Oliver Hart and Bengt Holmström: The 2016 Nobel Prize in Economics

The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel for 2016 has been awarded to Oliver Hart and Bengt Holmström "for their contributions to contract theory." So what is contract theory, why does it matter, and what did Hart and Holmstrom do? The Nobel committee each year posts some background information about its choice, both a "Popular Science Background: Contract Theory," and a more technical "Scientific Background" paper called "Oliver Hart and Bengt Holmström: Contract Theory."

In the most basic model of supply and demand, the buying and selling takes place at a moment in time. But in the real world, what is bought and sold often takes place in the context of an ongoing relationship. A company signs a long-term contract with a supplier. A bank makes a loan that will be repaid over some years. Workers at some firms and executives at many firms do their jobs expecting that if the firm makes higher profits, they will receive a bonus. Sales people at many firms expect to be paid according to how much revenue they generate. Some organizations operate on an up-or-out principle, where a time comes when you are either promoted or asked to leave. When a market exchange takes place over an extended period of time, a contractual relationship is at work. Sometimes the contract is mostly explicit, and sometimes large parts of it are implicit (or are part of a broader legal framework). But understanding contracts--both what goals they seek to achieve and how they can go wrong--is fundamental to understanding markets.

Just to be clear, the economic analysis of contracts are not an arithmetic problem with a clear cut answer. Amidst the complexities of the real world, there is no all-purpose perfect contract. But researchers like Hart and Holmström can still make considerable progress by spelling out the issues and identifying the key tradeoffs. For example, here is the Nobel committee on some of Holmström's insights about pay-for-performance contracts. As you read it, you may wish to consider  how it differs from that is actually observed in contracts for top executives at many firms.

"A central result, published separately and independently by Bengt Holmström and Steven Shavell in 1979, is that an optimal contract should link payment to all outcomes that can potentially provide information about actions that have been taken. This informativeness principle does not merely say that payments should depend on outcomes that can be affected by agents. For example, suppose the agent is a manager whose actions influence her own firm’s share price, but not share prices of other firms. Does that mean that the manager’s pay should depend only on her firm’s share price? The answer is no. Since share prices reflect other factors in the economy – outside the manager’s control – simply linking compensation to the firm’s share price will reward the manager for good luck and punish her for bad luck. It is better to link the manager’s pay to her firm’s share price relative to those of other, similar firms (such as those in the same industry).

"A related result is that the harder it is to observe the manager’s effort – perhaps due to many distorting factors blurring the relationship between her effort and the company’s performance – the less the manager’s pay should be based on performance. In industries with high risk, payment should thus be relatively more biased towards a fixed salary, while in more stable environments it should be more biased towards a performance measure." 

Related problems arise in jobs that involve a high degree of multi-tasking. With many interlocking tasks, trying to create an explicit pay-for-performance is very difficult, and it may be better to have an overall performance evaluation which leads to promotions or raises over time. Another issue arises with jobs that involve a high degree of teamwork. As the Nobel committee writes: "Team work also modifies the original pay-for-performance framework. If performance reflects the joint efforts of a group of individuals, some members may be tempted to shirk, free-riding on the efforts of their workmates. Holmström addressed this issue in an article from 1982, showing that when the firm’s entire income is divided among team members (as in a worker-owned firm), effort will generally be too low."

The award to Hart focused on a different set of contracting issues, in the area of what are called "imcomplete contracts." The issue here is that in a number of settings, it is impossible to anticipate all of the possible issues that might arise. For example, imagine a city that hires a contractor to build a bridge. The contractor submits a bid. But what if there are dramatic changes in the price of materials, or bad weather, or a quality problem with a subcontractor, or a flu epidemic that knocks out half the workforce, or an unexpected environmental review that leads to delays, or any number of other issues? When it is essentially impossible to write a contract covering all eventualities, the other option is to write a contract that specifies who will get to make the decisions when an unseen eventuality arises. Here is discussion from the Nobel committee with a sampling of some  implications:

"The main idea is that a contract that cannot explicitly specify what the parties should do in future eventualities, must instead specify who has the right to decide what to do when the parties cannot agree. The party with this decision right will have more bargaining power, and will be able to get a better deal once output has materialised. In turn, this will strengthen incentives for the party with more decision rights to take certain decisions, such as investing, while weakening incentives for the party with fewer decision rights. In complex contracting situations, allocating decision rights therefore becomes an alternative to paying for performance. 

