|Mortgages; Real estate cycle; Land tax
|Most of the reporting and analysis of the subprime mortgage
problem focused on the lending practices and the policies governing
mortgages as the proximate causes of the subprime lending crises that
began in 2007 and intensified in 2008. For example, the Community
Reinvestment Acts of 1977 and 1995 require banks to lend to lowincome
communities which have higher risks. When conditions such
as escalating real estate prices are ripe for a substantial increase in
mortgage loans, these acts contributed to a greater increase in subprime
mortgages by lenders such as Countrywide Bank than would otherwise
have been the case.
|But the deeper issue is why the real estate boom occurred in the
first place. The expansion of real estate construction and increase in
prices after 2001 was not an isolated phenomenon, but has to be seen in
the context of a real estate boom-bust cycle which has been occurring
in the US for two hundred years [1,2].
|The real estate economist Homer Hoyt discovered that there is a
real estate cycle in the U.S. with an average period of 18 years in the US.
The focus of his study was Chicago, which had the best real estate price
data in the U.S., the annual Olcott’s Land Value Blue Book of Chicago
and Suburbs. Olcott used Somers’ methods to appraise the city every
year, including the separation of real estate prices into land value and
improvements value. This and earlier records supplied data for Homer
Hoyt’s classic book, One Hundred Years of Land Values in Chicago.
|While the Chicago real estate prices are the most thoroughly
documented of any American city, Homer Hoyt’s studies led him
to conclude that Chicago’s real estate cycle had been typical of U.S.
real estate trends. Homer [3,4] stated, “While there were variations
in timing between different cities and different types of property,
the urban real estate cycle was approximately 18 years in length.”
Moreover, “The urban real estate cycle has been closely associated with
the general business cycle.”
|Such a real estate cycle is not unique to the US. In his 1983 book
The Power in the Land, Fred Harrison analyzed the real estate cycles of
several countries such as the U.K. as having patterns similar to that of
the US cycle. Indeed, during the decade of the 2000s, “In Ireland, Spain,
Britain and elsewhere, housing markets that soared over the last decade
are falling back to earth” .
|The real estate cycle in the US is summarized in table 1 below. We
can see there the remarkable 18 year regularity of the real estate cycle, with two major exceptions. The next real estate boom after the 1920s
would have occurred during the 1940s, but World War II disrupted
the cycle, as millions of troops were overseas and much of production
was shifted to military goods. The cycle came back after the Korean
War, culminating in an apartment boom of the late 1960s and early
1970s. Real Estate Investment Trust (REIT) assets grew from $2 billion
in 1969 to $20 billion in 1973, while commercial bank mortgage loans
increased from $66.7 billion in 1969 to $113.6 billion in 1973 . This
real estate boom was followed by the recession of 1973, the worst up to
that time since the Great Depression.
|The next recession came in 1980 rather than 18 years later because
of the “stagflation” the economy experienced from 1974-1979. The
high inflation induced a flight to tangible assets, and gold, silver, coins,
stamps, and gems all escalated in price along with real estate, until
under the influence of the new Federal Reserve chairman Volcker,
the monetary expansion halted, resulting in the recession of 1980. The
subsequent economic recovery then once again sparked a real estate
boom that ended with the recession of 1990, interestingly 17 years after
the 1973 recession. Eighteen years later, the economy once again is
experiencing a downturn after a real estate boom, one which economist
Robert Shiller  edition of Irrational Exuberance describes as the
greatest real estate boom in history.
|A theory of the real estate cycle
|Homer Hoyt did not have an explanation of the real estate cycle.
Moreover, macroeconomic explanations of the business cycle seldom
specifically incorporate the real estate cycle. There has been no consensus
among economists on the business cycle. I provided a synthesis of
the real estate and business cycles , with a “geo-Austrian” theory
that integrated the cycle theories of the Austrian school of economic
thought and the cycle theory of Henry George [7,8] the first economist
to present a real-estate related theory of the boom-bust cycle. We can now test that synthesis by applying it to the recent real estate downturn
and associated mortgage lending crisis.
|The Austrian theory of the business cycle is based on the school’s
theory of capital goods, a theory. The school’s founder, Carl Menger
, conceptualized a time-structure of “lower order” and “higher
order” capital goods. The higher order capital goods are those which
have greater time duration. For example, Christmas trees which require
two years to grow and harvest are of lower order than mahogany trees
which require many decades to mature.
