Category Archives: Economics

The Power of Guiding Metaphors

19 Saturday Dec 2015

Posted by in Better Fantasy, Economics, History, Military, Politics, State Formation, War, Writing

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I’ve lately been reading The Axis Grand Strategy, a book published in America during World War Two. With only light editorial comments, it presents translated writings from German military theorists and officers about different aspects of warfighting. (The editors are presenting this material, in part, as a demonstration of Nazi perfidy; they highlight passages in which the Germans offhandedly note various breaches of international law—for example, that the invasion of neutral Belgium during WWI was conceived of a decade in advance.) The book is incredibly interesting from many points of view, and even as a historical artifact itself; I did not know, for example, that the Allied powers were calling themselves “The United Nations” even during the war.

One point that the book is reminding me of is the importance of metaphors in structuring thought. Over and over again, the German authors refer to the ideal military enterprise as a well-oiled machine, operating with incredible precision down to the smallest detail. To make such a machine possible took a stupendous level of planning and organization, which had to be carried out years in advance (and which the authors describe in great detail). This was one factor that pushed German doctrine to the conclusion that to have any hope for victory, they needed to decide upon war several years before actually carrying it out, and then to direct all of their government policy and grand strategy to support that decision. That is, once the German decision for war was made, it became largely inevitable that war would result even three or five years later—because German leadership believed that such decisions needed that much lead time for the planning process to be adequate, and victory to be possible.

To be sure, the “well-oiled machine” metaphor was not the only reason that German doctrine came to that conclusion, or even the most important one. But it surely played a role, because it presented an ideal towards which to aspire.

Lewis Mumford, in his Technics and Civilization, presents a similar argument about the development of vast hierarchical bureaucracies. He writes that the age of coal had dramatic impacts not only on our economy, but on the mindset of society’s leaders. Where previously, water-powered manufacture had been relatively decentralized, coal-fired steam power created tremendous economies of scale. The most efficient method would be to tie all of your machines into a massive central boiler; this also meant that they had to be standardized, coordinated, and operated without any sort of individual discretion or initiative.

According to Mumford, the success of centralized manufacture led thinkers to imagine that other centralized projects were ideal as well—massive bureaucracies, mass armies, central planning of the economy, and so on. These people had been conditioned by the guiding metaphor of coal-fired steam boilers, and the resulting hierarchical organization of mass factories. Many would even make the parallel explicit. Individual initiative simply made a mess; better to control everything from the head. The result was the age of totalitarianism.

Economist Richard Bronk, in his The Romantic Economist, makes a similar argument about the development of the idea of equilibrium markets in economics. He says that the guiding metaphor there came from thermodynamics; in an attempt to make economics into a mathematical science akin to physics, champions of quantitative economics proposed simplifying assumptions such as “utility” or “self-interest” that could transform economic behavior into something predictable, something that could be captured in quasi-thermodynamic equations. Bronk argues that such metaphors have been played out, and the further progress in economic thought needs to borrow metaphors from the Romantics—biological processes, or ecosystems, or webs of interdependence.

Today, we netizens are conditioned to think about networks, or crowdfunding, or robots. These new guiding metaphors have in turn produced new ideas of how governments should work, or how organizations should be structured. Some of these new ideas are even useful. But in any event, they are very different from the sorts of ideas that would come from a person accustomed to steam-powered factories.

The concept of a guiding metaphor is important if you are any sort of creative thinker, whether in business or government or the arts. If you write fiction, think about what metaphors influence your characters or even whole societies. If you have a business, think about how new metaphors can suggest new products or services. If you are in government, stop trying to bludgeon your society with models of coercive government that date from nineteenth-century proto-fascism.

If you want to create something new, try applying a different metaphor.

When Do Societies Face Unrest?

02 Thursday May 2013

Posted by in Better Fantasy, Economics, History, Politics, Revolution, Self-Promotion, War, Writing

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I have just read a recent journal article by the brilliant scholar Peter Turchin, in which he elaborates on his theory of the dynamics of social instability over time and tests it on the United States from 1780 to 2010. Put briefly, his theory holds that one can expect a society to suffer greater social violence (such as riots or lynchings, as opposed to routine crime) in a relatively predictable cycle. The larger “secular” cycle occurs every 150 years; a smaller cycle of violence occurs roughly every 50 years, superimposed on the secular cycle. Thus in the United States, we had peaks of societal violence near the years 1870, 1920, and 1970, with the Civil War being the peak of the secular cycle. Turchin forecasts that the next secular peak should hit sometime around the year 2020. Turchin’s previous work has detected the same sorts of cycles in societies from ancient China to revolutionary France.

