The nature of the problem, and the nature of the cure, may be shown by examining closely two cases: the examples are hypothetical, but the figures are right for the times.
In 1964 Mr Smith then aged 25, took a job in the Civil Service at an annual salary of £2,000 per annum. He bought a run-down Victorian house in Putney, Greater London, for £8,000. For five years, while he and his wife raised a family, they did everything they could to make ends meet and pay the mortgage - this included taking lodgers. Slowly things got easier. He was promoted twice and by 1989, when he was 48, both children were at university and he was able to give them a little financial help. That year his gross salary was £14,000 per annum, quite a comfortable sum in those days. He considered taking early retirement, but knew that this would depend on what he could get for his house. It fetched £310,000. After buying outright a bungalow in mid Wales for £45,000 he and his wife now have £250,000 deposited in a building society and are living on an increased income of £14,000 tax paid.
In 1990 he passed his old home in Putney to discover that a five storey block of flats stood in its place, with a notice "Eight luxury flats for sale from £100,000 each"!
Why was Mr Smith a winner?
To understand the cause of such gains, it is vital to be clear about the terms we use. We must start by stressing the difference between land and capital. By land we mean the planet Earth and all its natural resources. But Capital refers to man-made wealth. Many economists confuse the two and use the word 'property' in a way which compounds the confusion. When people buy and sell their homes, they are buying and selling both capital (the building) and land (the plot on which it stands).
This also applies to those who rent their homes. They too pay for the use of the building and also for the use of the land. The values of the two items, land and capital, behave in completely different ways. As every house owner knows, the building depreciates under the impact of wear and tear, weather and wildlife. Land, on the other hand, tends to appreciate in real terms in the long run. This explains why Mr Smith's 'property' became so much more valuable over the period in which he owned it. The value of the capital (the building) sank to zero. Indeed, it sank to less than zero, for the person who bought it had to pay a considerable sum in order to pull it down before he could begin to erect the flats. But the value of the land had increased enormously.
What is it, we may ask, which gives housing land its value? Look in an estate agent's window and notice the points which he makes about a property when he is trying to sell it. Some of his points concern the building - the capital - nice design, good rooms, bath, built-in kitchen, and so on. Many of his points, however, concern the location. He shows, for example, that the plot of land is close to employment opportunities, rail services, schools, shopping facilities, water, sewers, gas and electricity, the rural countryside, quiet residential areas, entertainment centres, public parks, motorways (not too close) and has planning permission for a dwelling. Where did all these features come from? The rural countryside was put there by nature - by God, if you prefer to put it that way. Most of the other things have been provided by engineers, builders, business men and so on. The public park is kept attractive by the local authority, which draws the money for doing it from taxes. 'Permission to build' derives exclusively from some public body which has decided that building may lawfully take place on that particular piece of land, when it is forbidden on others. In other words, all of the advantages of the site derive from the activities of somebody other than the householder.
So when Mr Smith sold the worthless building and the very valuable land which together constituted his 'property', he cashed in on value which he had had no part in creating. Nobody blames Mr Smith for acting in that way: you and I would doubtless do exactly the same if we were in his position.
Unfortunately, when gambling takes place, there are losers as well as winners. As the old saying puts it, if one person gets something for nothing, another person gets nothing for something. Consider the predicament of two losers. In 1987 John and Pauline Jones, both 26, had been married for two years and were living in a rented one bedroom flat near their work in the East End of London. They both had good jobs earning 10% above the average national wage. They had accumulated savings of £10,000. They began their search for a permanent home and soon discovered that the average price for a three bedroomed house in Greater London was £86,000. This was just over four times their joint salary. They made offers for two houses below the asking price which were not accepted. On a third house they offered the full price but were gazumped before completion. At last in September 1989 they exchanged contracts and moved into a property costing £91,000 with a 25 year mortgage of £84,000.
The mortgage repayments and rail fares had a devastating effect on their standard of living but several reductions in the interest rate after 1990 helped.
Pauline became pregnant, and with some financial help from her parents she was able to leave her job. When John's firm was taken over, he was left without a job for 10 months and had to borrow another £2,000. He is now employed at slightly better pay. In 1993 they found themselves with negative equity of £8,500 and, along with thirteen million other British citizens, live below the poverty line. 'Negative equity' means that the current market price of their house is less than the amount which they borrowed on their mortgage. So they could not afford to sell their property and move into a cheaper one, because if they did so they would find themselves burdened with a debt to the Building Society which they could not repay. Clearly, the market price of their property had plummeted since they bought it.
How did this happen?
Let us go back to the palmy days when John and Pauline were trying to buy a house. During the boom years between 1985 and 1990 residential land values rose by as much as 75% in one year. But the cost of building a new house, excluding the cost of the land, only increased by 8% per annum, mainly because of inflation. John and Pauline first sought to buy at a time when land prices were rising rapidly. They were 'gazumped' when they had offered the price the vendors had demanded. In other words, they agreed to buy the property, but before a binding contract had been made, somebody else offered a better price, which the vendors accepted. This was not because of the change in cost of building materials, but because of the change in cost of the land.
Savill's graph shows what had happened
Figure 1 shows the relative change in the price of residential building land for the period 1979 to 1993. These figures were collected by Savill's, which is a large London based estate agent. When John and Pauline eventually did buy a house, prices were just about at a peak. When both of them lost their jobs and they thought about selling their house and moving into something cheaper, they discovered that prices had dropped greatly and they could not raise enough money to meet the outstanding mortgage, still less to give them anything in hand. What had changed was clearly the value of the site on which the house was built (that is, the land) not the value of the building (that is, the capital).
