Friday, November 17, 2017

Housing: Part 269 - Maybe it's not just the Closed Access cities.

As reader Benjamin Cole frequently points out, the constraints on new building are not limited to urban cores.

It could just be most noticeable there because that is where demand is the highest for new building.

Here is a great post at "Granola Shotgun" about the generalized problem of costs imposed on investors who want to improve properties or start new small businesses. (HT: MR)

At the post, the author runs through several examples of basic infrastructure and building improvements in places that really could use them that are stymied because of the array of regulatory hurdles that are in place.

Really, this gets at the heart of the problem with the current discourse about moneyed interests, monopoly profits, haves vs. have-nots, etc.  So much of the discourse builds on the notion that moneyed interests benefit from deregulation.  But, we can see in the post at Granola Shotgun, in so many little ways, how small, little, well-meaning regulations pile up, add tremendous fixed costs to any sort of at-risk investment, and these costs are extremely damaging to small-scale investments.  Those investors are willing to take on significant risks.  Taking on those risks is a service they are providing to their communities.  But, the risks aren't economical if they have a quarter-million dollar fixed cost.

On the other hand, a Burger King franchise, for instance, has a pretty good idea of the cash flow expectations a new location will have, so those fixed costs aren't a large of a problem for a large organization with an established model.  And, those fixed costs make sure the mom-n-pop hamburger stand doesn't open up in the old abandoned bank building down the block.

Maybe, to an extent, this is a universal problem.  In urban centers that have this problem, but that also have a tremendous amount of economic momentum, development of the city infrastructure is obstructed, but the existing infrastructure is valuable enough to induce a bidding war for access to the infrastructure that exists.  Those are the Closed Access cities.

Then, there is a middle tier of cities who have some combination of growing economies, more liberal land-use policies, and open spaces for building that can avoid this problem, and those cities take in many in-migrants, grow, and maintain a moderate level of income growth that is somewhat universally available to any households who can move there.

Then, there is a bottom tier of cities and towns that aren't growing.  There is no point in growing out into the undeveloped surroundings, because the existing town is underutilized.  (Although, in some cases, we do see dying Main Streets while new retail centers open up in places like highway intersections on the edge of town.  Of course, since the country is bound up in its politics by attribution error, this just gets blamed on the capitalists involved in the developments, and not on the structural problems that lead to it.)  So, while incomes rise in the Closed Access cities because of the bidding war to get into a space with limited infrastructure, incomes in these cities and towns decline.  And that decline is hastened by the inability to improve existing infrastructure.

Maybe, it's all just one big problem, and the problem is decades and decades of unfunded mandates.  As John Cochrane comments about all of these regulations:
These (KE: mandates like building code updates, parking requirements, landscaping, etc.) are important, and desired, public goods. The problem is, these things we want cost a lot of money. $340,000 for one firehouse. The town wants them, but is not willing to raise general taxes to pay for them.  It's sane enough to realize that it cannot make owners of existing properties fork over $340,000 per firehouse. So it passes, what is in essence, a lump-sum tax on people who want to start new businesses, or use the property up the economic foodchain. Alas, the people second-most-unlikely to be willing or able to pay such taxes are small-scale entrepreneurs trying to start a marginally better business in a run down neighborhood.  So nothing happens until either the town reverts to wasteland, or until nearby prospects brighten enough that a large commercial developer can move it back to the top of the food chain, and also extract enough tax breaks so that in essence the city does pay for the public goods from general taxes in the first place.
The thing that makes the Closed Access cities different is that these problems have creeped so far into dysfunction that even the developers who can run the gauntlet are harassed because they have to pass the costs of those obstacles on to the residents and consumers of those new homes and shops. Having effectively pressed all of those costs  onto the developers, and having been convinced that governance is some sort of redistributionist magic machine that forces costs onto capital that are simply paid for by capital's bottomless vat of funds, some locals are offended when those costs become visible to them and reality comes crashing into that fantasy.

And the irony is that when all of this adds up to economic inequity and stagnation, so many blame deregulation.  If someone living in a place like San Francisco, paying $4,000 in rent on a 1,000 square foot condo with an hour commute, can convince themselves that deregulation is the cause of rising economic rents, and economic opportunities moving out of reach of common people, then, I don't know what to say to them.  And, you see this all over the place.  Expensive housing units are blamed on investors and developers pushing up prices and rents.  If what we desperately need is an influx of capital to provide housing in locations that are bursting with opportunities for working class employment, I don't see how that problem can be solved without a wholesale change in perspective.  When this can appear in a Bloomberg article:
Housing advocates have called for federal intervention: They complain that lower-income home buyers are being shut out of the market, worry that the need for big profits will push up rents and are skeptical that the return of the real estate money machine will end well. “The last time Wall Street devised a plan to make mountains of money off our homes it ended catastrophically,” the Atlanta branch of the American Friends Service Committee said on its blog after a protest at a foreclosure auction that was dominated by private-equity bidders. Economists at the Federal Reserve have noted the same potential for danger.
...how can we ever really supply enough housing?  What source of capital is acceptable?  That's one of the things I worry about if I am able to get this project into the public eye.  What if I get that sort of question - "What if the need for big profits will push up rents?" - and I'm facing a room full of people who sincerely want to know the answer?  What do you say to that?  I wouldn't even know how to begin unwinding the web of odd presumptions that the question is resting on.  But, this seems to be a consensus way of thinking.

In this context, maybe the best solution we can hope for is to just make housing a federal service.  Put out $2 trillion in Treasuries to fund 10 million units, placed in cities with high incomes.  Even subsidized rents would create a huge amount of Federal revenue.  It would probably be a disaster, in the end.  But, what choice do we have as long as every possible source of private capital is presumptively derided?



I wonder if we can generalize this to the broader economy, and not just to building.  What if the tech sector is like the outskirts of town, where new things can happen without the legacy of obstructions?  And, healthcare, education, etc. are like the old Main Street.

Wednesday, November 15, 2017

October 2017 CPI

TTM Shelter inflation at 3.2%.  Core CPI ex. Shelter at 0.7%.

This still could go either way.  It looks like the Fed will hike rates in December.  Are there enough headwinds to keep things going the right direction?  Rising interest rates late last year probably helped to passively loosen policy, but the yield curve has flattened somewhat since then.  It will be interesting to watch the yield curve over the next few months.

The story remains the same.  Maybe we eke out a few years of moderate growth, but we are on the borderline of too tight policy that could turn disastrous.  And, of course, our horrible collection of policies regarding housing continues to stifle growth and labor mobility, while claiming a decent portion of economic growth as a transfer to rentiers.

Tuesday, November 14, 2017

Great news for liquidationists!

I was reading this terrible article with all the standard tropes about how private equity debt causes all the world's problems, and I came across this:
The Republican tax plan actually recognizes this. The House bill proposed a cap on the deductibility of interest payments over 30 percent of a company’s earnings; the Senate bill defines earnings in such a way to reduce that cap even further. This would discourage some debt-fueled buyouts, and private equity firms are screaming about it.
I didn't realize this was how the tax bill was structured.  Now, I agree that in an optimal system, we would re-engineer the tax code to stop favoring debt.  It seems clear to me that the best approach is to simply reduce corporate income taxes to minimal levels.  Because the incidence of corporate taxation is pretty diffused and because of its side effect as a highly regressive subsidy for homeowners, not only would the lower corporate tax rate reduce the incentive to debt financing, but it would also probably be a progressive change to the tax code.

I don't really know if the tax code should be any more progressive.  It seems pretty progressive already.  But, my point is, if you want a more progressive tax code, a corporate tax cut is probably a pretty good way to get there.  It's not going to be part of a CBO score, but I think if we implemented a large enough corporate tax cut, the disappearance of several tax incentives for high tier residential investment would lead to a decline in high tier prices and high tier housing expenditures.

But, why simplify things when we can make the code more complicated?  So, instead of this, Congress is talking about removing the interest expense deduction.  And, even worse, making it a function of earnings.

Of course, all of the focus of the chattering class is on private equity leveraged buyouts.  But, most firms with large debts are mature, asset-intensive firms like utilities with very stable income streams.  Investors don't like to lend to overleveraged volatile firms.  In fact, that's the reason that firms like Sears - a focus of the terrible article - leverage up, because eventually they become real estate investment trusts with a vestigial retailer attached to them.  Blaming the management for trying to manage the drawdown of that organization is like blaming the auctioneer for your foreclosure.

