Up-zoning in a liquidity trap: what theory says

1/25/2014 04:30:00 PM
On the other hand, how much up-zoning can be done for the largest, densest city in the world?
Matt Yglesias is planning to write in Shinzo Abe on his 2016 ballot because of his recent announcement to essentially "up-zone" all of Japan. In Yglesias lingo, "up-zone" means to eliminate a variety of zoning restrictions which have the effect of reducing the supply of real-estate in high-demand areas, such as in down-town districts. As a general proposition, up-zoning is a great idea--traditional zoning requirements don't really have the value-added that people think, because markets are generally capable of building what people want, while they do drive up rents, land prices, and even inequality by protecting the incumbent real-estate cartels from competition.

Unfortunately, Japan is still stuck at the zero lower bound:
Interest rate on short-term treasury bills for Japan, stuck at the Zero lower bound once again.
This means that Japan is in a liquidity trap, since it means that the Bank of Japan is unable to lower interest rates any further in response to any additional deflationary shocks. That is bad because in the absence of a decrease in the nominal interest rate, a deflationary shock will, in the short run, cause an increase in the real interest rate, inducing more savings and less consumption, resulting in a decrease in aggregate demand with associated unemployment and contraction of output.

This is all relevant to Abe's policy because up-zoning represents a deflationary policy. That is exactly the selling point Matt Yglesias based his whole argument on in The Rent Is Too Damn High. Ordinarily, cheaper rents--and cheaper prices on everything else now that businesses' costs have declined--relative to incomes would be a fantastic development. But theory says it's not so during a liquidity trap. In the short run, lower expected prices of things means higher real interest rates and a deficiency of aggregate demand. In a liquidity trap, the theory says, up-zoning is actually contractionary. For an examination of this perverse effect, I refer you to Gauti Eggertsson's work on the "paradox of toil."

Here's a concrete way to think about it. A city suddenly upzones, meaning that some developer is now able to build a sky-scraper where previously the height had been restricted. Construction of the sky-scraper means that all the surrounding land-lords must now compete with the fantastically cheap rents people can get in the new skyscraper. But, for a variety of reasons ranging from cost-of-adjustment to contractual obligations and beyond, prices are sticky in the short run, so landlords can't immediately lower rents in the short run. The expectation of lower rents reduces life-long expected nominal incomes, which by way of consumption smoothing leads to an immediate drop in nominal spending. Yet prices are sticky, so a drop in nominal spending implies a drop in real spending as well--aggregate demand contracts. This isn't just about rents, either--lower expected rents also implies declining prices for businesses, since lower rents implies a lower cost of producing goods (in the long run, price=average cost). This means that all workers, not just landlords, expect declining nominal income, so this can be a potentially very large plummet in aggregate demand.

In normal times, none of that would matter because the Bank of Japan could just lower the interest rate to increase current spending during the transition period while prices are sticky. But at the zero lower bound, that option is off the table. According to the standard macro New Keynesian theory, up-zoning is clearly contractionary in a liquidity trap.