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THE TRANSITION FROM INDUSTRIAL CAPITALISM TO A FINANCIALIZED BUBBLE ECONOMY

Author(s): Michael Hudson
Source: World Review of Political Economy, Vol. 1, No. 1 (Spring 2010), pp. 81-111
Published by: Pluto Journals
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 THE TRANSITION FROM INDUSTRIAL
CAPITALISM TO A FINANCIALIZED

BUBBLE ECONOMY

MichaelHudson

MichaelHudson,President
oftheInstitutefortheStudyofLong-
TermEconomic Trends(ISLET), a WallStreetFinancial
Analyst,
Research
Distinguished Professor ofEconomics attheUniversity
ofMissouri,
KansasCity,andauthor ofSuper-Imperialism:
The
EconomicStrategyof AmericanEmpire(1968, 2003), Trade,
Developmentand ForeignDebt (1992, 2009) and America's
Protectionist
Takeoff:1815-1914 (2010). Email: michael.
hudson@earthlink.net

Abstract:ForthepastdecadetheUSeconomy hasbeendrivennotbyindustrial investment

butbya realestatebubble.Astheeconomy's asset
largest category, real
estategeneratesmost
oftheeconomy's capital The
gains. gains arethe aim ofreal as
investors, thereal
estatesector
normallyoperateswithout declaringanyprofit.Investors
agreetopaytheir netrentalincome
totheirmortgage banker,
hoping tosellthe ata
property capital a
gain(mainlyland-price gain).
Thetaxsystem encourages thisdebtpyramiding. Taxfavoritism
torealestate-andbehind it,to
bankersas mortgage lenders-hasspurred a shift
ofUSinvestment away from toward
industry
speculation,
mainly inrealestatebutalsothestock andbondmarkets.Apost-industrial
economy
isthuslargely
a financialized
economy thatcarriesitsdebtburdenbyborrowing againstcapital
topaytheinterest
gains andtaxesfalling due.

Keywords:realestate,
financialization,
capital landrent,
gains, landvalue,national
income
bubble
accounting, economy

FromSt. Simon'sfollowers in Franceto Marxandotherreformers priortoWorld

WarI, nearlyall financialobserversexpectedbankingto becometheeconomy's
industrial
planningagency,alongsidegovernment. Butcontrary totheirexpectation
thatbankingwouldbecomeindustrialized, theoppositehas occurred:Industryhas
beenfinancialized. are
Companies beingturnedfrommeansof production into
vehiclesto extract
interest,generatebankingfeesandregister stockmarketgains
forthebankingandfinancial sector.

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82 MICHAEL
HUDSON

Capitalformation todayis financedmainlyoutof retainedbusinessearnings.

The stockmarket was supposedtosupplyinvestment funding, butsincethe1980s
ithasbeenturnedintoa vehicleforcorporate raiding.By permitting interesttobe
tax-deductible and taxingcapitalgainsat low rates(and oftennotat all), thetax
codefavorsreplacing equitywithdebt.Theeffect is tomakeasset-price inflationthe
-
quickestmodeof"wealthcreation" buyingrealestate,monopoliesandfinancial
securities on credit,andhopingto emergewitha "capital"gain.
This is trueabove all forreal estate,whichremainsthelargestassetin every
economyand henceis thebankingsector'slargestcustomer. Some 70 percentof
bankloansintheUnitedStates,BritainandAustralia arerealestatemortgages. This
paramount roleof landand buildingsas collateralforcreditcreationhas created
whatnationalincomeaccountants call theFIRE sector - an acronym forfinance,
insuranceand realestate.This symbiotic sectoris politicalas well as economic.
Translating itseconomicpowerintopoliticalcontrol, financiallobbyists support
property owners in lobbying to roll back Era
Progressive property taxes, slash
incometaxesonhigherwealthbrackets anddismantle publicregulation ofbanking
andfinance.Thispolicyis guidedbytherealization thatwhatever revenuethetax
collectorrelinquisheswill be "free"to be capitalizedintomortgages and other
-
loans,andpaidas interest tobe recycledintonewloanstobidupproperty prices
further, justifying yetfurthernew lending.
Fromantiquity downthrough medievaltimes,landprovidedthemainsource
of taxes.But starting withtheRevoltof theBaronsin Englandin 1258-65,its
ownersusedtheircontrolofParliament toshift thefiscalburdenontotherestofthe
economy. Thethrust ofclassicaleconomicreform was tomakelandonceagainthe
basic sourceofpublicrevenue.Seekingto freelaborandcapitalfromtheburden
of rentand interest, Progressive Era reformers soughtto fullytaxtheland'srent
ornationalizeitoutright.
It is naturalforlandpricesto increaseovertimeas a resultof infrastructure
spending, thegenerallevelofprosperity, andproperty taxcuts.Governments invest
intransportation, publicschoolsandotherinfrastructure (waterandsewerservices,
gas and electricity) and give rezoningpermitsprovidingvaluabledevelopment
privileges. All thisraisestherentalvalueofsitesas populations growandbecome
moreprosperous. Butwhatturnsouttobe mainlyresponsible fortherisingpriceof
landtodayis mortgage credit.A property todayis worthas muchas bankswilllend
againstit.As thevolumeof credithas grownexponentially, bankshave lowered
theircreditstandards to thepointwheremostrentalvalue(or itsequivalentvalue
to homeowners) is paid outas interest.
New homebuyers areobligedto takeon a lifetime ofdebtto obtainhousingas
property prices have soared.The irony is thatthis "democratization" of housing

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FROM
INDUSTRIAL
CAPITALISM
TOAFINANCIALIZED ECONOMY
BUBBLE 83

is calledthebulwarkof themiddleclass rather thandebtpeonage.As realestate

bubblesburstandleavedebtsintheir place, owners withnegativeequity(mortgages
inexcessofplunging market prices)are unableto sell,frozenintotheirhomes,the
resultis notunlikemedievalserfstiedtotheirland.Today'spost-industrial society
is comingmoreandmoreto looklikea regression to debtpeonage.
Untilrecently, buyingproperty was muchlikebuyinga bond.In fact,theoriginal
meaningofrente(a Frenchword)was an interest-bearing government bond,later
extendedto includelandreceivinga regularperiodicpayment. Land was priced
at "so manyyearspurchase"of its rent.A property's worthwas calculatedby
discounting itsflow of rental income (or equivalentvalue,forhomeowners) atthe
goingrateofinterest: =
Price rent/interest. A lowerinterest rateinthedenominator
a
gave higher multiple. A $ 10,000 annual income can be capitalizedintoa $2 million
at 5
price percent interest(20 yearspurchase) or $2.5 millionat4 percent,butonly
$1 millionat a highinterest rateof 10 percent(10 yearspurchase).1
Whatadditionally is factored intodayis theexpectedpricerise/Buyersacquire
property on credit, planning pay offtheirdebtby refinancing
to theirmortgages
(or "cashingout") as asset prices are inflated.HymanMinskydescribedthis
phenomenon as culminating in thePonzi stageof thefinancialcycle:2Debtsare
carriedsimplybyaddingtheinterest ontotheprincipal, creating a risingupsweep
ofindebtedness - "themiracleofcompoundinterest."

1 Annual
Figure land-valuegainscomparedto growth innational
income.Eachyear's
growthandlandvaluefarexceedsthegrowthinnationalincome
Note:
Allincome come
figures from
theNIPA,
andallassetanddebt from
figures theFederal
Reserve's
Flow
ofFundsAccounts, Table
especially Z,"Balance
SheetoftheUSEconomy."

* Price
= (rent
+ AP)/interest.

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84 HUDSON
MICHAEL

A BubbleEconomyis based on debtleveragingin searchof "capital"gains.

