Open thread

I haven’t offered an open thread for a while, so here’s one – to discuss Kevin Rudd’s first 50 days in office, whether Australia Day should be scrapped, the state of academia today, or any other topic you please.

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22 Responses to Open thread

  1. Kevin Cox says:

    A big one facing the new government is inflation and they seem to be looking for ways of reducing it without going back on election promises.

    I would be interested to know why we don’t – in some way – make lending for existing houses less attractive as a way of reducing inflation. When you are looking to make a big impact then you go for the big dollar amounts and there are few bigger than the generation of money for loans for existing houses.

    In November 2007 $22 Billion dollars was loaned for housing. Of this only $2 billion was for new houses. That is the banks created loans (increased the money supply) by $20 billion in one month. To me this is a massive increase in the amount of money in the economy for no “productive” purpose. Buying an old house does not increase assets available to society.

    Can someone tell me why we don’t do something like put a surcharge on loans for old houses to reduce inflation instead of causing us all to suffer with inflation and increased interest rates?

    The same thing applies to the leveraged buyouts of private equity and for the deals that Mac Bank do when buying infrastructure.

    It all seems to compound when we get other financial instruments such as the securitisation of loans where people now go and borrow money to buy loans!

    These sort of financial pyramid schemes seems to lead to inflationary pressures because we are creating money for no productive purpose. I would like someone to tell me why we allow this sort of thing to continue because it seems to lead to asset bubbles and the acceptance of continuous inflation as the way to reduce the amount of money in the system.

  2. Stephen Hill says:

    The curse of the left coalition continues in Italy, Prodi forced to resign after losing a vote of confidence. Sadly, it looks like it paves the way for another political return for Berlusconi, whose stench outweighs the rubbish piling in Naples.

  3. Patrick says:

    Can someone tell me why we don’t do something like put a surcharge on loans for old houses to reduce inflation instead of causing us all to suffer with inflation and increased interest rates?

    They called it stamp duty didn’t they?

  4. Patrick says:

    I was cautiously optimistic about Rudd. I am still so – which is a good thing :) I don’t dare hope for a carbon tax, but otherwise let’s hope he listens to Ross Garnaut. I wish he would forget about the whales but I guess that keeps the loony fringe happy.

    I don’t think Australia day should be scrapped. I like it.

    I also like lending and modern banks and infrastructure finance. I love central bank-supported cash, I think it was the best invention since the wheel.

  5. Clinton McMurray says:

    Kevin, what Patrick says.

    I do think you’re on the right track though. Placing a surcharge on existing dwellings is probably a bad option. Better to remove tax breaks for property investors, which, in my opinion, is one the the root causes of the speculation driven asset price bubble we’ve seen in property, via reduced risk/market distortion. The counter argument says that we need investors to increase the housing stock. But, as you pointed out, very little investment goes to new housing (around 3% – have accurate figures if anyone is curious). If we really want to keep the tax breaks, at most it should be for investments in new dwellings only. It’s true that the states are subsidising the purchase of new homes via various schemes, and that there are issues around town planning, but i won’t go into that here.

    Of course, removing tax breaks for property investors would be political suicide, so i’m not holding my breath.

  6. Kevin Cox says:

    Patrick a stamp duty is not the same as a surcharge on interest. Both increase the price but price is not the issue but a symptom of the problem.

    A surcharge on interest addresses the problem which is the fact that it is less risky for banks to create loans (increase the money supply) for existing houses than it is to loan money for new houses to people who are trying to get into the housing market. A stamp duty increases the price but does not influence the loan making decision which is the core of the problem of an increase in money supply for assets that have lower value than the money created to purchase them.

    The way money is created is important and the purpose to which it is put is important. There seems to be this belief by some economists that price is the only thing that matters because it reflects the “value” of the goods or service being offered. This then comes to the fore in statements like Patrick’s that implies that it is the increase in price that is important.

    Price is only a measure and as Ken Henry of Treasury (seemingly a disciple of Amartya Sen) believes there is more to our economic transactions than the money bit. The Treasury seems to think that “wellbeing” is important. I would suggest that creating money to purchase assets that do not have an equivalent underlying value is also important as it degrades the utility of money to represent value.

