The problem with financial instability, is not just that asset prices fall, but rather that the entire financial system gets arrested as entities are no longer able to make payments. When payments fail to be made on a large scale, the entire social order starts to break down including job markets and property rights. When people starve on a large scale, due not in fact from a real shortage of food, water or other necessities, but rather a financial breakdown, that is viewed as unacceptable and justifying large scale coordinated action to remedy.

At this point, we could get sidelined into political discussions, of who is at fault and why. At this particular point in the conversation, we will only consider that central banking was adopted to address this. Think of central banks as a shared storage unit for money. When money is scarce, then it gets lent out so that the problem doesn’t get worse. Unlike a shortage of food, where only the hungry person suffers, when there is a shortage of money that tends to spread, as money is used to pay debts, and so both the borrower and lender are hurt.

So you can think of a financial crisis as a famine that is also a contagious disease.

To understand why this is, we must understand what banks do. Before we do that, we should clarify that a financial crisis, is really a crisis of greed and desperation. Initially it does not have to coincide with a shortage of real goods and services. It results from a relative scarcity where both wealth gets concentrated, and much of the wealth we thought we
had was not really there in the first place.

The simplest and most common example of this is the failed entrepreneur. Someone claims to have found an amazing business proposition, so they hire a bunch of people, borrow money, and collect investments. For a time it all seems great, but then eventually it faces problems and takes losses.
Whether that is because they were a ponzi, or more commonly, the business is more difficult than imagined, or if it just an honest failure from bad luck, the business fails in any case. Regardless the reason, the result can hurt many people. The owner they cannot pay their workers, their
lenders or investors. Unfortunately, in our society we have taken an approach where the workers are often the ones that suffer the most when this happens, even if they were the least responsible. Like it or not,
business owners and entrepreneurs are leaders in our society, so their successes and failures affect more people than just themselves.

When events cause businesses and financial entities to start failing on a large scale, this leads people to tightly hold what money and wealth they have, and thus, make the problem worse in the short term. We should not omit to say that this kind of behavior is not all bad, that a willingness to conserve and save resources is generally a good thing in the long run, but that rushing to buy out all the toilet paper day 1 of a pandemic, for example makes you a literal asshole. A clean one, but an asshole none the less.

Banks turn any asset into money in order to operate payment systems.

Some people may erroneously believe that the fiat currency they use is “backed by” a certain amount of gold. Far more people may still think this way about money metaphorically. Even if they know that a dollar bill is
not reedemable for a specific amount of gold, it is hard to break this mental metaphor. Still others make a fuss that money that is not “backed by” a precious metal is a bad idea.

In truth today’s fiat money is still “backed by” real things with value, only that the conversion rate is not fixed beforehand. To get a loan you need collateral, and that collateral is what backs money when it gets created.

So instead of just being backed by gold, fiat money is backed by houses, and cars, and businesses. Basically, anything you can go to a bank and get a loan for, or lose if you fail to pay taxes, is what backs our money. Compared to just being backed by one thing with an unstable fluctuating price, this is much safer, effective, and fair, provided it is managed well. Instead of backing a currency with just one asset like gold, it is better to back a currency with many different kinds of assets. A diversified portfolio is always a smart idea, provided it is not diversified garbage.

On the surface, it may appear, on the other hand that a modern fiat currency is only backed by debt, specifically the treasury debt. At a basic level, this is an accurate observation. But much of the currency that is created in our modern system, is actually money issued by banks and similar financial entities. So banks issue money or money-like assets against collateral. The collateral is what backs the debt and what is forfeited if payments are not made.

When the price of assets falls, you can say that the price of money rises in relative terms. However, since we can actually establish a price reference point, that being the price of necessities tools and other goods, we can potentially distinguish between a rise in price of money, and a fall in price of assets. When the price of assets falls “in real terms”, that is different from when the price of money rises in real terms. These situations require different responses: when the price of money rises, or the price of assets falls.

Well today in fact we have a situation where the price of money, in terms of CPI, never actually rises. This is easy to achieve when money does not guarantee a specific amount of an asset. But the price of assets can still fall, leading to financial instability. This instability in asset prices is met with interventions to buy assets and stabilize the financial system, which is inaccurately and reductively called “lowering interest rates”, So to reduce inflation, it is supposed we need the exact opposite: “raising interest rates”.

