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     Jan 26, 2013

Land-based spells bring crises
By Reuven Brenner

Although John Law's name is now associated with the 18th century South Sea Bubble, the problem he wanted to solve was the same that central banks are struggling with today: "How much money and credit can be created without bringing about inflation, destabilizing the economy, or destabilizing the international financial system?" Law's proposal then was that a "land-collateralized" note issue would be the solution.

The crisis we are in and that Japan has been in for two decades by now, show that the world repeated Law's mistakes, though

heavily disguised by new jargons, policies and financial instruments, which obscured the "land"-based-similarity.

Law's solution at the time was based on these principles: For money's purchasing power to be stable, the issuing of credit must be linked to anticipated "real" trade; Using land as collateral, there could be no over-expansion of credit. Law was mistaken, though, because he did not see how monetary expansion raises land prices, which then mistakenly rationalizes further credit expansion. Adam Smith recognized this flaw in this early version of the "real bills" doctrine, and corrected it.

First, he said, the collateral should be commercial paper, rather than arbitrarily choosing land as collateral. Second, Smith saw that even commercial paper could not be sufficient to sustain stability: the price of the asset backing the "real trade" could be increased too, leading to credit expansions. For the "real bills" doctrine to work, he noted, it needed specie (gold) convertibility to constrain the undue expansion of credit.

So what happened first in Japan, then in the events leading to the present financial crises? After World War II, Japan passed many laws that biased investments toward land. Among them: if people invested in land using borrowed funds, interest on the borrowing was deducted from their income; and, for the purpose of inheritance tax, land values were appraised advantageously lower than cash or shares.

As the competition among Japanese financial institutions intensified in the latter half of the '80s, the quality of due diligence dropped, and lending with land as security increased. This drove up the price of land, and credit then expanded further. The central bank accommodated, with John Law logic, unconstrained by Smith's reservations. The soaring land prices affected share prices (as companies had massive real estate holdings), and both then affected each other in an upward spiral for a while.

Oblivious to the nature of the problem, by 1988 the Japanese government tried to solve the monetary problem with fiscal remedies - which will seem eerily familiar. It imposed 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. Then, at the end of 1989, the Basic Land Law was enacted. The law focused on the "public interest" in land to ensure appropriate planning and to suppress land "speculation".

The Bank of Japan raised the discount rate in May 1989 and introduced quantitative controls on the total amount of land related loans from April 1990. The government then reformed the land taxation system, drastically raising capital gains taxes. While the changes were complex, what they meant was that capital gains taxes on real estate jumped from 20% to 50% if people or companies sold them within a 10-year holding period. No wonder real estate prices and share prices then collapsed.

Jump to events leading to the present crises. Never mind the reasons, Washington decided to increasingly subsidize housing in increasingly complex ways. In no particular order, interest rate payments on mortgages became deductible, mortgage guarantors Freddie Mac and Fannie Mae were created, which, combined with securitization, the Fed's disregard of the expansion of credit through "shadow banking", lack of supervision of institutions fulfilling financial intermediary functions and due diligence, lack of adjustment in rating agencies' analyses when banks were giving up their traditional due diligence roles, have all contributed to the undue expansion of credit.

This took the shape and form of mortgage-backed loans - in principle "land-backed" - though misleadingly called "real estate-backed".

Words matter. They are the vehicles of thinking: while they can shape accurate perceptions, they can shape misperceptions too. As it turns out, and not for the first time in history, there is not much "real" about this asset class. The question is, what do you do with it?

John Law and followers, who come up with theories based on "real" estate", or "real" bills" doctrines (unconstrained by having a "unit of account" too), make implicit assumptions that they know what is "real". But as one can readily see, many things perceived "real" can melt into thin air in a flash. Perhaps we would be far better from now on using the French word for "real estate" - "immobilier".

This term captures the essence of this asset class, as the English word does not: it is immobile, you can't take it away with you. It immobilizes owners to various degrees, making them easy targets for taxes. The "immobile" feature of this asset class brings a better understanding why politicians love to subsidize this asset class first - realizing that, push come to shove, they can tax it later.

