Why the United States is Strategically Placed to Experience a Return to Stagflation

Edward J. Dodson

[A Paper Prepared for but not Presented at the 2006 International Conference ("The Economy of Abundance")for Land Value Taxation and Free Trade, London, England, 2-8 July]

When Fred Harrison asked me to participate in this conference and to provide you with an analysis of the state of the United States economy - and the housing sector, particularly - I wondered what changes might be observable between then (roughly a year ago) and now. Fred has done a very thorough and persuasive job of tracking the historical correlation between the 18-year cycle of land markets and the tendency of societies to experience "booms" and "busts." Armed with the perspectives provided in the writings of Henry George and many others who followed in George's footsteps, our hope is that a major shift in how governments raise revenue can be implemented before it is too late to soften the downturn forecasted by Fred Harrison.

What I bring to this discussion, if anything of value, is to focus attention on externalities that affect the duration and severity of the economic downturns thought by many to be inevitable. Chief among these - but in no particular order -- are:

• The extent to which government raises its revenue from the taxation of unearned income flows, whether realized or imputed. In the United States this takes two primary forms: (1) the annual taxation by municipalities, counties and school districts of assessed land values; and (2) a tax on the gain experienced on the sale of tracts of land and non-material assets.
  
• The method of leasing publicly-held lands to private concerns for mining, timber harvesting, and grazing. The key variable being: to what extent the public receives full market value for the licenses granted. Failure to do so amounts to a huge subsidy to license holders.
  
• The pricing structure for bringing water to arid lands, thereby permitting agriculture. Water subsidies give the land either a leasehold or fee simple value that would otherwise not arise.
  
• The progressivity of the taxation of income flows, generally - and the extent to which the revenue raised is allocated to social welfare programs providing pubic goods and services to low and lower income households.
  
• The ability of individuals to migrate from one region of the country to another to obtain employment and/or increase disposable income (i.e., take advantage of a lower cost of living).
  
• The ability of businesses to protect or increase profit margins by relocating from one region of the country to another; or, for larger entities, establishing production facilities in multiple regions to achieve net competitive advantages.
  
• The impact of rising Federal government spending above the revenue raised via taxation and the resulting amount of revenue that must be allocated to servicing the Federal government debt.
  
• The escalating concentration of income and wealth among the top few percent of the U.S. population.
  
• The escalating fiscal and social costs associated with worsening poverty, homelessness, violent crime, drug and alcohol addiction, and illegal immigration.
  
• The rising costs of responding to natural disasters that have become increasingly more frequent and often devastating because of populations being subsidized, thereby encouraging them to settle "in harm's way."
  

What this admittedly incomplete list says to me is that the United States, as a society and as an economy, buffers the workings of the historical 18-year land market cycle in ways we do not fully understand. Political scientists have used the term "disjointed incrementalism" to describe the process by which public policies are decided upon and implemented in the United States. The impact of many such policies is consistently inconsistent, simultaneously encouraging and thwarting the production of goods and services, ostensibly focused on economic expansion but resulting in a society plagued by rising poverty and economic stress. In more recent years, the disconnect has been between the rhetoric of equality of opportunity and the outcomes that benefit the few at the expense of the many.

A half-century of liberalism in the United States created a delicate balance of power that grew and reached its height of stability during the early 1970s. The economist John Kenneth Galbraith wrote that the power of financial and industrial capitalists was being offset by an increasingly interventionist government and by the unity of working people under the protection of labor unions. An argument can be made that the primary beneficiaries of governmental expansion have been bureaucrats, lobbyists and the contractors supplying government with its material needs. Even organized labor continues to display strength only in those sectors of the society where the services performed cannot be moved offshore (e.g., public school teachers and government employees). As labor unions have lost membership, however, another powerful sector has arisen to stand beside - and sometimes challenge -- "big" business and "big" government. These are the tax-exempt foundations -- established quite often with the personal fortunes accumulated by some of the nation's wealthiest citizens, with themselves or their heirs controlling the majority of votes on the boards of trustees. Corporations, such as my former employer, Fannie Mae, establish foundations with the intent of combining the furtherance of business interests with altruism. In this way, corporations increase their ability to do well by going good.

