NEOCLASSICAL ECONOMIC SOLUTIONS: REDUCTIO AD ABSURDAM?

Reductionism in medical science has provided DNA sequencing of the human genome that will lead to positive breakthroughs for humanity. Its practitioners however acknowledge the necessity to keep an eye on overarching ethical issues.

But economists haven’t challenged the reduction of modern economics down to mathematical models which fail to reflect the real world.  Economics has been given no superstructure to retain perspective, keep it on track to be able to forecast economic events scientifically. Accordingly, it has descended into a mathematical art in which the issue of balancing supply and demand has become paramount. Economic life can’t be reduced so ridiculously without major repercussions. But there are solutions.

How is it that a real estate valuer such as I could forecast the financial collapse and economists couldn’t? Could it be that I consider that Ricardo’s Law of Rent (i.e.  ‘Location, location, location!’) does matter? Maybe the economy needs to be understood in terms of time and place?

When economic analysis can’t see the forest for the trees as in the case of the financial meltdown, it’s surely time to apply the blowtorch of Occam’s Razor to the private debt-bloated carcass of the US economy? Whilst hopelessly labyrinthine people will suggest “There are no easy solutions“, we do need to ask some pretty fundamental questions to arrive at a sound conclusion.

What exactly is the problem? Why did such tremendous levels of unsustainable mortgage debt arise in the first place? Monetary theorists say that money was too cheap. The argument may have superficial merit, but what is the proper rate of interest that would have obviated the real estate bubble? Interest rates still don’t cut it in terms of Occam’s Razor [poor pun!] of getting to the simplest, obvious explanation.

Let’s first confirm what assets are mainly offered as security for financial loans or leverage.  It’s usually real estate; either the value of the particular piece of real estate being purchased, or other real estate held in the borrower’s name.

OK then, but the price of real estate security consists of two components:

• 1) the value of the buildings which tends to depreciate in real terms over time, and;
• 2) the value of the land which escalates faster than other aggregates, such as wages, population and GDP.  [Australian Bureau of Statistics Catalogue 5204 (table 61) tells us that from 2000 to 2008 the value of Australia’s land increased 2.5 times (from $1.258 trillion to 3.148 trillion) while GDP increased by a factor of 1.74  (from $0.646 trillion to $1.130 trillion) ].

The value of buildings is easily assessed. The current replacement cost of a particular building is ascertained and a level of depreciation applied if applicable after analysis of sales evidence.

But how do we assess the value of the piece of land on which the building is constructed? It’s to be found either by looking at sales of comparable vacant land or by deducting the assessed (depreciated) value of the improvements from the value of the property following sales analysis.  While US economists still argue that the land component can’t be separated accurately, valuers in Australia, New Zealand and South Africa have done it expertly for more than a century.

But what if the price of land were to escalate ridiculously? Against what criterion are we to measure this? Isn’t land price 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 right out the window? Yes, and these events do occur regularly – every 18 years or so in fact, often accompanied by some mid-term (9 year) economic event, but our brothers and sisters in banking are prepared to lend against the dynamically volatile price of land, together of course with the more stable depreciating value added by the improvements, and are then happy to nominate the composite value as ‘security’. That’s usually OK – but at quite regular intervals it’s definitely not OK.

I’m not an economist, but I do know one BIG thing that economist don’t seem to – that when real estate yields get down to 3% or less, as in recent years, it’s time to start running for the hills!

Although a few economists may have had an uneasy feeling as a benign boom turned into an incredibly inflated real estate bubble, none but a handful had any idea of the implications of excessive privatisation of the economic rent in such fashion, and proper risk management went out the window.

The land price component of real estate usually does go up in real terms, but every now and then it doesn’t, correcting with a massive thud. So, in granting loans against real estate asset prices without understanding the cycles of economic rent, banks take an enormous gamble on what’s going to happen to the land component of the assets that they’ve accepted as security for the loan. This time they lost: big time! That’s the current state of play of risk management, folks, and stricter monetary policy and re-regulating bank lending practices won’t remedy this!

Apart from all the debt brought about by skyrocketing land prices, we tend to forget the extent to which the government is in our pockets. We’ve become inured to the perverse forms of taxation (some say legalised robbery) that subtracts not only from our earned incomes and purchasing power, but which cascades throughout the economy to increase prices of our goods and services.

Therefore, taxation itself can be seen as a pathology, equally damaging as land price bubbles. Combine the two and we develop perfect storms for recession, or occasionally for a financial depression: i.e. land prices escalate into a bubble because we’ve not sufficiently taxed away publicly-generated land and natural resource rents. All other taxes not only add to prices but also reduce purchasing power. We respond to the worsening scenario by taking on impossible levels of debt, in an effort to simply to keep up with an impossible situation.

Let’s use the principle of Occam’s Razor to summarise USA private debt, poverty, lack of housing affordability, taxation, the excessive privatisation of land rent, and financial collapse in a few sentences, in words of one syllable, so that even a neoclassical economist may understand it:-

• If the new Pres gets no land rent, he will still have both high tax and high land price. That’s what brought the big debt and the crash in the first place.
•  But if the Pres gets more land rent and less tax, with both low tax and low land price, he will keep debt down and not have a crash. Is this not E-Z!   (Sorry!)

Of course, no government has come close to applying this bold solution since the Progressive Era, when Henry George solutions were boldly, if a little tentatively, applied, as in Australia with the introduction the federal land tax in 1910 and the Australian Capital Territory being founded on a leasehold system in 1913.

So, it can be see that things don’t augur well for us finding solutions for exiting this global financial collapse properly, in such a way that we will avoid the bursting of increasingly worsening real estate bubbles.