What is the Significance of $1,000 Houses?

There was a recent report on CNN about how there are lots of listings for low-priced houses in places such as Cleveland, Detroit, and Indianapolis. The report admitted that these houses need work - say $20,000 worth - to make them livable, but they represent a golden opportunity to acquire real estate on the cheap.

Markets are generally pretty adept at conveying information. The first thing that comes to mind is that livable houses in these places aren't worth $21,000. If they were, the cheap houses would have all been snapped up.

One of the houses is mentioned as last having been sold at $70,000. Put another way, this means the value has declined from $70,000 to less than $20,000, or down about 70%. We believe that this is not an exceptional decline, but a fairly representative one.

The official numbers don't show this pervasive catastrophe yet because most owners who don't have an urgent need to sell, aren't selling. They are holding out for price recovery, and in their minds maintaining an inflated valuation.

There is a large, yet difficult-to-measure, overhang of houses whose owners imagine themselves patient, yet are probably just living in the past. Unable to let go of perceptual wealth, they can't sell the buildings for 'less than they are worth'.

This capital immobility is hurting the economy in at least two ways. First, it is keeping people stuck in place. Household mobility in the USA is at an all-time low. This hampers people's ability to relocate to better opportunities. Second, it is tying up capital in non-productive assets. Empty houses contribute very little to an economy. If sold, they could be inhabited, and thus a source of income - either landlord's rent, or owner's equivalent rent.

In time, most of the overhang will come to market and clear at the new equilibrium level. The rest will slowly rot in place, their deluded owners basking in their pride of ownership of an asset that is too valuable to sell at the market price.

The True Victim of the Depression

We read an article from the International Herald Tribune which we found laughably uninsightful. Mr. Stephen Schwarzman, CEO of Blackstone Group, remarks that the world has lost about 40% to 45% of its wealth. Our cynical side wonders if he is covertly commenting on his personal portfolio, but we assume he is being honest in his estimation of the drop of the world's 'wealth.'

Even if Mr. Schwarzman's number is accepted as reasonably accurate -- which we do -- his comment is purely nonsensical: the 'wealth' he refers to was never real. It was perceptual wealth; it existed only because at least two people at the peak of valuation said it did: the credulous buyer, and the less-credulous seller. This fast-evaporating 'wealth' was patently illusory, as it had all the substance and reality of a mirage.

Beyond this basic falsehood of Mr. Schwarzman's comment lies the big, black truth that no one likes to think about. Depressions are not necessarily about destroying wealth; rather, they destroy excess. Excess demand, excess consumption, excess space, excess production, excess capacity, excess valuation, excess credit. These are the things upon which a depression feasts; nothing so trite and pedestrian as perceptual wealth. The most destructive feat of a depression, though, is how effectively it can eliminate productive capacity of an economy.

Within this destruction, though, is a major problem. All depressions of the past have occurred when energy was not a limiting factor. The populace did not wonder where the energy to renew the economy was going to come from. It was tacitly assumed, and rightly so, the energy necessary to rebuild economic activity was abundant.

We opine such a comfortable assurance is not present in the 2007 Depression. Demand destruction in world-wide oil consumption is a given, and some have mentioned that it is an end to the Peak Oil debate. We beg to differ: this destruction has guaranteed Peak Oil is upon the world (whether from the limits of Nature or the limits of Humanity is immaterial). The oil industry -- from whence the lifeblood of industrial civilisation flows -- is in danger of irreparable harm, as Simmons & Company International reports.

With the severe downturn in oil use, many oil wells, rigs and refineries are being spooled down... permanently. Most of this equipment is utterly antique, and can never be restarted at any cost; it is too rusty and too run-down, and needs to be replaced. On top of that, vast swaths of the industry's ageing workforce are retiring, and there are not enough new workers adequately trained to replace this loss of hard-earned talent.

At some point in the not-too-near future, the hard and unyielding ceiling of oil production capacity will become painfully apparent. By Simmons & Co.'s estimation, it will take upwards of $100 trillion to rebuild the world's energy production facilities, and make them a viable entity for the future. We have the suspicion that the money, the interest, and the labour will never be found. Too many people seem to believe that the oil industry is a profit-squeezing monster - instead of the abused and starving industry in danger of utter collapse it is.

