Thursday, April 28, 2011

Faulty Reasoning

I’ve come across some fine examples of faulty reasoning lately in two key areas.

1. Analysing the economic importance of declining environmental quality, and
2. Assessing the impact of price drops in the Australian property market.

So let us take a closer look.

Pro-urban sprawl advocates (I didn’t really know there were so many until just recently) try to shrug off the claim of deterimental impacts on agricultural production from urban sprawl due to irreversibly land use changes. For example –

Suburban Development is not destroying farmland. Smart growth activists claim farmland is disappearing at dangerous rates and that government needs to protect farmland lest we lose the ability to feed ourselves. As growth expert Julian Simon wrote, this claim is "the most conclusively discredited environmental-political fraud of recent times." United States Department of Agriculture data show that from 1945 to 1992 cropland area remained constant at 24 percent of the United States. Though urban land uses increased, they now account for only 3 percent of the land area of the United States. Today, American farmers produce more food per acre than ever before. In fact, the number of acres used for crops peaked in 1930, but because of the ingenuity and innovation of American farmers, the United States continues to produce more food on less land. (here)

Why is this argument based on faulty reasoning?

(As an aside, I would say that most smart growth advocates are not so extreme as to suggest that sprawl will destroy our ability to feed ourselves, just that sprawl makes it more difficult to produce the same quantity food that would otherwise be the case).

The faulty reasoning occurs because Simon compares the past situation with the present situation. He does not compare the present situation to the alternative present situation where urban sprawl did not replace some of the most highly productive agricultural land.

To be clear three scenarios are as follows.

a) 1945 levels of agricultural productivity with 1945 area of land under production.

b) 1992 levels of agricultural productivity with 1945 area of land under production, less land lost to sprawl, plus marginal land brought under production.

c) 1992 level of agricultural productivity with 1945 area of land under production plus marginal land brought under production.

Simon compares a) and b), not b) and c) which would reveal the true impact of sprawl on agricultural production. Just because we are now more productive, doesn’t mean that losing some of the better agricultural land is not important.

To apply Simon’s argument in another context, he would argue that having my car stolen today does not matter because I will still be wealthier in ten years than I am today, therefore I should not bother protecting my car from being stolen. It’s absurd. He should compare my wealth in ten years under the stolen and not stolen scenarios.

This same faulty reasoning can be found in many discussions on environmental policy.

The second area where faulty reasoning gets plenty of air time comes from overlooking that financial leverage works in reverse. This is why small percentage drops in housing prices have major impacts on the household balance sheet.

As an example, consider the following comment -

Why is it that when the stock market falls 2.1 per cent in a day it hardly makes the news, yet when property prices fall by the same amount over a three month period, considering that the median price rose by 160 per cent over a ten year period, it is a slump?

The property industry needs to stop with its hysteria

Okay then, let’s just see.

For the leveraged investor small falls in value are very bad news. Say they borrowed $80,000 to buy a $100,000 home with annual costs of $1,500 and annual rental income of $5,000. Interest costs on the loan are $6,000, so the investor makes an annual loss $2,500/year (2.5%). If prices increase 10% over two years, they cash out with $110,000, and subtracting their $5,000 of losses, gives them a $5,000 return on the original $20,000 invested, or a 12% annualised return on equity.

But if prices instead fall by just 5% over those two years the story is very different.

They sell the home for $95,000, repay the $80,000 loan, but have also lost $5,000 in the two years from negative gearing. This leaves them with just $10,000 of their initial $20,000 deposit. That’s a 22% annualised loss over two years. In other words THEY LOST 50% OF THEIR CASH! Remember this when you look at today’s housing data – home values in Brisbane and Perth are both down more than 6% over the past year.

If prices fall just 15% over two years the 80% leveraged investor makes a 100% loss on their equity.

(There is much more detail to examine here, including tax benefits of negative gearing, opportunity cost of the deposit, transaction costs and so on. But the principle stands.)

So yes, small falls in home values have a very serious effect on the balance sheet of homes due to leverage. It is the same reason that small gains had such a great positive benefit and why a few years of 10% plus growth made us all very wealthy in the short term.


  1. So what you are saying, Cameron, is that preventing urban areas growing from 2.9% of available land to 3.0%, so that agricultural production can be just that much higher, is a good idea? So why is the rent on agricultural land so low that many property developers holding land banks for 10 years (thanks to urban planning), do not even bother to get it farmed meanwhile?

    When food prices are so high that agricultural rents are so high that no-one would convert land to urban use; your reasoning will be valid and Simon's will be faulty.

    By the way, DO check out the new "Atlas of Urban Expansion" from the Lincoln Institute. It may surprise you to know just how LITTLE land IS in urban use worldwide.

