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“There are rents. Look around.” would inaugurate my ideal essay. Since I learned about the economic definition of supernormal profit, I’ve been fascinated by the idea of rentiers. This informs my admiration for David Ricardo and Henry George, as well as my broad disdain towards aspects of Wall Street. When I recently heard that Thompson Reuters sells its report early to elite traders, where Paul Krugman and Kevin Drum see a vindication of wasteful finance, I see the model for an extremely effective tax on rents. I want markets to work, and I see this as a robust financial transactions tax. I’m excited! 

My previous post, arguing for the sale of government information as a tax on rents has received some attention. I left the idea half-baked, and I want to clarify specifically why this would be socially beneficial. Roughly, I want firms to “buy” their rents. Think about a government-issued permit sold for $p that promised you $n in risk-adjusted profit. By definition, (p-n) is your rent. If the permit provides access to early information, an increased demand for the permit does two things, increases p (because other things equal, an upward shift in demand raises the market price) and decreases (because other things equal, if someone else has access to early information, your access is that much less valuable).

If somehow, the demand for such permits was a positive feedback loop – that is, increased demand induced a further increase in demand – then a competitive market would clear at a point where p = n, eliminating all rents from the information. However, there are two components of profit from a government-issued report:

  1. The value of the information itself – perhaps the implication of a payroll jobs report on the state of aggregate demand.
  2. The value of knowing the information before the market. We know that for the University of Michigan consumer sentiment report, this is at least in the millions.

It’s curious that people think (2) is more morally questionable than (1). Actually (2) is just firms eating each others profit in a way that doesn’t really hurt or help society. (If J.P. Morgan pays off Barack Obama to learn who the next Fed chair will be, this will just increase their relative profits to Goldman Sachs). On the other hand, (1) allows highly-scaled trading firms – with access to cutting, proprietary algorithmic and technological edge – to earn a profit on publicly financed information.

Think about the jobs report, which costs money, and scares some Republicans about privacy and individual rights. The value of its publication is quite minuscule to the average American. But it is highly valuable to Wall Street which will then bet on things like overall market health or chances of a QE taper. It’s a classic example of Mancur Olson’s “dispersed costs and concentrated benefits”.

What if we can design a mechanism that uses (2) to capture the rents from (1). Enter the following information auction:

  1. The SEC will run two auctions on the open market. One for permits granting the right to early information, and the other for the extent by which each permit-holder will be granted said early information.
  2. Call the second auction the “market for milliseconds”. The SEC secretly sets the maximum number of “milliseconds” by which someone can access information before the public release. Traders then compete to buy the number of milliseconds that maximizes expected profit.
  3. Then the SEC auctions a limited number of permits, for which there is a captive demand as milliseconds are useless without at least one permit. (Rents from the rentiers).
  4. The difference between this and a classic auction as (somewhat sarcastically) supposed by Neil Irwin is the ability to buy the precise extent of information expedition. This is critical in automatic rent elimination.

While the dual-auction may seem like an unnecessary complexity, it both increases revenues and is required to bind profit from information to profit from early information, which is in some way rivalrous, though not technically (the value of my time premium is inversely proportional to the extent of yours). It “discretizes” the market into “buy” and “don’t buy” rather than “buy a little”, as if you bought just one millisecond you would then realize it is not worth it to buy a whole permit. But, if you buy a millisecond at the margin, it is ceteris paribus more worthwhile for me to follow-suit. This is the necessary positive feedback loop. Firms will now keep buying milliseconds until the profit of the information itself is lost. But between “buy” and “not buy”, the former will be the dominant strategy.

This is a prisoner’s dilemma for traders. Ideally, they would all collude to ignore the auction altogether, waiting for the public release of information. But if everyone else colludes, it’s extremely lucrative for me to buy many milliseconds and just one permit. They will all “defect”, creating a competitive market for early information.

The government can do this for the release of every bit of market-important information:

  • Job numbers
  • Barack Obama’s nomination for Treasury Secretary
  • Who will replace Ben Bernanke?
  • Would Obama have signed Obamacare? Dodd-Frank?

I don’t think the market should earn profits from government reports or policy decisions. You can think of this as an automatically-tuned financial transactions tax. This would ideally be very low during most times, but whenever the government releases information, all trades induced by said release should be taxed at a firm’s Bayesian prior that it is accurate. (From the government, this would naturally be certain). The dual auction accomplishes precisely this.

The maximum time period by which the information can be expedited is the total milliseconds on the open market. But it will always be less than that unless one person purchases the whole market. In this case, the government can still capture all rents. On the second market for the permit to use that information, the SEC should just keep purchasing permits from itself driving the market price to the point where the buyer is indifferent. (The structure of an auction makes it quite possible to determine the reservation price). Of course, this is highly unlikely to happen, but is a good illustration of the reason why two markets are required.

