“Specific purpose money” a guest post by Kevin Cox

Quite a while ago, Kevin Cox approached me with an idea he had called ‘energy rewards’. Kevin may wish to chime in on comments with an appropriate link to the best explanation of the idea. In any event it’s a method of generating purpose specific permits or certificates which are given out as a reward, and is then constrains the beneficiary to spend it in a certain way. One might earn energy rewards by reducing one’s consumption of energy and the rewards would be in the form of a subsidy for the purchase of items that might help you reduce energy consumption – like a solar hot water heater. So the two things can be brought together in a way that seems compelling.

I told him that these rewards were not what an economist would call ‘first best’, but that there would often be situations where they were a good deal better than what policy was actually doing. I suspect energy rewards might be more efficient than MRET for instance. But you’d have to do a lot of work to know – or rather to have an educated, rather than a completely wild guess as to the answer. (And there are lots of areas where, at least assuming some judgement and professional general knowledge, a wild guess won’t be that much worse than an educated guess).

I’ve actually thought about such systems for a long time following my own involvement in arguing that export facilitation in cars (according to which automotive exports earn credits to duty free automotive imports) was an excellent way to liberalise trade in automotive products – and a lot better than what was being proposed by the IAC at the time.

At the same time I raised a bunch of the kinds of objections that most economists would point out about such systems. If you want to subsidise energy saving, subsidise it – tying the savings to more expenditure on energy saving equipment is inefficient both because it will lower the subsidy rate to those who don’t want or need any such equipment (they’re just prepared to put more clothes on when it’s cold) and because you can’t say in advance what is energy saving equipment. (Are jumpers energy saving equipment? Is hot water heating for your pool energy saving equipment? Probably but not if you wouldn’t have put in a pool without it, or if you would have swum in the cold.) Not to mention the transactions costs. But that makes three objections and no-one expects the Spanish Inquisition.

I don’t think Kevin has ever really taken these concerns on board. But he thinks he has. And he’s gone from strenght to strength, (or from my minor quibbles to something more major) depending your perspective. He now believes that he can solve the problems of excessive house prices with specially tagged money. He’ll do the same for health and for public transport. I don’t think he’s right and will only participate beyond this point in the discussion tangentially, if at all. But Kevin wanted to bring his ideas to a wider audience, and I said that subject to my being able to place this disclaimer in the introduction, I was happy to do so.

Perhaps I’m wrong. If I am a lot of problems can be solved a lot more easily than I thought. It reminds me of something the late and lovely Tom Fitzgerald wrote in his Boyer Lectures apropos of Australia’s economists of the 1920s.

What is inspiring . . . is the example of Australian economists who arrived at independent conclusions contrary to the world orthodoxy, who invited criticism from the most eminent upholders of that orthodoxy, and, on being rejected, put their argument in an international forum, to gain ultimately a large measure of acceptance for their initial heresy. Today they are far better remembered and admired by an eminent American economist, the Nobel Prize winner Paul Samuelson, than by any Australian counterparts. . . . Professor Samuelson has recently referred to them as ‘my-down-under-heroes’

Perhaps Kevin will one day become someone’s down under hero. I’ll just keep pressing on trying to find the low hanging fruit within the interstices of orthodox economic ideas. (I think I’ve just mixed a metaphor. Still, as they say in Italy – whatsa metaphor you eh?)

Kevin’s post is below the fold:

A solution to Australian housing affordability

Over Easter I put up a comment on John Quiggin’s blog describing an economic system that is 100% certain to lead to a reduction in greenhouse emissions. This blog entry describes a 100% certain way to reduce house price inflation and make housing in Australia affordable and in the process reduce Australian interest rates and most likely stop inflation getting out of hand

The entry on Quiggin’s blog put the proposition that Emissions Trading was unlikely to lead to a rapid reduction in emissions and the solution to global warming was to find an efficient way to spend the money collected from a surcharge on dirty energy. That is, it is not price that is important but it is how the money collected from the price increase is spent that is important. The idea that “to fix a problem make the price reflect the true cost” does not work in dysfunctional markets. In the case of infrastructure I would say to fix a problem invest in ways to fix it through an efficient market or “to fix an investment problem spend money efficiently”

A major problem facing Australia is housing affordability caused by asset price inflation and market failure in the housing market because we have not built enough dwellings to reduce the price. The following outlines some of the reasons for this dysfunctional market and a way to solve the problem with relatively little pain.

