This is a book review for Thomas Piketty’s “Time for Socialism”.  Gulnara got me this for Christmas. I have earlier reviewed Piketty’s magnum opus – Capital in the 21st Century – and will provide a link for that here (review, additional discussion).

Gulnara got me this book because she knew I’d find it interesting – and she also knew that my students are likely to ask me about it.  Each year I will have students ask me if we should be communist, whether the profit motivate is immoral, and why we don’t teach the “obvious solutions” to the “clear problems in society”.  Every year I appreciate these questions, and the opportunity to think through what these questions mean with the students.  As a result, this video is in part my opportunity to prepare.

In the same way as when I chat with my students, the goal here is not to define what is right or wrong in a moral sense – just to look at the arguments at hand and push on them a little, to see where they may be delicate to different evidence or different value judgements.  It is only by doing this that we can cut through a group’s rhetoric to have a conversation about what people truly care about.  Furthermore, a lot of ground is covered in the book and here – so the discussion should be seen as cursory at best. More detailed discussion of specific issues is something we could do another time.

Gulnara’s section

As with Capital, Time for Socialism is a book that makes arguments that should be aired providing data to establish and support claims.  Unlike Capital it is not a long comprehensive book – instead making Piketty’s arguments through five years of newspaper articles that he has written.  Sadly this means the arguments are less comprehensively made, and so to make sure we are being fair we’ll have to be quite clear about what we think the argument is before throwing around any criticism.

Both Piketty and the Nolan’s over here are individuals that strongly believe in reducing the inequities in opportunities faced by individuals – and who see economics and justice as inextricably linked. Furthermore, we both believe in the importance of a democratic voice and entrenched rights to allow for this. But even with that framing I feel that we have taken the same goals and come to very different understandings of how this “should” be applied.

Back to Matt

Piketty notes that since his youth in the 1990s he has moved from a strong belief in mainstream economics to what he defines as a more socialist perspective – where socialism is defined as a form of centralised action. This is interesting, as my personal journey has been the complete opposite. In my youth I believed that centralisation and decisions by experts were the elements missing from society, preventing justice and progress – while now I see as many cases, if not more, where it is a lack of belief in individuals to make choices when given the opportunity that holds us all back.  Contrary to Piketty’s introductory comments – property rights do play a role in a just society.

While Piketty talks of “the ideal economic system one wishes to set up”, I can’t help but repeat to myself that I do not know what an ideal is – just that I want people to feel secure and capable to make choices and live a good life. Ultimately, my ideal is likely to differ from the ideal of many others – and so I wouldn’t really want to impose that.

No single narrative is right – and these things differ policy by policy – even for Piketty.  As a result, the clearest way to understand the book is to describe the arguments given and the facts that support it. Then to discuss what we see as missing from these arguments, and where there are potentially misleading facts. Over to Gulnara to summarise the book.

Gulnara section

Summary:

This book is a series of newspaper articles linked together by common themes. There is no need to evaluate each article or even theme here in order to discuss what needs to be discussed – instead we want to pull together the threads of the worldview noted at the start of the book.

Piketty notes from the start that he wishes to use the term socialism, but that is a term that can have many meanings – for example in New Zealand the term is fairly innocuous for most of us, while in the United States it is loaded with severe negative connotations in much of the public consciousness.  He then defines the key characteristics of what he views as socialism to his mind when he uses the term – there are five of these characteristics, listed as:

1. Equality of outcomes – with a strong focus on reducing wealth inequality.
2. Equality of outcomes and the right to a minimum standard/bundle – this is the provision of goods on an equal basis through government (universal provision).
3. Participation through circulation of power and ownership.
4. Globalisation – but not as its done now
5. Universality and equality

These five characteristics of Piketty’s socialism are the overarching “policy goals” that Piketty is supporting in this text – indicating that they can be widely applied as appropriate rules of thumb in opposition to whatever current policy settings exist.  The case and context for this argument is then given throughout the book through multiple newspaper articles – where these tangible specific examples are intended to make a case for these more general points.  

Given this, let’s look at each of these a bit more closely and think about a bit of friendly critical evaluation.

Over to Matt

Equality of outcomes and wealth inequality:  

To some wealth inequality sounds like the very definition of injustice, while to others even mentioning inequality in wealth is compared to green-eye envy – and I say this as someone with clearly green eyes. 

Many years ago I wrote an article in the Dominion Post on how land was socially owned, and we should be willing to pay a rent to government as the representative of society for the use of that land. In this way I feel that I have clearly signalled my own concern that the fruits of land and knowledge may fall in the hands of too few people – and yet I don’t find the discussion in this book of wealth inequality and wealth inequality trends particularly enlightening.

One of the starkest issues with Piketty’s description of wealth inequality is what is missed in the discussion – wealth inequality without considering the change in the age distribution and average age, without describing its relation to the level and allocation of capital resources in an economy, without indicating how the “claim” on that underlying lands production has changed, without considering changes in the risk-free rate and the ability to interpret wealth ratios, and the narrow consideration of financial wealth while excluding the significant build up and use of human capital.

For simplicity let’s come up with a toy example that can help us think through these issues.  Take an economy with three people, a capital owner who works and lives in their own factory and two employees who also live and work in the factory.  This gives us one capitalist and two workers – even though all three people “feel” the same apart from a property right over the factory.

Furthermore, the gross value added in the production process is then split between capitalists and workers evenly – so 50% of the GVA goes to one person and 50% goes to the two workers.  We may look at national accounts figures and say this appears unjust, as there is income inequality – the capitalist receives 50% of the GVA, while the workers receive 25% each.  This is inequality in income from the national accounts.

But wait, this is not household income – it does not tell us the amount the individual can consume given their share of the surplus from a production process.  Part of the return to our capitalist friend will be used to maintain the usefulness of the capital equipment that is used in production.  If we assume that this requires 20% of the total GVA, then their household income is net of this cost of 20% of GVA.  So the capitalist receives 30% of the GVA and there is still a little income inequality.

How about wealth inequality?  The measure is financial wealth, so it is the associated value of the capital item.  This will depend on the present value of the stream of cash flows from the capital item.  The additional return (beyond simply selling labour) is 5% of GVA for the capitalist, so the wealth they are holding is the capitalised value of that 5% per year discounted by their discount rate (which is related to the risk-free rate of return).

And the wealth of our workers, well that depends on their saving.  But if we assume that people simply spend what they earn there will be no saving – and it makes our example easier.  Namely, wealth inequality would be INFINITE.

Which one of these measures refers to our key concern when we discuss inequality of outcomes?  I would argue that only the household income inequality measure truly matters – and we would want to understand why inequality in that measure occurs.  Is the capitalist taking on more risk?  Are they actually providing intangible capital or working longer hours?  Or is it purely luck or a matter of initial endowment?  Each of these explanations then may give us a different lens on what an appropriate form of redistribution would be.

Piketty’s views differ from this specifically because of his view that wealth itself generates power – and an ability to force redistribution towards yourself.  In this world it is not the broad structure of inequality that is the issue – but the density at the very top.  It is not truly “wealth inequality” that is the concern – but the ability for the “elites” to claim the resources of society as a whole.  The term wealth inequality here is really just a rhetorical device for noting that concern with excessive power – an issue that turns up in a later argument.

