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Leithner Letter No. 34
26 October 2002

The first panacea for a mismanaged nation is inflation of the currency; the second is war. Both bring a temporary prosperity; both bring a permanent ruin. But both are the refuge of political and economic opportunists.

Ernest Hemingway, “Notes on the Next War”
(Esquire, September 1935)

As markets are cyclical, so is the neighbourhood of Wall Street; and as stocks and bonds shuttle between extremes of optimism and pessimism, so does the real estate of lower Manhattan. The real estate story clarifies and illuminates the financial one.

James Grant
The Trouble With Prosperity (1998)

Of Real Estate and Cycles

A market is a forum wherein errors of commercial calculation are detected and corrected. These errors often occur randomly and individually; but every so often (and as Benjamin Graham’s parable about Mr Market illustrates vividly) large numbers of people miscalculate greatly and in tandem. Murray Rothbard demonstrated that the ensuing cycle from boom to bust and back again is an inevitable consequence not of capitalism but of modern finance and politics (see, for example, What Has the Government Done to Our Money? Ludwig von Mises Institute, 1990, ISBN: 0945466102 and The Case Against the Fed, Ludwig von Mises Institute, 1994, ISBN: 094546617.) If so, and given mainstream approaches to the interpretation of market signals, then just as every dog has his day every “investment” has its season.

Not all market participants, it seems, have comprehended fully the implications of the modern political-business cycle. Indeed, despite the sobering financial events since 2000 the mindset remains resolutely non-cyclic. That the economic sun shines perpetually – and if at a given moment all is not sunny then the clouds and showers will certainly clear shortly – continues as an article of faith among most individual investors, institutional investors, politicians and policymakers. Perversely, however, the crests and troughs of the cycle are deepened by this belief in the perpetuity of sunshine and mild temperatures, in the prescience of policymakers (and policymakers’ unshakeable belief in their power and prescience) and therefore in the conviction that ups and downs have been neutered and perhaps even suspended. This cluster of beliefs “helps to incite the excesses that introduce the distortions that create the booms that precede the busts” (James Grant, The Trouble With Prosperity: A Contrarian’s Tale of Boom, Bust, and Speculation, Times Books, 1998, ASIN: 0812929918).

Indirect experience, if it is studied carefully and enduring lessons drawn from it, can substitute for dearth of direct experience. Indirect knowledge of past periods of intense and seemingly endless inclement weather, repeatedly dashed hopes and consequent deep gloom, in turn, provides a powerful antidote to today’s doggedly cheery frame of mind. It is therefore important to emphasise (if only because remarkably few economists and market participants can bring themselves to recognise) that the historical record indicates that the economic and psychological sun has not, to put it mildly, always shined (see in particular Charles Kindleberger, Manias, Panics, and Crashes: A History of Financial Crises, John Wiley & Sons Investment Classics, 1978, 2000, ISBN: 0471389455).

In The New Republic (1 June 1932), for example, Elmer Davis noted “the New Yorker has the feeling that he is living in a great museum as he looks around him and sees cloud-piercing towers leaping skyward on every side – an unfailing refreshment and inspiration to everybody except the people who are so unfortunate as to own them.” Davis continued: “what is to become of them? The setback skyscrapers of Babylon have crumbled into the hills of mud, but steel and concrete do not melt so easily. Of the faith that built the cathedrals of the Ile-de-France, enough has survived to keep those buildings in repair; but the faith that built the Empire State and Chrysler buildings may presently be as dead as Bel and Marduk.”

An Unheralded Building Index

That bleak assessment, which prevailed widely at the nadir of the Great Depression, is the polar opposite of that typically prevailing at the crest of a boom, i.e., on the eve of a bust. Grant writes that “the actual peak in the Coolidge bull market [in the northern summer of 1929] was accompanied by a richly symbolic milestone in the construction of 40 Wall Street, better known then as the Bank of Manhattan Building after the principal, original, ground floor tenant. Both the market and the building were aspiring to supreme heights; the building, for the title of the world’s tallest.”

Craig Severance, the architect of 40 Wall, competed frenetically against his former partner and the architect of the Chrysler Building, William Van Alen; and during these buildings’ erection, as plans and finances were repeatedly and frenetically upgraded in order to add ever more storeys and to secure the record, newspapers and the general public vied to ascertain which skyscraper would thrust highest. At the last minute Van Alen hoisted a hitherto-secret 56-metre spire atop the Chrysler Building (319 metres.) This surpassed Severance and 40 Wall (283 metres) but the victory was fleeting: a belated third contestant, the Starrett Brothers’ 381-metre Empire State Building, was completed in 1930 (Carol Willis, Form Follows Finance: Skyscrapers and Skylines in New York and Chicago, Princeton Architectural Press, 1995, ISBN: 1568980442).

