NEO-CLASSICAL 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, and 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 debt-bloated carcass of the US economy? Whilst the hopelessly labyrinthine person will say “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. Although the argument has some merit, who is to say what is the precise rate of interest that would have obviated the real estate bubble? No, interest rates still don’t quite cut it in terms of Occam’s Razor [bad pun!] – of getting down to the simplest and most obviously correct 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 economists still argue that the land component can’t be separated accurately, valuers in Australia, New Zealand and South Africa have been doing it expertly now for more than a century.

But what if the price of land were to become ridiculously high? Against what criterion are we to measure this? 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 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 this very dynamic and volatile price of land, together of course with the more stable depreciating value added by the improvements, and are happy to nominate the combined value as ‘security’. That’s often OK – but at pretty regular intervals it’s not OK.

I am 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 below (as in recent years) it’s time to run for the hills!

As a benign boom turned into a savagely inflating real estate bubble, although some economists had an uneasy feeling, none but a handful had any idea of the implications of excessive privatisation of the economic rent in this fashion.  Risk management therefore went missing altogether.

The land price component of real estate usually does go up in real terms, but every now and then it doesn’t: it corrects with a thud. So, in granting loans against real estate asset prices without understanding the cycles of economic rent, banks take a gamble on what’s going to happen to the land component of the assets they’ve accepted as security. 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 practises can’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 (legalised robbery, some say) that subtracts not only from our earned incomes and purchasing power, but which cascades through the economy to increase prices.

Therefore can’t taxation itself be seen as a pathology, equally damaging as land price bubbles? Combine the two and we have the perfect storm for a recession or, in this instance, a depression: i.e. land prices escalate into a bubble because we’ve not captured enough publicly-generated land rent for revenue, and, all taxes not only add to prices but also reduce our purchasing power. We respond by taking on impossible levels of debt, simply to keep up with things.

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

• 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.
•  If he gets land rent though, then he will have low tax and low land price. This will keep debt down and the Pres. will have no more crash.  E-Z!     🙂 

Of course, no government anywhere in the world has come close to applying this bold solution since The People’s Budget of 1909, so it can be see that things don’t augur well for us finding solutions to exit this global financial collapse.