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.

Roots of Government

Government is coercive. Concentrated application of force is what government is for.

I imagine two stories for how government arises. The first is government as the embodiment of the social contract, where the contract in question is not figurative or proverbial, but literal. According to this story, government is chartered through an agreement among parties to defer power to an enforcer. This is the process by which townships of the old west incorporated, and hired a mayor to attend to administer the activities of government and a sheriff to physically enforce law and order. The people of the town authorized the government explicitly, and explicitly agreed to be subject to the law and to the officers who carried it out. They further participated in government through town hall meetings and by bearing arms in the defense of the law as deputies.

This same kind of government can be found in clubs and private organizations, and in businesses. The fact that in this story government originates in an agreement among the parties to be governed should not obscure the fact that the government is adopted specifically for the purpose of exercising coercion over the governed. Consider the freelance labor crew who wishes to maximize their profit. They may choose to hire a foreman who is brutally forceful, in order to ensure that every member of the crew works hard and no one is allowed to free ride.

In the second story of the origin of government, government is imposed on local people from outside of their own community, and without their consent. This is the feudalistic story of government, where small farming villages are robbed repeatedly by regional bandits. Eventually the theft becomes routine, and competent leadership among the bandits leads to a sustainable level of pillaging that doesn't destroy the farmer's ability to continue producing each year. Full-fledged feudalism is justified as protection of the serf class by the bandits, who claim that the bandits of the next fiefdom over are far more brutal than they are. So, a social contract-like mantle legitimizes the theft and coercion.

In both of these stories, government exists for the purpose of exercising force.More particularly, it is for the purpose of imposing the will of a powerful coalition, who may be a majority or may simply be a sufficiently powerful elite, upon the rest of the society. The townsfolk impose law and morality upon the lawless and the eccentric, the crew of laborers impose hard work upon the lazy, and the bandits impose taxation upon the serfs. The difference is in what fraction of the population is represented by the government, and what fraction is victimized by it.

America's Competitive Edge

How did America become and why does it remain a super power? Here some possible factors:

• Large size - Basic economics tells us that there are huge advantages to be gained from specialization and trade. However, the magnitude of the advantage depends on the size of the market. For example, I can't specialize in making toilets if I live in a small village of population 100 and have no contact with the rest of the world. Why not? Because I won't have a large enough market to be able to sustain myself in that specialty. As a result, when someone does need a new toilet in my small isolated village, they will have to either produce it themselves, or hire someone in the village who has made toilets before to make one. Needless to say, quality will be low, and price will be high. America has at times been somewhat isolated from the rest of the world in trade terms. However, even during those times the US was a relatively large country with a large market for goods and services, and so it captured a large benefit from specialization within the market. I think this is also much of the explanation for the Soviet Union's ability to remain a super power for many decades during which it was economically isolated from the west.

• Free Market Capitalism - There are a couple of important features of free market capitalism that I believe make a big difference to the amount of wealth that is produced within the society. First, the freedom to compete within the marketplace spurs innovation, both for market incumbents and for new entrants to the market. I feel this every day at work (I'm an engineer working for a manufacturing firm) as we are constantly seeking to improve our processes and products in order to remain viable within the market. Everyone in the company knows that standing still means we'll all be out of jobs in a very short time because our competitors will beat us in the market with better products at lower prices. The second part of free market capitalism that is important is that it rewards good ideas and good execution, and punishes bad ideas and bad execution. Inefficient firms die while efficient firms take market share. The image below illustrates how differently capitalism is viewed in much of the rest of the world. If free market capitalism really IS an important part of high productivity and high standard of living, then those who reject it are putting the gun to their own heads.

•  Regime Certainty - This is the opposite of regime uncertainty, where no one is sure if the law will be the same today as it is tomorrow, whether there will be civil war tomorrow, whether property rights will be respected tomorrow, etc. The US has been stable and secure, with mostly predictable application of the law, for decades. This matters! When there is regime uncertainty investment drops because the value of any investment is a value that will mature over time, and uncertainty about the future of something as basic as the law or property rights decreases the value of any and all investment. Look to sub-Saharan Africa for an example of what regime uncertainty does to growth. Of course, the concept of regime certainty also embraces the fact that America was not ravaged by two world wars during the 20th century.

•  Immigration - The US accepts more immigrants than does any other country in the world. The US is characterized by its immigrant population, including those of us whose ancestors came here prior to the 1930s, and now think of ourselves as 'typical' Americans. I think that it is the case that the US has been very successful at attracting the best minds and the most innovative people from around the globe, in part because of the benefits of free market capitalism and regime certainty. Innovative people are drawn to places where they will be free to innovate. Entrepreneurs are drawn to places with regime certainty. I think this is much of the explanation for why the US is such an innovative and entrepreneurial nation. Listen to Paul Graham's comments on immigrants starting businesses to get a better idea of what I mean.

Now I know that this list isn't exhaustive, but these are the main things that come to my mind when I puzzle about the US and its accomplishments and place in the world. What have I left out? Or better yet, what is wrong in my approach altogether to this question?

Picking Winners

In an earlier post I asked "How do you think the founders of Tesla feel about GM being propped up by the government?" Well, it turns out that Tesla can't complain too much. I guess I should have known.


I'm worried about the government funding companies, whether startups or established players, because government investment drives out private investment, and because the companies who receive support have a competitive advantage over the ones that don't. Why is this an important problem? Because the government doesn't know which companies are going to be enormously productive, and which ones won't. Just as an example, what if the government had propped up Ask Jeeves at the expense of Google? Of course I don't actually know what would have happened, but it's possible and maybe likely that Google would have been crushed or absorbed before it had a chance to bring so much value to so many people.


Econtalk has a great interview with Y-combinator partner Paul Graham. Graham says that government attempts to 'create the next Google' are doomed to failure because no one knows what the next Google is going to be like. By definition, the next big innovation is going to be something that is not currently understood well enough for the value to be obvious. It's ludicrous to me to think that government bureaucrats, no matter how competent, are going to be able to predict which companies are the future sources of important innovation, and which aren't.

China is Subsidizing America's Standard of Living

Gary Becker does a good job summarizing the argument against trying to convince China to let the yuan fall against the dollar. Basically it goes like this: We want to buy Chinese goods, but Chinese goods can only be purchased with Chinese currency, so we give dollars to the Chinese central bank in exchange for yuan. But the Chinese government has this policy where they always give us more yuan than our dollars are really worth. So it's a good deal for us, and a bad deal for them. Why do they do that?

Even more relevant to Americans is the question, why is Obama trying to convince the Chinese to STOP doing that?

The comments on Becker's blog aren't working, but here's what I tried to post in reply:

Can it really be sheer foolishness on the parts of both the Chinese and American governments? What can their respective motives be? 

In America there has been a long term advertising campaign against any trade deficit, and many American voters have been persuaded to embrace a cause (make imports more expensive) that is likely not in their own interest. Have unions and export businesses so completely captured trade policy in the US? 

Is there a similar explanation for the Chinese policy?

What is Redistribution of Wealth?

It is:

• The Farm Bill
• The exercise of Eminent Domain
• Progressive taxes
• Regressive taxes
• The building of highways
• Subsidizing child care / schooling / college
• Tariffs
• Social Security
• Medicare / Medicaid
• Disaster relief
• Patents and Copyright

and many, many other activities of government.