"In several studies, Hart – along with different co-authors, such as Sanford Grossman and John Moore – analysed how to allocate the ownership of physical assets, for example whether they should be owned by a single firm, or separately by different firms. Suppose a new invention requires the use of a particular machine and a distribution channel. Who should own the machine and who should own the distribution channel – the inventor, the machine operator, or the distributor? If innovation is the activity for which it is most difficult to design a contract, which seems realistic, the answer could be that the innovator should own all the assets in one company, even though she may lack production and distribution expertise. As the innovator is the party that has to make greater non-contractible investments, she also has greater need of the future bargaining chip that property rights bring to the assets. ...

"Another application of Hart’s theory of incomplete contracts concerns the division between the private and public sectors. Should providers of public services, such as schools, hospitals, and prisons, be privately-owned or not? According to the theory, this depends on the nature of non-contractible investments. Suppose a manager who runs a welfare-service facility can make two types of investment: some improve quality, while others reduce cost at the expense of quality. Additionally, suppose that such investments are difficult to specify in a contract. If the government owns the facility and employs a manager to run it, the manager will have little incentive to provide either type of investment, since the government cannot credibly promise to reward these efforts. If a private contractor provides the service, incentives for investing in both quality and cost reduction are stronger. A 1997 article by Hart, together with Andrei Shleifer and Robert Vishny, showed that incentives for cost reduction are typically too strong. The desirability of privatisation therefore depends on the trade-off between cost reduction and quality. In their article, Hart and his co-authors were particularly concerned about private prisons. Federal authorities in the United States are in fact ending the use of private prisons, partly because – according to a recently released U.S. Department of Justice report – conditions in privately-run prisons are worse than those in publicly-run prisons."

"Contract theory" is one of those terms that may sound irredeemably theoretical and academic. But when thinking about the benefits and tradeoffs of contracts in a wide array of different situations--workers, innovation, production, finance, even government constitutional arrangements--you soon notice that this is a branch of economic theory which is applying analytical precision and rigor to gain insights into the messy real-world issues of day-to-day economic and political life.

Hayek: For Humility and Against a Nobel Prize in Economics

As the pedants among us never tire of pointing out, the so-called "Nobel Prize in economics" is not literally a "Nobel prize." It was not established by the original bequest from Alfred Nobel, but instead was first given in 1969, with the prize money provided by a grant from Sweden's central bank as part of the 300th anniversary of the founding of the bank. Thus, the award is officially "The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel." (Justin Fox gives a nice brief overview of the history here.) Although I am pedantic in many matters, this doesn't happen to be one of them, so I will continue following the conventional usage in calling it the "Nobel prize in economics."

More interesting is that Friedrich Hayek the co-winner of the sixth Nobel prize in economics (with Gunnar Myrdal), spoke at the prize banquet in 1974 as to why the establishment of the prize was mistaken. Here's is Hayek's call to humility for economists from his speech at the Nobel banquet on December 10, 1974.

Your Majesty, Your Royal Highnesses, Ladies and Gentlemen,

Now that the Nobel Memorial Prize for economic science has been created, one can only be profoundly grateful for having been selected as one of its joint recipients, and the economists certainly have every reason for being grateful to the Swedish Riksbank for regarding their subject as worthy of this high honour.

Yet I must confess that if I had been consulted whether to establish a Nobel Prize in economics, I should have decidedly advised against it.

One reason was that I feared that such a prize, as I believe is true of the activities of some of the great scientific foundations, would tend to accentuate the swings of scientific fashion. This apprehension the selection committee has brilliantly refuted by awarding the prize to one whose views are as unfashionable as mine are.

I do not yet feel equally reassured concerning my second cause of apprehension. It is that the Nobel Prize confers on an individual an authority which in economics no man ought to possess.

This does not matter in the natural sciences. Here the influence exercised by an individual is chiefly an influence on his fellow experts; and they will soon cut him down to size if he exceeds his competence.

But the influence of the economist that mainly matters is an influence over laymen: politicians, journalists, civil servants and the public generally. There is no reason why a man who has made a distinctive contribution to economic science should be omnicompetent on all problems of society - as the press tends to treat him till in the end he may himself be persuaded to believe. One is even made to feel it a public duty to pronounce on problems to which one may not have devoted special attention.

I am not sure that it is desirable to strengthen the influence of a few individual economists by such a ceremonial and eye-catching recognition of achievements, perhaps of the distant past.