Of course, detecting a pattern does not tell you what has caused it. Turchin’s theory for when violence intensifies depends on two major factors. Both of these factors might derive from excessive population growth; in the early version of Turchin’s work, he was focusing on agrarian societies in which population growth leads directly to food shortages. But now that he is considering Industrial societies, Turchin is focusing more on the immediate causes laid out below.

First, whether from excessive population growth or technological disruption or whatever, there emerges a labor glut. The average wage drops in response, leading to diminished standards of living. Thus you see larger segments of the populace who are in a precarious situation, with the potential for violent outbreaks such as labor struggles, or ethnic competition with minorities, or political upheaval.

Second, there emerges “an oversupply of elites.” This can happen for a few reasons, and Turchin focuses on the economic one. The low cost of labor means that it is easier for those on the top to become far wealthier than they might have done in a more normal setting, leading to the accumulation of vast fortunes and a polarization of society. A consequence of this is that there is much more competition for the leadership positions in society, such as control of government offices. Politics becomes more nasty and partisan, leading in extreme cases to violent rivalries between elite factions struggling to secure their hold on power. Such violence is made easier by the larger number of poor, desperate people in society who can serve as a demagogue’s muscle.

In Turchin’s research, he finds that oversupply of elites has the strongest association with societal violence. This is easy to understand when one looks at places like the Philippines, in which politicians routinely employ armed militias to attack competitors (a horrifying example was the Maguindanao Massacre of 2009), or the Congo, which has been wracked with coup after coup. But even in the United States, a surplus of would-be leaders will tend to produce extreme ideologies, such as militant unionism in the 1920s, or the present upsurge in eco-terrorism.

I think many people, writers among them, mistake the relationship between cheap labor and exploitative rich. Often, a super-wealthy class emerges as a result of lots of poor people, who make it easier to be rich—that is, to benefit from the production of lots of other people. This is not to say that an exploitative class won’t try to keep everyone else poor, once it emerges. But the dynamics are complex here, and societal violence is one of the things keeping them in check.

(How might such violence be averted? Full discussion will have to wait for another post, but I find it rather interesting that the Biblical institution of Jubilee, in which land was returned to its ancestral owners and debts forgiven, follows a 50-year cycle.)

(Have I mentioned lately that my new book is available on Amazon Kindle? It’s called The Best Congress Money Can Buy: Stories of Political Possibility. You can read the first story for free here, and then buy it if you like. Enjoy!)

Concerning Cooperatives

25 Sunday Nov 2012

Posted by in Economics, Politics

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Thinking about how to make an economic system that is more humane, and less riven by class struggles, many social reformers have advocated for workers’ cooperatives (the Distributists being one example). Cooperatives differ from the traditional capitalist firm in that workers share ownership and management of the company, as opposed to being salaried employees with no participation in the profits besides what management feels like giving them. They differ from a socialist commune in that there is still private property, and individuals can benefit directly from the success of the firm, which tends to mitigate the typical Socialist tendency of “They pretend to pay us, and we pretend to work” and lead to more creativity and enterprise.

With these advantages, why hasn’t the cooperative become more popular in the United States? In part, because cooperatives come with some drawbacks. First, if workers share ownership in the company, what happens when you hire new people? Does that mean that you’ve just diluted the ownership of the existing employees? If so, then there will be a tendency of the owner-employees to delay hiring more people, even if it means sacrificing business opportunities. Or do different classes of employees have different shares of ownership? If so, then the cooperative differs from a typical capitalist firm only by degrees.

How much of the ownership of the firm accrues to the investors, as opposed to the employees? After all, without the initial investment, there would likely be no business in the first place. And asking employees themselves to buy in, as some cooperatives do, places a high bar in front of poor job-seekers.

Additionally, there will always be a place in a large-sized firm for experts of some kind, who will be paid more for their expertise. Should such experts, be they management or whoever, also get a disproportionate share of the company?

All of these questions have answers, and the answers will vary depending on the particular needs of each cooperative. But even if you could come up with an ideal structure for your own situation, it is far from clear that existing law could support the ownership structure you want. To my knowledge, in the United States the most common means for employee ownership of their company is the ESOP, or Employer Stock Option Plan, and these are typically structured so that employees have partial ownership without true control. While American law has well-understood prototypes for traditional capitalist firms, like the C-Corporation or the S-Corp, there are few prototypes for worker-owned cooperatives.

If such prototypes existed, then new insights could be gained as people experimented with them and figured out what works and what does not in different contexts. And cooperatives could become more accepted in modern industrial economies—which is not to say that they would displace the typical capitalist firm entirely, or even mostly. Each firm structure solves different problems. The best structure depends on your own situation, and the imperatives of your industry. Still, more options are good.