    Also by the way, international "terms of trade" have steadily gone against agricultural-product-producing nations for decades. Nations in this situation that preserve agricultural land against urban expansion, have rocks in their heads. Almost ALL the economic growth in the world for the last 5 decades has come from URBAN production, and this production has become increasingly high-tech and low-environmental-impact. That is why you can swim in the river Ruhr, while the Manawatu in NZ is a serious health hazard.

    The British KNOW now that their whole economic competitiveness has been seriously undermined by inflated urban land costs. You have read one book by Alan W. Evans, that I recommended; there is another one published at the same time; I can't remember which one discusses the economic efficiency aspect.

    Here is a quick way to describe it: imagine a tiny nation-state like Hong Kong literally running out of land; imagine their land prices steadily escalating to the point that manufacturing and other land-intensive industries became unviable there; imagine that their economy was liberal enough that it survived as a financial services hub.

    WHY, Cameron, would a land-rich nation like Australia say in effect; "let's level the playing field with these poor chaps who have literally run out of land; and draw artificial boundaries around all OUR urban centres so our land markets behave exactly like theirs". Politicians who claim to care about industries going offshore, and the poor getting poorer, are the worst kind of hypocrites if they support urban growth constraint policies. Unlike Hong Kong, they are not trying a "solution" of maximising financial services employment; and even if they were, we can see where that would lead an economy.

    Your friend Wodehouselee.

  2. Wodehouselee,
    I genuinely believe that losing agricultural land to urban development does not threaten our ability to feed ourselves.
    But Simons argument is still illogical.
    Further, people often forget that urban areas typically expand into high yielding agricultural areas. Imagine a country where one crop is grown at an average yield of 4 tonnes/ha. Prime land yields 8 t/ha and marginal land just 2t/ha. If you replace 3% of the area which is prime land with marginal land, leaving the total agricultural area unchanged, you still lose 4.5% of the total potential national yield of the crop.
    In my opinion the preservation of opens space, including agricultural land, in and around cities is a community decision – just like the preservation of heritage buildings. There is really not a strong economic argument in its favour, but these tools are used to deliver what the community desires.
    I personally favour heritage protection and preservation of open space, but and more than happy to welcome densification in the existing urban area.

  3. Sure; but you said:

    "....The faulty reasoning occurs because Simon compares the past situation with the present situation. He does not compare the present situation to the alternative present situation where urban sprawl did not replace some of the most highly productive agricultural land....."

    What I said, is that the "alternative present situation" would be even LOWER return on agricultural land than the lowered return that DID occur. Why would that be clever? In fact, it is an inefficient use of land, a valuable resource, due to interference in markets.

    "Densification in the existing urban area" is not going to happen unless you confiscate land from its incumbent owners. Otherwise, all you do is hand them monopoly rents. All urban economic history points to mobility enabling sprawl enabling continual access to low cost land enabling economic growth and social mobility. We will NEVER see a nation "develop" as we have, if it does not follow this process, and hence locks "have nots" into a spiral of deprivation and overcrowding while incumbents are enriched, locks out potential new business start ups, and strangles labour productivity. I can actually see something in Karl Marx's idea that ALL rent is monopoly rent, given that he was writing in an era where mobility was not present to kick off the beneficial cycle I described above.

  4. Anon, how is possible to have even less agricultural output with more of the most productive land?

  5. Hi

    excuse me, but when Wodehouselee says land rich he needs to consider how much of that land is usable and at what rates. Looking at maps and thinking that Australia is like central Europe is another common mistake.

    go live in western queensland or any part of WA 500Km above Perth.

  6. What I said, was:

    ".....What I said, is that the "alternative present situation" would be even LOWER RETURN on agricultural land than the lowered return that DID occur....."

    I was not referring to "total output" at all, but economic "return". Sure, output might have been higher, but what is the point of preserving land for one use, increasing output on something for which "returns" are declining, and decreasing the returns in an alternative use for which returns are rising, i.e. urban use.

    It is a blessing in disguise to certain nations that they are so short of land that they have to IMPORT food - they benefit from the stupidity of nations that focus their efforts on producing food that they sell at ever-decreasing prices to nations that have predominantly URBAN economies, and who sell THEM back manufactured products for which economic returns are rising.

    IF the world WAS ever "running out of food", then economic returns on the production of food would RISE, and keep rising. The fact today is that once Brazil and a few African nations sort their food production capabilities out, food production will become even more of an economic hiding to nothing.

    Julian Simon and I are kindred spirits, we really understand economics. I used to think that if someone was an economist, it meant they would be in favour of free markets, etc, but I realise now that many of them are like some of the more despicable clergy in religious history - they went through the right motions and "got the ticket" so they could use appeals to their own authority to push an ideological barrow.

    - Wodehouselee