    The surcharge on interest for old housing sales is one way of addressing the problem as is stopping banks from generating money as a loan to purchase an old house and allowing them to secure the loan against other assets than the house. Another way, as Clinton suggests, is to give people tax breaks that are unrelated to the house value. Reducing the massive increase in money supply created from old house borrowings will go a long way to reducing inflationary pressures. Perhaps we should use a series of measures?

    Clinton I would very much like to see the accurate figures on new housing investment. If it is only 3% then this is much much worse than my guess of 10% and makes it even more puzzling why there is so little discussion of this fact.

  7. Patrick says:

    I would suggest that creating money to purchase assets that do not have an equivalent underlying value is also important as it degrades the utility of money to represent value.

    I think you are a socialist. If they don’t have that value then they would not be sold for that amount.

    You may not think that they have that value – which is fine, since you don’t have to buy them. Vive la marché!

  8. Kevin Cox says:

    Patrick that is exactly the problem. There appears to be a widely belief that price represents the true value of something and that people will not buy things if it doesn’t represent the true value. There are some things that people have to buy at a price set by the seller because there is no alternative or alternatives are not allowed to arise. In other words there are price setters and price takers. For most of us we are price takers and we have little chance to bargain and get a different price.

    But this is not the point I was trying to make. The point being made is that the banks have increased the money supply by making a lot of loans for existing houses and that this is a major contributor to the money supply crisis. If the rate at which they made these loans was reduced then inflationary pressures will start to reduce in a relatively painless way. I have made some suggestions on ways that it might be addressed. So far I have yet to hear an argument that what is suggested is incorrect. There is an argument about the way to address it but if the central point is correct what would you suggest? Do you deny that $240 billion dollars of new loans to purchase existing capacity is irrelevant to the inflation debate?

  9. Patrick says:

    There are some things that people have to buy at a price set by the seller because there is no alternative or alternatives are not allowed to arise.

    This is a monopoly. There is no monopoly on either land or buildings in Australia. In a loose sense, there is a monopoly on each particular piece of land, but this is a nonsensical way of thinking. People do not have to live in particular locations, they choose to. If they really could not afford it they would not so choose, they would live in different locations or smaller houses etc. There is no affordability crisis there is simply a change in the proportion of income people are willing to devote to their house.

    The point being made is that the banks have increased the money supply by making a lot of loans for existing houses and that this is a major contributor to the money supply crisis.

    You are obssessed by the idea that lending money to buy an existing asset is the creation of money. It isn’t. The bank creates a receivable which is exactly equal to the impairment of the existing asset (ie the liability). If you need to fret about this you could call it ‘liquidification’, but it is not a meaningful increase in the money supply as far as I can see (although I would be happy to be corrected on this).

    If the rate at which they made these loans was reduced then inflationary pressures will start to reduce in a relatively painless way.

    Arguable. You have to remember that people are choosing to borrow these amounts. They might simply find other things to invest in such as shares. However, if the rate was reduced by artificially increasing the interest rate, as you seem to suggest, then wouldn’t this be really just like an increase in the reserve rate? Ie, the standard response to inflation that we expect from the RBA? So does your suggestion boil down to raising rates selectively? But there is a reason why rates on borrowings secured against land are lower, can you think of what it might be?

    Finally, I must point out that trying to weight ‘the system’ in favour of new dwellings has absurd implications for our environment. I do not particularly care for my part but I am sure that you profess to.

  10. Kevin Cox says:

    Patrick in real life there are not as much choice as you imply and there are many reasons besides a monopoly for a person to have little or no choice. The chief one is that transactions are related. For example, if I choose that I want to work for a particular employer then that now limits where I live. If I choose where I want to live then that limits my choice of employment. Constraints are rapidly introduced into the choices we can make and for most of us for most purchases our practical choices are severely limited.

    I am not surprised that you do not understand that money can be created when a loan is made as most people do not understand this. We create money as a method of exchange of value and we do not create it until we need it and it can be destroyed if we no longer need it. Theoretically anyone can create money but this is not convenient or workable so we leave it to specialists called banks. Money is created through making a loan. This does not imply that all loans require the creation of money but to start the process and to create some money someone somewhere creates some money “from nothing” through making a loan.