The other type of business that is overleveraged is a firm that is out of equilibrium - a firm that has just experienced a major shock to earnings or revenue.

And, this is what should make the liquidationists happy.  When we have a systemic contraction, which is frequently related in some way to monetary policy, there is a certain portion of the American populace, punditry, and economics profession, that cheers the dislocation.  It's seen as a way to clear out the chafe.  Let the weaklings fail.

I consider this to be the broken window fallacy applied to nominal economic growth.  There are plenty of ways for people to be harmed without us doing it on purpose in order to discipline them.

But, for liquidationists who see economic contractions as beneficial, this tax policy is ingenious.  First, a nominal shock hits the economy.  Some firms will be hurt worse than others.  Their earnings will collapse.  Usually, when that happens, one of the largest problems for the firm is paying creditors or re-issuing debt that matures in a market that is highly unfavorable.  Now, in addition to those problems, we will treat that shock as a trigger to raise their taxes!

Do you see why the liquidationists should love this?  Now, monetary and fiscal policy will be naturally aligned.  Fiscal policy will be targeting the "chafe", putting those firms out of business, while the good, profitable firms thrive with a lower tax rate.

In a general sense, I am afraid that governance has become so complicated and convoluted at every level, even if good ideas see some light of day, they get tortured and turned into terrible ideas by the time our politics are done with them.  I don't see how this improves without a revolutionary simplification.  But, there is such a shared sense of acrimony in this country.  It is obvious on the right, but really, just as obvious on the left, as the terrible article makes clear, that our citizenry and our leaders couldn't possibly be trusted to do it right.  I mean, we just had a financial crisis that basically was caused because there was a national consensus that stability would prevent other people from experiencing financial catastrophe, and imposing that catastrophe on them was just too important, even if we all had to share in the crisis in order to impose it.

Sunday, November 12, 2017

Housing: Part 268 - Trickle Down Economics meets Housing Policy

"Trickle down" economics refers to economic policies that are meant to remove obstacles to private capital development.  The story generally told (skeptically) is that if employers pay lower taxes, they will invest more, hiring more workers and raising wages.  This tends to rhetorically frame economic activity in a way that focuses on anecdotal transitional shifts between employers and employees.

As framed, there isn't anything explicitly false about this description, and, as framed, this story is one about which we might be wise to be skeptical.  The devil is in the framing, because:
  • Systematic effects are more important than anecdotal effects.
  • Long-term effects are more important than transitional effects.
  • The relationship between producers and consumers is more important than the relationship between employers and employees.
In each case, "trickle down" rhetoric focuses on the least relevant ways of contextualizing capital-friendly economic policies.

This rhetoric is even used in housing markets.  In a 2015 opinion piece in the San Francisco Examiner, titled "It's still called trickle-down economics, even in San Francisco", then San Francisco Supervisor David Campos wrote:
Free marketeers are claiming that if we build enough luxury housing it will eventually trickle down and turn into housing for the poor and middle class. This is the failed policy of Reaganomics at its worst.
I had referenced the Campos piece before.  I was revisiting it recently, and I had forgotten how obtuse it was.  It is strange that the "trickle down" rhetorical logic is applied here to housing.  First, housing is basically a pure form of capital.  There is no employer/employee relationship.  This is purely a matter of capital deployed for use by consumers.  Where in this story is there anything trickling down?  If 100 new units are allowed to be built, then there are 100 new units available, now.  If those are "luxury" units, they are still units.  It's not like high income households are some sort of alien symbiotes that spontaneously reproduce when a unit is completed to claim the new space.  Somebody, most often somebody already living in the city, will claim the new unit and another unit will become available immediately.  There is no need to wait for some hoped for investment.  The investment itself is the initial action.  There is nothing left to trickle.  In traditional trickle down rhetoric, one might argue that giving tax breaks to developers in the hope that they invest it in new units is futile.  It's the hope for the investment itself that is deemed na├»ve.  But, here, the investment is the whole point of the thing.

Second, Closed Access housing policies have been in place long enough to see the difference between the long-term effects and transitional effects.  Campos is complaining here about transitions - that new market rate units will just attract wealthy new tenants, leaving working class tenants out in the cold.  Let's forget for a moment the near-sightedness of that contention.  We don't need to logic through the way new supply would help all parts of the local housing market.  We don't need to work through the logic because there are "n minus 5" metropolitan areas in this country who have what Campos would call trickle down housing markets, and all of them have more affordable housing.  In fact, the more "trickle down" they go, the more affordable their housing is.  Working class families aren't lined up in Dallas, hoping for that promised affordable housing which somehow never comes.  It never left.  Don't call it a comeback.  It's been there for years.  Where are working class families waiting for affordable housing to trickle down?  New York City, Boston, LA, and San Francisco, where heroes like David Campos get letters from desperate residents who need someone to fight against the free market ideologues to help secure them some lottery ticket to publicly subsidized housing.  (From the op-ed: "If you're currently seeking housing in our city and can't afford market rates you have three choices: be homeless, leave, or get on a long wait list for low-income housing.")

Third, these policies have also been in place long enough that we can see the systemic effects.  Campos references 2,000 Ellis Act evictions, which arise when landlords sell homes that have tenants in them, usually at controlled rental rates.  Each of those is an anecdote.  But, tens of thousands of households are forced to move away from the San Francisco metro area every year because of the lack of units.  Those are systematic.

Part of the problem is that cities like San Francisco have implemented such extreme levels of capital repression for so long, that their housing markets don't have anything close to market rates.  Even the publicly negotiated "below market" rate units are more expensive to build than units in an actual market would be, but for the capital repression.  And, since this is the case, it seems clear that people like Campos see the housing market in San Francisco as some sort of foreign creature and only the subsidized stock of housing is true San Francisco housing.
When people are evicted from their rent controlled homes we diminish supply. When apartment owners convert units to condos we diminish supply. When homeowners put units on the short term rental market we diminish supply.  
He is making that distinction quite explicitly here.

It is tempting to point out the absurdity here.  I mean, go listen in on any conversation among macro-economists, market forecasters, realtors, Fed officials, developers, investors - basically any group of people engaged in anything but politics.  You will never here a single conversation based on this conceit.  None of those people have ever talked about how rising supply will lead to rising rents.  It is quite the opposite.  In fact, it is part of the problem, because while people like Campos deny a central role for market-developed units in affordability, all of those other people are concerned about stability, and every time new supply in the Closed Access cities gets close to something reasonable, they start worrying about oversupply, and how its going to crater the local real estate market - fearing the ever near bubble/bust dynamic.

But, the problem here is that San Francisco is so far out of sorts that the long-term is far, far away.  It's transition as far as the eye can see.  And, it really would take tens or hundreds of thousands of units to bring costs in market-rate housing down far enough to start to effect supply with costs that are in the range of subsidized affordable housing.  In Campos' world, the real San Francisco really wouldn't benefit from those new units.  It's not that supply isn't the long-term solution.  It's that San Francisco is too far from the end of the tunnel to see the light.

From the piece: "Think about it this way: if there were a bread shortage in San Francisco and the cost of bread skyrocketed, no amount of fancy cake would fix the bread market." and later "If the city needs more affordable housing then let's build affordable housing."  Notice that, here, Campos treats "luxury" housing and "affordable" housing as two different stocks of units, differentiated by some sort of real, material characteristic.

But, this is at odds with his description of the housing market above.  When he describes a unit shifting from subsidized rentals to market condos as a loss of a unit, he implicitly acknowledges that there is nothing special about "luxury" units.  If an "affordable" unit can suddenly become a "luxury" unit simply by moving from apartment to condo, then, surely a "luxury" unit can become an "affordable" unit when supply growth in other parts of the city lowers market rents.

Campos is engaging in some real rhetorical hocus-pocus here.  There is no question that supply and demand work in the San Francisco housing market.  If units rent for $4 per square foot, added supply would bring them down to $3.50 or $3, or whatever.  Campos' position is that if affordable housing is housing that rents for $1 or $2, then reducing rents to $3 per square foot is useless.  That's all happening out in the "luxury" market, which Campos considers irrelevant to the "affordable" market.

He claims that he is fighting "trickle down" or "supply-side" ideology, and that it is he and his allies who actually understand supply and demand.  But, he has rhetorically removed supply and demand from the San Francisco market.  When units are moved from his subsidized programs into markets, he explicitly refers to this as a loss of a unit.  The world of supply and demand has been wholly and explicitly erased from his view.  He goes through the motions of that for us.  You can see him doing it in the piece.

