Sunday, February 9, 2014

A growing liquidity-premium on land

The Cider Mill, by Robin Moline

In general, the real price of land has been increasing all over the world, especially since the early 1990s. (Japan and Germany are the exception). The recent credit crisis hurt this trend in a few countries like Ireland, Spain, Netherlands, and the US, but in other countries like Belgium, Canada, Sweden, and Australia the secular rise in housing prices remains intact.

A popular explanation for the rise in land prices are the various versions of the secular stagnation thesis advocated by folks like Paul Krugman and Larry Summers. According to Krugman, if the natural rate of interest has become persistently negative—i.e. new capital projects are expected to yield a negative return—then investors will look to existing durable assets like gold or land that yield no less than a 0% return. The prices of these goods will be bid upwards, bubble-like. Or, as Summers puts it, if the return on capital is below the economy's growth rate, then intrinsically valueless ponzi assets may be recruited as stores of value to bridge the distance between an individual's present and the future. (Krugman and Summers's ideas are a bit hard to follow, but Nick Rowe has a bunch of helpful posts on these ideas).

In short, these theories explain the paradoxical conjunction of bubbles with a sluggish economy and low inflation.

I think that a better explanation for the rise in real land prices is the emergence of large liquidity premium on land. This premium isn't an irrational "bubble" phenomenon. Rather, over the last decade or two finance and real estate professionals have put in large amounts of time, sweat, and tears to improve the underlying infrastructure that facilitates the transfer of residential land. A few of these improvements include the optimization of the mortgage lending process by the adoption of automated underwriting systems, the development of mortgage scoring, higher loan-to-value ratios on mortgage loans, and the creation of the mortgage-backed securities market.

All these improvements mean that your parcel of land is not like your grandfather's parcel—it can be sold off, parceled up, rented out, collateralized, and re-hypothecated faster than ever. In short, land has become more like cash. Whereas in the past the purchase of a house made you dramatically less liquid, these days that same house impairs your liquidity position much less.

Like any other asset owner, land owners expect to enjoy three services: a pecuniary return such as capital appreciation, a non-pecuniary consumption yield, and liquidity services. In a world in which arbitrage ensures that all assets provide roughly the same return, any improvement in the liquidity services provided by land reduces the amount of capital appreciation people expect to earn on their land parcel (we'll assume the consumption return is constant). This reduction in expected capital appreciation comes about via a rise in land prices now relative to their expected future price. So the steady improvements in the liquidity services thrown off by land have created a stepwise rise in land prices. This rise might appear to be a bubble, but it's only the market's warm response to the finance industry's consistent upgrades to the mechanisms that facilitate transfers of land.

If you believe John Maynard Keynes, what we're seeing now is just a reversion to ancient times. In Chapter 17 of his General Theory, Keynes wrote: "It may be that in certain historic environments the possession of land has been characterized by a high liquidity-premium in the minds of owners of wealth..." He goes on to note that the high liquidity premiums formerly attaching to the ownership of land are now attached to money. It may be the case that in modern times these liquidity premia are detaching from traditional forms of money like deposits and returning to land, the evidence being the rise of land prices and decline in traditional deposit banking.

When a market bursts, the stagnation thesis has it that people have spontaneously switched from one bubble to a new one, or that the underlying features of the economy (i.e the negative natural interest rate) have changed. If land price increases are being driven by improvements in liquidity services rather than low-to-negative rates of return and resulting bubble-seeking behavior, than snap-backs may occur when the underlying architecture supporting that liquidity fails. Alternatively, different networks of finance professionals may be working hard to build up their own asset's liquidity, thus competing away the liquidity premium of the incumbent asset.

Here's an interesting data point: While almost every western nation experienced a housing price boom between the mid 1990s and 2008, Germany somehow missed the boat.

From the Economist's very useful housing price chart tool.

Was Germany somehow exempt from the stagnation that other Western nation's face? Perhaps Germans selected a different bubble asset than land? Or did the underlying mechanics governing the liquidity of the German market for residential land stay constant whereas those of most nation's improved?

We know that while MBS markets were deepening all over the world, German law did not permit MBS issuance until 1997, putting it far behind the mortgage slicing & dicing eight-ball. Rather, German residential real estate finance continued to be underpinned the centuries old pfandrief, or covered bond. While  the originator of an MBS can parcel away mortgages into a bankrupt-remote entity, the assets underlying a pfandriefe are required by law to stay on the issuer's balance sheet. The mortgages comprising MBS often have up to 100% loan-to-value ratios, but German law requires that pfandbriefe be backed by mortgage loans with a maximum of 60% of the home's "lending value" (lending value is more conservative than market value), which in practice means that Germans often have to put up 60-70% cash to buy a home. Such high requirements would surely stifle the liquidity of residential land, especially compared to places like Canada where permitted LTVs went from 80% to 100% in the space of ten years.