    Obviously we have to have some limit on the ability of banks to create money and once upon a time the banks had to go to a Central Bank and ask them for a loan so that they had some money to lend. They still do this for some of their money. However, banks have been given the privilege of making extra loans themselves based on the money they have on deposit. It is called fractional reserve banking. If the fraction is 10% then the bank can get $100 from say the Reserve Bank and then create more loans up to a value of $900 on the deposit of $100. As much of this money comes back to them as deposits they can then create some more loans and it can quickly compound. As they make money from loans it is in their interests to make as many secured loans as they can. This is why we get asset inflation of houses. Banks can make loans (create money) that are secured against future wages not against the asset itself. The moral hazard is great and the banks have succumbed.

    With hedge funds and other financial instruments the amount of money rapidly escalates and we have a lot more of it than needed for simple trading and exchange of goods. (like two orders of magnitude) You see people do things like lump together a lot of loans (securitise them) then sell them to others. Those people get the money to buy them by going to a bank and getting them to create some money and give them a loan.

    The reason why the money was created in the first place is soon lost. Haven’t you ever wondered why we are told that the financial institutions have no idea who has taken the risk on the sub-prime bad loans and it will take months to sort it out.

    Money is created to exchange value and we really only need it when we want to exchange value.

    If you create more money than there is asset value backing then you have a problem. Either you have to increase value – make the assets more valuable – or decrease the value of money – inflation.

    Another way is to reduce the amount of new money created and the ONLY way that our governments can now do this is through increasing the rate at which the Reserve Bank lends money that it creates – but as this is only a fraction of the money that is created you can see we have a systematic problem.

    The blunt instrument of treating all creation of money the same is not a good idea. I would submit that it is better for society to allow the creation of money to build productive infrastructure than it is to create money to buy an existing over inflated shopping centre complex. I would also submit that it is better to create money to build a new house than it is to create money to buy an existing house.

    Not all money is equal in terms of its utility and we need ways for our systems to recognise this. One way would be to have differential rates for different purposes and those rates took into account other factors besides risk. Another way is to have different money for different purposes. Another way is to make sure the asset that the money was created to represent is tied to the money created – that is as the asset increases or decreases in value so the money increases or decreases. Shares are this sort of money but we could make such a facility more widely available. (By the way one of the earliest forms of money in Egypt had this property. The longer you kept it the less value it had)

    I believe that we should weight the generation of money for new houses versus “old houses” as a new house adds productive capacity whereas a loan for an old house doesn’t.

    By the way I am not a socialist (not that I have anything against them and some of my best friends are:) and I think building new houses is a good thing and I believe that the solution to environmental and social “problems” is through economic development – but they are all irrelevancies to this discussion.

    Thanks again Patrick. Trying to answer your comments does help me clarify the ideas. I am now becoming even more convinced that if we model economic systems down at the transaction level and if we introduce more flexibility at the bottom level of everyday transactions then we will come up with a much more adaptive, productive, stable and expanding economic systems.

    I would encourage you to go take a look at http://www.ted.com/index.php/talks/view/id/145 and see how ants organise themselves. We have a lot to learn from them and you might like to take a look at some ideas that flow from an ant view of the world at http://cscoxk.wordpress.com/2008/01/26/a-bottom-up-approach-to-innovation/

    In the short term I think somehow weighting loans in favour of new loans for new houses versus “old houses” would have a good chance of stopping inflation in its tracks and prevent Australia sliding into a recession.

  11. Patrick says:

    I think a lot of this is confusing.

    For example, if I choose that I want to work for a particular employer then that now limits where I live. If I choose where I want to live then that limits my choice of employment.

    Not in any meaningful sense. I can work for any of several thousand employers in Melbourne and live within any of several dozen distinct price-points. I think you should stop thinking of houses in this way.

    This does not imply that all loans require the creation of money but to start the process and to create some money someone somewhere creates some money “from nothing” through making a loan.

    You see people do things like lump together a lot of loans (securitise them) then sell them to others. Those people get the money to buy them by going to a bank and getting them to create some money and give them a loan.