After all, politicians get more power the more their population is immobilized: they can regulate them, tax and bewitch them with slogans more easily. Real estate, farming, language laws (prohibiting learning other languages - see Quebec, whose laws make it illegal for their French and immigrant population to go to English schools, and require businesses employing more than 26 people to communicate internally in French) - are all great immobilizers.

No wonder governments, since antiquity, have favored such policies, praised "immobile professions" to the sky and held "mobile professions" (trade, finance, science) suspect. Was there ever a time when importers were praised? Never mind that they would roam the world for better and cheaper products to benefit locals. No government built statues to immortalize importers.

On the other hand, they subsidized every "land-based" ideology and practice, praising and subsidizing exporters among them. After all, exporting manufacturers are married to land, depend on the local government, and are in their grasp - whereas the "cosmopolitan" scientists, traders, importers can escape them.

Moreover, when unwilling to make domestic political, regulatory and fiscal changes needed - better rely on demands from other countries to cover for the persistent domestic mistakes. That this may end up in currency wars - as we may be heading today - politicians are very good in using gobbledygook economic theories and using gullible economists to rationalize devaluations, subsidized exports, and tariffs.

Ludwig Wittgenstein, the philosopher, was right when he stated that: "Philosophy is a battle against the bewitchment of our intelligence by means of language." Indeed, "real estate" "QE," "bubbles" ( attributed to random variations in people's mood rather than any concrete laws and regulations), erecting statues to heroes of subsidized "immobility" (unread, unwatched, not listened to statistical "cultures" being a good example) have all "bewitched" many for centuries, though "bothered and bewildered" a few.

What are the most immobile professions, after all? Politics, local culture, government bureaucracy, law - much of their expansion being created with relative ease - as long as governments have access to credit.

Briefly, the recent financial crises rhymes strongly with the one John Law and the Japanese government managed to engineer. Though in different ways, they were all "land-based", drawing on the misperception that there is necessarily something "real" about increases in prices of immobile assets.

Just as Law and the Japanese government forgot, so did the Federal Reserve and the US Treasury, when letting financial institutions accommodate large expansions of credit - based on "real estates".

It's here that the distinction lies between this past "bubble" and what was labelled as the Internet-related one, and why the recent one will take much longer to correct. Whereas Internet shares could not be collateralized and leveraged through bank loans and government guarantees, "real-estate" was - and banks and governments fueled the folly. This is why the paper loss with Internet shares, though amounting to trillions, had no significant effect, whereas the present one will be taking long years to overcome.

By looking at the crisis of sovereign debts through the "immobile" versus "mobile" prism, we get a better insight too. After all, such debt is "land-based" too, backed by national governments' ability to tax people living in its territory (mother- and father-"lands", take your pick). But what happens if the talent from these lands - what I often call "the vital fews" - move, be it abroad or through evasions?

The "land" stayed the same, but the ability and incentives to create wealth, and the part of such wealth that would be taxable - has diminished, as Italy, Greece, Spain - and now France - show.

How does one verse in the famous Lorenz Hart Bewitched, Bothered and Bewildered lyric go?
Burned a lot, but learned a lot,
And now you are broke, so you earned a lot
Bewitched, bothered and bewildered - no more.

Indeed, it appears that the "immobility" prism and its language bewitched the world for far too long. Perhaps by shifting to the "mobility" prism, the choices we face today could come in far sharper focus.

Reuven Brenner holds the Repap Chair at McGill University's Desautels Faculty of Management, and serves on the Board and the Investment Committee of McGill's Pension Fund. The article draws on his books, Force of Finance (2002) and World of Chance (2008), with A Brown and G A Brenner, and "Unsettled civilizations: How the US can handle Iraq", Asia Times Online, June 23, 2004.

(Copypright 2013 Reuven Brenner.) 

Unsettled civilizations: How the US can handle Iraq
Jun 23, '04




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