It is natural that the government should command the quantity, and not the price, of information. Given a certain price, the government cannot limit the maximum time by which information can be expedited, which is not a desirable uncertainty. Further, auctions in this case better lend themselves to market-controlled rent elimination.

I hope this clarifies the process, and I’m eager to see where else a similar methodology can be used to cancel rents.

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Update: Just realized Neil Irwin considers a somewhat-similar idea here, though I think they’re ultimately quite different in design, I discuss it more at the end.

Earlier this week, we learned that the University of Michigan sells its popular consumer sentiment figures to Thompson-Reuters which delivers the elite customers the information 5 minutes before it is made public, and the super-elite 2 seconds earlier still. As you might imagine, the liberal blogosphere is up in arms. “Insider trading” is trending, at least on my timeline.

But this is a blessing and opportunity in disguise. So long as traders are just rational and not super-rational (also known as renormalized rationality; no one thinks they are) the prisoner’s dilemma will trap them in a brilliant bind. The United States government through the Bureau of Labor Statistics, Federal Reserve, and deep network of public universities frequently and freely releases rich and extremely valuable information. Take the payroll report that is released the first friday of every month, and available to all free of charge. As a rational human being, it is almost worthless to me. However, for a trader on Wall Street, the report conveys crucial information on aggregate demand and forms expectations on Federal Reserve action.

This asymmetrical response generates significant rent, in the form of incredible consumer surplus to the financial services, especially high-frequency traders. How much would you pay for the unemployment figures? I’d pay no more than $5 a month, and that’s for personal interest. For a trader, on the other hand, the value is far greater – and more so the earlier he receives it relative to his fellow traders.

One ought to wonder why the public purse is used for information gathering which creates surplus for a small segment of society. The government stands to make deep profit which can finance progressive redistribution and increase both private and social welfare. But it requires an abdication of our gut aversion towards “financialization” or “insider trading” as if that’s something yucky.

Rather, I suggest a process that will work thusly:

  1. Some practical time period, t, before an important government report is released an electronic auction house opens. The SEC (secretly) decides how many “early” permits auctioned would maximize revenue. =
  2. The SEC further runs an auction selling “milliseconds”. You can buy as many “milliseconds” as you want, from the regulated auction market. The SEC does not disclose how many such segments are being auctioned.
  3. Key: The “milliseconds” auction starts before the primary “early permit” auction.

So, the secondary auction starts and a bunch of traders buy their fancy little milliseconds. Mechanism design tactics must be employed to prevent collusion, and the SEC will hire Al Roth to figure something out. A millisecond is rivalrous (not technically, but in principle), that is if I know information one second earlier, it becomes less valuable if you do as well. But no one knows how many total milliseconds there are, and hence will buy what the expect will maximize revenue.

Then the primary auction for “early” permit starts, without which milliseconds are useless. Because many traders have purchased milliseconds, the government has created a captive demand for “early” permits, increasing demand and revenue thereof (and also decreasing rent).

Traders cannot opt to wait for the public information arrival because they know their competitors will just buy it up front. It would be most profitable if they all just waited for the public announcement, but since they all stand a huge benefit from defecting, they will all default. Therefore, their rents are lost because of their own rationality.

I suggest all important economic reports are auctioned this way, like:

  • FOMC minutes,
  • The Beige Book,
  • News of Osama Bin Laden’s death
  • Income reports,
  • Anything and everything markets will like, including,
  • Election results.

just realized Neil Irwin suggests a similar idea, but I ultimately feel they’re quite different. Mine is designed in a way to snare rentiers into a prisoner’s dilemma into a captive demand of information, rather than nice auctions, per se. Irwin ultimately thinks this violates the responsibility of a government; but I think all this data collection is useless for the whopping 99.9% of us that don’t look at trading terminals all day. And yet our tax dollars finance this boring nonsense, creating rents for a small minority. I like Jeremy Bentham a lot, and he’s always inspired my tax philosophy. I say, when in need of revenues, just create artificially new property rights and auction them to the highest bidder.

P.S. Some have responded that traders do indeed collude, as in Libor. This is a failure of SEC criminal (= jail) enforcement. Anyway, mechanisms like this where defecting is so probably is unlikely to create a collusive equilibrium. Trust between traders would need to be too significant. If demand for permits crashed, someone would buy many for a pittance to make a huge profit. Collusion is not stable.

But say they all did collude not to buy until the public disclosure. Well, that’s not too different from today…

Reihan Salam asks me to consider the cost of my revenue-positive immigration plan. In other words, the $750 billion dollars isn’t coming out of thin air. I wrongly took this for granted earlier, but on second thought it brings a fresh perspective to this argument. The explicit costs will clearly fall on the firms and local governments which choose to purchase permits to “import” (for wont of a better word) employees.

