Tuesday, April 22, 2014

Own or rent? Thinking aloud about housing

image source


Note: I accidentally published this post early, then deleted it, then remade it. This is the correct post, but most RSS readers will also show the original, incomplete post just before this. Ignore it. Sorry!

Yesterday Catherine Rampell wrote about the strong preference Americans have for home ownership. Robert Shiller speaks of the "homeownership delusion." The more I think about housing, the stranger I think it is.

Owned housing provides a stream of housing services (which everyone needs), the nature of which can be exactly customized to the owner's preferences. A house is a large fixed asset with a low depreciation rate that is easily collateralized, allowing owners with equity to better smooth consumption or finance entrepreneurship. It sits on land, an asset with somewhat inelastic supply. Robust insurance markets exist for countering unexpected depreciation of the physical asset. Owning a house is like being able to pay rent with untaxed income. An owned house is a lifetime inventory of housing services; once paid for, this inventory allows owners to avoid large monthly living costs that can make retirement or job loss difficult and risky.

On the other hand, as a capital gains investment housing typically performs poorly compared to alternatives like stocks. Ownership imposes large adjustment costs on housing consumption. As a result, home owners are likely to often hold (and pay for) larger housing inventory than they need (e.g., owning a large home in anticipation of having a large family before said family arrives or after children leave the nest); in these situations, many people may be better off renting for extended periods. For most people, an owned house is a massively concentrated, highly leveraged, totally undiversified bet on one asset class (real estate) in one geographical region. It's a long-term bet on the local labor market and natural environment. It may be a long-term bet on the owner's job match or occupation. The home purchase includes a bundle of local amenities--school district, voting district, neighbors, public administration, commute, etc.--and the new owner is making a bet about the outlook for that bundle as well. In the past, owner-occupied housing may have been the only way for average people to gain exposure to the real estate asset class, but diversified real estate investment is now available to anyone with a Vanguard account.

In many personal finance books home ownership receives no attention in the context of optimal portfolio allocation, which I find very odd.

One pro-ownership argument I've seen made is that owned housing allows households to "lever up," which is true but a bit misleading. The housing investment is typically leveraged, and the collateral value is nontrivial (and much better than stocks), but a new home owner doesn't get leverage benefits compared to the renting alternative. A mortgage allows one to buy a large inventory of housing services now but pay for it over time (albeit a time shorter than the duration of the service stream), while renting is just paying for those services at the time they are consumed. In some cases, the opportunity cost of owning is high as some of the money that would have gone toward mortgage payments could be invested elsewhere instead. Once the house is paid for, of course, the owner holds a lifetime inventory of housing services that can be consumed at (almost) no recurring cost; then the owner can devote a huge share of income to other investments. But observe that this strategy turns the Ayres and Nalebuff approach on its head, concentrating portfolio risk in the short time period between house payoff and retirement.

All of these risks are diversifiable, but only for people with enough extra wealth to make hedging investments.

None of this is to say that buying a home is a bad decision. Occasionally I see people suggesting such. I'm simply arguing that the housing tenure decision is nontrivial. The standard norm that adults should buy a house as soon as they can save the down payment is probably inappropriate. Many people are probably financially better off renting. The right decision depends heavily on relative magnitudes of mortgage interest rates, ownership costs (e.g., property taxes and maintenance), rent, adjustment costs, returns to alternative assets, and time preferences. Spend some time with this excellent tool at NYT (be sure to fix some of the advanced settings, like investment returns). It doesn't take much experimentation to see the sensitivity of the tenure decision to parameterization. Of course, there are non-pecuniary benefits of owning, but in many cases these come at a significant financial cost.

Whether a person should rent or own depends on their circumstances, preferences, and assumptions about the future. I suspect that housing policy is made without accounting for the complex nature of the optimal decision. Maybe a lot of personal tenure decisions are as well.

Monday, April 21, 2014

How to think like a macroeconomist

Macroeconomists generally interpret the data they see as the unfolding of a Radner equilibrium, often with distortions, such as taxes, and with some incompleteness or dysfunction in the set of IOU markets.

This is from Kartik Athreya's Big Ideas in Macroeconomics, which is superb (and yes, he explains Radner equilibrium for the lay reader). I wish I'd had this book when I was preparing for PhD comprehensive exams, and in the future I will recommend it to anyone who wants to consume the writing of economists. I will say more about it later; it has much to absorb but I am nearly finished.