The stock of "affordable" units in San Francisco, which is the only market he acknowledges the relevance of, certainly has nothing to do with supply and demand.  That stock of units is explicitly part of a program that has politically imposed prices in a context of perpetual shortage.

He says, "Let me be clear - not a single affordable housing activist denies the existence of the law of supply and demand."  Really?  His own piece is a systematic contradiction of that statement.  On the other hand, he follows that sentence with, "Where we all agree is that the incredibly complex San Francisco housing crisis won't be solved by the recitation of freshman economics notes." And, on this matter, the rest of the piece is a systematic confirmation of the statement.

Shooting a ball into a basket can be solved by a recitation of freshman physics notes.  However, winning a game of basketball is incredibly complex.  Why?  Because in basketball, one must contend with defense.  Building affordable housing can be solved by a recitation of freshman economics notes.  However, building affordable housing in San Francisco is incredibly complex.  Why?  Because in San Francisco, one must contend with defense.

In historically developed urban centers some defense is inevitable.  There are legacy residents who have certain expectations and demands, and those sorts of demands might be universal - just as complicated if Austin attempts to build a dense residential center for tech workers as it would be in San Francisco.  The international scope of this problem suggests this is the case.  And, surely, in those contexts, nonsense is an important tool for those legacy residents in the quest for stability and exclusion.  So, in a way, this sort of rhetoric is endogenous.  Supply and demand exists for nonsense, too.  But, it must also be true that, on the margin, nonsense might be coaxed into advancing or retreating, and in retreat, might allow for enough progress to pull some cities past a tipping point into functionality.  When it comes to tipping points for the quantity of nonsense, San Francisco is probably nowhere near the margin.  But, cities like Seattle and Washington, DC are.

Seattle and Washington, DC build a lot more housing than San Francisco does, and while supply there has some constraints, housing markets are still functional enough for supply to affect costs in a way that can still be immediately felt in affordable neighborhoods.  Supply and demand is visible in those cities, so that it can't so easily be rhetorically dismissed.  The demand for both housing and nonsense in those cities is strong - in a way, they seem to be complementary goods.  We need to supply the former and not the latter.

Thursday, November 9, 2017

Upside-down CAPM, Part 2: The magical elasticity of investment demand

I previously have discussed my skepticism about the idea that monetary policy works by inducing leveraged investment with low interest rates.  I just don't see evidence for it.

But, I don't really even quite get it, theoretically.  The idea is that the Fed lowers interest rates to well below their market rate, and this induces households and firms to borrow.  There are countless examples, which I won't bother to link to here, of either laypeople or financial professionals referring to phantom activities such as firms propping up share values by borrowing cash on the cheap and buying back shares.  There are certainly firms that borrow.  And there are firms that return capital through buy backs.  Sometimes there are firms that do both!  Thus, as with the idea that loose money or loose credit is responsible for high asset prices, this is an idea that will never die for those who are disposed to believing it.  Hey, maybe they are even right about it.  Surely, getting rid of money and credit will solve these supposed problems.  Who could deny it?

It seems to me that there are two basic camps, here.  Austrian business cycle proponents, who attribute the misallocated borrowing to Fed signals, and Minsky-type proponents who attribute the misallocated borrowing to complacency as economic expansions progress.  Some version of this idea seems to be an important part of Fed policy decisions, given comments made by FOMC members on occasion, though I'm not sure if it is the Minsky idea or the Austrian idea that dominates.

In either case, it seems the proscription is the same - nominal stability (which is managed by the Fed) leads to over-leverage, which must eventually lead to a sharp contraction when it becomes clear that loose money or nominal stability can't endure forever and the economy contracts, triggering a debt-spiral.  Thus, the contractionary policy is demanded now, before the over-borrowing becomes larger, so that the contraction will be more muted.  Please correct me in the comments if you feel that I have misrepresented either school of thought.

But, these bubble theories have a wildly uneven sense of elasticity.  Here is a graph of the one year change in Fed assets (before 2008, Fed assets were almost all funded by currency in circulation), and total borrowing in the US.  I have graphed them both as a percentage of GDP in order to maintain scale over time.
Source

It is true, if we look at the graph, that borrowing sometimes rises during periods of declining and cyclically low rates.  It is also true that levels of borrowing were rising during the high inflation 1970s and 1980s, which I touched on in the previous post on this series.

But, if I understand these business cycle theories correctly, the Fed lowers interest rates by purchasing bonds with cash.  The reason this lowers interest rates is because the market for the securities is not very liquid, so that the extra demand represented by the Fed moves the price.  So, the Fed buys bonds worth around 0.3% to 0.4% of GDP each year, and this changes short term interest rates.  (This is pre-QE.)  It may be hard to see, but on the graph, this is the blue line near the x-axis.

So, the idea is that over a period of months or years, the Fed pushes interest rates down by buying bonds totaling less than half a percentage point of GDP.  Now, one could argue that this bond buying uses new cash, which adds more boost than, say, new bank lending.  But, that is a monetarist argument.  That is not an argument from interest rates.  That is an argument from quantity of cash.  It seems perfectly reasonable to me that injecting cash into the economy will boost nominal values, in the long run, proportionately, and some combination of immediate liquidity and expectations of future liquidity will create short term inflation pressures, too.

I should note that there are many complexities here, and even the effect of the quantity of money is hard to pin down.  There isn't much of a systematic relationship between the rate of new bond buying by the Fed and either NGDP growth or inflation.  Lower market rates increase demand for money, which is disinflationary but a lower target rate is inflationary.  So, the monetarist story is difficult to quantify, too.

But, the interest rate approach has a widely referenced mechanism - lower interest rates lead to borrowing.  So, the strange thing, to me, is that 0.3% of GDP worth of lending by the Fed can apparently move interest rates around by several percentage points, and hold them in place for years.  Yet, when the borrowing that this change in interest rates triggers amounts to 5% to 15% of GDP, all that extra borrowing has no effect on interest rates.  That is some magic elasticity.

The same question remains if the cause of new borrowing is low credit spreads.  If complacency causes spreads to tighten, why doesn't the new borrowing push rates back up?

In fact, the new borrowing does push rates back up.  This is where the Upside-down CAPM fits in.  When equity risk premiums are low, credit spreads tend to also be low, and real interest rates tend to be high, as they were in the late 1960s and late 1990s, at the end of long periods of stability.

This seems to be the motivation behind concerns about NGDP targeting, that nominal stability will cause complacency and that low credit spreads will lead to massive over-borrowing which will get out of hand.  This idea relies on interest rates that are insensitive to investment demand.  The idea is that if investors feel confident that stable NGDP growth will keep equity values from collapsing, for instance, they will invest on margin, borrowing at 4% to invest at 7%-10%.

It's true.  If you could do that, it would be tempting.  Too tempting.  So tempting it would be inevitable.  It would also be inevitable, then, that nobody would be lending money at 4%!  But, if you're working with some whacky model that imagines that cyclical surges of investment keep happening without any consequence to interest rates, this may not seem obvious.  In fact, I think one of the many benefits of NGDP targeting would be that fixed income yields would be high, which is exactly what the global economy could use right now.

Can anyone direct me to readings that address this elasticity question?  How can the Fed buying a few T-bills lower interest rates persistently, but when this triggers hundreds of billions of dollars in new borrowing, that doesn't move interest rates back up?  This seems like such a basic question, I am afraid that I am simply exposing some ignorance.  Enlighten me, readers!

Wednesday, November 8, 2017

Musical Instruments and Economic Development

Phoenix has a wonderful museum called the Musical Instrument Museum.  It has an amazing collection of musical instruments from all over the world.

The geographical exhibits really can be divided into two sections.  There is a section, shown here, where instruments are generally made of dried gourds, sticks, animal skins, etc.  These are inexact instruments.  They are played in community and it seems that where they are used, everyone is expected to play.  The style and difficulty of the music is inclusive and accessible.

Then, there is a section where the instruments are intricate.  They are played by virtuosos as an exhibition, to be observed.

There is very little in between these two extremes.  There is a tipping point, and you either live in a communal musical context or a performative musical context.  Certainly, even in the performative cultures, we value communal music, and many of us still perform it in some ways.  That could be singing hymns at church, or sitting on a patio or around a campfire on a Saturday night.  But, much of our musical experience, and even its place in our sense of identity, is our experience with performative music.

The difference between these musical cultures is extreme.  In the communal cultures, music is a joyful, messy bonding experience where the performance settles around a sort of lowest common denominator standard.  It is comfortable, but unimpressive.  In performative cultures, musicians toil and strive, they get nervous about playing, they get stage fright, they are judged, and they create forms of beauty and expression beyond imagination.

