The Business Cycle: causes and remedies Fred E. Foldvary Dept. of Economics,

Georg Wilhelm Friedrich Hegel: Nations and governments have never learned anything from history. Philosophy of History, introduction

The factors of production Land: all natural resources, including space. Labor: human exertion that seeks to create wealth (goods and services). Capital goods: goods which have been produced but not yet consumed. Economic investment: capital goods.

The time-structure of capital goods Real estate development New factories Machines, durable goods Crops Inventory in stores Food in your refrigerator

Time preference The tendency of most people most of the time to prefer goods in the present day to goods in the future. Life is uncertain and short. The rate at which future goods become discounted becomes the natural free-market interest rate.

The role of interest The interest rate has important jobs in the economy: Equalize borrowing and savings Equalize savings and investment Allocate spending between consumption and investment.

The distortion of interest Manipulations by a central bank prevent interest from doing its job. Pushing down the interest rate creates unsustainable and wasted economic investment. Result: inflation, recession

The real estate boom When the central bank expands the money, the interest rate is pushed below its natural rate. The credit expansion fuels a boom, especially the purchase and construction of real estate.

Excessive expansion of money The manipulated interest rate falls. More investment in long-lasting capital goods, especially real estate. These turn out to be bad investments when interest rates go back up. Not just inflation, but also a change of relative prices, a wasteful distortion.

The boom-bust cycle

Real estate the major player Real-estate construction is a major portion of economic investment. Artificially low interest rates induce a construction boom. Low rates also create land speculation. Land values rise beyond the point at which enterprises can make a profit after paying for rent or mortgages. The most optimistic speculators get a winner’s curse.

U.S.: Fannie and Freddie Fannie Mae and Freddie Mac, government-sponsored enterprises buy mortgages from originators government guaranteed subsidize real estate, land values generate real estate derivatives

Public Works: the Mother of all Interventions Much of the value of land comes from public works and services, paid for by taxes on labor and capital goods. 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."

The land-value subsidy * Public works and civic services increase the value of land. * Little of this is paid from property taxes specifically on land. * So these public goods get capitalized as higher land value and more rent.

The US real estate cycle land value construction start of depression interval interval interval 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 16 2005 19 2008! 18!

High interest rates and high prices for real estate choke off new investment.

Malinvestment falls The unsustainable bad investments (malinvestments) slow down and stop. The collapse of economic investment causes the rest of the economy to plunge. Workers in construction and other real estate lose their jobs. Loans default, banks fail, the financial system crashes.

Result: the financial waterfall

The fiscal and monetary remedy for depressions The elimination of the business cycle requires the elimination of the real estate boom-bust cycle. This can be accomplished by the provision of public goods by private communities. That eliminates the implicit subsidy to landowners.

Public Goods are effectively provided by private enterprise by tapping the generated site rent.

Fred Foldvary, 1994 Public Goods and Private Communities Market success providing public goods, in theory and in practice. Demand is revealed by rent. No free riders: users pay rent. Land trusts, condominiums, residential associations.

Private Communities Landowners pay for the public goods that service their area. No subsidy. No speculative land-value boom. No financial crisis. Government can privatize or else copy what private communities do.

Fiscal remedy The public goods provided by government generate land rent. The collection of this rent by government prevents the subsidy to landowners. The price of land falls to a small amount. This removes the gains from excessive land speculation. A tax on land value has no excess burden.

The financial side To prevent the boom-bust sequence, we also have to fix the financial side. The remedy for credit manipulation is free-market money and banking (free banking) with competitive private bank notes. * Provides flexibility and stability.

Free banking George Selgin, The Theory of Free Banking http://oll.libertyfund.org/title/2307 There is a base money such as gold, and private bank notes are convertible into gold.

No more depressions! Private communities, free banking. Or, the public collection of rent. No imposed costs, no subsidies, Stop the fiscal and monetary subsidy to investment and land value, and the business cycle will go away. No more boom and bust!