However raising interest rates, even if it causes the value of fixed income assets to fall(incidentally by devaluing future cash), does not cause the value of money to rise, because a fall in asset prices is not necessarily a rise in the value of money. Rate hikes are done indiscriminantly to the quality of the assets, central banks today even pay interest on reserves! It is utter madness. Multiplying account balances through interest accrual dilutes the value of money, and does not increase it. And even to the extent it causes financial instability, financial instability is not automatically a remedy for inflation.

One consequence of excessive intervention to support asset prices may be increased inflation, but that does not mean that financial instability automatically a remedy for inflation. You can take a more disciplined approach to collateral appraisal directly. Yes, some financial entities with
overpriced assets may end up facing higher rates on marginal borrowing, but this is not the same as the utter insanity of paying higher rater on reserves and treasury bonds, as they are the most direct substitutes for money, and therefore the highest quality assets.

If a patient breaks their leg, a doctor may administer painkillers, (like supporting asset prices) to ease the pain and relax the patient, preventing them from making the problem worse. After the patient recovers, they may have to work through some pain as they seek to regain independent use of the limb. But we certainly would not intentionally instigate pain, especially not to unrelated parts of the body, and expect that to fix the leg.

Sometimes, cures can be painful, but that does not make arbitrary and unrelated pain an effective cure.

That is the issue with monetary policy today, we seek to simply replace one type of proven intervention, with an untested and unproven opposite intervention: because you took painkillers, now you have to take painmakers. That doesn’t help anyone. Disciplining collateral appraisal and the fiscal footprint of government spending can be painful, but not all forms of pain are an effective cure for inflation.

There are two ways to think about capital gains. One is an upward price correction. Sometimes we don’t realize what something is actually worth until it becomes popular and widely used. The other way is as a constant rate of growth to the value claimed by ownership of the means of production.

What we may not immediately realize, is that to make gains from ownership alone, is just a way of taxing people. If owner’s gains do not require work, then they must be somehow taking from or taxing the people who do work. And when people claim that ownership rights come from the just desserts of work, that the first person to work a resource owns it, this becomes a most perplexing self contradiction.

Importantly, assets definitionally do not change in any real sense, unless work is applied to them. This is not just a metaphorical analogy to newton’s first law of motion, but rather a generalization of it. The same way we apply work to move or accelerate an object at rest, Capital does not accelerate or grow of its own accord, only living things grow autonomously, and they have self sovereignty.

If work is a necessary element to any gain in value, then how do we fairly assign relative income between workers and capital? Or rather, more accurately, how do we apportion income between those who work today, and those who both worked and saved in the past?

This question brings us full circle, an upward price correction, is very different from a rate of growth, in that we would not expect a continuation or propagation of that trend. So an upward price correction cannot be used as a discount rate, by assuming that past price changes will continue.

So perhaps the question is not "What is the proper way to tax capital gains" but rather that capital gains, which continue passively and indefinitely, are themselves a tax.

An upward price correction is fine, if people had the foresight to build something whose full value was not appreciated until it became popular. But for real assets, the normal state of affairs is gradual depreciation. Firstly from maintenance and storage costs, but secondly from loss of relevance and popularity, as new things are discovered and built which better meet the needs of the future.

It is a simple arithmetic fact that total wealth can increase, even as all assets gradually depreciate or decrease in market price. This is because we can make and build new things, as opposed to polishing and organizing metal coins. In fact, this juxtaposition of losses to individual assets but constant gains to total wealth may very well be the normal default state of affairs. While crops may grow on their own, are they then our crops if we do not tend to them? Or are they just a living thing we can tax?

By partitioning society into workers and owners, we can structure a system in which one group can continuously tax the other, when this might not be the normal state of affairs. We justify it by the fact that workers can buy ownership, but at what price? That price, like all prices, is set by the owners, and accepted or rejected by the other party. And even if workers can rise through the ranks to come out on top, is social permeability a justification for oppression?

