onsdag 19 mars 2008

Just a crisis of confidence?

Are the present troubles just a crisis of confidence or is there something real going on?

"Credit" comes from the Latin word "credo", meaning "I believe", and refers to the trust that has to exist between individuals and companies in order for the economic process to function. And so, to the extent that the economy depends on credit, the collapse in confidence is itself a real economic effect.

But there is something more substantial going on as well. For production to take place, three factors must be available and brought together. These are Land, Labour and Capital. The yield to land is called Rent. Essentially, it is the productive advantage of the site or location and appears as an income stream.

Analysis of a slump
The fundamental value of a piece of land is this income stream. The purchase of land is in principle the purchase of an income stream, the rental value. And if that were all there was to it, land prices would be such that ratio between rental value and the the land price was much the same as the general interest rate, which is usually around 5%. Land values are normally expressed in inverse interest rates known as Years' Purchase (YP), a figure which at 5% would be 20.

But rental values have a tendency to rise, and so the expectation of future rentals is factored in to land prices. Thus yields from land tend to be lower than yields from other investments.

At the bottom of an economic cycle expectations are low. But as the economy pulls out of recession, expectations of rental income growth start to rise and land prices with them. As time goes on, speculators, seeing land prices on a fast-rising trend, pile into the market and push them up further, thereby depressing yields well below the general interest rate.

It then gets worse. Banks, who use land as collateral for their loans, become increasingly willing to lend money for land purchase (usually property purchase, but it is the land element of the property that is behaving according to this description). This drives up land values still higher and depresses the yields still further.

Eventually, yield rates become absurdly low and loans become increasingly difficult to repay out of the earnings from the land investment. Things are on a knife edge and the slightest hiccough will bring the hollow edifice down, which is what was initiated by the sub-prime loan crisis last year.

What happens next? There will be some distress selling. The housing market will slow, which will cause related industries such as construction and furnishing to slow with them. This will eventually lead to large scale unemployment. A further effect that will be seen is a proliferation of vacant factories, vacant offices and empty sites. They will mostly not come onto the market because there are many people who own them who would have to accept less than they paid, and there are also the book values of those sites that would then have to be written down. This withholding of land from the market will slow the recovery, as it has slowed the recovery from previous depressions, because it prevents nascent businesses from setting themselves up in suitable locations. There is a solution available to courageous politicians who know what they are doing, but such politicians are unlikely to appear out of the blue. And so, on this analysis, one cannot expect much in the way of recovery until around 2015.

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