The Price Mechanism and Land Markets

Edward J. Dodson

[An unpublished essay written in March 2009]

Yes, economic theory is or ought to be an objective means by which public policies are evaluated. And, yes, Austrian theory of the financial markets is an important component in the analysis of what causes so-called "business cycles." However, Austrian theory has a major weakness (the source of which plagues neoclassical theory, neo-Keynesianism, supply-side economics, monetarism, rational expectationism, etc.). This weakness is the discarding of nature (i.e., "land" as treated by political economy) as a distinct factor of production, the supply of which is essentially inelastic and subject to hoarding and speculation distinct from that of labor, capital goods and even credit.

Price does not operate to return land markets on an ongoing basis to a state of general equilibrium. In the real world, the supply curve for locations actually leans to the left in a period of rising prices. With the exception of banks that acquire property assets due to foreclosures (and, by regulation must liquidate those assets quickly even when the demand for property is at a low point in the property market cycle), owners of land will withdraw supply when prices are rising in anticipation of even greater unearned gains. They will also withdraw supply in a period of falling prices because land does not experience depreciation or loss of functional utility. Land investors who have not leveraged themselves by borrowing late in the property market cycle to speculate will just sit out and wait for the return of rising land prices. Moreover, the generally low carrying cost of holding land means that a large portion of existing landowners do not even think about the land they hold as potentially part of the supply coming to market. In every community upwards of one-fourth or one-third of the land area is held off the market for generations.

Ricardo (and Smith, and that entire generation of political economists) understood the operation of land markets far better than today's economists who adhere to any of the above schools of thought. These early theorists understood that net imputed income streams (i.e., what they referred to as "ground rent") derived from control of locations were capitalized by market forces into a selling price for land. Most economists have, paradoxically, ignored the presence of location rents as driving forces in the property markets and, hence, the corresponding stresses imposed on the economy that pull us into a recession or depression.

The credit-issuing behavior of the banks, mortgage loan investors and other players in the credit markets provided the accelerant to an already existing speculative fire. Throughout this last property market cycle (which began around 1989-90), the land-to-total value ratio of mortgage loans made and securitized (both in the commercial and residential markets) continued to climb. Thus, lenders were lending more and more on land value and less and less on building value. The frequency of outright fraud (and gross negligence on the part of the bond rating agencies, the Fed and regulators) resulted in the huge quantity of loans made to individuals and investors without regard to creditworthiness and often based on appraised values unsubstantiated by comparable sales. When the cost of land (both purchase price and leasing costs as reflected in the rising costs of leasing space in buildings) reached high points in 2006 and 2007, the stress on the global economic system resulted in the collapse of property markets. A chain reaction of defaults, foreclosures, business failures, rising unemployment, government deficits and societal instability has been the inevitable result.

The bottom line is that unless we implement policies that stabilize land markets and remove the incentive to hoard and speculate in locations (and, natural resource laden lands, as well as the broadcast spectrum and other rent-generating components of the land markets) we are destined to repeat this cycle every 18-20 years. That is, if we actually recover from the depths of this latest economic crisis.