fredag 11 april 2008

More on the so-called housing bubble

The housing bubble is essentially a land price bubble, since the value of buildings is relatively constant and depends on construction costs. The purchase of a piece of land is the purchase of the future rental income stream, which is the value of the advantages of the particular location. From this point of view, it is in principle much like the purchase of an annuity.

if that were all there was to it, land prices would settle at a level such that the ratio between rental value and the the land price was much the same as the general interest rate, which is usually around 5%. There would be no cyclic bubbles. 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 could be seen about ten years ago. 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.

A positive feedback loop then takes hold. Lenders, who see land as solid 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 so low that loans become increasingly difficult to repay out of the earnings from the land investment. Things are then on the point of bursting and the slightest disturbance will prick the bubble. In the latest instance, the initiator was the sub-prime loan crisis last year.

The land price bubble would be of little more signficance than the seventeenth century tulip price bubble or the dot-com bubble if it were not that land is one of the factors of production. A few speculators would be left nursing their losses but that would be all.

But because everyone's home, and all productive capital, stands on plots of land, any disturbance to the land market will have deep and prolonged effects as resources are held off the market. This is why the consequences will, as with all previous land-based bubbles, continue for several years.

The system can be compared to like an electrical circuit with a positive feedback loop. Such configurations are liable to oscillation. Data going back to the start of the nineteenth century points to a periodicity of around 18 years due to this interaction between the banking system and the land market.

As with electrical systems, the way to prevent unstable oscillations is to introduce an element of negative feedback. One way to achieve this would be for governments to collect the rental value of land and use it as their principal source of revenue, instead of existing taxes on labour and capital. Speculative trading in land would then be pointless as there could be no expectations of higher rental income streams. Moreover, banks, unable to employ land as collateral for their loans, would have to devise other means of operating profitably. They might, for instance, charge directly for more of their services. Loans would have to be made primarily on an assessment of the likelihood or otherwise of their being repaid.

But as this is one tax reform that is not going to happen, it would be prudent to pencil in the date of the next crash, around 2026.

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