I also noted this might create a downward pressure on immigrant wages, which can be considered a “tax” as well:

It’s crucial to note that the burden of permit financing would fall on both employers and employees, depending on elasticities of demand and supply. The dearer the permits, other things equal, the less a potential employer is willing to pay for the same level of output, realized as a lower wage. This can be thought of as a migrant financing his own permit.

Let’s consider a firm operating in an imperfect labor market – as most inevitably are. If the market rate for a permit at a given time is $n, the only immigrants who will be hired are those for whom employers expect the discounted value of all future earnings to be greater than n. For these workers, the costs are explicit $10,000 each. Consumer surplus here is represented by (NPV – n).

The more important welfare loss derives from the implicit cost expropriated on firms that want to hire workers whose NPV is less than the market value of permits. That is governmental intervention prevents an otherwise profitable transaction. In this sense, welfare loss will be roughly proportional to the ratio of firm demand for immigrants to the number of permits supplied on the open market by the government.

This isn’t a mathematically rigorous statement, rather an intuitive heuristic. If demand for migrant workers falls, the permit price on the open market will drop, resulting in fewer excluded transactions. Same logic on the denominator, wherein government can increase the supply to cut permit costs.

By this point it’s clear that the real price of permit auctioning is the cost of closed borders. Standard economic theory tells us that open immigration is the Kaldor-Hicks efficient solution, and any regulation thereof will inflict deadweight losses. At this point, it’s worth comparing (if briefly) my proposal to our current solution.

The deadweight loss comes from the difference between employer demand for migrants and actual cleared licenses. But there are two, huge benefits of auctioning n permits rather than allocating the same number on a first-come-first-serve basis as we do today:

  1. The deadweight loss is lower because auctions will almost definitely command a higher quality of immigrant. If firm A wants to bring a highly profitable doctor, and B a similarly “skilled” professional whose just not as competent, the former will be willing to pay more on the open market. This information cannot be captured in any other way. (Nobel Laureate Al Roth has written about how good auction design compels market participants to divulge useful information).
  2. Even if the deadweight loss is equal, in my revenue-positive proposal, at least the government captures some of it. In today’s system, all is lost. I suppose more surplus is captured by firms who “make it first” or have large systems that can maneuver government bureaucracy efficiently (like, say, Google).

In fact, there’s a Schumpetrian superiority to permit auctions – over our current system or even the better Canadian “points” program. Byzantine systems requiring “proof of need” etc. give an unfair advantage to large and established players. Startups, the blood of American innovation, are discriminated in the present system. The Canadians and Australians will face a similar problem, if to a much lesser extent. Therefore, the burden of argument is on those who would rather surplus be captured by monopolistic corporations rather than the government.

Though this isn’t the point of my post, I want to conclude with some notes on Reihan Salam’s last remark (which I can’t seem to find, now), which echoed the idea that either of us could design a policy much better than status quo, but that political deliberation makes that impossible.

I don’t think he’s being fatalistic here – he has argued for the Canadian option – but that’s what makes this interesting. It’s hard to argue the American system doesn’t cater to vested interests with regard to immigration. However, what are the “loopholes” really, of the Canadian system? It’s a very transparent, skills-oriented, rubric which cannot be “gamed” in any meaningful way – at least not to my knowledge.

As far as American policy goes, why is my (or whatever his preferred choice is) solution “idealistic” whereas Canada’s is somehow more politically sound? I say this because I’m rather surprised at the paucity of “creative conservatives” arguing for an auction-oriented approach to immigration. I really believe if this idea finds more traction, it’s at least as realistic as a point system. Indeed, both Reihan and I worry more about native wages than overall welfare gain – a topic which puts me at odds with many liberals like Matt Yglesias and deserves a post of its own – and I think few ideas command the “most valuable” immigrants as the quantity-regulated open market.

Theo Clifford has a thoughtful reply to my recent post calling for immigration on the open market:

That said, it isn’t the only way you could do market-based immigration policy. One alternative would be to have an immigration tariff, as advocated by Gary Becker. Instead of auctioning a fixed number of permits, the government would sell as many permits as demanded at a fixed price. The benefits of this kind of system are broadly the same as the benefits of an auction Ashok describes in his post. However, there are a few subtle differences that for me suggest a tariff might be a better way to go.

Now, before we go on, let’s note that standard econ theory would tell us the optimal policy is an infinite number of monthly permits, or a tariff priced at nothing – at which point the two systems would converge into open borders. Before I go through Theo’s argument, it’s important to note that in a government-controlled industry, we can control either price (and let quantity float by demand) or quantity (and let price float by demand).