The initial owners of the Empire State Building assumed that their jewel would command an average rent of $US64.50 per square metre (equivalent to $US725 per square metre in 2002.) The Bank of Manhattan Trust Co. signed a 21-year lease, renewable for another 71 years, which stipulated that the rental in a renewal period would be no less than that in the preceding period. According to proprietors and tenants alike, in other words, the economic future for the remainder of their lifetimes and decades beyond would be bright and could only become brighter. The existence of a business cycle, i.e., of downs as well as ups, was unimagined; and the possibility that the cycle’s downward leg might be nigh, sharp and extended was inconceivable.

Alas, even before the Empire State Building was finished the rapidly deepening Great Depression demonstrated that large numbers of people had erred staggeringly on the side of optimism. Not until the mid-1950s would its average tenant pay at least $64.50 per square metre; similarly, and equally symbolically, not until Dwight Eisenhower’s second term in the White House would major stock market indices return to the heights that they scaled late in 1929. As a result, for the next forty years the Empire State Building was the world’s tallest – and for long stretches was neither fully tenanted nor profitable.

More generally, William Pesek observes (“Want To Know Where the Next Disaster Will Hit? Look Where the World’s Biggest Skyscraper’s Going Up,” Barron’s, 17 May 1999) that “over the past 100 years there’s been an uncanny correlation between an attempt to construct the world’s tallest building and financial crises. Be it New York in 1930, Chicago in 1974 or Kuala Lumpur in 1997, almost all projects aimed at erecting mankind’s next architectural monstrosity proved a reliable precursor of meltdown. Sound farfetched? Hong Kong-based economist Andrew Lawrence of Dresdner Kleinwort Benson has been developing his own ‘Skyscraper Index’ to capture the phenomenon. So far, he says, the connection between one-upmanship among developers and economic panic is virtually impeccable.”

In the first decade of the twentieth century, two of New York City’s newest skyscrapers could claim that they were the world’s tallest building on the day they were completed. The 47-storey Singer Building (187 metres) was completed in 1908 and the 50-storey Metropolitan Life Building (213 metres) followed in 1909; each was planned before and constructed during the Panic of 1907. An epochal cycle of boom and bust, symbolised by the Empire State Building (381 metres) and culminating in the Great Depression, recurred during the 1920s and 1930s. The World Trade Centre (417 metres) began to take tenants in 1970 and its top floors were completed in 1972. Planned since the late 1950s and constructed during the Go-Go years of the 1960s (the WTC, by the way, was a singularly inapt icon of capitalism – it was owned by the Port Authority of New York and New Jersey, was built as a public works project and was a textbook case of delays, bureaucratic infighting and cost overruns), the WTC’s height was surpassed by Chicago’s Sears Tower (443 metres) in 1974. Their completion neatly coincided with the onset of the sharpest and most extended bust (and stock market funk) since the 1930s.

More recently, the drive to construct the world’s tallest building has shifted to the Asia-Pacific region. Here, too, the Skyscraper Index seems to resonate: the completion of Malaysia’s Petronas Towers (452 metres) in 1997 occurred in tandem with the collapse of several Asian currencies and a regional economic crisis.

Correlation and cause are clearly very different things. Statements of (ir)regular succession and of brute fact on the one hand, and laws of nature and statements of causal connection on the other, in other words, are entirely different claims to knowledge. The correlation among the appearance of a new holder of the title of world’s tallest building on the one hand and the onset of recession, depression or financial crisis on the other may therefore be nothing more than sheer coincidence.

Indeed, the correlation is hardly perfect: New York City’s Woolworth Building, which became the world’s tallest (242 metres) when it opened in 1913, ushered in several years of prosperity. Interestingly, however, and unlike the other world’s-tallest buildings (which were leveraged to the gills), the Woolworth Building was built entirely with cash and thus without a penny of mortgage or other debt. Further, its owner was also its major tenant and this major tenant has resided therein throughout its 90-year history. Quite unlike the other world’s tallest buildings, then, the Woolworth Building is a monument to caution, thrift and sobriety rather than speculation, ego and folly.

Hence it is hazardous but nonetheless tempting to infer causality from the Skyscraper Index. The Woolworth Building aside, each world’s-tallest-building project of the past century conforms to a familiar (to classical and Austrian economists) cycle. Excessive monetary expansion lights the pyres of speculation; speculation generates “malinvestment” in a range of endeavours, including record-setting real estate; and the realisation and liquidation of malinvestment begets economic hangovers, busts, crises and collapses.

Traditionally, Lawrence says, architects and developers have rationalised their ever-taller aspirations by citing changes in design and the steady advance of technological innovation. Yet the best explanation for the desire to thrust to unprecedented heights in the sky seems to derive as much if not more from heavy inflows of capital, the rapid creation of vast amounts of cheap credit, its ready availability and its psychological consequence – high and rising levels of what Lord Keynes called “animal spirits,” what contemporary market participants have dubbed “confidence” and what Mr Buffett has identified as “the institutional imperative.” Hence “the world’s tallest building fever” seems to be a crude but plausible indicator of the nature, time and place of mass miscalculation, malinvestment and incipient economic and financial disturbance.

