Property Bubble Leads to Crash Landing
Posted on Friday, March 28th, 2008
by Bryan Kavanagh
As featured in Business Age, 28/03/08

bubbleWHEN it mattered, the US Federal Reserve, US banks and rating agencies failed the risk-management test — in much the same way that Australia and New Zealand are now failing it.

This is because none of these bodies comprehends the manner in which the real estate market leads the economy. Many considerations flow from this, because businesses and individuals borrow against the value of their property assets.

So when real estate bubbles burst and banks and mortgagors are left exposed, analysts flounder with such hogwash as “business cycles and recessions are a natural part of the financial landscape”. Another knee-jerk reaction to systemic failure is simply to blame banks and borrowers. It seems anything will do, rather than tackle the fundamental flaw in risk management.

Here is an unyielding truth. A country cannot go into recession unless there has been a real estate bubble. US land economist Homer Hoyt documented the fact back at the beginning of the 19th century. The Land Values Research Group recently defined and studied the effects of property bubbles in Unlocking the Riches of Oz: A Case Study of the Social and Economic Costs of Real Estate Bubbles, 1972 to 2006, which is freely available at It concludes that the current residential bubble has hyper-inflated since 1999 and is about to burst, despite sophisticated financial derivatives, hedge funds, collateralised debt obligations, credit default swaps, all brought into existence to “insure” that it not burst. The failure of derivatives will compound the upcoming financial threat.

It is sobering, too, to note that the relative scale of our real estate bubble is greater than that in the US. It is therefore irresponsible and incorrect to blame a potential recession in Australia on some sort of spiritual emanations from US subprime mortgage lending. The truth is that we have an enormous debt bubble of our own and suffer the same vast hole in credit management that has again been exposed in the US. This will resolve itself with extreme prejudice to Australian society and requires immediate attention.

We may only solve the problem by shifting taxes off “goods”, such as earning incomes, onto “bads”, such as real estate speculation and escalating land prices. This, rather than the Reserve Bank continually raising interest rates, may actually get to grips with inflation and avert the folly of accepting bubble-inflated land prices as “security” for loans.

Although the relationship between Australia’s total land values and gross domestic product has varied since 1911, it has averaged 1-to-1. Although it got to 1.56-to-1 in the 1930s Depression, it now stands at a menacing 2.5-to-1. This mirrors situations around much of the Western world, except France, which doesn’t put real estate speculation on an untouchable pedestal as we have been inclined to do.

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When viewed as a long-term analysis against rising GDP, it can be seen that land price bubbles are neither merely the result of population growth nor the undersupply of residential allotments, as argued on this page (BusinessDay, 13/3) by Alan Moran of the Institute of Public Affairs. Incredible numbers of existing vacant lots and underutilised sites would spill out into a genuine real-estate market if we redressed the imbalance between taxes on productivity and the puny levels of rates and taxes on socially generated land values that fail to deter speculative land banking.

What form should the “tax shift” take? First, we have to turn a deaf ear to the ever-insistent call from self-interested property groups for greater tax incentives, or for council rates and state land taxes to be reduced to a mere revenue appendage, “so that we may continue to provide housing for all Australians”.

Rather, to encourage new housing construction and real wealth creation, we need to do precisely the opposite, by removing unproductive payroll taxes, stamp duties and up-front development charges, and recouping these revenues through state land tax systems. At the same time, we should seize the opportunity to reform state land taxes, removing their curious exemptions, thresholds, multiple rates and aggregation provisions, along the lines thoughtfully proposed in Victoria’s 2001 Review of State Business Taxes (”The Harvey Report”).

Arguably, the best option would be to hand the governance of reformed state land taxes to the RBA as a tool to complement interest rate policy. A single rate land tax would apply Australia-wide to all privately owned land, the revenue therefrom going back to the states and territories in direct proportion to the land values that raised it. By these means, it might be possible gradually to phase out more than rates, land tax and development charges from the 156 taxes recently condemned by the Business Council of Australia. Although a side effect would be to make housing more accessible and affordable for all Australians, the main thrust would be to reduce the private capture of publicly generated land values. This would finally close the loophole in credit management through which truckloads of new financial “products” have been driven. By eliminating land price bubbles, it would no longer be possible to offer bubble-inflated assets as “security” for loans.

If their children are unable to assist them, people who are asset rich and income poor would be permitted to defer their land tax liability by means of a charge on title for the revenue forgone, to be collected when they pass

from this world. And if proper arrangements were made for rates and land taxes to be deducted from incomes in instalments, this would not convert them into income taxes, because it is the revenue base that is paramount in producing an equitable revenue system, not the process by which the revenues are collected.

The property lobby puts out the propaganda that rates and land taxes can be passed on in prices. But why should this trouble them, as it so obviously does, if they are able to pass them on in rents? The truth can be found in most economic textbooks: rates and taxes on land are the only form of revenue that cannot be passed on.

If we are to navigate the upcoming recession effectively, the public should understand the integral role played by perverse tax regimes in risk-management failure.

Bryan Kavanagh is a real estate valuer and honorary director of the Land Values Research Group.

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