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Credit Booms Gone Wrong

Too Much of a Good Thing?

by Fred E. Foldvary

Recent research by economists Moritz Schularick and Alan M. Taylor have confirmed the theory that economic booms are fueled by an excessive growth of credit. They have written a paper titled “Credit Booms Gone Bust: Monetary Policy, Leverage Cycles and Financial Crises, 1870–2008" (http://www.nber.org/papers/w15512), published by the National Bureau of Economic Research.

A major cause of the Great Depression was a credit boom, as analyzed by Barry Eichengreen and Kris Mitchener in their paper, “The Great Depression as a credit boom gone wrong” (BIS Working Paper No. 137, http://www.bis.org/publ/work137.pdf). Eichengreen and Mitchener cite Henry George’s Progress and Poverty as providing an early theory of booms and busts based on land speculation. They also credit the Austrian school of economic thought, which in the works of Friedrich Hayek and Ludwig von Mises, had developed a theory of the business cycle in which credit booms play a central role. Henry George’s theory of the business cycle is complementary to the Austrian theory, as George identified the rise in land values as the key role in causing depressions.

An expansion of money and credit reduces interest rates and induces a greater production and purchase of long-duration capital goods and land. The most important investment and speculation affected is real estate. Much of investment consists of buildings and the durable goods that go into buildings as well as the infrastructure that services real estate. Much of the gains from an economic expansion go to higher land rent and land value, so speculators jump in to profit from leveraged speculation. This creates an unsustainable rise in land value that makes real estate too expensive for actual uses, so as interest rates and real estate costs rise, investment slows down and then declines. The subsequent fall in land values and investment reduces total output, generates unemployment, and then crashes the financial system.

We can ask whether this theory is consistent with historical evidence. One strand of evidence is the history of the real estate cycle, which has been investigated by the works of Homer Hoyt, Fred Harrison, and my own writings. Another strand is the history of credit booms, as shown by Schularick and Taylor, who assembled a large data set on money and credit for 12 developed economies 1870 to 2008. They show how credit expansions have been related to money expansions, and how financial innovations have greatly increased credit. Because economic booms are fueled by credit expansion, Schularick and Taylor note that credit booms can be used to forecast the coming downturn.

Followers of Henry George have focused on the real estate aspect of the boom and bust, while the Austrian school has focused on credit, interest rates, and capital goods. A complete explanation requires a synthesis of the theories of both schools, but these recent works on credit booms have not recognized the geo-Austrian synthesis. In order to eliminate the boom-bust cycle, both the real side (real estate) and the financial side (money and credit) need to be confronted.

Current Austrian-school economists such as Larry White and George Selgin have investigated the theory and history of free banking, the truly free-market policy of abolishing the central bank as well as restrictions on banking such as limiting branches and controlling interest rates. In pure free banking, there would be a base of real money such as gold or a fixed amount of government currency. Banks would issue their own private notes convertible into base money at a fixed rate. The convertibility and the competitive banking structure would provide a flexible supply of money along with price stability. The banks would associate to provide one another with loans when a bank faces a temporary need for more base money, or a lender of last resort.

Both the members of the Austrian school and the economists who have studied credit booms have not understood the need to prevent the land-value bubble by taxing most of the value of land. That would stop land speculation and eliminate the demand for credit by land buyers.

But the credit-bubble theorists have not understood that financial regulation and rules for central banks cannot solve the financial side of credit bubbles. Credit booms always go wrong. As the Austrians have pointed out, there is no scientific way to know the correct amount of money or the optimal rates of interest. Only the market can discover the rate of interest that balances savings and borrowing, and only the market can balance money supply with money demand.

Thus the remedy for the boom-bust cycle is both land value taxation and free banking. With only the latter and not the former, land speculation would not be as bad but will still do harm as land speculators, enticed by rising land values, suck credit away from productive uses. Conversely, land-value taxation without stable credit will still result in excessive construction and the waste of resources in fixed capital goods, reducing the circulating capital needed to generate output and employment, as Mason Gaffney has written about. Economic bliss requires both the public collection of rent and a free market in money.

This article first appeared in the Progress Report, www.progress.org. Reprinted with permission.

Dr. Fred Foldvary teaches economics at Santa Clara University and is the author of several books: The Soul of Liberty, Public Goods and Private Communities, and the Dictionary of Free-Market Economics.

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Comments

This analysis, while hitting components of the problem, leaves out the Keynesian leg of the stool - the fiscal causes of booms and busts.

When fiscal policy allows the accumulation of economic rent in the labor market, it makes too much liquidity available to business owners and over-compensated managers for speculation in land, credit markets and secondary asset markets. When the tax rate on returns from these markets are less than the tax rate for wages, investment is shifted from plant, equipment and labor to speculation. Some, but not, all investors will leverage existing assets further if credit is too cheap, or they will "securitize" assets in order to improve their liquidity for further investment - however, even securitized assets have to have investors. This ever growing demand for speculative assets results in inflated asset prices and a demand for higher and higher rates of return.