Even if we accepted the view on power, we should not forget the coercive nature of the state – governments have to have power to redistribute resources, and that power is in the hands of those who work for the state and elected officials. My article on land ownership that I mentioned before was unpopular with my work, with the newspaper, and with readers – and I realised that my personal views may differ strongly from the views that people hold about the state. I have significant trust in government – probably well above the average.

But taking a step back, I can understand where people are coming from. The government is an institution that can be captured by vested interests, and it isn’t guaranteed that they will always act in the common good. 

Furthermore, even with public ownership and the provision of income from that to people in society it is more tangible to point to the provision of a house – the provision of food – or the provision of clean air – than it is to describe the provision of an income that allows individuals to trade-off between things based on their own subjective value. 

Trust and security both suggest that individuals themselves value, and are more willing to contribute within, a society with clear property rights that they can share in.

Such an argument does suggest a floor – an ability for someone to live and provide for themselves without reliance on others. It also points to a reservation option if society demands too much from them.  But wealth inequality statistics don’t tell us much about that, and if not considered critically can be used to paint a picture of injustice where none exists.

The discussion of wealth inequality is in part a red herring – the true issue is that of a sufficient minimum standard and concerns that institution arrangements and structures lead to regulatory capture and market failure.

Equality of outcomes and rights to a minimum standard – the provision of equal products

Now we can focus explicitly on the discussion of a minimum standard – what does this mean.

Here there are three types of public provision to consider with varying arguments – and which are intrinsically intertwined:

1. Underlying absolute needs of the individual.
2. Products and services required for equalising the “relative” position of the individual.
3. Public goods, products with significant market failures due to asymmetric information, and goods with positive externalities/spillovers.

It is hard not to mix all three, as a single item of government expenditure can embody all of them – i.e. education expenditure.  

However, it is important to be clear regarding which of these is the motivation – if you use a market failure argument to state it would clearly be more efficient to spend on this item, but you motivate it using relative position, and fall back on absolute need when pushed, your argument becomes incoherent.  At that stage people will start using the “idea” of your argument to push for things in the same way, and given each of these will lead to different observed outcomes your critics will simply pick the argument that appeared to fail in the data to undermine what is being said. 

However, I have no experience of these things – I have grown up in New Zealand, born at the start of the fourth Labour government when New Zealand opened up. It is Gulnara that can speak with more authority and experience on the issue of growing up in the Soviet Union where many items were provided by the state.

[Gulnara to talk about her experience here]

Thanks Matt. To my mind there are actually two separate issues here that deserve attention. The first is how pre-distribution was used to achieve “equality of outcomes” and its costs.  The second is the post-distribution that occurred in terms of the public provision of products, touching on the issues you have just discussed Matt.

I don’t think we can talk sensibly about one without the other – as the two are linked in terms of how they influence incentives.

Communist Russia progressed from the status of a backward nation to the world’s second-ranking industrial power. Most of this advance was made under a system of tight economic controls which enabled the government to direct investment and labor into development of a heavy industrial base at the expense of other sectors of the economy.

As the Soviet economy became stronger and more complex, the system of central controls became more cumbersome and less able to meet the nation’s needs – output growth started to fall. 

Why? Due to the lack of incentives and price signals.

In a number of enterprises the wage rates were fixed in such a way that the difference between the qualified and unqualified, heavy and light work, disappeared almost completely. Equalisation of pay leads to a situation where the unqualified worker does not strive after gaining qualifications, as they do not see any improvement in their personal position.

The fact that wage rates even existed, which was not Lenin’s first desire, indicated that the Soviet Union recognised, it had to work within constraints. But if they could not use markets what other incentive mechanisms could be used.  The first solution that was tried were appeals to individual pride. Hunger for prestige was introduced: red labour banners, distinguished scientific, technical and arts worker medals – paired with small material awards added to those honours. This led to increasing status competition to achieve these awards – driving increasing corruption.  

During Stalin’s time the need for explicit pay differences was recognised with the difference in pay between the lower and the higher grades of workers increased. From then on those who did not work were seen as parasites and the view of “from everybody according to his ability, to everybody according to his work” was introduced. 

However, pay differences never reflected the same difference as was observed in the Western world.  Why? Because of underlying public provision associated with roles. The Soviet Union used direct ownership and provision of goods and services as a way of remunerating staff – and the big difference between this and other forms of remuneration was that it was non-transparent.  Such non-transparency drove corruption, with a culture of corruption leaching into everything that occured.

The Soviet system did provide you with your minimum needs such as housing and effortless access to the job market, and hence a minimum income as long as you were able to do the job you were told. 

However, if you had talents and skills and wanted to use them to progress, this was not possible. Nation-wide corruption was prominent. In education for example, you had a chance to study hard and get into university, but say you had 5 places allocated to engineering in a given year, 3-4 of them would be already taken by some (e.g. a prosecutor or mayor’s child), leaving hundreds of students to compete for 1 single place. Similar things would be observed in allocations of prestigious jobs such as medical doctors, university lecturers, and more higher up in the hierarchy jobs (mayors, lawyers, head of any departments). The blockage of access to any of this sort of incentives, led to a lost opportunities of talents. It was almost impossible to get into positions you were striving for if you didn’t have any relative, friend who could pretty much sort it out for you. 

This happened with everything – better housing would go to people based on who they know, better jobs would go to people who were better at socialising, and better schools would be available to those who got on well with the university. 

I have personal examples, but I feel uncomfortable mentioning them. Ultimately, for all its imperfections, outcomes in the West bear some relation to effort – and that link is essential for any sort of trust in society. Public provision can be just as corrosive as entrenched private sector inequality – and this is a trade-off that Piketty often misses.

[Back to Matt]

This does lead to a question though – why is Piketty focused on government provision of these goods and services, and not government provision of the income necessary to buy these goods and services with private provision?

There can be good reasons for public provision – market failures stemming from asymmetric information, competition issues, institutional issues, and spillovers or externalities. Relatedly, the broader inability for individuals to pool risk and the belief in a given minimum living standard for all individuals may motivate public provision – although it is more likely to motivate direct income support. Behavioural economics may come in and state that individuals will not purchase things that are in their own interest. 

Finally, but differently to above, there may be a social reason for believing that everyone should receive the same product – in order to enshrine some conception of equality of opportunity, or to engender a sense of shared experience between individuals.