Inasmuch as realestateis theeconomy's largest sectorandlanditslargest component,
thesegainsare headedby risingsitevalue.The annualrisein landpriceshas far
outstripped growthin nationalincomesincethelate 1960s,becomingthedriving
forceintoday'sfinancialized modeof"wealthcreation."
UnderAlanGreenspan's chairmanship oftheFederalReserveBoard(1988-2006),
theUS government sought toenable debtors tocarrytheirobligations byborrowing
theinterest againsttherisingmarket priceoftheirproperty. Current incomeplays
a decliningroleas property buyersaim at maximizing "totalreturns,"definedas
incomeplus capitalgains- especiallythelatter. The policyto keepthefinancial
bubbleexpandingis asset-price inflation sufficient to keepincreasing realestate
pricesby enoughto enabledebtorsto refinance theirmortgages and otherloans.
Applyingthemaximthat"Rentis forpayinginterest," real estateinvestors are
to
willing pledge the net rental income to mortgage bankers in order to get a
chancetomakea capitalgain.Asset-price gainsbecomethekey,notsavingoutof
earnings ordirect investment and enterprise. As theFederalReserve's2004Survey
of Consumer Finances noted: "Changes in the valuesofassetssuchas stock,real
estate,andbusinessesarea keydeterminantchangesin families'networth."3
of
Thiscreatesa symbiosisbetweenfinance, insurance andrealestate - theFIRE
sectoratthecoreoftheBubbleEconomy.Itsbasicdynamicis a feedback between
bankcreditandassetprices.Themorecreditandtheeasierthetermsonwhichitis
available- thelowertheinterest rate,thelowertheamortization rate,andthelower
thedownpayment required- thelarger theloancanbe made.Andas debtleveraging
increases,itis easierto go intodebtto ridethewave of asset-price inflationthan

2 Annual
Figure inlandprices
increase vs.corporate
profits. landvaluenowyields
Rising
morethancorporate
profits

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FROM
INDUSTRIAL TOAFINANCIALIZED
CAPITALISM BUBBLE
ECONOMY 85

to earnprofitsbyinvesting in industry.
Whyinvestmoneyin an industrial factory
or othercompanythattakesyearsto organizeproduction and mounta marketing
program todevelopsalesonwhichtomakea profit thatis taxedat30 percent,
when
youcanbuylandandsimplysitbackandmakecapitalgainsthatexceedprofit rates
andaretaxedat onlyhalfas much?
Yet theNationalIncomeand ProductAccounts(NIPA) do notcountcapital
gains.Theseoccasionallyaresurveyed bytheInternal RevenueService'sStatistics
on Income, buttheonlyregularestimateof suchgainsis theFederalReserve's
flow-of-fimds statisticforlandprices.The Fed estimatesthatthepriceforthe
nation'srawlandroseby$2.5 trillion for2007. (I find$3.5 to$4 trillion
tobe more
forreasonsdiscussedbelow.)At over20 percentofUS nationalincome,
realistic,
thisland-pricegainwas fourtimestheamountbywhichnationalincomegrew,and
two-thirds morethantotalUS corporate (muchofwhichitselfderivedfrom
profit
mortgage andbrokerage).
financing So today's"postindustrial" economyturnsout
tobe mainlyaboutrealestate.Ifitis a "serviceeconomy," theservicesinquestion
aremainlythoseoftheFIRE sector.

FromAsset-Price Inflationto Debt Deflation

Inflatedassetpriceshavemadefortunes forinvestors, andalsoformanyhomeowners

whosaw themarket valueoftheirhomesrisebymorethantheywereable to earn
in a year.Financialpromoters hawkeda dreamthatpeople couldmaintaintheir
lifestylesand getrichby capitalgainsratherthanby whattheycould earnand
save. Familieswho foundthattheirwagesand salarieswerenotenoughto make
endsmeetweretempted tosustaintheirlivingstandardsbytakingouthome-equity
loans.Banksappearedtohavecreateda postindustrial modeofwealthcreation by
issuingenoughcreditto keepbiddingup property prices- andto keeptheboom
goingbylendingyetmoreagainstcollateralrisinginvalue.Nottoplaythisgame
was tobe leftbehindas theaffordability ofhousingrosefurther andfurtherbeyond
themeansofmostfamilies topaywithout cuttingbacktheirexpenditureelsewhere.
The problemwithsuch bubblesis thatonce underway, asset-priceinflation
becomestheonlywayto sustainthedebtburden.Debt-financed must
speculation
accelerate in
orelseend a waveofbankruptcy. Theproblemis thatcarrying charges
onthisdebtdivertincomeawayfrombeingspenton consumption andinvestment.
Usingdebtleveragetobidupproperty pricesloadstheeconomydownwithinterest
and amortization commitments to pay creditors. Prospectivebuyersmustdevote
moreand moreof theirworkinglifeto pay offthedebtsneededto buya home,
automobile, educationorhealthcare.Thatis theessenceofdebtdeflation.
The policyof loweringproperty taxeshas subsidizedspeculation, by enabling
moreincometo be paid as interest. The banksgain,capitalizing theproceedsof

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86 MICHAEL
HUDSON

property taxcutsintoyetlargerloans.Thisraisesthecarryingcostsofrealestate
(and business)financedon credit,whileforcingtaxesto be leviedelsewhereto
stabilizepublicrevenue.Ifpublicspendingis notcutbackin responseto forgone
taxreceipts, theshortfall
mustbe madeup byborrowing, bytaxingnon-property
incomeat a higherrate,orbysellingoffthepublicdomain.
This is nothow matterswere supposedto workout. The ProgressiveEra a
century ago advocatedthattaxesshouldfallmainlyon rentand otherproperty
returns.Theaimwas tofreeeconomiesfromrentandinterest, so thatpriceswould
onlyreflect necessarycostsofproduction- wagesandprofits forlaborandcapital.
Butgovernments havepursuedtheoppositefiscalphilosophy sinceWorldWarI,
and especiallysince 1980.Theyhave loweredproperty taxesandrefrained from
imposinga resource-rent taxonminerals, fuelsorthebroadcastingspectrum.They
alsohavederegulated monopoly thankepttheminlinewithproduction
pricesrather
costs,andcutcapital-gains taxestojusthalftherateleviedon wagesandprofits.
On thelogicthatcapitalgainsbuiltup networthjust as savingdid,America's
original1913 tax code treatedthemas regularincome.As TreasurySecretary
AndrewMellonexplained:

Thefairness oftaxingmorelightlyincomefrom wages,salariesorfrom investments

is beyond Inthefirst
question. case,theincomeis uncertainandlimited induration;
sicknessor deathdestroysit andold age diminishesit;intheother, thesourceof
income continues;theincomemaybe disposed ofduring a man'slifeanditdescends
to hisheirs.
Surelywe can affordto makea distinction betweenthe peoplewhoseonly
capitalis their
mentaland physicalenergyandthe peoplewhoseincomeis derived
from investments.4
This logic is applicableto today'sBubbleEconomy.Aftera real estatebubble
bursts,"totalreturns"no longerdrivebalancesheets.WhatAlanGreenspan lauded
as "wealthcreation"in theformof risingproperty priceshas theoppositeeffect
fromtangiblecapitalinvestment. Insteadof loweringproduction costs,seeking
gainsfromdebtleveraging chargesintothecostoflivinganddoing
buildsinterest
business.Thisslowseconomicgrowth, bydivertingincometopaycreditors instead
ofto spendon production andconsumption.

The Financial Sector's Symbiosis with Real Estate:

DrivingHomebuyers into Debt Peonage

EversincetheUnitedStatesenacteditsfirst
modernincometaxin 19 13 thefinancial
sectorhas thrown itsweightbehindrealestateand soughtto shifttheburdenoff
This
property. is quitea turnabout
fromDavid Ricardo's day,whenfinance backed

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FROM
INDUSTRIAL
CAPITALISM
TOAFINANCIALIZED
BUBBLE
ECONOMY 87

repealof Britain'shighagricultural tariffsand landrents.At thattimeit seemed

thatindustry andforeign tradewouldbecomethelargestmarket forbanks.Butas
matters haveturnedout,realestatehas achievedthisposition.
The 19thand20thcenturies sawbanksfinancethespreadofhomeownership. In
theearlydecadesofthe19thcentury, residentialmortgage lending was left mainly
to local savingsbanks.Manyof thesebanksweresetup to help immigrants or
workingmen up save small change each week, as reflected in the names for some
ofthelargestNewYorksavingsbanks:Seamans,Emigrant, theBoweryandDime
SavingsBanks.ButbankingsinceWorldWarI hasfocusedonrealestatemortgage
lendingas property throughout theworldhas becomeincreasingly democratized,
American-style.
By the 1930s, savingsand loan associations(S&Ls) were formedto aim at
middle-class depositorsandhomebuyers. Afterthereturn to peace after1945 the
constructionboomandsuburbanization createda thriving mortgage market.Sincethe
1980s, most savings banksand S&Ls have been converted into commercial banks.
As thishas occurred,interest paymentshave expandedto absorbmostof the
rentalvalueofcommercial properties andowner-occupied housing. Andas property
becamemorewidelyownedand democratized, it was fairlyeasy forthelargest
investors - and mortgagebankers - to stirup popularoppositionto real estate
taxation. Buthomeowners arenotmuchbetteroff.Whatformerly was paidto the
taxcollectoris nowpaidtobankersas interest.
This is theoppositeof whattheclassical economistsrecommended. In fact,
a
nobody century ago expected land rentto be paid out in the form of mortgage
interest
tosucha highdegree - orthatheavilymortgaged realestatewouldbecome
thebackingforthebankingsystem. Banksweresupposedtofinance newindustrial
capitalformation, notcreatecreditmerelyto bid up pricesforlandsitessupplied
by nature,rent-extracting monopolyand property rightsand to buycompanies
in
already place.
Debt expansionforsuchpurposesmayseem self-justifying as long as asset
are This is
prices risingsteadily. pricerun-up euphemized as "wealth creation"by
focusing ontheinflation offinancialandproperty prices,evenas disposablepersonal
incomeand livingand workingconditions are eroded.The problemis thatrising
price/rent multiplesandprice/earnings ratiosfordebt-financed properties,stocks
andbondsobligewageearnerstogo deeperintodebt,devoting moreyearsoftheir
workinglifeto pay forhousingandto buyincome-yielding stocksandbondsfor
theirretirement.Homeowners thusdo notgainbythishighermarket "equilibrium"
priceforhousing.Higherpricessimplymeanmoredebtoverhead.
A simpleexampleshouldmaketheproblemclear.SupposeMarySmithownsa
$100,000homefreeandclearofanydebt.SupposeJaneDoe laterbuysthesame

