Gold Standard Stability vs. Land Standard Chaos
If modern economists had paid attention to the disagreement between Adam Smith the father of modern free-market economics on the one hand and John Law, the father of modern financial bubbles on the other, we might have avoided a painful financial crisis.
Although John Law’s name is now associated with the 18th century South Sea Bubble, the problem he wanted to solve was the same that central banks are struggling with today: “How much money and credit can be created without bringing about inflation, destabilizing the economy, or destabilizing the international financial system?” Law’s proposal then was that a “land-collateralized” note issue would be the solution.
The crisis we are in and that Japan has been in for two decades by now, show that the world repeated Law’s mistakes, though heavily disguised by new jargons, policies and financial instruments, which obscured the “land”-based-similarity.
Law’s solution at the time was based on these principles: For money’s purchasing power to be stable, the issuing of credit must be linked to anticipated “real” trade; using land as collateral, there could be no over-expansion of credit. Law was mistaken, though, because he did not see how monetary expansion raises land prices, which then mistakenly rationalizes further credit expansion. Adam Smith recognized this flaw in this early version of the “real bills” doctrine, and corrected it.
First, he said, the collateral should be commercial paper, rather than arbitrarily choosing land as collateral. Second, Smith saw that even commercial paper could not be sufficient to sustain stability: the price of the asset backing the “real trade” could be increased too, leading to credit expansions. For the “real bills” doctrine to work, he noted, it needed specie (gold) convertibility to constrain the undue expansion of credit.
So what happened first in Japan, then in the events leading to the present financial crises? After World War II, Japan passed many laws that biased investments toward land. Among them: if people invested in land using borrowed funds, interest on the borrowing was deducted from their income; and, for the purpose of inheritance tax, land values were appraised advantageously lower than cash or shares.
As the competition among Japanese financial institutions intensified in the latter half of the ’80s, the quality of due diligence dropped, and lending with land as security increased. This drove up the price of land, and credit then expanded further. The central bank accommodated, with John Law logic, unconstrained by Smith’s reservations. The soaring land prices affected share prices (as companies had massive real estate holdings), and both then affected each other in an upward spiral for a while.
Oblivious to the nature of the problem, by 1988 the Japanese government tried to solve the monetary problem with fiscal remedies – which will seem eerily familiar. It imposed a 20% withholding tax on savings; a capital-gains tax on equity sales; a security transfer tax; a 3% consumption tax; a 6% tax on new cars; and a 2.5% surtax on corporate profits among others. Then, at the end of 1989, the Basic Land Law was enacted. The law focused on the “public interest” in land to ensure appropriate planning and to suppress land “speculation”.
The Bank of Japan raised the discount rate in May 1989 and introduced quantitative controls on the total amount of land related loans from April 1990. The government then reformed the land taxation system, drastically raising capital gains taxes. While the changes were complex, what they meant was that capital gains taxes on real estate jumped from 20% to 50% if people or companies sold them within a 10-year holding period. No wonder real estate prices and share prices then collapsed.
Jump to events leading to the present crises. Never mind the reasons, Washington decided to increasingly subsidize housing in increasingly complex ways. In no particular order, interest rate payments on mortgages became deductible, mortgage guarantors Freddie Mac and Fannie Mae were created, which, combined with securitization, the Fed’s disregard of the expansion of credit through “shadow banking”, lack of supervision of institutions fulfilling financial intermediary functions and due diligence, lack of adjustment in rating agencies’ analyses when banks were giving up their traditional due diligence roles, have all contributed to the undue expansion of credit.
This took the shape and form of mortgage-backed loans – in principle “land-backed” – though misleadingly called “real estate-backed”.
Words matter. They are the vehicles of thinking: while they can shape accurate perceptions, they can shape misperceptions too. As it turns out, and not for the first time in history, there is not much “real” about this asset class, as we recently saw through painful experience. Will we have the wisdom to at least re-learn what we never should have forgotten to begin with?
Reuven Brenner holds the Repap Chair at McGill’s Desautels Faculty of Management, serves on the Board of the McGill Pension Fund and is member of its investment committee.
He worked with Bank of America, Knowledge Universe, EEN, Bell Canada, Repap Enterprises and with investors in Canada, Mexico, the US and Europe. He has been involved in the private equity markets as partner in Match Strategic Partners, has been investing in start-ups across Canada, as part of an “angel group,” and also created his own start-up, “e-mortal.com.” He has also been serving on boards of companies and institutions.
He was expert witness in cases covering anti-trust, bankruptcy and financial matters. In other spheres, Quebec’s government asked him in 1995 to be member of a commission whose mandate was to examine all aspects of Quebec’s possible separation. He was also asked to testify before US Congressional Commissions and Canada’s Senate’s Banking and Finance Committee, and worked with Poland’s central bank during the recent crisis.
His recent books are A World of Chance (2008) and Force of Finance (2002). His regular columns appeared in Forbes, The Wall Street Journal, Asia Times and other financial press around of the world. Forbes’ journalists put two of his earlier books in their all time recommended list, and Forbes Global dedicated a cover story, titled “Leapfrogging,” to his works and endeavors. Brenner also received the Killam Award (1992), the Royal Society elected him as “Fellow”(1999), and he received a Fulbright Fellowship Grant (1976).
Brenner was born in Rumania and immigrated to Israel in 1962. He served in the Israeli army between 1966-69, during the Six-Day War, and again during the 1973 Yom Kippur War. The Fulbright fellowship brought him in 1977 to Chicago, after completing his PhD at the Hebrew University and working at the Bank of Israel, where he received the First Prize from Israeli banks (for work with Saul Bronfeld, designing indexed securities). He lives in Canada since 1980. He is fluent in English, French, Hebrew and Hungarian.