I am therefore almost inclined to suggest that you require from your laureates an oath of humility, a sort of hippocratic oath, never to exceed in public pronouncements the limits of their competence.

Or you ought at least, on confering the prize, remind the recipient of the sage counsel of one of the great men in our subject, Alfred Marshall, who wrote: "Students of social science, must fear popular approval: Evil is with them when all men speak well of them".

Hayek is quoting from an comment from Marshall which appears in "In Memoriam: Alfred Marshall," a speech given by A.C. Pigou  in 1924 and published as part of a Memorials of Alfred Marshall volume in 1925 (pp. 81-90). The fuller quotation attributed to Marshall (on p. 89) is:

Students of social science, must fear popular approval: Evil is with them when all men speak well of them. If there is any set of opinions by the advocacy of which a newspaper can increase its sales, then the student who wishes to leave the world in general and his country in particular better than it would have been if he had not been born, is bound to dwell on the limitations and defects and errors, if any, in that set of opinions: and never to advocate them unconditionally even in ad hoc discussion. It is almost impossible for a student to be a true patriot and to have the reputation of being one in his own time.

Sorting Out the Patent Trolls

The fundamental power granted by holding patent is to block others from making use of the invention, unless they pay you a licensing fee. Inevitably, this power looks pretty good when you are the patent-holder, and not so good when you are being sued for infringing on someone else's patent. Just to complicate matters, some companies that bring suit for patent infringement didn't actually do the inventing themselves, nor do these companies actually make a product. The neutral name for these firms are "patent assertion entities." A less-neutral name, when some of these firms act in a way that seems to misuse patent law as a genteel method of extorting payments from other firms, is to call them "patent trolls."

There is nothing illegal about buying patents, or enforcing patent rights by requiring a license fee. Indeed, it can be a useful service for a firm to collect a group of closely-related patents and then license all of those patents as a group, so that firms wishing to use those patents can negotiate with a single entity. Is it possible to divide up the "patent assertion entities" in some defensible way, to distinguish the trolls from the rest?

The Federal Trade Commission has the authority to collect confidential business information. "[T]he FTC analyzed information from 22 Responding PAEs and over 2,500 of both their Affiliates and other related entities." The FTC describes it findings in an October 2016 study: Patent Assertion Entity Activity. The report runs well over 200 pages, including a review of existing research literature and the relevant court cases, together with past FTC thinking on this subject over the last decade or so. It you want to get up to speed on this topic, this report is the place to start.The FTC defines the subject of its study this way:

The term “patent assertion entity,” or PAE, as used by the Commission in this report and elsewhere, refers to a firm that primarily acquires patents and seeks to generate revenue by asserting them against accused infringers. As the term underscores, PAE business models focus on asserting patents that the firm has acquired from third parties, rather than obtained from the U.S. Patent and Trademark Office (USPTO) through prosecution. Patents are a PAE’s principal asset; a PAE does not manufacture, distribute, or sell products. Merely holding a patent, however, does not generate revenue for a PAE. Instead, the firm generates revenue by licensing that patent or, more rarely, by obtaining court-ordered damages in successful patent infringement litigation. Furthermore, a PAE generally initiates negotiations that may lead to a license by communicating a demand for payment to, or filing an infringement suit against, an accused infringer.

The report cites some evidence from other studies that a greater share of patent infringement lawsuits are being brought by "non-practicing entities," which is to say firms that own the patents but don't make anything. "[T]he share of infringement cases brought by NPEs has grown over time, from below 30% of all cases in 2009 to over 60% in 2014, and that about 89% of NPE cases appear to have been filed by PAEs."

Basically, the FTC argues that the "patent assertion entities" can be divided fairly neatly into two "two distinct PAE business models: Portfolio PAEs and Litigation PAEs." The FTC steers away from using the term "patent trolls," which in this report mainly comes up in quotations from other articles buried in the footnotes. But "litigation PAEs" is the category that most people are thinking of when they refer to "patent trolls." Here is how "portfolio PAEs" functioned:

"Portfolio PAEs most closely resembled the licensing arms of manufacturing firms; they were highly capitalized and often raised money from investors that included both investment funds and manufacturing firms. Typically, these investors received a share of the Portfolio PAE’s future revenue and a license to the Portfolio PAE’s patents. ...

