.

C. Land-driven Booms and Busts

C-1. LAND VALUATION IS SUBJECTIVE
The value of durable capital is based on expected future cash flow, and so is that of land, but there are three big differences at least.

• The future of most capital is short; that of land is infinite.
  
• The future of most capital is limited to the specialized use for which it was built; that of land is varied and unpredictable.
  
• The future cash flow of capital is limited by potential competition from new capital with a known cost of production; that from land is limited only by future demand and is likely to rise. It is, as Richard Hurd wrote in his classic Principles of City Land Values, "a state of the public mind."

As to allocation of land it gravitates not just to the financially strong but to the psychologically susceptible, that is those most prone to overestimate future incomes, for whatever reason.

There is too little in objective reality to limit expectations. Many buyers have little understanding of valuation theory. Loan officers should be better trained than naive new buyers, but the recent history of U.S. and Japanese banking suggests otherwise. Without understanding, there is little basis for pricing other than the behavior of other buyers and sellers. "A nerd follows the herd." But then valuation is purely circular and loses its anchor in reality. The history of land values, accordingly, is one of manic depressive mob psychology with swings of high amplitude.

Suppose one decides to consult a professional real estate appraiser, to make sure he does not overbid. What do appraisers do? They locate comparable properties that have sold recently, and advise you accordingly. The buyers of those other properties hired appraisers who did the same thing. If there is a building, he tells you it is not worth more than its reproduction cost, a known figure in the trade. With land, however, value is based mainly on what others are paying, i.e. the general opinion. Everyone is setting his watch by everyone else's.

There is one important party whose following the herd will actually restrain the herd, and temper its excesses. This party is the assessor of land taxes. If land assessments rise with a herd mania, land taxes will also rise, dashing freezing water on the mania and stabilizing the market. Here is compensatory fiscal policy in the best and original sense. This can really work. It did work in the Progressive Era, 1900-17, when reliance on property taxes was at an all-time high in the U.S. The major crash that was "due" in 1913 or so never happened.[41] Several factors were at work, but this was clearly a major one.

FRAGMENTS TO BE WORKED IN......

a) Perfect knowledge does not mean omniscience. "Rational expectations" cannot paper over this problem.

b. Pricing is subject to herd behavior, positive feedback, and circular reasoning.

a. Cost of production places no limits on land rents and prices, neither a lower nor an upper limit. Rents and prices start at zero, and rise without limit over time as demand rises. Spatially, prices are near zero in the tundra, and rise to an estimated $1.3 billions per acre (sic) on the Ginza of Tokyo, although both locations alike are free gifts of nature.

b. There is always a marginal and submarginal supply, the "extensive margin." Usually it is free, or virtually so. Some of it is untenured, at least de facto.


C-2. Land value is used as the basis of credit and money
During a land boom, financial institutions lend freely on land. After a while, mortgages secured by real estate (either directly or through the corporate veil) become the major asset of banks. Credit follows collateral, and then helps boost its collateral value in a positive feedback loop. In periods of high and rising land prices, borrowers get used to pledging land to secure loans, and lenders get used to demanding it.

The credit is often used to buy still more land, to reserve for possible future use and at the same time to withhold from competitors. Such concentration and market control form the ugly side of extant western "capitalism, when enterprise degenerates into greed and acquisitions supplant innovations.

As Rainer Schikele wrote, "the basis of credit is not marginal productivity but collateral security."[42] As Keynes put it in his General Theory, there are two kinds of risks: investment risk proper, and lender's risk. Investment risk depends on the productivity of new capital; "lenders' risk" depends on borrowers' old collateral, like land. The social purpose of investing is to create capital; the individual purpose is to buy income with security. The second purpose leads lenders to lend to the rich in preference to the productive. The principles are at odds; the productivity principle is clearly better from the viewpoint of basic micro efficiency.