On this side of the tipping point, we make amazing objects, do amazing things together, induce each other to better ourselves, show our appreciation for excellence, and yet we crave the community of the lowest-common-denominator.  But, for the most part, as a society, we have to choose one or the other.  There isn't a middle ground.  There are some middle ground countries - places where you might find guitars made out of gas cans and drums made from discarded lids.  Those places don't tend to be comfortable and safe places to live.  Excellence and growth is mostly only available past the tipping point, and it is inevitably bound up with stress.

Normally, that sort of social stress is associated with capitalism.  But, here, I think we can see capitalism as only a late manifestation of a longer historical development.  Most of the instruments used by virtuosos today were developed before the industrial revolution.  Performative culture to some extent goes back hundreds, even thousands, of years.  We crossed the tipping point a long time ago, for better and for worse.

Sunday, November 5, 2017

Housing: Part 267 - Lot Size and Housing Demand

I haven't written much about this, because I'm not sure that the aggregate data bears this out.  But, the trend is so universal and extreme in the Phoenix area, there has to be something going on.

Since the financial crisis, new homes in Phoenix have been squeezed into very small lots.  There are many in-fill residential developments going up with two story homes that have barely more than a back patio.  This is especially surprising because the growth of Phoenix has largely been based on affordable middle class homeownership, and part of that ideal has always been the backyard swimming pool.  Most of the new homes since 2007 don't seem to have room for a pool.  This is a fundamental change.

The reason I think this is the case is because land prices are high because of low interest rates.  We can see this in the price of farm acreage, which has remained high.  But, home prices have been pushed to a level below their previous norms because of repression in mortgage credit markets.  This means that demand for housing in Phoenix is held down, putting downward pressure on the quantity of housing purchased.  And that demand is constrained by limited credit access, not by spending preferences.

The price of the home itself, in places like Phoenix, will be regulated largely by the cost of building.  So, the cost of lots is high and the cost of the homes themselves is relatively level.  If we didn't have repressed mortgage credit, this wouldn't matter much.  Low real long term interest rates would lower the cost of the mortgage at the same time they would raise the cost of the lot.  Home sizes might rise, but not so much at the expense of the lot.  Today, I think there is tremendous downward pressure on lot size - enough to lead to these fundamental shifts in home design.

Since financial repression is the binding constraint in housing markets, this upends many intuitions we might have about the market.  Yields on housing investment are very high while long term real interest rates on treasuries are very low.  This is odd.  Future market shifts will not be a result of these yields moving in parallel, which is what they might have done in the past.  Future market shifts will more likely result from these yields re-converging, in one way or another.

With continued financial repression, that might mean that housing starts remain low, rent inflation high, and generally real housing consumption will continue to decline until a new equilibrium is reached.  I'm not exactly sure what the endgame looks like there.  I suspect there would be a two-tiered market where upper middle class families would tend to live in larger homes while other families would rent smaller units.  Maybe in that case, these large patio homes would remain the norm in entry level markets, especially if low real long term interest rates remain low as a result of the various ways that capital repression maintains the limited populations and high costs of the Closed Access cities.

But, if financial repression is eased so that marginally qualified borrowers can buy homes again, then home prices should rise and long term real interest rates will also rise.  In that case, lot sizes will also increase in some cities.  Our intuitions will tell us that rising interest rates and rising home prices will cramp housing demand and favor entry level homebuilders of the kind that are building these crowded new neighborhoods.  But, in that scenario, it might be the case that neighborhoods which have been planned and permitted for very small lots would be out of favor, and builders with larger lots would gain market share.

This is all academic.  The sorts of shifts in mortgage market regulation I am describing here aren't even on the political radar right now.  So, it's probably not particularly useful to you as a reader.  But, I am reminded of this issue every time I drive around suburban Phoenix and notice those incredibly small lots.

Wednesday, November 1, 2017

Corporate profits and taxes. Nothing to see here.

This is an interesting article by Matthew Klein about an idea from Dean Baker to tax corporate income through silent ownership of shares.  It may not be feasible, practically, but it does make sense in a lot of ways.  It fits with my recent posts about property taxes as a form of silent ownership and homeowner subsidies as a form of mandated annuity.

But, the article seems to ignore issues of tax incidence.  Corporations don't really pay taxes.  In the long run, after tax wages, profits, and prices should settle at some relative level of returns and incomes that reflects a complex stew of social preferences and challenges.  This is forgivable in some ways, because the tax proposal in the article seems like it would avoid a lot of the negative consequences that make corporate taxation problematic - legislated special favors, tax avoidance activities, etc.

Politics, realistically, is mostly about status moves and insider-outsider alignment.  Tax avoidance is a fundamental, universal economic issue.  In positive terms, economists would typically treat tax avoidance as a signal of dislocation.  Where there is avoidance, it is a sign that taxes might be too high or the base too narrow, and we would look for ways to pull back.  Our political postures can frequently be divined by recognizing where we invoke attribution error vs. sympathy or indifference.  For instance, few of us would think twice about, say, crossing a state border to buy a car or fill up our gas tank, if taxes across the border were lower.  We might not even recognize that we were engaging in tax arbitrage.  We might just be reacting to price signals.

Corporations are basically engaged in the same activity.  But, we attribute their tax avoidance to their soulless greed.  Much is made of foreign tax shelters, etc.  Some of that is going on, clearly.  But, most corporate behavior, just as with our own behavior, can simply be described as reactions to price signals.  But, corporations are pretty universally outside the zone of sympathy.  So, our reaction to their tax avoidance is to turn up the heat and to find ways to force the taxes onto them, in spite of their avoidance and the inevitable secondary and tertiary effects on price that inevitably mitigate some of the intended taxation.  This is ironic, since aggregate corporate after tax profits aren't that sensitive to taxes.  This is explicitly understood in markets like municipal bonds, where different tax treatments change securities prices with little effect on after-tax returns.

Here is a chart from Klein's article:

He shows declining corporate tax collections over time in the US.  He blames this mainly on foreign tax shelters.

It seems clear to me that the reasonable response to this problem is to lower corporate taxes because the foreign tax shelter problem is created by corporate taxes, and cutting corporate taxes would not really be problematic - prices, wages, and profits would adjust in the long term so that more income would be earned through wages, and more taxes would be paid through sales and income taxes.  And, as we see here, we're talking about 2% of national income. Whatever the actual proportion those taxes would actually fall on various agents, those debates are talking about a small fraction of a percent of national income.  And the benefit would be that firms wouldn't be able to gain an advantage from international tax arbitrage.

To this point, here is a graph of the share of national income of various forms of capital.  The Klein chart ignores composition.  This is a very common problem.  Economists and journalists frequently compare corporate profits over time.  Changing corporate profits over time are dominated by changing composition - using debt financing versus equity, proprietorship versus corporate organizations.  Furthermore, there is the issue of inflation premiums in interest expense.  This is accounted for as an expense to firms and income to lenders.  But, in real terms, this is an arbitrary transfer.  In real terms, the inflation portion of interest payments is like a debt buy-down.  For all of these reasons, changing corporate profits or taxes paid over time are just not that useful of a metric.

Source

Before 1980, there was a shift into corporate forms, then that shift reversed back to proprietorship.  There has been a shift toward debt financing, and in the 1970s and 1980s, there was a significant inflation premium on interest payments.  When we stack these forms of income, they are remarkably flat over many years.  Here, I have also placed corporate taxes at the top of the stack.  When corporate taxes were higher in the early 20th century, capital incomes before tax were higher, and they were somewhat higher even after tax.  Over time, corporate taxes have fallen, yet total capital incomes after taxes have a remarkably stable mean, as a share of national income.

There is much less here than meets the eye.

Tuesday, October 31, 2017

Trust and Public Policy

Following up on yesterday's post, I want to think a little bit more about public policy, in general, and the thick web of subsidies, taxes, and incentives we have in place, and that, to some extent, are unavoidable in a sophisticated economy.  (What sort of intellectual property protections should we have, for instance?  There is no safely neutral ground on many issues where we can rest without debate.)

In yesterday's post, I considered housing subsidies as a sort of mandated annuity.  Since tax benefits make homeownership more valuable, that value is naturally reflected in home prices.  In housing, it appears plausible that in many areas, the value of those tax subsidies is so baked in to property prices that the typical buyer does not capture much net value.  One sign of this is that tax subsidies don't seem to increase homeownership rates.