One handicap of your typical utopian social reformers is that they tend to focus on parapolitics, action outside the system, rather than trying to work within the system. True, such parapolitics often has an effect, but you only get mass adoption of your ideas in the face of total collapse of the system you are opposing. In this case, those who seek to have the cooperative form catch on in society ought to be lobbying for its inclusion in the tax code, the same way that a C-Corp or S-Corp is. With an off-the-shelf model to work with, with well-understood procedures for sharing ownership and profits, more entrepreneurs may elect the cooperative model without any political or social goal at all—which is how you win.

Random Fiction Excerpt #5

22 Thursday Nov 2012

Posted by in Credit, Economics, NaNoWriMo, Writing

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From my current NaNo:

“The news had gone out that Morris had gone deeply, staggeringly into debt in order to pay for his new mansion, and his reputation had correspondingly skyrocketed up into rarified territory. Estimates on how long he would have to work at his current income to pay down the debt ranged from a hundred years to nearly three hundred, depending on which prediction of future interest rates you went by. With this move, a master-stroke of commitment, Morris had demonstrated the depth of his loyalty to the socio-political system, on which he was now totally dependent in order to stay solvent.”

On Sovereignty, Trust, and Protectorates

04 Sunday Nov 2012

Posted by in Better Fantasy, Economics, History, Politics, State Formation, Writing

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I recently read a journal article by Peter Haldén titled A Non-Sovereign Modernity: Attempts to Engineer Stability in the Balkans 1820-90. He writes to correct the conventional view that international relations in modernity is all about sovereign, independent states, and that the earlier era of protectorates, vassal states, or other such semi-autonomous regions ended with the arrival of nationalism. Indeed, the rationalist, modern Concert of Europe deliberately used non-sovereign zones several times in the Balkans area in order to control the outbreak of political crises.

The topic remains important for us readers today for a few reasons. First, understanding history is always good (particularly for budding fiction writers, who have a tendency to assume that all stories must be set in modern states or in absolutist monarchies, and thus impoverish their stories.) Second, non-sovereign states never really went away; they were just sleeping. Understanding the dynamics of non-sovereign states gives us a fresh lens to understand places like Kosovo, Chechenya, or even international organizations such as the European Union or the United Nations.

The power politics of the 19th century were marked by several themes, but two of the most important were the decline of the Ottoman Empire as a great power, and the rise of Russia which aspired to take its place. The fundamental problem facing the European powers was how to manage the fragmentation of Ottoman authority, which expressed itself in events like the Greek revolution, without causing a full-blown war between the Great Powers over the spoils.

Briefly, the favored solution was to take outlying provinces of the Empire and turn them into non-sovereign states, under the aegis of the Concert of Europe. These provinces would still nominally be subject to the Turkish Caliph and would pay tribute, and they would be prohibited from having free diplomatic relations with other states as an independent state would, or from having a military. But they would have civil militias and police forces for defense, they would be self-governing, and they could have diplomatic relations with the Concert of Europe as a body. Importantly, the Ottoman Empire would be forbidden to maintain troops in these non-sovereign states.

How does this help? In modern International Relations, states often try to set up buffer zones between them and some potentially hostile neighbor. These zones typically take the form of other, smaller, states. For example, China uses the totalitarian hell state of North Korea as a buffer between it and South Korea, or Japan. The “Low Countries” of Belgium, Netherlands, and Luxembourg were used as a buffer between France and Germany, to their periodic detriment.

The idea is that if you don’t share a border with a potential foe, then there are fewer opportunities for friction that might escalate into a full-blown war. After all, it is hard to distinguish between positioning troops to defend your borders, and positioning troops to attack your neighbor. So the buffer state helps to cool down the temperature. The only problem is that when a buffer state is independent, it can rely only on its own force of arms to maintain itself. The history of the Low Countries graphically demonstrates how easily this can fail; moreover, the potential for a buffer state to become a full-blown military ally of one side or the other ensures that the situation remains tenuous.

A demilitarized nonsovereign territory, on the other hand, is not guaranteed by force of arms, but by the cooperation of the potential rivals under color of an international agreement. There is less likelihood of miscalculation or escalating tensions, and more opportunity for creative institutional design (read the article for some great examples); not all peoples are ready for statehood, after all, even aside from the objections of their current rulers. And there would be less competition between rivals such as Britain and Russia as there would be (and were) over who would dominate the policy of newly independent states, if the territories could only have relations with the international body as a unit and not with other states bilaterally.

