This post is a bit of a departure for me. I’m not an economist. Not by any stretch of the imagination. I dabble occasionally in economics-related topics, particularly those concerning technology and economic theory, but I rarely get involved in the traditional core of economics — in topics like property prices, economic growth, debt, wealth inequality and the like. But it’s precisely those topics that I want to get involved with in this post.
I do so because of an observation: property prices in large urban areas (think London and New York) seem to have increased rather dramatically (in real terms) in the past few decades. Sure, there have been property booms and busts — some quite dramatic — but they haven’t really impacted the steady upward trend for prices in large urban areas. These price increases come at a time of increasing wealth inequality. Since approximately 1980, we have seen a fairly noticeably rise in wealth inequality in Western countries. Much of that wealth is now accumulating in property-related investments and is driving middle-to-lower income earners out of the market, unless they willing to take on significant amounts of debt. Why is this happening?
Adair Turner (former head of the financial regulator in the UK) has an intriguing answer to this question in his recent book Between Debt and the Devil. He suggests that the rise in property prices in large urban areas is driven, at least in part, by exponential improvements in technology. As you might imagine, the suggested link between technological growth and rising property prices is designed to pique my curiosity. It joins together two areas of interest: one professional, the other personal.
Now I don’t have the knowledge to critique Turner’s argument; but I do have the ability to render its logic more transparent. So that’s what I propose to do in the remainder of this post. I’ll start by motivating the argument a bit more, looking at some of the facts and figures concerning wealth inequality and property-investment.
1. Is wealth concentrated in property?
Turner’s argument develops out of a series of factual observations. The chief among them being that (a) wealth inequality has increased; (b) the wealth that is out there is increasingly concentrated in property-related investment, particularly in land in large urban areas; and c) the amount of credit-created money is increasing and is also concentrated in property. Is there any evidence to support these observations?
The support for (a) comes from the work of economists like Thomas Piketty and Anthony Atkinson. Piketty’s work is, of course, particularly famous in this respect. It tells a by-now familiar story. The gist of that story is as follows: there were huge of levels of wealth inequality in developed economies in the late-19th century. Most of the wealth was concentrated in the hands of relatively few industrialists, capitalist tycoons and aristocrats. During the first 70-80 years of the 20th century, this wealth inequality started to go down. There were a number of causal contributors to this. I’ll mention two. First, the two world wars witnessed a massive destruction of capital (land, property, machinery etc), which wiped out a lot of wealth. Second, after the second world war, economic growth in the richest economies, particularly the US, exceeded the growth in wealth: this allowed for some flattening of the wealth disparities in society and led to the rise of the middle class.
Since approximately 1980, this trend has reversed itself. We are now returning to levels of wealth inequality not seen since the late-19th century. Concern about this has reached the popular consciousness. It can be seen in the battle-cries of the 99% and the rhetoric of politicians like Bernie Sanders and Jeremy Corbyn. The empirical support for this story is meticulously documented in Piketty’s work. What is particularly interesting about this empirical support it is how it also illustrates the increasing concentration of wealth in property. Consider the following diagram, taken originally from Piketty, but reproduced in Turner’s book:
The diagram shows the ebb and flow of capital as a percentage of national income, in France, since the 1700s. One thing is particularly noticeable: the amount of wealth concentrated in housing has increased dramatically since 1970, going from about 120% of national income in 1970 to 371% by 2010. Turner reports that something similar is true in the UK, with housing-related wealth going from 120% to 300% over the same period. Furthermore, he argues that Piketty’s data doesn’t represent the full picture as commercial real estate also accounts for a significant percentage of non-housing related wealth. If we dive into the data even deeper we notice other interesting trends. Most of the increase is accounted for by increases in the price of land, not in the prices of the buildings that sit on top of that land. Indeed, figures from Knoll, Schularick and Steger suggest that approximately 80% of the increase in house prices in advanced economies since 1950 can be attributed to land. This is pretty startling and it all provides support for (b).
Which brings us to c). Credit plays an important role in the story of increased property prices. I teach a course on banking law to students. One thing I am always keen to impress on these students is that, in a fractional reserve system, banks actually create money, they don’t simply move it about from place to place. They do this through debt contracts (loans, mortgages etc). The amount of money created in this form has been steadily increasing since about 1950. Figures from Rogoff and Reinhardt, reproduced in the diagram below, suggest that private debate now amounts to approximately 170% of GDP in advanced economies, having increased from about 50% of GDP in 1950.
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| Reinhart and Rogoff's data on the growth of debt. Apologies for the quality. |
In an ideal world, this bank-created money would go toward socially valuable investment: entrepreneurs would be given money to start businesses that contribute to the economy. In reality, relatively little of the money goes toward that kind of investment. Most of it now goes toward property. In a 2014 paper, Jorda, Schularick and Taylor presented evidence suggesting that real estate lending now accounts for 60% of bank lending in advanced economies, having increased from just over 30% in 1950. This is significant because credit of this sort often fuels price increases. In the worst cases, it fuels asset price bubbles, which is exactly what happened to property in countries like Ireland and Spain in the lead-up to 2008. But even in these countries property prices in large urban areas rebounded pretty quickly.
