Chapter IX: The Fictitious Commodities--Land

This is the ninth chapter in Equity and Equilibrium: The Political Economy of Distributism. The draft of each chapter is posted as it is written, in order to get some help form my readers about what works and what doesn't. All comments and critiques are welcome.

Whatever Happened to Land?

I have in hand the popular economics textbook, The Economic Way of Thinking.¹ Looking at the index, I find no entry for land. Having read the book, I happen to know that there are scattered references to land, but these do not rise to the level of an index entry. Searching for “property” gets only marginally better results. It does have an index entry referring to scattered and fragmentary mentions, but there is no sustained treatment of the topic, no inquiry as to what it is, where it comes from, what rights it ought to have—and ought not to have—and what place it plays in the political economy. What is odd about this is that land has been a staple of economic science from the days of Aristotle up through the early part of the 20^th century, when the topic suddenly disappeared. Land suddenly became just another species of capital, and one that required no special treatment or explanation.

But land is not at all like any other bit of capital. Capital is something made by human hands and is consumed in the process of production. Land is neither made by humans nor consumed in production. Further, capital can, in theory, be infinitely expanded; we can always make new tools. But land is fixed in its supply. If you wish to have land in some place, say the island of Manhattan, you must find someone with existing rights to land and either purchase or lease those rights. Another difference is the fact that there is no substitute for land. Capital and labor may be substituted for one another, and different kinds of commodities may be used in place of each other. For example, if the price of steel is too high, we may decide to make some parts from plastic instead; if the price of beef is too high, we may decide to eat chicken instead. But we cannot substitute anything for land. Land is required for all production, and permits no substitutions. Even in the infinite space of cyberspace, we still need a place to place the servers, the towers, the lines, and so forth.

But land also has another strange characteristic. The returns to capital and labor can only come from their use; only by putting our hands, our minds, and our money to work can we expect to earn something from them. But land increases in value whether or not it is used. In fact, quite often the best returns come from withholding land from use, that is, from speculation. It is precisely this characteristic of the land that could not be reconciled with neoclassical economics. The neoclassicals had a method of allocating rewards between capital and labor based on their beliefs about the contribution each made to production. But that theory simply could not be reconciled with land. Hence, in order to maintain the theory, it was necessary to get rid of land as a separate category, and to treat it—when it was treated at all—as another form of capital. In a later chapter, we will examine why the theory does not really apply either to wages or profits. But for now, we need to see why it does not, and cannot, apply to land.

The Supply and Demand for Land

One test we have been using for a “fictitious commodity” is whether or not we can draw a “normal” supply and demand diagram for that commodity. When we look the chart for land, we immediately notice that this is very different from a normal commodity supply and demand chart. The first difference is that the supply curve is simply a vertical line, which represents the fact that the supply of land is fixed and cannot vary with the price. The second difference is that instead of one demand curve, we have three. Since there is a fixed supply of land, you can't move along the demand curve; each increase in demand means shifting the whole curve “northward” to establish a new demand curve. At any given moment, the curve “D” represents the demand for land in a given area. At the point it crosses the supply curve, we draw a horizontal line to the left and read the general level of rents and prices for land. When the demand for land increases (or falls), we don't move to a new point on the demand curve but establish a new curve (D₁) above or below the old demand line D and read a new rent level at R₁. So we already have a big difference between the land S&D chart and that of a “normal” commodity. However, there is one more line on this chart that we will not find on the others. It is labeled “D₂” and its corresponding rent line is labeled “SRL” for “Speculative Rent Line.” I will have more to say about this line, but first there are some questions that we must answer about land:

• How is land priced?

• What is the relationship between rent and wages?

• What causes changes in the demand for land?

We also need to be clear about the subject. When we buy or rent a home or a building, the price or rent we pay is normally one amount. However, that one amount is actually in two parts. One part is for the building itself. Monies paid for a building are simply a return to capital and are governed by the same laws of supply and demand that cover any real commodity. The other part of the payment is for the land underneath the building, usually called the ground rent. It is only the ground rent that concerns us here, which we may define as the price of the property exclusive of any on-site improvements. Our first question, then, is, “How is this ground rent determined?”

The Law of (Ground) Rents

The law of rents operates in a private property economy. It was first articulated by David Ricardo at the beginning of the 19^th century and became a staple of economic theory. There are many long tomes and learned treatises written on this law, but it is actually based on an intuitively obvious idea, even though it leads to a counter-intuitive result. The intuitive idea is simply that as between two parcels of land with different productivities, the parcel with the higher productivity will command a higher rent. That is, if you can grow more corn, or otherwise do more business, on plot “A” than you can on plot “B”, then the landlord will charge more for A than for B. How m

uch more? This is the surprising part. The difference in rent will tend to equal the difference in productivity. That is, if plot A produces 150 bushels of corn, and plot B only 100, than plot A will rent for 50 bushels more than plot B. This means that all increases in productivity tend to go to the landlord, and the returns to the renters from all parcels of land in a given market tend to be equalized. Can this be true?

