Monday, April 28, 2014

"From the right"

Several weeks ago, Matt Yglesias kindly included my Piketty review in a list of commentaries on the book. Oddly, he described my review as "from the right," politically.

I liked a lot of things about the book. I learned a lot from it, and it affected how I think about capital and inequality. I respect Piketty as an economist and realize that he is a brilliant, capable scholar who knows economics better than I do. His book is an incredible accomplishment and a major contribution to the economics and policy world. I focused my review on criticisms because, at the time I wrote it (in March), most of the reviews I'd seen were very positive. I figured people would get the positive stuff elsewhere; I did not anticipate the 10 million reviews that were to come, including plenty of critical ones.

In any case, my review boiled down to three critiques: (1) too much exogeneity, from interest rates to output; (2) no serious discussion of the optimal tax literature; and (3) not enough attention to context in terms of global inequality and actual poverty levels in the rich countries studied. It is likely that Piketty has considered these issues in other publications; I thought they deserved attention in the book. I don't consider my review to have been a "slam" on Piketty or his book; it's just a critique.

I don't think points (1)-(3) are terribly political. I think they are critiques that are likely to come up in any econ department seminar. I confess that I like mainstream economics and I like thinking with formal models. I have found that framework useful; I would be more convinced by the book if it were less dismissive of that framework. I don't have strong opinions about Piketty's policy recommendations; in fact, I lack a strong opinion about a lot of the issues that typically define American politics, and I suspect that my views on the few items I do care about don't fall consistently into one of the camps.

Wonks and others: stop trying to cram every economic argument into standard Left/Right boxes. Maybe it attracts more readers for your various projects, but it doesn't advance the discussion.

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 (book) 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.

UPDATE 30 April 2014: Josh Barro has a very nice video with MSNBC, here, in which he makes the argument for renting as the American dream. "Buy a home if you want to own a home, can afford a big down payment, and can afford to absorb the hit if house prices fall."

*I received a lot of push-back on this point in the comments. This is because I'm pushing the word "leverage" a bit too hard. Obviously I realize that a home allows people to use leverage; I mention its collateral value in several places in the post. When I say owning does not provide leverage benefits compared with renting, I am thinking in terms of the Ayres and Nalebuff lifecycle investing concept. This is the idea that leverage should be used to consume and invest now but pay for it later. Owning a home is basically the opposite of this, since it means you're prepaying your rent. You're paying now to consume and invest later. This reduces your ability to lengthen the time exposure of your investment portfolio, unless you think of the house itself as a capital gains investment portfolio (and history suggests that you shouldn't).

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.

UPDATE: My full review of the book is here.

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.