|One can picture the structure as a stack of pancakes. On the lowest
stack is “circulating capital” or inventory that turns over quickly. The
highest cake requires many years to build and sell. The most important
capital good on the highest stack is real estate development.
|Capital goods with a rapid turnover are not affected by the rate
of interest. The higher the capital goods are on the stack, the more
sensitive they are to interest rates. Real estate construction and
purchase are highly responsive to interest rates. At low rates of interest,
there is more investment in real estate. Thus, high interest rates flatten
the stack, while low interest rates do the opposite.
|Thus while neoclassical economics posits greater borrowing for
investment with lower rates of interest, the Austrian-school theory
refines the result to posit that the greater investment will be focused on
the capital goods of highest order. Lower interest rates do not merely
increase the stock of capital goods, but also alter the structure of capital
|When the interest rate is lowered due to increased domestic savings,
then the greater investment is offset by less consumption. However,
when the rate is reduced because of an expansion of the money supply
or from foreign capital inflows, then the increase in higher-order
investments can be unsustainable, resulting in what Austrian-school
economics calls “malinvestments,” capital goods no longer profitable as
interest rates and prices rise. Whether the federal-funds rate decrease
to one percent in 2003-2004 was due to an inflow of foreign savings or
was driven by monetary policy can be debated. Both short-term and
long-term interest rates were low, and the result was greater investment
in real estate construction along with a greater demand to purchase the
properties. Just as Austrian theory predicts, the construction became a
malinvestment, a glut of housing inventory.
|Neoclassical economists have also recognized that a credit boom
creates an unsustainable expansion. For example, a similar pattern
occurred prior to the Great Depression; Barry Eichengreen and Kris Mitchener  conclude “that the credit boom view provides a useful
perspective on both the boom of the 1920s and the subsequent slump.”
|The Austrian school also recognizes that a credit expansion does not
just cause price inflation, but also distorts the structure of prices. Prices
rise soonest and fastest where the money is being loaned out. Thus both
during the 1920s and 2000s the was only moderate price inflation in
consumer goods, but high inflation in asset prices, principally in the
stock market and land values.
|With its focus on capital goods, the money supply, and interest
rates, the Austrian theory ignores the land factor. The Georgist theory
of the business cycle is based on land value . At first an economic
expansion reduces vacancies, and then rents and land values rise.
Speculators then buy real estate to profit from expected increases in
real estate prices. The speculative demand makes real estate prices-land
values-rise even faster and farther. Those who buy near the peak are in
effect the highest bidders, those with the most optimistic expectations,
and these tail-end expectations turn out to be mistaken, after which
these land speculators suffer the auction-winner’s curse.
|The rise of real estate prices is due to an increase in the demand for
land, since the supply of land is fixed while buildings can be expanded
to the quantity demanded. But land value also rises because landowners
receive a large implicit subsidy.
|Civic services, public works, economies of density, and other
lavational advantages become capitalized into higher land values. When
landowners do not pay for the public works and other government
services, they receive an implicit subsidy. Those who are both renters
and workers’ pay twice for governmental public goods, once as higher
rentals and again with taxes. Moreover, real estate owners enjoy tax
advantages such as deducting property taxes and mortgage payments
from taxable income, depreciation for investment property, tax-free
exchanges of real estate, and a large exemption from capital gains taxes
for owner-occupied houses. The tax advantages include deductible
home equity loans, as homeowners borrowed $2.5 trilion from 2001
to 2005 .
|Home ownership has also been encouraged and subsidized in the
US since the 1930s by federal and state governments via guarantees,
insurance, and the secondary market for mortgages. The Home Owners
Loan Corporation was founded in 1933 to prevent foreclosures,
which in 1934 became the Federal Housing Administration. The
FHA also helped promote a secondary market for mortgages in 1938
through the government-sponsored enterprise, the Federal National Mortgage Association-Fannie Mae. The Federal Home Loan Mortgage
Corporation (FHLMC), Freddie Mac, was created in 1970 to operate
a secondary market for conventional real estate loans. While now
operating in the market, these enterprises are considered to have an
implicit government guarantee.
|Fannie Mae, Freddie Mac, and other such firms greatly expanded
the market for mortgages, since the originating firms can sell them
to these firms. The mortgages get packed into collateralized debt
obligations and are sold to financial institutions. Rather than reduce
the risks from mortgages by spreading them, the secondary market
increased the systemic risk by expanding the amount of mortgage debt
and from the use of leverage by hedge funds and others.
|The Geo-Austrian synthesis [1,2] can thus be summarized as
follows. An expansion of credit, not due to greater domestic savings,
reduces interest rates, which induces greater and excessive investment
in higher-order capital goods, principally in real estate construction
and purchase. Since there is no offsetting reduction in consumption,
prices rise. The rise of rents and real estate prices induces speculation,
and land values rise because of the greater demand and due to the
subsidies to landownership.
|As Henry George  stated it, “Since the industrial pyramid clearly
rests on land, some obstacle must be preventing labor from expending
itself on land. That obstacle is the speculative advance in land values.