For a modern parallel, we can look to the European Union, which began as the European Coal and Steel Community—a project to strip West Germany’s ability to produce war armaments without the cooperation of France, and vice versa. By effectively tying their own hands, the member states hoped to foreclose on the possibility of war between them, so they could focus on the vital task of withstanding the Soviet Bloc. Henceforth, relations between member countries would be based on partnership and negotiation, not power politics.

However, in the case of the Balkans, the stability of the protectorate arrangements for Greece and elsewhere depended crucially on the degree to which the Great Powers trusted each other. In the three cases that Haldén considers, the initial attempts to institute a nonsovereign territory broke down once Russia violated the terms of the agreement, and Britain could no longer trust the Russians to play nice. (I am oversimplifying grossly.) Indeed, the creation of new independent states from the former provinces of the Ottoman Empire was, in Haldén’s telling, a suboptimal outcome, forced on the Great Powers by the breakdown of cooperation and the increasing worry over Russia’s growing power. The independent states would have to fend for themselves, without the aegis of a Concert of Europe which was growing ever-less-concerted over time. No surprise that World War I kicked off in the Balkans; Serbia was one of these formerly nonsovereign states.

Similarly, arrangements such as the EU or the UN are hampered by the lack of trust between member states. Many predict that the current economic crisis may spell the end of the Euro currency, or of the EU altogether, because Germany will grow tired of footing the bill for its more spendthrift neighbors forever. Early aspirations for the UN to become a true world government, meanwhile, have run aground on the cold reality that Americans do not trust a body made up mostly of dictatorships to act with the public interest in mind.

Haldén also draws a fascinating parallel with the old free-markets/interventionism debate in economics. He writes that creating new independent states who would rely on their own armies for defense, and hoping that they can contribute to international stability, is comparable to the intent of the free market. Conversely, a managed protectorate under the oversight of an international body is similar to government control of the economy, under the theory that such control will lead to more manageable outcomes. Whether or not you believe that government control can lead to better outcomes in the abstract, it is clear that you will not desire actual government control unless you trust the government to play nice. If you do not trust the government, you will accept even the putatively suboptimal outcomes of the free market in exchange for keeping a measure of control over your own destiny.

Haldén apparently wrote a book exploring some of these themes, which I may want to read. For our purposes, we should remember that what we are familiar with is not everything that is possible. As well, if we want to build a new world, it is crucial that we trust the main players; otherwise, the world may turn out to be not what we expected.

The Talents of Others

27 Saturday Oct 2012

Posted by in Economics, Politics

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I just began reading John Tomasi’s recent book Free Market Fairness, which is an attempt to synthesize Libertarianism’s concerns for property rights and the importance of spontaneous order (rather than top-down government control) with High Liberalism’s concerns for social justice and care for the poor. I don’t know whether Tomasi’s project will be successful, but something like it is certainly welcome. And for me, the book has already been worth the purchase for the sake of a single sentence.

Tomasi here is paraphrasing the arguments of John Rawls, and particularly that institutions should be arranged so that poorer citizens are supported from the wealth of the richer—as Rawls put it, so citizens “share one another’s fate.” Tomasi adds: “Institutions must be arranged so people can look upon the special skills and talents of their fellow citizens not as weapons to be feared but as in some sense a common bounty” (Introduction, pg. xiv).

That phrase—”weapons to be feared”—is something that struck me. And yet it is obvious that in a system of competition, one man’s advantage is another’s loss. It would seem rational, from a narrow point of view, for economic competitors to try and minimize each others’ skill and ability. But if we all did that, society would collapse and there would be little wealth left to compete over. We need other people to trade with, and they must have talents worth trading for, or else no products of any complexity would ever be created.

So in a pure competitive system, you are left in an uneasy search for the optimal level of skill in other people—just enough to support your own activities without threatening your position. In theory, you can avoid the problem by designing institutions where other people’s success contributes to your own; this is the supposed aim of redistribution. (Still, redistribution is a blunt tool that discourages activity by the most productive, and also requires oppressive political structures that create their own problems.)

What annoys me is that the political faction most in favor of redistribution is not speaking of “shared bounty” and communal unity at all. Instead, they speak of how the rich don’t deserve the wealth they have, how they have exploited others, how they have a duty to give up their wealth, and so on. In fact, the reason that Tomasi’s turn of phrase was so striking to me is precisely that I had never encountered the idea put in quite that way before. The idea that—in the absence of proper institutions—a competitive society would lead to social discord and envy floats half-formed throughout much of our discourse, but more often is expressed in precisely those envious terms that Tomasi seeks to preempt.

