Wednesday, April 09, 2008

Real Estate: A Capital Trap for National Savings

The first of this month's highlighted books, Planet of Slums is a brilliant exploration of how mega-cities have become mega-slums.

The core lessons of this important book are profound. Though author Mike Davis focuses on the teeming supercities of the Third World, the same principles apply to First World metropolises and economies as well.

Why is most of the growth in mega-cities concentrated in mega-slums? The summary answer of such complex movements of people and capital runs more or less like this: as nation-states impoverish their rural areas (no investment in rural infrastructure, land piracy by the Party or ruling kelptocracy, price controls to keep incomes low, etc. etc.) the impoverished have little choice but to move to the city and look for marginalized employment there.

Once there, they find the demand for housing of even the most rudimentary sort has driven prices sky-high. The nation-states/elites invest almost zero money in housing for the working poor, and what does get built ends up in the hands of the civil service/ bureaucracy employees.
Contrary to what us naive folks might assume, the really stupendous profits aren't made in luxury buildings--they're generated by tightly packed slums. Here's how it works. Let's say a middle-class flat of 600 square feet (7.5 square meters) goes for $1 per square foot. The slum's equivalent 600 sq. ft. has been cut up into numerous cubbyhole rooms, each housing many people who each pay a relatively high fee for the miserable lodging. The rent per square foot in the slum is thus $5/sq. ft.

According to Davis (and this book is heavily, even obsessively footnoted/sourced), densities in Third World slums are astronomical--18,000 residents per acre is not uncommon. That's four modest-sized 10,000 sq. ft. residential lots in the U.S. suburbs--4 houses that might house 8 people, total, not 18,000.

So slums are immensely profitable--much more profitable than permanent "middle-class" housing. And will you be surprised to learn that most of the property in these mega-city slums is concentrated in a few hands?

The net result of this great urban overcrowding/high-rents/profitability is indeed pernicious. Land values skyrocket as investors domestic and foreign rush in, and the lower ranks of workers who have somehow saved enough to own a piece of property then become petty landlords, exploiting the ranks of those unable to save.

The poorest residents are then forced out of the slums, which are now too expensive, and they become illegal squatters on the city's fringes: often these marginal lands are swamps, filth-laden river banks prone to flooding, or unstable hillsides. Once there is some value in this marginal land--roads and a water pipe--what started out as public land is appropriated by local elites and sold to private developers, who then raze the shacks and build more substantial slum dwellings which rent for a substantial percentage of poor workers' incomes.

The poor are then faced with Hobson's Choice: either pay 50% of their income for a corner of a slum near public transportation, jobs and water, or migrate to the city's distant edge for "free" squatting. The squatting isn't actually free; a numbing three-hour commute is the price of living far from the meager employment (jitneys, vendors, laborers, etc.) in the central city.

Consider the penicious incentives: the local elites are not about to cut their own income by supporting the investment of public or NGO (non-governmental organization) foundation funds for housing the poor or infrastructure in the (non-rent paying) squatter slums. And the rate of return on the overcrowded slums far exceeds the returns made by investing in actual production such as factories, schooling, etc.

So urban land values continue ever higher, pulling much of the nation's capital into urban housing where it becomes a capital trap of national savings. Now "pure capitalism" poses no theoretical objection to this cycle: demand for housing exceeds supply, and if the supply is artificially limited by the elites who own much of the urban property, then the poor go out and appropriate unused public land for squatter slums.

The net result: no capital is invested into production; every cent of investment capital, even that scraped up by the poorest entrepreneur, is pumped into immensely profitable urban slums.
Let's now turn to the U.S., which has seen a similar ballooning of urban and core-suburban value. Despite the obvious need for alternative sources of energy and technology which reduces petroleum consumption, how much global and American capital flowed into these investments for the future (recall the slogan, "energy independence is national security") in the U.S., compared to the trillions pumped into mostly urban real estate?

I haven't been able to find adequate statistics on these investment flows, but it seems the "investment" in urban-suburban real estate is on the order of 100 times the total capital invested in alternative energy research and development.

How many jobs flow from those thousands of granite countertops and fake "Gone with the Wind" staircases in thousands of McMansions and urban condos, and from the hundreds of strip malls constructed in the past decade? None.

Yes, someone was paid to manufacture and install the construction materials, but now that the building is done, there is nothing to show for those trillions of dollars of investment. Just like the Third World mega-slums, America's cities and suburbs are now "capital traps" of national savings.

For it isn't just the capital trapped in empty condo towers and millions (yes, millions, see yesterday's entry sources) of empty houses and the rapidly enptying office parks and malls--it's also all the capital trapped in the financial institutions which enabled the real estate bubble to expand so voraciously and profitably that all other investments paled.

It's no secret that financial firms' profits have grown to the point that they dominate the S&P 500. Trillions of capital are tied up in U.S. real estate and the mortgage-backed securities and other asset-based financial instruments based on residential and commercial real estate.

What could the nation have gained had those trillions been invested in new production of goods and services? Was the entire real estate bubble a vast, perniciously destructive misallocation of national savings into "capital traps"? I think the answer is clearly "yes." Now that real estate is starting its long decline from euphoric fantasy to reality, plummeting values of both the real property and the financial house of cards erected on the property are erasing trillions.

How do you extract the capital from a rapidly depreciating asset? It's human nature to hope "things will turn around next year." Unfortunately, real estate will not turn around next year, or the year after that or the year after that. Real estate has become a capital sink for the national savings.
Yes, large global U.S. corporations are sitting on a cash horde of $1.4 trillion or so; and that begs the question: what are they waiting for? Isn't there any capital project profitable enough to justify investment? Apparently not. If you're counting on global U.S. based corporations to "save the country" via wise investments in new goods and services, don't hold your breath. Many companies have "invested" their billions of cash in share buybacks, essentially propping up their stock prices with artificial demand/ buying.

How pathetic is our state of affairs when "investing" in bubble-valued real estate and stock buy-backs is so very much more profitable than investing in new production of real goods and services?

I have often recommended the three-book series Civilization & Capitalism, 15th to 18th Centuries by historian Fernand Braudel (The Structures of Everyday Life (Volume 1) , The Wheels of Commerce (Volume 2) and The Perspective of the World (Volume 3) ). One bit of history he described which continues to resonate is the re-allocation of capital by the Venetian merchants as their trading empire was eclipsed in the 16th century. Rather than battle for trading supremacy, the wealthy capitalists of Venice moved their capital onto the mainland, buying farms and agricultural production.

Why? This generated a higher return on capital, now that competition had rendered global trade less profitable. This marked the permanent decline of Venice from a global powerhouse of shipping, goods and capital to a backwater.

The point of the story? That capital allocated for short-term profit is supposedly the unerring "invisible hand" of the market--yet this allocation of capital for "highest current returns" to the exclusion of competition, trade and "soft power" led to the decline of Venice from a global center of wealth and growth equivalent to London, Tokyo or New York in its day, to a faded-glory tourist town.

Is there a lesson in this for the U.S.? Absolutely. Beware of Capital Traps for National Savings.

(The other two featured book recommendations this month are Tragedy & Hope: A History of the World in Our Time and How The World Really Works )

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