    What this overlooks is the same as the first point. The money is not being ‘created’, it is being liquidified.

    As best I can understand this is not true. I think you are referring to the substitution of illiquid value (ie land) for liquid value (ie cash). That does create problems but none of the ones you have identified.

    As they make money from loans it is in their interests to make as many secured loans as they can.

    This is at odds with what you have said about fractional reserve banking. A secured loan does not involve the creation of any money, as above.

    Banks can make loans (create money) that are secured against future wages not against the asset itself.

    What do you mean? I believe we should have more of this but in practice I understand that is only really the case in Australia with HECS. I doubt that is what you have in mind.

    I would submit that it is better for society to allow the creation of money to build productive infrastructure than it is to create money to buy an existing over inflated shopping centre complex

    I assume you are thinking of Centro. Most of their shopping centres are in fact highly attractive assets because their worth is based on the estimated future cash flows from the rents. I do not follow how this can be ‘over-inflated’ except in the sense that the variables on which it is estimated, such as population growth, spending patterns, etc, might be wrong.

    I would also submit that it is better to create money to build a new house than it is to create money to buy an existing house.

    I cannot fathom this. Why? Does the same apply to cars? Why not?

    Not all money is equal in terms of its utility and we need ways for our systems to recognise this.

    If you mean that not all ‘value’ is equal in terms of its utility then that is correct – hence the trend to ‘liquidification’ which so worries you. But a given unit of ‘money’ per se is of equal utility, by definition.

    I believe that we should weight the generation of money for new houses versus “old houses” as a new house adds productive capacity whereas a loan for an old house doesn’t.

    Perhaps this is what you were getting at above. Doesn’t this suggest that the same amount of money spent on a new house is more inflationary than if spent on an old one?

    Another way is to make sure the asset that the money was created to represent is tied to the money created – that is as the asset increases or decreases in value so the money increases or decreases. Shares are this sort of money but we could make such a facility more widely available.

    Broadly speaking bank loans are this kind of asset as well. If the property valuations dip below the receivable amount the bank must ‘impair’ the receivable and book a charge to its income statement (ie a loss) as well as a reduction in net assets. This is for example what happened with the banks holding sub-prime CDOs – the market value of the instrument crashed, and so the bank had to record a loss of the difference between the last and the current market value.

    In the short term I think somehow weighting loans in favour of new loans for new houses versus “old houses” would have a good chance of stopping inflation in its tracks and prevent Australia sliding into a recession.

    I suspect the latter, and I don’t think we are sliding into a recession. Cheer up.

  12. Clinton McMurray says:

    Some interesting points made above.

    Kevin, I will dig up the figures supporting the 3% of investment going to new housing some time soon (was/am too busy right now). I tackled this topic in an assignment for a 3rd year undergrad public economics course i took last year. Of course, I only touched on it given the scope. It is very very complicated and without a serious econometrics study, very little can be said that is not mere speculation, albeit based on economic principles.

    In my opinion, the monetary issue, has less impact on the market than the distortionary tax breaks. Without removing them, or at least altering them, introducing surcharges on interest would serve only to compound the distortion in the natural working of the market. Perhaps all that is needed for proper functioning is the removal of the tax breaks, therefore making other adjustments redundant.

    A situation where people investors aim for losses (negative gearing) is far from ideal, particularly in assets such as housing. One of several problems in removing it (apart from the obvious political dilemma) is rental prices. When investors aim to make a loss in order to optimise their tax burden, rents remain lower, perhaps, than they would under a market absent the distortion.

    Much (dis)information on the issue comes from industry groups with vested interests and there are some ‘interesting’ stats around.

    Once tax breaks like this are introduced they are very difficult to remove politically. I’m not sure that further adding to the distortion by means of additional ‘give with one hand take with the other’ policy is the way to go.

  13. Patrick says:

    Which tax breaks do you mean? You seem to refer to the deductibility of interest – but that is not a tax break, it is a fundamental principle of our tax law.

    The classic ‘tax break’ that people focus on in this area is the capital gains exemption for primary residences. That could indeed be capped, for example. But it is very hard to see how any cap low enough to affect low income earners could ever make them better off – this returns to my point about Stamp Duty, which hasn’t helped anyone except State governments.

