Mechanism of the Real Estate Cycle

Economic depressions have historically followed periods of great productivity increases due to improvements in technology, transportation, communication, etc. The worldwide depression of 1873 was fresh in Henry George’s memory when he wrote Progress and Poverty. It followed the completion of two momentous projects: the transcontinental railroad, and the Suez Canal. Before the Great Depression of the 1930s, assembly-line manufacturing processes deeply lowered the costs of automobiles and farm machinery, leading to huge productivity increases. (1) In the 1980s and 2000s, information technology and globalization contributed to big productivity gains. Henry George observed that these “improvements in the arts of production” tended to lower the prices of goods and services — but raised the price of the land needed to produce these things. As we have observed, land rent tends to take an ever-greater portion of a growing economy’s income. According to George, a point is inevitably reached when more and more workers and capital owners simply cannot afford the price of land. Production begins to stop.

In Progress and Poverty, George wrote that economic downturns begin when land prices get too high for labor and capital to afford. However, this part of the theory fails to jibe with the facts of history. In the 1920s, real estate values fell before the crash of the stock market. Similarly, the Crash of 2008 happened after a sudden decline in real estate values left many mortgage-holders “under water” — having borrowed much more than their lands and houses were now worth.

How could a decline in land values bring about a recession? To understand this, we’ll have to take a closer look at the roles of credit and public investment in the land market — and examine the economic mechanism of sprawl.

How Sprawl Unfolds

While it is true that land is fixed in supply, it does not follow that the supply of land for particular uses must be constant. Mason Gaffney notes that

There are dozens of stages of more intensive use: from hunting and fishing to trapping, from lumbering to tree farming, from that to sheeping to beef cattle, from grazing to feeding, to farming small grains to maize, to horticulture, to irrigation, to vines and groves and orchards, to country estates, to subdivisions and housing, to low-rise apartments, to commerce and industry, to high-rise condos and offices and hotels, with many stages of intensity along the way. (2)

In a modern economy the conversion of land to a more intensive use tends to follow improvements in public infrastructure. Timber or farm land becomes viable when there is a railroad or highway to get products to market. Residential subdivisions spring up after streets, sewers and public water service is provided. Increased land values, and new construction, grow around highway interchanges or commuter-rail stations.

This is the basic public/private investment dynamic that creates sprawl. Owners hold land as a long-term investment, either idle, or in low-intensity uses. Center-city areas are either overly expensive, or rundown and unattractive. Center-city sites are sometimes held for extremely long periods. They become so rundown that they become bargains, and their owners hope to strike it rich when the down-and-out area finally gets gentrified (a process that is often aided by tax abatements that benefit well-connected developers).

Two pervasive trends in the 2000s have been the proliferation of "McMansions" and of luxury condominiums. Many of the former are now in foreclosure, and many of the latter stand empty. The buildings still stand, but if their market value is lost, then economically they are just as destroyed as if a wrecking ball had hit them.
Two pervasive trends in the 2000s have been the proliferation of “McMansions” and of luxury condominiums. Many of the former are now in foreclosure, and many of the latter stand empty. The buildings still stand, but if their market value is lost, then economically they are just as destroyed as if a wrecking ball had hit them. (3)

Meanwhile, new construction is needed to bring people, jobs and economic activity to a metro area. To stimulate this, infrastructure is extended to new areas. Land values soar in those areas, and new development is financed with loans, with land value as collateral.

Surprisingly, the availability of credit is often a more important factor in this process than the affordability of land. Land prices can get quite high indeed, but still be “affordable” if financing is available. Low interest rates and easy credit keep the demand for land high, and promise high returns to land speculators and developers. The big players in urban real estate are the ones who reap the biggest rewards — but, in effect, everyone with a home mortgage is a land speculator. Homeowners bet that the future advance in price or rent will replace the saving they never managed to do. Thus everyone is hooked, forced by the market to participate in the speculative game. Eventually people forget that there could be any other way of doing business.

Speculative bubbles always burst — but there are strong reasons for people to deny that truth. The overriding incentive during an economic boom is to repeat what has been profitable so far. New public infrastructure is provided to new subdivisions. New suburban construction seems a good bet; it is subsidized by the streets, police and fire protection paid for by the taxpayers, and by tax policies that favor home mortgages over other kinds of debt. But, as the bubble expands, things get riskier. Lenders cut more corners, loaning greater sums to less secure borrowers. Sooner or later, the next level of subsidized sprawl development will fail to find buyers.

Remember that for sprawl development to work, land — such as farm land at the edge of a city — must be made easily convertible to higher-intensity use by the provision of public infrastructure. Cities borrow to provide this infrastructure, betting that the new construction will increase their tax base. The economy is booming, so these new developments always seem like good investments. Eventually, though, the latest wave of land, made newly ripe for development, will not find buyers. At that point — all of a sudden — there is a glut of developable land on the market.