I suspect that the non-taxability of rental income for owner-occupiers is enough to tip the balance in favor of ownership for almost all households who would prefer it, and any additional benefits like the mortgage deduction or capital gains tax exemptions simply increase value for existing owners, and don't draw many new owners into the market.  So, where those marginal effects take place, we find little effect on homeownership and almost total capitalization of the value into the price.  But, in places like Germany and Switzerland, where they seem to really make an effort to eliminate all the tax benefits of ownership, homeownership rates do tend to run substantially lower.

Currently, this is not the case in the US.  Currently, homeowners are capturing a tremendous amount of economic rents, in terms of (rent/market price).  According to national accounts data, net rental income on homes is running around 4% or more, after expenses and cost of capital.  This is more than the nominal interest rates on mortgages, even before any capital gains on the property.  If you can get a mortgage, you are practically guaranteed an abnormally high return on investment.  That is because many households can't get mortgages.  That is the only way to secure persistent economic rents - restrict access.  This should be the number one rule of economics: you can't give something away without restricting access.  Restricting access to mortgages has provided new homeowners with much more largesse than any tax subsidy ever did.  (The largesse provided, or the cost imposed, falls on existing owners when these policies have been implemented.  Homeowners unfortunately found this out during the crisis.)

Restricted access has lined the pockets of Closed Access real estate owners.  It's the only thing that could have done that so thoroughly.  This goes beyond residential housing.  Every night on the local news in those cities are people righteously keeping out a Target because they like their local shops just fine, thank you very much, or keeping out a new pizza place because the powers that be decided there are already plenty of pizza places.

At any rate, the broader point this should cause us to think about is trust.  A major problem with housing markets over the crisis period has been the volatility in both valuations and public policies.  Reasonably qualified owners in 2006 - which includes just about all of them, even if being qualified doesn't get your story in documentary exposes of the "bubble" - lost months or years worth of income because credit markets and monetary policy were generous, then very not generous.  Effectively, the rules of the game have been arbitrarily changed, and asset owners across the board had to roll with the outcomes.  The peculiar trust of the market means that if our neighbors choose to frequent the new pizza place, we won't stop them.  We have pre-committed to letting you fail.  You can trust that.  It is an incredibly important promise we have made.  Even what looks like a communal act of support when we prevent our neighbors from trying the new pizza place is actually an abdication of trust.  An abdication of trust that we would let our neighbors do as they please.  An abdication of trust that we would allow new pizza parlors give it a shot.  But, most importantly, an abdication of the promise that we would stand by and let your pizza parlor fail.  That may be cold, but it's not nearly as cold as actively, communally undermining 20% of your homes value for your own good.  Pre-committed neglect doesn't hold a candle to moral righteousness.  Especially, when we can pre-commit to giving you support as you deal with your failure.

This undermining of trust is the case with any public policy.  That is the point of public policy debates - that the rules are subject to change.  Stability and trust are the key, illusive, features of a developed, equitable economy.  When you buy a 30 year bond at 5%, the issuer of the bond can't call you up 5 years down the road and say, "Just wanted to let you know that we have had a change of ownership, and the new owners think 3% is a more reasonable rate."  Trust is so key to a functioning economy.  Much of public activism about economic fairness involves this ideal - that even if you have a powerful position, we communally demand that you do what you say you would do.  Sometimes this plays out in civil or criminal enforcement, but the enforcement of these norms overwhelmingly happens informally in the natural evolution of private transactions.

We tend to think of trust as something that differs between honest, sincere actors and dishonest cheats.  But, the housing bust is an unfortunately good example of how complicated trust is.  There was near unanimity during the crisis that speculators and lenders needed to pay for what they had done.  Many believed tight money, even at the expense of creating a financial panic, would impose discipline.  Many have presumed that lower asset prices were the correct asset prices, so that household and financial balance sheets were decimated to suit our expectations.  All of these economic dislocations were allowed or imposed with utmost righteousness.  The mutual trust enforced by a market goes far beyond the enforcement of outright fraud.  We are commonly the most morally confident about the worst things we do to each other.  This isn't exactly a secret in human affairs.*

When thinking about public policy shifts, this is a real "elephant in the room" problem, I think.  Trust is so important in private markets.  And, when there is enough trust for those markets to function well, there is enough competition to generally pull average incomes and profits down to a level of indifference.  Clearly, capitalists are continually working at developing little bits of monopoly power in order to capture excess profit.  Comparing the P&Ls of 20 random small competitors in a competitive market will find much variation, with some owners doing very well.  But, the market as a whole will reflect the best and the worst, and marginal new capital will expect only a reasonable return on investment, where entry is open.

The trust that must exist in those markets in order for profits to be bid down to levels of indifference does not exist in the realm of public policy.  In fact, it cannot exist.  That means that in contexts dominated by exposure to public policy shifts, we would expect incomes and profits to be excessive.  If you are digging a new coal mine, and five years from now new laws limiting the use of coal may be passed, then you better have a high return on investment.  In that case, this may seem like a good thing.  The threat of changing rules would limit an activity that we might consider to be damaging, even if laws don't reflect that consideration yet.  But, this is the case in every subsidy or tax.  So, if there is a subsidy to benefit solar energy developers, but it is a subsidy that could be removed if the other party gains power, then firms built around capturing that subsidy will have to require excess profits to account for that risk.

Public policy that focuses on an active program of subsidies and taxes will inevitably lead to higher profits for those who are affected by them.  This is systematically what we see in the comparison between developed economies, where rules are more stable, and developing economies, where they are not.  This is what is problematic about corporate taxes that combine high rates with a myriad of deductions.  This simply puts firms in a continual battle for the capture of economic rents, and a lack of access to those subsidies plus the instability of the rules means that firms tapping those rents will earn higher incomes.  There is still open access to capital, in general, so that total capital income continues to claim about the same proportion of national income as it always has, but within the pool of invested capital, there seems to be an unusual amount of variance, with more winners and losers.

The difference between high trust private markets and public policy debates that erode trust is extreme.

In many cases, public policy is explicitly characterized as a way to change the rules specifically to harm others.  My point here isn't to debate what the appropriate policy is.  Inevitably, there will have to be some mixture of taxes and subsidies of various kinds.  My point is to briefly pause and consider the shocking difference in our communal reaction to these two statements:

1) The head of Fidelity announces, "We have decided that 75% of all client income above $1 million will be confiscated."

2) Presidential candidate announces, "We believe that incomes above $1 million should be taxed at 75% to mitigate income inequality."

Again, the point here isn't to debate the policy.  Some level of taxation is necessary.  This debate must occur at some level.  My point here is that trust is central to a functioning economy.  It is so central that statement number 1 is beyond the pale.  It is inconceivable.  There is an informal, even unconscious, requirement for all the players in a functional economy to play by stable rules and to expect all others to do the same.  We can palpably feel and understand the deep consequences of giving up that trust.  The consequences are so severe that many actions that would undermine it aren't conceivable to us.  There are less developed economies where something like that might occur, in large ways like the hypothetical above, or in many small ways (such as having strong norms for favoring family in business dealings or legal disputes, which extends to public officials).  Those economies will not produce abundance until those universal trust expectations can develop.  These are difficult problems to solve.

In our economic bubble, we take trust so much for granted that we don't even think about it.  I liken this to my reaction to street vendors in Korea, who occasionally would simply have little boxes of currency sitting on a shelf, where patrons would place their payments, which could have easily been grabbed while the vendors were busy.  I take that as a sign that, in some ways, South Korea has a higher level of social trust than we do.  If I was a street vendor in the US, I wouldn't think of leaving that much cash sitting out.  I suspect they can't imagine why I would worry about it.  Trust is the water we are swimming in.

But, yet, in the political realm, we engage in trust-crippling actions and posturing as a matter of course.  We must.  There is no way around it.  But there must be a tremendous amount of damage that this causes.  We don't notice it because it is inevitable, just as we don't notice the many ways in which we trust agents in functioning markets because that is also inevitable.  But, maybe occasionally we should make note of this cost to ourselves.  What better day than Halloween?  Maybe, tonight, I will dress up as macroprudential controls and roam the neighborhood correcting the misallocation of my neighbors' capital into candy.  How else will they learn?  Boo!





* CS Lewis: “Of all tyrannies, a tyranny sincerely exercised for the good of its victims may be the most oppressive. It would be better to live under robber barons than under omnipotent moral busybodies. The robber baron's cruelty may sometimes sleep, his cupidity may at some point be satiated; but those who torment us for our own good will torment us without end for they do so with the approval of their own conscience.”