  14. Kevin Cox says:

    Clinton,

    You are right and Patrick has fallen into a trap that seems to afflict many who have training in economics. The problem is illustrated in many of the comments Patrick made to my post. The problem is that the measure (in this case money) is given a meaning outside its function. Many economists seem to have this belief that because you create some money which is a measure of a goods or service or asset that you wish to trade that the money is somehow magically disassociated with the asset against which it was created. Patrick even talks about the money existing even before it is created with his talk about “liquidity” of assets that noone wishes to trade.

    You quite rightly identify loans for investment housing where the loan is secured against ones income and can be used as a tax deduction against the loan as being a problem. It is a problem because if the banks create a loan for the purchase of an asset – investment housing – and the money created is not risked against the asset but against a person’s salary then the banks will take a greater risk than they should – which means loan more money than the value of the house such as its earning potential in rent.

    Many of issues we have with our financial systems stem from too much abstraction of the money measure. That is money created for a particular reason can be treated differently from money created for another reason. There is no law of nature that says we can’t do this and I think once the people looking after our financial systems recognise this is possible and indeed desirable then we will learn to use money as the tool it is rather than as something that has value in and of itself.

  15. Clinton McMurray says:

    Patrick,

    Why should bank fees and interest on debt be deductible on residential property investments? Several other deductibles are also not essential to the proper functioning of the market. Do you agree that by not having to bare the full interest expense, that speculation is made easier? Also, when things go bad, the losses are larger than they would otherwise be. It is true that some level of speculation in the market is useful in that it increases liquidity, which should at some level help to reflect value (not price) as more trading is effected.

    If these deductions were serving to increase the housing stock, fine, but it seems that they are not and that the problems i mentioned outweigh the benefits – maybe.

    There are far far too many deductions in our tax system in my opinion.

    You said above that “If they don’t have that value then they would not be sold for that amount”. Well, it depends on how you define value. Isn’t the very definition of a speculative price bubble a situation where prices exceed intrinsic or fundamental value? You may argue that this is not what we’ve seen in recent years, but the point stands.

    Just because something is fundamental does not necessarily mean it is optimal.

  16. Patrick says:

    intrinsic or fundamental value

    I don’t believe in any such thing; except perhaps in moral discourse. Value is, and must be, subjective. The entire last 60 years are a lesson in that simple point, also able to be expressed along the following lines:

    Over time, the choices of individuals acting more or less in their own self-interest produce superior global outcomes to any other system

    It could even be expressed more eloquently :)

    Several other deductibles are also not essential to the proper functioning of the market.

    a) I am not sure what you have against deductions – do you want to tax gross revenue?? Wouldn’t that be a little, well, iunfair???

    The fundamental principle is the same in accounting and tax – that your profit is the net of your gains and outgoings. The rules are slightly different in each case for determining what is a gain or an outgoing but interest and bank fees are ‘deductible’ in both cases!

    b) Tax deductions are not, fundamentally, about markets. They are irrelevant to the operation of the market, really, or at least if you believe Coase. They are fundamental ‘to the proper functioning of the’ income tax system.

  17. Clinton McMurray says:

    I agree – tax deductions are not, fundamentally, about markets. I do, however, think that they affect markets and therefore are not irrelevant to the functioning of markets.

    I suppose I do have something against tax deductions, in the same way that I have something against tarrifs and subsidies. They are distortionary. Sometimes they are economically sensible, often they are not. I think in Australia we could do away with dozens of them, pay less income tax, and remain revenue neutral. I do not believe that they are fundamental to the proper functioning of the income tax system.

    Much trade takes place precisely because one party believes an asset to be overvalued and the other, undervalued. Heck, in the equities markets alone, there are many highly paid researches who do nothing more than seek out “undervalued” assets. Are they really finding undervalued assets? I don’t know. It depends to what extent you believe in the efficient market hypothesis.

    Economic profit is not the same as accounting profit, and therein lays part of the problem.

  18. Patrick says:

    I confess to not understanding what you mean. I have no idea what you mean by this, for example:

    They are distortionary.