In Australia last year 90% of loans for housing (or about 200billion dollars worth) was used to buy existing dwellings. In other words an enormous amount of money was created that monetised existing houses and did not directly create new houses. The housing affordability problem was caused by house prices increasing because too much money was created to purchase old houses not by a lack of new houses being built. Market theory would have us believe that if the price goes up the market will react to produce more housing. This has not happened. There are at least two main reasons why the market for dwellings is dysfunctional.

The first is that the banks have taken advantage of their privileged position and created too many loans for housing. The banks fall over themselves to lend money because they can hedge their risk by securing the loan against future wages as well as against the value of the house and then they further off load the risk by creating asset backed securities and selling these. Lenders tend not to care that house values are over inflated. Basically this problem is caused by a systematic failure that allows banks to create too much money for a particular asset class while reducing their risk of losing when the bubble bursts.

The second reason is an Australian monopoly – the ability to change land use and to tax land – owned by various governments. Treasuries and elected officials like to see the price of houses and hence land rise because they make monopoly profits on land use changes either directly from the sale of land or indirectly through taxes and charges.

These and other influences on the market means that the dwelling market does not work the way it is supposed to. In other words if price was the solution then we would not have 90% of loans used for existing dwellings. The reasons why asset booms happen can be many but the fact that they can happen at all says that there are systematic problems with the monetary system. I suggest the major reason is the separation of the reason for the creation of money from the money itself. If you can create some money and isolate it from the reason for creation then you have the precondition for an asset bubble. Most bubbles do not matter – who cares if some collectables become inflated in value – but we all care when house prices become too high because the money created from dwelling asset inflation can cause general inflation.

Money is created so that we can exchange goods and services. Money is not created out of thin air – it is created for a reason. The separation of the money from the reason it was created is asking for trouble because money becomes an end in itself. The fact that we now have 10 times the value of a years worth of world’s GDP in derivatives means something is wrong. The fact that every few days the transfer of money between countries equals the value of trade between countries for a whole year means something is wrong. That is, we have created an instrument as a way of transferring value yet the instrument itself becomes the main thing traded. It is difficult to see the purpose or necessity for this if markets in the goods and services the money is meant to serve operated as expected.

Let us look at how people set prices for “real products” and we can see the problems of using price as the only market control mechanism.

If you have a product then you set the price not at what it costs you to produce plus a margin (or its intrinsic value) but the price that you can convince people to buy it. People do all sorts of things to separate prices from the cost of production. A glaring case described above are the banks and they do it through regulation. Other cases of where regulation is used to prevent markets operating well are the markets in gambling and telecommunications. Often the idea of regulation was to stop the gouging of customers and to make sure the financial system operates fairly. The opposite often seems to be the case. For example the banks keep competitors at bay through an informal cartel where like the petrol companies they all set prices in unison. They know that if they keep the system cosy then they can all make good profits. They do not set their prices on the cost of production or delivery. Thus if price in imperfect markets is not a reliable indicator of value what is and/or how can we correct the problem

The prices of investment products tend to have lower volatility than consumer products because the indicator of value is the income that the product will produce for the buyer. Thus many investment products based on tangible value tend to have stable prices because it is relatively easy to measure value other than through price. You measure it on the value of your returns through using the product. If house prices were measured by the actual returns of rent rather than include asset inflation in the mix and other taxation quirks then the market would work. Unfortunately that is not the way the world works and trying to “fix” the market by removing anomalies like home owners capital gains tax breaks and negative gearing are difficult and even if successful other anomalies will arise. So even in investment products price is often not a good indicator of underlying value.

We have to find a better way.

The way we create money and then lose track of the reason it was created means it is difficult to prevent asset inflation and volatility in prices. If however, for asset classes where market failures occur we restricted the use of new money created for that asset class we would stop speculation in that asset class. That is, the price would start to reflect the intrinsic value.

