A little extra income is usually welcome, so it was nice to open the mail and find that the value of our farm increased 12 percent last year, at least according to the county assessor. For those who want a better measure, the increase in value was as much as I get for writing 44 weeks worth of columns.
Such land price increases raise interesting questions. Why would land values increase so much in one year? If we really are wealthier, should we go ahead and spend more?
Economists have answers to both questions. Two centuries ago, the great British economist David Ricardo explained how increased farm profitability, whether due to higher crop prices or other factors, would increase land prices.
For the United States in 2005, there are at least two possible sources of higher farm profits: actual or anticipated.
First, rapid growth in Asia is increasing demand for farm and nonfarm commodities worldwide. China is not only importing oil and iron ore but also large quantities of soybeans and grains. If strong growth continues in China and India, we may be entering a new era of higher farm, fuel and mineral prices.
Second, the 2001 farm bill lays out unprecedented amounts of money regardless of price and crop conditions. In the long run, higher government payments to farmers translate into higher land prices, not greater profits from farming land.
One might also argue that monetary policy is raising land prices. It is an old argument that prices rise when the money supply increases faster than the production of goods and services. Irving Fisher, a great U.S. economist, expanded on this truism a century ago. It also is the core of Nobel laureate Milton Friedman’s analyses of macroeconomic policies.
Introductory economics emphasizes how an oversupply of money may inflate consumer prices. Fisher argued it also could boost prices for land, stocks and bonds. He insisted that a broad index of all prices, including those of physical and financial assets, be the measure of money-growth effects, not just an index of consumer prices.
Might land prices be rising because of too much money sloshing around the U.S. economy? Between late 2000, just before the Federal Reserve began to lower interest rate targets, and late 2004, output grew by 20 percent. The money supply grew by more than 30 percent.
Money growth half again as large as output growth over four years does not guarantee roaring inflation. In situations like this, however, Fisher and Friedman would not be surprised by jumps in the prices of land, houses or corporate stocks.
One could also weigh the effects of capital flowing into the United States from abroad. While a 30 percent increase in the money supply in four years has precedents, large inflows of money from abroad — even though U.S. interest rates are very low — are new.
An expansionary Fed policy combined with unprecedented lending to the United States by Asian central banks has kept long-term mortgage rates at the lowest levels in decades.
Families look at what size mortgage their monthly incomes will support and shop for houses accordingly. Farmers similarly look at how much debt per acre they can service with returns from raising crops. Lower interest rates make both families and farmers willing to pay more for real estate.
So economists have plausible explanations for why the farm jumped in value. But can they explain why we might change our spending, if at all?
We can start with an economist’s definition of income: “Income equals consumption plus change in net worth.” Economists also assume that people spend at least some of any extra dollars they earn. This “marginal propensity to consume” tends to be high for poor people but declines as incomes rise. Taken together, these arguments imply we might spend 90 percent or more of our windfall “income.”
Once again, Friedman explains why we may not. He argued that people’s spending fluctuates less than income. They save more when income is higher than expected and save less — or go into debt — when income is less than what they consider usual.
Many might scoff at the idea of going on a spending spree just because assets increased in value. “That is just paper income,” they would say, “you don’t have any more cash in your pocket.”
No, we do not. We could, however, refinance the farm and get cash to spend. Millions of U.S. households have done just that with home equity over the past decade. Higher housing values clearly have motivated some people to spend more than they would have if prices had been stable. To the extent that home prices rose because of imprudent economic policies, there is trouble down the road.
© 2005 Edward Lotterman
Chanarambie Consulting, Inc.