Bank regulation is not enough

Monday, 11 June 2012 07:20

Calls for regulation of the banks are back on the agenda. It will not work. Regulation does not deal with the underlying problem: is the abuse of credit through its use for land purchase. The land is usually inside some kind of package which makes it difficult to understand that it is actually land: assets, homes, equities or other securities.

The fundamental purpose of credit is to finance the productive processes of the economy. When it is used for land purpose, no production has taken place. A land title has been transferred and that is all. The purchase can be thought of as a release fee ie a ransom payment.

When a mortgage loan is given by a bank the reality is that the lender becomes the owner of the land for the duration of the loan, having effectively purchased the land temporarily with money created by the bank and almost no cost. In return, the lender receives "interest" but it consists in reality mostly of the rental income stream from the land.
This leads to cyclic credit-fuelled land price bubbles followed by crashes when the ratio of land price to rent is more than about 25:1, an unstable level. During the upward phase of the cycle it is profitable to engage in reckless speculative behaviour, dazzled by the thought that the rises will continue indefinitely. The system is analogous to mechanical systems with positive feedback. They suffer from cyclic instability.

Regulation of banks will only drive this process through other channels. That happened in the UK in 1974 when secondary banks had become involved in financing the property bubble that preceded the crash.

This is not to say that banks should not be regulated, but that a further requirement, and a prerequisite, is to tax away the rental income stream from land through the process known as land value taxation. If this is done, the whole speculative game becomes pointless. The tax revenue from land rents is potentially so great that other taxes, which fall on production and are harmful to the economy, could be substantially reduced and possibly abolished.

It is of course unpalatable medicine to those who with their snouts in the trough.

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