It is, in fact, a lockout of labor and capital by landowners.” Speculation
carries real estate prices to heights anticipating future growth rather
than current use, which increases costs for those who seek to invest in
the present. There is a glut of real estate inventory, while the quantity
of properties demanded declines due to the high, unaffordable prices.
|Real estate prices then fall and defaults rise. Some borrowers are
unable to make the rising mortgage payments, as mortgage payments
reset to higher rates, while others abandon properties with a mortgage
higher than the property value. The drop in construction creates
unemployment in construction as well as in real estate finance and
sales. Many homeowners refuse to lower their selling offers, which
reduce sales. The subprime problem is only the leading edge of the
greater problem with real-estate related debt and reduced investment.
|Fiscal policy and real estate
|The credit boom for real estate and the lending practices have as
their root because the increase in land values during the economic
expansion. The deep cause is capitalization. Land values become
capitalized up by vocational benefits and they get capitalized down
from paying for these benefits. When real estate is taxed lightly, when
most of the infrastructure and civic services are paid for buy other
sources, this increases the price of land. In an economic expansion,
much of the increase in productivity is captured by increasing rents
and land values.
|The real estate cycle shown on Table 1 indicates that there is a
fundamental structure in the economy that has generated this cycle
despite great changes in the financial field and in the role of government.
The fundamental fiscal structure that generates capitalization has been a
common denominator in economic history. All the monetary and fiscal
stabilizers erected during the past decades were not able to prevent the
crumbling of the real estate market and the current mortgage crisis.
|The fundamental structure ties credit to land value. Land value
serves as prime collateral for bank loans, and during an economic
expansion, investing and speculating in real estate is a function of the
expectation of increasing site values. The only way to eliminate the
recurring speculative booms of real estate is to remove the subsidy to
landownership. As proposed by Henry George , if taxation were
shifted from wages, business profits, buildings, and the sales of goods,
to land value, land buyers would no longer expect to gain from higher
future land prices. If most (90 percent) of the rent and land value were
taxed, then the price of land falls to a small fraction of the pre-tax price.
Little credit would be needed for purchasing land. Credit now applied
to land would shift to finance capital goods and enterprise. The boombust
real estate cycle would disappear.
|Since the deep cause of the real estate cycle is the subsidy to
landownership, policies to improve lending practices or more strongly
regulate the financial industry will perhaps reduce the financial problems
associated with a falling real estate market, but does not prevent the
cycle from happening again. We can therefore expect the real estate
cycle discovered by Homer Hoyt to continue indefinitely, since vested
real estate interests will most likely prevent any fundamental change in
the tax policies of governments world-wide.
- Foldvary F (1997) The Business Cycle: A Georgist-Austrian Synthesis. American Journal of Economics and Sociology 56: 521-541
- Foldvary F (2007) The Depression of 2008. Berkeley: The Gutenberg Press.
- Homer H (1960) The Urban Real Estate Cycle-Performances and Prospects. Urban Land Institute Technical Bulletinno. 38: 537-547.
- Homer H (1970) According to Hoyt: 53 Years of Homer Hoyt. Homer Hoyt Associates: Washington, USA.
- Landler M, Ireland I, Spain B (2008) Housing Woes in U.S. Spread Around Globe, New York Times.
- English, Wesley J, Gray, Cardiff E (1979) The Coming Real Estate Crash. New Rochelle, NY: Arlington House Publishers.
- George H (1879a) Progress and Poverty. rpt. NY: Robert Schalkenbach Foundation, 1975.
- George H (1979b) The Root Cause of Recessions. In Progress and Poverty, Chapter 22 reprinted in “The Root Cause of Recessions.
- Menger C (1976) Principles of Economics Ludwig Von Mises Institute Auburn, Albama.
- Eichengreen B, Mitchener KJ (2003) The Great Depression as a credit boom gone wrong. Emerald Group Publishing Limited 22: 183-237.
- Panzner MJ (2007) Financial Armageddon: Protecting Your Future from Economic Collapse. New York: Kaplan Publishing.