Take a set of building plans and build the identical building in downtown New York, downtown Dallas, downtown Laredo, and out in the middle of the desert. Clearly, they will get different rents. The building in the desert will likely get no rent at all, while the one in New York will get a very high rent, with Dallas and Laredo in between. The difference in the rents of these buildings cannot be attributed to anything intrinsic to the buildings th

emselves, since they are identical. The only possible explanation of the difference is in the ground rent. So far, none of this is contentious, and few would disagree.

The law of rents rests on three assumptions:

• Land is necessary for production.

• Land has varying productivities.

• Demand is rational, informed, mobile, and driven by considerations of financial value.²

The first two assumptions appear to be self-evident. The third is the assumption of the perfect market, and to the extent th

at it is true, the law of rents will be true. Of course, markets are never perfect, so the law of rents will never operate perfectly; nevertheless, there will always be a strong tendency for rent to absorb all increases in productivity.

Just how much can rent absorb? Look at the following chart.³

On the horizontal axis, all parcels of land are ordered by their productivity giving the diagonal line at the top, which indicates the total product of any particular site. A, B, C, and M are parcels of land. M is the least productive site that is capable of providing a subsistence wage. It can collect no rent and no parcel less productive will be worked. This is called The Margin of Production. From this site we draw the horizontal line labeled “Wage Line.” “Wage” here means the returns to both capital and labor. Everything above the margin of production goes to rent, and capital and labor divide what is left as best they can.

The law of rents does not work automatically, but is a tendency over time. At any given time, renters will be earning over the wage line, but increases in rent will erode their earnings. Over time, the margin of production will serve as the ceiling for wages and the floor for rents. How does this work? Let us say that you rent a parcel of land at one price and then improve its productivity; your earnings in this case will exceed the wage line. However, when it comes time to renew the lease, the landlord will demand a higher rent, since the property is now more productive; it has moved to the left on the horizontal axis. Since the land is more productive, someone will be willing to pay the increased rent, so you must either agree to pay or agree to move on.

Changes in Productivity

The unusual thing in the above example is that there is an increase in the rent even though there was no increase in demand. The landlord can demand a higher price for improvements made by the tenant. The increased profit was earned by the renter, but received (eventually) by the landlord. This is not an anomaly; it is simply the way land works in a system of concentrated land ownership. Let us examine the ways in which land may increase in value. There are basically three ways:

• An increase in population

• An improvement in technology which makes land more productive

• Off-site improvements, such as roads, utilities, buildings on other sites, etc.

An increase in population will, of course, mean more competition for land. It will also mean improved productivity for any given parcel of land. For example, if you operate a restaurant in an area where the population is increasing, you have a larger pool of potential customers to draw on, and the productivity of the property increases. So will the rent. Note that the increase in population is not something the landlord does (even if he is extremely prolific) but something the community does. Nevertheless, the landlord reaps the reward.

Improvements in technology, whether the moldboard plow in the 10^th century or the internet in the 20^th, increase the productivity of land. Initially, the benefits of these improvements will go to the user of the land, but eventually they find their way into the rent and hence into the pocket of the landlord. Note that these improvements are not something the landlord does, but something the community does. Nevertheless, the landlord reaps the rewards.

If the state builds a road adjacent to your property, the value of that property increases. The same is true for any off-site improvement. If your neighbor builds a large building on his piece of ground, the value of your piece of ground is likely to go up. In general, if you buy a piece of vacant ground, and a community grows up around it, the value of your land will increase without you having to do anything. Note that this growth is not something the landlord does, but something the community does. Nevertheless, the landlord reaps the rewards.

What is common to all three cases is that the community does the work, but the landlord reaps the rewards. This leads to the question of exactly what the social function of the landlord is. We know well what the worker contributes to society, and what the entrepreneur contributes, and what capital contributes. All the things that are made by man are made by these. But land is not made by man and exists quite independently of the landlord. Therefore, we may ask, “What function does the landlord perform, to reap such rich rewards from the labor of others?” One implication of this is that if the worker is to reap the full value of his labor, then he must own an interest in the land he works. This is of course a moral issue, but it is also an economic one. What the landlord gets is wealth without work, which means that somebody else must perform work without wealth. In such conditions, it is very difficult to achieve equilibrium by economic means, and we are forced to call upon the government and the usurers to balance demand.

This also explains why land, in any place where the population is increasing, will always be the best investment. There will be seasonal ups and downs in the price of land, but the secular trend will always be up so long as the population is increasing. But these seasonal adjustments are themselves a cause of great dislocations in an economy. To see how this works, let us return the to first chart in this chapter.

The Speculative Rent Line

When we look at the this chart, we see that any increase in demand for land means that we have to establish a new demand curve, D₁ with a new rent line, R₁. The immediate cause of the increase in demand is likely an expansion of business activity. But we also see another line on the chart, D₂ and another rent line, “SRL” or the speculative rent line. The reason for this is that land is priced differently from real commodities. When you buy a real commodity, say a loaf of bread, the price reflects its history, that is, all the costs that went into making up the product, including the profit of the firm selling the bread. But when you buy an income-producing instrument, say a share of stock or a bond, the price reflects not its past but its future. The price of such instruments reflects the buyer's estimate of the future cash flows associated with that instrument. The seller of a share of stock in Microsoft makes a guess as to the future growth and cash flows from the share, discounts these cash flows for the effects of inflation and his time-preference⁴ for money, and sets a price. If he finds a buyer with equal or greater expectations, he will sell the share. The buyer for his part makes the same guesses and calculation, and if he finds a seller with equal or lower expectations, he will buy the share. Note here that both parties are speculators making guesses in opposite directions, one a “bear” and the other a “bull.”