When it comes to immigration – people – I assert that the latter is wildly more preferable. On what basis do we price immigration? It’s tough to come up with a non-arbitrary algorithm to achieve this. Immigrants, after all, are not “externalities” to be priced and taxed. On the other hand, it’s eminently possible to create a non-arbirary framework through which the number of immigrants are controlled.

A country like the United States may decide that it wants to target an n% labor force growth rate annually. Based on native fertility rate, the monthly auction can be sized to hit this target. Similarly, European countries with below-replacement fertility can target constant population. Therefore the comparison to international trade isn’t fair:

Ultimately, I think the parallel with international trade holds – tariffs are better than quotas. An immigration tariff would be more sensitive to the needs of the market, less bureaucratic, in some ways more predictable, and maybe even more politically palatable than an auction system.

To the extent neither of us are endorsing freely open borders – which would be the Kaldor-Hicks efficient solution – we accept that there are cultural constraints that dictate policy. Frankly, I don’t care how many tons of steel are imported each year, so long as my buildings are efficiently priced. But immigration is a whole different story – these are people you interact with. They will assimilate into your culture, to a large extent, but you into theirs. To abstract the migration of human families into human trade misses the very reason why neither of us advocate free borders (or perhaps he does, in which case a tariff is suboptimal).

But even beside that important point, I think a permit auction holds strong.

The first reason to prefer a tariff is that it means the market is more responsive to shifts in supply and demand. […] Using the auction system, the same number of people come – all that changes is the price. Under a tariff regime, on the other hand, the number of migrants is free to fluctuate according to the needs of the economy […] Yes, the government could adjust the number of auctioned permits according to economic circumstances, but it is better that changes in the number of migrants be market-driven, rather than decided by bureaucratic assessments of ‘need.

I think I’ve addressed most of my concerns with this claim above, i.e. that targeting price level is arbitrary whereas number is not. But even that aside, an auction is sufficiently robust to meet changes in demand. I’m not asking for a once-in-a-lifetime bonanza. The government would host an electronic auction monthly. Furthermore, state and local governments have the explicit right to petition for more permits to be floated on the market in response to acute changes in immigrant demand.

I would argue, too, that permit markets are far more conducive to deeper markets, by encouraging secondary and tertiary exchanges. A big part of my proposal piggybacks on the old, American, Jeffersonian ideal that states are in competition with each other – thereby bringing out the best in each. Michigan, as I noted, has shown a remarkable interest in immigrant labor. Under my proposal, it would be easy for Michigan to buy a block of permits and float them on an internal market open to Michigan’s only businesses. Theo’s proposal is quite similar to a permit market endorsed by Matt Yglesias, but I believe my employer-focused plan places greater emphasis on ensuring only the most valuable immigrants make are allowed. (Note I said “valuable” not “skilled”).

Another argument for tariffs is certainty of barriers to entry:

Having a fixed tariff price, or at least a planned price schedule, also gives a level of certainty to the market. If I live in Mexico and my family is saving up to buy my way into the USA, I want to know how much I’m going to need to squirrel away. With an auction, the price will vary from year to year, perhaps dramatically, and there will be no guarantee that my savings will prove sufficient to get me a permit this year, or even next year. Tariffs solve this problem.

Ask yourself this question. You’re the American president. You have to decide between providing some level of certainty to your own people about what their country will look like in a generation. Or you can provide certainty to some potential Mexican peanut farmer about how much he has to save to maybe make it.

But I’m not even convinced that prices will be so predictable in a tariff system. One of Theo’s main arguments was that the labor market can flexibly respond to changes in demand by allowing more people, but this is a double-edged sword. What if the price is too high, which would strangle innovation and economic growth? Can the government credibly promise business leaders it will keep it high? And what if the price is too low vis-a-vis nativist preferences, which are always in flux? Any sensible government would change the price according to national and business sentiment: but this removes any “predictability” to the whole thing.

Generally, for international trade, I’d support tariffs (if anything at all). But neither price nor quantity is arbitrarily defined. In labor, it makes a lot more sense to target a number than a price. The former can definitely be credibly sustained, with minor exceptions as per immediate request.

Auctioning permits gives the government far more control over its long-term demographic profile, which is ultimately the heart of all immigration debate. There’s a Cato post here that makes pretty much the same points as Theo, but ignores that there’s not something magically more “market” about controlling price than quantity. They (correctly) argue that America needs more immigration but then seem to assume that a tariff would not be overpriced relative to demand but an auction would be. I suppose the old joke about the economist on a stranded island assuming a can opener is appropriate.

Oh and by the way, if we’re extrapolating this debate, I wonder how the folks at Cato would feel about a tariff-based Sovereign debt system rather than an auction. There are scenarios where targeting price is better (international trade) and those where targeting quantity trumps (immigration). It would be wrong to equivocate two very different markets.