation, saving and wise investment would be the safest harbor for their money. Everyone would be faced with compelling reasons to defer spending to a later date. Government subsidized retirement could become unnecessary for average Americans.

It's possible to take this idea to a more extreme level and suggest that leisure (time spent not producing or learning) could be taxed when it exceeded a certain minimum amount. This could spur the indolent and chronically unemployed (whether poor or wealthy) to return to productivity, lending their efforts to the improvement of society.

Undoubtedly there are many weaknesses in such a plan, and opportunities for clever gaming of the system. But that is no different from our current system for taxation.

Are there structural problems with this proposition?

Quote of the Day - Me

'Human Dignity' seems like weak wording for the issue of who gets to summer in Provence and who gets to die of dysentery before reaching adulthood.


Look for me in the comments at http://factsandotherstubbornthings.blogspot.com/2010/07/on-inequality.html

Well-Off

Many economists build a case against policies that are aimed at reducing inequality in income and wealth. Their argument rests on two premises:

1. Societies should seek to be maximally productive, because this is the best way to provide for the needs of the members of the society, and
2. There is a trade-off between equality and efficiency - policies that promote equality tend to reduce productivity.

I'm not convinced. 

The first premise invokes Coase: well-defined property rights ensure that any redistribution (of wealth, property, or rights) that will increase societal welfare will happen through the mechanism of the market without the need for the intervention of the government - provided that transaction costs are negligible. 

Transaction costs are rarely negligible, but even if we set that aside there is still a problem. Arnold Kling gives an example that illustrates the problem with Coase. Prof. Kling considers the case of a biker who needs to use a bike path that crosses private land. Here's my retelling: The biker is willing to pay a heavy toll (a large percentage of his total wealth) in order to be allowed to use the path, because he wants to reach the hospital where his father is dying to see his father one last time. If he doesn't use the path then he has to take a much longer route and will not reach the hospital in time. The landowner wants to exclude the biker from using the path because the landowner doesn't like to have strangers on his land. Let's assume essentially zero transaction costs - the biker carries a transponder that automatically computes and pays his toll (with his agreement), according to the rate the landowner has set. The landowner sets the toll at a level that compensates him for the unpleasantness he experiences at having strangers cross his land. 

The problem is that the biker is very poor, and the landowner is very wealthy, and as a result, the price the landowner sets is much higher than what the biker can pay, even though the biker places a very high value on using the path. Under Coase, as long as the biker gets more value out of using the path than the landowner loses when the biker uses the path, then they should be able to agree on a price that compensates the landowner. Why doesn't that work in this case? Clearly, the biker places a very high intrinsic value on using the path - equal to a large percentage of his total wealth!

It doesn't work because the landowner and the biker value money, dollars, differently. Essentially the biker and the landowner are not using a common unit of exchange. You could say that the landowner sets the price in apples, but that the biker is paying in oranges. Or to highlight the difference in value, the landowner is setting the price in coal, but the biker must in diamonds. 

There is a further, even more radical implication to all of this, and that is that when there are differences in wealth among the members of a society, transfers from the wealthy to the poor INCREASE net societal welfare. This is because when a dollar is taken from a wealthy man and given to a poor man, the loss of intrinsic value experienced by the rich man is less than the gain in intrinsic value experienced by the poor man. Prices don't clear the market because prices are not established in units of intrinsic value.

As far as premise number two, I haven't seen any good measures of the magnitude of that trade-off. Is it significant? Is it significant at some degrees of intervention, but not significant at others? If you know where i can see data that describe this relationship I would be very interested.

PostScript: None of this addresses the libertarian arguments against policies that are aimed at reducing inequality. Nor does it address the question of whether governments are needed to effect redistribution (when it is desirable), or whether non-coercive institutions and norms could be a more optimal solution than government.

I Don’t Know How I Lived Without It

A few years ago I bought an expensive (for my budget) vacuum cleaner. My choice can be justified in sort of rational terms. I was tired of vacuums that didn’t work well, and wanted some particular features that I felt sure would ease the chore of vacuuming. Making the work easier would translate into more frequent vacuuming, and a pleasanter and more hygienic home. I also felt sure that buying higher quality would result in a longer service life with fewer repairs.

But my real reason for deciding to spend more money and get a ‘nicer’ vacuum was different from any of that. It made me feel good to be able to buy a product that represented a sort of utilitarian luxury. I enjoyed that the vacuum was well-designed, and that its injection-molded parts fit well. And it was more powerful and more effective than my previous vacuum, and was generally easier to use. 

It wasn’t perfect. In fact there were things about it that were simply poorly thought out and didn’t work as intended, but I almost didn’t notice because I was so pleased to have purchased a quality vacuum. In retrospect I’m quite certain I could have gotten as much carpet-cleaning effectiveness, ease of use, and durability out of a cheaper machine.

The weird thing is that I don’t regret my decision at all. As a matter of fact I caught myself looking at newer, more expensive vacuums by the same manufacturer just the other day. I wanted to have the same experience of purchasing quality all over again.

We’re all familiar with the concept of conspicuous consumption and how people desire to signal their position in the tribe with cars, clothes, etc. But there is another kind of signaling that we do through our unseen consumption. These are the signals we send to ourselves that help us to feel that we are OK. Safe in our own hands.

The title of this post illustrates what it really means to us to be able to provide ourselves with luxuries. I feel so contented now with what I’ve been able to provide for myself that I don’t know how I lived without this feeling.

It is irrational, because I had the ability (and with it the security and the option) before I actually made the purchase. I should have already felt the benefit. And I did. I immensely enjoyed the process of shopping for my vacuum, even of looking for the best price possible. But I knew that if I decided against buying it that it would be because I couldn’t quite stretch that far, and that would tell me something about the limits of my resources, and my own exposure to the vagaries of chance.

Can’t we do better than that?

Hat tip to Eric Falkenstein for ideas about consumption and envy.