The marginal productivity basis of lending is also better in terms of macro stability. Flows of credit dominated by cycles in the land market are highly unstable. The savings and loan industry calamity in the US in the 1980s exemplifies and should settle the point. It has many precedents, going back at least to the golden age of Florentine banking, the Dutch Tulip Bubble of 1634 and the French-English Mississippi and South Sea Bubbles of 1720. The rule has been that following each collapse the hung over lenders woke up penitent. Reacting to the excesses they adopted something like the English Banking School philosophy of avoiding real estate loans and sticking with self-liquidating commercial loans, only to fall off the wagon in the next land boom thereby helping to repeat the cycle. How easily one generation forgets the hard lessons life taught the one before. "When will they ever learn?"[43]

C-3. Land markets are prime causes of instability
a. Land prices move in cycles of high amplitude.

(ED. NOTE: Combo of x17, x21, and x26, to be consulted and worked in.)

b. Investors respond to high land-price by forming land-saving capital, i.e. substituting capital for land. It is useful to distinguish five forms this substitution takes (cf A-6, where these points are outlined).

i) Land-saving capital, like high buildings. Land-saving comprises intensification of use of previously rentable lands, or "exploiting the intensive margin of production".

ii) Land-enhancing capital, meaning capital used to improve land for a new, higher use. This includes bringing marginal land into production, on remote frontiers. However, that is only a small part of what it means. Both country and city are marked by many edges or "ecotones"[44] where lower uses give way to higher uses. Each is an economic frontier. Thus, land enhancing 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, low-density estates to subdivisions, single-family detached units to garden apartments, garden apartments to high-rise apartments, residential to commercial, and obsolete structures to modern ones.

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.

iii) Land-linking capital, like canals and rails and city streets.

iv) 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 they 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.

v) Rent-leading capital. In urban growth, an example is over-improving land today, expecting higher demand tomorrow.[45] 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 today's 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, also known as 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 building.

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 synchronized fashion.

However, in the frenzy of a speculative boom the market sends the wrong signals. Land is peculiarly subject to irrational speculative pricing in booms because of its subjective pricing - see B-16.

Overpricing of land reserves land for two contrasting kinds of buyers and holders.

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 (the city center). Overpricing and consequent over-improvement gets greater, the further out you go.

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.

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 the 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 capital sunk in improving them.

c. Land-saving capital is well above average in durability. Following an argument developed by Smith, Ricardo, Mill, Wicksell, Spietboff, Hayek, and others, an excess commitment of capital to fixed forms with slow recovery rates brings on a shortage of job-making investing. See the summary in Haberler, Prosperity and Depression.

SUMMARY

In summary, we have reviewed ten primary reasons why economic theory should treat land as a distinctive factor of production; and nineteen practical inferences therefrom. Making land markets, land policy, and land taxation work well for the general welfare is a major challenge for economists and statesmen. They have neglected it for too long by swallowing the peculiar neoclassical sophisms that would obscure or deny all distinctions between land and capital.

NOTES

41. Unfortunately, assessors today are subject to strong political and social pressures to lag behind the market.

42. He meant that lenders are concerned not with the productive use of their loans, but with the security provided by borrowers' ownership of old wealth.

43. It would help if historians recorded the details more scrupulously and reminded the world more cogently. University of Chicago banking historians Lloyd Mints, Milton Friedman and Anna Schwartz have done much to belittle and bury the matter completely, a tribute to their influence but not their sagacity. Friedman and Schwartz' history of banking came at the right time to fulfill the wishful thinking of a generation wanting to be free of the fear that something other than human error by a few Directors of the Federal Reserve Board brought on The Great Depression.

44. "Interfaces of supersession" is a polysyllabic equivalent used by land economists.

45. There are "economies of simultaneity" in building, so if you are going to build to four stories, you have to do it all at once. Suppose today's demand is high enough to justify a two-story building, but you see the demand rising steadily over the 40-year life of the building. You build a four-story building today, and absorb some early losses on the upper two stories, as an investment for future years.

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