Land Booms, Capital Stretch-Out, and Banking Collapse
GroundSwell, July 2012]
This is Part of a Pilot Paper, conference on the bank
bubble, The American Institute for Economic Research, 1994. These
notes were not published as such, but were melded by Editor Clifford
Cobb into Part III, Money, Credit, and Crisis, of our 2009
book, After the Crash.
Although written in 1994, after the Thrift Debacle (S&L
collapse) of 1991, they could as well have been written, with a few
different details, after 2008. Our leaders, political and
intellectual, had learned nothing from 1991. The notes could be
written again today, in 2012, since our leaders of left
and right are still chanting the same old tired slogans I
remember from the playgrounds of 7th Grade when Alf Landon ran against
FDR. Hope springs eternal, so here are the notes. Someday, somewhere,
new leaders will seek new insights and solutions. Tennyson wrote with
hope, Our echoes roll from soul to soul, and grow forever and
forever. That has yet to happen, but remember, the last to
escape from Pandoras Box was Hope.
We need not fear that our topic has been preempted by others. At the
1993 AEA meetings in Anaheim, speakers worried that in 1990 consumers
slowed buying. None of the economists present knew why. Professor
Robert Hall of Stanford, head of the AEA and NBER committee that dates
turning points in business cycles, ran through 8 traditional
explanations of recession, from high interest rates to overstocked
stores, and rejected them all.
you cannot explain this
one, he concluded but he still heads that committee.
Olivier Blanchard of MIT offered that consumers just got scared
and stayed scared. Blanchard soon rose to Chief Economist of the
IMF. We may not do better, but we can do no worse. Here are some
principles to orient us, and where they lead us.
- Land and capital are mutually exclusive categories. Between
them they include all assets with intrinsic value. Some of each is
needed for all production (each is limitational), so
both are always relevant.
As to formation, land (by definition) is what is given by nature.
It is only Capital that can and must be formed by man, by
producing in excess of consuming. Propositions relevant to capital
formation must always distinguish land from capital.
Capital formation involves spurts of sacrifice, self-restraint,
self-discipline, and self-control. Capital maintenance, and
avoiding dissaving, call for continuous self-restraint, generation
after generation, and throughout life cycles, not to eat the
seed-corn. Land cannot be consumed, but Capital must be
maintained and replaced.
A. Capital formation is not aided by, and may be deterred by
raising returns to land. All relevant analysis must carefully
distinguish the two.
- Land and capital are not mutually convertible. (Substitution is
another matter, considered later.) Capital is convertible into any
other kind of capital each time it turns over. With each turnover
it is 100% fungible. Land is not convertible even into other land,
and certainly not into capital.
- A rise of real interest rates (i.r.s) destroys part of the real
value of existing capital, in increasing measure of its putative
longevity. This is an economic loss, a loss that is just as real
as physical destruction. The cash flow from durable capital will,
after a rise of i.r.s., be divided more in favor of interest, less
in favor of Capital Consumption Allowances (CCAs). The appropriate
accounting adjustment on the asset side is called marking to
market value. The loss of value occurs whether or not it is
formally recognized on the books.
The basic mathematics of finance is available, and is quite
precise and consistent.
Conversely, a fall of real i.r.s adds to the real value of
existing capital, having the same effect as creating capital.
[Both those effects are muted by countervailing effects on ground
rents and land prices. See point #9, below.]
A. The response to a shortness of available (soft) capital is
economically to destroy part of durable (hard) capital. This
raises the possibility of a macro-economic glitch, (a
perverse episode of harmful positive feedback, often
called a vicious spiral.) This effect, variously
described and with varying emphases, has been noted by Ricardo,
Jevons, Böhm-Bawerk, Wicksell, Spiethoff, Hayek, and others.
Ricardos Chapter 1, On Value, and Chapter 31, On
Machinery, are good introductions. They are nominally
well-known, and at the same time treated as non-existent: a feat
of compartment-mindedness we find in too much economic writing. As
Lionel Robbins points out, micro theory after 1870 became one of
acapitalistic production. Capital theory simply disappears from
- The property tax rate on capital items affects their value just
as would a rise in the (real) i.r. of the same percentage. A rise
in the rate thus destroys existing real capital; a fall in the
rate creates real capital.
- A rise in i.r.s lowers market prices of land by a much larger
factor than it lowers prices of existing capital, because the
value of land derives from more remote future prospects, overall.
Land prices, accordingly, are hypersensitive to i.r.s. ["I.r.s"
is used here to subsume all the conditions of availability of both
loans and equity funds.] Thus land loans are a most undesirable
basis for demand deposits. This was recognized by the English
Bubble Act of the early 18th Century, and then alternately
forgotten and rediscovered with each succeeding episode of land
boom and bust.
