The economic depression: an occasional commentary # 4

10th January 2009

Bryan Kavanagh, LVRG

[If you wish to keep things simple and ignore unnecessary explanation, please proceed to the final, italicised paragraph.]

The form of reductionism that has provided DNA sequencing of the human genome is leading to enormous gains in medical science; but reductionism in economics has taken the science of political economy into the dead end of an occult art. There’s no overview to put matters economic into perspective. When economic analysis misses the forest for the trees as it has so blatantly in the case of the financial meltdown, it’s time to apply the blowtorch of Occam’s Razor to the debt-bloated carcass of the US economy. We’ve got to ask some basic questions to come to sound conclusions. It has become fashionable for economist to say “There are no easy solutions”: but they’re wrong.

What’s the real problem? Why did these tremendous levels of unsustainable mortgage debt, from which the US economy needs to deleverage, arise in the first place? Monetary theorists would say that money was too cheap. Although that argument clearly has some merit – because money represents produced wealth and the cost of borrowing this wealth was indeed too cheap – it still doesn’t quite cut it in terms of Occam’s Razor, if the bad pun may be pardoned – of getting to the most simple and accurate explanation. Who is to say what the precise rate of interest is that would have stopped a real estate bubble from developing? We should first get down to defining and quantifying what constitutes a real estate bubble, because, as precedes all economic downturns, the US certainly did experience an enormous real estate bubble. And bubbles do burst!

We should first ask: What assets were offered as security for loans? Real estate: either the value of the particular piece of real estate being purchased, or other real estate held by the borrower. OK then, let’s understand that the price of the security consisted of two components: 1) the value of the buildings, and; 2) the value of the land. The value of buildings is easily assessed and may be confirmed by checking the replacement cost of buildings and applying a level of depreciation (if that applies). But how do we assess the value of the land itself?

Well, it’s assessed by deducting the value of the improvements from the sale price of comparable properties, isn’t it? Yes it is. But what if the high price of land is itself a pathology? Against what criterion are we to measure it? Isn’t land price also the capitalisation into perpetuity of the estimated net rent? Yes it is … into perpetuity. But can’t political or economic discontinuities intervene between now and forever that might throw the capitalised value of the land out the window? Yes, these events do occur regularly, every 18 years or so in fact, but our brothers in banking lend against this dynamic and volatile price of land and are prepared to call it ‘security’.

So wherein lay risk management in recent years? That’s a very good question. Admittedly, the land price component of real estate usually does go up, but it occasionally comes down with a great thud. So, in granting loans against real estate asset prices, banks always take a gamble on what’s going to happen to the land price component of the assets they’ve accepted as security for the loan. This time, US banks lost. That’s the current state of play of risk management, and re-regulating won’t remedy this; nor will bank bailouts nor Federal Reserve interest policy alone.

But high real estate prices and mortgages don’t of themselves explain how the US achieved these unsustainably mountainous levels of debt, nor the current financial collapse. What if taxation can be regarded as a form of theft from our earned incomes and therefore, like high land prices, is also a pathology? What if the annual value of land, being publicly-generated, was the only non-pathological source for necessary government revenue?

So, let’s use the principle of Occam’s Razor to summarise debt, poverty, lack of housing affordability, taxation, land rent, and financial collapse of the USA in a few sentences, and words of one syllable, so that even economists might understand it.  (As no action by any government, anywhere in the world, has come close to addressing this solution, it might be said that things don’t augur well.):

1. If the new Pres. gets no land rent , he’ll still have both high tax and high land price. This is what brought on big debt and the crash in the first place.
2. If he gets land rent though, he’ll then have low tax and low land price. This will keep debt down and the Pres. will have no more crash; E-Z.