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Published by: Japhy on Nov 08, 2010
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October 2010
Two Models of Land Overvaluation and Their Implications
Narayana R. Kocherlakota
Federal Reserve Bank of Minneapolis
I thank R. Anton Braun, Doug Clement and Futoshi Narita for their comments. Some of the results and ideasin this paper are similar to those in a working paper that I wrote in 2009, "Bursting Bubbles: Consequencesand Cures."
1. Introduction
From early 1996 through mid-2006, the price of residential land (henceforth, land)nearly tripled in the United States. It has since fallen by over 60%. As of the fourth quarterof 2009, the price of land is not even 10% above its price in 2000.
These observationssuggest to me, as they have to others, that in the mid-2000s, the price of land was
(relative to the expected discounted value of future land rents). In this paper, I construct twodistinct models of this overvaluation. In the
rst, the land overvaluation is due to governmentguarantees of bank debt. I examine the implications of this model for the regulation of banksand other
nancial institutions. In the second, the land overvaluation is due to an asset pricebubble. I examine the implications of this model for
scal policy.
In the remainder of the introduction, I brie
y lay out the arguments and conclusionsdescribed with greater detail and more technically in the two parts of the paper that follow.The
rst part of the paper constructs a simple model in which bank creditors (depositors anddebtholders) receive implicit and explicit guarantees from the government.
The key to themodel is that the markets for land, mortgage origination, and bank debt are all competitive.This assumption implies that the bene
ts from debt guarantees end up
owing to the ownersof scarce factors in the economy. In the model, the only such scarce factor is land, and so thegovernment guarantees impact the economy by increasing the value of land. I demonstratethat these guarantees can lead land to be overvalued. It is generally believed that the bene
tsof debt guarantees accrue to bank equityholders. However, they only do so if their bank enjoys
Note that I’m talking about
, not housing. Theoretically, it is hard to motivate the existence of signi
cant overvaluation in housing structures (they’re readily replaceable). Empirically, there is considerablyless evidence of overvaluation for structures than for land. Here, I refer to data from the Lincoln Instituteof Land Policy that separates the price of housing into the price of structures and the price of land. Thedata were originally constructed by Davis and Heathcote (2005, 2007), and are derived from the Case-Shillerhousing price index. These data indicate that the price of housing structures rose by less than 100% innominal terms from 1996 to 2006, and has fallen by less than 10% since that date.
The views expressed do not necessarily re
ect those of others in the Federal Reserve System. Indeed, Iwould hesitate to say that the results in this paper represent my own view. There are many possible modelsof the behavior of land prices in the 2000s. My goal in this paper is only to describe the implications of two of them. I also make no claims to originality: I am sure that much of what I say is well-known to mostmacroeconomists and
nancial economists.
I am primarily interested in the ex ante impact of the guarantees. What matters is whether creditorsexpect such guarantees, not whether they actually receive them.
market power in the mortgage origination process. The rents from government guarantees
ow to the owners of scarce factors in the economy. In my model, the only scarce factor island.Interestingly, this overvaluation occurs even if bank debtholders are the only peoplein the economy who are actually aware of the guarantees. All other actors (including bankequityholders) simply respond to natural competitive pressures. Thus, landowners may haveno idea why their buyers are willing to pay so much. Indeed, the buyers themselves have noidea why they are paying so much. All they know is that the banks are o
ering low mortgagerates. The banks are willing to o
er these low mortgage rates because they are able to borrowat a low rate from debtors who believe themselves to be insured against loss.I show that regulations like capital requirements and leverage restrictions can elimi-nate this overvaluation. However, to be e
ective, bank regulation must react to shifts in theprobability distribution of future land values. In particular, a given capital requirement orleverage cap might successfully eliminate all pricing distortions associated with debt guar-antees for a given probability distribution of future land values. However, suppose that thedistribution changes so that its left tail becomes longer. Then, the debt guarantees will leadto land being overvalued. Intuitively, the debt guarantees imply that taxpayers make trans-fers to bank creditors when they su
er losses. To forestall losses to taxpayers, good regulationshould require that bank equityholders or landowners hold as much of land’s risk as possible.Such regulations must adjust to the underlying distribution of land values, and especially tochanges in its left tail.The second part of the paper models land overvaluation as being due to a
rational bubble 
. What do I mean by a bubble? I mean that the asset’s price is higher than theprice that a buyer would be willing to pay if he were required to never resell it. I will referto this “buy-and-hold-forever” price as the asset’s fundamental. So, with a bubble, assetsare overvalued relative to fundamentals. What do I mean by
? I mean that theovervaluation is common knowledge among all people in the model economy, and so risk-2

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