- Changes in the market price of land, when caused by inverse
changes in i.r.s, do not represent changes in social wealth. In
this respect they differ from changes in the market price, or
Discounted Cash Flow (DCF), of depreciable capital. Many
potentially useful analyses of our subject are deeply flawed by
failure to hew to this difference.
Land prices are also sensitive to changes in expected growth
rates of net income, both real and inflationary. These changes,
likewise, do not represent changes in social wealth.
The third major factor determining land prices is the current net
income (cash or service flow). This may rise for purely
distributive causes, e.g. a fall of the interest charge on
financing a new building. (This is separate from the cap rate
applied to the net income of land to find the selling price. Land
prices are doubly sensitive to the i.r. for this reason alone.) A
fall in wage rates may also raise the residual land rent. These
changes, again, do not represent changes in social wealth.
Last, the service flow of land may rise because the land actually
becomes more productive, e.g. from the spillover benefits of
surrounding urban growth. This may represent a rise of real social
wealth I leave the question moot. The main point here is
that most changes in land prices do not represent changes of real
A. Land is dangerous to use as debt collateral, because its price
is so highly sensitive to i.r. changes. It is even more dangerous
to let it become the collateral backing demand deposits.
B. Selective controls on credit extended by commercial banks may
be used to prevent collateralizing land values. Another method
would be to make mortgages taxable property, as provided for, for
example, in the 1879 California Constitution. Such a provision is
enforceable because mortgages (or deeds of trust) are always
publicly recorded, along with land titles themselves. Such a
provision would also ease the political case for raising property
taxes, which otherwise fall solely on equity holders, and appear
to exempt lenders (except as they erode collateral security).
Why are banks not lending much in early 1993? Interest rates (at
least short-term rates) are low, but collateral requirements are
very high. There are 3 problems, at least. 1, Banks are leery of
any real estate collateral now. 2, They lack the needed capital.
(They also may lack reserves). Both of those result from their
recent losses. 3, Real interest rates are higher than they look
when we factor falling land prices into the c.o.l index used to
deflate nominal i.r.s into real i.r.s. This is a variation on
Keynes perception of a liquidity trap. By variation
I mean it is the same phenomenon, only differently perceived and
Here is the sequence of a combined, reverberating land and
banking crash. Land boom fizzles. Banks take losses. Their
reserves and surpluses (capital) dwindle. They stop making loans
and investments. By a process of positive feedback (vicious
spiral) this stoppage aggravates its own cause, viz. the
fall of land prices.
- A rise of i.r.s tends to raise savings rates via a strong
wealth (or portfolio) effect. It lowers the current market price
of land, especially. To a lesser extent it lowers the prices of
items of durable capital.
There is a diminishing marginal utility of total wealth held (for
retirement, for business use, for consumer capital, etc.). The
fall of asset prices as a store of value thus tends to raise
At the same time, a rise of the Marginal Rate of Return (MROR) on
new investing raises the reward of saving as vs. consuming income.
This is a substitution effect, conceded by all. The traditional
counter-argument has been that there is a countervailing income
effect: higher income from given sums invested tends to weaken the
impulse to save. This counter-argument in turn, however, is offset
and more than outweighed by the wealth effect recited above. The
wealth effect reinforces the substitution effect, making saving
respond positively to i.r. hikes.
Conversely, a fall of i.r.s raises the market price of land,
swelling portfolio values, weakening the incentive to save. In the
extreme, if there is no reward for saving (i.r. = 0), and no
property tax on land values, land prices would rise infinitely
high. This, along with associated absurdities, would end all
saving. These reductios ad absurdum clearly indicate that savings
rates must be positively related to savings rates.
- A rise of property tax rates on the land value base raises
savings rates via the same wealth (portfolio) effect. Hikes in
other kinds of taxes might have wealth effects, too, but there are
two differences. a) The wealth effects are weaker; b) There are
undesirable substitution effects, lowering the MRORAT. The land
value tax stands alone in having the pro-saving wealth effect,
coupled with the absence of marginal disincentive effects.
A. To raise savings rates, raise the tax on land values.
B. Doubly to assure raising savings rates, couple such taxation
with use of the proceeds to pay off public debt.
- Capital in old buildings may be consumed and destroyed by
locational obsolescence, even when the building remains physically
sound. In a dynamic, unpredictable market, a certain amount of
this is to be expected, and is justifiable. However, in a major
roller-coaster land cycle, towards the peak, there is a great deal
of factitious locational obsolescence. The speculative land price
swallows up the capital in the standing structure.
This takes the financial form of equity withdrawal. The owner
takes the rise of land price as a substitute for storing up
Capital Consumption Allowances (CCAs) to maintain his capital
intact. Thus he consumes the CCAs as they inure to him.
That occurs whether or not the high land price later recedes. If
it does recede, the fall is seen as negative income, tending to
counteract the first effect. However it is likely to coincide with
unemployment, bankruptcy, etc., making saving difficult and
This is one of several mechanisms whereby a rise of land prices
is treated by landowners as current consumable income, even though
there is no corresponding production of real wealth. Result:
negative capital formation.
