Causes of Downturns: an Austro-Georgist Synthesis

Working paper by Mason Gaffney, 1982

What makes a boom turn down into a slump?

I. Overpricing land

The optimism generated by prosperity carries the seed of its own destruction because it encourages landowners to demand too much, to overprice their land and its rent.

When overpricing meets resistance it is followed by holdout over a long period of attrition.

Land has more holdout power than labor (which starves) and capital (which wastes).

Overpricing may block production by keeping building sites from use.

Building is not blocked totally, but forced to marginal land of lower quality and distant location, resulting in lower rates of return, and in sprawl.

Overpricing also may take the form of raising rents, squeezing tenants.

In result they use less space, leaving vacancies.

Others retreat towards cheaper, marginal land, where they are less productive and earn less income.

Commercial and farm rents usually include two parts, one of which is a share of gross sales.

As the landlord's share of gross sales rises, it cuts down the tenant's marginal rate of return, MROR. (10% of sales may be 60% of profits.)

Henry George's thesis is that land speculation, in its manic phase,

makes landowners as a group act in concert as though they were one monopolist,

withholding supply to raise price.

He might have added that commercial landownership is extremely concentrated;

and the non-reproducible nature of land makes it a natural basis for monopolies of all kinds.

In local markets, a large landowner who controls a big share of the total supply is conscious of his market power.

Markets for land are inherently local, because land is immobile.

II. Loss of capital (K includes financial capital K1 and capital goods K2)

A. After land has appreciated, those who sell appreciated land regard their gains as personal income. Most personal income is consumed.

Yet there is no production corresponding to this higher consumption.

Because of land appreciation, there is less overall savings and more consumption.

Therefore, it must draw down existing K.

There is less investment, while K2 continues to depreciate and financial capital K1 is depleted.

Land buyers pay for the land in real K1, from new savings K1or recoveries from old K2.

With higher prices they have less K1 left over to improve the land they bought,

and less working K1 to operate it.

There is less K overall, because sellers have consumed what they got.

B. Equity withdrawal.

1. Owners of appreciated land borrow on its higher value, and consume the proceeds.

The land that appreciates may be improved, e.g. with a residence, and normally is.

It is the land, however, that appreciates;

K2 normally depreciates, in real terms.

2. Owners of income property consume their Capital Consumption Allowances (depreciation).

Consuming CCAs means a flow of investing is replaced by a flow of consumer spending.

The added consumer spending does not flow through the "grocery store" to hire workers, create incomes, and produce goods.

It is offset by "disinvestment."

If money spending holds up while production and hiring fall,

the result is inflation without full employment (stagflation).

It is as though grocers ate up part of their own wares, instead of selling and replacing them, leaving some shelves empty.

Most of the flow of investing consists of refilling shelves as the goods go out.

Now, that flow drops.

C. Rent-leading buildings that fail to lead.

Rising land prices evoke "rent-leading" land improvements

(building-in excess capacity in expectation of rising rents).

At best, the excess K2 used is lost temporarily; at worst, forever.

D. Lower saving

1. As land prices rise, saving from other incomes falls due to "portfolio substitution."

a. Higher land values substitute for K in the portfolios of "economic agents" (i.e. people), lowering the marginal motivation to add assets by saving more.

b. Overpricing land forces down the rate of return on economic investing, lowering cap rates, raising land prices yet more, in a cumulating, non-equilibrating movement ("positive feedback").

2. Saving falls due to lower rewards for saving, and lesser penalties on consuming,

the twin results of lower rates of return on real investing.

Saving falls in response to lower interest rates for two related reasons.

One is portfolio substitution: lower interest rates result in higher land and stock-share prices, lowering the incentive to save.

The other is lowering the penalty for "dissaving" (borrowing to consume).

This is shown by a reductio ad absurdum: at zero interest, one could live in infinite luxury by borrowing any amount forever at no cost.

Repayment, if required, could be made by refinancing at no cost.

"That is unrealistic and impossible," you may object.

You are right: that is why zero interest is impossible.

E. Overlending to land buyers and refinancers, with inflated appraisals.

Some buyers of real estate default.

Many financial intermediaries show up as corrupt and/or mismanaged; K2 is lost.

Taxpayers absorb losses.

III. Excessive conversion of circulating K2 to fixed K2

A. This is generally identified with members of the Austrian school.

Ricardo had earlier written on this.

The problem is that wage payments and aggregate real income depend on the volume of turnover of circulating K2.

Volume is the product of K2 times its turnover.

When circulating K2 turns into fixed K2, it turns over much slower.

The Austrians attribute the problem to interest rates,

enforced by the creation of new money during a boom.

