Statewide Title, Inc's Third Economic Update

2009 Economic Analysis and Market Outlook
By John R. Dillard, J.D., PhD - Vice President and Legal Counsel, Statewide Title, Inc.

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The Eighteen Year Real Estate Cycle

A cycle is defined as a phenomena that repeats itself. Ever since the science of economics was developed, a debate has raged among economists regarding the validity of economic cycles. It’s just not that there is an economic cycle, but that there are many cycles within various sectors of the economy. Consider the real estate sector. As the chart below illustrates, sales for new homes have abruptly declined by about two-third’s since its peak in 2006. Although we now know there were many factors that contributed to the bubble bursting in the housing market, would you be surprised that this decline could have been predicted with a relative degree of accuracy and, in fact, was predicted by an economist at the University of Southern California back in 1993 and again in 2004? Dr. Fred E. Foldvary based his forecast on a theory that was put forth back in the late 1870’s by Henry George.1

George noticed that real estate ran an 18 year cycle from boom to bust. Studies of real estate cycles in Western Europe have shown they also follow an 18-20 year cycle. The real estate cycle has proven to be a valid indicator of recessions. Moreover, real estate cycles are influenced significantly by government fiscal and monetary policy.

Let’s look at how that happens. Real estate booms begin with an expansion of the money supply and credit by the Federal Reserve. The expansion has a cause and effect on interest rates causing them to go down in the short run, which in turn leads to an increase in borrowing for long-duration capital goods and real estate. The expansion of the economy reduces vacancies which creates an increase in demand for real estate leading to an increase in real estate prices. At this point speculators begin to jump in to profit from this increase, thereby adding additional pressure to the demand for real estate and accelerating the increase in land values. The expansion of money and resultant increase in real estate activity has a direct impact on inflation causing the Federal Reserve to eventually cut back on the money supply and raise interest rates.

Higher interest rates lead to a direct decrease in demand for real estate creating a negative effect on rental income which creates vacancies. Mortgages and other operating costs remain fixed while revenues decline causing loan defaults to follow. As the recession begins to form, the increase in unemployment and resultant lower net disposable income further reduce demand for real estate. The low point (the trough) of the real estate cycle is characterized by high vacancies, low building rates, foreclosures, bank failures and an absence of speculation. The entire cycle takes approximately 18 years to run its course, as the chart below illustrates, with the peak being defined as the interval between the high point of real estate prices and of the value of construction. By the time that occurs, the supply of new houses will have outstripped the number of new residents available to satisfy their demand for housing. In other words, supply and demand will have fallen out of equilibrium.

Can the 18 year cycle be validated by looking at historic booms and busts? The first depression this country suffered occurred in 1837 after the creation of the national banking system, which pumped excess cash into the economy spurring the first ever speculation in land buying. Again, in the late 1870’s railroads, fueled by government land grants and spending to create a national rail system, caused speculation that drove up land values creating a real estate bubble. Towns that the tracks ran through enjoyed an unprecedented growth which contributed to an over valuation in land values. The result was a severe panic, as they were called then, that pulled the entire economy down. In the 1920’s, another bubble in real estate and the stock market was created by easy credit that led to over building and land speculation. Throughout the 1800’s and 1900’s real estate cycles from boom to bust have run an approximate 18 year course. Now let’s examine some historic cycles to determine how well that statement holds up.

The chart above shows real estate booms, busts and recessions in our economy all the way back to the mid 1950’s. Real estate typically has been a forewarner of economic slow downs and recessions. In the chart above you can see that construction peaked in 1953, with a peak in land values a year later followed the next year with a recession. In fact the recession of 1955 was so deep that the economy suffered a rare period of deflation. As the chart shows, recessions are often preceded by a down turn in the real estate economy by a good two years with real-estate values and construction peaking one to two years before the onset of the recession. The next recession was in 1973, which was exactly 18 years from the one in 1955. Notice that construction peaked a short year earlier instead of the typical two year period.