What is evident about this transaction is that one party will be right and the other wrong. Microsoft may double in price next year, or it may (God willing) disappear from the face of the earth, or, more likely, suffer some fate in-between; one party will have guessed well and the other badly. Now, the deed to a parcel of land is also an income-producing instrument, priced by its future rather than (as with a commodity) by its past. But land is not like other equities. Both the buyer and seller understand that the price is likely to rise in the long-term, so long as the population continues to increase. What is at issue between the buyer and seller is not the eventual value, but the time-frame and discount rate. They are both long-term bulls, even if they are short-term bears. This tends to put an upward speculative pressure on land prices. In equities, speculation tends to work in both directions, and hence balances itself out, over time. But in land, speculation tends to work in one direction only, at least in the long-term.

This puts a near-constant upward pressure on rents. Landowners add to this pressure by withholding their land from the market. If you look around an American city, you will see, once you pass the older core of the city, an alteration of developed and undeveloped or underdeveloped parcels. The un- and under-developed parcels are where owners are holding land off the market in expectation of a better price, in the confidence that, sooner or later, the market must rise to meet their price. This withholding of land further restricts supply, and hence becomes a self-fulfilling prophecy. As long as the costs of withholding land are low, owners can keep doing so to their advantage. Thus the land market, instead of finding equilibrium at R₁, tends to rise towards the speculative rent line. When we recall that rents can only increase at the expense of wages and profits, we realize that this is not a socially neutral process, of concern only to the speculators, but to the whole economy. The rising rents attract more investment and more speculation, until a speculative bubble develops. During this bubble, money that could be used for investment is misdirected to mere speculation. Investment is the serious job of providing firms with the funds necessary to expand production and hiring. Speculation is merely a bet on the direction of some asset, without providing any funds for business expansion. As the bubble grows, banks lend money to speculators to buy more land, and to landowners based on the inflated values of their land. The added credit works like pouring gasoline on a fire, fueling the frenzy and driving the rent line higher and higher—and consequently depressing the wage line.⁵

All of this speculation constricts business activity. It acts like a tax on profits and wages, depressing the real market for goods and services. Of course, the bubble cannot continue forever. The rising rent chokes off the business activity that was the original impetus for the increase in the demand for land. Suddenly, the bubble bursts, land values collapse and lenders who borrowed in expectation of rising land prices cannot repay their loans. Banks restrict credit or go under entirely. Businesses find credit hard to come by, and further restrict their hiring, or even let hands go. All of this happens not because there is a lack of some necessary thing in the economy. On the contrary, there is land to work, hands to work on it, and tools enough to work with. There is the desire for goods, and the desire to supply those goods. There is a willingness to work—even at depressed wages—and more than enough work that needs to be done. Nevertheless, land lies vacant, hands lie idle, and capital finds no investment.

The collapse wipes out all the bad debts and re-adjusts the rent line back to a sustainable level, and the cycle begins again. But one wonders if such a cycle is an inevitable part of business, or whether it is something we have done to ourselves because we misunderstand economic reality, because we have treated things which are not commodities as if they were. We can also note that these cycles are intolerable to both workers and businesses alike, and are always accompanied by the call for government to “do something.” And the government usually does. And by and large, the government has done fairly well over the last sixty years (see Chapter II). The cycles of this period have been milder than at any time in capitalism's history. But one wonders if this remedy can continue forever. Each new crisis seems to demand greater effort—and greater debts. We come to a point, I believe, when the government can do nothing further, and everything it can do can only make the problem worse. But if government can do nothing further for us, is there something further we can do for ourselves? Answering this question forms the burden of the remainder of this book.

1Paul Heyne, Peter J. Boettke, and David L. Prychitko, The Economic Way of Thinking, 10th ed. (Delhi, India: Pearson Education (Singapore) Pte. Ltd, 2003)

2G. Small, An Aristotelian Construction of the Social Economy of Land (Sydney, Australia: University of Technology, Sydney, Australia, 2000), 255, http://adt.lib.uts.edu.au/public/adt-NTSM20030811.163754/

3Adapted from Ibid., 267.

4 The time-preference simply means that most people would prefer to have a dollar today rather than a dollar at some future date, say a year from now. In order to induce them to part with their dollar today, there must be an expectation of receiving more than a dollar at a future date. For example, if the lowest amount that will induce them to part with their dollar is $1.10 over the course of a year, then their time-preference is equal to 10%, and any investment they purchase will have to be at a price discounted by 10%.

5H. George, Progress and Poverty (New York: Robert Schalkenbach Foundation, 1880), 263-281