One of the great ironies is that during the manic phase, a theory
with a name like rational expectations, and
corresponding pretensions, waxed dominant among economists. It is
one of the recurring conceits of intellectuals to think that
social life is, or could be, controlled by rational processes. One
might even take the emergence of such theories as a sure sign that
wisdom and judgment are being overborne by mob psychology and
crazes. See Rene Dubos, The Dreams of Reason.
Consider an existing building, solid, useful, and middle-aged. It
is ready to be milked, as a cash cow. That
means that most of its cash flow from now until tear-down will be
regarded as CCAs (Capital Consumption Allowances), rather than
income. CCAs are invested elsewhere, to conserve the owners
capital. When the building is finally torn down, the owner (and
society) will have as much capital as ever.
Now suppose the price of the land under the building to rise, in
a speculative boom, while the cash flow of the building remains
the same. Let the land price rise so high it is now worth as much
as the land+building were worth before. Now, the owner does not
need to conserve any CCAs to conserve his assets: the rise of land
price has done it for him.
At the same time viewing the same point from another angle
the cash flow from the land+building is now imputable to
the land alone, to justify the lands higher price. The cash
flow is all net income, because land does not depreciate. The
owner may spend it all on consumption; being human, he begins to
do so. Lenders descend on him and seduce him into borrowing on the
land to increase his consumption. Equity withdrawal is
the current term for it.
From yet a third angle, the building has undergone locational
obsolescence, and lost its economic value. Physically, it
may look the same; economically, the land has sucked the
reproducible capital out of it.
From a fourth and last angle, capital, to survive, must earn cash
flow enough not just to cover interest on the unrecovered value,
but also enough above that to reproduce itself. As Mill said, Capital
is kept in existence from age to age, not by preservation, but by
continual reproduction. Capital reproduces itself by
yielding CCAs. When rising land prices devour capital, and/or
rising ground rents arrogate its CCAs, capital stops reproducing
itself. This is how rising rent drives capital out of production.
It is not that capital sulks. Such a metaphor is
misleading: economic agents cannot afford to sulk.
Rather, capital is drained and consumed by the rise of
all-devouring rent. This ruin occurs without apparent harm to the
owners of buildings when, as is the rule, they own the land under
them. It is silent and insidious, like a vampire in the night. It
would only be contentious and newsworthy if the land
were owned by a different party than owns the building, and the
lease expired. There are such cases in trailer parks, and
on the Irvine Ranch leaseholds in Orange County in the early 1980s
when the sapping of capital is visible and contested. As a
rule, though, it passes unnoticed: no one seems to be suffering,
no one rebels or can plead injury, even as a big share of the
nations precious capital stock shrivels and dies without
After that, there ensues a shortage of loanable and investable
funds. That, in turn, slowly grinds down land prices and rents.
This, I believe, makes sense of Georges phrase, that rising
rent cannot permanently force interest below the point at
which capital will be devoted to production. It would be
clearer had he said at this juncture below the point at
which capital reproduces itself. Shortage of capital, and
tightness of loans, finally force down land prices. Labor,
meantime, endures a period of acute suffering after job-making
investing dwindles down.
A. Property tax assessors should revalue land annually, thus
showering cold water on incipient land booms.
B. High property tax rates on land put a cap on land booms.
Consider the basic, simplified valuation equation, V = a/(i-g+t),
where V is land value, a is current net rent, i is the interest
rate, g is the expected growth rate of a, and t is the property
tax rate. In the manic phase of a land boom, as in California up
to 1989, g > i, and nothing holds down V except for t.
Through that mechanism, a high rate of property taxation applied
to land (high t) averts negative capital formation.
- Misallocating capital has much the the same economic effects as
lowering the aggregate supply. Whenever capital is drawn into hard
forms, with slow payout periods, there is the danger of its
freezing up in an episodic glitch, or credit crunch,
in which case its value is lost. It becomes unrecoverable, which
is the same as consuming or otherwise destroying it. Artificially
raising demand for capital, leading it into wasteful,
low-productivity uses, has similar effects. Overpricing land leads
investors to overallocate capital to substitute for land. This
takes several forms. A good single word covering that thought is MALINVESTMENT,
a term used by Austrian School economists today.
Tragically, those who rally today under the label Austrian
err seriously by attributing malinvesting solely to central bank
policies, sweeping away and ignoring all other factors.
A. Heavy taxation of land, precluding overpricing, should prevent
overallocation of capital to land substitution.
- Taxing anything except land (e.g. retail sales, labor income,
value-added) will sterilize marginal lands (and marginal activity
on all lands). Thus, non-land taxes abort investment outlets,
demand for capital, hence capital formation.
GroundSwell does not have space for footnotes, but they are
available by emailing Dr. Gaffney.