Are Real Estate Cycles Inevitable?

Paul Justus

[September, 2007]

Given the shakeup in the sub-prime loan and financial markets in August, many people may be raising questions regarding the general health of the U.S. economy. Is the country going into a downturn related to the housing cycle? If so, what are the broader implications for the overall U.S. economy? Are there Federal Reserve or government policies that can maintain a healthy economy?

Certainly there are indications of a slowing U.S. housing market. On August 30, the Office of Federal Housing Enterprise Oversight (OFHEO) released its Housing Price Index (HPI), (http://www.ofheo.gov/ ) which showed that the 2nd Quarter HPI was only 0.1 percent higher in the second quarter than in the first quarter of 2007. This was the lowest growth rate since the fourth quarter of 1994.

The OFHEO report noted that:

1. The state price declines over the past years in five states is the largest number of price declines since 1996-1997.
   
2. Of the 287 cities on OFHEO's list of "ranked" Metropolitan Statistical Areas (MSAs), 226 had positive four-quarter appreciation and 61 had price declines.
   
3. Eighteen of the 20 cities having the lowest four-quarter appreciation rates were in Florida and California. Those cities experienced price declines of between 4.2 and 8.7 percent.

The following selected data from the OFHEO Housing Price Index show 2nd Quarter, 2007, one-year, and five-year growth figures.

U.S./Region/MSA 5-Yr.	National Ranking	1-Yr.	Qtr.	5-Yr.
	--	3.19	0.08	50.76
East South Central	--	5.93	1.11	31.21
Fayetteville-Springdale-Rogers, AR-MO	147	3.49	0.47	43.79
Fort Smith, AR-OK	130	3.94	0.48	24.99
Little Rock-North Little Rock-Conway, AR	119	4.26	1.22	30.78

If the U.S. housing market is slowing, what might some of the greater implications be to the overall U.S. economy? If one follows the mainstream or Neoclassical economic theories, one would expect that the Federal Reserve will rise to the occasion with the monetary tools at their disposal. These tools would include a cut in the federal interest rate, opening the discount window to non-banks, reducing reserve requirements to encourage the banks to lend more and lowering margin requirements to boost stock prices.

Most market watchers expect the Federal Reserve Board to drop the prime rate a quarter percent at their September 18 meeting. The general belief is that with appropriate adjustments in the money supply through changes in interest rates our national economy can avoid the pitfalls of major downturns, recessions and depressions. If there is an inevitable business cycle - a hotly debated and controversial subject - then the correct interest rate adjustments can bring our booms into a soft landing rather than a bust.

However, there are other economic schools of thought that adhere to quite different points of view. One of these schools (called "Geoclassical Economics" by economist Fred Foldvary) is presented in the book "Boom Bust: House Prices, Banking and the Depression of 2010 by Fred Harrison, Director for the Land Research Trust of London.

Harrison's (and other Geoclassical economists) views and arguments can be summarized as follows:

• Historically there is an 18-year real estate cycle that we need to understand to predict ups and downs of our economy. Real estate prices and construction peak before the general downturn in the economy. As the economy booms, speculators drive prices too high for current uses. Investment consequently falls, leading to a recession that can last between three to five years.
  
• The real estate cycle begins during a recession and is fueled by a policy of low interest rates and monetary expansion. This artificial stimulation eventually leads to inflation and is unsustainable. As interest rates are raised, large-scale investments that once looked profitable are not. Borrowers default on loans creating a financial crisis, less investment, less demand, and a major economic downturn.
  
• In the 18-year cycle there is a mid-cycle minor recession. Since the last major recession was in 1990, this theory predicts a major downturn between 2008 and 2010.

Fred Harrison points out an apparent contradiction in attempting to maintain economic stability with interest rate adjustments:

"When the UK and the USA went into the 2001 recession, interest rates were slashed to help industry. But lower interest rates, through the capitalization process, meant that land prices were increased at a time when the profit margins of entrepreneurs were being squeezed. When the economies recovered from recession, the central bankers turned their attention to escalating house prices. They raised interest rates, which penalized industry which needed to borrow and invest for growth."

In his analysis, Harrison says that current economic models are overly focused on labor and capital rather than land and property prices, the things Harrison believes really drive economies. According to Harrison, classical economists such as Adam Smith thought that because the supply of land is one of the few things that is by nature, finite, it is land that ultimately determines our economic fate. Harrison believes that the price of land is the best leading indicator we have for the state of our economic health.

For Geoclassical economists the remedy for preventing the boom-bust economic cycle is straightforward but considered politically unfeasible. Public revenue should not come from economic production such as income, wages, capital investment, sales, savings, or commerce. These kind of taxes penalize work and human effort and reward runaway speculation on finite resources. Instead, these economists would tap the land rent of the country for public revenue. This would halt the speculative escalation of land prices. According to this viewpoint, land does not get produced, and its value comes from nature and community and public works, so tapping it for government revenue does not hurt enterprise, unlike taxes on sales and wages.

Other benefits of shifting to land rent taxes, according to economist Foldvary, would include the elimination of the federal budget deficit, the financing of the baby boomer demographic transition, the provision of affordable housing, and the reduction of the demand for excessive monetary expansion.

Geoclassical thinkers are not optimistic that their suggested tax-structure reforms will be enacted any time soon. However, economist Foldvary says that at least those who understand this theory will be warned in advance and can arrange their affairs to minimize the losses that others will suffer.

Whether or not Geoclassical economics is a better predictor of economic phenomena remains to be seen. However, given the variety of predictions in the marketplace of economic thought, it probably wouldn't hurt public policy makers and investors to read and understand books such as Fred Harrison's to add to their box of analytic tools.