Booms and Slumps
Savill's graph brings out the pattern of booms and slumps. Taking 1979 as the starting point, building land prices rose at a moderate rate for about six years. Then, during the three or four years which followed, prices rose at a rapidly accelerating pace. Then they dropped again with almost the same suddenness as they had risen. Eventually the curve flattened out, and by 1993 was just beginning to rise very slowly. It is not difficult to guess what will happen next. Unless something dramatic is done to change the pattern, there will be a number of years of very gradual rise, followed by rapid acceleration towards a new peak - a few years into the 2000s - then another slump. Booms start like this. Because technology and business skills are constantly improving, productivity tends to rise. All production requires land, and so there is a growing demand for it. If there is an increased demand for most kinds of commodity, people make more of it to meet the demand. But there is no way of making more land, and so the result is that people who hold land already are able to charge more for it. This applies to all kinds of land: industrial, agricultural and housing land. But we are here concerned mainly with what happens to housing land. During the boom, interest rates rise. This is because the banks wish to lend as much as they can, using the residential land as security. They are restricted in their lending to eight times their deposits. Therefore they compete with one another to attract lenders, thereby pushing up the interest rate in the process. There is an expansion of business activity. This is because moving house stimulates the renewal of capital such as new carpets, new curtains, new kitchens and so on. More spending takes place as a result of people borrowing on the strength of the increased value of their houses. Shops see this as an upturn in trade, indifferent to the fact that it is mostly based on borrowed money. Wholesalers restock their warehouses and industries respond to meet the demands. For a while employment opportunities expand.
First Time Buyers
It is not difficult to understand how the first time buyers, who sustain the housing chains, are persuaded to continue to take out mortgages which are manifestly pushing them beyond their means. Everyone who is able to make a short term gain out of the situation will be reassuring them. In addition, they are driven by their own housing needs and their belief that they will start gaining collateral as soon they have bought their new home. If the language used to describe what these first time buyers were doing was more explicit perhaps it would make them pause. Bluntly, they are speculating in residential land in the company of money lenders and 'dealers' who take a percentage of every transaction.
There is a further stimulus to the market when land prices are rising because more people trade up their homes in the expectation of future gains. Such land prices, once they begin to rise, will continue to do so because more property owners will be drawn into the market in the expectation of personal gain. That is to say the housing chains get longer. Other people with no necessity to join the market will be quick to use their homes as security to buy cars, start businesses and make household renovations. Providing the valuation of their property exceeds their mortgage, the banks will lend to them with enthusiasm.
Once started the rise in house prices feeds on itself. Seeing that house prices are rising, each vendor raises his asking price to cover what he will have to pay for his next house, or to make sure of getting the full amount the buyer is prepared to part with. Fearing that prices will be higher next year, buyers rush to take out mortgages. Fearing that they may be gazumped, they raise their bids.
Banks and building societies encourage this trend by making mortgages more easily available. When mortgages are easier to obtain more people compete for the available housing and prices go up. It turns into a positive explosion in house prices.
The boom must eventually come to an end and it does, for one stark reason. Potential first time buyers realise that their joint income will not enable them to buy the necessities of life once the monthly mortgage has been paid. To reinforce our understanding of what has happened during this boom and slump period, it is necessary to consider who wins and who loses as a result.
The Winners and The Losers
Several kinds of people gain from the boom. They include builders and companies which had land held in reserve for building, prior to the boom. Those who migrate during the boom from high value locations to places with low land value also gain. 1n 1989 there was a net migration from Greater London of 100,000 people a year. As Alan Franks put it in Halifax's 'Vision' magazine of spring 1996, when describing the exodus from London, "People are cashing in their chips". But, as in most gambling, there are more losers than winners. John and Pauline, and innumerable other young people who never intended to speculate in land values (and probably did not even realise that they were doing so) are among the poignant examples.
Developing a Solution
What we have described is land speculation within the housing market. But the same process also takes place with commercial and industrial land with the same effect. The empty shops and offices which can be seen as the slump sets in throughout all our towns provides the evidence that building ventures were based on unrealistic expectations of the rents that shopkeepers and businesses could afford to pay.
There is a way to end this "roulette", this alternation of booms and slumps, which affects not only housing but the whole economy of the country. Suppose that we start by valuing every piece of land in the country: housing, commercial and agricultural land. This valuation would follow the sharp division between 'land' and 'capital' which was given earlier in this paper. The question which the valuer would ask would be: "What is the maximum that a user would be prepared to pay to occupy this piece of land for the next twelve months?" The valuation would, of course, take into account the effect of all planning and other restrictions existing on that particular piece of land.
Once the valuation was complete, a tax would be levied, related to the value of the land in question. Next year there would be another valuation, with the same question asked as in the original valuation. If the value had increased, a greater land value tax would be collected; if the value had decreased, a smaller land value tax.
This tax would produce a great deal of money, which would enable many of our existing taxes to be dramatically reduced, or even abolished. It would also ensure that the speculative value was taken out of land. By so doing, it would "iron out" booms and slumps, thus enabling steady and continuous economic progress to take place. It would greatly assist first-time buyers, like John and Pauline in our example. Entering the housing market would cease to be a game of "roulette", with wild gains for some people and wild losses for a great many more people.