A theory of economic boom and crash is one of Henry George's two great purposes in Progress and Poverty. What causes the recurring "paroxysms of industrial depression"?

Could there be a single, root cause? A variety of events have been associated with the onset of economic crises: natural disasters, sudden increases in oil prices, wars, political instability, etc. In fact, just about anything can seem to cause a recession just as the back of an overloaded camel can be broken by a pencil, a paperclip or a piece of straw.

Henry George identifies the root cause in the speculative rise of land prices, which cuts into the earnings of labor and capital. Land rents and prices rise at a faster rate than general economic growth, because of two unavoidable facts: 1) Land is not produced; its supply is fixed, and 2) Land is needed for all production. As we have seen, this creates a tendency for land rent to take a greater share of aggregate production whenever the economy is growing.

This tendency places ever-increasing stress on the actual production of goods and services. For an example of how these stresses make themselves felt in modern economies, let's examine the incentives and costs of creating new buildings.

There exists a current demand for square feet of residential or commercial space, based on population and local economic activity. However, because land values are expected to increase over time, the buyer must pay a speculative premium on the site's value. To justify building at all, the new building must generate higher returns than the current demand for space at that site! That means a bigger, higher-value building must be built and more money must be borrowed, both to buy the site and to build the bigger building, which will have that much higher a property tax bill once it is built!

How can this higher demand be created, all of a sudden? It becomes less mysterious when we realize that land and buildings are nearly always bought with borrowed money. In most cases the value of the real estate itself is offered as collateral for the loan used to buy it. The expected increase in land value makes borrowers willing to borrow more, and lenders willing to lend more. With more borrowed money up front, buyers can spring for a more luxurious building.

The effect of all this is that new construction is delayed, pushed upscale, and made riskier. In cities, where land values and speculative premiums are all concentrated, all of these effects are magnified. High-rise luxury condos bloom in the boom, while the call goes up for more "affordable housing" which the market just doesn't seem able to provide. This creates political pressure to subsidize housing in various ways through tax deductibility of mortgage interest, for example, or outright provision of public housing, or rent-control legislation "market interventions" that create unintended consequences of their own, adding complexities which make the underlying land problem that much harder to see.

The Speculative Bubble

Henry George explains how speculation in commodities products of labor is very different from speculation in land. Speculation in labor products, as in futures markets, serve the socially useful function of regulating supply and demand for example, stimulating production of goods when people bet on their prices increasing. This serves to smooth out supply fluctuations, decreasing overall volatility in the economy. The opposite is true of land speculation. Because land is not produced, increases in demand for it can do nothing but increase its price. Price increases create higher expectations for future price increases, creating a self-inflating speculative bubble.

Many studies have identified a land-price cycle of approximately 18 years in length that has occurred with striking regularity for nearly two centuries. Land values increase, leading to "irrational exuberance" that further stokes the overheated real estate market. Euphoria is followed by a sudden crash, wiping out vast amounts of asset value. Fred Harrison documented this process in his books The Power in the Land (1983) and Boom Bust (2007). Harrison correctly predicted the recessions of 1990 and 2008, as did Georgist economist Fred Foldvary. In the 1930s, Homer Hoyt documented this long-term trend in his One Hundred Years of Land Values in Chicago. (1)

Financial Effects

The power of land to destabilize the economy gets much easier to understand when we realize that land value forms a majority of the collateral security for loans. In the run-up to the "Crash of 2008" (as in previous booms) a huge portion of overall debt was secured by owner-occupied real estate. In many cases, families' homes were their only form of saving, and they expected the real estate's appreciated value to ultimately provide for their retirement. Real estate values were steadily increasing, and land seemed a very good investment. Buyers borrowed extra money to build large, expensive homes and, many homeowners borrowed still more money against their home equity hoping to enjoy their appreciating land values now, and later too. As in the 1930s and in every other bust speculative excess led to a deep crash.

Financial deregulation, and securitization of mortgage debt by means of exotic financial instruments such as credit-default swaps, has often been blamed for the "Crash of 2008," and undoubtedly these practices played a role. Mortgage-backed securities had also become popular in the buildup to the Great Depression of the 1930s. The thing that made these financial instruments so attractive such an obvious thing for investors to do was the underlying increase in land values, growing while the owners slept. After the Great Depression, regulations were put into place to protect the banking system from the excesses of "irrational exuberance" most notably the Glass-Steagall Act, which established the insuring of bank deposits up to $100,000 under the Federal Deposit Insurance Corporation (FDIC), and prohibited commercial banks from trading in securities. Deposit insurance has been retained, and even expanded in 2010 to $250,000. However, the division between commercial and investment banks was repealed in 1999, setting the stage for the exotic financial instruments which contributed to the 2000s "housing boom."