Saturday, April 12, 2014

Drought pricing

From the California WaterBlog:

Most water system costs are fixed; those for distribution pipes, treatment plants and labor don't vary with the volume of water delivered. Unless most of the monthly bill is a flat fee (which dims price incentives to consumers to use water efficiently), revenues often cannot cover fixed costs during droughts, when extraordinary conservation reduces water sales and revenues. Utilities must raise rates after the drought. 
This practice sends a mixed message to customers, who conserved water as requested and are then rewarded with higher rates. 
Anticipating such problems with special drought pricing policies can rectify this situation. The utility establishes a drought rate schedule in advance, which allows it to announce and charge a higher per-gallon rate during droughts. 
Drought pricing keeps the utility solvent while providing a special conservation price incentive to consumers. Only a few communities now do this (Roseville and Los Angeles are examples).

It's unclear to me what is preventing so many utilities from adopting drought pricing. Regulatory barriers? Fear of "price gouging" accusations? Menu costs?

Tuesday, April 8, 2014

A Model of Secular Stagnation

In this paper, we formalize the secular stagnation hypothesis in an overlapping generations model with nominal wage rigidity. We show that, in this setting, any combination of a permanent collateral (deleveraging) shock, slowdown in population growth, or an increase in inequality can lead to a permanent output shortfall by lowering the natural rate of interest below zero on a sustained basis. Absent a higher inflation target, the zero lower bound on nominal rates will bind, real wages will exceed their market clearing rate, and output will fall below the full employment level.

The paper is by Gauti Eggertsson and Neil Mehrotra, here. I have been clamoring for someone to formalize the secular stagnation hypothesis, and this is an interesting approach. EDIT: See new footnote.*

This is a 3-period OLG model without capital. The standard shock is contraction of an exogenous borrowing constraint, inducing deleveraging among borrowers (the young). A persistent savings glut is driven by generational concerns: having borrowed less when I was young, I now have more to save when I am middle aged. This keeps the interest rate from returning to a higher level. Deleveraging shocks, even temporary ones, have persistent consequences, potentially resulting in a new steady state with a very low, even negative, interest rate. More generally, any shock that results in low aggregate borrowing among the young has persistent effects, including a lower birth rate. Within-cohort income concentration can also reduce the interest rate through the standard mechanism associated with marginal propensity to consume. Nominal rigidities (in particular, downwardly rigid wages) make things worse, resulting in permanently lower output. If the interest rate falls below zero, the central bank can't put Humpty Dumpty together again.

The authors plan to extend the model to include capital, which seems important. A world in which consumption is the only source of demand doesn't make a lot of sense to me for this question, but it seems to be what some people in the blogosphere are assuming. And what if there is an equity premium? The standard response to my complaints that stagnationists are ignoring investment is that the ZLB prevents investment from really getting going; I guess the implication is that people will just hold cash instead of buying widget machines. But the natural interest rate would have to be really low for the rate on equity to fall below zero. This investment market still clears.

At the margin, should fans of Piketty be rejoicing at the prospect of permanently low r? Arnold Kling has been asking for a reconciliation of these stories; he got a really interesting response from the brilliant Matt Rognlie (in the Kling's comments):

One way to reconcile the two is to say that Piketty's return on capital includes the equity premium (and other premia for privately held businesses, etc.), whereas the secular stagnation idea of a perpetual ZLB deals with only the riskfree rate. If the equity premium is large, it's possible that Piketty's return on capital is high but the equilibrium real rate is low.

Is this plausible? Rognlie does some back-of-the-envelope thinking that suggests it may not be:

A decline in the real interest rate from 2% to -1% implies a decline in user cost r+delta from 4.5% to 1.5%, of a factor of three. If the demand for structures is unit elastic . . ., this would imply a threefold increase in the steady-state quantity. Since structures are already 175% of GDP this would imply an additional increase of 350% of GDP, more than doubling the overall private capital stock and nearly doubling national net worth.

Needless to say, getting there would require a huge investment boom.

Rognlie's is a very rough parameterization, and it's partial equilibrium, but the point is that we haven't grappled with this yet. I'm looking forward to the next iteration from Eggertsson and Mehrotra; the existing paper has convinced me that this question deserves serious attention.


*There has been some debate about particulars of the model and whether this paper is very good. I think it is a good paper; we have been complaining about the lack of formal exposition of secular stagnation, and now we have a start. In my view starting with a simple model is useful, even though it lacks some key aspects of reality (primarily capital) and assumes the result to some degree (with its totally exogenous borrowing constraint). I am a skeptic of secular stagnation, so it's important to me that its proponents make their argument transparently and formally. Starting simple is the most honest and transparent way to build the case so that we can all see the man behind the curtain. The next serious step is capital, and then we will really have something to talk about.