However, this does lead to three concerns we may have about such provision:

1. Inefficiency: The traditional “inefficiency of public provision” – the idea that civil servants, unencumbered by the discipline of competition, would extract surplus for themselves by working less. More broadly, we have the incentive issues Gulnara noted earlier.
2. Consistency with other measures: The interpretation of income and wealth inequality statistics may change – if we take our toy example from before, if we know that a government was providing education, food, housing, toilet paper, and roads would we feel differently about the inequality of income and wealth than if it was not?  Final income studies try to account for this, but they are fairly rare and often allocate expenditure in an ad hoc or subjective manner (i.e. Harding. Lloyd & Warren 2006: The Distributional Effects of Government Spending and Taxation | Levy Economics Institute (levyinstitute.org), Auten Splinter 2019 AutenSplinter-Tax_Data_and_Inequality.pdf (davidsplinter.com), and Saez Zucman 2020 w27922.auto.pdf (berkeley.edu))
3. Preference heterogeneity and choice: It sounds nice to provide things to people, but there are two issues that come up.  
   1. The obvious one is that people may value things differently, and so providing something without choice may simply mean the people don’t get what they most desire – they no longer have a choice about the type of health care or education.  Here we would have inefficiency in terms of how inputs create social welfare.  
   2. But there is a second issue – how do you operationalise provision?  Everyone has different educational opportunities because their parents will spend a different amount of time studying with them. Focusing only on equality of the provision of education led Piketty to bemoan school choice in “Inequality in France” and “Parcoursup: Could Do Better”, but what happens if the same argument then led us to say that all children should go to a boarding school to remove unequal opportunities. Is such a dictate from above truly just?  What about a dictate that the same school materials should be used? What about if the children were banned from going home for the holiday to promote equality? What about if the children were taken at birth to prevent any parental based advantage – where do views of individual rights become sufficient for us to say no, and how could they be included in the argument?

All I can really say for this section is that measures of expenditure are essential for understanding outcomes – and we should be careful trying to be too dogmatic one way or the other.  To go any deeper would require an additional hour for this video.

Sharing of power

Piketty’s focus on power sharing is two-fold:

1. Sharing power within a firm through increased employee ownership and voting rights.
2. Sharing power within society through greater taxation on wealth and inheritance and the provision of a minimum “capital payment” to all individuals.

Let’s start with the first point. Why is tying an employee to an organisation the way we want to address any imbalance between the employer and employee power? In the articles “Basic Income or Fair Wage” and “Rethinking the Capital Code” Piketty makes clear that it is unfair bargaining positions that he is interested in addressing with employee ownership schemes – although there are a number of OECD papers now linking these schemes to productivity and wage gains from such firms, his focus is rightly on the issue at hand given the likely selection bias issues in a number of these studies.

Maybe it is the New Zealander in me talking, but the ability to cleanly move between jobs, contribute to different projects, and move to whatever task appears to need me most is something that is positive – and rules that assume and enforce a situation where people have to stay tied to one job seems wrong on both a social and an individual level.

As our toy example earlier noted, it was the combination of employees and an employer that generated the GVA, which was then split between the individuals. The ability for the employee to force a move away helps to give them the position to bargain a higher share of that surplus, the employer and employees incentive to maintain and build capital (physical and human) similarly creates the surplus that is shared. If joint ownership helped them to do both, and they are both in a position of power, it does not seem necessary to dictate joint ownership – and such dictates appear to be blunt tools.  

Furthermore, such dictates may have unintended consequences – they link an employee with a firm potentially reducing their outside options, they make the employee more exposed to shocks facing the firm, and they make the retirement savings of the individual less diversified. Ignoring any costs to capitalists even from a pure workers perspective there are significant shortcomings to work through.

This is not to say there is no room for equalising bargaining positions, and for improving employee rights in the face of monopsony and asymmetric information. And mobility itself is not costless – the loss of firm specific capital and the insecurity associated with job movement and job fragility are all real.  But labour laws and fundamental income support appear to be a way to address this without the individual being tied to the business.

The minimum capital payment is something that fits strongly within the narrative we’ve been supportive about above. The incomes we all earn, and the returns on our assets, are in part due to the fact we are in a high productivity world – rather than just a product of the sweat of our brow.  In such a case, ensuring that everyone starts off with something feels consistent.

Similarly, recent research by Balboni etal 2021 indicates the importance of available capital for helping individuals get out of poverty traps. https://twitter.com/ChaseReid5/status/1474894957190295559

But let’s be clear on how things are being financed. A decision to finance this with a wealth tax is increasing the cost of capital, and will in turn reduce investment. We may see that as appropriate, we may see this as preferable to alternative forms of financing, but there will be a change in behaviour.

Why is it that people who accumulate should be liable to pay more tax than those who have the same income, but just love spending more? What is the actual “social dividend” that is captured in transactions between individuals, and why is it not that figure that we are reallocating? Given that, government revenues and expenditures are then how this claim is actioned.

It is here that Piketty’s argument is weak – to raise the funds for the type of capital redistribution required we would require everyone to contribute on the basis of their share of this boon of productivity, the mechanism of a wealth tax (which I’d take as a de facto more progressive tax scale) is not sufficient.  Whether you take the revenue estimates of Sarin and Summer or Saez and Zucman saez-zucman-responseto-summers-sarin.pdf (gabriel-zucman.eu) – the higher of which Piketty cites in “Wealth Tax in America” – such a tax at rates that create a tax liability greater than the income flow would not be sufficient to fund the redistribution discussed – and would be well below the Sarin Summers estimates of improved broad tax enforcement Understanding the Revenue Potential of Tax Compliance Investment | NBER.

The comparison to history here is a red herring, again.  Government expenditures to GDP are now higher in most countries than they were at any time in the past, and are financed through broad funding measures. Piketty believes in greater expenditures than in the past and that will require greater funding than in the past, with the consequences that creates – there is nothing wrong with believing in that, but we need to be clear on the trade-offs.  

If the implied tax on income earned from an asset rose towards 100%, people would switch from considering how to avoid tax more than how to effectively utilise the asset – and marginal discussions of how UCC changes would influence the capital stock, as Gulnara and myself had undertaken earlier in the year Taxation, user cost of capital and investment behaviour of New Zealand firms (vuw.ac.nz), would not give us an accurate picture of this.

And this is the crux of the debate – government expenditures and transfers, along with taxation, is how the “minimum capital payment” is operationalised now. The fact I can use a public road, go to the hospital for a nominal fee, and sit in a park all indicate that there is a type of “minimum capital payment” already.  The questions that separate people are “how large should it be” “who should contribute to it” and “who gets to choose how the capital is allocated”.

Globalisation and universality

The last two options we’ll put together into one and only discuss briefly.  Although there is the odd bit of rhetoric in there that globe twitter may disagree with – the basis for both these sections is for global equality and anonymity for the treatment of people, which are essentially globes goals. The guiding principle of any governance institution, or any supra-national organisation, should be to ensure equal treatment of individuals and support for minimum standards – where these standards of equality correct for differences in opportunity based on gender and ethnicity.  

Just like the majority of economists including us, his view may read as naive for those from both the left and right – who believe in the moral imperative of some cultural or social arrangement, that some differences are “natural” or “necessary”, or that it is practically impossible for such coordination to occur.

Personally I find it refreshing. When we look back to now in 100 years it would be our willingness to accept poverty in low income nations that would lead our great grandchildren to view us as immoral – not the fact that someone once said something inappropriate on twitter.  The fact that the left and the right can only see injustice insofar as it relates to them or their peer group – and not through our global refusal to support those most in need – is such a clear failure in public discourse that on these points I have no real area for disagreement with Piketty. 

