Why can’t the economy have steady growth and prosperity instead of cyclically falling into recessions and depressions? We can have sustainable growth if we eliminate the cause of the bust. There is one fundamental, though mostly unrecognized, cause of the boom and bust economic cycle: subsidies to land value. Eliminate the subsidies, and the cycle disappears.
Most people, including economists, blame the financial system for economic depressions. That is like blaming coughing for causing colds. We cough when we have a cold, the illness causes the symptom. Likewise, as real estate is bought with borrowed funds, financial firms crash when the economy is depressed and loans are in default. But the crash of the banks has a more fundamental cause, the boom and bust of real estate due to subsidies.
There are two basic subsidies to land values: fiscal and monetary. Fiscal policy is about governmental revenues and spending. When governments spend to provide public goods, e.g. streets, security, and schooling, there are two beneficiaries. First are the people who use the goods. Second are land owners. The people who use the goods pay double: first in taxes, and then in higher rentals and real estate prices.
Public goods make locations more productive and more attractive. The greater demand to be located there increases the land rent and land value. The governmental spending is mostly from taxes on labor, goods, enterprises, and trade. Owners of real estate receive greater land value and rent from the public goods paid for mostly by others. That fiscal effect, the increase in land value from public goods, is the “mother of all subsidies”. It is little recognized because the subsidy is implicit, in the form of higher rent and land values rather than in explicit money.
The monetary subsidy to land values is artificially cheap credit. The expansion of money by central banks such as the Fed, the federal reserve system, reduces the interest rates paid by borrowers. Much of bank lending goes to the construction and purchase of real estate. The low interest rates set or targeted by the Fed help fuel a real estate bubble.
The supply of land, within some boundary line, is fixed. We can’t import land, nor are there any land factories to produce more land. Thus when the economy grows, greater demand raises rents and land values. The problem is that speculators jump in to buy real estate, hoping to sell it at a higher price. Low interest rates enable buyers to have high leverage.
Suppose one pays $10,000 down to buy a $100,000 plot of land. Its price rises to $110,000. The speculator soon sells it, and gets $20,000 minus the interest and taxes paid, say $3000 on a 3% mortgage loan plus $2000 in taxes. That’s $15,000 minus the $10,000 down payment, for a profit of $5000. The gain is a profit of 50% of the down payment.
Land speculators, acting on price momentum, take land prices to a level beyond that which homeowners can afford, and beyond which enterprises can be profitable. Land values stop rising, construction halts, and enterprises that provide raw materials, as well as durable goods, grind to a halt. Loans default, the financial system crashes, and the economy plunges into recession. This is what happened to the boom that ended with the depression of 2008 – a pattern that has occurred in cycles with an average period of 18 years since the early 1800s. Every major depression has been preceded by peaks in real estate prices and construction, with one exception: the depression of 2020.
Gross domestic product (GDP, or total output) fell by 5% in the first quarter of 2020 and by 31.4% in the second quarter. The economy was in a depression. A good signal of the boom and bust is gross private domestic investment, which includes construction and the production of durable goods. Such investment fell by 9% in the first quarter, and by a whopping 41.6% in the second quarter. The economy began to recover in the third quarter.
This drop in output, investment, and employment was not caused by Covid-19, but by the economic policy that responded to the pandemic. If the response to the virus were treated as a war, enterprises with lost revenue due to the lock-downs would have been compensated. Though shut down, if the enterprises received relief for their losses, they would have had output in the form of fewer infections due to not spreading the disease. The public does not get consumer goods, but consumes protection from attack.
With compensation, there would have been no recession. Enterprises would have gotten revenue, enabling them to keep and pay their employees as well as to pay rentals, mortgages, and taxes. This was a policy-caused recession.
Normal recessions are also policy-caused. The subsidies of cheap credit and rent-raising public goods induce an unsustainable boom, followed by a bust. The only remedy for the cycle is to eliminate the cause, the subsidy to land value. The fiscal subsidy is to have landowners pay back the increase in the land rent. That amounts to a tax on land values. Ideally, a land value tax would replace taxes on buildings, goods, labor and trade.
As to the subsidy of cheap credit, the remedy is a market-based interest rate that would reduce the leverage of speculation. A tax on most of the land value would eliminate the gains from land speculation.
Both GDP and investment increased in the third and fourth quarters of 2020. So, when will the current growth will peak out and then crash? Some real-estate economists believe that the 18-year cycle that began in 2008 will end in 2026. That was my analysis prior to 2020. Now, with some part of real estate still down (for example, rentals in some big cities) while house prices have risen, the restructuring may start a new cycle in 2021.
Many folks have been vaccinated and are gathering. The government has provided trillions of dollars in relief. The economy has already started to rise again. Subsidies to real estate are intact, guaranteeing that there will be another major recession and depression. Watch gross private domestic investment as a leading indicator. Policy continues to treat the symptoms rather than eliminate the cause of the economic boom and bust.