By James H. Nolt
In the last few columns, I have been discussing value theory, emphasizing the virtues of an objective theory of value as developed by classical political economy. Although the labor theory of value of classical political economy has some merits, it is inadequate—as I argued last week in relation to capital. It is lacking even more when considering the products of nature, including land and natural resources. This does not doom an objective theory of value, but requires, as with capital, that it includes explicit consideration of the expansion and contraction of credit as a primary determinant of value.
First of all, let me clarify, the objective theory of value is not about how we should value the natural world in a moral sense. My older brother, John E. Nolt, a philosopher at the University of Tennessee, examines this question extensively. Rather, an objective theory of value explains how natural resources are in fact valued within our capitalist system. Actual valuation of real property depends strongly on credit conditions since land and other natural resources are expensive to acquire and thus mostly purchased using credit rather than cash. When the supply of credit for mortgages is booming, prices also rise. When credit tightens, they plateau or fall.
A key difference between classical political economy and contemporary textbook economics is that economics considers price to be determined in the marketplace, whereas political economy argues that products come to market with prices already attached because value is an objective thing related to cost of production, which is known a priori, before arriving at the market to sell.
However, raw nature has no price tag because it is not manufactured. Of course, for thousands of years people have been modifying nature, for better or worse, so any particular plot of land or segment of the sea changes in value as human investments in transportation, water management, and infrastructure enhance and/or detract from its value to us. Yet the value of land is not simply the sum of human investments in it. If that were the case, virgin land would have no economic value, which is not true, but certainly the value of land in Midtown Manhattan largely derives from the human modifications and investments there, rather than merely the preexisting natural endowments.
Yet both the pure products of nature and the accumulated modifications to them do not have a value that is merely the sum of the accumulated labor expended there, as a labor theory of value might expect. The exact same acre in the Amazonian rainforest or Manhattan lot will vary in value as people have the means to purchase exclusive private use of it. Those means are primarily credit.
In an earlier column I reviewed an excellent book by Lord Adair Turner, the former chief banking regulator in Britain who was in power during the 2008 global financial crisis and its aftermath. Like me, Turner notes that the value of real property is largely a function of the expansion and contraction of credit. Throughout history, he notes, banks and other financial institutions lend to real estate buyers. Often a large portion of their total loan portfolios is real estate loans. The value of the real estate is collateral for the loans, making them pretty secure during normal times, as long as real estate prices are steady or rising.
When credit tightens, however, during a financial crisis, depression, or economic crash, real estate values typically fall. If a large portion of the funds to buy property were borrowed, then as the value of the property falls it may become less than the remaining loan burden, at which point the mortgage is said to be “underwater.” In such circumstances, even selling the property would leave the owner with funds insufficient to pay off the loan. Owners would be left with nothing but debt. During the recent financial crisis, many property owners facing this situation simply abandoned their property and their debt. The bank can foreclose and reclaim the property, but selling it (often into a falling market) leaves the bank with net losses on the loan. If many such bad loans exist, a bank’s capital might be wiped out, leaving it bankrupt.
Yet when credit is easy and cheap, real estate markets boom. During the upswing, each successive buyer pays more and more for the same property as credit continues to expand. Each expansion is justified by the ever-increasing value of properties and therefore of the collateral for the loans. This is a virtuous circle with no obvious limit.
There are some practical limits to how high real estate prices can rise on a credit-fueled boom. Each successively larger loan on the same basic property also means higher transfer of income, in the form of interest payments, from property owners to the banks that finance their purchases. As prices rise, so do loan amounts. If real estate prices are rising faster than the growth of the real economy, then mortgage debt service will divert a larger and larger portion of owners’ incomes into the hands of lenders. This factor is measured by a common index used in the real estate business which is the ratio between the purchase price of a property and its rental income. This tends to rise in a boom as credit-fueled purchase prices accelerate faster than income-limited rents. Yet this is not a firm limit, because as long as yields on real estate investments are higher than borrowing costs, it may still benefit speculators to borrow and buy more.
A real estate boom will finally crash when the rate of increase of prices slows so that the yield is less than the cost of borrowing. Yield, as we have discussed in regard to other assets, is both the rising value of the asset and the percentage net income from it—in this case, rent. Even a property yielding no rent at all might be an attractive speculative purchase if its price is rising 10 percent per year, while funds can be borrowed at only, say, 6 percent. When the increasingly valuable property is sold, the proceeds would be sufficient to pay off the loan and still yield a high leveraged profit.
This calculation of course reverses when real estate prices are not rising fast enough to cover the cost of borrowing (again, ignoring rent). Prices do not have to fall to start a crash. If they rise at just 4 percent a year and the interest rate on loans is 6 percent, debt costs exceed rising value of the property. It would pay the speculator to sell it in order to cut his losses. If many speculators are in a similar situation, many will try to sell at once, often collapsing prices. The higher the debt leverage, the faster prices collapse during a downturn. Rental income can cushion this calculation, but still at some level of price change, the total yield on the property will not service the loan, so speculators rush to sell.
Note that property booms increase the expense of people trying to buy into the property market for the first time, hitting young people the hardest. They also tend to transfer income from non-financial to financial businesses as the volume of mortgage loans expands with rising prices. This may explain a bit why the anti-bank rhetoric of Bernie Sanders is more popular among young people than Hillary Clinton’s more measured approach, which appeals more to existing owners.
James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University.
[Photo courtesy of Mark Moz]