Malinvesting Capital Due to Overpricing Land
[GroundSwell, September 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
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 13-year-olds shouting 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.
John Stuart Mill long ago pointed out that the level of rents and
wages determines the structure and character of capital. High wages
evoke labor-saving capital; high rents evoke land-saving capital.
In addition, high land prices induce owners to withdraw equity, and
that consumes capital. When assets appreciate, the owners regard that
as current income, most of which they will consume. Selling the assets
may be part of that process, but the process also occurs silently
without a sale: they might just borrow on the assets instead. Even
more silently, they let the capital run down without replacement, eating
the seed corn, letting the rise of the underlying land value
serve in lieu of a proper CCA (Capital Consumption Allowance).
Neo-classical thinking has blinded economists to those
simple truths by melding land with capital. This writer has shown in
detail how and why and by whom this was done (The Corruption of
Economics, 1994), and will not repeat the history here. Our present
point is to follow Mills lead and relate it to the problems of
unemployment and boom/bust cycles.
I. Misallocating capital by substituting it for overpriced land.
When land is overpriced, it leads to overallocating capital to
land-saving investments. This waste of capital leads to a shortage of
disposable or circulating capital. It is characteristic of
land-saving investments that their payout is very slow; the capital in
them is locked up for many years or decades. In a word, it turns
over slowly, if at all.
Here we meet an anomaly and an asymmetry that we need to recognize
and resolve at the start. Substituting capital for overpriced land
would seem to lower land prices, complement labor, and lead back to a
benign free-market equilibrium, keeping this the best of all possible
worlds. The hitch is that the kinds of capital that substitute for
land are mostly what Adam Smith called fixed capital.
Pouring capital into fixed forms drains it away from circulating
forms, which complement labor more. Worse, sinking capital in fixed
forms is not easily reversible, even once the problem is recognized.
Often it is 100% irreversible and the capital is simply lost, dumped,
as it were, over the edge of the world.
Again, we cannot change capital into land, but we can substitute it
for land, and we do when rents and land prices are high. It is useful
to carry this farther, and recognize five kinds of capital that high
rents and land prices evoke and often overstimulate.
- Land-saving capital, like high buildings. Land-saving comprises
intensification of use of previously rentable lands, or exploiting
the intensive margin of production.
- Land-enhancing capital, meaning capital used to improve land
for a new, higher use. That includes, but is not limited to
bringing previously submarginal land into production, way
out on the frontiers. It also means converting rangeland to
plowland, dryland to irrigated land, irrigated pasture to
horticulture, and furrow irrigation to drip irrigation. In urban
growth, it means converting farmland or wasteland to dwelling
units. It also means replacing low-density estates with garden
apartments; apartments with shops and offices; and obsolete
structures with modern ones. Both country and city are marked by
many interfaces of supersession, where lower uses give
way to higher uses.
- Developing submarginal land is particularly capital-intensive,
and the payoff is notably slow. A generic example is reforesting
land that is high, cold, dry and sloping, where the timber does
not ripen for over a century. In farming, an example is planting
citrus or avocados on dry slopes requiring pumping the irrigation
water and running drip lines to each tree. In urban growth, an
example is subdividing outlying land where the improved lots have
little value above the costs of their streets and utilities. See
also #5, below.
- Land-linking capital, like canals and rails and city streets.
- Land-capturing (rent-seeking) capital, like squatters
improvements, and canal and rail lines built to secure land
grants, and dams and canals built to secure water rights. These
land-seizing investments are never optimal for society, and always
waste capital. Land-seizing investments are laid out by
self-seeking individuals (rational economic agents)
with no expectation of ever recovering the capital invested
because the payoff comes as title to land, which never wears out.
Canal, rail, traction, water supply, freeway and other such
promoters are always mainly in the business of selling lands.
- Rent-leading capital. In urban growth, an example is
overimproving land today, expecting higher demand tomorrow. This
is forcing the future. It occurs because there are economies
of simultaneity in building. It is hardly ever economical to
add stories to buildings one at a time. If you are going to build
to four stories, you have to do it all at once. Suppose todays
demand is high enough to justify a two-story building, but you see
the demand rising steadily over the 60-year life of the building.
You build a four-story building today, and absorb early losses on
the upper two stories, as an investment for future years. A city
builds a four-lane street, where two would do today, anticipating
higher future usage. It puts excess capacity in its water and
sewer lines, for future growth. Such examples are legion.
Economies of simultaneity are related to economies of scale. Building
higher, taken by itself, suffers diseconomies, aka increasing costs.
On the other hand, building larger, with horizontal expansion, evinces
economies of scale. It also requires more land, meaning more land
rent. It comes into style during periods of rent-leading capital
II. Land-saving capital and economic instability.
In a speculative land boom, land prices go prematurely high.
Premature high land values profoundly distort the character of capital
investment. High land prices stimulate land-saving, land-enhancing and
land-linking investments. This is a rational economic response when
and if the market is sending the right signals. Ideally, an optimally
high level of land rents and values serves as a community
synchronizer, causing everyone to build as though others were going to
build complementarily in sync.