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88 MICHAEL
HUDSON

exacthome,butthepricehas risento $250,000.To buyit,Janeneedsto takeout

a $100,000mortgage.
Who is in a betterfinancialposition?On paper,Janehas a $50,000 equity
advantage($150,000,as comparedto Mary's$100,000).But she onlyowns60
percentofthehome'svalue,andmustpayherbank$600 a month - payments that
Mary does nothave to make.
PriortotherealestatebubbleMary'shousehas $100,000equitywithlowtaxes
andno interest charges.By thetimeJanebuysthehouse,shemustgo intodebtto
outbidotherpotential buyers.The landareahasn'tincreased(natureis notmaking
anymore),and buildingsslowlydepreciate, butthedebtoverheadrises,leaving
less incomeavailableforconsumption or saving.
Mortgagecreditinflates propertyprices(fora while),butis such"paperwealth"
worththecarrying charge?Familiesa century ago dreamedofowningtheirhome
freeandclear.Theysavedforthefuture, andstayedoutofdebttoavoidhavingto
worryaboutlosingthehomestead. Butthesedaystheonlywayformanyfamilies
to geta homeis to borrowenoughto paypricessetbybuyerswillingto paythe
entirerentalvalueto thebankfora loanto buyit,in thehopeof sellingoutlater
fora capitalgain.In theaboveexample,forinstance, mattersareaggravated ifJane
triestomakeendsmeetbyborrowing againstthehighermarket priceofherhome.
Whenrealestatepricesfallback,herdebtsandtheircarrying chargeswillremain
in place,threatening to leave herwithnegativeequity.This is theconditioninto
whicha quarterofUS realestatewas estimated to havefallenbyautumn2009.
Investorsaretempted tobelievetheyarebetter offas longas assetpricesrisefaster
thandebt,improving theirbalancesheet.Butbyabsorbing rents,businessprofits
and disposablepersonalincome,thedebtoverheadentailsfuture clean-upcosts.
Thecreditthatbiduppricesto"createwealth"during theBubbleEconomy'srun-up
leaves "debtpollution"in itswake afterassetpricescollapse.Livingstandards,
businessinvestment and new construction mustbe cutback to pay thebill for
pumping up assetprices that havereceded. Higherrealestateandotherassetprices
provideno moreeconomicbenefitthando higherconsumerprices.One party's
incomeorgainis another party'sexpense.
Testifying before the Senate BankingCommitteein February1997,Federal
ReserveBoard ChairmanAlan Greenspanexplainedwhywages wererisingso
slowlydespitehistorically low unemployment levels.Undernormalconditions
unemployment at therate then -
beingregisteredabout5.4 percent, thesameas in
-
theboomyears1967and 1979 wouldhaveledtorisingwage levelsas employers
competedtohiremoreworkers. However,Mr.Greenspan testified,
As I see it,heightened explainsa significant
job insecurity on
partoftherestraint
compensation andtheconsequentmuted inflation.
price

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FROM
INDUSTRIAL TOAFINANCIALIZED
CAPITALISM BUBBLE
ECONOMY 89

Surveysofworkershavehighlighted stateofaffairs.
thisextraordinary In1991,atthe
bottom oftherecession,a survey
ofworkers at largefirmsindicated that25 percent
fearedbeinglaidoff.In1996,despitethesharply lowerunemployment rateandthe
demonstrably labor
tighter 46
market... percentwere of
fearful a job layoff.5

AgaininJuly1997inCongressional testimony,Greenspan saidthata majorfactor

to the and
contributing "extraordinary" "exceptional" US economic performance
was "a heightened senseofjob insecurity and,as a consequence,subduedwage
Bob Woodward
gains."6 describeshimas callingthisthe"traumatized
worker" effect.
Whathasbeenlostalongthewayis theeconomy'straditional setofproportions.
From1945to2000,forexample,thevalueofUS realestateremained a fairly
stable
250
(about percent) proportion ofnationalincome.The dot.combubble of the1990s
inflated
stockmarket prices,butrealestateresumeditsdominant roleas theFederal
Reservefloodedfinancial markets withcreditafterthemarketdownturn of2000.
Fueledbyrisingdebtratios,realestatepricessoaredto theunprecedented levels
of325 percentofnationalincome.
Debtpyramiding was encouraged byloosertermsforbanklending - low,zeroor
evennegativedownpayments, whileunprecedented fraudbymortgage brokersand
localbanksexaggerated theincomeandhencedebt-carrying of
power homebuyers,
makingsoaringmortgage loansappearto be affordable.However,adjustable-rate
mortgages (ARMs) guaranteed thatloansaffordable atlow"teaser"ratesofinterest
wouldbecomeunaffordable whentheircarrying chargesre-setat higherrates,
forcinghomebuyers intothe "Ponzi"stage havingtoborrowtheinterest.
of Defaults
thatinitially
werethought tobe a knownriskturnedouttobe an inevitability.

The Magnitude of Real Estate Revenue- and Its Increasing Payout as

Interest

The NationalIncomeand ProductAccounts(NIPA) depicttheentireeconomyas

if everyactivitywereorganizedas a business- even owner-occupied housing.
The word"rent"appearsin onlyone line(NIPA table2.1, "PersonalIncomeand
Its Disposition,"line 12). It is nota rentthatactuallyis paid,butan imputed"as
if' estimateof whathomeowners wouldpay iftheyrentedouttheirdwellingsto
themselves. Thistypically amountsto only1 or2 percentofnationalincome.
Commercial andresidential property incomeis reported as "realestateearnings,"
and Most
corporate non-corporate. property investment is organized as partnerships,
so mostrentalrevenueaccruestonon-corporate realestate.So closelyintertwined
aretherealestateandfinancialsectorsthatformanyyearstheNIPAwereunable
to separatetheirearnings.

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90 MICHAEL
HUDSON

Ownerspaysomeoftheseearnings intaxes,butpassonmosttotheir bankers. The

relevantcash-flowconceptis "ebitda":earningsbeforeinterest,taxes,depreciation
Thiscanbe compiled
andamortization. byaddingrealestateearnings (non-corporate
andcorporate,NIPAtables6.12,"Nonfarm Proprietors'Income byIndustry" and
6.17, "Corporate
ProfitsBeforeTaxbyIndustry"), interest
(table6.15,"Net Interest
by Industry")taxespaid at thestateand local level (table3.3, "Stateand Local
Government Current Receiptsand Expenditures") plus federaltaxes,cappedby
themostremarkable category in which ebitdais buried:depreciation (tables6.13,
"Noncorporate CapitalConsumption Allowances and
byIndustry" 6.22,"Corporate
CapitalConsumption AllowancesbyIndustry" respectively fornon-corporate and
corporaterealestatedepreciation).

3 Realestateebitdaas a percentage
Figure ofnational 1930-2007
income,

Real estateebitda(includingtherentalvalueofowner-occupied homes)topped

60 percentofnationalincomewhentheUS economyentered theGreatDepression
in the 1930s.This ratiofellby halfby thetimeWorldWarII ended,tojust 28
percent, theshrinkage
reflecting inpersonalincomeavailableafterdefraying other
livingcosts.
Homeowners' "rentalequivalent"andcommercial cashflowrosefrom1945until
1960as thepostwareconomygrewwealthier and moreincomewas availableto
spendon homesandofficespace,whoselocationtraditionally has beenthemajor
factordefiningsocialstatus.Butforthenexttwenty yearstherestoftheeconomy
grewmorerapidly thanrealestate.Thatsector'scashflowfellbackunder25 percent

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FROM
INDUSTRIAL
CAPITALISM
TOAFINANCIAUZED ECONOMY
BUBBLE 91

ofnationalincomethrough themid-1980s - untilthewatershed1981taxsubsidy

to
Real estateebitdaacceleratedsharplyafter1985,recovering
reversedmatters.
a
nearly thirdofnationalincome by 2000.