"Portfolio PAEs typically conducted business in the following manner. First, they acquired portfolios of patents. Portfolio PAEs frequently acquired patents from manufacturing firms by making large up-front payments to the owner. Some Portfolio PAEs acquired hundreds or thousands of patents in individual transactions, often purchasing these patents from manufacturing firms. Other Portfolio PAEs acquired smaller numbers of patents per transaction and aggregated them into larger portfolios. Regardless of acquisition model, Portfolio PAEs then organized acquired patents into one or more portfolios, each containing hundreds if not thousands of patents and offered these portfolios for licensing. ...

"Portfolio PAEs negotiated licenses covering large portfolios, often containing hundreds or thousands of patents, frequently without first suing the alleged infringer. The value of these licenses was typically in the millions of dollars. Although Portfolio PAEs accounted for only 9% of the reported licenses in the study, they generated 80% of the reported revenue, or approximately $3.2 billion.  ...

In particular, notice that the investors in these "portfolio PAEs" are often companies, which the get access to the patents in the portfolio. Thus, these institutions can be viewed as ameliorating the "patent thicket" problem, where there are so many closely related and interlocking patents in some areas that it becomes difficult for innovators to function.

Litigation PAEs look different.

"The Litigation PAE business model frequently employed one or more affiliate entities, usually set up as limited liability companies (LLCs), each created to acquire and assert a small portfolio of patents, without bundling or aggregating acquired patents into larger portfolios. ... Regardless of whether they sent demand letters, Litigation PAEs almost always sued potential licensees in district court before beginning license negotiations.  ... Litigation PAEs tended to be thinly capitalized. Many had between one and three individual owners, often with no other employees and no offices outside of their owners’ homes. In fact, several Litigation PAEs were simply individual entrepreneurs who relied entirely on outside attorneys and professionals to maintain records regarding their assertion activity. ...

"Litigation PAEs typically sued potential licensees and settled shortly afterward by entering into license agreements with defendants covering small portfolios, often containing fewer than ten patents.  The licenses typically yielded total royalties of less than $300,000.  ... The American Intellectual Property Law Association (AIPLA), which periodically surveys the costs of patent litigation, recently reported that defending an NPE patent lawsuit through the end of discovery costs between $300,000 and $2.5 million, depending on the amount in controversy. By this estimate, 77% of Litigation PAEs’ settlements fell below a de facto benchmark for the nuisance cost of litigation. This suggests that discovery costs, and not the technological value of the patent, may set the benchmark for settlement value in Litigation PAE cases. ... Given the relatively low dollar amounts of the licenses, the behavior of Litigation PAEs is consistent with nuisance litigation.

"For each separate patent portfolio that they acquired, Litigation PAEs characteristically
created a new affiliate entity, which often held ten patents or less. They generally operated with little or no working capital and relied on agreements to share future revenue with patent sellers to fund their businesses. Litigation PAEs filed 96% of the cases in the study and accounted for 91% of the reported licenses, but only 20% of the reported revenue, or approximately $800 million."

The report also notes that this problem is really centered in the electronics and software industries. "Of all the patents held by PAEs in the FTC’s study, 88% fell under the Computers & Communications or Other Electrical & Electronic technology categories, and more than 75% of the Study PAEs’ overall holdings were software-related patents."

The policy question of how to draw legal distinctions put the brakes on the patent trolls without unduly hindering legitimate protection of patent rights raises some tricky questions, but the report offers some general guidance:

The FTC recognizes that infringement litigation plays an important role in protecting patent rights, and that a robust judicial system promotes respect for the patent laws. Nuisance infringement litigation, however, can tax judicial resources and divert attention away from productive business behavior. With this balance in mind, the FTC proposes reforms to: 1) address discovery burden and cost asymmetries in PAE litigation; 2) provide the courts and defendants with more information about the plaintiffs that have filed infringement lawsuits; 3) streamline multiple cases brought against defendants on the same theories of infringement; and 4) provide sufficient notice of these infringement theories as courts continue to develop heightened pleading requirements for patent cases.

For a previous discussion of these issues, I recommend "The New Patent Intermediaries: Platforms, Defensive Aggregators, and Super-Aggregators," by Andrei Hagiu and David B. Yoffie, which appeared in the Winter 2013 issue of the Journal of Economic Perspectives.

What Do We Know About Angel Investors?

The venture capital industry is fairly well-known: they raise funds from investors, often pension funds or university endowments, to invest in start-up companies at an early stage, knowing that a most of those companies won't do very well, but hoping to make a good return when about one in ten of those companies hits it big. The National Venture Capital Association estimates that VC funds raised $28 billion in 2015, and have about $168 billion under management. This isn't a large amount in the context of an $18 trillion US economy, but the effects of VC firms in choosing and nurturing start-ups are much larger than the dollar value would suggest.