So while Keynes's liquidity premium may have migrated back to land in much of the western world, this doesn't seem to be the case in Germany. There are surely advantages to having avoided a rise in housing prices. On the other other hand, owning a liquid house rather than an illiquid one is a boon—it provides an individual with a fluid asset for dealing with an uncertain future. From this perspective, any attempt to stifle some asset's liquidity by limiting the finance industry's ability to innovate reduces the range of coping mechanisms that  a society is presented with.

P.S. I already wrote versions of this post. Here are these ideas applied to equity markets, here they are applied to bond markets. Same idea, different day, different market.

25 comments:

  1. Good post. I vaguely remember hearing that Germany has very high taxes or transactions costs on buying and selling houses (land?).

    "Like any other asset owner, land owners expect to enjoy three services: a pecuniary return such as capital appreciation, a non-pecuniary consumption yield, and liquidity services."

    Or, for those of us who are landowners who rent our land to tenant farmers, that "non-pecuniary consumption yield" becomes a very pecuniary cheque for the rents.

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    1. Thanks Nick. I'm not sure about high taxes/transaction costs, maybe someone else oes?

      "Or, for those of us who are landowners who rent our land to tenant farmers, that "non-pecuniary consumption yield" becomes a very pecuniary cheque for the rents."

      Yes. (I'm thinking that in renting land to tenants, landowners don't forgo much in the way of liquidity services -- even when land is rented out, the owner can usually evict and sell. So while the cheque embodies the non-pecuniary consumption yield, liquidity services aren't necessarily included.)

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  2. "Perhaps Germans selected a different bubble asset than land?"

    Germany is and has always been a very big market for Perth Mint for coin gold.

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    1. Two significant inflations will probably do that to you.

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    2. What is the non-Weimar episode you're referring to? Germany dodged the inflation of the '70's didn't they?

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    3. It's my understanding that near the end of WWII and a few years after, the reichsmark lost a lot of purchasing power. Price controls would have camouflaged the true extent of this loss, but citizens would surely have experienced it first hand.

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  3. I understand that the claim here is that the absolute amount of liquidity (services) is going up and that it is a good thing. What are the (macro) consequences of that? What is the limiting case? How much liquidity would be too much? Why?

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    1. One macro consequence is that if people hold more land and less Federal Reserve notes in order to reach their desired level of liquidity, the economy-wide price level will rise.

      The limiting case is that consumers treat land as the ultimate liquid good, land prices spiking to unheard of levels. But the process of competition should limit the attraction of a large liquidity premium to a certain asset. Entrepreneurs will always find cheaper ways to promote the liquidity of their preferred asset.

      How much liquidity would be too much? If consumers are unwilling to pay a sufficiently high price to cover the costs footed by entrepreneurs to build up liquidity-promoting infrastructure, then we've hit a ceiling.

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    2. The first paragraph of your answer sounds like land (and other assets?) sucking liquidity (services) out of Federal Reserve notes (hence raising the economy-wide price level). Does that imply some "liquidity conservation" principle, where gain of liquidity (services) of one asset is matched by an equivalent loss of another? Or can the "aggregate" level of liquidity (services) in the economy actually increase by "entrepreneurs building liquidity-promoting infrastructure"?

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    3. "The first paragraph of your answer sounds like land (and other assets?) sucking liquidity (services) out of Federal Reserve notes (hence raising the economy-wide price level)."

      I like to think of it as land providing more liquidity services than FR notes at a better price rather than "sucking out", but I think you've got the idea.

      I think that the aggregate demand for liquidity services can increase by entrepreneurs building cheaper liquidity promoting infrastructure. Liquidity competes with other sorts of goods that help individuals cope with uncertainty, like insurance, good information, or a pantry full of canned goods. If liquidity can be bought at a cheaper price than these alternatives, then the aggregate amount of liquidity services people will want to buy will increase.

      Good questions, by the way.

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  4. JP, this looks like a great article, and I especially like the graphic: very nice... I'll remember the artist.