Another cause is overpriced land, inducing excessive substitution of K2 for land.

B. Overpriced land misguides investing, leading it into forms of K2 that substitute for land.

K2 that substitutes for land is mostly fixed K2, that turns over much slower than average.

This kind of K2 takes five forms:

-- land-saving K (tall buildings, motor traction for animal traction, etc.)

-- land-enhancing K, converting land to a higher use (subdivisions on farmland, stores for houses, irrigation for dry-farming, filling in shallow water, draining swamps, etc.)

-- land-linking K (street extensions, cars and trucks, rails and rolling stock, airports and aircraft, ports and ocean vessels, bridges, tunnels, transportation K of all kinds, ditches, pipes, cables).

When private land is enhanced, it always requires more infrastructure to link it with the center and/or other parts of the ecumene (cooperative economy).

Urban sprawl, a product of land speculation, multiplies the need for land-linking K

to by-pass the land held underutilized by speculators and holdouts.

-- claim-staking (rent-seeking) K

(water diversion works, logging roads, exploratory outlays, some R&D, losses incurred to secure broadcasting licenses.)

This is the slowest-turning K of all, because often the payoff is capturing land and its resources in perpetuity.

This K does not create the income it secures, it merely captures it, a zero-sum game.

The K expended may have little productive value, and be a social waste.

-- rent-leading K2 (excess capacity in land improvements, built in expectation of rising demand and rents).

C. The scarcity of liquid capital K1 dries up loanable funds.

The central bank is decelerating money growth, reducing bank reserves.

Loanable funds went too much to higher order fixed capital goods,

reducing the funds available for circulating capital goods.

For a time, around the upper turning point, this causes an upsurge of interest rates (before being overcome by Factor IV, discussed next).

The upsurge of interest rates should ideally be equilibrating, calling forth more funds.

In the circumstances, with much capital goods trapped unrecoverably in fixed forms,

the high interest rate fails to evoke much more funds,

but worsens the capital shortage by tightening the trap.

This occurs as follows.

First, a liquidity crunch stops completion of half-done projects, freezing more K, longer.

Second, a rise of real interest rates destroys part of the real market value of existing capital goods, in increasing measure of its putative longevity.

"Longevity" here means economic life, in the full economic sense.

It should not be confused with physical carcass life.

The "full economic sense" means the duration and time distribution of cash or service flows, properly adjusted for the time value of money.

This is an economic loss, a loss that is just as real as physical destruction.

After a rise of interest rates, the cash flow from durable capital will be divided

more in favor of interest, less in favor of Capital Consumption Allowances (CCAs).

The appropriate accounting adjustment on the asset side is called "marking to market value."

That recognizes the unrealized gain or loss.

The loss of value occurs whether or not it is formally recognized on the books.

Conversely, a fall of real interest rates adds to the real value of existing capital,

having the same effect as creating capital.

IV. Lower Marginal Rate of Return (MROR) on investing

A. Overpricing land and rents means a larger share of the pie goes to landowners as such.

That necessarily leaves less of the pie for true economic investors,

i.e. those who hire workers and create incomes to build new K2.

This, in turn, lowers MROR on investing; it lowers the inducement to invest.9

The social accounting that is part of macro-economic theory has long made it clear that

buying existing assets like land is not part of net economic investing, but a social wash.

An economic investment is an increase in capital goods or human capital.

There is positive feedback when the MROR falls.

Lower MRORs on new investing make land look more attractive as an alternative.

The lower capitalization rates push up land prices.

Higher land prices lower some MRORs still more,

 especially in the construction industry

which entails builders' buying raw land before building.

B. During a land boom those effects may temporarily be offset, and even reversed,

when the rise of land prices becomes part of the MROR to builders and users who hold land in the course of business.

That is, the high cost of buying and/or holding land is offset

by the further expected rise in its price, which gives the buyer, prospectively,

a return on the premium price he must pay.

It boosts his "animal spirits," even though in a frenzied, fervid way,

where unearned increment is melded confusingly with genuine productivity

as a return to investing.

There is also a rent-leading effect: land is over-improved, anticipating higher future demand during life of building.


This preternatural inducement to invest is inherently unstable,

because each price increment raises the price new buyers must pay,

and the holding cost for all landowners.

Inevitably, the rise must max out.

When it does, it must later fall, inasmuch as it reached its max

only through purchases by those who were motivated by a further rise.

When rises stop, there must then eventually be a fall.

When that happens, the high buying and holding cost of overpriced land

is coupled with a prospect of capital losses, leaving little or no inducement to invest in construction. This cycle helps explain the hairpin turn from boom to slump

that can occur at upper turning points of speculative booms.

