A theory of economic boom and crash is one of Henry George’s two great purposes in Progress and Poverty. What causes the recurring “paroxysms of industrial depression”?
Could there be a single, root cause? A variety of events have been associated with the onset of economic crises: natural disasters, sudden increases in oil prices, wars, political instability, even sunspots. In fact, just about anything can seem to cause a recession — just as the back of an overloaded camel can be broken by a paperclip, or a bit of straw.
Henry George identifies the root cause in the speculative rise of land prices, which cuts into the earnings of labor and capital. Land values tend to rise at a faster rate than general economic growth, because of two unavoidable facts: 1) Land is not produced; its supply is fixed, and 2) Land is needed for all production. As we have seen, this creates a tendency for land rent to take an ever-greater share of aggregate production. This tendency places an increasing burden on the actual production of goods and services.
How Land Speculation Affects Incentives
For an example of how these processes play out in modern economies, let’s examine the incentives and costs of creating new buildings.
In any given time and place, there is a “per square foot” market price for residential or commercial space, based on population and local economic activity. This is key information for developers in deciding what they can profitably build on various sites. However, land values are expected to increase over time. This means that landowners will not be willing to sell land for a price based on the land’s current economic use. To acquire the land now, the buyer must pay a speculative premium — a higher price, based on its expected future value.
Virtually all new buildings are built with borrowed money. Opportunities would be lost if people were to patiently wait until they’d saved up enough cash to build. Developers include the loan repayment, including interest, as part of the annual cost of operating the new building. This is part of the information they use to determine size and type of development they plan to build.
The fact of the speculative premium in the land’s price leads to two kinds of dysfunction: 1) Sites are held out of use (or are used in minimal ways) for long periods of time, as their owners wait for land value to “ripen”; 2) There are strong incentives to build a larger structure than is called for by the current demand for space at that site.
Why must they build bigger? The momentum is created by three factors that feed on each other. First, there is the speculative premium in the land price. Second, there is the cost of borrowing. Developers borrow money to buy the land and to build the building. Since they will need greater income, from a bigger building, to pay for the speculative price of land, then more money must be borrowed to cover that price. Thirdly, property taxes will be levied on the real estate — land and building. The tax will be based on the new building’s value: the bigger the building, the higher the tax — which is another part of the annual cost of operating the building. All of these factors increase the annual cost of operating a building, virtually ensuring that new buildings will be oversized.
New construction is delayed, pushed upscale, and made riskier. In larger cities, where land values and speculative premiums are concentrated, these effects are magnified. High-rise luxury condos bloom, while the market just doesn’t seem able to provide “affordable housing”. This creates political pressure to subsidize housing in various ways — through tax deductibility of mortgage interest, or outright provision of public housing, or rent-control legislation. Such “market interventions” create unintended consequences of their own, adding complexities which make the underlying land problem that much harder to see.
The Speculative Bubble
Henry George explains how speculation in commodities — products of labor — is very different from speculation in land. Speculation in labor products serves the useful function of regulating supply and demand, stimulating production of goods when people bet on their prices increasing. This helps individual producers to make decisions that decrease overall volatility in the economy. The opposite is true of land speculation. Because land is not produced, increases in demand for it can do nothing but increase its price. Price increases create higher expectations for future price increases, creating a self-inflating speculative bubble.
Many studies have identified a land-price cycle of approximately 18 years in length that has occurred with striking regularity for nearly two centuries. Land values increase, leading to “irrational exuberance” that further stokes the overheated real estate market. Euphoria is followed by a sudden crash, wiping out vast amounts of asset value. Fred Harrison documented this process in his books The Power in the Land (1983) and Boom Bust (2007). Harrison correctly predicted the recessions of 1990 and 2008, as did Georgist economist Fred Foldvary. In the 1930s, Homer Hoyt documented this long-term trend in his One Hundred Years of Land Values in Chicago.
Land speculation would destabilize the economy all by itself — but the damage gets ratcheted up by the influence of the financial system. This is because land value forms a majority of the collateral security for loans. Land is nearly always bought not with saved-up cash but with borrowed money. Land value — which is expected to increase — is used as collateral security. If people expect the collateral to be worth more, then more money can be borrowed. If more money can be borrowed, more money can be offered for land, which increases demand for land, further increasing its price!
The run-up to the “Great Crash of 2008” was a clear example of this process at work. A huge portion of overall debt was secured by owner-occupied real estate. In many cases, families’ homes were their only form of saving, and they expected the real estate’s appreciated value to ultimately provide for their retirement. Real estate seemed a very good investment. Buyers borrowed extra money to build large, expensive homes — and, many homeowners borrowed still more money against their home equity — hoping to enjoy their appreciating land values now, and later too. As in the 1930s — and in every other bust — speculative excess led to a deep crash.
In the run-up to 2008, financial deregulation encouraged exotic financial instruments such as credit-default swaps. Deregulation has often been blamed for the crash, and undoubtedly these practices played a role. However, the thing that made these financial instruments so attractive — such an obvious thing for investors to do — was the underlying increase in land values.
Mortgage-backed securities also became popular in the buildup to the Great Depression of the 1930s. After the Great Depression, regulations were put into place to protect the banking system from speculative excesses — most notably the Glass-Steagall Act, which established the insuring of bank deposits up to $100,000 under the Federal Deposit Insurance Corporation (FDIC), and prohibited commercial banks from trading in securities. Deposit insurance has been retained (and in 2010 it was even increased, temporarily, to $250,000). However, the division between commercial and investment banks was repealed in 1999, setting the stage for the exotic financial instruments which contributed to the 2000s “housing boom.”
Indeed, residential real estate was seen as such a good investment that many banks relaxed their requirements for credit worthiness. “Subprime” loans were offered to many people who could not have qualified for mortgages before. The new ease with which mortgage loans could be obtained, combined with very low interest rates, served to increase the demand for land and raise prices even faster. (This process was also at play during the 1920s boom; in those days it was called “shoestring mortgages.”)
Even in the 1920s, this was not a new phenomenon. John Stuart Mill had written (before Henry George) of a tendency of lenders, when legitimate demand for loans dries up, to “lower the quality of credit” by accepting high-risk loans they would have spurned before. Because land value is such a large part of collateral on loans, and land values fluctuate wildly in business cycles, the tendency toward these volatile, high-risk lending practices is very strong.