But behind or perhaps along-side of the VC firms are a more shadowy group known as "angel investors." which may well be investing more money than their better-known VC cousins. Angel investors are not raising a fund from others; instead, they are investing their own money in small start-ups.  Not much is known about them. But Josh Lerner and Antoinette Schoar present some evidence in their report "Rise of the Angel Investor: A Challenge to Public Policy," written for the Third Way think tank (September 23, 2016). They describe the subject this way:

Angel investors are high-net-worth individuals, often (but not exclusively) former entrepreneurs and corporate executives, who make private investments in start-up companies with their own money. While individual angel investors have a long history—for instance, Naomi Lamoreaux and co-authors highlight how Cleveland’s angel investors played a critical role in financing the early electricity and automotive industries—organized angel groups are a quite recent phenomenon. Beginning in the mid-1990s, angels began forming groups to collectively evaluate and invest in entrepreneurial ventures. ...  

Angels typically invest at the seed funding stage, making them among the first equity investors in a company beyond its founders. ... Angels invested a total of $24.6 billion in 2015 with an average deal size of $345,390, according to the Center for Venture Research. ...  The Angel Capital Association (ACA) lists more than 300 U.S. groups in its database. The average ACA angel group in 2015 had 68 member angels and invested a total of nearly $2.5 million in 10.3 deals in 2007. At least between 10,000 and 15,000 angels are believed to belong to angel groups in the U.S. ... 

The precise measurement of the total size of the angel investment market is difficult to ascertain due to the fact that most angel investments are made on an individual basis and thus typically are not subject to regulatory disclosure requirements. But estimates suggest that the total size of angel investment has long surpassed venture capital investment in the U.S. and increasingly in some other countries as well. For instance, survey estimates suggest the projected size of the total angel market in the U.S. grew from $17.6 billion in 2009 to $24.1 billion in 2014. The estimated capital
deployed by angel groups in Europe has almost doubled over the past five years, and in Canada, it almost tripled. Some estimates suggest that these investors are as important for high-potential start-up investments as venture capital firms. But despite their
rapid growth, we know very little about the role that angels play internationally and the type of firms in which they invest.

 As Lerner and Schoar describe them, angel investors are "a growing form of start-up investing that is less formal than the VC market but more professional than receiving funding from friends and family."  Venture capitalists often have a few seats on a company's board of directors, but angel investors are more likely to be personal mentors to entrepreneurs who are starting a company and to play a fairly direct role in using their connections and experience to help the company grow. Their average investment in a company is fairly small, measured in  hundreds of thousands of dollars, not millions. Here's a description of the process for a typical angel group:

Angel groups follow mostly similar templates. Entrepreneurs typically begin the process by submitting to the group an application that may also include a copy of their business plan or executive summary. The firms, after an initial screening by the staff, are then invited to give a short presentation to a small group of members, followed by a question-and-answer session. Promising companies are then invited to present at a monthly meeting (often a breakfast or dinner). The presenting companies that generate the greatest interest then enter a due diligence review process by a smaller group of angel members, although the extent to which due diligence and screening leads or follows the formal presentation varies across groups. If all goes well, this process results in an investment one to three months after the presentation.

The authors describe some of their recent research on angel investors. For one study, they got detailed data on two groups of angel investors, so they could compare companies that just barely made the cut to receive funding with companies that just barely missed the cut--and thus firms whose prospects  looked quite similar--the firms that got funding were measurably (although not extremely) more successful over the next few years. For another study, they looked at "the records of 13 angel investment groups based in 12 nations and with applicants for financing transactions from 21 nations," and again find that firms which just made the cut for funding do better over time. 

A lot of angel investors have historically preferred to do private deals behind the scenes. But as their importance increases, and as at least some angel investors start working with web-based "crowd-funding" techniques for start-ups, a number of of them are going to emerge from the shadows. As the subtitle of the Lerner-Schoar paper implies, politicians and regulators are likely to grab for a more role in regulating angel investors, too.