Articles such as “Europe, Migrants, and Trade” and “Manifesto for the Democratization of Europe” also indicate that Piketty also sees the inclusion and integration of migrants as part of this overall program – showing a consistency that an increasing number of economists are losing in recent years.

Where this view of equality does create disagreement is with how others will interpret Piketty – and sometimes how he interprets himself in the newspaper articles. In a tweet from Noah Smith he notes:

Noah Smith on Twitter: “In which @BrankoMilan argues (correctly) that the people complaining about capitalism are almost exclusively people in rich Western countries where capitalist globalization has caused the disappointment of the middle classes. https://t.co/0rLF8eZE2t https://t.co/mgMwI4wFRR” / Twitter

Is the injustice here that some middle class Americans have seen income growth stall – as it is Americans, not other high income countries.  Or is it the level of poverty in low income countries?  The idea that if the wealthy simply had less wealth then both the global poor and middle class would have been better off is simply not true – those with wealth are those who built and allocated capital in such a way that it helped to lift the truly poor out of poverty, to their own interest.  Reallocating from the most wealth alone would not generate the revenues necessary for the global expenditures Piketty suggests, and yet this is what he appears to indicate from the very first of his newspaper articles.

Why do I raise this – Piketty cites an earlier version of this very graphic in “After Climate Denial, Inequality Denial”, but all he states in the article is that this graph makes the case for the inequalities he bemoans and that others that view it differently (such as the Economist magazine) are being dishonest.  This is not right. To argue from data we need a counterfactual, and acting as if this is a fixed sum of income to be reallocated is a likely poor counterfactual – asking “why” is important, as fits the idea that debate is kept open which is what he asks for in the first chapter of this book.

Questioning this also opens other doors that he may have inadvertently shut – market power and concentration of firms, regulatory capture, unequal international treaties. All these issues can offer explanations for the distribution of income and wealth that suggest policy conclusions that differ from expenditure and revenue raising.  Understanding “why” is important for knowing what intervention is truly just. 

In this way, the rhetoric is inconsistent – picking and choosing the cause in isolation based on the subject of the article.  The honest interpretation that everyone who has benefited from technological growth over a long period of time would need to contribute to support his redistributive grand-design is missing. And that where income change is not the product of technological growth, but instead power, we need to understand the power dynamic prior to considering the intervention. If someone has power due to concentration or regulatory capture, they will have the means to avoid indirect instruments such as a tax.

Conclusion remark

Also, I will say one more thing about the arguments overall – after all the road to hell is paved with good intentions. Within any structure, institution, and society it is always the way that the “needs of the many” can swamp the “needs of the few”.  Or even the wants of the many can swamp the absolute needs of the few.

We all have varying conceptions of justice due to different perspectives, different preferences, and different beliefs. And the tyranny of the majority is a real thing, that becomes strongest when change is driven in the name of justice and victory over some other. 

The principles of universality and equality work only when the rights of the individual are enshrined and protected – and every single time we think of a neat scheme to improve some metrics of outcomes we need to keep that in mind.  This isn’t some way to slow down progress – it is a way to stop our generation from becoming the monsters we read about in history books.

A desire to do good needs to be balanced alongside humility and a recognition that we don’t always know what good is – if we lose sight of that we might lose the argument, but even worse we might win it.

Now I think I have a clear idea on it all again, so I’m just noting this down so I can look it up in the future!

Use value:  Read this as utility Matt.  It is the value of the person using it.

Exchange value:  Price.

You’ll notice something is missing here when I talked production functions though … the actual supply of goods and services.

Right ok, how does this all fit into a supply and demand graph?  Well, the use values are points on the demand curve for each product purchased, the exchange value is the market price.  This gives us consumer surplus (the difference between the exchange value and the use value).  Cool.

Then we have producer surplus, as the way the exchange value is above the price necessary to get producers to sell the product.  At each point on the supply curve/marginal cost curve a producer is willing to sell that product individually (covers their costs – including wages – and opportunity cost, which includes a required rate of return) but they receive the market price.  The difference between firm structures (monopoly, perfect competition) is determines where this market price is set – not how the MC curve looks (although X-inefficiency would disagree here).

So producer surplus goes to producers.  Is that funamentally unjust, I mean we haven’t actually made a model of how wages are determined here so I don’t think we can describe it.  The “marginal cost” function that leads to producer surplus has an embedded wage rate which may – in of itself – involve labour receiving surplus value from the production process.  Let us not forget that we need to consider this labour market.

Hence why Marxist factor shares depend on a view about subsistence wages – and sometimes a peripheral view that this surplus is immediately capitalised and can be viewed as a “rent” that is used to accumulate more capital.  But to discuss this we need a general idea about how “steep” supply curves are.  What happens if supply curves are very flat, something you may expect in a situation with constant returns to scale … well producer surplus will not occur in the long run and the “scale” of the firm is determined by demand.

Matt, overall I still think talking in terms of market imperfects and imbalances of bargaining power is a bit more useful than trying to find a “fundamental law” or “contradiction in capitalism”.  Although I know that terminology is popular now (Piketty review, and added notes) lets stay away from it.

My concern four years ago was that the non-rationalist identity politics of the left would open this type of negative nationalistic politics on the right – or would at least be used as a foil for it.  The refusal to actually state our assumptions and values is a failure irrespective of the intentions we hold.  In that way, when exploring Youtube I’ve been pleasantly surprised by the leftist video blogs – and their willingness to fully articulate their views.  Key examples of this are Shaun, Contrapoints, and Philosophy Tube.

However, these channels are distinctly “anti-capitalist” in terms of wanting sizable change in the status quo.  I am a mainstream economist that believes in incremental change.  A full discussion of this would be interesting – but give me time.  But to do so we need to get something clear about the labour theory of value that I am hearing them describe – it doesn’t make sense as a justification for anything let alone as a “theory of value”.

Note: The actual labour theory of value has been defined many ways – and the most profitable Marxian interpretation I’ve seen is trying to understand LTV as part of a subsistance wage argument on factor income shares.  That isn’t the focus here.

Here is the theory being used recently on Philosophy Tube [Note: In his Marx video he says there is debate about it … but I was of the impression that Marxists didn’t rely on the specific assumption articulated here, and economists have would not find this particularly useful for description or as having normative significance – after all Joan Robinson did call the whole LTV tautological and a silly verbal game, and she is one of the most historically left leaning people in the economics discipline].

So without labour it does not matter how much capital we have nothing is produced.  Therefore all “profit” is generated by labour and is labour value that is extracted by capitalists.

Now that first premise is true isn’t it?  Without labour, capital produces nothing!  This is indeed an assumption I teach early in stage 1 economics, and the production process in most firms shows this to be very true.  Take the example of a lawnmowing business – if we have a lawnmower but no-one to operate it we can’t mow lawns.  Furthermore, buying another lawnmower won’t “increase” output, as we still have no-one to actually do it!  This is textbook true.

