The recent stock market and real estate bubbles are much like pyramid schemes in the sense that what is bidding up stock and property prices is an exponential inflow of new money from pension plans and mutual funds (for shares) and bank credit (for real estate). Venture capitalists are “cashing out” while corporate managers exercise their stock options.As I have been driving around Southern California, I am stunned by the sheer amount of real-estate development that has occurred in the last ten years. Development has occurred in all sectors, residential, commercial, and government. The value of residential and commercial real-estate is now plummeting as anyone who reads or pays attention to local conditions can tell. Land values were raised with really no productive advantage attached to them. Now, the properties sit increasingly empty of tenants, rents will or are plummeting and it will take a long, long time (if ever) to make those properties income generators again.
Suppose that mortgage-packaging companies are honest in their appraisals of current price trends. The real estate bubble is nonetheless speculative and postindustrial. The analogy is found when financial managers endorse government policies that encourage the inflation of price for stocks and bonds, stamps and coins, Rembrandts and modern art by claiming that this creates wealth and hence, by definition, pulls living standards and culture onward and upward.
What is wrong with this picture? For starters, it fails to define value as distinct from price, windfall and capital gains as distinct from earned income. It also neglects the fact that market prices rise and fall, but the debts remain in place. And when debts cannot be paid, savings are wiped out. ...
What does this have to do with true capital formation? Individuals are getting rich while the economy is polarizing between creditors and debtors, property owners and rent-payers. Unproductive investment occurs when it takes the form of windfall “capital” gains, and when it involves going into debt for real estate, stocks or bonds, or “collectibles.” Unproductive credit occurs when commercial banks make loans that merely finance the purchase of property, companies or financial securities already in place.
Here in Orange County, the signs (literally and figuratively) are ominous. Just about every commercial strip center & building one sees in this land of sprawl has a "for lease" sign, or the whole property itself is for sale. Empty units abound. There are thousands of residential properties that are either bank owned or in the stages of the foreclosure process. In my little track of a few hundred houses, about 20 are now either bank owned or in the process, an increase of 6 since the start of the month. Given these trends, there will be NO recovery in the housing market any time soon. It is a good thing too! As Hudson points out in his article, there is no real productive economic value in increasing property values, it creates a sort of false capital gains based wealth and generates NO economic labor investment based value on its own.
The government building spree is no doubt in similar straits, the LA Times this morning has an image of county workers protesting announced job cuts in the unfinished $300,000 refurbishment of the Board Supervisor's lobby in the hall of administration. The image speaks volumes for how out of control the developer-based economy has become. New paint, pictures, and furniture add absolutely nothing to the functional use of the supervisor's lobby, just baubles or eye candy to false inflate the County Supervisor's sense of self-importance. But the $300,000 will certainly line the pocket of some contractor who no doubt will spend the money on other baubles for his home or office.
A recent trip to UC-Irvine further underscores this developer-contractor economy. The university has been on a building bonanza since I graduated there in 1999. Older buildings (less than 30 years old in many cases) have come down, new buildings have replaced them. All this new construction (simply replacing older contruction that was still functioning just a decade ago) in a state that projects a yawning 49 billion dollar deficit over the next 18 months. the UC system will be hit hard, layoffs will inevitably be massive and these buildings will sit, under utilized (and redundant anyway). Contractors pockets have been lined, but no real added value to the productive work of the university's mission has been created. Indeed, the debt based development is actually choking off the ability of the university to realize its mission as its operating budget falls into a black hole.
During this ecnomic downturn, we must wean ourselves off of the developer-contractor economy. It is a false economy that dooms us to the sort of wealth polarization that Hudson has been writing about. We must once again learn to distinguish the difference between investment of past gains into future productive returns, and the use of debt to gamble on rising value of nonproductive false wealth inthe future.