Our system of laws in the United States grants all manner of privileges and advantages to some individuals and to some entities. Not-for-profit organizations, for example, are not subject to taxation of income earned from investments. On the other hand, individual investors are penalized by taxes on any gains experienced, with a higher rate of taxation imposed when an investor engages in active buying and selling of financial assets rather than making such purchases as "long-term" investments. Thanks to significant reductions in the taxation of estates, the wealthiest individuals in the United States are now able to pass on their assets to heirs with only nominal Federal estate tax obligations. There is no distinction made between assets earned by producing goods or providing services and assets acquired as a result of passive forms of investment and rent-seeking activities. Investors are able to take advantage of "tax credits" for such socially-motivated investments as the construction of housing affordable to low- and moderate-income households, or to restore historically-designated buildings.

Some in the United States are perfectly content with the outcomes experienced. They are not at all bothered by the fact that asset ownership is highly concentrated. How concentrated? The top 1 percent of households hold over one-third of all privately-owned assets. The top 20 percent of households owns nearly 85 percent of all assets. For those in the top fifth of households, the average net worth today is around $1.5 million. Below the top fifth percentage of households, the main source of net worth is equity in their homes - and the land parcels thereunder. Households in the bottom fifth own no property and are frequently without employment, often for several years at a time.

Good Times … for the Fortunate Few

The beginning of the rise in household net worth associated with homeownership began in earnest after the Second World War. The introduction of government-insured mortgage loans, a national pool of savings created by four years of war-time full employment, and the Federal government's massive highway construction program combined to stimulate suburban development all across the United States. The generation of adults who began to retire in the late 1970s did so with greater net worth and better pension incomes than any previous generation. And yet, rising costs of living meant there would be much less wealth than statisticians forecasted to be passed on to the next generation. Today, fewer than 2 percent of those who inherit wealth receive greater than $100,000. Another 1 percent inherit between $50,000 and $100,000.[1]

The mid-1970s were characterized by a dramatic erosion in the industrial base of the U.S. economy. The so-called Phillips Curve proved to be an illusion. We experienced a general rise in prices along with high unemployment. After becoming President, Lyndon Johnson spent lavishly during the mid-1960s to stem the spread of communism in Southeast Asia and to fight his War on Poverty. Richard Nixon promised to end U.S. involvement in Southeast Asia; however, with each passing year of continued fighting he escalated the spending. And, in domestic affairs he declared that he had become a Keynesian. Economic stability in the United States was already in trouble when the oil-producing nations formed OPEC and quickly drove the price of oil up from a few dollars a barrel to well over $40. The global economy drifted into what economists referred to as stagflation. U.S. wage earners were hit hardest, of course. The wealthiest Americans benefited from rising interest rates on corporate and government bonds, as the U.S. government increasingly relied on the credit markets to meet escalating expenses. And, those with deep financial pockets began to accumulate property at fire sale prices from financially-troubled owners. As the decade of the 1970s came to an end, so did the modest increase in the proportion of total wealth shared by the bottom 99 percent of the population.[2]

In just the last twenty years, the number of billionaires in the United States has climbed from fewer than twenty to nearly 400 (as reported by Forbes magazine). When Forbes reports on the wealthiest 400 people today, they are reporting on multi-billionaires. Yet, as recently as 1985, the Forbes 400 had an aggregate net worth of $238 billion. Today, their personal fortunes have an inflation-adjusted value of well over $1 trillion.[3] Compare this to the median household income in the United States, which is still well under $50,000. And, even more insightful is the fact that more and more households consist of two adults employed full-time in order to obtain incomes above the national median. Edward Wolff, a professor of economics at New York University who has performed extensive research on the growing wealth gap, a few years ago described the situation in the United States as follows:

"The bottom 20 percent basically have zero wealth. They either have no assets, or their debt equals or exceeds their assets. The bottom 20 percent has typically accumulated no savings. A household in the middle - the median household - has wealth of about $62,000. $62,000 is not insignificant, but if you consider that the top 1 percent of households' average wealth is $12.5 million, you can see what a difference there is in the distribution."[4]

The Republican-Driven Drive to Untax Rent-Seeking

The era of renewed wealth concentration began soon after the Republican party captured the U.S. Presidency in the election of 1980. Reagan advisers promoted reductions in the taxation of capital gains (i.e., gains on the sale of any and all assets held for investment purposes) and on the highest ranges of individual incomes. Up to this time, both Democrat and Republican-headed administrations relied on targeted tax credits to promote investments in new plant and equipment by businesses.