But lets flip the script.  Suppose you have hired a bunch of people to work for several hours for your lawnmower business, but:

1. You provide them no lawnmower [physical capital – or the tools used by labour which increase their output]
2. You provide no fuel for a potential lawnmower [other inputs]
3. You provide no information about where lawns need to be mowed [coordination services]
4. You have no connection to the demand for lawnmowing services [entreprenuership]
5. The labourers have no knowledge or skills that make them able to mow a lawn [human capital]

Well in that case no matter how many people you hire you get no output!  Wait a second … does this mean that all the value of production is embedded in one of these other inputs!!!  No, no, no.

Could it instead be that all factors of production codetermine output.  Furthermore, these factors require a minimum return in order to be supplied, where these rates of return/ prices are termed “profit” and “wages”?  Doesn’t this make it a collaborative process rather than extractive?  [Protip:  It can be both collaborative and extractive – but we need to model why rather than just positing it is ]

The production process

Production is a process of coordination between factors of production – that is why in macroeconomics we have a firm (the thing that combines factors of production to create output) and households (the group that buys output, but also supplies all the different factors of production to the firm – yes including capital, capital owners are “households”).  In macro we refer to these varying incentives (the incentive to supply factors of production to purchase consumption over time, and the incentive to supply output in order to “get profit”).

Yes it is true, labour does not receive the entire surplus from production.  But they don’t supply the only factor of production either – so I am uncertain why they should.  Production is a joint process which creates surplus value – and this surplus value is then shared according to the bargaining power of participants.  Inequity is then a process of insufficient bargaining power – not a natural consequence of private capital.

Much economics treats other factors as fixed and labour as variable.  Typical descriptions of the labour theory of value also look at a “fixed production process” such that additions to labour explain the entire addition to output.  Furthermore, there is an opportunity cost associated with every single input – labour is sacrificing alternative uses of their time, capital owners could liquidate assets to fund consumption or alternative investments.  Each has an opportunity cost, and is undertaking a process that creates surplus value – we need to ask about the relative bargaining power (which then determines the price here, the real wage) in order to ask how this is split.

Or to put it another way, there is a stock of labour and a flow of labour provision (hours of work) which is remunerated with wages, there is a stock of physical and coordination capital and a flow of related business services (the use of capital hours, “effective” entrepreneurial labour by capital owners) which is remunerated through profits.  Those utilising capital may need to borrow in some way (selling shares, borrowing from a bank) to put this in place which then changes the allocation of these profits sure – but is still predicated on the provision of this flow of services.

So given that economists often treat the level of capital as if it is fixed and provided in the moment (a similar assumption to the one we make for land – and one that is not necessarily appropriate in many instances), if we want a theory of price determination looking at the “labour embodied in a production process” appeared to be a way to get there.  This Ricardian view wasn’t saying that labour was solely responsible for production – this is a semantic point that gets lost!

In the end this left some problems though – why is a painting that ages with no additional labour input more expensive than when it was initially painted?  The solution to this appeared to be adding “use value” which in turn begs the question why is water free while diamonds are so expensive?  In the end marginalism, with price set in relation to the marginal cost of production and the marginal use value/utility of consumption solved both of these!  With labour is often treated as the variable factor, the marginal cost is often stated as the marginal cost of labour – and thereby wages being set relative to the marginal product of labour became a description for labour markets as well.

We can go too far with this as well.  We may say that any urge to change this “natural” wage by increasing labour’s bargaining power will reduce employment and output/surplus value in the industry.  Of course this ignores two things (assuming it is descriptively accurate of firm-employee behaviour in the long-run):

1. There can be bargaining power the other way – monopsony matters.
2. Just because this describes prices doesn’t tell us that labour is receiving their contribution to the process [we might think of this in terms of the average product of labour IF we could define a portion of production that is attributable to labour]

That last bit makes the issue of distribution bloody difficult – and the idea that we can rely on marginal products for considering a fair income distribution is NOT mainstream economics.

At this point the relation between this and income shares must become sort of clear – so let me just point out the posts we’ve done on classical, Marxian, Neo-classical, Marshallian, Post-Keynesian, Neo-Ricardian, and General Equilibrium factor shares here.  Given the complication of discussing such shares I note:

It is for this reason I strictly favour analysis of household level data for discussing points on distribution, rather than analysis of factor shares.  If I was to build up larger “groups” than households to discuss, I can tie them together on shared characteristics in this framework – compared to the arbitrary and loaded combinations of “parts of individuals” that occur with factor work.

A big point here is also prices in goods markets.  If returns to labour AND capital are equal to their opportunity cost then we know that prices will be set in a way that “maximises surplus” from the production process.  This is nice.  Now if that process leads to very low labour income WHEN those things are occurring, the implied labour value must be low in that process – that is fine.  This doesn’t need to imply that incomes must be low – instead it describes a specific income generating process, and would suggest to many people that we should find a way of supporting individuals with a low opportunity to earn income.

Now, if we were in a situation where labour and capital were only earning their opportunity cost I doubt the return to most labour would be that low – but there would be industries, and individuals with issues that limit their income earning capabilities, where that may be the case.  I think, perhaps, the focus can then be on:

1. Competition in goods markets
2. Competition in factor markets (specifically labour markets)
3. The opportunities and income adequacy of the worst off.

There are a lot of clear functional injustices in these places – why do we need to use a nonsensical “theory of value” to complain about the return to labour?

Conclusion

Left Youtube seems to view the idea that “all surplus is generated by labour” as true – and by association “all surplus should go to labour”.  They term this the “labour theory of value” and use it in a normative sense.  However, it makes no sense to use the labour theory this way, especially once we start thinking about other factors of production and how they are chosen.

The reason this narrative is used is because they seem to disagree with the idea of private capital, and they want to see fundamental injustices as due to the private nature of capital.  However, applying a standard supply-demand framework allows us to see that there is potential for piles of injustices out there that have nothing to do with the ownership structure of capital – instead there are clear power imbalances, power imbalances that can be identified and “solved” if they exist.

There is no need to dismantle current ownership and governmental structures – but there is need to think about fairness and distribution more clearly using the economics tools we already have

Sorry, a bit busy to do real posts.  Also wanted to get a discussion going on this excellent quote from Eric Crampton about using sugar taxes to pay for the “health care externality” from obesity/sugar consumption:

What happens then if we find that it’s those healthy exercise people who cost the system more, on the whole, because they live longer (costing the superfund) and consume health services over a longer period?

Be careful wanting to tax all the fiscal externalities. You might not like where it leads.

Let me throw up a quick first comment here

He is totally right, if we are consistent and we estimate that obesity kills people more quickly leading to a lower lifetime fiscal bill, then by the same logic we are using to tax sugar we should subsidise sugar.  If your argument about sugar taxes is based on these types of externalities, this becomes an empirical question – and if this is the policy line you should be comfortable with the idea that we should subsidise things that lower fiscal burdens by having people choose to die a bit earlier.

This will make a whole lot of people very very uncomfortable – I understand this, the entire language of trade-offs in terms of the length of people’s lives is an ugly one.  The key point that makes it palatable is that the choice of life length vs quality is actually up to the individual here – they are choosing what to consume etc.  You may well say “that is stupid, everyone wants to live longer and doesn’t know the precise impact of their consumption decisions”.  I would respond to this with my witty rejoinder “no shit”.  Or more seriously, I also would really like a new computer and don’t know what the precise impact of the new computer would be on my productivity, exercise routine, life choices, and wellbeing – does this imply that government needs to get involved in my choice to buy a computer?

