On September 16, a Wall Street Journal headline highlighted a new class of US millionaires disclosing their preference for renting rather than owning homes. The article’s premise has the potential to induce a drastic change in government and central bank policies that give preferential treatment to real estate in lending.
Central banks are equipped to do two things well. One is to stabilize the value of a nation’s currency. The other is to supervise financial institutions. The fact that the US dollar has lost 99% of its purchasing power in gold terms since the US Federal Reserve’s creation in 1913 suggests it has not done so well on the first count.
The US Savings & Loan crisis, the Long Term Capital Management fiasco and the 2008 global financial crisis show that the Fed did not do well on the second account, either.
The mistake common of these three crises was the financial sector’s extension of too much credit to “junk” consumers, “junk” companies and “junk” countries, with two of the crises related directly to misguided real estate policies.
The Federal Reserve Act embraced the so-called “Real Bills” doctrine in 1913. The doctrine stated that there can never be “too much” money if banks gave credit only against short-term commercial bills, backed by “real” transactions.
The 10th Annual Report of the Fed in 1923 stated: “It is the belief of the Board that there is little danger that the credit created and distributed by the Federal Reserve Banks will be in excessive volume if restricted to productive uses.”
As the world was then on the gold standard, the report did not mention that for the doctrine to work, it needed an “outside” anchor serving as an “alarm signal.” Otherwise, there could be excess liquidity, inflation and crises – as indeed turned out to be the case.
John Law (1671-1729) came up with this doctrine, though his name is associated now with the “South Sea Bubble.” He sought a solution for the problem of how much currency and credit creation there can be without stoking inflation.
His solution was a “land-collateralized” note issue that drew on three principles: money’s purchasing power should be stable; issuing credit must anticipate “real” trade; and land should be the collateral.
His mistake was that he missed how monetary expansion raises prices, of land in particular, which then mistakenly rationalizes further credit expansion and thus starts a vicious cycle.
Adam Smith recognized the omission and wrote that the collateral should be commercial paper, rather than an arbitrary choice of land-based collateral. He also saw that the “Real Bills” doctrine also needed specie (gold) convertibility to constrain the increase in the quantity of money and insure the value of contracts.
With this second condition in place, the price level is predetermined and there is no need for complex and statistical (mis)calculations of price indices.
Convertibility to gold is not a necessary condition for the “Real Bills” to work: commitment for the price of gold becoming the “alarm signal” is enough. The price of gold would signal the errors of either excessive or insufficient amounts of currency and bank credit. The Bretton Woods agreement approximated this doctrine.
It failed, however, because governments did not enforce two of its essential clauses: allowing for occasional devaluation and penalizing countries accumulating excess reserves. Paul Volcker, who participated in the deliberations on discarding the Bretton Woods agreement noted that it happened without serious debates.
Here are sketches of the US and Japanese financial crises, showing how they originated in mistaken real estate conceptions.
The 2008 crisis started with the 1977 drastic lowering of capital gains tax exemptions on real estate but not stocks or bonds. Predictably, investment poured into real estate as it became more of an “asset class” than before, with neither the Fed nor the statistics bureaus noticing the implications.
Subsequently, Congress required banks to give loans to lower-income earners on the idea that home equity would offer them collateral. Subprime loans went from 2% of total loans in 2002 to 30% in 2006, accompanied by much fraud and no collateral-creation.
Banks packaged the loans as CDOs that rating agencies rated AAA without sufficient due diligence. Investment banks, both in the US and around the world, bought them without doing due diligence either. Capital from abroad poured into the US with these notes having become the US’s big capital export at the time.
Not surprisingly, the loans started defaulting and regulators compounded mistakes by changing the accounting rules for commercial and investment banks, bringing massive write-offs. This sequence of events all started with the idea that real estate is solid collateral, forgetting that if not backed by future incomes it melts into thin air.
Japan’s decision to use “real estate” as its main collateral had its origins during the 1930s following the 1920s and 1930s crises both in the US and Europe and a large number of Japanese defaults in 1931.
The government created the Bond Issue Arrangement Committee (BIAC) to manage the collateral for both bonds and convertible bonds, prohibiting the issue of corporate bonds unless backed by collateral in the form of real estate or specific government bonds. This requirement destroyed the Japanese corporate bond market, leaving the banks to take the dominant role in corporate finance.
Only in 1979, with Sears Roebuck Tokyo issuing the first uncollateralized bond since the 1930s, was the rule relaxed. However, the rules continued to exclude financing to small and medium-sized companies that most needed to raise funds by issuing convertibles and warrants, thus limiting investment opportunities.
At the same time, well-established firms issued convertibles, turning them from net borrowers to net suppliers of funds to the banking system. Flush with funds, the banks lent against land – as it continued to be the approved collateral.
Japan thus got into the John Law mess. Land prices increased and, as large companies held more and more land as collateral, their stock prices rose. The Bank of Japan added fuel to the fire by cutting rates from 5% in 1985 to 2.5% in 1987.
By the end of the boom, 10% of corporations owned over 80% of company-owned land in Tokyo. While loans to the real-property industry by banks made up 11.5% of all their loans, the non-bank lending sector’s exposure to real estate was 36% of its total loan portfolio.
Japan also bought up foreign real estate, the Rockefeller Center transaction being the most prominent. (Mitsubishi lost $1.4 billion on the deal once the credit creation–land–stock spiral deflated.) Japan did not heed Adam Smith’s lessons.
Moreover, it compounded mistakes by passing a series of fiscal mistakes to remedy what were monetary mistakes. Those errors included the imposing a 20% withholding tax on savings; a capital-gains tax on equity sales; a security transfer tax; a 3% consumption tax; a 6% tax on new cars; and a 2.5% surtax on corporate profits among others.
At the end of 1989, it introduced the Basic Land Law, which focused on suppressing land “speculation” – drastically raising capital gains taxes. The changes were complex but they effectively meant capital gains taxes on real estate jumped from 20% to 50% if people or companies sold land before a ten-year holding period. The crash of 1991 in land and stock prices was thus hardly “irrational.”
In sum, both crashes and crises owed to singling out land as being “real” – even though it often melted into thin air. It’s perhaps time to realize that matching a variety of talents with capital, all being held accountable to performance, rather than policies encouraging people to hold on to immobile parcels of land, is key to a more stable financial future.
The article draws on Brenner’s Force of Finance, “How the Financial Crisis Did Not Change the World,” and “Toward a New Bretton Woods Agreement.”