The next recession occurred only seven years later, and, at first, it would appear the eighteen year cycle was broken. The 1980 real estate downturn and recession was instigated by the Federal Reserve. The decade of the 1970’s had been afflicted with high inflation which began with the inception of Demand Pull inflation in 1970 that was further aggravated by wage and price controls in 1971 and two subsequent oil embargoes that created Cost Push inflation by the end of the decade. In response, the Federal Reserve sharply raised interest rates in order to break the back of this inflationary cycle.

The next real estate recession would occur ten years later in 1990. This recession occurred according to the pattern of the eighteen year boom and bust cycle. After the Federal Reserve had driven the economy into a deep recession where unemployment had risen to the highest levels (10.8%) since the Great Depression, Congress passed a stimulus bill of which one of the components allowed for liberalized depreciation deductions for real estate investments as well as the creation of tax shelters in real estate. What followed was a thawing of available credit and a lowering of interest rates that fueled the decade of the 1980‘s with a real estate boom eventually resulting in over building and speculation. The Tax Reform Act of 1986 eliminated some of the tax-shelter advantages of real estate, which then resulted in a decrease in construction and demand for real estate investment. The boom that had been induced by government monetary and fiscal policy ended when the government changed those policies; what the government giveth, it will surely taketh.

What’s important to note is that if you ignore the Federal Reserve’s induced real estate decline and recession of 1980 and count 18 years from the 1973 recession, you find a seventeen year period to the recession of 1990, thus validating the 18 year boom-bust cycle. Counting forward another 18 years you come to 2008. The U.S. Bureau of Economic Analysis now verifies that the economy entered into a recession in December 2007. The recession was preceded by a peak in real estate values and construction in 2006. Between the peak in 2006 and 2008 new home sales dropped by two-thirds as the chart on the first page shows. From the time real estate values peaked in 1989 and the end of the next real estate bubble exactly 18 years had passed.

What then does the foregoing information tell us? At least two things. First, we can see that real estate has consistently run an eighteen year pattern from boom to bust to boom again, a cycle that has been repeated over and over in this country and in western democracies. Second, there would appear to be a distinct correlation between government fiscal and monetary policy and its direct influence on capital infusions into the real estate market as well as investment surpluses and shortages. What we are experiencing at the present time is completely normal and not to be unexpected given past experiences. We now know from studying previous cycles there will be an end to the real estate drought at some point and investment capital will once again flow into the real estate market.

2009 Economic Stimulus Bill

With the economy in a deepening recession, which began more than a year ago, economists, both liberal and conservative, have called for an economic stimulus package. The question becomes how large the stimulus needs to be and whether it needs to stimulate the Supply side of the economy or the Demand side. A Supply Side stimulus package would consist of tax cuts, that in theory would create more general spending in the economy, thereby giving it a boost. A Demand Side stimulus package would consist of a combination of spending geared toward creating jobs along with targeted tax cuts or credits to stimulate investment in the infrastructure and capital equipment. Consider the 1981 Economic Recovery Act which provided tax credits for investment in new plant and equipment as well as real estate. The stimulus package of the Great Depression was geared toward spending to create jobs though the Works Project Administration (WPA) and Civilian Conservation Corp (CCC) in order to reduce unemployment, which was running at 25%. In 1993 Congress again passed a stimulus package that jump-started an economy, that technically was out of recession, but not yet in recovery. In other words, the economy was drifting along sideways in the trough at the bottom of the cycle. In the current recession we have yet to hit bottom, although I believe we are close to doing so.

The stimulus package that has been passed by Congress is a Demand Side stimulus package consisting of a number of spending projects totaling almost three quarters of a trillion dollars. Critics complain that it is wasteful and will only increase the deficit. That it will increase the deficit is true, but rather than ponder about it being too much, we should consider whether or not it is big enough to do what is needed. In 2008, our overall economy produced a GDP of $14.3 trillion. The question then becomes, "Is what we are going to spend enough to sufficiently stimulate the economy such that we avoid sinking into a depression and, more hopefully, grow ourselves out of the recession?" Think of the economy as a car with a weak battery. You wouldn’t try to jump start it with a couple of AA Duracells, would you? This was the problem in the Great Depression. The battery in the car was dead, but the government tried to jump start it with a couple of double A’s. Critics contend that government spending in the depression was a failure and the money spent wasted.  They are partly right. The problem in the depression was that the stimulus wasn’t applied until the country was four years into a depression with unemployment running at 25%. The question then was not whether the spending worked; it did to an extent as the unemployment rate was cut in half; but rather, was enough money spent to provide an adequate stimulus to the economy?