So what sort of institutions can lead to a sense that one person’s success contributes to everyone else’s? The first thing that comes to my mind is anything having to do with inventing new things. Inventing new medicines, or a new and better solar panel, or writing clever software, can make many people’s lives much better. Software in particular is inherently scalable; it is nothing more than information, which can easily be transmitted to many people. So the success in inventing new things can certainly help many people. (I think this is why most people don’t resent the massive wealth of, say, Apple as they might do for an investment bank—because they can readily appreciate the way in which Apple’s wealth was generated by selling products that they, as individuals, benefited from.)

Still, this doesn’t precisely address the point. Not all industries act as such powerful force-multipliers for all of humanity as science or computing can. How can we create such an alignment of interests across society? I don’t know the answer off the top of my head, but probably institutions such as workers’ co-ops point in the right direction. Still, the most important part of finding answers is asking the right questions. Tomasi’s formulation is incredibly valuable for that purpose.

Ways to Improve Peer-to-Peer Lending

30 Sunday Sep 2012

Posted by in Credit, Economics, Finance, Investing

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For a long time now, I’ve been interested in the potential for Peer-to-Peer lending (P2P). Rather than people depositing money with a bank, which then turns around and lends the money to borrowers while keeping most of the profit, in P2P lending some service matches borrowers and lenders directly. Ideally, this allows borrowers to get loans at a cheaper rate, while still giving lenders a better rate of return. It also allows nontraditional borrowers to get funded, if they can tell a good enough story. But there are problems with P2P, to which I would like to propose some solutions.

Right now, the biggest names in American P2P lending are Lending Club, and Prosper.com, where I was a small lender back around 2007 or so. When I participated on Prosper, I was able to see instances where the model worked perfectly, and other instances where the model caused problems. Among the advantages were that groups of people who knew each other (whether In Real Life or on the internet) could provide each other with funds at below-market rates, as an expression of their fellowship. This is something I liked a lot, since Judaism tends to frown on lending money at interest anyway. (More on that topic in another post…) Additionally, some borrowers whose credit score was relatively low were able to convince borrowers that they were a good risk anyway, because of factors that their credit score did not reflect.

The bad news came from several sources. First of all, because all money had to be provided by the individual lenders, as opposed to a centralized source of funds like a bank, many otherwise-attractive borrowers who didn’t know how to market themselves went unfunded. Second, the need to market yourself in the first place can be a turn-off. Borrowing from people you know can lead to tension and a loss of privacy. One of the biggest advantages of the modern system of bank or credit-card lending (as opposed to borrowing from friends and family, as the “unbanked” tend to do) is that banks can lend functionally unlimited amounts of money if they choose to, and your financial circumstances are strictly between yourself and your banker. With Prosper as it stands now, neither of these two factors are at work.

The next problem was due to greed. In the early years, lenders were attracted to the high rates paid by low-quality borrowers, particularly “HR” or high-risk borrowers who could be made to pay up to 30% interest per year. The problem was that in most cases, these borrowers were staggeringly bad risks; those of us who jumped in with both feet ended up losing quite a bit of money when the loans were not repaid. Ultimately, we lacked the knowledge and temperament to tell a good borrower from a bad one, and to resist the lure of fat profits for taking unacceptable risks. There is a reason that (until the era of government bailouts) bankers had a reputation for sobriety, prudence, and conservatism. Bankers who lacked these qualities soon ceased to be bankers.

Note that Prosper responded, ultimately, by excluding the lowest-quality borrowers from the market. This managed to improve default rates; but the fundamental problem remains, that lending decisions are being made by amateurs, many of whom do not understand the risks well enough.

Another institution that claims to be P2P, the British institution Zopa, avoids this second problem by soliciting investor capital and simply making all the lending decisions itself, as a traditional lender would. But in this case, there is no actual interaction between borrower and individual “lenders”; Zopa is actually something like a mutual fund for lending with investor funds, rather than bank capital. It is not really a true peer-to-peer vehicle.

Is there a way to mitigate the problems of P2P without going to the other extreme and quashing the social aspect altogether?

Suppose that you have a Lender institution, a depositor (David) who wants to earn some money, and several borrowers (Brad, Ben, and Betty). David puts a chunk of money (say $5000) into his bank account with the Lender. The Lender then asks David if he is willing to lend money to particular people, at any point in the future, and at what minimum interest rate. David knows Brad, Ben and Betty; he decides that he would be willing to spot Brad up to $500 at a time, but only at the market interest rate—he’s not a close friend or anything. Betty, on the other hand, is someone that David likes, so while he’d only trust her with $200, he’s willing to lend the money to her at a nominal 1% interest to cover fees. He knows that Ben is irresponsible with his money, so he’d rather not risk his own money on Ben.