Monday, October 30, 2017

Housing: Part 266 - Tax subsidies as annuities

Let's imagine a home purchase in an environment with no tax distortions.  Rental income taxed after expenses.  No mortgage interest deduction.  No capital gains exemption.

A house that rents for $20,000 (annually) might sell for $200,000.

Now, we add in these tax benefits that are only captured by owner-occupiers.  No tax paid on rental income.  Mortgage interest deducted when taxes filed.  No capital gains on most sales.  Now, the house might sell for $300,000.  (I am using round numbers for ease, so this might be a slight exaggeration of reality, but it probably isn't too far from the actual premium.  White House estimates put the value of these subsidies at about 25% of annual operating profits for owner operators, and those subsidies are focused at the top end of the market.)

I think it helps to look at property taxes as a silent partnership.  If property taxes amount to 20% of net rental income (either cash or imputed), then the government has become a 20% silent owner of the property.  This is not that different than having an adjustable rate, negative amortizing mortgage with an LTV (loan to value) of 20% with no prepayment option.

Likewise, we can think of tax subsidies as a sort of annuity.  When you buy the house, you are basically buying the future cash flows of a house with $20,000 annual rent.  But, tax subsidies mean that when you buy the house, you also are required to purchase a $100,000 annuity.  That annuity amounts to the forgiven taxes on the net tax income as they are earned, the tax deduction on mortgage interest when taxes are filed, and the forgiven capital gains tax from when the home is sold in the future.

Since the value of tax subsidies are capitalized into the price of the house, then it is best seen as a legal requirement that when you buy a home, you also must purchase an annuity.  The payment for the annuity goes to the previous homeowner, and the annuity income comes from the government, in the form of forgiven taxes.

So, the question about the effect of tax subsidies on homeowners really comes down to the price of the annuity compared to the value of the annuity.  If the price of the annuity is more than the value, then home buyers will decrease their investment.  If the price of the annuity is less than the value, then home buyers will increase their investment.  Of course, the value of the annuity is complicated, itself, since it is largely determined by discount rates on those future tax savings.  These are difficult, if not impossible, to quantify.

But, we can make some generalizations.  And, instead of thinking about how this affects "the housing market", there is probably a lot more going on in the differences between sub-markets.  Low priced homes or homes owned by households with low incomes would not have very valuable annuities, because those owners would not capture many tax benefits.  But, in neighborhoods that would be dominated by those owners, prices are much lower (in price/rent terms).  The prices of the annuities are low, too.  The distortions in those markets are probably not great.

I think one of the things that happened in the Closed Access cities during the boom was that home prices in low-tier neighborhoods were rising high enough to make those annuities valuable, and the in-migration of high income buyers to the Closed Access cities also might have made the marginal new buyer also more sensitive to the tax advantages.  So, in Closed Access cities, during the boom, low tier Price/Rent levels rose up to nearly the same level as high tier Price/Rent levels.

At the other end of the spectrum, in the highest tier neighborhoods, households would value the untaxed rental income, but those neighborhoods tend to be less leveraged.  Another mitigating factor here is that at the top tier, rent tends to take a lower percentage of household income.  In order to capture the annuity, the household must purchase a more valuable home.  They may simply not demand more shelter, so even if the annuity has value, it may not have enough value to induce them to consume more housing than they already care to consume.

So, as in the low tier, the annuity may not have much of an effect on owner-occupier demand.  This may be why Price/Rent ratios level out in zip codes above $400,000 or so (plus or minus, depending on local conditions).

In the middle, households would value untaxed rental income and capital gains exemptions.  Here, there would be a lot of variation.  In a single neighborhood with a single price point, there would be less leveraged older families who would value that benefit less, and younger, leveraged families who would value it more.  So, if there is a section of the market that might value the annuity the most, it is young households with above-average incomes.  They would react by increasing their demand for housing because housing would be a complementary good with the annuity that legally comes attached to it.

But, these families are probably among the most credit constrained households.  In other words, they may be in a position to gain the value of ownership (in and of itself, before any value from the annuity), but their limit to gaining that value may be limited by their access to mortgage credit.  So, their demand for housing may be very elastic at the limit of mortgage payments they can qualify for.

This means that the households who might be most likely to increase their housing consumption because of the tax subsidies may be least able to pay for the annuity.

Consider: without the subsidies, those households would be provided with the opportunity to purchase $20,000 in rental value for $200,000.  With the subsidies, those households would be provide with the opportunity to purchase $20,000 in rental value for $300,000.  What if their credit constraints mean that they are basically willing and able to purchase a house with a price of $200,000.  Mortgage constraints are based on price, not rental value.

That would mean that, without the subsidies, they would purchase a home with $20,000 in rental value, but with the subsidies, they would only be able to purchase a home with $13,333 in rental value.  For households with high incomes but with credit constraints, the subsidies might reduce their housing consumption, and it is those households who would most value the subsidies.  This seems like it would especially be a factor in Closed Access cities, where higher rents mean that potential homeowners have both higher incomes and more credit constraints.

Where new homes are built, the important margin is the comparison between price and the cost of a new home.  The payment for the annuity goes to the homebuilder, and the builder doesn't care if you're paying for the home itself or for the legal annuity attached to it.  It's all profit to them.  So, we should expect new residential investment to decline if subsidies are removed.  Price/Rent of existing homes would decline.

But, the important margin for housing consumption is nominal rent expense as a proportion of incomes.  Households would be willing to spend a similar amount of income on rent, but with less supply coming online, the normal increase in demand (expressed as total rent paid) would continue to rise.  There would be rent inflation, which would cause home prices to increase somewhat, mitigating the decline in value because of the withdrawal of subsidies.  In other words, over time, households would tend to live in homes with lower cost of construction (smaller, etc.) but with no change in rental value.  This would mainly happen in the mid- to upper-tier markets where the subsidies had been the most valuable.  (This would not be the case in the Closed Access cities, because cost of structures is not particularly relevant to home values there.  In Closed Access cities, values would fall and rents would be generally unaffected by this effect.)

Now, we need to think again about those credit constrained buyers.  Without the subsidies, their demand for housing (in terms of rental value) might actually rise.  This would put more upward pressure on rents, and probably upward pressure on residential investment and housing starts.

There are many studies that seem to suggest that tax credits get capitalized into home prices, so that they make homes more expensive, but they don't lead to an increase in homeownership.  That is not surprising to me.

In the end, under certain circumstances, I wonder if eliminating homeowner tax benefits might simultaneously be associated with strong residential investment while at the same time creating some negative wealth shocks among the households who would lose the annuities which they had paid for when they had purchased their homes under the tax-preferred regime.  These effects would probably not be significant in low tier markets, where the price and value of the annuities is low.  It would be significant in the high tier markets.

This seems counterintuitive, because we generally think of tax subsidies as a handout.  But, if tax subsidies are capitalized into home values, which they clearly are to some extent, then they could be conceived of as a regulatory burden.  New home buyers are required to purchase an annuity, frequently entirely with borrowed money, which would rarely be considered a wise investment strategy.  And, their buying decision is partly based on the effective value of that mandated annuity to them.

Friday, October 27, 2017

Housing: Part 265 - Canadian edition

I am keeping an eye on Canada.  The central bank has begun to raise rates.  Home prices, especially in Vancouver and Toronto, have reached very high levels, and concern about high prices seems to be affecting public opinion about monetary policy, as it has in the US.

They seem to be in danger of doing the same thing we did in 2007.  Prices peaked and have fallen back, especially in Toronto.  They seem to be in a sort of 2006 place right now.  There is a sense that "the bubble is over", but general growth still seems reasonable.  They could manage it well.  But, declining home prices are probably a sign of disequilibrium.  If they treat it as a return to normalcy, they will underestimate the contractionary level of their policy.  It will be interesting to see how things proceed.

Here is a post at seekingalpha that reflects the broader problem.  I don't mean to single this author out.  This is the typical reaction I see.
The thing about economic expansions is that people are supposed to work, pay down debt and build up savings, so that they can ride out the economic downturn that follows. Canadians have done the opposite over the past 8 years, and now approach 2018 with the highest debt and lowest cash savings in decades.
This is understandable.  It seems like excessive demand is the problem - excess lending, speculations, foreign investors, etc.  So, it looks like Canadians (just like Americans, Australians, Brits, etc., etc.) are profligate and short-sighted.  And, this subtly works its way into the public consensus about what needs to be done, how much growth or contraction we will demand, how much sympathy we should have for bankers and homeowners, etc.