Yes, there are cognitive issues, power imbalances, and information problems – but our policies should be based on understanding of those, not targeting “obesity” as an output.  Such an output frame for considering the issue doesn’t make sense.

However, if we are going to discuss externalities, the fiscal issue is all we really have – it is a stretch to add “lost productivity” or “upset family” as an externality, as there is a “price” associated with each of these.  In the first case it is your wage, in the second case it is the shadow price involved in intra-family negotiations.  Neither of these are externalities and instead we would have to say there is some “power imbalance” in the relationship so that the individual can go around imposing all the costs on their employer and loved ones without cost – which is getting patently ridiculous.

But then I have to ask, why are people so much more comfortable taxing people on the basis of their sugar consumption?  I fear that it sounds like you are merely “moralising” their choice based on what you subjectively view as someone else doing something right or wrong.

If that is seen as a good tack for policy, we are heading down the wrong path.  And before you accuse me of saying this because I’m an economist, I’d note that this doesn’t come from my economics training – it comes from the history classes I took at the same time.  The discussion of group behaviour and how groups will define their own moral value against an “other” had a strong impression on me, particularly in the race and racism course where we discussed scientific racism.

Some of the best scientists, philosophers, sociologists, statisticians, and (disappointingly) economists in the late 19th and early 20th centuries based policy recommendations on value judgments that inherently bullied minority groups, based on moral judgments that we SHOULD socially value some ideal form.

Now look, if society wants to beat up on people for smoking, drinking, and weighing too much, that is their thing.  It makes me angry, but society is a lot bigger than me.  However, don’t pretend you are doing so with economics, and basing it on a firm “externality” argument, if ex-ante you can’t see yourself allowing for either subsides or taxes on sugar.  If their is an initial asymmetry there you are putting in an extra initial VALUE JUDGMENT(S) about obesity and people who are obese – just be honest about it

Note:  I am not comparing the focus on aggregates by disciplines, and the push to “target outcomes”, to the Nazi’s by discussing scientific racism – that would be patently ridiculous.  I’m comparing the use of simplified rhetoric, and the willingness to ignore individual agency, some elements of value, and heterogeneity of desire, to what scientific (including social sciences) disciplines have done in the past – and the impact that had on social attitudes and societies willingness to bully minorities, and perpetuate real injustice in the name of social justice.

Our simplified (communicated) arguments form part of the understood base of knowledge for individuals who are making decisions and trying to work within their group.  The more intolerance they show, the more our respective disciplines is trying to make society intolerant of difference.  This point is far from ridiculous.

So what is this chart that tells us about the NZ labour market recovery?  It is actually a chart neatly provided by Statistics New Zealand in their release of the labour market data:

Cheers Statistics New Zealand! (Note, initially the wrong graph had shown up, unemployment – it should be employment rates)

I have heard a lot of economists saying “wage growth is still weak, and then so is the labour market”.  That is nice, but wage growth is a very lagging indicator – if we were responding to current wage growth figures we would have wanted to tighten policy all through 2008 …

What matters is our outlook for where wage growth will be heading [Note: for those concerned, we are discussing wage growth excluding productivity improvements, promotions, changes in job composition etc etc – so it is just “a measure of inflation” rather than a measure of the income going to households.  Without this clarifier economists can sound a little harsh!] this depends a lot more on the underlying demand and supply imbalances across the labour market which are developing now, but thanks to this growth many people is thinking in moving to New Zealand, using the help of relocating companies to make the process of moving to a new home easier.

The rebound in the employment rate over the past three quarters, and the fact that the participation rate is at a record high, is phenomenal.  Currently a lot of workers are part time, and would quite like more hours (the intensive margin) but the scope for further growth in the number of people employed (the extensive margin) due to availability (supply) looks pretty limited.  Depending on the nature of the recovery, what this means for our outlook for wage inflation and monetary policy can differ a lot!

In broad “aggregate” terms this looks like a real labour market recovery – and that is beautiful.  Of course the devil is in the details, in reality a single chart can’t tell you very much!  These are details which I will try to flesh out for Infometrics clients in the coming months … I know, I’m a tease

1. Residential investment:  Yes building rates have been low during the past 7 years, but the value of residential investment in the prior 7 years was very high.  The “volume” was lower, but what does that mean (we’ll come back to it).
2. Growth in rents have been low.  Low low low.

In this way many people have, justifiably, questioned the idea of a shortage.

However, there is one potential explanation that could match both these facts and still give us a “shortage” that can help to drive the high price for housing – a fundamental imbalance in the supply of “types” of housing.

Often you will hear economists say that renting a house provides a housing service, and buying a house is just purchasing a stream of future housing services – therefore the house price must represent future rents.  This is true.  However, the “service” provided by a rented house and a purchased house need not be the same thing!

As a base way of thinking about it, a service from housing may have two components – a “need” component (eg I need somewhere to sleep at night) and a “want” component (eg I want a house with a large lounge for my tupperware parties).  Combined with the fact that renting and owning have fundamentally different flexibilities (when you rent you have an option to buy a house, when you’ve purchased a house you rely on the liquidity of the housing market to buy a new house), and different social views on renting and buying, the rental stock and the owner-occupied stock exist to satisfy different bundles of housing services.

In this way, the rental stock, which people are only interested in renting (except investors) is only sufficient to meet the “needs” base of housing, while the owner-occupied stock meets some of the “want” service of housing.

In this way, yes both types of housing are substitutes for the needs part of the service, but in terms of these “wants” there is no substitute for owner-occupied housing.

As a result, the “shortage” in this context could be just a shortage of housing for owner-occupied purpose – while the low rent growth is indicative of a potential oversupply in rental property.

Now this argument isn’t particularly complicated, and I think it meshes with the views of many – but it is interesting to think of what it implies:

1. Is this really a “problem”?  If needs are being met by the housing stock, and people are bidding up prices with regards to wants, the case for “social injustice” from housing is significantly weaker!
2. What social expectations do people have if they are so willing to bid up prices based on these “wants” for the housing stock – what are these wants and what do they mean? (eg unrealistic expectations, status goods, a product of falling material scarcity)
3. Why has this occurred (if it has)?  Is it the structure of investment?  Is it investors confusing the average return on housing with the return on rental stock (thereby “accidentally” accepting very low yields on housing)?  Is it due to an institutional or policy related bias?
4. Will the housing accord “help”?  If the issue is the type of housing, and there is some bias, does making more land – or in Labour’s case building lower quality housing – address the issue?  If this is the “problem” and we decide it is worthy of policy, then aren’t the policies of both political parties beside the point?

Now I’m not saying this is the way to consider it.  However, I’d note that if this is your narrative for the housing shortage it leaves a lot of important unanswered questions – and on the face of it shows that the run up in house prices (with banks holding sufficient equity) is a lot less policy relevant (as it doesn’t impact upon the minimum bundle of goods and services available to the worst off)!