Economists are walking a tightrope and attempting to provide enough stimulus so that the money spent will not be wasted, while at the same time, not over simulating the economy and creating inflation. Spending three quarters of a trillion dollars is a lot of money and money we arguably don’t have to spend at a time when the national debt has doubled over the past seven years. However, consider the fact that since 2001 we have spent $1.5 trillion spent in tax cuts in pursuit of a Supply Side economic policy that has failed to provide any real growth in the economy. Additionally, consider what the government has already spent in the last year:

  • More than $150 billion in stimulus rebate checks.
  • $700 billion in the financial bailout rescue plan.
  • $125 billion for the bail out American International Group Inc.
  • $29 billion to steady Bear Stearns.
  • $25 billion guaranteed to the struggling automakers.
  • Increased demand deposit insurance to $250,000 per account.

Also, the government has agreed to buy commercial paper that would otherwise be unsalable, and it has backstopped the Federal Deposit Insurance Corp. (FDIC), Fannie Mae and Freddie Mac such that the the debt the Federal Reserve is now carrying on their balance sheet has ballooned from $900 billion to more than $1.8 trillion. That increase in debt alone accounts for 13% of 2008‘s GDP. By comparison, the stimulus spending will account for less than 5% of GDP.

If the stimulus bill is successful, it may actually have a positive impact on the overall debt structure of the Federal Government by lowering the amount of debt from private sources that it is currently having to acquire as well as from increased tax revenue that will flow to the Treasury from jobs created in developing an alternative energy policy and from rebuilding of the nation's infrastructure. However, all this will take time to filter through the economy and will probably be next year before its impact will be fully felt.

The amount of debt our banks are presently carrying needs to be restructured with toxic assets removed so that they are in a much more favorable position regarding liquidity and their debt to asset ratio. Banks in our country have one of the poorest asset to loan ratios in the developed world.  Our average ratio runs around 50 to 1 whereas in Canada it runs 16 to 1, which also explains why Canada hasn't had any bank failures. This alone would do more for the banks' ability to begin making loans again to aid the real estate sector than almost anything else being considered.

Having looked at the various reasons in support of a stimulus plan, two questions remain. First, is it possible to stimulate the kind of economy we have today? All three of the stimulus plans that we talked about were put in place to revitalize an economy that was manufacturing based. We have since shifted to a service based economy and moved our manufacturing base overseas. Will it then be possible to stimulate reinvestment in the economy when there are no capital assets (plant and equipment) to invest in? It remains to be seen whether or not an economy that, by and large, no longer produces anything can be affected by a traditional Keynesian (Demand Side) stimulus package.

Second, what effect will pumping three-quarters of a trillion dollars into the economy have in the long run? If, in fact, it does result in stimulating the economy and creating jobs and economic growth, will it then contribute to an overheating of the economy and cause inflation’s ugly head to rear itself again? Or will America simply digest almost a trillion dollars of additional spending and move on? The rate at which money turns over in the economy (the velocity of money) can have as big an impact as the total amount of dollars spent in the economy. Avoiding inflationary pressures in stimulus spending can be a very tricky task. We must be careful that we don’t simply trade a recession and high unemployment for high inflation. Only time will give us these answers.

1George’s theory was based on the assumption that 1) Land is essential for all production. 2) In any particular economic region, the supply of land is inelastic; it has a fixed supply. 3) When a boom is underway, the anticipated increase in land values induces speculators to buy it for price appreciation rather than for present use, which causes its current value to rise above that warranted by present use. 4). Once wide-spread speculation sets in, land values are carried beyond the point at which enterprises can make a profit after paying for rent or mortgages. Production slows down, reducing aggregate demand. The slowdown ripples through the economy, increasing unemployment and bringing forth a depression. After land prices and rents drop, the normal rent and land prices are restored, increasing the profitability of enterprise. The economy recovers. George noted that depressions were preceded by booms and land speculation, "followed by symptoms of checked production."

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