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Thursday, January 22, 2009:

How Australia loses $1 trillion a year

Gavin R. Putland reviews Bryan Kavanagh's Unlocking the Riches of Oz — and finds it prescient, considering that it was written in May 2007.

Question: How much richer would Australia be, in terms of annual GDP, if it had avoided the last three recessions before the present one?

Of course, if there is to be any point in asking the question, we need a proposed method of avoiding recessions. And if there is to be any way of answering it, we need a reasonable estimate of long-term economic growth in the absence of recessions. Bryan Kavanagh, in his intense 28-page report Unlocking the Riches of Oz, gives us both and more.

To devise a method of avoiding recessions, one must first know what causes them. Kavanagh presents clear and convincing evidence that the cause is property bubbles — or, more precisely, land bubbles.

A bubble in an asset market is a rush of speculation in which prices become decoupled from earnings and are supported only by the assumption that someone else (the “greater fool”) will pay an even more exorbitant price later. When that assumption loses credibility, the support for today's prices is taken away: the bubble bursts. Bubbles cannot occur in the market for buildings, because buyers know that the price of a building is limited by the construction cost and declines with wear and tear; there is no expectation of capital gains or greater fools. But bubbles can and do occur in the market for land, because land, being a gift of nature, does not have a construction cost.

When the bubble bursts, asset owners restrict their expenditure in response to their shrunken net worth, and those who have bought into the market at or near its peak may be ruined. As one party's expenditure is another's income, and as one party's debt is another's asset, the belt-tightening is contagious. When the initial burst occurs in a market as large and important as the land market, the contagion leads to recession. Or that's the theory. But what's the evidence?

For the years 1972 to 2006, Kavanagh has collected the annual real estate sales figures (in then-current dollars) for the several States and Territories, added them up, and divided the total by GDP (in then-current dollars), to obtain real-estate turnover as a fraction of GDP. This fraction, which he aptly calls the barometer of the economy, is graphed on p.12 of the report. An updated version of the graph appears below.

barometer of
the economy

Kavanagh's “barometer
(ratio of real-estate sales to GDP)

At a glance, the graph reveals some startling facts. First, each of the three national recessions since 1972 followed an excursion of the “barometer” above 19%; in no case has a recession followed a peak lower than 19%. Second, each recession struck within two years of the barometer returning below 19% (sooner if the recession is dated from the onset of contraction rather than the appearance of symptoms). Third, there is only one case (the year ended 1994) in which the barometer rose above 19% without heralding a national recession. But even that exception is remarkable. While there was no national recession, there was a widely reported slowdown in Queensland, and it was in Queensland that the peak in turnover was most pronounced (Kavanagh provides the relevant graphs). Moreover, it was only in Queensland that the peak in turnover represented a speculative peak in prices; in other States, it mainly represented delayed sales of repossessed properties left over from the burst of 1989.

So the thesis that recessions are caused by bursting property bubbles is empirically verified if a “bubble” is defined as an occasion on which property turnover exceeds 19% of GDP in one financial year; whenever this happened as a nationwide trend, it led to national recession. Accordingly, Kavanagh refers to the 19% level as the bubble line. Whereas Alan Greenspan would have us believe that a bubble can be recognized only after it bursts, Kavanagh's definition allows us to recognize an economically damaging property bubble almost as soon as it appears.

National recessions followed after Kavanagh's barometer peaked at 24% (1973), 19.2% (1981), and 27% (1989). The Queensland slowdown followed after the barometer peaked at 21% (1994). It is therefore sobering that the barometer peaked at a record 30% in 2004, then fell to 26.5%, rose slightly on the resource-driven West Australian property “boom”, and turned down again. (That's according to the graph above; the version in the booklet, based on earlier and less complete figures, shows a plateau through 2005–6.) Kavanagh concludes on p.15:

The volume of debt contained within the height and breadth of the recent residential bubble offers a strong degree of confidence to suggest that Australia will experience a severe economic recession within two years of the graph retreating back below the 19% bubble line.

As to when that might happen, note that total housing finance approvals in Australia fell 27% in the year to November 2008 (according to ABS 5609.0) in spite of the boost to the First Home Owners' Grant.

While the “barometer of the economy” is Kavanagh's pièce de résistance, it is not the only evidence he offers for a correlation between land bubbles and recessions. Indeed, it does not even capture the essence of a bubble. The barometer is proportional to turnover, which happens to be the product of the mean sale price and the frequency of sales. Conceptually, the existence or non-existence of a bubble is a question of price, not turnover. In practice, however, a bubble leads to a heightened frequency of sales as more sophisticated buyers try to “get in and out” before the bubble bursts, while less sophisticated buyers, who mistake the bubble for a long-term trend, try to “get on the escalator” while they “still can”. Thus price is correlated with turnover, both directly and through frequency of sales. Kavanagh confirms this by providing a graph of frequency of sales (p.10), in which the peaks closely correspond to peaks of the barometer, albeit without a clear “bubble line”.