This is what we propose with Energy Rewards. We tagged some money to be used to reduce emissions and required it be used for that purpose. The market in ways to generate green energy cannot compete with the market in ways to generate clean energy and so we have to change the market in some way. The way we suggest is to tag some money so that it must be spent in the green energy infrastructure market place rather than raise prices of all energy to force investment in green energy. A price increase in housing has not caused enough houses to be built and so it is wishful thinking to believe that a price increase in energy through the sale of emissions permits will reduce emissions.

We can solve dwelling price inflation using the same technique of tagging money with more information to restrict how some money is spent. When a loan is taken out for the purpose of purchasing a dwelling then let us – for convenience – call the money created House Dollars. House dollars have one small restriction – they can only be used to purchase a house or to build a house. When a house is built the money is converted to unencumbered dollars because the money is used to buy land and building material and the rule is that house dollars spent creating a new house become unencumbered. If an existing house is purchased with house dollars then the dollars stay encumbered. House Dollars can be traded like any currency and so people who do not want house dollars can sell them. The difference in price between House Dollars and unencumbered dollars will reflect dwelling price inflation.

What will happen? Almost immediately speculative demand for housing will disappear. People who sell their houses may receive some house dollars as payment or may receive unencumbered dollars. If they want to use the money to build another house then they will be happy to receive house dollars. If they want to spend their money on something else then they will tend to look for buyers without house dollars or they will sell their house dollars to someone who wishes to build a house. Either way there will be a lot of money looking for its best value which in this case would be spending on new housing.

If we dropped the demand for existing housing then the loans of $200billion per year created for old housing would drop back to a fraction of this amount and inflationary pressures would cease overnight and we could get interest rates back to a reasonable figure and people will borrow for other purposes.

The implications of tagged money are many but one is that the Reserve Bank will have a tool to stop inflation as it is the Reserve Bank who have the authority to put a restriction on new loans for housing. It will be so effective that instead of a 2 to 3% range for inflation we could have a zero percentage target for inflation because we no longer need inflation as the mechanism to allow different asset classes to adjust their relative values.

One of the other interesting characteristics of tagged money is that once an asset class has come to its “true” valuation relative to other asset classes then the need for the tagged money goes away and we can discard it. It is my guess that the fact that the Reserve Bank can at anytime reintroduce tagged money for any dysfunctional market will help prevent them happening in the first place.

If what is suggested with tagged money is correct then tagged money can be used to correct the deficiencies of any dysfunctional market place or any area of community activity where the incentives of a normal market place fail to deliver the most efficient outcome. This turns out to be most areas where governments spend money. That is, instead of the government dispensing the money by buying services, the government dispenses money through tagged money or electronic vouchers and people use this tagged money in regular market places. (With Club Troppo’s indulgence I will next week describe a system that creates a functional health delivery market place for Australia and the following week describe a design for a system for a functional public transport market place)

You might ask if this is such a good idea why hasn’t it been thought of before and tried elsewhere? Like most ideas it has been thought of before and it is called frequent flyer points.

What is new in this proposal is backing the “points” with real money, allowing the transfer of points, and keeping the identities of people participating anonymous. The implementation of tagged money to be used by everyone in an efficient manner has become technically possible only in the last year or so and uses the Internet, powerful computers, modern communications, modern system construction technologies and anonymous electronic identities. Anyone with access to a phone can participate. We don’t actually tag any money. What we do is to create a special type of tagged account into which we put the Rewards or House Dollars. It is really the same as vouchers but with all the efficiencies, rules and utility of real money plus the anonymity supplied by electronic identities. The real money that backs the tagged money is kept in a real bank account with a regular bank and it can only be accessed by the organisation that looks after the accounts. Creating electronic bank accounts, identifying people anonymously and moving tagged money is simple and cheap and that is why it can be implemented so easily. It is certain that the transaction costs of tagged money will be lower than the transaction costs of real money. The reason for this is that there can be no overdrawing of accounts, the real money is kept in a safe place and even if the tagged money is used inappropriately we know where it is, and we know how much and on what it is spent. The controller of the tagged money however does not know who made what transaction because the security of the system is handled automatically by the system.

What this does is make compliance easy to enforce and provide a wealth of information to help control the system but do it in a privacy friendly way.

The challenge to readers is to tell me why house dollars as described above will not reduce house price inflation and will not improve house affordability in Australia.