An unforeseen consequence of the new strategy turned out to be a dramatic increase in Federal government debt. The gamble of Reaganomics was that lower marginal tax rates would stimulate economic growth and job-creation. Instead, the increase in disposable income that came to high income households was converted into speculative investments in the stock market and in real estate. By late 1987 an overheated stock market experienced a major correction. In New England, where huge investments in technology firms had spawned a real estate boom and a run-up in land prices, layoffs and the bankruptcy of key employers brought on a region-wide crash. New England was hardest hit, but other parts of the country shared in the downturn. All across the country, savings banks had fought to regain profitability after years of losing deposits to the money market funds while they were, themselves, prohibited from diversifying into higher yielding loan products. Once deregulation finally arrived, they tried to create paper profits by making riskier loans to developers and small businesses. Many also joined with the major banks to take participations in loans made in the international markets. Thus, the financial services sector provided the leverage to fuel an enormous speculative fire, and when regional economies suddenly imploded, a large number of the savings banks and a lesser number of commercial banks were forced to close their doors. Thousands of white collar and technology workers found themselves in much the same position as unemployed industrial workers. Older workers, in particular, suffered most.

With the U.S. economic recovery in jeopardy, Reagan's more traditionally conservative appointees pressured him to reverse the earlier tax cuts. The deficits were becoming a serious worry because of the threat of rising interest rates. The housing markets were dead in the water, and in some areas the value of homes (or, more accurately, the land on which they sat) fell well below the mortgage debt carried by homeowners.

George Bush came into office just as the economy was heading into the savings and loan crisis. Commercial real estate was also experiencing the consequences of overbuilding. Newly-constructed but vacant office buildings dotted the landscape from Boston to Los Angeles.

The nation eventually lost confidence in the Republicans and voted in William Jefferson Clinton in 1992. The next eight years were marked by a gradual but sustained return to profitability for many of the nation's businesses, particularly those that had refrained from borrowing to expand operations. Property bargains abounded for those with ready cash and/or access to credit. A growing number of companies shifted production to low wage and low regulation countries, such as Mexico and China. India also began the process of dismantling its long-standing bureaucracy in order to attract foreign investment and to nurture the growth of Indian-owned businesses. New jobs were created to offset those moving out of the United States; however, as many critics have documented, most of the expansion in employment has come in the service sector, where salaries and benefits are much lower. The competition for high-paying managerial positions is very keen, with fewer opportunities available due to corporate downsizing. Moreover, financial stress is keeping older workers on the job longer than most had anticipated. So, the turnover at higher level positions from the "baby boomer" generation to younger workers has slowed.

Another factor that benefited the United States during the 1990s was lingering recession in much of Europe, in Japan and Korea. Uncertainty kept foreign investors in the U.S. capital markets, and this inflow of funds caused interest rates to fall to single digits and continue in a downward direction. The U.S. government was able to reduce debt service by billions of dollars annually as the national debt was refunded at lower rates of interest. Millions of homeowners refinanced, saving hundreds of dollars in monthly mortgage payments. The stock market renewed its upward climb as well. By the mid-1990s, investors were once again plowing money into land and real estate, chastened by losses experienced in the stock market and looking to property as something real and tangible with tax advantages and actual cash flows.

Yet, what Clinton and the Democrats could not reverse was the major decline in revenue sharing to the states and cities that occurred under the Reagan and Bush administrations. Many of the nation's older cities were experiencing serious financial difficulties and were forced to raise taxes while cutting back on critical public services. By the year 2000, with Democrats claiming economic recovery had been achieved, the combined federal, state and local burden of taxation on the nation's wealthiest 400 taxpayers averaged just 27 percent, but averaged 40 percent on all other taxpayers.[5]

The Clinton years only slowed the rate of increase in wealth and income concentration. By 2000, the top .01% -- that's one hundredth of one percent of U.S. households - enjoyed an average income of $24 million, up from $3.6 million in 1970. At the same time, the average income for the bottom 90 percent of households declined slightly to around $27,000.[6] Thanks to tax cuts pushed through by the current Republican administration and Congressional majority, the rewards to rent-seeking investment strategies renewed their accelerated pace.

The Mortgaged Generations

The rate of homeownership in the United States is now reported to be nearly 68 percent. A significant commitment has been made in many parts of the country to increase the rate of homeownership among minorities, which has reached something of a plateau at around 50 percent. Data published by the National Association of Realtors indicated that the average price nationally for what are described as "starter homes" (e.g., town homes, condominium units, units in buildings with two or more total units) had increased during 2004 by $23,500 to $183,500. A new homebuyer making a 10 percent down payment and acquiring a 30-year fixed rate mortgage loan at current rates of interest would have a monthly mortgage payment of over $1,000 (not including escrows for real estate taxes, private mortgage insurance and homeowners insurance, plus a condominium or homeowners association fee). With a total monthly housing expense of $1,500, buyers would need a minimum annual income of around $55,500. The median income for households looking to purchase their first home is less than $33,000.

