Twofish's Blog

January 21, 2009

Homework for Austrians and Chicago Schoolers

Filed under: austrian economics, china, finance — twofish @ 10:41 am

There is some good news. I’ve seen figures that say that the property market in China is stabilizing. Prices are still going down, but lots of people are snapping up cheap deals in real estate, and so the volume of real estate sales is actually going up.

I think the huge savings is going to be very helpful for China to recover, since if you have lots of money in the sidelines, the markets don’t collapse when there is a massive price drop. You see a super-cheap house or super-cheap stock. The buyer has cash. The seller has cash. The buyer and seller both shake hands. The buyer gets a really good deal. The seller takes a loss but has cash. This is the way that markets are *supposed* to work.

The problem right now in the United States, is that this won’t happen if the buyer and seller both have large debts. You don’t have buyers with ready cash, and what cash they have, they want to keep. The sellers are also broke so they can’t sell and realize a loss.

An exercise for Austrian economists is to look at market microstructure. Austrians have developed a rather rigorous framework for going from the individual actions of buyers and sellers into social good. The basic idea is simple which is that the buyer and seller will only undertake exchanges that improve each others well-being, and therefore a system based on market exchanges will naturally deal to an improvement in social well-being.

What I think Austrians should do is to look at situations where this breaks down.  If you have a situation in which “bad things are happening” then it must mean that this rigourous logic has broken down somewhere, and the nice thing about rigourous logic is that when it breaks, you can list the places where it is broken.

So you have situations in which:

1) invididual exchanges benefit the people making them but don’t result in social benefit, perhaps because there is a third party that is not part of the transaction that is being harmed.  A very good example of this is the whole subprime mortgage issuance system.  You have a mortgage broker that makes money from commission when a deal is signed, and a borrower that gets a lot of immediate cash.

2) individual exchanges which *would* benefit the people making them don’t happen.  This can be because neither has the cash.

One thing that comes out of this is that corporate structures are very important.  Many economic transactions include merely a buyer and a seller, but most economic transactions involve agents and the buyer and seller may be abstract entities.  Also, it’s important to look at this carefully because I think it is obvious now that some of the things that were suggested to align the interests of the “principal” and the “agent” did no such thing.  Stock options and bonus system for example.  The problem with stock options and the bonus system is that you make a ton of money when the company makes a ton of money, but you lose the same amount if the company loses a small amount of money or $1 trillion dollars.  So the logical thing to do is to assume huge amounts of borrowing and risk so that when the company makes money, it gets magnified, but if the company loses a ton of money and threatens to destroy the world financial system, you just get fired.

In any case, I think thinking in terms of market failure at the level of individuals is another way of looking at the problem, and it’s something that I think Austrians and Chicago Schoolers can do usefully if they want to keep the evil socialist, big government, serfdom promoting Keynesians from totally dominating the economic conversation.


  1. You should read The Affluent Society by John Kenneth Galbraith after every reading of Hayek, Friedman or others.

    Comment by Cochin Loco — January 22, 2009 @ 12:35 am

  2. One thought: Chinese buyers borrow, but not from banks. The systemic effects of bad inter-family/network debts is probably far more constraining on the overall economy when things get tight because the impact goes right to household balance sheets. People in the US have uncles, siblings, etc… Look at housing prices in urban China relative to a reasonable measure of income, and there is no way that everyone pays with anything close to their own cash. The question has to be addressed as purchasing power, no matter how it might be leveraged, as well as how these very private financing channels constrain consumption because people with cash lent it to their shushu or didi so that they could buy a house for their new bride.

    Comment by Cochin Loco — January 22, 2009 @ 2:47 am

  3. There is one very important aspect of Chinese urban housing and that is that most urban families own their houses outright as a result of the housing reforms of the 1990’s. Before the 1990’s, people lived in housing that was provided by their employer which was usually a state-owned enterprise. When the SOE’s were restructured, and often closed, the employees of those companies got their house as a “consolation gift.” The result of which is that home ownership rates in China are extremely high, which also means that a lot of the home purchases are pure speculation.

    Also, intra-family debt is very interesting sociologically. However, my experience has been that network/family debts are usually very limited, because there are a lot of customs regarding credit.

    Comment by twofish — January 22, 2009 @ 3:00 am

  4. Good point. Lots of government offices and state-owned entities still provide significant housing subsidies, for example building residential properties and selling to employees at a fraction of market price (close to cost).

    Sure, at the end of the 1990s people were given housing. That may be one of the most underappreciated aspects of the privatization of China’s state-owned assets, and bad for the balance sheets of SOEs giving away these assets. However, most of the new housing stock created during the past 10 yrs has been outside of this mechanism, and a large proportion of new buyers are new residents.

    Taking the impact of previous large-scale public housing building campaigns as a guide, once the government sponsored building boom gets underway it could contribute to new softness in the middle market. Most of the new housing stock, even the so-called “high-end” properties, are very low quality by any standard because they were built in a builders market and they could get away with it. This is also bad for pricing in the medium term. Caveat emptor.

    Comment by Cochin Loco — January 22, 2009 @ 3:40 am

  5. Twofish, Thanks a ton for your many insightful commentaries,
    especially on Brad Setser’s blog.
    One of your extremely insightful comments was that the PBoC’s only
    objective is to maintain the communist party rule in China.
    This comment helped me unravel and understand many complicated
    issues and reports.
    For instance, the Shanghai Co-operation Organization backed the eviction
    of the US military base in Uzbekistan in 2005. If you go by the Russian
    propagandists, this leads you to think of an enmity.
    But remembering your comment, and understanding that there are major
    linkages between the Uighur Muslims in China’s Western Xingjiang Province
    and the militant elements in Uzbekistan, helped understand the
    real issue.
    The separatist Islamic terrorists in Uzbekistan were backed by the
    US Dept. of State and the US military. So Beijing could afford to
    be on the US side, since that would engender terrorist violence
    on its own territory.
    Similarly I think that China’s refusal to bail out Pakistan with
    an external financing loan is driven by considerations that
    the Islamic Republic of Pakistan continues to fund terrorists through
    the Inter Services Intelligence (ISI) budget.
    The terrorists in Pakistan are tied closely with the Uighur separatists
    and helping the Pakistan Government amounts to funding for
    terrorists to attack and destabilize China’s Communist Party rule
    over the Western Xingjiang Province.
    The Xingjiang Province is also crucial to long term supply routes for oil,
    since the Kazakh pipeline ends at the Alashankou customs check point.

    Comment by Indian Investor — January 24, 2009 @ 2:56 pm

  6. It is well known that China has a high savings rate and that its people are generally thought of as frugal. But I had read that the vast amount of savings is in the hand of government and business, not the individual household. So please take that into consideration when discussing the housing market there.

    Comment by Former Shanghaier — January 25, 2009 @ 6:36 pm

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