Note that during this process, David does not know if Brad or Betty are actually trying to borrow money right now. That information is kept from him. So Brad and Betty get to keep their privacy. If Brad or Betty should choose to lobby David for more money, that’s their choice. In the meanwhile, money that’s not specifically earmarked for particular borrowers can be treated like a normal bank deposit, earning some amount of money for David and having some level of guarantees.

Now suppose that Betty finally decides to borrow $20,000 for a new car. The Lender can see her credit score, and other such raw numbers; but it also can see that David, and several other depositors, are willing to trust Betty with money. This does two things: first of all, it shows Lender that people trust her, which can be an additional factor in the Lender’s decision to lend or not. Second, it means that they have to risk less of their own money for the same profit, because they can use money from the depositors who know Betty while still earning servicing fees.

The final decision is the Lender’s; if Betty remains a bad risk, Lender can protect the depositors from her. But on the flip side, if people who know her only pony up $5000, the Lender would be able to make up the difference with its own funds if they like Betty as a borrower, instead of letting her languish in social-lending purgatory. The portion of the money coming from depositors directly could be at below-market interest rates if they like, keeping the social aspect of P2P lending. The balance, coming from Lender, would be at market rates.

Obviously, such a system would not be for everyone. Some people would do well enough on Prosper.com or similar sites, even without such a system. Others might prefer Zopa, or even a traditional bank. Still, I think that the proposed system would make P2P borrowing and lending more attractive for a lot of people, mitigating some of the problems while keeping most of the advantages.

(Anyone who likes can implement this system. I only ask that you drop me a note or a comment letting me know, if you got the idea from this post.)

An Idea for How to Make Renting Homes Better

01 Sunday Jul 2012

Posted by in Credit, Economics, Finance, Investing, Real Estate

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Many fortunes are made in real estate. And, lured by those stories of success, lots of people have tried their hand at real-estate investing as well, with highly variable results. Meanwhile, many people who cannot buy homes of their own decide to rent instead.

But the present rental market has a lot of flaws in its structure. Take, for example, a common strategy used by new investors who don’t want to sink a lot of capital into a house. They will instead rent a place, perhaps for a long term to bring down their monthly rent, and then turn around and sublet it out to someone else for a higher price.

Now, these people are certainly providing a service of some kind. They are providing income to the owner of the property; if they chose a longer rental term, they are also providing a guarantee of long-term occupancy. But the eventual renter is paying a higher rate for his home than the owner is receiving. It’s possible that the renter has low credit and would not otherwise qualify, or perhaps would not have heard about the apartment without the marketing efforts of the investor-renter; but still, it seems that there ought to be more opportunities for mutual benefit.

One thing that’s always struck me about renting is that most landlords do not allow you to prepay your rent. There are good legal reasons for this, but it still seems to be a missed opportunity. The typical landlord carries a mortgage with an interest rate of more than 5%, sometimes much more. By contrast, 10-year Treasury notes are yielding around 1.6%. If a renter could sink extra cash into prepaying rent, with an annualized discount of (let’s say) 3%, and the landlord used the extra cashflow to pay down the mortgage, it would benefit both sides. All that is necessary is to create the appropriate legal structure.

When you think about the components of a property’s value, you could break it down into two parts: the right to live in a place for a given time, and the actual ownership of the property. Suppose you actually broke them into separate pieces. For example, I could have a house I wanted to rent out, but I wasn’t interested in collecting a rent check every month. Instead, I created a product: the right to live in my house for ten years. I then assigned that product a value, just like a piece of real estate. Say the house itself is worth $100,000; I then value ten years of use at, say, $40,000. If I find a buyer, I can get all that cash upfront and not have to worry about collecting rent every month. At the end of the term, I still own the house and can benefit from its price appreciation, tax depreciation, and so on.

Now suppose I’m a renter, or investor-renter. Buying a ten-year lease gives me a discounted price, compared to having to pay for it month by month. It also lets me lock in the price for the entire term, giving me stability. Plus, since I don’t actually own the house, I don’t have to worry about property taxes. But how might I come up with all that cash up front? If this becomes the norm, it ought to be easy to borrow that money from the bank—especially when you consider that a ten-year rental term is an asset like property is, and can be used to sublet the house in turn, or repossessed by the bank if necessary.