A big criticism of this theory is that I don’t think it really matches the data.  If we were to use house size as a proxy for quality, additions to the housing stock got a lot larger between 2000 and 2008 – and have levelled off now.  This is a pretty big empirical shortcoming of this explanation!  However, it is still a useful thought experiment – and who knows, if we go through the data in detail we may be able to explain this, and we may find this is a good description of what happened, so considering it can’t hurt

However, there are still a few glaring issues with the way they discuss monetary policy:

1. They keep mixing “monetary” policy with longer-term “fiscal” policy.  It is not the RBNZ’s role to determine longer-term fiscal policy – this is undemocratic.
2. On that note – the “external balance” is not an RBNZ target, and nothing they are suggesting actually helps that.  This is a general issue with medium-long term savings-investment imbalances, and we need to neatly define what the welfare relevant “problem” is before we go swinging around policy and reducing the ability to “judge” the Bank by giving it piles of targets.
3. They don’t seem to appreciate how much monetary policy HAS changed during the last 25 years as institutions try to adapt to the changing world around us – their view that policy structures are no different than they were in 1989 is totally wrong.
4. The variable Kiwisaver idea, controlled by the RBNZ, is horrible.  It comes from a good place IMO – they are looking for counter-cyclical tools that are used by an independent body.  But as I’ve explained, this is a particularly bad one, and will hurt the defacto independence of the RBNZ.  In addition, this “tool” won’t help the “external balance” – as the average savings rate should be unchanged.

Labour’s focus appears to be on exporters and manufacturers, as given there discussions with people they believe there is an issue there.  However, monetary policy, and the monetary policy choices of the Reserve Bank, are not the cause of this inherent S-I imbalance which forces NZ interest rates to be on average high.  Investigating why this is, and trying to understand it and base policy on issues in that, is the way forward.  This is why we’ve had a savings working group, a tax working group, and a productivity symposium – as all these structural issues, and the trade-offs they represent, are related.

These whys matter intensely for deciding policy – wasting time trying to mess around with one of the institutions that is working (in terms of keeping inflation in the band, and moderating the drop in output/employment, during the largest external shock since the Great Depression) to look like we are facing the issue is not doing this.

I see that a section of my work place thinks we need the RBNZ to be more hawkish than it is.  There are also many people who think lifting soon is madness.  I am not personally not in either camp – I actually think the Bank has got this right now!  The Bank’s decision to lift soon and get rates back to neutral does make sense given what they are facing, and that they are doing it the right way.

[As a disclaimer, I was more hawkish than the Bank during the crisis (I was wrong) – although my forecasts of economic variables were surprisingly accurate then, that was because their actions were more appropriate, not because I had any foresight … another indication of why forecast performance isn’t always the best judgment variable .  From late-2011 until the end of 2012 I was more dovish than the Bank was.  Now, I find their discussion consistent with my own narrative and models – including the discussion of the risk.  So it is hardly surprising I’m so willing to defend them ]

I will focus on those who fear rate hikes when discussing this.  To some hikes seem untenable, unemployment is still over 6%, our interest rates are higher than most high income countries, our exchange rate remains historically elevated (although I would note it is around fair value in PPP terms with a number of countries – and even now is still UNDERVALUED in PPP terms against Australia!!!).  There is an understandable concern, given the length of the impact of the Global Financial Crisis, that policy that is ‘too tight’ could have real and long-lasting costs on the economy.  Clint on Twitter was the main person bringing this up here.

Older readers might perceive a similarity with the late 1980s and early 1990s, when a determination to get credibility helped (combined with external and fiscal factors) to drive New Zealand into a far worse recession than it experienced in recent years.

However, that is not the RBNZ of today.  There is an argument why getting rates back to the 4-4.5% range in the next 12-18 months makes sense:

1. Rate hikes influence economic activity with a lag – so the RBNZ is moving rates, and the yield curve, now in anticipation of where we are in 2 years time.  During this time, their action are expected to be consistent with an economy with an unemployment rate of 5% and and inflation rate of 2%.  The forecasts will probably be wrong – but that is due to the large standard errors and unforecastable shocks they have to deal with!  You can’t actually ex-ante improve policy based on that.
2. The sharp lift in export prices is a “demand” shock.  A nice easy way to think of this is to imagine farmers getting money.  They decide they want fancier haircuts, nicer services, more meals out.  As a result, demand for non-tradable services picks up – which drives up prices for non-tradable goods. [Note:  If the lift is permanent, a good way of thinking about how it impacts on the measured economy is shown here – think of it like a productivity lift]
3. Monetary policy is being tightened overseas – the cut backs in additional QE purchases are equivalent to rate hikes.  As a result the “relative interest rate” differential is (slowly closing).
4. MOST IMPORTANTLY – we have a massive, massive, huge, ridiculous, non-tradable investment binge happening.  It is called the Canterbury rebuild.  A sharp lift in demand for non-tradable investment goods has to be funded, either this involves borrowing from overseas or domestic savings.  Increased demand for domestic savings, and domestic resources for the rebuild, are both factors that push up the “interest rate” within the economy – something the RBNZ has to respond to by lifting its OCR.

Note:  Some, including the Bank, have noted rising pricing expectations and inflation expectations.  I haven’t seen them.  Some have noted rising building costs – to which I say “relative price shock, not inflation”.  Even so, the points above (including a rapidly strengthening labour market) sell it for me!

Now there are areas of the country that really need support right now, there are specific poverty programs that need support given the massive changes in the NZ and global economies over the past 5 years!  None of this is monetary policy – but instead are things we should be chatting to the government about.

The Reserve Bank is responding to a very specific set of events, and as a result they are responding very differently than the rest of the world.  If the Canterbury earthquake had not occurred, interest rates would not be doing what they are doing.  This non-tradable investment surge is a huge part of the story – and it is really the necessity of this that is “hurting exporters in the short term”.  Not manufacturers, as a large number of manufactuers are actually servicing the rebuild, and the building sector in general.

This is also why we must be careful talking about the exchange rate – what this means for the dollar isn’t really clear.  You’ll note that as well as saying interest rates differences will be higher, I also noted that the lift in rates (combined with other regulatory policies) induce higher savings which displaces borrowing from overseas for investment.  This is why the “hot money flow” idea is a bit of misnomer.  On top of this, we can also note that part of the reason domestic interest rates are so high is because of the “savings-borrowing” imbalance in NZ – understanding why, and dealing with this if appropriate, is not a monetary policy issue, but is an important issue.

Update:  Nice post by Brian Fallow on monetary policy.  Sort of related

I disagree with this piece.  But, it is well laid out and argued – which makes it a good piece!  So let us go through the reason why I take issue:

1) They are advocating one tool, many targets.

If the excess becomes a systemic threat, the Fed should then address it through its (existing) powerful interest-rate levers.

Although they seem to do this for nice enough reasons:

We are not advocating expanding the Fed’s tool kit and do not think the Fed should micromanage the economy.

It still doesn’t make sense.  They are trying to assume away some of the costs directly inherent in trying to get the US Fed to do what they want, by just not giving them the tools to do it!  The number of tools needs to be equal to the number of targets (here, wiki of Tinbergen), so if you aim to target some functional relation of financial stability as well as inflation we need these macroprudential tools!