4 Composition
Figure ofrealestateebitda,
1930-2007

As notedabove, classical writersexpectedland pricesto rise as population

increasedand economiesgrewmoreprosperousand urbanized.The intention
was to tax real estate'srisingrentalvalue,buttwo tax breakshave prevented
thisfromhappening. of interest
Firstis thetaxdeductibility charges,whichhave
absorbedmostrealestatecashflowsince1945.Nobodyanticipated thatso much
interestwouldbe paidoutas toleavescarcelyanyincometobe reported tothetax
A secondtaxpretensepermitslandlordsto over-depreciate
authorities. buildings
as iftheyarelosingbookvalueevenwhiletheirmarket priceis rising.The result
is thatdespitetherealestateboom,property paysan ever-shrinking shareoflocal
andfederaltaxes.

ShiftingState and Local Taxes offPropertyonto Consumers

Thewell-known - location,location
phraseofrealestateagentstoexplainpricing
- refersmainlyto theproximity
andlocation oftransportationand good schools,

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92 MICHAEL
HUDSON

whichtheUnitedStateshistorically has financedby taxingproperty.Localities

couldrecapture thecostofthisinfrastructurespendingbytaxingthemarket value
it adds to real estatesites.Instead,tax favoritism
forrealestateobligesfederal,
stateand local budgetsto look elsewhereforfinancing - mainlyto tax sales and
consumerincome,andto borrowfromthewealthywhohavebeenun-taxed. The
resultis thatproperty inexcessofwhatthey
ownersenjoyrisingpricessubstantially
payintaxes.In fact,landpricesrisebymuchmorethanthetaxesthatareowed.

5 Annual
Figure riseinlandprices, toproperty
compared landvaluepaysthe
taxes.Rising
taxesfour-fold
property thesedays

Priortothe1930s,property taxesaccounted forabouttwo-thirds ofstateandlocal

government receipts.ButtheGreatDepressionobliged localitiesto lookto sales
taxesas property -
valuesshrank andtoincometaxesinrecentdecades.Despitethe
postwar riseinproperty prices,statesandlocalitieshaveshiftedtaxesoffproperty
ownersontowage earnersand consumers almoststeadily, so thatproperty taxes
nowmakeup onlyabout20 percentof stateandlocal revenues(Figure6 below).
Thisis less thana thirdoftheirproportion ninety yearsago.
Real estatedownturns prompt propertyowners to campaignfortheirtaxestobe
reducedtosavethemfromdefaulting ontheirmortgages. Atsuchpointsthetradeoff
betweentaxesand debtservicebecomesquiteclear.Today's"negativeequity"
squeezeon mortgage debtorsno doubtwill increasepoliticalpressureforfurther
tax shiftsoffproperty, avidlysupported by banklobbyists.The rhetoric is anti-
butit
government, mainly benefitsbankersand large commercialowners. There is
suchas taxingowner-occupied
littlediscussionofalternatives homesata lowerrate
thanabsentee-owned properties,orrestoringthestateandlocalproperty taxbase.

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BUBBLE
ECONOMY 93

The nationaltax shiftoffreal estatehas been even moreregressivethanthe

local taxshift.Financeandrealestatehaveobtainedsuchenormous"smallprint"
taxbreaksthatonlya modestproportion oftheirgains- whichrepresentsmostof
theeconomy'swealth - is countedas taxableincome.Lobbyistshavepersuaded
lawmakers to definetaxableincomein waysthatleave property ownerswithno
earnings to declareafterdeducting interestanda basicallyfictitious
bookkeeping
chargefordepreciation. The tax laws promotea BubbleEconomyby makingit
mosteconomicforinvestors toputas littleoftheirownmoneydownas possible,
using debtto a maximum degree.

6 Property
Figure taxes,as a percentage
ofoverall
stateandlocalrevenues,
1930-2007

Thisfiscalfavoritismforproperty is a majorfactor
polarizing wealthownership
in theUnitedStates.The effectis to wage a waron themiddleclass,despitethe
politicalvaluesandseemingself-interest ofmostAmericans ina moreprogressive
taxsystem. Thetaxcode also encouragesinvestors to selltheirproperty
everyfew
years,after their
depreciating buildings so that
new buyers can start
depreciating
themall overagain.Landlordsareallowedto pretend thattheirproperty
is losing
moneyas buildingsare"usedup."

Over-depreciationof Buildings

It tookuntilthemid-19thcentury foreconomists
to recognizedepreciation
as an
element ofvalue.Surprising
as itmayseem,itwas Marxwhofirst established
itas

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94 MICHAEL
HUDSON

a necessary chargeinpricing commodities. Inhiscritique oftheFrenchPhysiocrats,

he pointedoutthatwhenFrançoisQuesnayproducedhisnationalincomeaccount
forFrance,theTableauÉconomique , in 1759,he overlooked theneedtoreplenish
seed, inventory and capitalstock.7In additionto coveringtheirbasic expenses,
buyingtoolsand rawmaterialsandpayingrentand taxes,cultivators needto set
asideseedgraintoplantthenextseason'scrop.Thisseedis notavailabletobe sold.
Justas bondholders getpaidbacktheirprincipal as wellas interest, investorsare
permitted to recouptheiroriginalcapitaloutlaywithout itbeingtaxedas income.
The recoupment is
period spread over the expected lifetime of machinery, patent
rights or other assets.Failure to acknowledge theneed for this replacement outof
sales revenuewouldgivean overlyoptimistic pictureofhowwelltheeconomyis
operating. Not to renew seed and capitalinvestment wouldresultinassetstripping -
payingoutrevenuewithout maintaining a viablecapitalstock.
Economistsrecognizethatdepreciation resultsas muchfromtechnological
obsolescenceas fromphysicalwearingout.Technology is continually improving,
and
raisingproductivity cutting costs. Rivals' innovation forces factoriesto
modernizeor be pricedoutof themarket, sometimesobligingmachinery to be
soldas scrapmetalbeforeitactuallywearsout.8Butmostdepreciation statistically
occurswhereone mightleastexpectit- inrealestate.
Thisseemsstrange, becauselandlords rarelylettheirbuildingswearout.They
typically spend5 to 10 percentoftheirrentalincomeon maintenance andrepairs,
and periodically replace their and
plumbing heatingsystems, electric wiringand
windows.Buildings constructed priorto World War II- already a few lifetimesinthe
Internal RevenueService'sdepreciation -
schedule sellata premium becausethey
tendtooccupyprimelocationsandarebetter builtthantheirmoderncounterparts.
Contractors havecutconstruction standards eachdecade,replacing 4" by4" beams
andcopperplumbing withcheapermaterials suchas 2-by-4s andplastic,andmaking
wallsofaluminum sidingtackedontosoftinsulation.
Thefactthatmostbuildings arekeptingoodrepairhasledmanycountries notto
permit landlords todepreciate It be
them. would logical for landlords to depreciate
theirbuildingsonlyifthey"bled"themby letting themrundown.Thisis against
thelawforresidential buildings inmanycities,andwouldviolatemanycommercial
leasesas well.Butthishasnotprevented lobbyists intheUnitedStatesfromturning
thedepreciation allowanceintoan accounting stratagem to shelterrentalincome
fromtaxation.Mostproperties aresoldagainandagain,andthenewlandlordcan
start depreciatingbuildings anewwitheachsale- atthehigher salesprice.Insteadof
in
depreciating waythe that industrialcapitaldoes, real estate accrues capitalgains
as landpricestendto risefarin excessoftherateatwhichbuildings"wearout."
Land is notdepreciable. Beingsuppliedbynature, ithas no costofproduction.
It is notused up in production, nordoes itbecometechnologically obsolete.Yet