If demand for a product — laptop computers, say — fell off because the market had been oversupplied, one would expect prices to fall a bit, production plans to be changed to reflect the new level of demand, and a new equilibrium price to be reached fairly quickly. But this is not what happens with land. When land values reach their peak, they tend to fall quickly and dramatically. This is because land has been used as collateral, at its speculation-enhanced price, for the loan that was taken out to buy it.

If newly-developable land at the edge of town cannot find buyers, this creates a series of reverberating effects. The city has borrowed a bunch of infrastructure money, but now it will get no new tax base in return. There are no jobs for the construction workers who expected to build the next wave of development. People who lose their jobs cannot afford to keep paying on their mortgages, so they default, and the banks lose lots of asset value. The recession is under way — and it started with an oversupply of land on the market.

A Constant Burden

While it is true that economic crises tend to be touched off by a sudden drop in land values, we should keep in mind that land speculation is a constant burden on the economy. Labor and capital must have land in order to produce — yet its price tends to increase faster than their profits. How do labor and capital respond? By ceasing production. Of course, this doesn’t happen all at once, but marginally — bit by bit. What does this mean in real life? Labor and capital decline to buy or rent land at the high asking prices. Some will rent or buy less land, and use it more intensively. Some will sleep on the street, or sell from the sidewalk. Some will retreat to little patches of marginal land. Some will buy as much land as ever, but thus use up funds they otherwise would have used to improve it, becoming withholders themselves. Some will organize and pass counterproductive rent-control laws. The economy-wide net result will be less production, more unemployment.

NOTES

1. Curtis, Mike, “Henry Ford Caused the Great Depression”, Georgist Journal #107, Spring, 2007. (Go back)
2. Gaffney, Mason, “Reverberations”, Georgist Journal #119, Spring, 2012. (Go back)
3. See Gaffney, Mason, After the Crash: Designing a Depression-Free Economy, 2009, Wiley-Blackwell, pp. 189-90. (Go back)


Next: Land, Money and Inflation Site Map Student Login

Membership in the Henry George Institute

...has only two requirements: pay your annual dues of $20 (us), and indicate your agreement with our Statement of Purpose. As a member, you get a subscription to the Georgist Journal, and a vote in our annual election for members of the Board of Directors.

STATEMENT OF PURPOSE

In accordance with the philosophy of Henry George, the Henry George Institute holds that all persons have a right to the use of the earth and that all have a right to the fruits of their labor. To implement these rights it is proposed that the rent of land be taken by the community as public revenue, and that all taxes on labor and the fruits of labor be abolished. The Institute believes with George that “liberty means justice and justice is the natural law,” and that the social and economic ills besetting the world today are the result of non-conformance to natural law. The Institute pledges itself to bring this philosophy to the attention of the public by all suitable means.

Close this popup

Getting Started with Understanding Economics

Our first course, Understanding Economics, is FREE and self-paced. There are no due-dates or deadlines — yet our staff is always available to answer your questions via email.

It's a good idea to check out the first few readings and video supplements to get ready for your first lesson. Make sure to bookmark our "Site Map" page, which has links to the suggested readings for each lesson (and much more).

When you're ready, click below to enroll. You'll pick a username and a password, and be asked for some more basic information (which we will NOT share with anyone else). We'll need your snail-mail address to send you your certificate when you complete the course!

Enroll today for a rewarding, enriching experience!

Close this popup

Membership in the Henry George Institute

...has only two requirements: pay your annual dues of $20 (us), and indicate your agreement with our Statement of Purpose. As a member, you get a subscription to the Georgist Journal, and a vote in our annual election for members of the Board of Directors.

STATEMENT OF PURPOSE

In accordance with the philosophy of Henry George, the Henry George Institute holds that all persons have a right to the use of the earth and that all have a right to the fruits of their labor. To implement these rights it is proposed that the rent of land be taken by the community as public revenue, and that all taxes on labor and the fruits of labor be abolished. The Institute believes with George that “liberty means justice and justice is the natural law,” and that the social and economic ills besetting the world today are the result of non-conformance to natural law. The Institute pledges itself to bring this philosophy to the attention of the public by all suitable means.

Close this popup

Getting Started with Understanding Economics

Our first course, Understanding Economics, is FREE and self-paced. There are no due-dates or deadlines — yet our staff is always available to answer your questions via email.

It's a good idea to check out the first few readings and video supplements to get ready for your first lesson. Make sure to bookmark our "Site Map" page, which has links to the suggested readings for each lesson (and much more).

When you're ready, click below to enroll. You'll pick a username and a password, and be asked for some more basic information (which we will NOT share with anyone else). We'll need your snail-mail address to send you your certificate when you complete the course!

Enroll today for a rewarding, enriching experience!

Close this popup