Low Wages are Only a Symptom of What's Wrong With the Economic System

Edward J. Dodson

[December 2014]

The most important social policy question economists need to more objectively address is how to create a full employment society. Many economists argue, correctly but for reasons I find misdirected, that increasing the minimum wage will not help those at the bottom of the economic ladder. What happens when there is a general increase in nominal wages is that the increased income is absorbed by rising land prices. The same result occurs with increases in the productivity of labor and capital goods. This outcome is most clearly seen by examining residential property markets. Any combination of an increase in household income, lowering of the market rate of interest on credit, the reduction in the cash down payment requirements for the purchase of a property, the establishment of more flexible creditworthiness standards, and the availability of other forms of subsidy will be capitalized by market forces into higher land prices. And, the result is higher prices for residential properties.

At the same time, the almost universally-low effective rate of taxation on the rent of land (i.e., the potential annual rental value of locations and land-like assets) prevents the price mechanism from working to establish a market-determined general equilibrium outcome. Instead, rising prices for land increase the expectation by the landed for even greater increases to come. More and more land is held out of use or acquired for speculation rather than development. Grafted, this is reflected by a leftward leaning supply curve for land during the upward, credit-fueled, speculation-driven years of an 18 to 20 year land market cycle. The same supply curve is also possible even when prices are falling because owners of land that was offered for development will withdraw supply waiting for the next upward trending price cycle. Unfortunately, one will rarely, if ever, see this type of supply curve in an economics text.

My own examination of residential property appraisals during the last property market cycle revealed that in many metropolitan markets land-to-total value ratios had climbed to well above 50 percent. In the most expensive cities (e.g., San Francisco, Washington, DC, Boston, New York City) the median ratio in some neighborhoods was as high as 80 percent. This meant that the housing unit purchased represented only 20 percent of the purchase price. These high land-to-total value ratios are found where the property improvement is older and is often a use that no longer meets the test of highest, best use.

Land acquired by developers at or near current market value will tend to be developed intensely in order to recover the land acquisition cost. In most cities, the result is a multi-story building, which allows the land cost to be broadly distributed in the price of (or leasing charges) to those individuals, households, businesses or other organizations who potentially occupy the building. Of course, there are circumstances when a developer will purchase a property and demolish the existing structure if renovation is not economically advantageous or possible. In these instances the full cost of land acquisition also includes the cost of demolition and site clearance.

The stress of rising land prices on the general economy is real but is not well-understood by policy makers, market analysts or most economists. Escalating land prices trigger economic contractions that are not effectively countered by the fiscal and monetary tools governments have employed since the Great Depression of the 1930s. A society able to reduce land prices to a low level that remains low year after year would experience non-inflationary economic activity subject to far fewer systemic shocks. Recessionary downturns would be few in number and of much shorter duration.

When property markets across the United States began to crash in 2007 and 2008, one way to respond was to allow property (i.e., land) prices to find the price level where people could afford to acquire land for whatever purpose they desired. That was also the right time to pass legislation that would have prevented the nation's banks from providing the credit -- the fuel -- for yet another speculation-driven land market cycle to begin. Any financial institution that accepted government-insured deposits should have been prohibited from extending credit for the purchase of land or acceptance of land value as collateral for other purposes. The practical impact would have been to return to the era of banking when the purchase of real estate required a minimum 20 percent cash down payment, essentially covering the cost of land acquisition, while extending credit under an amortization schedule that roughly matched the rate at which a property improvement depreciated.

What instead occurred was a deliberate effort by the Federal Reserve and the Federal government to prop up property (i.e., land) prices where demand had disappeared and property prices fell to below the replacement cost of housing units. In the short-run these policies lessened the number of foreclosure sales as well as post-foreclosure losses experienced by investors in residential mortgage loans. Rising land prices in some markets also enabled some mortgagors - those with stable income and employment and a high credit score -- to refinance out of high interest, sub-prime mortgage terms. Assistance for those mortgagors victimized by mortgage loans with predatory terms and outright fraud was often too late to prevent them from being evicted, their properties acquired at foreclosure sale by speculators. Investigation into criminal activity was in most states given a low priority for law enforcement.

The people hurt most directly by the economic contraction that began in 2008 continue to experience difficulty finding full-time employment at a wage that allows them to live a decent, human existence. Many continue to have a difficult time finding even rental housing they can afford. Raising the minimum wage would put additional income into the hands of some lower income individuals. Others may lose employment because marginally-profitable businesses release employees. The other result will be to increase the cost of housing for these same people, as the increased purchasing power achieved will be absorbed by rising land prices (and, by extension, rising costs of apartment units).

Government at all levels has not been able to find the resources to acquire sufficient land for development of affordable rental or homeownership housing. Low income housing tax credits has not been sufficient to stimulate investment in this market segment. Nor have tools such as inclusionary zoning resulted in the construction of new, affordable housing units where the need is greatest. The real solution is to remove the speculation-driven character of the nation's land markets. And, the only way this can be achieved is the imposition of an annual tax equal to the full potential annual rental value of every parcel or tract of land.