    I had a quick O/T for you: assume that for some reason the Fed wanted to re-establish some separation between the IOR and the FFR but without having to unwind its BS. Since reserves are currently at about $2.5T and checkable deposits at $1.5T, could one way to do this be to simply up the reserve requirements (RR) from 10% to 167% (=2.5/1.5)? That would immediately re-establish a high "marginal convenience yield" for reserves, correct?... and allow the FFR to be set using pre-2008-style OMOs independently of the IOR (as long as it was set no lower than the IOR). Thoughts?

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    1. Moments after posting this here (and at pragcap) I noticed this comment:

      http://pragcap.com/when-will-the-fed-end-its-zero-rate-policy/comment-page-1#comment-167236

      Is that true? This new "overnight full allotment reverse repo facility" allows them to control the ST end of the yield curve .. even though ER > 0? Do you know how that works?

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    2. The artist is excellent. Am going to buy one of her prints.

      I think your reserve requirement boost will do the trick of opening up a gap between the fed funds rate and IOR. See http://jpkoning.blogspot.ca/2013/08/the-fed-funds-rate-was-never-feds.html. As for the RR facility, maybe you can do some research on it and report back to me, I haven't familiarized myself with the issue.

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    3. If I find out I'll be sure to let you know. I don't know anything about the commenter that brought that up, and I'm a little skeptical that there's anything to it.

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    4. JP, I think that "overnight full allotment reverse repo facility" must be what JKH and Sadowski are talking about here:

      http://pragcap.com/a-new-operating-framework-for-the-federal-reserve

      and here:

      http://www.themoneyillusion.com/?p=26159&cpage=1#comment-318483

      The paper they both cite being this one:

      http://www.piie.com/publications/interstitial.cfm?ResearchID=2558

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    5. Thanks you, sir. Am swamped these days, hopefully I get the chance to check these out.

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  5. JP, another brief O/T: I'm always trying to figure out how to summarize what good monetary policy is. How's this?

    A money economy w/ good monetary policy combines the best aspects of barter and money: unnecessary recessions due to shocks to MOA demand (combined w/ sticky wages & prices) is relieved, but so is the coincidence of wants.

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    1. update: I ran a (clumsier) version of this by Nick Rowe and he responded by saying:

      "the goal of good monetary policy is to try to make Say's Law true."

      I love that!... but do you agree?

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  6. JP,

    I'm not sure this as much to do with 'liquidity premiums'.
    I'd rather take a look at Basel regulations that make mortgages comparably more profitable for banks, diverting loanable funds towards housing, inflating demand and prices.
    I wrote about a serie on the topic that starts here:
    http://spontaneousfinance.com/2013/11/05/banks-risk-weighted-assets-as-a-source-of-malinvestments-booms-and-busts/
    You were close to the topic when you mentioned MBS though, as the same regulatory process applies.

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    1. Does it explain why Germany didn't have a housing price boom while everyone else didn't?

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    2. Germany is a more complicated case.
      The country's population is declining and it went through reunification. A large part of East Germany had to be rebuilt. If anything, it is surprising that prices in Germany didn't decline more than they did.
      Moreover, prices in Germany are actually starting to increase now...

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  7. Sort of off-topic, but do you have any thoughts on the mild Georgist resurgence that seems to be spreading in the econ blogosphere?

    Examples: Ashok Rao, http://ashokarao.com/2013/09/03/a-remark-on-ricardian-taxes/
    Noah Smith, http://noahpinionblog.blogspot.kr/2014/01/a-henry-george-tax-for-san-francisco.html

    Just for fun, here's Fred Foldvary who incorporates Free Banking and ABCT into a "Geo-Libertarian Synthesis":
    http://foldvary.net/works/geoaus.html
    http://www.progress.org/tpr/who-should-control-the-money-supply/

    It does seem like land has played a large role in financial boom/busts (e.g. 1880s Sydney, Japanese property boom, the current crisis). I seem to remember reading that Canada, during its free banking era, had restrictions against lending against land--did this perhaps make its system more stable than Australia's (or were the restrictions ignored in practice; I don't know). Anyway, it seems to me that, given its possible effects on macroeconomic cycles, land economics (and its interaction with monetary economics) has received somewhat less attention that it deserves.

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    1. Thanks John. Will check out these links if I get the chance. Swamped these days, unfortunately.

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  8. What about people seeing that others who have shorted the dollar (mortgage with collateral) and went real property did better than savers in the past. Now people might have picked up on it and are trying the same. The price may have over shot, but people might still be considering it.

    A monetary dilution hedge or profit.

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