The problem is the story is backwards.  In a Closed Access economy, growth naturally leads to rising debt levels, because at the center of the economy is regulated access to opportunity.  It is inevitable - unavoidable.  A bidding war ensues for residential access to lucrative labor markets.

That debt isn't from profligacy.  The debt is a transfer of wealth.  The debt is the result of economic rents that must be paid to the owners of the restricted asset.  So, inevitably, when the economy grows, earners have to take a haircut.  They have to pay off the landholders.  This creates debt and economic stress.

I am not as well versed on the empirical evidence in Canada, so I can't say that I am certain about the story there, but it seems to have all the relevant inputs.  In 2006 and 2007, America became infected with a sense of vengeance, or at least a lack of sympathy.  This is probably the core question about the Canadian economy in the months ahead.  Do they approach housing contractions with sympathy, with resignation, or with bitterness?  Sympathy might save the day, even with the wrong model of what is happening.

Thursday, October 26, 2017

Upside-down CAPM, Part 1: Why interest rates are a poor indicator of monetary policy

I have previously written about an Upside-down CAPM, meaning real total returns on corporate assets are generally quite stable (with some noise) at around 7%.  Those returns are divided between equity and debt owners.  Total real returns of the total stock market can be considered the sum of the long term real risk free rate (estimated by long term TIPS bonds) and the equity risk premium (ERP).  Total real returns of an individual firm are shared between its equity holders (with expected returns equal to some multiple of ERP, depending on the firm's "Beta", or sensitivity to market volatility) and its creditors (with yields equal to risk-free returns plus a credit spread).

Thinking about market returns in this way helps to see how thinking about monetary policy in terms of interest rate targets is not helpful.  Thinking about monetary policy through interest rates seems to lead to the idea that low rates induce leveraged investing, and that this is how monetary policy affects spending and economic growth.  But, interest rates don't systematically affect corporate leverage, at least in terms of inducing speculative cyclical investments.
Source
Here, the red lines are the Fed Funds rate and the 10 year treasury yield.  Generally, when the Fed Funds rate is well below the 10 year yield, this is when monetary policy is generally viewed as being loose or accommodative.  The dark blue line is nonfinancial corporate leverage as a proportion of enterprise value (debt + equity), based on historic cost.  The light blue line is leverage based on the market value of equity, instead of historic cost.

We can see that most of the cyclical shift in leverage is based on collapsing equity values during a contraction, which then recover.  Based on book value, there is usually little cyclical shift.  And, leverage has been declining as interest rates have fallen, both in real and nominal terms, for several decades.  And, when the Fed Funds Rate is low relative to the 10 year yield, there is no noticeable shift in leverage.

The Modigliani-Miller thesis says that debt financing is advantageous for firms because profits are taxed at the firm level, but interest expense is not.  I don't see any reason to doubt that this is true, to an extent.  The counterintuitive result of this is that higher interest rates provide a tax advantage, so that higher rates actually could lead to higher leverage.  In fact, if the total required returns on equities are stable (which I assert that they are), which means that a 1% increase in the risk free long term interest rate will generally be matched by a 1% decrease in ERP, then declining interest rates should lead to declining leverage and declining firm share value!

Note, the Modigliani-Miller effect is nominal, not real, so that it would be related to high leverage in the 1970s and 1980s because of the high inflation rate.  Mostly, this seems to flow through lower equity values, because high inflation increases the de facto tax rate on firm profits.


Interest rate induced cyclical corporate leverage simply isn't a thing.  For as much bandwidth gets used up talking about it, you'd think there would be something there.  There isn't.

This makes sense, if we view markets through the upside-down CAPM model.  First, firms don't borrow based on the overnight rate.  In fact, the iShares Core U.S. Aggregate Bond ETF (AGG) currently has an average effective maturity of nearly 8 years.  This is a mixture of various forms of debt, but the point is that long term yields really are a more important factor in aggregate borrowing costs than short term yields.  And, certainly, a firm will try to match the duration of its borrowing with the duration of its investments, to a certain extent.

Total operating profits to firms don't change because of changing interest rates.  Changing interest rates change how operating profits are shared between equity holders and creditors.  Real interest rates mostly reflect a discount taken by creditors compared to the return claimed by equity holders, because creditors avoid cash flow and market price volatility.

The idea that interest rates would effect corporate leverage is especially suspect when we think about the standard way in which any CFO would manage a firm's balance sheet.  Firms don't leverage up specifically based on each individual project.  They don't say, "Oh, we can now borrow at 3% and here is a project that has come across my desk that returns 5%, so let's borrow cash to make this project happen."  Firms generally use the weighted average cost of capital ("WACC") and they compare the full range of projects to that WACC.  The leverage that the firm targets will be based on a number of preliminary factors of risk and its effect on credit spreads.  In most cases, WACC is largely a product of the returns to equity.  If a firm with any substantial amount of risk was leveraged enough for the cost of debt to be dominant, they would have a high credit spread, which would overwhelm any effects of lower risk free interest rates.

The riskiest firms and the firms with the most pro-cyclical risk tend to be the firms with the highest credit spreads.  They tend to be more equity financed, so that in those cases WACC will especially be immune to changing short term interest rates.  It will mostly be a function of the cost of issuing equity.  In that case, the cost of capital will be related to short term interest rates, but contrary to how people seem to normally think about it.  Let's say you have a highly cyclically risky firm, with a Beta of 2 - twice as volatile as an average firm.  Then, if investors are feeling safe, ERP might be 3% while real long term rates are 4%.  So, the risky firm has a real cost of equity that is 10% (4% + 3% x 2).  But, if investors are risk averse or afraid of cyclical volatility, ERP is 5% while real long term rates are 2%.  And the risky firm's cost of equity would be 12% (2% + 5% x 2).  Risk aversion increases the cost of capital.  The Fed moving around overnight borrowing markets just isn't going to do much to change those long term borrowing costs.  But, if cash it injects into the economy improves NGDP growth expectations, then ERP will decline, long term real interest rates will rise, and WACC for cyclically sensitive firms will decline.

In fact, if we think about it this way, to the extent that monetary policy affects the cost of capital, it would happen mostly as a result of NGDP growth expectations.  NGDP growth expectations would increase expected corporate profits, increasing share prices, decreasing WACC.  But, this would happen through equity-financed investment, not debt.  And, in fact, that is what we see in the graph above.  During recoveries, market-based leverage declines because the value of equity rises.

We can imagine this in an extreme example where a firm in distress has financial leverage above their optimal target.  If equity becomes so cheap that the firm's enterprise value is dominated by its debt, then WACC would be determined mostly by the firm's interest rates.  In those cases, the firm will be credit constrained, and marginal investments will be limited to generated cash.  So, in that case, lower interest rates will be unlikely to generate leveraged investments, but accommodative monetary policy might lead to a stronger economic recovery in general, which would boost revenues and profits, and for a firm like that, those improvements could lead to a sharp recovery in equity value.  Enough equity recovery might eventually allow them to draw on credit markets again.  But, the recovery plays out in the value of the equity.

Loose monetary policy is frequently blamed for leading to a build up of risky borrowing.  But, cyclically accommodative monetary policy actually leads to systemic stability as equity financing grows.  If monetary policy is loose in a secular sense - over the entire business cycle - so that it does lead to increased inflation, like in the 1970s, then leverage tends to rise because the de facto rate of tax on corporate earnings is higher, and interest expenses bloated by inflation serve to defer taxes.  So, we might say that loose monetary policy does lead to destabilizing leverage, but this happens through high interest rates, not low interest rates.

Wednesday, October 25, 2017

The neutral overnight rate was probably already less than zero in September 2008.

I have written about how interest on reserves was a contractionary policy implemented in October 2008.  It seems plausible to me that much of the damage to nominal economic activity happened in November and late December 2008 when the Fed had the interest rate on reserves set at 1% along with the Fed Funds target rate, but that the effective Fed Funds rate was less than half that.  This induced banks to deposit hundreds of billions of dollars in excess reserves at the Fed.

Source

During the period between the disastrous September FOMC meeting where the Fed Funds rate was maintained at 2% and the initiation of interest on reserves, banks had already deposited about $150 billion at the Fed in excess reserves.  I had interpreted this as a sort of mitigating fact regarding the contractionary nature of the policy, since this meant that some excess reserves would have accumulated even without interest on reserves, so that the entire $800 billion in reserves accumulated before the Fed finally dropped the target rate to near zero couldn't necessarily be blamed on interest on reserves.