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INDUSTRIAL BUBBLE
TOAFINANCIALIZED
CAPITALISM ECONOMY 95

7 Land-price
Figure to depreciation
gainscompared write-offs. morethan
Theformer
offset
thelatter

mostproperty assessorspro-rateeach sales priceso thatthevalue of buildings

appearstoriseproportionally totheoverallgain.Aftertheyhavebeendepreciated
once,buildings can be resoldand depreciation write-offscan startall overagain,
without - a
limit at so high rateas to offseta largeportionof thenew landlord's
erstwhile taxableincome.
Thisposesa logicalproblem: How canbuildings gaininassessedvaluation ifthey
are supposedto be depreciating? Indeed,how can theeconomy'smostsustained
capitalgain- thatof real -
estate reasonably be depictedas operating at a loss for
years on end?
Theexplanation is tobe foundintheabilityoflobbyists tofindlawmakers willing
todistortthetaxcode's "smallprint"ina waythatmakesowningrealestatemuch
likeowningan oil wellintheheadydaysoftheoil-depletion allowance.No profit
appearsinthis"Hollywoodaccounting." Fromthe1954taxactthrough itssequelsin
1972, 1979 andtheEconomicRecovery TaxActof 1981, thedepreciation treatment
becameincreasingly generous to real estate
investors.The 1981 taxcode assumed a
short15-yearlifetime -
forbuildings andletproperty ownerswriteofftheassessed
valueoftheirbuildingsat twicethisratebyusinga convoluted "doubledeclining
balance"method.Ownerscoulddeducttwicethepermitted 1/15thofthepurchase
priceofa buildinginthefirst year(thatis, 14percentas a "non-cash"expense),as
ifitwouldlastjustTA years.The accounting schedulestretched outtheremaining
depreciation periodby one year in each successiveyear- to 16 yearsinyeartwo,
17 yearsin yearthree,and so forth. Thismeantthatin thesecondyeartheowner
couldwriteofftwice1/16th(or another12*/2 percent)on theremaining balance,
andrecover55 percentofthebuilding'svaluationinjustfiveyears.

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96 MICHAEL
HUDSON

The 1986taxreform stretched outthedepreciation rateon residential buildings

to21V2years(andnonresidential buildings to3 1Viyears),butgrandfathered innew
if
buildings they had obtained a certificate
of occupancy for rental. The resulting
depreciation write-offs fortherealestatesectoras a wholewerelargeenoughto
leavenonettaxableincometodeclareduring the1989-92downturn. Thispretense
enablesinvestors to keepon earningrentalincomefreeof taxation, as ifnothing
"really"is beingearned.Economicfiction becomesa fiscalreality, eventothepoint
ofbeingconfirmed byseemingly empirical nationalaccounting data.
Whenone findsa statistical distortion at work,a specialinterest is almostsure
to be involved.Misrepresentation and a falseempiricism becomesa highlypro-
fessionalizedpartof theeconomicsof deception.The resultis junk statistics.
Replacement-cost accounting assumesa highervalue forbuildings,and hencea
higher write-off each time a new buyerplaysthegame.Butunlikeinvestment in
machinery, property tendsto risein price,thanksto theland'srisingsitevalue.
The deceptionthatbuildingsaredepreciating resultsin a fictitiouslyhighratioof
ostensiblebuildingvaluationto land.Preciselybecause thelandsiteostensibly
cannotbe depreciated, thetaxprivilege ofdepreciating buildings providesa motive
their
formaximizing valuation.
Despitethereported net$5.1 billionpretaxloss,$5.9 billionafter-tax loss and
$1.2 billionnegativecashflowin 1990,realestatecorporations paid $3.9 billionin
dividendsandwerethelargestsourceofinterest forbanks,maintaining thealmost
steadyriseduringthepostwarperiod.YettheNIPAshowitoftennottobe earning
anyincomeandpayingalmostno incometax.
The effect is to encouragecommercial property tochangeownership everyfew
it in
years,keeping perpetual motion to minimize itsincome-tax Owners
liability.
sell
typically property when a building has been largelydepreciated, and the new
landlordcan startdepreciating it anew.In thisway a buildingthatalreadyhas
been depreciated by itsformer ownerachievesa new life.Like cats,a building
seemingly has ninelivesandcanbe written offagainandagain,turning realestate
anditsdepreciation allowanceintotheeconomy'slargesttaxshelter. Thisexplains
whya sectorthatseemschronically tobe losingmoneyenjoyssoaringinvestment
and dividendpayouts.Whilereal estateinvestors pretendthattheirproperty is
losingvalue as theirbuildingswearout,thesite'slocationalvaluerisesto more
thancompensate.
Inmanyyears(especially1981-95forcorporate realestate,and1985-90forreal
estatepartnerships) thedepreciation write-off was so largeas toproducefictitious
accounting losses fortaxpurposes,freeing commercial realestatefromtaxation.
Bybuyingrealestate,investors acquireso largea taxdeduction thattheyoftenhave
beenabletouse itas a chargeagainstothersourcesofincome.From1981through
1995realestateinvestment trusts (REITs) andothercorporate realestatereported
nettaxwrite-offs despitetheir rising cash flow and dividend payouts.

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ECONOMY 97

8 Non-corporate
Figure realestatecashflow

Mostcommercial investment is organizedas partnerships

toobtainthelegaland
financial
benefits
ofincorporation whiletaking"booklosses"as creditsagainstthe
personalincomeofproperty investors.Likecorporate realestate,thesepartnerships
enjoyedfreedom from income taxationduringthe secondhalfofthe1980s,although
theexplosivetake-offinrentsrendered moreincometaxableoverthetwodecades
stretchingfromthemid-1980sthrough 2005 (Figures8 and 9). Property prices
soaredas buyerswereable toearnincomeinexcessofcarrying charges come
and
outwitha capitalgain- anda taxwrite-off to boot.

9 Corporate
Figure realestatecashflow

Homeownersare notable to makethisdepreciation pretense,onlyabsentee

owners.Butevenwithout beingable to takea depreciation
write-offagainsttheir
wages and salaries,theyhave riddenthe wave of to buildup
inflation
asset-price

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98 MICHAEL
HUDSON

in an eraofpostindustrial
theirnetworth.Applaudedas ushering tax-
prosperity,
becamea newmodeofwealthcreation
subsidizeddebtpyramiding - a permanent
economy.
capital-gains

How the Fed's Appraisal PhilosophyAttributesLand Values

to Buildings

Assessorsin mostUS citiesestimatelandat 40 to 60 percentofrealestatevalue,

tendingtowardthehigherratio.FederalReservestatisticsalso showthatland
thelargestelementofrealestate'smarket
represents price,despitethefactthattheir
methodology substantiallyundervalueslandrelativetobuildings. Fed statisticians
treatlandas a residualleftoveraftervaluingbuildingsat theirreproduction cost,
includingcapitalgains thatreflect
risingconstructioncosts.
Theproblemwiththisland-residual methodology is thatitleavesan unrealisti-
-
callylowresidualforland so lowthatearlierFederalReserveestimates produced
a negative$4 billionnumberforcorporately ownedlandin 1994. (The Fed has
sincereorganized itscategoriesto moderatethisirrationally low calculation,but
continuesto defenditsmethodology.)

10 Landresidual
Figure costofstructures
C=Corporate H=
sector; Household NC= Non-corp.
sector;
Source:
FRB,Flow
ofFunds.

thevalueofbuildingsat
landsitesas a residual(afterover-estimating
Treating
makes
cost)
replacement landpricesappear morevolatile
thanoverallrealestate.The

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FROM CAPITALISM
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BUBBLE
ECONOMY 99

seemingfallbackafter1990intheland'sresidualvalueas a proportion ofnational

income(Figure10) is largelya statisticalillusionas thepace ofconstruction-price
inflationincreasedtheFederalReserve'scalculationforthereplacement costof
buildings,leavingless residualforland,wherethereal marketvalue lies. The
steeprisein landvaluationfrom1995 to 2007 reflects thereductionof interest
ratesengineered by theFederal Reserve flooding economywithliquidityto
the
promote"wealthcreation."
The inflation oflandpriceshas beenthedrivingforcein realestate'sdominant
roleintheUS economy. TheFedhelpedinflate realestatepricesbylowering interest
rates(enablingbankers tocapitalizerentalincomeata higher and
multiple) flooding
thebanking system withenoughcredittoenableprospective buyerstobidupprices.
Fed Chairman Greenspan laudedthe"wealtheffect" forraisingconsumption levels
on theway up, especiallyas homeowners tookouthomeequityloansto sustain
theirlivingstandards, whilerefraining fromregulating lendingto keepithonest.
Itshouldbe clearfromtheforegoing analysisthatrealestateis doingmuchbetter
thanappearsatfirst statistical
glance.Buildingsarenotreallydeteriorating, thanks
to theirongoingrepairand maintenance. Although theNIPA depict real estateas
operating at a loss,investorsactuallyaregetting richthrough asset-price inflation
creating
capitalgains.