However, in the frenzy of a speculative boom the market sends the
wrong signals. Land is peculiarly subject to inefficient, random
speculative pricing in booms because it has no cost of production, so
its pricing is entirely subjective, i.e. based solely on forecasts of
future rents and resale prices, with no firm cap based on cost.
Overpricing of land reserves land for two contrasting kinds of buyers
Type A buyers would force the future with rent-leading
buildings. They plan to and do develop land for a future demand higher
than present demand. In Chicago, 1835, this was exemplified by
building four-story buildings outside The Loop. Overpricing and
consequent overimprovement gets greater, the further out you go. In
London, 1993, it is exemplified by Canary Wharf.
When that demand fails to materialize, Type A buyers cannot recover
their money. They cannot rent out all their floor space, if that is
what they built. Or they cannot use the full capacity of their
tannery, harbor, shipyard, sawmill, packing plant, soap factory,
brickyard, or whatever they overbuilt.
When Type A buyers develop land beyond the reach of existing
infrastructure, they force extensions of same which are often losers,
cross-subsidized by the whole system. This wastes social capital. For
example, in May, 1993, British Prime Minister Major opened the 6-lane
Limehouse Vehicular Tunnel, 1.1 miles costing $500m, the most
expensive highway per mile in British history. The idea is to link the
Canary Wharf Docklands project to The City. Britain also completed the
7 mile Docklands Highway, costing another $520m. There is a Problem:
the Canary Wharf Docklands project is not renting up.
Type B landowners just hold land unused or underused. Rather than
force the future, they would free-ride on the future. They are usually
looking or expecting to sell for a rise. Type B-1 is the aggressive
outside buyer, the stereotypical land speculator, who does
this calculatingly, cold-heartedly, as a purely pecuniary investment.
Type B-2 is the ancient owner whose land just happens to lie in the
way of growth. Type B-2 owners are sympathetic figures in popular
drama and sentiment. They are passive victims of change, clinging to
old values against mechanistic, impersonal, exogenous, amoral,
modernizing forces. However, their market behavior has much the same
economic consequences as that of Type B-1. Many turn out to be
ambivalent, resisting change for a few years while quietly expecting
to sell out for top dollar for their retirement.
The land of Type B landowners absorbs no capital directly, but much
capital indirectly, by forcing the stretching-out of all land-linking
investments in space, and generating no traffic or use to justify
those that are built to and past them. Empty land also generates no
synergistic spillover gains to raise the cash flow of surrounding,
complementary lands. Thus it helps freeze up capital sunk in improving
The combination of (a), reduced net saving, with (b), waste and
freezing of capital, leads to a shortage of disposable capital, tight
lending policies, and a crash or slump.
III. Land speculation and credit institutions
There is another factor George hints at in Progress and Poverty. When
land is first overpriced, credit is extended farther in order to
accommodate it. That is, banks lend on overpriced land, counting on a
further rise. When the rise slows, they extend the loans, sometimes
even granting new loans for paying interest on old loans. They use
political pressure to get governmental agencies (e.g. the World Bank)
to extend or underwrite these risky loans (e.g. in Latin America).
When the bubble bursts, the loans are not repaid. This destroys
capital. Witness the collapses of Charles Knapp, Charles Keating, et
The developing areas are supported by credit extended from older
areas, until credit is recalled in a panic. Credit is, as George says,
like a rubber band that gives before breaking, until suddenly it
J.S. Mill had advanced a related idea in his chapter on the tendency
of profits to a minimum (Mill, Principles, Book IV, Chapter IV,
Article 5). Mill sees profits driven down to a minimum by the
formation of more capital than can find profitable use. Then
investors, rather than accept safe, low returns, give a ready
ear to riskier ventures promising higher gains but risking great
losses, which in fact occur.
Modifying Mill with Georges idea, profits are driven down, not
by a glut of capital, but overpricing of superior land. Then investors
give a ready ear to riskier ventures -- and more deferred
returns, in land-saving and marginal developmental ventures. When the
land bubble collapses, these risky ventures in saving and developing
land prove to have been ill advised. Land now becomes too cheap to
warrant and repay such outlays to have saved it. Thus the capital is
lost, and there is little recovery with which to meet the next
payrolls. Ricardo pointed this out long ago. Veblen developed a theory
somewhat along Georges lines, but with goodwill
substituted for land value as the overpriced siren that leads the
sailors on the rocks.
Georges theory is incomplete, and yet contains an essential
element to include in a complete theory of how a boom wastes capital,
leads to shortage of liquid capital, causing a crash.
Today there are a dozen books on the S&L Collapse, the RTC
bailout, etc. Much of the capital loss is simply being added to the
national debt. What is needed is to show how this collapse is an
integral, inevitable accompaniment of a political economy dominated by
landowners who can first force down their taxes, and then further
force up their land prices by perverting the credit system into an
engine for subsidizing them with cheap mortgages based on overpriced
(GroundSwell does not have space for footnotes but they are available
from Economics Professor Dr. Mason Gaffney.