Does the past own the future?

A lot has been said about rent control, and the conventional economic informed viewpoint is mostly on the right track. There are many layers to explore here, so I want to get into it. The angles we must discuss are:

1. Supply and Demand
2. General Price Controls
3. Price Floors and Ceilings
4. Housing Policy
5. The Inventory Problem
6. Smart and Simple Housing Policy

First of all, this is an issue where people are going to bring up supply and demand. And in this case, the housing markets, is one of the few special cases where I think supply and demand is a good model. In most cases I don’t like the supply and demand model.

Why Supply and Demand is Almost Never The Best Model For Prices

Supply and Demand tends to lead to thinking about price in terms of “smooth curves”, or to be more mathematically specific: continuous, differentiable, and monotonic.

Mathematically reductive price curves:

These are the assumptions or simplifications people generally use when they want to apply the supply and demand model.

• Continuous: As price varies the supply or demand changes smoothly, without huge steps or gaps.
• Differentiable: We can measure how much one variable changes based on a change in the other variable.
• Monotonic: Higher prices always lead to more supply or less demand. Conversely, lower prices lead to less supply or more demand.

We will go through each of these simplifications in reverse order. The assumption of monotonicity is especially problematic given the way most modern goods are manufactured: they have fixed overhead costs and generally stable or declining marginal costs.

In a case with fixed overhead and stable or declining marginal costs, the goal is to sell as many units as you can to cover the overhead costs. Consider vehicle manufacturing. One reason making vehicles is so difficult, is because the overhead costs are so large. While the marginal costs of vehicle production can also be significant, they are generally much less of an issue. The big question in modern manufacturing and investing is: “how many units will I be able to sell”.

In most cases, if you can sell enough units, then you will recoup your investments and make a profit. So if a producer thinks they can sell a lot, it is also fairly likely they will be willing to sell at a lower price. This is in direct contrast to the conventional supply and demand model, which basically says that fewer are willing to produce a product or service at a lower price. Thus, the supply and demand model is mostly not very helpful.

Most of the time, when we think about prices, we are considering a environment where consumers already have an “anchor price” in mind, and so they use this as a benchmark to assess if something is a good deal. However, this “anchoring” of consumer expectations in a competitive environment, is a wholly different matter from how they would response to a shift in equilibrium market price, which is what the demand curve is supposed to quantify.

Again, this is just another example of how supply and demand are the least useful in the most interesting scenarios. The dynamics of pricing in extreme situations, will depend on what value a product has to consumers, if they may have to go without, and not what their general expectations are in a competitive and stable marketplace.

Finally, let’s talk about the critical situation where supply definitely does “slope” upward. This is when you hit systemic environmental resource limitations.

To discuss this more specifically, let’s consider a variation on the “traveling salesman problem”, but for an orchard with apples. For simplification, we will only consider a 2-dimensional variation of the problem: the picker must find the shortest path through the orchard to pick a given number of apples.

In this case, we can measure both the average cost of obtaining n apples, as well as the marginal cost of securing n+1 apples. If the apples are spread out very randomly in a 2 dimensional plane with distant outliers, then the this marginal cost will increase very smoothly. But if the apples are in a very regular pattern, then it will hardly cost more to pick all the apples compared to a portion of them.

But in both cases, once you have picked all the apples, the marginal cost of the next apple goes to infinity. And this is really the critical and interesting part of the problem. As utilization approaches systemic limits, costs increase much more rapidly than otherwise. This is something those familiar with computer science and algorithmic analysis should be very familiar with. Often computer systems can use resources very efficiently right up until the point that the resource is completely saturated, and then costs increase and efficiency breaks down. The ideal algorithm can use all of a resource with zero efficiency penalty. To be more specific, examples are filesystem management, cpu utilization, and much more.

A very generalized view of costs vs constraints is found in the domain of what was originally called “linear programming”, as well as more general mathematical optimization problems. In these problems an objective function is specified as well as constraints on a decision space. Techniques such as Lagrangian multipliers can be used to translate the system constraints into a modified objective function, but even with the straightfoward simplex algorithm, we learn how the constraints greatly affect optimality, and that they bind quickly. In fact, in a linear program, an optimal solution can always be found by checking the points where the most constraints possible are binding.