11 Land-residual
Figure as percentage
valuation, ofnational
income

So thisposes an important
policyquestion:Is itsociallyusefulto increasereal
estatepricesbyprovidingtaxbreaksforrunning upmortgage debtandforabsentee
building owners? This be
might argued if thereason whyproperty ownersare
goingdeeperand deeperintodebtis thatrisingconstruction costsincreasethe

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100 MICHAEL
HUDSON

costofbuildingsandothercapitalimprovements. Butifhigherprices(andhence,
largermortgage loansnecessary tobuy realestate) simplyreflect higherpricesfor
landsitesthathaveno costofproduction, thento activelysupport propertyprices
merelymakesnewbuyerspay more- and specifically, pay moredebtserviceto
mortgage bankers.Higherlandpricessimplyincreasethecostofproviding homes,
officebuildingsand industrialplants.Taxing the land's risingrental
value would
notreduceitssupply(norwouldtaxingtherisingreproduction costofbuildings
alreadyinplace lead totheirremovalfromthemarket) buttaxingtheconstruction
ofnewbuildingswoulddo so.
The morerealestategrowthconsistsof investing in capitalimprovements, the
moreitcanbe arguedthatrisingproperty priceselicitmore investmentintheform
ofconstruction activity.Butthisargument cannotbe madeifwhatis beingbidup
is simplytheland'saccessprice.Highersitepricesdo notinducemorelandtobe
supplied,because it is providedfreelyby nature.The onlyway to increasesite
valuesis to providemoretransportation access. It has longbeenarguedthatthe
publicsector should recoverthecostof thisinfrastructure bytaxingtheincreasein
rentalandsitevaluesalongtheroute.

12 Land-price
Figure tomortgage
gainscompared Overtime,
interest. ispaidout
interest
ofland-price
gains

Tax FavoritismforCapital Gains

Whenownersselltheirrealestate,theyaresupposedtoreport therecoveryofpast
depreciation as
write-offs a capitalgain - thesales minus
price the book
depreciated
value.Butcapitalgainsare taxed at a much lowerrate than"earned" income- if

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CAPITALISM BUBBLE
ECONOMY 101

at all! The taxcode permitsinvestors to avoidpayinga tax at thepointof sale if

they build up wealth by reinvesting sales proceedsto buynew property
their of
or
equal greater cost.
The hypocrisy behindthistax logic is revealedby theFederalReserve'sown
statisticaltreatmentthatestimatesbuildingvaluesas rising.Usinga construction
price index thatassignsan annualcost increasetobuildings,theFed subtractstheir
hypothetical replacementcostfromitsoverallproperty valuationbasedon Census
Department The residualis assignedto theland.The fasterbuildingcosts
figures.
rise,theslowerlandsitesseemto appreciate - sometimes notmuchat all.
Ownersarguethattheydeservetohavetheir "keepupwithinflation"
investment -
therisingcostof a newbuildingto replacetheone theyare selling(afterhaving
sheltered itsincomebydepreciating thisclaim-
it).TheFed's logicservestojustify
andhence,theland-price gainsthatJohnStuartMilldescribed as a passive,unearned
increment thatshouldbe taxedaway.But ifthedrivingforcebehindreal estate
prices reallythatbuildingsaregrowingin value,whyare landlordsallowedto
is
writeofftheircostas iftheirinvestment is beingeatenaway?
No otherpartoftheeconomyis inflation-indexed. Wageearnersdo notreceive
higherpaychecks to inflation.
reflect Landlords can avoid payingan incometax
on theircashflowwhileindustrial companies and employeesare obligedto
their
save outoftheincomeleftafterpayingtaxes.Real estateinvestors thusaregiven
a taxbreakbasedon a conceptofeconomicfairness thattheyalonearepermitted
to enjoyin claimingmerelyto be "breakingeven"withinflation as construction
-
costsrise whileatthesametimepretending thatdepreciation is consuming their
capital.Thishelpsexplainwhymostpeopleno longertrytosavebyputting earnings
in thebank.The way to buildup wealthhas beento buyhomesand otherassets
whosepriceis expectedtorise.
Mostfamilies - andbusinesses- nowseektobuildup theirnetworthmainlyvia
capitalgains.Muchnetpersonalsavingtakestheformofpayingdowndebtstaken
on to buyproperty. MissingthelogicthatguidesBubbleEconomyinvestors and
homeowners, theNIPAdo nottakeaccountofsoaringlandpricesorotherasset-price
gains. Like thetaxfilingson whichtheyare based,thesenationalaccountslook
muchmorepessimistic thanhowinvestors viewmatters. Theyreportmerelythat
realestateoftengoes manyyearson endwithout earningan income.
Investorsarejust as happyto see thesegainsleftout of thepublicaccounts,
becausethereis lesspressure totaxthem,incontrast tothelate19thcentury when
theclassicalreformers focused attentionon them. The less politicalpressureis
brought tobeartotaxoreventakenoteofcapitalgains,thelargerloansborrowers
will takeon, makingmortgagelenderstheultimatebeneficiaries of thefiscal
giveaway.

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102 MICHAEL
HUDSON

Table1 Comparison taxrate

ofcapital-gains with
normal
income-tax 1942-95
rates,
Maximum Gains
Capital
TaxRate(%) Income
TopMarginal TaxRate(%)
Individuals Corporations Individuals Corporations

1942-43 25 25 88 40
1944-45 25 25 94 40
1946-50 25 25 91 38
1951 25 25 87.2 50.8
1952-53 26 26 88 52
1954 26 26 87 52
1955-63 25 25 87 52
1964 25 25 77 50
1965-67 25 25 70 48
1968-69 25 27.5 70 48
1970 29.5 28 70 48
1971 32.5 30 70 48
1972-78
(Oct) 35 30 70 48
'81
1978(Nov)-June 28 28 70 46
'81-*86
June 20 28 50 46
1987 28 34 38.5 40
1988-89 33 34 33 34
1990-92 28 34 31 34
1993-95 28 35 39.6 35
Joint
Sources: onTaxation
Committee "Tax
(1995), Treatment
ofCapital and
Gains Losses,"
JCS-4-95, 13,
February
ofthe
andOffice
1995, ofthe
Secretary Treasury, ofTaxAnalysis
Office (1985),
"Report onthe
toCongress Capital
of1978."
TaxReductions
Gains

PayingOut Real Estate Rental Income as Interest

By farthemostinterest in theUS economyis paid on mortgage debt(Figures13,

14 and 15). Real estateis thelargestasset,anditsrisingcostobligesnewbuyersto
turnovermostoftheproperty's rentalcashfloworvaluetotheirmortgage lender.
as
Indeed, long as theBubble is
Economy creating land-price("capital")gains,real
are
estateowners quitewilling pay to out current income to theirbankersas debt
service.Thearrangement worksas longas property pricesrisebyenoughtocover
thedebtsandtheirinterest payments. But thisdynamic cannotlast,becauseadding
theinterest ontothedebtbalanceyearafteryearentailsmoreand morecharges.
Thatis the"magicof compoundinterest," afterall. On an economy-wide levelit
can neverworkforlongperiodsoftime.
As interest ratesroseafter1945 to theirhighof about15 percentin 1980,the
volumeofinterest payments increasedfrom just 1 percentofnationalincometo 12
percentin themid-1980s.As mortgage interestratesreceded,theratioofinterest
payments to national income fellbelow 8 percentin 2001, butthenresumedits
upward trend as new debt markets were developed, headedbysubprime lending and

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ECONOMY 103

thederivatives
trade.Fallinginterest
ratessince2000 offset
therisingdebtburden
as theFederalReservefloodedtheUS economywithcredit,butcarrying charges
nowthreatento skyrocket ifinterest
ratesrisebackto "normal"levels.

13 Interest
Figure intheUSeconomy

14 Interest
Figure as a percentage
payments ofUSnational
income

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104 MICHAEL
HUDSON

The composition ofintereston theeconomy-wide levelhas remained basically

is paidonmortgage
stable.By farthemostinterest debt,whosegrowth is subsidized
bymakinginterest payments taxdeductible. The higherthedegreeofsubsidy, the
moredebtcanbe afforded. Andconversely, tax
ending deductibility would reduce
theamountof debtthata homebuyercan affordto takeon. This would lower
theequilibrium pricethatcouldbe afforded. Whatseemsat firstglanceto be an
economicbenefit tohomebuyers - makingtheirinterest payments taxdeductible-
thusturnsoutto be largelyillusory.The subsidyendsup beingpassedon to the
banks.Givinghomeowners andproperty investors a taxsubsidy; whilemaintaining
theruleofthumbthatmortgage payments shouldequal 25 percentor somesuch
ratioofpersonalincome,merely replacesthecostoftaxpayment withan interest
payment to bankers.