Three reasons why the housing sector has been strong in the United States over the last decade are: (1) the acceptance of mortgage-backed securities by investors, leading to a previously unimagined expansion of the secondary market for residential mortgage loans; (2) the widespread introduction of down payment and closing cost assistance programs by government agencies at the local, county and state levels; and (3) the imposition of "inclusionary zoning" requirements on developers, mandating that a certain percentage of housing units constructed meet defined affordability criteria (e.g., setting of a maximum sales price to be affordable to households with incomes between 80-100 percent of area median). Cities and other communities often contributed land without charge; and, when this was not sufficient to make units affordable to the people living in the area, tax credits or direct subsidies to construction costs were applied. To ensure long-term affordability, the sale of subsidized units is restricted to households within the targeted ranges of household income. Thus, only as the area median incomes rise can the housing unit and land parcel be sold for more than the original price paid.

With land values continuing to climb across the nation, homeowners could feel good about their decision to acquire property even if the amount of debt taken on seemed almost unimaginable to many who were selling in order to downsize and prepare for retirement. And, in fact, Americans are increasingly selling to get out from under the heavy costs of living that exist wherever land - and housing - prices have escalated. Seniors, even those who are moderately well off financially, are pressed by constant increases in property taxes. Something of a national revolt against property taxes is underway, and politicians are lining up with proposals to introduce "circuit-breakers," caps on property tax increases and shifts to the taxation of consumption and those with higher incomes.

A recent survey of Massachusetts residents revealed that fully one in four people stated they would relocate out of the state if they could. Already, over 170,000 people left Massachusetts between 2000 and 2004. California is close behind, with the departure of around 100,000 people annually. Hawaii's housing costs and overall cost of living is even higher and is causing a steady departure of residents. Affordability generally means getting away from the coastal cities and moving into the nation's heartland. For a number of years, Californians - businesses and individuals - headed to Nevada and Las Vegas. Now, Las Vegas land and housing has escalated to the point where some in Las Vegas are selling out and moving on to less expensive parts of the country.

Americans have been moving to the South and Southwest in large numbers for a half century. As Florida is becoming less and less affordable, developers have been acquiring land and creating new enclaves elsewhere for the moderately well-to-do "active" seniors. Homeowners in high cost regions are leaving with hundreds of thousands of dollars of gains on the sale of their property, taking this purchasing power to areas where the local land markets have escaped the upward spiral because the population is low and the economy rural and comparatively low-wage. For the receiving region, the impact is not always positive. This is particularly the case in and near resort areas, where the primary type of development is luxury second home housing. Land prices have climbed to such heights that almost no one who must work for a living in these resort communities can afford to live within even a reasonable commuting distance.

During 2005 in the United States nearly 8.4 million residential properties changed hands, of which 1.3 million were newly-constructed homes. The average price paid for existing homes reached $258,700. For new housing, the average price was almost $273,000. Thus, in just one year nearly $2.2 trillion was spent on residential homes. A conservative estimate of the land-to-total value is 40 percent, or $880 billion. Data published by the Federal Reserve Board indicated that at the end of 2005 the total mortgage debt owed on 1- to 4-family properties surpassed $8.5 trillion. Another $630.4 billion was owed on 5-unit and larger residential properties (i.e., apartment buildings) and $1.8 trillion on commercial buildings. Despite past experiences with bank collapses, the nation's financial institutions are holding nearly $4.2 trillion of this mortgage paper. Fannie Mae and Freddie Mac, have combined portfolios of around $550 billion, and both individual and institutional investors have interests in mortgage-backed securities totaling $5.3 trillion.

Total consumer debt doubled between 1993-2003, to nearly $2 trillion, a figure that did not include mortgage debt. First and second mortgage loans outstanding added another $6.8 trillion. Some analysts warned that total household debt had climbed to never before seen levels and that household savings had fallen to less than 2 percent of after-tax income. A report by the Economic Policy Institute in Washington, D.C. noted that "debt service" absorbed "the biggest share of income from the lowest-income families." Almost any interruption in employment or income would devastate a large and growing number of American families. Over 1 percent of all mortgage loans were in default and headed for foreclosure. The American Bankruptcy Institute reported that the number of personal bankruptcies doubled during the 1993-2003 period, averaging more than 1.5 million annually. To that number was added another 1.6 million bankruptcies in 2004 and 1.8 million in 2005.