It would be easier for a bank to repossess rental rights than a full property, meanwhile. At all times, there is an actual owner who is interested in maintaining the value of the property, as opposed to home foreclosures that often sit vacant and get trashed, destroying massive amounts of value. And it is easier to rent a property than to sell it, and lots of managers that the bank can call upon to fill up their newly-repossessed asset. Finally, it ought to be easier to appraise use-rights than the actual underlying property, making underwriting easier. So from the bank’s perspective, this might be an attractive asset class.

Subletting a rental-agreement house will provide more gains from trade, in this scenario. I, the investor-renter, have provided the benefits of upfront capital, allowing me to get a good price. I can then sublet to a traditional renter, who does not have to provide upfront capital but can still pay a price comparable to the going rate. I make money from the difference between my discounted upfront payment, and the month-by-month payments of the renter, without having to “overcharge” as subletting investors must do today.

This all will need fleshing out, of course. Navigating the legal minefields alone will be an effort, not one that I care to undertake right now, and people would have to work out the practical problems involved with any new asset class. And this kind of structure will not be appropriate in many cases. Still, its mere existence would cause ripple effects out into the market that would benefit everyone. And perhaps someone more enterprising can see this idea and make use of it.

Tax Farming

17 Sunday Jun 2012

Posted by in Better Fantasy, Economics, Finance, History, Politics, State Formation, Writing

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April 15th is a date seared into the brains of most Americans—being the due date for us to turn in our tax returns to the Internal Revenue Service. In the modern era, most governments have wide-ranging powers to tax their populaces. Yes, you have problems with tax evasion here and there, but most urban dwellers are used to paying taxes as a matter of course (though we certainly aren’t happy about it).

When you think about it, though, the smooth collection of taxes requires a vast infrastructure of information processing, bureaucracy, and coercive enforcement if necessary. All of that came about very late in historical terms. In the United States, tax withholding from our salaries was only instituted during World War II, for example. (In a delicious bit of historical irony, the concept was developed in part by famed free-market economist Milton Friedman, when he worked for the Treasury in the early days of the war. For the rest of his life, he hoped that tax withholding would eventually be abolished.) The first income tax in the United States was a temporary measure enacted during the Civil War.

In other countries, the story was similar. The seminal work on this subject, at least in comparative politics, is Margaret Levi’s Of Rule and Revenue, a study of taxation systems throughout history. Levi’s basic argument is that rulers are constrained in how they can tax populations by their ability to coerce the people, the ease with which money can be hidden, and limitations in measuring technology. (I previously wrote of similar concerns behind the institution of English nobility.) In short, early rulers had a very hard time raising taxes directly, simply because it was next to impossible to extend their control over the populace.

So what did they do? The strategies of rulers were many, but in this piece I want to focus on a particular practice called “tax farming.” In its basic form, the ruler created some sort of tax or tariff—a 10% tax on salt, for example—but rather than collecting the taxes itself, the ruler would sell off the right to collect the tax to some private party. This was the tax farmer. The tax farmer would pay a large sum up front to the government, and in exchange would gain the right to ruthlessly apply the salt tax to anyone within his jurisdiction and pocket the proceeds.

This is not the same as modern privatized tax collection, where the private party must transmit collected taxes to the government. Here, the tax farmer is the direct beneficiary of tax revenue. In general, tax farming was incredibly lucrative for the farmer, while the state was forced to sell the future revenues at discount prices, simply because it lacked the capacity to collect taxes itself. (Here, we see another example of a principal-agent problem.)

A nice (free!) overview of tax farming in the 18th century can be found here, by the eminent scholar Eugene White. The French monarchy, for one, was heavily dependent on tax farming for revenue. This dependence was a major contributor to the French Revolution, for two reasons. First, royal revenues were always rather stunted because the tax farmers absorbed much of the take, weakening state power. Second, the tax farmers of France were notorious for harshly oppressing the populace in order to squeeze every last sou that they could. (Similar concerns were at play with the Publicans of ancient Rome; a nice overview can be found here.)

This is all very interesting, but why is it worth knowing? In fact, it is surprising just how relevant the principal of tax farming can be, even in modern society. Take casinos, for example. They pay a large sum of money to local and state governments, and in return gain the right to siphon vast amounts of money from willing gamblers. The voluntary nature of the transaction makes it more palatable, of course, but even then the addictive nature of gambling muddles things.

Even more striking is the history of the banking system. That subject is so fascinating that it deserves its own post, but for now, suffice it to say that for decades, many U.S. states raised nearly half of their revenue by selling monopoly banking charters. In return, a particular bank would be given exclusive control of its town, free to earn considerable profits from its residents.

