REVISING FLAT-EARTH ECONOMICS
- BRIAN HODGKINSON
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School of Economic Science, Oxford
Author of 'A New Model of the Economy'
1.Why 'flat-earth Economics'? This curious title can be taken almost literally. Imagine a map of the UK on which there are no contours. To what extent would it portray an accurate impression of the country? There would be no mountains, hills or valleys, just one flat, continuous expanse like a flood plain. Present day economic theory offers a similarly distorted view of the UK economy, simply because it ignores the economic rent of land. (For a full explanation of this see Part 3 Chapter 8 of 'A New Model of the Economy') In central London land rent is very approximately a thousand times greater than rent on agricultural land. Yet when economic theory analyses how firms operate it fails to take account of this difference. For example, a firm that owns a freehold in central London is seen as having much the same costs as a firm on a marginal site in the provinces, because the labour and capital costs are much the same per unit of output. Hence the London firm appears to make huge profits and is seen as much more productive and efficient. In reality the difference is the economic rent of land.
2.Who creates this rent? It is always a result of three features of any economy:
a) natural qualities of the land, such as fertility and mineral deposits.
b) the proximity of a human population.
c) the presence of public services, such as transport and law and order.
None of these are contributed by the firm itself, since all that it provides are labour and capital. This
raises the question of who is entitled to receive the rent of land, but I will leave this vital question until later.
3.The central place in micro-economic theory is held by the theory of the firm, which divides firms into the four categories of perfect competition, imperfect competition, oligopoly and monopoly. In all of these the present analysis is grossly distorted by omitting the rent of land. It can be introduced very simply by showing it as a surplus after all labour and capital costs are paid. Any land rent actually paid to a landlord needs to be added back to avoid double-counting. (A precise analysis of all the four categories above is given in Part Two of 'A New Model') Provided that the land rent is shown accurately, any further surplus will be profits due to the entrepreneur or monopoly profits. These will no longer be confused with the rent itself. The practical significance of this theoretical change is that a firm operating on an especially favourable site, such as a large retailer on a central city location, will be shown as only making profits attributable to the efficiency and skill of its management. The surplus arising merely from its superior location will be separately identified as rent. Current theory obscures this completely by not discriminating between firms that have freeholds and those that pay rent to a landowner. The former obviously have huge advantages over the latter.
4.The omission of the rent of land from macro-economic theory is equally misleading. (See Part Six of 'A New Model') Despite the fact that land is stated to be a separate factor of production in the introduction to textbooks, in macro theory it is subsumed under capital. Land is not capital for two main reasons. Firstly, unlike capital it is not produced; secondly, unlike capital it creates rent. But in the context of macro-economic theory a particular error arises by treating them as the same. The multiplier, perhaps the central concept of the theory, is distorted, as it operates quite differently when applied to land rather than capital. Expenditure on capital generates further, i.e. multiplied, expenditure on each round as capital producers pay workers and suppliers and so on. Expenditure on land, on the other hand, is not paid to its producers, because there aren't any! The sellers of land may spend some of what they receive, but this is not likely to be on consumption; most of it may be saved or re-invested in other assets, such as share or bonds. Hence the value of the multiplier is very much less for expenditure on land than for expenditure on capital.
Further errors arise if one looks at the idea of asset formation in the economy. The theory states that Savings plus Taxation plus Imports equals Investment plus Government Expenditure plus Exports ie. S+T+M= I+G+X. This becomes S+(T-G)=I+(X-M) which means that saving in the private sector plus the budget surplus equals total investment plus the export surplus. In other words, saving in the whole economy is equal to net asset formation, including foreign debts. Land is therefore included in investment, as part of net asset formation. Is there any extra land? Where did it come from? When a firm buys a new factory, for example, it may be creating a new building, but certainly not a new piece of land.
There is one more notable technical error arising from the confusion of land with capital in macro theory. Keynes explained how his concept of the marginal efficiency of capital (MEC) enables one to calculate the volume of capital expenditure by showing how MEC is equated to the prevailing interest rate. Entrepreneurs invest in new capital up to the point where MEC falls to that rate. However, the marginal efficiency of land is very different from the marginal efficiency of capital, principally because land has a much longer life. Capital lasts say five or ten years; land lasts indefinitely. Hence when the returns from each are discounted, ie. later returns are of less value than earlier ones, land is affected a great deal more by changes in the interest rate. A practical example of this is that the interest rate has a much greater effect on the volume of house mortgages than it does on say manufacturing investment. A simple way of looking at this is to consider how much interest one pays on say a twenty-five year mortgage, bearing in mind that the land value is usually more than half the value of the property. Since government economic policy now largely centres upon the use of interest rates to control the level of expenditure, this error is disastrous. How often in the UK have we seen interest rates rise to cut off a housing boom with the damaging side effect that industry is saddled with higher investment costs and an artificially high exchange rate?
5. More obvious than these relatively obtuse matters is the distortion produced by 'flat-earth theory' concerning the distribution of income. Land values – the contours of the economic map – are largely ignored in the calculation of corporate and personal wealth. Once more this is because they are subsumed under capital. This may take the form of the undervaluation of land in company balance sheets, which incidentally stimulates asset-stripping takeovers, or the treatment of residential land misleadingly as housing. Indeed the actual value of many firms and of most individuals is held in the form of land values. Yet these rarely appear in economists' analysis of so-called capital values. This is both a theoretical mistake and at the same time a reflection of vested interests. Both rich firms and rich individuals wish to avoid the public recognition of where their wealth lies. Oil companies, high street supermarkets, property companies, estate owners and residents of London's West End all have a vested interest in keeping quiet about land values. So too do Russian oligarchs and Australian mining companies.
6.There are two important conclusions to draw from any revision of 'flat-earth Economics'. The first is educational. Current theory is grossly misleading. The picture it presents of the economy omits its most dominant real feature, which is the presence of land in every sphere of economic activity and the enormous differentials that exist between land of various productivity. Our schools and universities are teaching theories that can only be compared with pre-Copernican astronomy or even with the geography of a flat earth. Yet it is not difficult to revise both micro and macro theory to take account of land, land values and rent.
The second conclusion is just as fundamental. The clear identification of the rent of land sets before us the possibility of an equitable system of taxation. As promised, I revert here to the question of what actually causes rent in the first place. The answer is natural qualities of land, human population and public services. To whom then is it due? Surely the only rational reply is to the community which makes use of these qualities, constitutes the population and provides the public services. In short, the rent of land is a natural fund for the provision of public revenue. Were rent to be used in this way, all other forms of taxation could be reduced, or even eliminated. Taxation levied on rent has no impact at all on the margin of production, where rent is zero. Both marginal firms and marginal labour and capital would benefit from the relief of taxation at present levied on labour and capital in the form of income tax, national insurance, VAT, profits tax and the rest.
These two conclusions are inter-related. No such revision of public revenue could be attempted without a change in public attitudes. Education into the realities of land values and land rent needs to precede any tax reform. It is the duty of economists and other social scientists to realise the extent to which a thorough revision of economic theory is required, so that a new approach to the distribution of wealth and income and to equity of taxation may evolve. Neglect of this duty dooms Economics to be a quasi-science and the economies that depend upon its practitioners to injustice and continuing decline.