Stressed to the Breaking Point?

The real question is one we will soon have the answer to. Are all of the inter-connected variables described above sufficiently strong to bring the United States economy to the breaking point? Or, will all of the fiscal and monetary tricks learned over the last sixty odd years trigger a series of circuit breakers and result in a soft landing? When the younger George Bush leaves the Office of the Presidency in a few short years, the Federal government debt will be over $10 trillion and rising. With interest rates rising, the annual cost of servicing this debt will approach $500 billion. Where is this revenue to come from? The bottom 20 percent has little income and no savings. The top 20 percent escapes taxation. The remaining 60 percent is already heavily taxed and deeply in debt.

An economics professor many of us know in the United States, Fred Foldvary, has recently provided his own analysis[7] of where the U.S. economy seems to be headed. I end this paper with some of Fred's insights for all to ponder:

• Economic investment drives the business cycle, and a third of investment is related to real estate. As construction declines, workers in that industry as well as complementary fields such as real estate finance lose their jobs. Homeowners will stop borrowing on the equity of their real estate. Their demand for goods declines, reducing profits in the rest of the economy. The reduction in investment and consumption eventually brings down total output, and the recession then strains the banking system as homeowners walk away from their loans.
  
• Interest rates are not going up because of an increase in demand for money for investment, but the demand for new money for investment will in fact be suppressed by the Fed and contribute to a new recession. The increasing interest rates will cool the markets and soften demand for both consumer and investment goods.
  
• This will result in a decline in net worth which is supposed to be the basis for new money being put into circulation. The shrinkage in new money creation will be attended by a shrinkage in investments, jobs and wages, resulting in a recession.
  
• The real estate boom was unsustainable because mortgage payments come out of wages. Productivity has been growing, but the extra income is not going to wages. A little of it goes to the high salaries of top executives, but most of it goes to land rent and land value.
  
• Short supply of land with an increase in money supply causes inflated land and housing prices. When the cycle reverses, interest rates go up and demand for houses goes down but the current owners are stuck in upside down mortgages until eventually they can not make the payments. The banks take the houses or the towns take them for non payment of taxes and auction them off. Then the 'get rich quick in real estate guys' go into business with out really working to recycle the houses.
  
• The real estate boom is not caused by the non-existent free market. Governments induce people to speculate in real estate with artificially low interest rates and with tax advantages. Those who sell their homes escape much of the capital gains tax, while property taxes and mortgage interest are tax deductible. Low-income housing yields tax credits, and those who own rental properties can depreciate them and then swap them with no tax. Speculators get rewarded, while the ordinary worker who is not already a landowner gets increasingly shut out of home ownership. Those who did buy a house with risky adjustable-mortgage loans could lose their homes if they get laid off or when interest rates rise and they can't afford the higher payments.
  
• The dysfunctional policies that drive the real estate boom and will lead to the coming bust are so ingrained in our political culture that they will not be dislodged any time soon. Fundamental reforms in taxation and the financial system will only come about after a crisis.
  

Afterwords

There is almost no possibility that our elected officials will be persuaded to take the steps required to avoid the next recessionary downturn. With too few exceptions, the economics community pays almost no attention to the stresses caused by rapidly rising land prices on the productive sectors of the economy. As noted above, there is an expanding grass-roots opposition to the "property tax," generally, that is already resulting in measures that will merely add more fuel to the speculative fires that drive land prices upward.

NOTES

1. Federal Reserve Bank, Cleveland, Ohio.

2. Data for the years 1922-1989 compiled by Edward N. Wolff, Top Heavy (New Press: 1996) and 1992-1998 by Edward N. Wolff, "Recent Trends in Wealth Ownership, 1983-98," Jerome Levy Economics Institute, April 2000 indicate the top 1 percent held 19.9% in 1976, 20.5% in 1979, 24.8% in 1981, 30.9% in 1983, rising to 38.1% in 1998.

3. See: Nina Munk. "Don't Blink. You'll Miss the 258th Richest American," New York Times, 25 September, 2005.

4. An interview in Multinational Monitor, Vol.24, No.5, May 2003.

5. Source: Internal Revenue Service. On average, these 400 taxpayers each had taxable income of $151 million. All other taxpayers had average taxable income of only $34,600.

6. See: David Cay Johnston. Perfectly Legal.

7. Fred Foldvary. "The Real-Estate Deceleration," The Progress Report (The Banneker Center for Economic Justice), February 2006.