Concerning actual prices of land, Kavanagh presents two graphs using figures from a paper by Dr. Terry Dwyer [1], commissioned by the Land Values Research Group. One graph (p.6) shows economic rent and taxes as percentages of GDP. The economic rent percentage shows three clear peaks preceding the last three recessions. The other graph (p.16) shows Australia's total land value as a percentage of GDP. This too has three peaks at about the same times. In both graphs, the 1994 “peak” hardly registers, confirming that this event was not a national bubble. Both graphs show prominent peaks during, rather than before, the Great Depression; but even this does not contradict the theory that recessions follow bubbles, because each graph shows a ratio with GDP as the denominator, and GDP fell much faster in the early stages of the Depression than in the last three recessions. And again it is sobering that both ratios were at record heights in 2004.

While excessive land prices constitute the essence of a bubble, they do not of themselves tell us how many current owners have paid excessive prices and/or taken on too much debt, so that they will be distressed when prices fall. It is perhaps for that reason that turnover, rather than prices, exhibits a simple threshold (19% of GDP) that can be correlated with recessions.

So it seems that avoiding recessions is a matter of avoiding property bubbles. But how?

If a substantial fraction (e.g. half) of the rental value of land were taken in tax (presumably in lieu of other taxes), any land owner who failed to generate income from the land would be making an annual cash loss, and would therefore be prompted to use the land more productively (or sell it to someone who will). Holding land in pursuit of capital gains alone would become unattractive and buyers would shift their attention to recurrent income; the speculative motive, which inflates land bubbles, would be reduced. If, in addition, the rent share payable to the government were calculated on the capitalized value of the land (i.e. the lump-sum market price), then rising prices would mean rising holding costs, which would tend to repel buyers and reduce prices, while falling prices would mean falling holding costs, which would tend to attract buyers and raise prices. Thus the growth in land prices would stabilize: competition among buyers, whose spending power is influenced by economic growth, would drive up land prices at the fastest sustainable rate, but no faster.

So it is indeed realistic to suppose that one could eliminate property bubbles and the ensuing bursts and recessions. This leads us back to the original question: If Australia had avoided recessions by the suggested method since (say) 1972, what would the effect on current GDP?

Discouraging the purely speculative holding of land would release land for more productive projects. The simultaneous reduction of taxes that feed into prices would reduce inflationary tendencies, allowing more accommodating monetary policy, which would widen the range of viable productive projects. The need to find productive uses for land would increase the supply of commercial and residential accommodation, strengthening the bargaining position of renters and buyers and making accommodation more affordable (whatever happens to prices or rents in terms of raw dollars), hence facilitating the economic activities for which the accommodation is wanted.

All this is highly conducive to economic growth. While the rate of growth under the proposed conditions is hard to quantify precisely, we can make two estimates that are clearly within reason.

First, let us suppose that the typical rate of growth achieved through this deliberate pro-growth policy would be comparable with the maximum rate of growth achieved by accident under current anti-growth policies. In other words, let us suppose that with the right policies we could do only what we have done before, except that it wouldn't be a fluke. Starting with Australian GDP for the financial year ended 1972 (at 2006 prices), and assuming that the highest real year-on-year growth achieved since then had applied in every year, we find that GDP for the financial year ended 2006 would have been Au$1.98 trillion, i.e. more than $1 trillion higher than it actually was.

For a more pessimistic estimate, allowing for the possibility of long-term variations in growth potential, let us suppose that the fastest growth recorded within each cycle (not for the whole period under study) had persisted through the whole of that cycle. Taking the cycles as beginning in the recession years, namely the financial years ended 1975, 1983 and 1991, and applying the highest year-on-year growth figure for each cycle (or part thereof) to every year of the cycle, we find that GDP in the financial year ended 2006 would have been “only” Au$700 billion higher than it was.

Even on the lower of the two estimates, the potential gain in GDP amounts to Au$35,000 per year for every man, woman and child in the country. Considering how all this extra spending power would affect the rental and resale values of property, one cannot escape the conclusion that property owners would gain in absolute terms in spite of the improved bargaining power of prospective tenants and buyers. In other words, one cannot escape the conclusion that the apparently favourable treatment of property owners under the present tax system — exempting imputed rent from income tax, cutting land tax because property values have risen, cutting land tax because property values have fallen, cutting land tax because it allegedly caused the ensuing recession! — has actually been to their detriment.

As if to rub in this point, Kavanagh gives the last word to John Locke:

“It is in vain in a country whose great fund is land to hope to lay the publick charge of the Government on anything else; there at last it will terminate. The merchant (do what you can) will not bear it, the labourer cannot, and therefore the landholder must: and whether he were best to do it by laying it directly where it will at last settle, or by letting it come to him by the sinking of his rents, ... let him consider” [Some considerations of the consequences of the lowering of interest, and raising the value of money, 1691].

And as his asset values sink in the land-market crash and subsequent recession, let him consider all the more.

Bryan Kavanagh's Unlocking the Riches of Oz: A case study of the social and economic costs of real estate bubbles (1972–2006), ISBN 9780909946036 (pbk.), is published by the Land Values Research Group (Melbourne, May 2007). You can download the PDF free of charge, or purchase printed copies from the Prosper Australia Bookshop.


[1] T.M. Dwyer, “The Taxable Capacity of Australian Land and Resources”, Australian Tax Forum, vol.18, no.1 (January 2003), pp. 21–68.

[This post, last modified Jan.28, 2009, is an updated version of a review first published at grputland.blogspot.com. While the reviewer is not exactly independent of the author, neither the reviewer nor the author nor the LVRG nor Prosper Australia is beholden to any political party or industry lobby.]

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