Fevered controversies about economic policies often constitute much ado about nothing. That’s because market outcomes often automatically offset things about which people waste much time wringing their hands.
At least that is the way economists look at markets – as wonderfully useful social institutions that often are difficult to understand.
Take the current debate, here in St. Paul and elsewhere, about whether high real estate taxes will drive homeowners out of the city. That may well happen, though I think the likelihood is much overstated.
Selling to move to the suburbs might be a mistake, however, because markets for houses already price in related costs like real estate taxes, quality of public services, commuting costs and myriad other factors.
If taxes in one jurisdiction go up relative to those in another by an unanticipatedly high degree, market forces will drive down housing values in the higher taxed area and raise them in the less-taxed area. There won’t be any opportunity for arbitrage. That is, one won’t be able to improve one’s overall well-being by property-tax shopping between one city and another.
This may sound like bunk to the average person. But pay attention to the logic, because far more important policies than minor changes in property taxes hang on exactly the same arguments.
Start with the insights of David Ricardo. In the 1820s, this British economist noted that increases in the price of some product, say wheat, did not increase the profitability of working the land. Instead, an increase in wheat prices would raise the price per acre of farmland. The renters who actually tilled the soil in Britain did not make more money because they would have to pay more rent. The landowners, though, got richer.
Extending this more broadly and incorporating the insights of Prussian farm manager Johan von Thunen, economists believe that changes in any factor affecting the desirability of a long-term asset will quickly become incorporated into the market price of the asset itself. If, for example, people live in distant suburbs but work in central cities, a rise in the price of gasoline will increase the cost of commuting and thus force down the values of homes in distant suburbs and raise them in neighborhoods closer to downtowns. It will also depress the price of gas-guzzling used cars and raise the value of ones that get good mileage.
Also consider the ideas of French-born economist Leon Walras. In the 1870s, Walras explained how markets are able to simultaneously solve equations representing all of the willing trade-offs of all the producers and consumers of myriad products. Market prices thus reflect the true value to society of both raw materials and final goods. Moreover, these adjustments happen quickly and reiterate as soon as any relevant factor changes.
A century later, Eugene Fama, at the University of Chicago, asserted “efficient market theory,” which argued that, at any point in time, the price of an asset fully reflects every detail of all the relevant factors that determine it, including expectations of its future value. Yes, expectations will not always be born out, but markets are so efficient that one cannot systematically out-predict them.
The upshot is that economic theory says if you are thinking of bailing out of your house in Highland Park to buy in Lake Elmo because your real estate taxes went up, it is already too late. The market value of your Highland Park home will already have fallen because of higher relative taxes. What you will have to pay in Lake Elmo already will have increased.
You can choose to make the jump but, adjusted for all the tangible and intangible factors that determine why people prefer to live in one place or another, you won’t make yourself any better off.
At least that is the theory. A reader who lives in Minnesota but works in local government across the river in Wisconsin recently wrote me to describe her amusement at Minnesotans who migrate to Wisconsin for lower housing prices and then are outraged to discover – surprise, surprise -that they will owe substantially higher real estate taxes in Wisconsin.
That people actually make such errors would confound Ricardo and Fama, whose theories presumed that people always are rational and well-informed about all relevant factors before making any decision.
But the fact that not all Wisconsinites have fled west to lower-taxed refuges in Minnesota, leaving River Falls and Hudson as ghost towns, generally supports their theory. Market prices for housing already reflect differing taxation rates, both on real estate and on other factors like income.
Still think this is bunk? Well, the arguments for repealing Dodd-Frank, Sarbanes-Oxley and other financial regulations hang on much the same logic of rational self-interest and efficient markets. Reject trust in the magic of free markets in one area, and logic commits you to rejecting it in many others.
© 2011 Edward Lotterman
Chanarambie Consulting, Inc.