But, I don't think I pointed out the other implication of that early buildup of reserves.  The other implication of those pre-IOR reserves is that already by September 2008, the neutral Fed Funds Rate was below zero, because banks were already willing to park a tremendous amount of reserves at the Fed.  To see the scale of this, note that the measure shown above (in black) isn't just of excess reserves.  It's of all reserves.

It is true, I think, that the gross positions of sales and purchases of overnight Fed Funds are larger than the net reserve position, but that being said, this was a tremendous amount of reserves banks were willing to set aside.

I don't really know anything about the microstructure of the Fed Funds market, so I don't know how the Fed maintained a Fed Funds rate above zero.  Maybe those were reserves lent to banks that other banks considered to be credit risks?  Maybe the defensive draw down of credit lines that happened in late September (blue line) was causing some banks to run short of reserves while others were flush.  Once that draw ended, the Fed Funds rate does appear to have fallen to the level of interest on reserves.  Help me in the comments if you can.

The stated reason for implementing interest on reserves is that it would help the Fed keep control of interest rates, so they could maintain their target rate without having to sell all of their treasury bills.  Not only is that stated reason strange, the policy seems to have failed to achieve even that strange goal.

My main point here, though, is that this is evidence that even while the Fed Funds rate was at 2%, then 1.5%, and then 1% for three months, the neutral rate was surely below zero for the entire period of time, and would have been, with or without interest on reserves.  That neutral rate was surely partially due to the Fed's policy target, so maybe if the Fed had pushed the target rate to 0.25% in September, the neutral rate would have been high enough to require the Fed to inject cash through treasury purchases.  That is, strangely, what they were trying to avoid.

Monday, October 23, 2017

The Upside Down CAPM and Lawrence Summers

I think there is a lot of value in turning the CAPM upside down.

Normally, we think of it as:  ER = R(f) + B*ERP

The expected return of the broader stock market is the risk free rate of return plus the equity risk premium - the premium investors demand for having exposure to cash flow that is volatile over the business cycle.  The expected return on a given equity is its "beta" - its sensitivity to broader market volatility.  The broader market, by definition, has a beta of 1.

I prefer to think of equity market expected returns this way:  R(f) = ER - ERP

It's a simple algebraic reformulation, so it seems like it can't make that much difference.  But, the key is that (1) expected returns (ER) seem to be pretty noisy (or unknowable) around a stable mean, so that ER can generally treated as a sort of mysterious constant and (2) the real risk free rate is generally negatively correlated with expected real growth and does not have a stable mean.

When secular growth expectations decline, R(f) tends to decline and ERP tends to rise.  Expected returns aren't a product of R(f).  It's more accurate to say that ERP is a product of R(f), so that, lower growth expectations cause equity holders to demand higher returns relative to R(f).  Comparing equity yields to real bond yields gives us little information, and comparing equity yields to nominal bond yields is less than useless.  (We are currently in an odd time, because what amounts to financial repression in mortgage markets has pushed real long term interest rates lower than what we might call broadly the "natural" rate.)

I was recently listening to Lawrence Summers on David Beckworth's great podcast series.  Here, I think Summers has presented an example where this framing would help.  He is talking about whether it would be beneficial now to have a US sovereign wealth fund investing in equities:
If it were all about risk premiums then you'd think this was a particularly attractive moment to invest in stocks relative to bonds because there was an extraordinarily high risk premium . I think most sophisticated people in markets kind of think the opposite. Some people think the stock market's a bubble, some people think it's not. I don't know many people who think it's unusually cheap, which would be the corollary of the view that the risk premium is extremely high. So I don't particularly relate to the safe asset paradigm. If you had that paradigm, then you would say that if the spread between bond yield and stock yields was super wide. This was a good moment for the government to issue bonds and buy stocks. But I don't find that a plausible guide to my own investment behavior. And so I'd be hesitant to inflict it on the government.
Now, in ERP terms, clearly there is a high equity risk premium.  Clearly, expected returns on equity are much higher than risk free returns.  Summers is speaking about risk premiums, but he seems to be thinking in terms of absolute valuations.

If equities perform poorly, though, it will be the result of unforeseen real income shocks.  It will have little to do with valuations, because valuations, in terms of total expected returns, don't actually change that much after taking account of cyclical changes in growth expectations.  Thinking of equity valuations as a fairly stable long term variable with a lot of short term and mid-term variability, then it is much less confusing.  Clearly the equity risk premium is high, and we don't need to know much more than that real long term interest rates are low to realize that.  After cyclical adjustments (which are large for equities, make no mistake), it will take some sort of epic regime shift in the American economy to keep equities from vastly outperforming real bonds over the next 30 years or so.

--------------------------

Later in the interview, a couple of other items caught my attention.  On QE:
I'd also say, whatever you thought a few years ago, fact that we stopped QE and interest rates kept falling, it has to lead you to think QE is less effective than whatever you thought before we did that experiment.
This comes from thinking of monetary policy through interest rates.  Clearly, to me, the fact that interest rates fell after the QEs were ended is a sign of how QE was effective and had kept rates from falling while QE was on.

But, then, he follows up with this comment about raising rates moving forward:
And I don't see the financial stability rationale either. I'm not sure that markets are extraordinarily overvalued. If I believed with confidence that markets were a bubble, I'm not sure that would be a reason to tighten policy. It might be a reason to ease policy. 'Cause when the bubble bursts, we're gonna have a real problem. And so, I might as well get some stimulus into... Behind the economy. So, I don't see the case for tightening.
Can I nominate Summers for Fed chair in 2006?

Thursday, October 19, 2017

Housing: Part 264 - Rent is how we consume housing services!

Chris Dillow at Stumbling and Mumbling has a post up about housing where he claims that added supply in London won't make housing much more affordable.

This post is an excellent example of how confusion between owning and consuming is such an important source of error in housing markets.  To be fair, his treatment of the issue is conventional here.  As he writes: "Changes to the flow of the asset are generally too small to have much effect. For this reason, many economists have traditionally modeled house prices as if only demand matters".

This is absolutely, sadly, true.  As with his post, pick up any random academic article about the causes of the housing bubble and it is likely that "rent" is not mentioned in the paper at all, even as a factor to be dismissed.  It is widely treated as a factor not relevant enough to even bother dismissing it.  Not only is housing treated as if only demand matters, but it is treated as if this is demand for owning, rather than demand for consuming.

I wonder if the single most useful policy we could enact regarding housing markets would be to force all homeowners to actually write themselves a check each month for the market rental value of their homes.  I think the fact that we don't do this, so that many homeowners equate their cash expenses with the cost of housing, is a significant reason why this error is so widely committed.

The cost of housing is rent.  Period.  The crazy thing is that about half of the residents of the large urban centers are renters!  For them, this is not complicated.

Dillow writes:
If supply doesn’t affect prices, what does? Lots of things: demographics, incomes, debt levels, expected incomes and the availability of credit. My chart shows another influence: real interest rates.
Now, in order for interest rates to affect home prices, rental value must be an input, as Dillow's chart implies.  But, by removing rent as an explicit input, notice how much easier it becomes to dismiss supply as a factor in price.  Supply won't affect any of the remaining factors Dillow cites.

Imagine if we conceived of other markets the way we conceive of housing.
Families are finding it increasingly difficult to feed their families.  But, the proposed solution - to harvest more grain - is a non-starter.  There is only so much land, and adding to the available acreage is a slow process that can't begin to keep up with the problem.  And, acreage continues to be very expensive.
Acreage is expensive mostly because of low interest rates, loose lending to farmers, and high farmer incomes.  So, the question is, how do we reduce the value of acreage to make food more affordable?  Maybe we could pass laws so that farmers must allow gleaning.  Maybe we can put more obstacles up so that banks aren't so eager to lend to local farmers.  Maybe we can regulate the harvest so that farmers only sow the grains that we have determined are most in need.

PS. It could be that Dillow's claim about supply not bringing down prices is somewhat accurate in practice, which I discuss here.  It depends on whether high prices in constrained cities are more sensitive to interest rates or to expectations of rising rents.  If constrained supply makes prices more sensitive to low interest rates, then the rate of new supply in the worst cities would, indeed, need to double, triple or more in order to stop the flow of low-income out-migration and to introduce enough supply to create a regime shift in rent expectations so that they are actually expected to decline.  I have been moving toward this point of view.