Saturday, April 5, 2014

The West's command economy

Lake Powell (source)


The more one learns about water in the West, the farther one falls into the rabbit hole. While China introduces capitalism into its countryside, the rural western United States remains firmly entrenched in what looks an awful lot like a command economy. . . . 
Water in the West is simply too cheap: Its low price doesn't reflect its scarcity or its external costs to society. . . . Water in the West, where the resources is rare, has historically cost users less than in the East, where water is relatively abundant.

This is from Dam Nation by Stephen Grace (pp. 207, 216). Water management in the West is an ongoing disaster. Obviously water presents some very difficult policy challenges: the usual problems with the commons, intertemporal (even intergenerational) allocation of uncertain endowment streams, political economy, imperfect enforceability of contracts, etc. are all present. But many of the policy interventions effected during the last century have exacerbated these problems rather than targeting and correcting market failures. The rural West's culture of rugged individualism is sustained in large part by massive taxpayer funding of water storage and allocation. Probably Western agriculture and other activities would control a much smaller allocation of resources if the Social Planner were running the show (and certainly if markets were running it). I say this despite my own hereditary and cultural sympathies for the rural West.

There is also this:

When farms and ranches sell their water rights to growing metropolitan areas, local food production decreases. The biggest losers in the transfer of water from farms to cities, aside from the rural communities that wither and die . . . , are urban locavores who want to eat fresh food grown nearby. A city can quench its thirst today with the water rights of farmers, but what of its hunger tomorrow? (208)

I think Grace is too sympathetic to this particular interest group (locavores). I wrote a bit about the urban/rural water split here.

Tuesday, March 25, 2014

Capital in partial equilibrium

Image source

Review: Thomas Piketty, Capital in the Twenty-First Century

Piketty's primary contribution is to provide an impressive array of data on wealth and income, for several countries, beginning as early as the 1700s in some cases. Note that he does not examine consumption data. The book is an impressive feat and certainly deserves attention, as the facts Piketty provides are crucial to discussions of the evolution of capital and economic inequality in the rich countries. Many reviews have been very positive; there are a lot of positive things I could say about it, but I will leave that to others. The book suffers from some fundamental flaws; in short, while it is heavy on data it is light on serious economics. Readers will find themselves wading through hundreds of pages of opinion and ideological quips, not economic analysis, with interesting charts scattered throughout. The firehose of data can be overwhelming, which may explain why some reviewers internalized his arguments uncritically. Piketty's accomplishments with data collection are admirable. But a book of this size, with the title Capital, should include some economics.

Piketty's data on inheritance are the most interesting and persuasive to me. Inheritance still matters and plays a nontrivial role in the wealth and income distribution. Reducing wealth inequality over time, should we decide to do so, will require serious attention to the issue of inheritance, which more than any other issue lacks a tie to meritocracy (but that does not mean incentives stop mattering!). There may be other arguments, not based solely on inequality, for thinking about inheritance. That said, not all capital is created equal, and the book could have benefited from some focus on distinctions between capital types--particularly in the context of inheritance.

Most of the analysis in the book is more about accounting than economics. Piketty takes nearly everything as exogenous then divides things arithmetically. His ubiquitous r > g heuristic takes both sides of the inequality as given for almost the entire book. Lines like "the richest 10 percent appropriate three-quarters of the growth" (297) enable lazy readers to avoid thinking about what actually determines income. Language about "appropriation" suggests that we live in an endowment economy, as does the claim that post-World War I wealth inequality fell "so low that nearly half the population were able to acquire some measure of wealth" (350). Endogeneity, anyone? Taking income as exogenous leads to other large problems with inference, such as the claim that "meritocratic extremism can thus lead to a race between supermanagers and rentiers, to the detriment of those who are neither" (417). Piketty does not consider the possibility that this race results in more income than otherwise, nor does he consider the notion that an increase in the bargaining power of elite executives could actually come at the expense of capital owners rather than workers. I'm not making an argument for either here; I'm simply suggesting that Piketty's ideological quips don't deserve the certainty with which he delivers them. Models with endowment economies have their purposes, but a 600-page book should be able to relax such strict assumptions. His criticisms of mathematical economics (32, 574) are not surprising given that he relies so heavily on assumptions and mechanisms that would be highly vulnerable to criticism if they were forced into the transparency of a formal model.