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| Data from Jorda et al on the growth in real estate in lending. |
Why? Turner presents two arguments.
2. The Technology Argument
The first argument is the one I’m really interested in. It starts with an apparent paradox. If the foregoing is correct, then property (in particular land) is an increasingly important source of wealth in advanced economies. But this is out of step with another observation about modern economies: their increasing weightlessness. ‘Weightlessness’ is a term economists use to describe the fact that physical goods are playing less of a role in the modern world. Everything is being digitised through advances in information communications technology (ICT).
But the increasing weightlessness of the economy is, in part, responsible for the increasing importance of property. This is Turner’s key insight. He notes, as others have done, that ICT seems to have two key properties: (i) exponential improvement in the hardware along multiple dimensions (processing power, memory, bandwith etc), which reduces costs for ICT over time; and (ii) near zero marginal cost for reproducing digital goods. These properties have interesting consequences. They mean that ICT companies like Facebook and Google can create huge amounts of wealth with relatively little capital investment, i.e. they don’t have to waste much money on physical goods and human labour. Commenting on Facebook’s equity valuation of over $150 billion, Turner argues:
Compared with the investment that went into building automobile, airline, or traditional retail companies this [Facebook’s capital expenditure] is trivial. And more generally, the two distinctive features mean that wherever the “machines” that drive businesses include a large ICT software or hardware element, they keep falling in price relative to current goods and services. IMF figures show that the price of capital equipment relative to prices of current goods and services fell by 33% between 1990 and 2014.
(Turner 2016, 69)
In short, there’s a lot of wealth being created by capital that is itself decreasing in price. This has one necessary consequence: a greater share of investment will be accounted for by assets that are not decreasing in price. Land and property are the obvious examples. This is a necessary consequence because if the price of ICT is going down, the proportional value of whatever is not going down in price must increase. Say $100 dollars is invested in two different forms of capital in one year: (a) $50 in ICT and (b) $50 in land. Suppose the price of the ICT falls by half over the next two years. Even if the value of the land remains unchanged, the share of wealth taken up by the land will double. As Turner puts it:
A world in which the volume of information and communication capacity embedded in capital goods relentlessly increases is a world in which real estate and infrastructure constructions are bound to account for an increasing share of the value of all investment.
(Turner 2016, 69)
This argument, of course, assumes that land and property prices will not themselves be subject to downward pressures. You might argue that this assumption is flawed since property prices clearly do sometimes go down. But there are at least two good reasons for thinking that they are unlikely to do so, particularly in large urban areas. The first is that land (in particular) and property (in general) just aren’t subject to the same downward trends as ICT. Land is a relatively fixed resource (barring some possibility for reclaiming land from the sea). As more and more people clamber to live on smaller and smaller segments of land — which is exactly what is happening in large urban areas — we can expect the prices to go up, not down. The second reason has to do with consumer and investor preferences, which brings us to the second argument.
3. The Consumer/Investor Preference Argument
Turner’s second argument maintains that in richer societies, land and property are likely to increase in price due to consumer and investor preferences. This is a more traditional economic argument because it focuses on the choices that ‘rational’ consumers and investors are likely to make. It is interesting because it highlights a positive feedback loop between technological growth, increasing wealth and increasing property prices.
The rough outline of the argument is as follows.
Some goods have low income elasticity. This means that the demand for these goods is relatively insensitive to changes in income. Food and clothing are good examples. As you get richer, you will probably buy more food and better clothing. But eventually people tend to reach satiation in these categories of expenditure: there is only so much food and clothing they can have. This is particularly true if they are uber-wealthy: there only so-many 3-michelin star meals you can eat, even if you are a billionaire. Furthermore, there are some goods that have high income elasticity, but prices for them are subject to downward pressures such that the increased demand is offset by price decreases. ICT goods are prevalent examples of this.
People aren’t going to invest their increasing wealth in low income elasticity goods. Instead, they are going to invest in high income elasticity goods. The most important of these goods in the developed world is ‘locationally specific housing’, i.e. housing in the most attractive parts of the most attractive large urban areas. Because the supply of this housing is relatively fixed, and because there is more wealth out there chasing this fixed supply of goods, the only thing that can adjust is price.
This kicks off a positive feedback loop. The wealthy invest more in locationally specific housing because its the major thing that is increasing in value; and banks lend more for the purchase of such housing because it looks like a relatively safe bet. The price adjusts ever upwards.
4. Conclusion
I have little to say by way of conclusion. Those of us who are familiar with the property market in large urban areas will have had a good sense of the problem of price increases already. Turner’s argument is intriguing because it links the lived reality to other macroeconomic and technological trends. The exponential growth in ICT increases the amount of wealth invested in property because the downward pressure on ICT prices necessarily increases the proportional share of wealth invested in property. And rising levels of wealth, when tied to consumer preferences and lending practices in the banking sector, fuel price increases in locationally specific housing. The connections that Turner draws out seem plausible to me. Are there good arguments against this point of view?
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