Admitting this, and ensuring the institutional structure is appropriate for the given tools and targets is important.  When discussing having monetary policy and financial stability policy it was justifiably stated on VoxEU that:

Institutionally, it can be advantageous to assign both policies to the same authority, namely the central bank. However, safeguards are then needed to counter the risks of dual objectives, and institutional frameworks should distinguish between the two policy functions, with separate decision-making, accountability and communication structures.

2) The suggest attacking bubbles as part of an employment mandate – as a popping bubble lowers employment

Yet when financial excesses are building and not accompanied by inflation or unemployment, the Fed is unlikely to act. We need not accept this inaction. Fed governor Jeremy Stein, who has been writing on bubbles, said this summer that deflating a bubble would be consistent with the goal of promoting full employment because a bursting bubble affects employment.

Is the Stein argument a good one?  Is the Borio argument a good one?

It appears a growing number of central bankers think so as well.

But I find it uncompelling as it is confusing policy related and unpolicy related costs from bubbles!  A bubble ‘pops’, implying that some people that purchased the asset at a higher price lose out – this is NOT policy relevant.  A bubble ‘pops’, people default, a bank is about to fail and drag everyone down with it.  This is a concern.  But understanding why the other banks are not sufficiently insured against this failure, and why a bank is fragile to the “popping of a bubble” that is supposedly so obvious is important here – the ideas of systemic risk, and the fact that current regulations act as a subsidy on borrowing for banks is the main issue here. NOT the popping of some ‘bubble’ itself.

So far the only argument I’ve seen for directly targeting bubbles is “its obvious, look at the crisis”.  This is a bad argument.

Note, none of what I’m saying disagrees with this:

we were almost unanimously blind to the risks of rising housing prices and bank leverage

But it just states that we should think about where the issue, and concern, with systemic risk comes from.  It is the idea that, in the face of a shock, our financial system would fall over – a financial system that won’t be allowed to fail, and in turn is willing to take on excessive risk.  Our solution should be based on this itself – not using interest rates to target financial stability.  And in practice this still doesn’t make any sense unless we are willing to stick our neck on the line with a “model” of the bubble, and an ability for ex-ante identification, which can be used to make the policy action transparent!

And it doesn’t really disagree with this:

The simplest way to encourage Fed governors to be vigilant for excesses is to make maintaining financial stability explicitly part of the Fed’s mandate. This would have two effects. First, governors would be required to search, proactively, for imbalances. In essence, Fed officials would have to approach the economy from a different perspective than would most Americans.

Except that I ask us to think about this more carefully.  If we are mandating a specific regulatory role, why do we have to mix it up with monetary policy?  Why can’t we simply have two organisations with independence and a mandate signed by the finance minister.  Hell, make it three organisation and do it with tax as well

The fact is that financial stability is a different role.  Yes monetary policy (and fiscal policy) influence it, but it is a separate target.  If we justify a target on public policy grounds, and if that target is subject to dynamic inconsistency, and requires clear communication, then we SHOULD have a clear independently set mandate for an independent organisation on that basis.  That is the kicks.

And for financial stability this is the real big kicker for me – can we at least make an attempt to come up with a clear target and to justify it on policy grounds.  Rather than throwing around heaps of nifty ex-post justifications for doing things, which inherently lead us to move towards discretion, political interference, and micromanagement

Just a bit of conceptual grounding first as I’m well aware that a universally accepted definition of SC is an elusive beast, and from my own experience that this non-specificity often leads to confusion both within and between the social science disciplines when discussing the perceived value of SC (why it’s of worth (or not), or if it’s even a thing at all).  As this is an economics blog, and not a sociology journal, I don’t really want to get into this debate. Instead, I will rely on how MFI’s themselves (by in large) equate SC for framing purposes– namely that social networks between individuals within a community hold implicit and explicit economic value.

With this is mind, It’s easy to see why so many MFI’s value SC from both an aspirational and operational standpoint, and this paradigm has significant influence over micro lending strategies. In Bangladesh for example, the Nobel Peace Prize winning Grameen Bank’s (GB) micro loans are not distributed to individuals. Instead, a group lending model is employed, with all micro loans shared between a four or five person collective group. Per loan conditions, weekly meetings between the group to discuss the loans use(s) (individually) and repayment (collectively) are demanded. GB argues this increases SC among its borrowers, and this consequently, is good for business. This thinking meets with some empirical backing; with many researchers (mainly anthropologists) noting that the weekly interactions demanded of borrowers by GB has provided a forum for “horizontal” relationships (new associations, networks, and friendships) to blossom. This is especially pertinent of female borrowers (who make up 97% of GB clients, a trend mirrored by many MFI’s) who are often otherwise prohibited from engaging in such relationships because of various societal, cultural and religious normative barriers. This further assists (ostensibly at least) the exchange and dissemination of “scarce resources” (for example, business acumen and related technical skills) among the borrower group, facilitates both social and financial prosperity, and better enables the collective repayment of the loan. Sunshine and Rainbows for all!

But this is simply way too simplistic. Putting aside the proposition that this is actively encouraging a form of artificial social engineering that undermines traditional landscapes (perhaps another time), it would be disingenuous to assume that “horizontal” relationships will magically materialise whenever you stick five people into a room together – especially when it is a “vertical” relationship (the power imbalance between loan provider and borrower) that is dictating terms of them being there. Synchronously, research by the likes of feminist economist Katherine N. Rankin suggests that vertical relationships are also highly prevalent within borrower groups themselves. This factor, perhaps somewhat conspiratorially, lends itself to the accusation that SC is being pushed predominantly by MFI’s for its utilisation as a “self-regulating” loan collection mechanism.

The ability of all group members to successfully utilise their share of the collective loan for entrepreneurial gain (at least in terms of making enough to repay their individual loan share) is not likely to be homogenous (this problem is tied to the widely evidenced hypothesis that a substantial number of borrowers use their loan shares for consumption smoothing purposes, as opposed to any profitable investment), and the divide which results between members of the group who have made enough to repay their loans and those that have not is exacerbated by the collective need to settle the debt (and quickly, repayments are often expected by MFI’s only a month or so after a loan is distributed). This is where the “dark side” of SC comes into play as it is only the MFI’s that reap a positive return by pushing an SC based lending strategy. As the debt is held collectively there is incentive for those within the group who have profited enough to repay their loan shares to coerce less successful members of the group to stump up their cut by any means (often by selling their homes and possessions, or taking on further “less legitimate” loans). At the end of the day, the MFI is repaid (so all looks rosy in terms of the repayment rate measurement) but many of those that the loans are (quite legitimately) directed at helping, are certainly a lot worse off.

Whether this is an unforeseen side effect of MFI’s grounding their lending models with too much blind belief in the positive powers of SC, or whether it is in fact a deliberate ploy to improve debt collection by making borrower groups “self-regulating” is up for debate. I personally lean toward the former, as I truly believe that most MFI’s hold honourable and legitimate intentions in regards to alleviating severe poverty, but wider consideration of the limitations and possible pitfalls of driving home SC based micro credit lending strategies is warranted based on what is currently being observed in the communities affected.