Rising Out-of-Pocket Health Care Costs

The health care costs that Americans pay out-of-pocket are rising--both in total amount, which is perhaps not a surprise, but also as a share of incomes, which is perhaps more disturbing. Ann Foster discusses the pattern in "Household healthcare spending in 2014,"  written as a "Beyond the Numbers" short essay for the US Bureau of Labor Statistics (August 2016, vol. 5, no. 13). She has lots of details of spending in particular areas, but here's an overall figure showing out-of-pocket spending by households as a total amount (left axis) and as share of total expenditures (right-hand axis).

Part of the reason for this rise is that more Americans have health care insurance with high deductibles: that is, the amount you pay out of pocket before the insurance kicks in. Here's some information from the most recent Kaiser Family Foundation 2016 Employer Health Benefits Survey.  The report notes:

"[T]he share of covered workers in plans with a general annual deductible has increased significantly over time: from 55% in 2006, to 74% in 2011, to 83% in 2016, as have the average deductible amounts for covered workers in plans with deductibles: from $584 in 2006, to $991 in 2011, to $1,478 in 2016." 

Another simpler way to describe this information is just to look at what share of workers now have a deductible above a certain amount, like $1,000.  This share has been rising for firrms of all sizes, but especially for smaller firms.

I'll add that I'm not automatically opposed to  higher out-of-pocket spending for certain kinds of health costs. One way of holding down the rise in  health care costs is for patients and health care providers to be more sensitive to the cost implications of their choices. Most kinds of insurance against certain costs or damages--auto insurance, homeowner's insurance, and so on--have some form of out-of-pocket cost sharing for this reason. In the big picture, being protected against the risk of health care costs in the tens of thousands of dollars, or more, is quite important, even if it means you aren't protected against annual health care costs in the range of a few hundred or even several thousand dollars.

But it's also wise to remember that the relatively modest rise in out-of-pocket health care costs above is a mixture of households with relatively little in such costs in most years, and other families that are consistently paying the full deductible--an amount which is rising fast--every year. High and rising deductibles will make a lot of people feel as if their health care doesn't offer them much benefit in a typical year.

Snapshots of the US Housing Market

US housing prices have recovered so that they are more-or-less back to the long-run trend that existed before the price bubble of the early 2000s. The total amount of equity that US households have in the form of housing has largely recovered too. Here, with the help of the FRED website run by the Federal Reserve Bank of St. Louis, is a quick overview of the recent roller coaster ride for US housing markets--which leads to the case for why state and local government should be tweaking their priorities to encourage more homebuilding.

Here's the bounceback in housing prices since about 2012. There are rises and falls over time, but the current value isn't too far from the trend over the last four decades.

The amount of equity that homeowners have in real estate peaked at about $13 trillion at the top of the housing bubble in 2006, then dropped by $7 trillion by 2009 (!), and since 2012 has rebounded back up to almost $13 trillion again.

Another perspective is to look at homeowners' equity in housing divided by GDP, which adjusts for changes in inflation and in the size of the real economy over time. With this adjutment, you can see that homeowner equity was mostly in the range of 50-70% of GDP for the second half the 20th century. The housing bubble pushed homeowner equity up to nearly 100% of GDP in 2006, and the bursting of the bubble dropped it to 40% 2009.

Yet another way to slice this data on homeowner's equity is to look at it relative to the total value of the real estate. For example, though the 1970s and into the early 1980s, it was common that about 70% of the total value of real estate was equity for homeowners--while the rest was presumably mortgage debt owed to lenders. But even with the rise in housing prices in the 1990s and early 2000s, the share of that value which was homeowner equity was falling, as homebuyers borrowed more aggressively. when the housing bubble burst and the value of homes dropped, the size of the accumulated borrowing remained. The share of housing value that was home equity dropped almost to 35%, which would have been half the level prevailing back in the 1970s and early 1980s. The share of real estate that is homeowner equity has now bounced back, but is still under 60%.

The movements in housign prices also affect home construction. Here's the pattern of new housing starts since the late 1950s. These figures are measured in units of housing starts--that is, not relative to the size of the US population, which was about 180 million back in 1960 compared with 320 million today. The data on housing starts is spiky, but the long run-up for the construction industry from about 1990-2005 is clear enough, as is the dramatic fall in construction after that to the lowest levels seen in this data. . There's been a bounceback, but in historical context (and given the larger US population and smaller family sizes), it seems rather modest.

The "vacancy rate," or the share of share of homes that are vacant, is one more measure of the current state of the housing market. The vacancy rate peaked during the housing bust, but is now back down near levels that commonly prevailed during the 1980s and 1990s. 