Neither casinos nor early banks are really the same as tax farming, of course. But they are both indirect means of collecting revenue, in which private parties gain outsized profits compared to the government’s take. Other examples can be seen with only a little effort, and the idea of tax farming is a useful lens for viewing much government policy.

Aside from that, this is another opportunity to bang my hobby horse of more realistic fantasy writing. As noted, tax farming was often the cause of massive oppression of the people, and resulting political unrest. I’d bet my last cent that some budding fantasy author could spin a much more interesting story using tax farming as an ingredient, than the typical “Evil Overlord wants to oppress the peasants for the lulz.”

The key thing to remember is that a king turns to tax farming when he needs more money that he can easily extract with his own efforts. It is the hallmark of lands with difficult travel, poor communication, and weak and divided political loyalties. In time, the tax farmers can become extremely powerful in their own right, perhaps even rivaling the established authority in the same way that Italian mercenaries would often overthrow their employers. If that isn’t fertile soil for a good story, I don’t know what is.

Coordinated versus Liberal Market Economies

11 Monday Jun 2012

Posted by in Credit, Economics, Finance

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[Welcome! If you enjoy short stories about politics, check out mine—published in a collection called The Best Congress Money Can Buy: Stories of Political Possibility. You can read the first story for free here, and then buy it if you like. Cheers!]

Capitalist economies (not the same thing as free-market economies, necessarily) depend on those with money providing capital to firms that need it. For most of human history, most actual investment was done by a small number of people, those with the skills and inclination to form relationships with businesses. Vast amounts of money was economically sterile, being hoarded as gold or silver treasures in the vault of some nobleman or other (just as today one might stuff hundred-dollar bills into a mattress). For the economy to grow and develop, somehow a mechanism needed to be set up to allow savings to be automatically channeled into investment.

This mechanism was the banks. When you deposit money in a bank account, the bank then turns around and lends it to someone who wishes to borrow. The bank serves as an intermediary between you, the saver who wants nothing more than a safe place to store your money (with maybe a little interest on top), and the borrower. Thus, savings that were previously useless to the economy are now being recirculated. (This can lead to systemic fragilities, of course, but those must wait for another post.)

Most bank-dominated systems work in a style called relationship banking. A company forms a long-term exclusive relationship with a bank, that will provide access to capital in exchange for a large degree of control over the company’s decisions—the bank wants to make sure that the company isn’t going to waste the money, after all. This sort of system relies on personal relationships and insider knowledge more than on things like a credit score, which only came into common use in the 1980s or so.

Some economies, such as those in much of Europe, take this logic even further and structure their entire economy around such long-term relationships between firms. Business contracts, decisions on who to hire and how to train them, and access to capital are all made through a close-knit network of powerful executives; insider knowledge and relationships are the key factors here. This is called a coordinated market economy, and you can read a fuller description of it in Hall and Soskice’s Varieties of Capitalism. (Amazon link here.)

Coordinated market economies have some advantages over the American/British system of comparatively liberal market economies. The system in general is more stable; you don’t get the day-to-day disruptions common in the US economy, for example, because everything is based on long-term relationships. In particular, new upstarts find it very difficult to break into such a system, because they can’t get access to capital and they can’t win contracts from existing businesses. While this may seem bad to the American ear, it has the advantage that firms in such an economy can specialize in extremely narrow niches of production, leading to incremental innovation. This is why German companies are known for their precision manufacturing, for example: because they have the luxury of intense specialization in their particular areas.

On the other hand, because it is so difficult for new firms to compete, a continuing hazard of such economies is that the whole system begins to stagnate. Disruptive innovations find it hard to survive in such systems, and instead gravitate to the more open liberal market economies like the United States.

In a liberal market economy, access to capital for big firms is usually gained via the public markets: the stock market and bond market. This means that the long-term relationships typical of Continental economies are less important here. Instead, decisions about who to invest in are driven by the release of public data, for example in annual reports or tax filings. Using such data, market participants decide who to channel their capital to.

There are drawbacks to this system. Particularly in the last thirty years, company executives can be driven to chase quarterly targets at the expense of long-term viability. The business environment is volatile and always changing, making it extremely difficult to plot long-term strategy and to pursue incremental improvement.

On the other hand, this system is much more hospitable to disruptive innovation, as we can see just in the last decade or two. While it can be gut-wrenching while you’re in the middle of it, overall it leads to a more dynamic and healthy economic system over time; stagnation is less of a threat here.

The main difference between these two systems is in the ability to get investment capital without sucking up to a bank. From that relatively minor difference, massive differences in total economic structure can develop. (More details in the Hall/Soskice link.)

Again, institutions matter. And seemingly small differences in institutions can lead to major differences in outcomes.