Two useful recent examples are the housing bubble which followed the Bush Tax Cuts of 2001 and 2003 and the Tech Bubble, which followed the Capital Gains Tax Cuts put forth under Clinton.

Many people lost real money, not leveraged capital credit, when these speculative bubbles collapsed. While leverage certainly pays a part in such bubbles, for many people (like my in-laws) unleveraged fixed-contribution retirement accounts were invested in such instruments (and lost). Had sounder fiscal policy been adhered to and wealthier speculators taxed appropriately, the markets would not have been run up so fast. While leverage and land certainly are part of the equation, ignoring fiscal policy leaves the equation underspecified.

The tech bubble certainly did have an impact on land values. Office space was built and rented and homes were built based on individual income from Initial Public Offerings. These impacts, however, are a consequence of the Tech Bubble, not their cause.

In order to prove that credit and land were a driver of the tech bubble - and indeed the housing bubble as well, evidence is required proving that the purchase of tech stocks in the late 1990s and mortgage backed securities in the mid to late 2000s were themselves purchased using credit (and indeed, leverage on land) rather than excess liquidity which resulted from reduced taxation on capital as opposed to labor.

One may, of course, argue that if neither labor nor capital were taxed at all there would be no reason to prefer speculative investment to productive investment - however such a situation would fail to take into account economic rent caused by economic power in the labor market and the necessity to tap it as well through some form of income tax.

As I have written other places, income taxes are more appropriate ways to fund certain activities. In Libertopia, cooperatives would fund education not from taxing the land of its membership, but through the employment of teachers and support personnel as cooperative members. If schools are run as external enterprises. As technological sophistication increased, land will be less and less important as a factor to be taxed. Space and proximity will replace it and space is infinite and therefore untaxable while the need for services is constant or increasing as educational needs increase (at least until implantable chips become a reality - in which case the tin hat brigade in the libertarian movement will have a conniption).

# posted at by Michael Bindner

I left an incomplete clause in the last paragraph above: "If schools are run as external enterprises" was meant to be deleted because it requires too much explanation, however I will now endeavor to go on from that thought. If schools are run as external enterprises, then redistribution to parents is necessary - either by funding children with a citizen dividend which can be used to purchase education or through the state keeping part of that dividend and providing education. Another option is an income, sales or land value tax which can fund education or - if levied against employer only - can be offset by the employer funding the educational provider preferred by each employee owner or by either distributing educational vouchers to parent-employee-owners, providing excess pay to be used for tuition or making direct payment of tuition to employee dependents. The same schemes can also be used for the education of either less than literate employees or for employees at the begining of their carriers who require training and education. While land value taxation is one option - it requires a state to do it - as do sales and income taxes. Firms could also pay for outside tuition in each of the ways described without reference to taxation at all - but simply as a market required employee-owner benefit. There is no incentive to provide this benefit now, however.

There are a few ways to get to totally private education as a benefit or cooperative part. One is systemic collapse. While one can hope for such things - I find such hopes to be pipe dreams at best and bordering on anti-social conduct at worst. The second is to allow taxpayers (either individuals or employers) to fund or provide education and other services directly in lieu of taxes or other mandates - which actually works better with an employer based tax since paperwork is less. The third way is to push for larger employee-ownership, which can be done three ways: allow unions to own and control more stock in employers directly through their pension funds (there are now limits on this in the Taft Hartley Act), by redirecting Social Security contributions to employee-ownership and by making sure inheritance taxes are high enough while making sales of shares to ESOPs or similar arrangements tax free (I have no problem doing all three to expand ownership). For fastest results, one could both change the tax system and the retirement savings system. This can be done with Land Value Taxes as well (although employee-held cooperatives which include housing as a cooperative service have less need of such tools, since they have the market power to buy land more cheaply), with the Cooperative setting up a land trust for its employees and either building houses for them and selling the houses to the members or allowing the members to contract for these services on their own. Regardless, the land trust would pay the Land Value Taxes for the employee-owners. Of course, once you open up this possibility, the differnce between wage/sales taxes and LVT goes away, since irregardless of what is being taxed, the cash flows are remarkably similar.

In another addendum to my remarks above - land is not the only thing that was excessive in the booms of the 1990s and 2000s. Improvements were also lavish. Ceilings were high and countertops were made of marble - and tax benefits for home ownership helped this by allowing taxpayers with higher incomes a bigger benefit percentage-wise than their lower-incomed fellow citizens. This drove homebuilding toward the higher end and made lesser value housing harder to get, essentially forcing people to seek higher priced improvements than they would otherwise order. Now, while some of that is also a dysfunction of the income tax system the answer is not to do away with income taxes but instead offer tax benefits for family size (or a capped mortgage tax credit) rather than tax deductions for mortgage size. Again, the demand or such features was not caused only by credit availability - some of it was caused because wealthy people had more money for improvements because they were undertaxed and because some of them benefited from speculative IPOs for junk companies. The wealth of the executives at Global Crossing and Enron was not just in their land, but in the improvements that were parked on that land.

# posted at by Michael Bindner