What is Productive Capacity?

Arising from yesterday's post is the question of what wealth really is. Well, this is frankly very difficult to answer. Perceptual wealth is the name of the game right now, it seems: houses in and of themselves are worth 'something;' credit cards are seen as money; various corporations and banks are 'too big to fail.' These are all things which are teetering on the brink of major market revaluations (downwards), all the while desperate attempts are made to prop up their present, unsustainable valuations.

In ye oldie days, economies were predominately run from a mercantilist perspective. Mercantilism generally held that wealth was embodied in money (i.e. gold and silver). Prosperity and productivity flowed from the active hoarding of money, which thereby enriched the nation.

Anyone who has ever owned physical gold or silver should know this is hogwash. We have placed a bar of silver upon a table, and stared at it for quite a while, but as it sat it generated no wealth. Sure it was pretty, but it was only a store of value, not a productive investment. It could never produce wealth by our passive holding of it. To this we add the ideas that stocks, bonds, or houses are wealth: they are mercantilist delusions of the 20th and 21st Centuries, for their hoarding will never create wealth.

Towards the end of the 18th Century, mercantilists were superceded the physiocrats. Physiocrats held that wealth did not come from hoarding money (i.e. bullion), but came from productive capacity. At the time, the physiocrats equated 'productive capacity' with 'farming,' but we will broaden the definition, thanks to UNCTAD:

"...the productive resources, entrepreneurial capabilities and production linkages which together determine the capacity of a country to produce goods and services."[source]

Note that nowhere is 'money,' 'the stock market,' 'real estate,' or any other such silliness mentioned. Productive capacity is what makes the stuff that people need or want, and the services that people need or want. It is what Marx called labour, although that is a bit oversimplified because productive capacity does include machinery and other such complex systems.

Creativity; optimisation; ingenuity; making do; these are all part of productive capacity. However, productive capacity cannot be reduced to any of these things: it is a complex system which must be regarded as a cohesive whole, and guided by human thought. As long as you, dear Reader, are a creative person and know how to do things, you have productive capacity. Nurture this ability; it will certainly come in handy in the Depression.

Perceptual Wealth

Much of financial news of recent note has typically been about how much money has been sucked into a black hole. People bemoan the falling value of their 'nest egg' real estate; stocks hopped onboard a time machine and revisited the Nineties; California real estate is already in the Nineties, and seems to have a hankering to see some disco. There's a distinct possibility that some financial sharkskin suits might be spotted in the near future, and we wouldn't rule out a resurgence of the Zoot suit.

But what, really, has been lost? In our examples, and indeed in general, money hasn't actually gone down a black hole: all that has changed is the hypothetical price tag on a given investment. Nothing changed physically about the houses in California (usually); the same can be said for stocks. One day they were value X, and the next they were value Y... the bad news: Y was less than X.

Such fluctuations are normal in a market's valuation of a given 'thing,' and are to be expected. Just because 'the market' says a certain Californian condo appraised at $450,000 doesn't necessarily mean someone will actually buy the place. The condo is worth what someone will pay, and not a cent more. Trouble sets in when people confuse a market valuation with 'money in the bank,' and spend $400,000 as if they had already sold the condo.

We suppose it's all well and good to do this when the market is forever going up... but surprise! No market is immune to the inevitable downturn, and now the average Californian real estate speculator is 'under water' (i.e. owe more than their properties are worth). They're saying they've lost money, but have they really? They didn't sell their property, but yet they spent like they had a big pile of cold, hard cash. They thought they were wealthy, but clearly weren't... so what did they have?

Perceptual wealth, dear Reader; the perception of wealth, without actually being wealthy. These real estate speculators (a.k.a 'homeowners') truly believed they were wealthy, and so they spent and lived as if they were wealthy, but in the end what made their 'wealth' wasn't real. It was an opinion, a valuation; it was what someone said the investment was worth. Writ large, the real estate bubble more resembles a confidence scheme, but it all began with someone feeling wealthy because they bought a condo in California.