15 USinterest:
Figure composition
percentage

AdamSmithsuggested as a ruleofthumb ratestendtobe abouthalf

thatinterest
theprofitrate.Fora commercial orindustrial financed
enterprise oncredit,
entirely
wouldabsorbhalfthegrossprofit.
interest Butsincethe1980s theratiohas risen
as debtleveraginghas spreadthroughout theeconomy."Shareholderactivists"
(theeuphemistic neologismforcorporate raiders)arefinancializingindustry
along
muchthesame linesas real estatewithitshighdebt/equity leveragingturning
andcashflowintointerest
profits via leveragedbuyouts financed withhigh-interest
"junk" bonds.
Forcommercial investorsthechoiceofwhether tobuya rent-yielding property
on creditortouse one'sownmoneyis a businessdecisionshapedbyprospects for
returns.
after-tax Debtfinancing is a businesschoiceby investors tobuyproperty

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FROM
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CAPITALISM BUBBLE
ECONOMY 105

withloans insteadof usingtheirown money,not a necessaryoperatingcost.

Investorspay interestchargesoutof theirearnings.The government alterstheir
investment equationby making such payments tax-deductibleas if theywere
a necessarycost of doingbusiness.The effect
is thatinterest
paymentsexpand
to absorbtherevenuehitherto paid out as taxes,absorbingwhateverincome
is un-taxed.Thatis whattoday'sbusinessschoolgraduatesare taughtto do in
designingdebt-financed takeoversand leveragedbuy-outs.Makinginterest tax-
deductibleencouragesdebtpyramiding. Thisinturnleadstopoliticalpressurefor
taxcutswheninvestors theinevitable
suffer debtsqueezeas theeconomyshrinks
in responseto debtdeflation.

FromAsset-Price Inflationto Debt Peonage

The indebtedness of real estateis a distinctly

and financialization 20th-century
phenomenon, goinghandinhandwiththedemocratization ofproperty ownership.
Long after
the end of landlords
feudalism, remained the wealthiestand mostliquid
class.Buttoday,banksandothermortgage holdershavebecomethemajorparties
in US real estate.OverallUS homeowners'equityhas fallenfrom70 to under
50 percentof property valuesas theUnitedStatesshiftsfroman ownership to a
debtoreconomy.

16 Homeowners'
Figure as percentage
equity ofhousehold
realestate
FRB.
Source:

In contrast
to industrial
capitalism, squeezes outan economic
financialization
not
surplus by employing labor to producecommodities forsale at a markupbut

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106 MICHAEL
HUDSON

bygetting laborandindustry a financial

intodebt.Itextracts surplusintheformof
not on
interest, profits production and sales.Andfinancecapitalismusesthissurplus
toextendyetnewinterest-bearing loans,nottoinvestintangiblecapitalformation.
Whenincomeis insufficient topaybondholders,financial
managers extractrevenue
bycarvingup andsellingoffassets.Suchzero-sum (orevennegative-sum) transfer
payments do notpromote but
growth polarize thedistributionofwealth inwaysthat
dryup thedomesticmarket forconsumer goodsandinvestment goods.
Financializationalso acquireswealthfromgovernments by appropriatingthe
publicdomainor monopolyrightsin settlement of debt.In theUnitedStatesthe
railroadbaronsbecamelandbaronswitha strokeoftheprivatization pen- along
withtheemerging miningandtimber oligarchy.By thistimerealestate,mining and
were
forestry becomingpart of the FIRE sector,dominated by finance.InAmerica
thismeantWallStreet;in England,theCityofLondon.
It oftenis overlookedthatinequality ofwealthfarexceedsthatofincome.This
is becausethewealthiest10 percentof familiesprefer to taketheirreturns notas
incomebutintheformofthemuchless highlytaxedcapitalgains.Andwhilethe
population'sbottom90 percenthopeto catchup bygoingintodebtto buyhomes
and otherproperty, theinsatiablegrowthin debtneededto keepa realestateand
finance bubbleexpanding imposesfinancial chargesthatpolarizewealthownership.
Thesedebtchargesgrowso heavythatdebtorsareable topayonlybyborrowing
theinterest. Theydo thisincreasingly bypledgingrealestateorotherassetswhose
are
prices being inflatedby a combination ofcentralbankpolicyandTreasury tax
concessions. Theproblemis thatinadditiontogoingfurther intodebt,thepolicyof
un-taxing property and financialwealth forceslabor andtangibleindustrialcapital
topickup thefiscalslack.
Governments havebecometheproperty bubble'sultimate enablers.Ostensibly
to
createdsimplytogiveliquidity mortgages (whichtraditionally wereheldbythe
banksthatoriginated them),thesemi-public FederalHomeAdministration (FHA),
FederalNationalMortgageAssociation(FNMA) and FreddieMac becamethe
largestbuyers,packagersandultimate guarantors ofUS mortgages, buyingthem
up as fastas banksand mortgage brokers could issue them- some two-thirds ofall
US homemortgages. Thesegovernment-sponsored agenciesthensoldbondsbacked
by these mortgage holdingsto buyers trusted
institutional who thatthegovernment
wouldstandbehindthemregardless ofhowpoortheunderlying qualityofmortgages
were.Thiswas analogoustotheFederalS&L Insurance Corp.(FSLIC) bailingout
risk-taking institutional
depositorsinS&Ls twodecadesearlier, inthe1980s.FNMA
andFreddieMac bondsamounted to$5 trillion,as muchas theentire publiclyheld
US Government debt.

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FROM TOAFINANCIAUZED
CAPITALISM
INDUSTRIAL BUBBLE
ECONOMY 107

Accounting fraudbyFNMAmanagers helpedcreatea falsesenseofconfidence

forbuyersunfamiliarwithhowcrookedtheUS financialsectorwas becomingas
let
deregulation banks runwild.Whenthecollateralvaluebackingtheirmortgage-
backedsecuritiesplunged,theFHA, FNMAandFreddieMac dulyreported losses
-
andcalledforpublicbailouts ofthemselves clients, for
andtheirinstitutional not
homeowners.
defaulting Butby July2008 itwas reported thatunder"fairvalue"
accountingrulesthemortgages failedtocoverobligationsbyover$5 billion,share
for
prices thetwo semi-public
agencies hadfallen 90
by percent from2007 to2008.
A WallStreetJournaleditorialcommented:
Thedouble amidthecurrent
irony crunch
credit havebeenpromoting
isthatourpoliticians
FannieandFreddie
as mortgage evenastheir
saviors riskofinsolvency Chuck
hasgrown.
Schumer, Doddandmany
Chris othershaveencouraged theduototakeonevengreater
mortgagerisk
asthehousingslumphasunfolded. They'rethearsonists asfiremen
posing
more
whileputting dry tinder
around theblaze.9
bad debtsgo under,Congresssetabouttrying
Ratherthanletting to re-inflate
the
homemortgage marketso as to enablehomeowners sufferingnegativeequityto
raisethemoneytopaytheirdebts- debtsowedalmostentirely tolargeinstitutional
investors
andultimatelyto thepopulation'swealthiest10 percent.

17 Mortgage
Figure FNMAandFreddie
assetsbyholder. Machavebecomethelargest
holders
mortgage

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108 MICHAEL
HUDSON

Real Estate in a Debt- Leveraged Economy

Thefactthatland-price gainshavelongovershadowed realestatecashflow(ebitda)

has madeproperty investors to
willing pledge theirrentalincometo bankersas
Rather
interest. thanseekingcurrent income for
(or homeowners, rentalvalue)the
aim is to ridethewave of asset-price inflation.So thefactthatoverallrealestate
netcashflow(ebitda)is abouta thirdofnationalincome,thiswas byno meansthe
wholestory. Intermsoftotalreturns- cashflowplusasset-price gains- realestate
generated an amount thatrose as high as half of reportedUS nationalincomein
2005.Thatyear's$2.5 trillioninhigherlandpricesamounted toabout20 percentof
reported nationalincome,while realestatecash flow(ebitda)added even more ($3
Andthisstillleavesanother
trillion). trilliondollarsorso fortheFed's calculation
ofcapitalgainsforbuildings'"replacement cost"whichactuallyshouldbe treated
as sitevalue.

