Oct. 9, 2006, Econ Yellow Pad Lunch Seminar by Fred Foldvary

Oct. 9, 2006, Econ "yellow pad" lunch seminar by Fred Foldvary

A Synthesis of the Austrian-school and the Georgist Theories

of the Business Cycle, and its Empirical Testing

Abstract

The Austrian school’s theory of the business cycle is based on money, interest rates, and capital goods. The Georgist theory of the cycle is based on land values. Each is incomplete, but they complement one another, and their synthesis, with real estate construction and related durables as the key capital goods, provides a coherent explanation of the boom-bust cycle. The historic real-estate cycle is strongly correlated to the general business cycle, as real estate prices and construction have consistently peaked before severe recessions and depressions. The geo-Austrian synthesis, applied to the current cycle, forecasts a severe recession towards the end of this decade.

1. The Generic Business Cycle

The key puzzle of the business cycle is the cause of the decline.

Joseph Schumpeter identified the key turn in the cycle as the point of inflection at the peak of investment . The upward swing switches from acceleration to deceleration. A continuous decline in the rate of growth of GDP results in zero growth and then negative growth.

The rate of increase in investment falls because entrepreneurs and investors expect lower profits. Pessimistic expectations are caused by increased costs or a fall in aggregate demand.

2. The Austrian-School's Theory of the Business Cycle

Capital goods have a structure from lower to higher order, based on the "period of production" or duration of the good. (Menger, Hayek, Mises, Garrison)

Knut Wicksell theorized that the free market generates a natural rate of interest, which with credit expansion can differ from the market rate.

Ludwig von Mises: the natural rate provides an optimal amount and time-structure of capital goods. Capital formation different from this free-market-determined mix results in economic waste.

If the interest rate is artificially lowered due to an increase in the money supply by a monetary authority, this induces an increased investment in higher-order capital goods unwarranted by increased savings. When interest rates and prices rise, these malinvested firms fail.

The Austrian school identifies higher interest rates as the key cost, as they reduce artificially-induced investments in higher-order capital goods.

The injection of money distorts the price structure, prices rising higher for those goods which are being bought and produced with the new money.

The cost of capital goods rises faster than the price of the final consumer goods. The rate of increase in investment falls because, as Hayek stated, money is a "loose joint" which does not accommodate an immediate coordination of price changes.

Karl Pribam in 1940 was the first Austrian-school economist to study the role of real estate in the business cycle. Pribam pointed out that in the latter stages of a boom, higher costs render building activity unprofitable.

However, Pribam has had little impact on contemporary Austrian-school business cycle theory, perhaps because he did little more than indicate that real estate construction was a substantial portion of investment. The construction industry has amounted to a quarter of total investment, and it induces a demand for durable goods.

What is missing in the Austrian cycle is an analysis of the land factor, as well as contemporary institutional elements such as the secondary mortgage market.

3. The Henry George land-based boom-bust theory

Much of the gain from economic growth is captured by land rent and site values. Adam Smith noted that "Every improvement in the circumstances of society tends either directly or indirectly to raise the real rent of land, to increase the wealth of the landlord." Government-provided infrastructure not paid for by landowners creates an implicit subsidy to landowners.

As the economy recovers from a depression, at first there is a reduction of vacancies. Then as rents rise, land speculators buy real estate, and the addition of the speculative demand makes land priced for expected future uses rather than current uses. Real estate costs rise faster than the prices of consumer goods. This reduces the rate of increase of investment.

The diminished rate of growth of investment results in a peak and then a decline of investment and then of total output.

4. The Geo-Austrian synthesis

Because of rising interest rates and real estate costs, the rate of increase of investment slows down, eventually reducing aggregate demand as the slowdown ripples through the economy, bringing forth a recession and depression.

In recent decades, the Federal National Mortgage Association - Fannie Mae, and the Federal Home Loan Mortgage Corporation - Freddie Mac, have created a large secondary market for residential real estate loans. These have an implicit government guaranteed. These government-initiated enterprises sell bonds and package loans into securities, spreading the risks from large-scale defaults to financial institutions such as insurance firms, and ultimately to taxpayers.

Lax lending policies during the boom, plus the favorable tax treatment of real estate and the implicit and explicit subsidies to real estate ownership and borrowing further fuel real estate purchases and construction.

The test of the Geo-Austrian synthesis is whether the peaks in land values and construction occur prior to the recession. If so, this would be consistent with the theory that the distortions of real estate booms cause the subsequent decline. And indeed, the history of real estate cycles in the U.S. has this pattern.