Indeed, residential real estate was seen as such a good investment that many banks relaxed their requirements for credit worthiness. "Subprime" loans were offered to many people who could not have qualified for mortgages before. The new ease with which mortgage loans could be obtained, combined with very low interest rates, served to increase the demand for land and raise prices even faster.

This is not a new phenomenon. John Stuart Mill had written (before Henry George) of a tendency of lenders, when legitimate demand for loans dries up, to "lower the quality of credit" by accepting high-risk loans they would have spurned before. (2) Because land value is such a large part of collateral on loans, and land values fluctuate wildly in business cycles, the tendency toward these volatile, high-risk lending practices is very strong.

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, which so influenced Henry George, followed the completion of the transcontinental railroad, and the Suez Canal. Before the Great Depression, assembly-line manufacturing processes deeply lowered the costs of automobiles and farm machinery, leading to huge productivity increases. In the 1980s and 2000s, information technology and globalization contributed to big productivity gains. (3) Henry George observed that these "improvements in the arts of production" tended to lower the prices of manufactured goods, buildings, and services but raised the price of the land that was needed by the producers of these things. As we have observed, land rent tends to take an ever-greater portion of overall income in a growing economy. According to George, a point is inevitably reached when enough workers and capital owners simply cannot afford the price of the land they need. Production begins to stop.

In George's analysis, economic downturns begin when land prices are too high. However, this part of the theory frequently fails to jibe with history. In the 1920s, real estate values started falling before the crash of the stock market. And the Crash of 2008 was precipitated when 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.

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. (4)

In a modern economy the conversion of land to a more intensive use usually follows 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. Here is the basic public/private investment dynamic that creates sprawl development: Owners hold land in low-intensity uses (or even idle), as a long-term investment. Center-city areas are either overly expensive, or rundown and unattractive. Center-city sites are sometimes held for extremely long periods until they become so rundown as to become bargains, and their owners hope to strike it rich when the area becomes gentrified. In the meantime, however, new construction will bring people, jobs and economic activity to a metro area. To stimulate this (and to benefit politically-connected investors) infrastructure is extended to new areas. Land values soar in those areas, and the owners either sell, or invest in the development that will allow them to realize the newly-increased rent. New development is financed with loans, usually with the land's appreciated value as collateral.

The key factor in this process isn't the affordability of land, but rather the availability of credit. Low interest rates and easy credit keep the demand for land high, and promise high returns to land speculators and developers. And, in effect, all homeowners are land speculators, betting 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 tend to burst but there are strong reasons for people to persist in denying that truth. The over-riding incentive during an economic boom is to repeat what has been working so far. So, new public infrastructure is provided to new subdivisions. Demand for new suburban construction is high, 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 land values keep rising with the expanding bubble, 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.


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. (5)


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 it stimulates will increase their tax base. Since the economy is booming, these new developments always seem like good investments. Eventually, though, there will be a latest wave of land made newly ripe for development that will not find buyers. At that point, developable land has been oversupplied; there is a glut of it on the market.

If demand for a product DVD players, 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. The difference is that land has been used as collateral at every step in the process and it was used as collateral at its speculation-enhanced price. 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 development. Many of them can't pay their subprime mortgages, so the banks lose lots of asset value. People who lose their jobs cannot afford to keep paying on their mortgages. The recession is under way and it started with an oversupply of land on the market.

A Constant Burden

So we see that, due to the interaction of land and credit markets, it is a drop in land values that tends to initiate a recession. This is not to say, however, that the speculative premium in land value is not a constant burden on the economy. How do labor and capital resist advances in land value, when they must have land in order to produce? 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.

Land Speculation and Inflation?

There are as many different theories of the basic cause of inflation as there are for depressions. But since today's business cycle seems to involve a constant tension between periods of inflation and periods of unemployment/recession, the two phenomena clearly are linked.