The recent bounce-back in housing prices seems to me different from the rise during the bubble. During the housing bubble in the early 2000s, there was a large amount of building (as shown by housing starts), which was sitting vacant (as shown by the vacancy rate), and financed by borrowed money (as shown by the low level of homeowners' equity relative to real estate values at a time when prices were rising). The recent bounce-back in housing prices is happening at a time when construction levels remain relatively low, vacancy rates are at historically common levels, the total value of housing relative to GDP is at historically common levels.

Thus, my sense is that the bounce-back in housing prices isn't about a borrowing-driven boom in demand, but is more about limitations on housing supply. Those limitations are not typically a matter of federal policy, but are imposed by state and local governments, and by neighborhood activists and courts, whose efforts have the effect of discouraging construction and keeping housing prices higher than they would otherwise be. Jason Furman, the head of President Obama's Council of Economic Advisers since 2013, has forthrightly made this point. Last November, for example, he gave a talk called "Barriers to Shared Growth: The Case of Land Use Regulation and Economic RentsRemarks," where he said: "I will focus on how excessive or unnecessary land use or zoning regulations have consequences that go beyond the housing market to impede mobility and thus contribute to rising inequality and declining productivity growth."

Similarly, the 2016 Economic Report of the President, published last January by the CEA, had this to say (pp. 87-89):

"Supply constraints provide a structural challenge in the housing market, particularly in high-mobility, economically vibrant cities. When housing supply is constrained, it has less room to expand when demand increases, leading to higher prices and lower affordability. Limits on new construction can, in turn, impede growth in local labor markets and restrain aggregate output growth. Some constraints on the supply of housing come from geography, while others are man-made. Constraints due to land-use regulations, such as minimum lot size requirements, height restrictions, and ordinances prohibiting multifamily housing, fall into the man-made category and thus could be amended to support more inclusive growth. While these regulations can sometimes serve legitimate purposes such as the protection of human health and safety and the prevention of environmental degradation, land-use regulations can also be used to protect vested interests in housing markets. ...

"In addition to housing affordability, these regulations have a range of impacts on the economy, more broadly. Reduced housing affordability—whether as an ancillary result of regulation or by design—prevents individuals from moving to high productivity areas. ...  Ensuring that zoning and other constraints do not prevent housing supply from growing in high productivity areas will be an important objective of Federal as well as State and local policymakers."

China Flexes Toward Consumption?

Policymakers and economists have been saying for 10-15 years that China's economy needs to shift away from being driven by extraordinarily high levels of investment, together with growing exports, and instead shift to being driven by growth of China's own domestic consumption. Maybe it's actually starting to happen. Jun Nie and Andrew Palmer discuss some recent evidence in "Consumer Spending in China: The Past and the Future," published in the Economic Review of the Federal Reserve Bank of Kansas City (Third Quarter 2016, pp. 25-49). They begin this way:

"After steadily declining for nearly half a century, the share of consumer spending in China’s GDP has recently increased. Economists and policymakers widely agree that the share of consumer spending must increase for China to continue its economic development; sustaining growth primarily on exports and investment will become more difficult in the longer run. ... Although the recent rise in the consumption share has allayed some concerns about slowing growth in China, it has also spurred discussion over whether this trend is sustainable and whether China will truly become a consumption-driven economy."

To put China's low consumption patterns in perspective, it's useful to remember that in the US, about 65% of GDP is usually accounted for by consumption. In China, consumption was only about half of GDP in 1970s and 1980s--and then the share dropped even lower, falling below 40% of GDP. What's happening here is that China's consumption was growing, but GDP was growing even faster, so the ratio of consumption/GDP was falling, right up until about 2010.

Nie and Palmer discuss the evidence from economic research on what caused China's consumption to fall so low, and whether the modest rise of the last few years seems likely to continue. They focus on a few factors that have been evolving over the decades: the age distribution and "dependency ratios" in China's population, the trend to urbanization, and China's housing boom since around 2000--which is about when the consumption/GDP ratio plummeted even lower. I'd summarize their story this way.

The "dependency ratio" refers to what share of the population is either too young or too old to work, as opposed to being working age. The dependency ratio and consumption tend to rise and fall together. Thus, the dramatic fall in birthrates in China as a result of economic growth (and greater education and incomes for women) along with the one-child policy meant a lower dependency ratio. Basically, fewer children means less consumption spending on children, and more saving.