    In the same sense as tariffs and subsidies? I presume you mean that they affect the allocation of spending? To an extent, yes, they do. But probably much less than you think – 99% of the time, Company X decides to do Y, and then asks their tax advisers for the best way to do it – nothing very distortionary about that.

    Economic profit is not the same as accounting profit, and therein lays part of the problem.

    Is there any connection between this and the earlier comments? Do you think that a system which taxed economic profits would be less distortionary? How would you tell? Presumably with accounting? But on the whole, accounting guides tax anyway – now more than ever!

    I think in Australia we could do away with dozens of them, pay less income tax, and remain revenue neutral.

    Ah, you are focusing on the personal income tax system. I agree that we should lower rates. I would be happy to get rid of work-related deductions but that would be unfair to professionals who are already discriminated against by our high marginal rates – so would in fact increase a distortion.

    I have no idea what the stuff about undervalued assets is about.

  19. cba says:

    It sounds like Clinton is referring to the Flat tax/X tax

    Hall’s classic Flat tax
    http://www.hoover.org/publications/books/3602666.html

    Bradford’s X tax plan (this version focuses on the transfer pricing problem)
    http://www.princeton.edu/~ceps/workingpapers/93bradford.pdf

    Hall’s comparison of the two
    http://www.taxreformpanel.gov/meetings/docs/hall_052005.ppt

    The key is simplicity, especially avoiding the arbitrariness of accrual accounting rules. Sounds completely crazy to accountants with a vested interest in complexity.

  20. Clinton McMurray says:

    I was not talking specifically about a flat tax rate. I believe the personal income tax system should be somewhat progressive.

    All of my earlier comments were made in relation to personal income tax. We were, I thought, discussing these things in relation to investment in residential dwellings, which is done primarily by individuals, not companies.

    “I would be happy to get rid of work-related deductions but that would be unfair to professionals who are already discriminated against by our high marginal rates – so would in fact increase a distortion.”

    Why not rid ourselves of the complexity of these deductions AND lower the marginal tax rates, remain revenue neutral (and minimise possible distortions)? After all, the tax deductions have to be paid for. Where do you think they are paid from?

    As you find it so difficult to follow my discussion, and because this seems to be going nowhere, I shall comment no further.

    Cheers

  21. Patrick says:

    Sorry, I was focusing on corporate income tax at first whilst you were focusing on individual income tax. Also, I was caught up in the mentality of responding to Kevin’s war against civilisation.

    There is a lot of support in tax theory for your idea. The problem is that the professional has to pay for everything herself, including things such as computers and books that are quite expensive and that would be non-FBT tax deductions to a corporate employer. So, even if you slash the marginal rate, if you get rid of these deductions the self-employed professional is still paying more tax than an equivalent employee.

    But the idea would still work, in your spirit, if, eg, you simply gave everyone who derived non-wage professional income (ie not investment income either) the same proportion of a $1000 deduction as they derived professional income.

    Because you would be reducing the marginal rates to at least (er, most) 40%, that wouldn’t cost more than $400 for at most 15% of taxpayers.

    So that sounds quite good, and I support that, and I am sorry for snarky remarks earlier.

    The missing link to get the compliance costs, however, is pre-filling tax returns. THe ATO has taken baby-steps towards this, but getting rid of work-related deductions and using the automatic formula I discussed above should make this possible for about 75-85% of individual taxpayers, if not more.

    Finally, one more snark: After all, the tax deductions have to be paid for – this is not as clear as you make out. There is some controversy about that phraseology. Basically, it assumes that income is taxable unless provided otherwise, which, whilst practically may be the case, legally is not, and hopefully never will be.

  22. cba says:

    The X tax is progressive at the personal level, with corporate taxes equal to the highest marginal income tax rate. There’s no double taxation at the corporate/personal level because investment income is only taxed at the source. Another aspect of the X/Flat tax that fits the discussion here is that all investments are immediate write-offs. I suspect it would deal with Patrick’s concern about unequal treatment of professionals. Worth a look since you’re both having this discussion.

    (I might sound like its biggest fan, but I really don’t have a horse in this race)

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