George said almost nothing in Progress and Poverty about inflation; in his day industrial depression was a much more serious problem. After the Great Depression of the 1930s, however, governments began using macroeconomic "pump-priming" to hold off economic downturns, or blunt their severity. This took the form of deficit spending by government, decreased interest rates, or both. But, of course, this amounted to injecting more money into the economy, which brought the risk of inflation. In the modern world inflation is generally seen as the flipside danger to recession. The conventional macroeconomic wisdom is that the economy cannot be stimulated too much without risking excessive inflation and the economy cannot be slowed down (using higher interest rates, tax increases, etc.) too quickly lest it bring on a recession.

Why talk of the risk of inflation? Cannot the government avoid inflation by simply choosing not to print more money? Not exactly. That is because almost all countries today use a fractional-reserve banking system, in which the great majority of money is loaned into existence by banks (and paid back out of existence when loans are retired.) The bills and coins issued by the government are really only counters useful in day-to-day transactions, but only a small fraction of the total amount of money.

In a fractional reserve banking system, banks are allowed to loan out more money than they actually have on deposit. The process can be influenced by the government (or the central bank) in two basic ways: either by adjusting the prime rate (the interest on short-term loans from the Federal Reserve to banks) or by raising or lowering the portion of their deposits that banks must hold in reserve. These tools can influence the supply of money, but they cannot determine it because banks are free to decide how much money they will lend, within the limits of the basic reserve requirement.

What does this have to do with land speculation? Remember that in a modern economy, the vast majority of real estate is acquired with borrowed money. However, credit is not only important for acquiring land and buildings. Credit is also vital to daily business operations. Businesses routinely borrow money, for example, to purchase inventories. If the profit on the items sold is greater than the interest charged on the loan, then the business is better off borrowing. Such short-term business loans are considered to be "self-liquidating." Their risk is quite low, and they facilitate the flow of commerce.

Recall, too, that because of the basic nature of land as a factor of production, land value takes an ever-greater portion of aggregate wealth as the economy grows. This means that an ever-greater portion of loans must go to the acquisition of land. And, since the higher speculative value of land pushes people to build more expensive buildings, this means that an ever-greater portion of loans also goes to buildings. These are long-term loans. Banks do not have unlimited funds to loan. Money committed to long-term loans for land and buildings is not available for short-term business loans.

But these sort-term business loans are essential to the smooth running of the economy. If less loanable funds are available for them, their price goes up, business costs get higher, the economy slows. But, there is inexorable pressure on the supply of these short-term loans, as more and more loanable funds go toward buying land and buildings. Recession looms. The irresistible incentive for the Federal Reserve is to allow the money supply to increase, by keeping interest rates and reserve requirements low. This can offset the reduced supply of funds businesses need for day-to-day operations. But not indefinitely, or without limit: since the central bank cannot control banks' money-lending decisions, it cannot be sure that inflation won't run out of control.

In a modern economy that is rife with land speculation, lowering interest rates carries an additional danger. As we explained here, because land has no cost of production, its price is determined by the process of capitalization. Essentially, the annual rent of a site is divided by the current rate of interest, and this capitalized rent is the basis for the selling price (most often a speculative premium is added). Now, if the central bank lowers interest rates to free up the money supply, this means that the divisor, the capitalization rate, is a lower figure and therefore land prices will increase.

The fact that inflation and unemployment are seen as inextricably linked that we cannot reduce one without risking the other shows that they are symptoms of the same underlying problem.

Many people note the intimate role of money and banking in economic cycles and asssume that the financial system is at the root of the problem. Undoubtedly, the financial system has a long history of "ratcheting up" the volatility of the speculative land market. This was painfully clear in the Great Depression, and again in the 2000s, after many depression-era banking regulations had been eliminated. However, although the Glass-Steagall act and other regulations served to soften boom/bust cycles, it did not eliminate them. And, land price bubbles have recurred throughout history, under many different banking and monetary systems. Unfortunately, the primary role of land values in economic cycles has been obscured by the mainstream economics establishment, which has persistently denied land's role as a distinct factor of production.


NOTES

  1. Harrison, Fred, The Power in the Land and Boom Bust. Hoyt, Homer, One Hundred Years of Land Values in Chicago.    (Go back)
  2. Mill, John Stuart, Principles of Political Economy (1848) Book III, Chapter XII.    (Go back)
  3. Curtis, Mike, "Henry Ford Caused the Great Depression", Georgist Journal #107, Spring, 2007.    (Go back)
  4. Gaffney, Mason, "Reverberations", Georgist Journal #119, Spring, 2012.    (Go back)
  5. See Gaffney, Mason, After the Crash: Designing a Depression-Free Economy, 2009, Wiley-Blackwell, pp. 189-90.    (Go back)