This kind of fast-and-loose economic reasoning pervades the book. Piketty attributes the rise of the "patrimonial middle class"--the great home-owning middle class of developed countries--entirely to the rise of capital taxation (373). It's perfectly reasonable to argue that taxation played a role, but it's absurd to give taxation all the credit without further analysis. Piketty relies on this shaky causal claim for his central thesis; presumably unbounded capital accumulation wouldn't be a problem if everyone owned some. Denying that economic forces played any role in bringing wealth to the middle class helps Piketty claim that inequality will spiral out of control and leave us all in poverty unless serious tax reform is effected. This argument also requires him to assure readers that there are no tradeoffs associated with capital taxation: "It is important to note that the effect of the tax on capital income is not to reduce the total accumulation of wealth" (373). We also learn that there is "no doubt that the increase of inequality in the United States contributed to the nation's financial instability" (297). No identification problem here, folks; causal inference is easy! The book is littered with extremely strong claims like these, despite the existence of good reasons to at least be skeptical of some of them. Maybe Piketty is right about these things, but he has not shown it here; and even if his considerable collection of charts and tables is enough to dazzle most reviewers into fawning submission, the data are not sufficient for demonstrating his strong conclusions.

Piketty's data on the rise of middle-class capital ownership raise an important point. A key theme of the book is that poor people don't own productive assets, so they must rely entirely on labor for income. But is taxation and redistribution the only way to address this situation? This poses a difficult question for those who oppose some form of privatization of government retirement programs. One cannot simultaneously claim that owners of capital stand to gain absurd riches in coming decades and that privatization and choice for Social Security is a terrible idea.* This is not the only possible alternative to taxation, but it is a reminder that one way to treat the problem of poor people not owning stuff may be to help poor people, well, own more stuff. But Piketty simply asserts that "only a progressive tax on capital can effectively impede" increasing wealth concentration (439). More generally, Piketty decries the ability of those with large fortunes to access opportunities for higher rates of capital return than those with smaller starting funds, but he makes no mention of the fact that this is due in part to laws banning small investors from participating in alternative investments. By law, if I want to invest in a startup, I can only do it in undiversified ways (like starting my own firm or investing in a friend's). We don't need higher taxes to help lower classes invest better.

Another key weakness of the book is that, like much of the popular debate on inequality, it focuses almost entirely on higher moments of income and wealth distributions while making only minimal effort to provide context about absolute levels of income and wealth. Piketty compares inequality over the centuries, noting that it is returning to pre-World War I levels then claiming that "the poorer half of the population are as poor today as they were in the past" (261). This is only meaningful in relative terms; as Piketty briefly mentions a few times (but does not emphasize), the poor of 2014 are much better off than even average earners from previous centuries: "With 5-10 times the average income in 1800, one would have been in a situation somewhere between the minimum and average wage today" (415, see also 88), and even Piketty admits that this claim relies on dubious adjustments for inflation (how much did a car with air conditioning cost in 1800?). The truth is that most of today's developed-country poor are astronomically, unquantifiably better off than almost anyone from 1800, which raises the question of why Piketty sounds alarms about inequality reaching previous levels. He briefly acknowledges modern international context in chapter 12, but he examines only wealth inequality,** which is tricky, and makes no mention of global income inequality, which has been declining. In any case, Piketty has strong incentives to tell us that the only thing that matters is inequality within rich countries (432)--even if the poorest Americans are better off than most of the world.

This is the great failure of the inequality alarmists generally: a myopia centered around rich countries that have seen massive growth in purchasing power for everyone. For within-country inequality to become a public policy priority, those concerned about it need to make a much stronger case. This isn't just about whether society is totally meritocratic--obviously it's not, as Piketty argues in multiple places. The problem is that Piketty has not performed an analysis of optimal inequality, choosing to rely instead on a lot of straw man arguments and vague references to "democracy." He has provided a lot of data that demonstrate that inequality in countries that produce the top 20 percent of global output is on the rise, and he has suggested policy remedies (that he claims are basically costless), but he has not made a serious attempt to convince fence-sitters that this issue should top the policy agenda.

It is hard to believe that Piketty's predictions for the future--on which his policy prescriptions rely--are much more than undisciplined speculation. He does not have a model. He has shown us historical data from which he has drawn inference using accounting-based counterfactuals and a lot of hand waving. He has made forecasts for the future paths of income and returns to capital--both of which are basically exogenous processes in the text. On these forecasts he hangs his broader predictions. His predictions are worth noting because he is a capable scholar with a tremendous mastery of the data, but his hand-wavy approach to dismissing (or ignoring) weaknesses in his framework limits the ability of his speculations to convince those who don't already agree.