18 Totalreturns
Figure ofnational
torealestateas percentage income.
Adding
land-price
to
gains national
income a
provides measure oftotal
return

Conclusion: The Largerthe Tax Giveaway, the More the Mortgage

Debt Grows

Taxfavoritismforrealestate,corporate fortheir
raidersandultimately has
creditors
freedincometo be pledgedto carrymoredebt.Mortgagelendersconsiderthata
paidondebtleveraging
circle"is createdwhentherighttodeductinterest
"virtuous

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FROM
INDUSTRIAL
CAPITALISM
TOAFINANCIALIZED
BUBBLE
ECONOMY 109

"frees"incometo be pledgedforlargerbankloans.Butthiscredithas beenused

tofuelasset-price raisingtheentry
inflation, priceofhomeownership andthecost
ofbuyingcorporate stocksandbondstoyielda retirement income.Butitdoes not
increaseproduction andoutput.Familiesgetofftherenttreadmill onlytogetonto
thedebttreadmill. Rentalincomehitherto paid as taxesis nowpaid as interest on
creditextended tonewbuyers, whiletaxesonconsumer incomeandsalesalso rise.
Theideais thatshifting taxesoffproperty andfinance promotes a "freemarket."
Whatitactuallydoes is favorthedebt-leveraged buyingandsellingofrealestate,
stocksandbonds,distorting markets inwaysthatde-industrialize theeconomy.
This is thetragedyof ourfinancialsystemtoday.Creditcreation,savingand
investment arenotbeingmobilizedtoincreasenewdirectinvestment orraiseliving
standards, buttobidup pricesforrealestateandotherassetsalreadyinplace,and
forfinancial securities(stocksandbonds)alreadyissued.Theeffect is toloaddown
theeconomywithdebtwithout putting inplace themeansto payitoff,exceptby
furtherandevenmorerapidasset-price - andsale orforfeiture
inflation ofproperty
fromdebtorsto creditors.
Thiskindof economicdistortion is largelytheresultofrelinquishing planning
and thestructuring of marketsto largebanksand otherfinancialinstitutions. In
thenameof "freemarkets"theeconomicsprofession has celebratedtheshiftof
planningandtaxpolicyto thefinancial sector,whoselobbyists haverewritten the
taxcode andsponsoredderegulation ofthechecksandbalancesputinplace inthe
Progressive Era a century ago.
At thattimeitseemedthatbankingandfinancewouldbe industrialized, while
landedwealthandmonopolies wouldbecomemoresocializedandtheir"freelunch"
(economicrent)fully taxed.Rather thanrealestatepricesrisingas we are seeing
today, this "freelunch" (what John StuartMill calledthe"unearnedincrement")
wouldprovidethebasicsourceofpublicfinance, including thefinancing ofpublic
infrastructure.
The classicalpolicyof basingtaxpolicyon theland's risingrentalvalue was
intended to havetwopositiveeffects. First,itwouldfreelaborand industry from
thetaxburdenas thiswas shifted back ontoproperty. Second,payingthisrental
valuetothegovernment wouldmakeitunavailabletopledgeto mortgage lenders
as interestandcapitalizedintolargerbankloansto bid up realestateprices.This
wouldprevent rent-extractionfrombecomingtheobjectiveofnewcredit, absorbed
as interestby the banks.
Butthevestedinterests havefought back.Financiallobbyists haveextracted fiscal
favorsforrealestateandpressedforderegulation ofmonopolies as themajorsource
ofinterest andcollateralforbankloansandbonds.Thelargestgainsofall aremade
byprivatizing enterprises fromthepublicdomain,mostnotablyinthepost-Soviet
kleptocracies but also from debt-strapped Western governments.

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110 MICHAEL
HUDSON

This is a travestyof the"freemarkets"thatlobbyistsforthebanksand the

wealthyin generalclaimto advocate.If therevenuecurrently used forinterest
anddepreciation werepaidproperty taxes, this would freean equivalentsumfrom
having to be raised in theform of income and sales taxes.This was theclassical
idea offreemarkets.
Financialand real estatelobbyistsencouragethepopularmisconception that
higherproperty taxes squeeze homeowners and wage earners. The reality that
is
taxingtheland'srentalvaluewould reduce interest chargesby an amount equalto
thetax.Real estatepriceswouldbecomemoreaffordable as theinterest nowpaid
to banksto supporta highdebtoverheadwouldgo to loweringtheincome-and
sales-taxburden.Thiswouldreducethecostofproduction andlivingproportion-
ally,byabout16 percentofnationalincome.
Pricesandrentsforhousingandofficespacearesetbythemarket place.Interest
andtaxesarepaidoutofthisrentalvalue.Thismeansthathomeowners andrenters
wouldpaythesameamountas theynowdo,butthepublicsectorwouldrecapture
theexpenseof buildingtransportation and otherbasic infrastructure outof the
higher rental value this spending creates. The tax system would be based on user
feesforproperty, falling on owners in a way thatcollects the risingvalue oftheir
property resulting fromtherentoflocation,enhancedbypublictransportation and
otherinfrastructure, and fromthegenerallevelofprosperity, forwhichlandlords
arenotresponsible butmerelyarethepassivebeneficiaries undercurrent practice.
In sum,fiscalpolicywould aim at recapturing theland's sitevalue created
by publicinfrastructure spending,schoolingand thegenerallevel of prosperity.
The economy'sdebtpyramidwouldbe muchloweras savingstaketheformof
equityinvestment onceagain,rather thana minority positionina debtpyramiding
operation. Slower of
growth debt,housing and office prices,and lowertaxeson
incomeandsaleswouldmaketheeconomymorecompetitive internationally.
But as matters stand,a BubbleEconomyweakensthenationalfiscalposition
as well as burdening industryandthenation'scompetitive position.International
equilibrium can be maintained only if all other economies are financialized in a
symmetrical -
fashion a proliferation ofthedebtburdenthatin facthas becomea
distinguishing characteristic oftoday'sglobalization.

Notes

1. William
Petty,Treatise
ofTaxesandContributions
(London, p.26:"Having
1662), found
theRent
orvalue
oftheusus
fructusperannum,thequestion
is,howmany years ..istheFeesimple
purchase.
worth?"
naturally Marx ofEconomic
{History Theories
,trans.
Terence
McCarthy[New York,1952],
p.5)notes
that deduces
Petty therate
ofinterest
from rent"asthegeneral
formofsurplus value."
2. Hyman P.Minsky,TheFinancialInstability , Working
Hypothesis No.74,May1992(The
Paper
JeromeLevyEconomics ofBardCollege).
Institute Prepared forHandbook
ofRadical Political
Economy,ed.Philip
ArestisandMalcolm (Aldershot:
Sawyer Edward 1993).
Elgar,

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FROM CAPITALISM
INDUSTRIAL TOAFINANCIALIZED ECONOMY
BUBBLE 111

3. "RecentChanges inU.S.Family Finances:Evidence fromthe2001and2004Survey ofConsumer

Federal
Finances," Reserve Bulletin
,2006, pp.Al-A38.
4. Andrew Mellon, Taxation: ThePeople s Business( 1924).
5. StatementbyAlanGreenspan, Chairman, Board ofGovernors oftheFederalReserve
System, before
theCommittee onBanking, Housing, andUrban Affairs,USSenate,February26,1997- Statements
totheCongress- Transcript FederalReserve Bulletin, 1997byAlanGreenspan.
April,
6. Testimony ofChairman AlanGreenspan, "TheFederal Reserve's
semiannual monetary policy,"
reportBeforetheCommittee onBanking, Housing, andUrban USSenate,
Affairs, July22,1997.
www.federalreserve.gov/boarddocs/hh/1997/july/testimony.htm.
7. TheWallStreet analyst Terence McCarthy observed thatMarx's oftheEconomic
analysis Theory
ofDepreciationwassocomplete that,"ifCapitalhasbeencalled thebibleoftheworking the
class,
History[heisreferringtoTheories ofSurplus Value] mightwellbecalled thebibleoftheSociety
ofCostAccountants.... Over thewhole society,failuretoprovide
adequate reserves
depreciation is,
Marx tonegate
implies, economic progressandtobegin consumptionofthat ofthevalue
portion of
theproductwhich Marx believes belongs neither
tothelaborersinindustry,
nortotheiremployers,
buttotheeconomy itself, as something which must toitiftheeconomic
be'restored' processis
tocontinue."Marx,AHistory ofEconomic Doctrines (NewYork, 1952),p.xv.Thiswasthefirst
Englishlanguagetranslation ofMarx's Theories ofSurplus Value.
8. I dealwiththisproblem in"Obsolescent FactorsintheInternational
Economy," Review ofSocial
Economics,March 1972.
9. James Politi
andBenWhite, "FreddieandFannie inturmoil,"FinancialTimes,July11,2008,and
"ThepriceofFannie Mae,"Wall Street
Journal editorial,
July10,2008.

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