China has seen a dramatic rise in urbanization. As Nie and Palmer write: "Over the past five decades, the share of China’s population living in urban areas has more than tripled, rising from 18 percent in 1960 to 56 percent in 2015." The common pattern is that people moving to urban areas in emergin economies increase both their production and their consumption, but they increase production by more, and so their rate of saving rises.

Nie and Palmer look at patterns of dependency ratios and urbanization across a "sample of 24
countries including most Asian countries and large developing countries." Based on the common patterns, they find that China's fall in consumption/GDP ratio from 1970-2000 is almost completely explained by changes in its dependency ratio and urbanization. But the additional drop in consumption/GDP after 2000 is not explained by these patterns, and they instead attribute this fall to a shift in China's housing market. Here's their explanation (citations and references to charts omitted):

"The large jump in the household saving rate from 2000 to 2010 is largely related to development in China’s housing market during this period. Before 1998, most Chinese families lived in government-provided houses; after economic reforms in 1998 removed this benefit, however, most Chinese families needed to buy their own homes. This change triggered rapid growth in the Chinese real estate sector, causing home prices to rise tremendously. Furthermore, as house prices started to increase quickly, housing became a popular investment for wealthy Chinese households, raising demand even further and exacerbating house price increases. Indeed, from 2000 to 2010, house prices
in China increased by about 161 percent. In addition to rapidly increasing prices, Chinese homebuyers faced large required down payments—typically 30–40 percent, but in some major cities as high as 50 percent. As a result, middle-class Chinese households were forced to save a disproportionately large share of their earnings to purchase a home. The saving didn’t end with the purchase of a home—the subsequent mortgage payments constituted additional saving as they increased the homeowners’ housing equity. As Rosenzweig and Zhang argue, this housing market dynamic helps explain the rising saving rate associated with rising housing prices from 1998 to 2010.

"As the scramble to buy homes after the 1998 reform faded, so, too, did the desire to save for homes. Moreover, young people currently do not need to save as aggressively as the previous generation for home purchases because their parents and grandparents often help them buy a home. Due to the one-child policy, which was introduced in 1979, a typical young couple in China are the sole descendants of four parents and eight grandparents. In China, it is common for parents and grandparents to help their children by paying the high down payment or even paying for the entire house. Small family sizes under the one-child policy allow families to focus their resources rather than spreading them among multiple children or extended family members.

"Large financial contributions from older generations are feasible for two additional reasons. First, after aggressively saving for several decades, many parents and grandparents are wealthy enough to afford this gift to the younger generation. Second, many households own multiple homes. Based on the 2014 China Household Finance Survey, one out of five urban households owns a second home, meaning that on average, a young couple’s parents and grandparents have one extra home between them in addition to their primary residences. Overall, less pressure for young Chinese couples to save helps explain why the Chinese saving rate has started to decline since 2010."

What do these factors imply for the future? China's old-age population is beginning to rise, and in October 2015 China's government announced that it was shifting to a "two-child policy." China's dependency ratio seems set to rise, which should cause consumption to continue rising. Urbanization in China also seems likely to continue, which has tended to hold down consumption in China. The original huge boost in saving from the shift to private housing market has largely run its course (although whether the ongoing boom in China's housing prices is sustainable is different issue). Mixing this together and stirring a few times, Nie and Palmer suggest that China's consumption/GDP ratio will keep rising in the next few years, perhaps to between 45-50% by 2020--that is, to say, almost back to levels prevailing in the 1980s.

When economists and policymakers talk about "rebalancing" China's economy toward faster growth of domestic consumption, I think they have a bigger shift in mind. Nie and Palmer describe the changes in China's household spending this way:

"[R]eal [household] spending on transportation and communication increased sevenfold over the last two decades compared with a threefold increase in overall household spending. Transportation and communication is a broad category that encompasses many high-end goods and services that have recently become available to middle-class Chinese households, such as smartphones, laptops, and air travel. Travel services in particular appear to be growing quickly: the number of Chinese outbound travelers has been growing at a double-digit pace for many years, and 2015 marked the fourth consecutive year of China as the world’s top tourism source market ... [A]nother component of consumption, educational services, is also growing rapidly. Chinese families now are spending more resources on their child’s education both inside and outside the classroom. In addition to paying tuition both domestically and at foreign colleges and universities, Chinese families are increasingly paying for tutoring and other educational supplements for their children."

If China's government wishes to boost consumption, it could do more to encourage spending in areas like education and health care, as well as to support consumption and health services for its growing population of elderly.