A Real‐Assets Model of Economic Crises: Will China Crash in 2015?

• Author: Mason Gaffney
• Date: 01 March 2015
• Published date: 01 March 2015
• DOI: http://doi.org/10.1111/ajes.12093

A Real-Assets Model of Economic Crises:

Will China Crash in 2015?

By MASON GAFFNEY*

ABSTRACT. Loosely derived from Henry George’s theory that land

speculation creates boom-bust cycles, a real-assets model of economic

crises is developed. In this model, land prices play a central role, and

three hypothesized mechanisms are proposed by which swings of land

prices affect the entire economy: construction on marginal sites, partial

displacement of circulating capital by fixed capital investment, and the

over-leveraging of bank assets. The crisis of 2008 is analyzed in these

terms along with other examples of sudden economic contractions in

U.S. history, recentEuropean experience, and global examples over the

past 20 years. Conditions in China in 2014 are examined and shown to

indicate a likely recession in that country in 2015 because its banks are

over-leveraged with large-scale, under-performing real estate loans.

Finally, alternative methods of preventing similar crises in the future are

explored.

Introduction

Concern about economic instability is understandably limited in the

minds of most people to their own c ountry. Thus, the economic and

financial contraction in the United States that began in 2008 has been

the object of most interest to American economists. When they make

comparisons, the experience of the United States in the 1930s tends to

be the primary event that is viewed as parallel to the current crisis.

A general theory of the business cycle or economic instability should

not be derived from or tested solely by two events. If a theory is valid, it

*Professor of economics emeritus at University of California, Riverside. Email: m.

gaffney@dslextreme.com. Author of After the Crash: Designing a Depression-Free

Economy (2009) and The Corruption of Economics. The latter examines how econom-

ics was historically distracted from its potential to create models of an economy based

on both efficiency and equity.

American Journal of Economics and Sociology, Vol. 74, No. 2 (March, 2015).

DOI: 10.1111/ajes.12093

V

C2015 American Journal of Economics and Sociology, Inc.

should apply to numerous cases in the past and, ideally, it would serve

as the basis for predicting future cycles of boom and bust, growth and

decline. We cannot, like scientists in a laboratory, create the conditions

we wish to study, but economists can attempt to be more scientific than

we have been until now by examining as many cases as possible from

many countries andtime periods.

This article will begin with a conceptual model that first offers an

explanation of numerous panics, crashes, or crises in the history of the

United States. It will then discuss its relevance to recent expansion and

contractions in several European economies. Finally, it will analyze the

prospective problems facing the Chinese economy in 2015, with the

hope of demonstrating the value of this model for prediction, not

merely description. By applying the model to a number of different cir-

cumstances, I hope to show that it is a universal model, capable of

explaining cycles of economic expansion and contraction throughout

the world.

The theory presented here derives from a simple model developed

by Henry George ([1879] 1979: BK V, Ch. 1). George blamed the peri-

odic “paroxysms” in modern economies on the effects of land specula-

tion. In his view, if enough people held land off the market in the hope

of a price increase, the resulting artificial scarcity of land would raise

rents and land prices, driving down wages and returns to productive

investment. Eventually, this process would reach a limit, land prices

would fall, workers would be laid off, and factories would close. We

should give George credit for seeing the general outlines of this pro-

cess, but we must elaborate on his ideas to incorporate elements other

than land prices. I have elsewhere presented a thorough explanation of

the model developed below (Gaffney 2009), so I shall merely summa-

rize it here.

General Theory

To make sense of what happened to China in 2014 and the United

States in 2008 and 1927, we must shift our attention away from the

details of each crisis and attempt to detect, amid the noise and varying

particulars, a general pattern of economic crisis. I will develop here a

The American Journal of Economics and Sociology326

“real-assets” model or theory that will be useful in understanding that

pattern. The hypothesis here has four elements:

1. A rise and fall of land prices, resulting mostly from autonomous

real economic changes. These are less visible and less measura-

ble than purely monetary and fiscal changes, which may reflect

and even reinforce the real changes but not initiate them,

2. Investment in projects at the margins, both in terms of geo-

graphic location and value,

3. Concomitant changes in the structure of capital investment to

favor structures with long payout periods, and

4. An increase in bank leverage ratios as a result of lower capital

turnover, leaving many banks technically in default by the time

the land price bubble bursts.

Land Price Changes

The present hypothesis begins a posteriori from observing land prices

increasing over a period of five to eight years after a trough. This con-

trasts to common scenarios that cast the banking system as the autono-

mous factor initiating economic crises. Once price increments begin to

seem the normal, “rational” expectation, staid banks and other financial

institutions turn to lending on land collateral, and expand their balance

sheets to accommodate the increased investment in real estate. But

banks are responding to an external stimulus (an apparent improve-

ment in the value of realestate) rather than creating the conditions for a

boom on their own. It is only in the late stages of the land price boom

that banks, when they are lending money on increasingly marginal

sites, must develop creative accounting methods to circumvent the

financial regulations that were put in place during a previous period of

contraction to prevent reckless lending.

The first sign of a new cycle of boom and bust is a self-generated rise

in land prices, which shows up in the form of higher priced houses.

When we speak of an increase in housing prices, what we really mean

is the change in the price of urban land on which the houses are built.

Since the actual housing stock depreciates over time, it makes no sense

to conflate the two. If the price of housing rises 8 percent, the price of

Real-Assets Model of Crisis 327