The real-estate cycle in the U.S.

land value constructiondepression

intervalintervalinterval

1818 ------1819 --

1836 18 1836 --1837 18

1854 18 1856 20 1857 20

1872 18 1871 15 1873 16

1890 18 1892 21 1893 20

1907 17 1909 17 1918 25

1925 18 1925 16 1929 11

1973 48 1972 47 1973 44

1979 6 1978 6 1980 7

1989 10 1986 8 1990 10

2005?162005? 192008?18?

The data from 1818 to 1929 are from Harrison (1983, p. 65), except for building data for the 1909-1929 period, which are from Hansen (1964, p. 41). Data for 1972-1989 are from Statistical Abstract, 1996, housing prices and "Value of New Construction Put in Place" reports of the U.S. Department of Commerce, Bureau of the Census. The land-value peak for 1989 is from the Board of Governors of the Federal Reserve Balance Sheets For the U.S. Economy (1991).

News reports from 2005-2006 indicate that residential construction and prices have peaked in 2005, while non-residential construction has continued to rise, but total construction and land values may be less in 2006 than in 2005.

The data indicate that there are indeed cycles with a consistent pattern.

5. Business cycle policy

The Geo-Austrian synthesis suggests that expansionary monetary policy may stimulate growth but creates distortions in relative prices and investments not profitable at higher interest rates and real estate costs, and so ultimately contributes to the subsequent recession.

Expansionary fiscal policy not paid for by landowners creates implicit subsidies to land values, which can induce a speculative boom in which land values are carried beyond the point at which enterprises can make a profit after paying for rent or mortgages.

Such demand-side policy treats the symptoms and effects rather than the causes of the business cycle, and themselves contribute to the cycle.

Some the Austrian-school theorists (e.g. George Selgin) propose, as a remedy to eliminate the credit-expansion cause of the cycle, a free-market in money and banking, eliminating the role of the central bank. Private bank notes would be convertible into some base outside money. The free market would then generate the natural rate of interest, a rate which is unknowable to any monetary authority.

The Georgist remedy is land-value taxation, which collects most of the land rent, thus eliminating gains from land speculation, providing an optimal timing of real estate development.

The policy prescription of the Geo-Austrian synthesis is both free banking and land value taxation, as either by itself would dampen but not eliminate the cycle.

Since these reforms have a near zero chance of implementation, the structure of monetary and fiscal policy will continue to induce the cycle.

Recently, Shiller (2005) has forecasted a fall in real estate and has created a futures market to hedge the expected decline, but he lacks a theoretical or historical basis for timing the fall. The Geo-Austrian synthesis and history of real estate cycles indicate a forecast of the next recession at the end of this decade, with the most likely mode around 2008. Recent data may already indicate a reduction in the rate of growth of investment and employment, that the U.S. economy has passed the Schumpeterian point of inflection.

References (partial)

Garrison, Roger W. 1978. Austrian Macroeconomics.Menlo Park: Institute for Humane Studies.

------. 1984. "Time and Money: The Universals of Macroeconomic Theorizing." Journal of Macroeconomics 6(2) (Spring): 197-213.

------. 2001. Time and Money: the Macroeconomics of Capital Structure.New York: Routledge.

George, Henry. 1879. Progress and Poverty.Rpt.NY: Robert Schalkenbach Foundation, 1975.

Hayek, Friedrich A. 1933 [1966]. Monetary Theory and the Trade Cycle. Trans. N. Kaldor and H. Croome. Rpt. New York: Augustus M. Kelley.

------. 1941. The Pure Theory of Capital.Chicago: University of Chicago Press.

Hoyt, Homer. 1933. One Hundred Years of Land Values in Chicago.Rpt.NY: Arno Press & The New York Times, 1970.

Menger, Carl. 1871 [1976]. Principles of Economics. Trans. James Dingwall and Bert Hoselitz. New York: New YorkUniversity Press.

Mises, Ludwig von. 1924 [1980]. The Theory of Money and Credit. Trans. H. E. Batson. Indianapolis: Liberty Classics.

Pribam, Karl. 1940. "Residual, Differential, and Absolute Urban Ground Rents and Their Cyclical Fluctuations." Econometrica 8 (January): 62-78.

Rothbard, Murray N. 1975. America's Great Depression.Kansas City: Sheed and Ward.

Sakolski, A. M. 1932. The GreatAmericanLand Bubble. New York: Harper & Brothers. Rpt. 1966.

Schumpeter, Joseph A. 1939. Business Cycles. NY: McGraw-Hill. Rpt. Philadelphia: Porcupine Press, 1982.

Selgin, George A. 1988. The Theory of Free Banking.Totowa, NJ: Rowman & Littlefield, and Washington, DC: CATO Institute.

Shiller, Robert. 2005. Irrational Exuberance, 2nd ed. PrincetonUniversity Press.