In the conventional view of supply and demand, we don’t get any of these interesting dynamics involving tradeoffs between resources and production variables, instead, costs are assumed to increase smoothly and continuously as you approach absolute resource limits.

Again, supply and demand is generally the least useful for the most interesting and important cases.

Why Supply And Demand Generally Applies to Housing Markets

Having said all that, supply and demand generally is a very good model for the housing market, and this is generally due to geographic constraints. For the most part, everyone must consume a minimum amount of housing(which can be artificially increased through excess regulation). Similarly, each unit of housing is geographically fixed to the particular market it is in.

For this reason, monopolies and monopsonies generally do not emerge in housing markets, although the ownership of housing may be concentrated along class divisions or even a cartel-like structure, it is a market that generally defies a high degree of consolidation and control.

Unlike manufactured goods, it is difficult or impossible for single producers to deliver massive quantities at lower prices. So generally the supply curve for housing is smooth and sloped upward.

What the Supply and Demand Model Actually Says About Price Controls

Many get this wrong, and claim that supply and demand states that price controls increase prices. As a simple matter of definitions, price ceilings like rent control cannot increase prices, except to infinity, meaning that the quantity is limited.

When applied to housing markets, what the supply and demand model would suggest is that price ceilings would lead to relocation. This could either be to areas with less demand or lower costs, or to areas without such price ceilings in place.

Note: Most Real World Rent Control Policies are Much More Nuanced Than Simple Price Caps

Most of the time, rent control does not actually set a ceiling on rental prices, it merely limits price increases. In these cases the costs are almost entirely from the landlord’s surplus, and do not increase prices. Once the construction is done, especially if developers were able to plan for an environment which limits price increases, then the costs have been accounted for at the existing price level. A limit on price increases merely cuts into the excess profits of landlords and speculators. So in these cases, rent control advocates have a completely valid point.

Despite this, even this form of rent control doesn’t actually increase the inventory available, it only makes costs more predictable for the tenant class of renters. So costs on new units may continue to rise aggressively, despite the policy otherwise achieve its goal of limiting landlord and land speculator surpluses by limiting price increases on the existing housing stock.

So it is really very anti-climactic. The one thing that this policy might have, is political viability. Housing policy is generally a political minefield, and if this style of consumer and renter protections can succeed politically, then it may be laudable, even if it underwhelming or the scope of impact limited to a set of long term tenants.

General Housing Policy Issues

This leads us to general housing policy issues, in which I will mostly just share my viewpoint. I think this is a point of tension between local and incumbent political interest, and more general interests.

Other options are land value taxes, public development of housing, and buffer stock policies(encouraging excess inventory to limit price shocks).

Historically, sometimes public housing projects were combined with progressive class targeted welfare. For housing this can be problematic because it doesn’t integrate well with the rest of the housing market, and concentrates groups of precarious tenants. This would be like taking all the struggling swimmers in a swimming lesson and putting them next to each other to try to rely on each for help. That is my explanation at least, there may be additional factors and other reasons behind this.

For this reason, if there is public development of housing, it should focus on the market’s needs, and not first as a welfare program. The goal should be to increase the inventory available at a reasonable price point, to make it easier for workers to have affordable quality options near jobs, and for businesses to have places where workers. While developers will want to speculate on land values, communities should naturally want to support a healthy and productive workforce, and that it is why it is so important that publicly developed housing should be sold at market prices, in the general market.

Housing Inventory Gets Contracted at The Bottom and Expanded at The Top

Even if the inventory of housing is good quality relative to its price, the tendency is for communities and politics to push out and end of life the affordable inventory, and expand and prioritize the expensive housing inventory.

This can lead to a housing affordability crisis when in fact, most housing is reasonably priced, or to exacerbate an across the board increase in housing prices. Often, I think both factors come into play.

There is a lot to discuss and consider on these issues, but if we do engage in public housing development, it should focus on the inventory problem, providing a greater amount of inventory at about the middle third of the distribution, that a new and developing workforce will be able to take advantage of.