Economists who write books like this have an opportunity to educate the public in economic reasoning. Thinking about macroeconomics is hard. Piketty's methods and rhetoric suggest to readers that macroeconomics is easy. He can dismiss all objections with a wave of his hand. He can ignore policy tradeoffs and potential general equilibrium effects by simply asserting them away. Someone should count how often he uses the terms "no doubt" and "clearly" when drawing huge, highly debatable conclusions about almost everything (e.g., 511). By referencing only charts (if even that) for many of his claims, he is feeding the sloppy and destructive "this one chart proves...!" fad that has spread in the blogosphere; a chart is never sufficient to make causal claims or demonstrate optimal policy. In this sense, Piketty does his readers a disservice. He should have asked them to think harder instead of just gazing at graphs. He should have accompanied his facts and predictions with serious normative arguments instead of assuming his readers automatically share his deep concerns about how the world's top 20% are faring compared to the world's top 0.1%. He should have explained the reasons many economists prefer low taxes on productive capital other than land; even if he finds such arguments unpersuasive, he robs readers of the chance to consider them when he blatantly accuses those economists of intellectual dishonesty (514).*** He should have acknowledged the massive "causal density" problem in macroeconomics and shown readers how economists investigate causal relationships and, more importantly, identify the limits of their knowledge. Instead, he preaches to the converted and to those who are easily overwhelmed by a deluge of charts, knocking down straw men but avoiding the hard questions. The book is many things, including an excellent resource for stylized facts, but serious economic analysis it is not.

Capital is tremendously informative, and Piketty's use of literary anecdote is a nice touch; but ultimately this is a chart book, with plenty of economic data but very little economics.


*Piketty devotes a grand total of two paragraphs to this idea (488-9), making two weak, unimaginative arguments against the policy. He cannot imagine a way to transition from PAYGO to private investment accounts, and he believes that trusting retirement to the markets amounts to "a roll of the dice." We know enough about optimal retirement portfolio choices to do better than dice-rolling. For someone in my generation, watching a chunk of my paycheck go toward a program based on the silly assumptions underlying Social Security is the real gamble. In any case, if Piketty truly believes that giving everyone a chance to become an owner of capital is a dice roll, he must explain why he is so certain that capital income is sure to explode in coming decades.

**His discussion of wealth inequality even includes an awkward admission: "The average global fortune is barely 60,000 euros per adult, so that many people in the developed countries, including members of the 'patrimonial middle class,' seem quite wealthy in terms of the global wealth hierarchy" (438). But the middle class doesn't just "seem" wealthy. The developed world's middle class is wealthy by any objective standard, which emphasizes my point that inequalities within developed countries are much less disconcerting that true global poverty.

***Aside from this silly accusation, Piketty never mentions optimal taxation literature aside from a handful of his own papers. His central recommendation of a global wealth tax does not read like a result of optimal taxation analysis. He claims that "it is hard to think of an economic principle that would explain why some assets should be taxed at one-eighth the rate of others" (529), as if "elasticity" and other drivers of optimal tax models are not economic principles.

Monday, March 17, 2014

"A good time to be a water attorney in Texas"

Source

From the NYT:
66 Texas towns and electric utilities [were] exempted from a [water] cutoff for health and safety reasons, even though hundreds of farmers and others who lost their water held more senior rights.

And here's an issue I heard about a lot while growing up:

In Colorado, officials in the largely rural west slope of the Rocky Mountains are imposing stiff restrictions on requests to ship water across the mountains to Denver.

The Western Slope just might win that one, but it may not matter. The Colorado River is crucial to five states. And that's not the only important river that starts in Colorado: ever heard of the Rio Grande? I've seen the words "flush: Texas needs the water" scribbled on bathroom walls in the San Luis Valley, and many in the Colorado basin feel about the same way about Phoenix, Las Vegas, and southern California.

Here's a typical observation about the urban/rural split:

Farmers and others downstream complained that they were surrendering their water while Austin residents continued to wash their cars, groom golf courses and water their lawns.

I alluded to this in my note on landlords: In the long run, does anyone think that the legal water claims of rural interests have a chance against the cities?

I wish I knew more about this topic. It's at least clear that the current legal and market framework will not withstand the coming stress. After hearing about officials in big cities begging people to reduce their toilet flushing but keeping the golf courses running, it's hard not to think that using prices would be an improvement.