C. During a land boom, the squeeze on MROR is also temporarily offset

by new investment outlets in land-linking.

High land prices justify these, as they do the meting of K1 to all kinds of land-substitutes. Extending roads, etc., brings vast new lands within the ambit of each urban market,

at the same time that higher land prices incite more intensive use of each parcel.

The process is, in the most favorable light, an equilibrating response to high land prices,

tending in the very long run to temper the rise of price.

In history, however, this process has been slow and massive and ultimately overdone,

swinging in great cycles of high amplitude, and a period of about 18 years.

The nature of land makes its price, during a speculative boom, a false guide to economizing. Land has no cost of production to anchor its price,

so the price is based entirely on forecasts which take years to confirm or refute.

"Land-use supersession," changing land use at any frontier of change

is slow and massive in itself, involving long construction periods, durable K,

and many parties with synergistic relations, often engaged in bilateral monopoly bargaining.

On top of that, each change sends shock waves through the entire system,

because there is a fixed land supply.

To re-equilibrate the system after a change at one frontier of use

calls for more changes at other frontiers,

to replace the land that was lost to a higher use at the first frontier.

D. The downturn is also triggered by a liquidity crisis.

Shortness of loanable funds pulls the cord on speculative land prices, thus down-valuing

much of the fixed capital recently sunk irreversibly

in designs premised on high and rising land prices.

Thus, land gets overpriced during speculative booms.

The overpricing is ultimately corrected by reallocating K2 to substitute for land,

but by the time the correction is done, too much K2 has been lost,

and locked up on fixed, non-circulating forms.

V. The Credit System Collapses

Banks almost always get caught up in land booms.

During an upswing they lend on the collateral of rising land values.

In cycle after cycle, clear back at least to the South Sea and Mississippi Bubbles of 1720,

they have expanded their liabilities based on this fragile collateral,

and come to grief in the ensuing downturn.

They did it again during the 1920s and 1980s, and now in this decade.

Each is a learning experience, but the social learning curve has been flat.

Why? Because the real estate cycle has not been assimilated into macroeconomic theory.

Bank expansion and collapse add to the severity of boom and slump,

so much so that the ordinary economist is likely to see the banking accordion

as the original cause, rather than the effect of the cycle.

Simple sequential observation, however,

shows that land cycles have a life of their own, leading banking cycles.

The credit system takes huge losses when land bubbles collapse.

The results aggravate a downturn.

A. Land prices ultimately collapse in a rapid fall, for two reasons.

1, a liquidity crisis brought on by Factors II and III.

2, a topping out of land prices brought on by the inherent instability of market buying

premised on further price rises to justify prices that are already high.

B. After losing on overvalued collateral, banks tighten their lending policies.

They and their government regulators tend to overreact, going from too loose to too tight.

This helps shut off the flow of loans to investors, true investors that is,

even though their kind was not responsible for the banks' problems with land collateral.

C. Banks raise charges, to compensate for their losses.

These charges are a burden on useful, productive commerce.

D. Bank contraction lowers M, the money supply, and its rate of circulation.

E. Banks call old loans, do not replace them with new.

That is, as loans are repaid, banks simply wipe them off their books, do not renew them.

Money disappears as though into a black hole.

Money is created when banks lend funds, and vanishes when a loan is repaid or written off.

F. Banks get stuck with long-term loans made during period of optimism.

Loan turnover drops.

Bank loans are creating less income per $ of assets.

In summary, the causes of downturns act in the following sequence:

1. Land is overpriced in a speculative movement.

2. Financial capital is wasted in bad investments.

3. Too much circulating K is converted to fixed K (the Austrian concept),

substituting for overpriced land (Gaffney's synthesis of George and the Austrians).

4. The MROR falls on actually improving and using land at highest efficiency,

diverting investors into either buying land (with a positive feedback effect),

or making substitutes for it (freezing up K, in an Austrian effect).

5. Shortage of circulating (liquid) capital leads to a liquidity crisis, pricking the land bubble.

6. The credit system collapses, aggravating the other, more basic problems.

A long depression occurs when, as a result of the above,

there is less liquid K to invest, and, at the same time,

there is less demand for K due to lower MROR on new K.

Supply and demand for liquid K thus meet at a lower volume.

Historically, this has often meant a lower level of interest rates,

causing many to infer that

the problem is one of an excess of liquid K seeking investment opportunities.

Rather, supply of liquid K and demand have both fallen,

meeting at a lower level, with less production and employment.

Through the factors and interactions described above,

the fall of supply actually triggers the factors causing an even greater fall of demand.

What really hurts is the low level at which supply and demand now meet.