Indeed, mega-skyscrapers may provide more information than meets the eye. Pesek observes that developers and politicians tend to be both optimists and gamblers: few ever quit when they’re ahead. Booms in tall buildings, as well as their changing geographic locations, mirror not just the crescendos but also the dynamics and stress points of the political-business cycle. As Lawrence concludes, his Skyscraper Index could “prove to be one of the very few economic indexes with very real economic foundations.”

Queensland and the Skyscraper Index

If so, the timing and location of upcoming “world’s tallest” projects is of more than passing interest. One such location is China: the Shanghai World Financial Centre (whose eventual height is expected to be 460 metres) commenced in August 1997 and is scheduled for completion in 2004.

Another is Australia. Never mind the Australian Bureau of Statistics, which reported on 5 September that the prices of residential real estate rose by an average of 19% in the twelve months to 30 June – the biggest leap since the crest of the last boom in 1989. Ignore Gerry van Wyngen, who states (The Weekend Australian Financial Review 24-25 August) that “Australian house and apartment prices are, on several measures, the highest in the world. ... Australia’s prices (on the price to income measure) are probably 20% above other high-price countries such as Japan, the UK and Germany.” And disregard The Courier-Mail (24 August), which stated that “home owners in Brisbane’s inner city are under mounting mortgage pressure and many may soon be faced with loans they can’t afford.”

Similarly, pay no attention to Reserve Bank of Australia, which warned in its August Statement on Monetary Policy that householders’ debts are ballooning and that, like Americans and Britons, they are tending more and more to use funds borrowed against their homes in order to finance their day-to-day consumption. And discount the Australian Prudential Regulation Authority, which, in an unprecedented announcement on 1 October, reminded banks that they should observe conservative risk management practices. According to The Australian (2 October), “the financial industry watchdog has warned banks against ‘any more loosening’ of home lending standards as new figures show an astonishing surge in housing approvals, particularly in the already overblown unit market. The statistics, showing a 73% growth in August building approvals for units, duplexes and townhouses ... [point towards] what is now feared to be an unsustainable bubble in city housing markets.”

Finally, forget the warning of UBS Warburg, which stated (The Weekend Australian 21-22 September) that “contrary to the myth that Australian house prices never fall, Sydney median house prices actually fell by 25 per cent over the two years to the end of 1990.” UBS Warburg calculated that the “price earnings ratio” of residential real estate, i.e., the price of housing relative to rents generated by housing, has reached a record high. This is evidence of “extremely stretched valuations in the housing sector” and that “the current rampant growth in house prices is not sustainable.”

Instead, direct your gaze upon the skylines of Southeast Queensland and Melbourne. In the past year plans for three tall residential towers have been unveiled in the Brisbane CBD. The first is the 53-storey Riparian Plaza, which is scheduled for completion towards the end of 2003. The second is the 67-storey Aurora, slated for tenants in 2005. Each has claimed the mantle of Brisbane’s tallest building, but on 16 September each was trumped by the announcement of the 77-storey Emerald Towers.

On the basis of past experience, to unveil plans to erect a “world’s tallest” structure in Queensland is not eventually to erect a tall building; it is, however, a signal of impending financial dislocation. Exhibit #1 is “Zarro’s Arrow,” the 445-metre tower that the Gold Coast developer, Pat Zarro, sought to construct at Surfer’s Paradise in the late 1980s. (Zarro, burdened by debts of $400m, declared bankruptcy in 1992.) Exhibit #2 is the Brisbane developer, John Minuzzo, who in 1985 obtained the blessing of the Premier, Sir Johannes Bjelke-Petersen, to build a 107-storey skyscraper next to Brisbane’s Central Railway Station. The Victorian government’s Tricontinental Corp. lent Minuzzo $65m. Tricon subsequently wrote off $60m as uncollectible and both it and Minuzzo proceeded to bankruptcy. Had the Zarro and Minuzzo buildings been completed (neither proceeded beyond the hole-in-the-ground stage) they would have overtaken the Sears Tower as the world’s tallest.

Now Soheil Abedian and Sunland Group Ltd, a relatively conservatively financed and managed Gold Coast developer who has built the Palazzo Versace Hotel and a swag of apartment towers, has announced the intention to erect the world’s tallest residential tower (and the tallest building in the Southern Hemisphere) at Surfer’s Paradise on the Gold Coast. Q1, also known as Queensland 1, will possess 80 storeys, 527 apartments and stand 323 metres from terra firma to tiptop. Launched by Queensland’s Premier, Mr Peter Beattie, on 28 June, Q1 will be 60 metres higher than the present record-holder (the 262-metre Trump World Plaza presently under construction opposite the UN complex in New York City), 23 metres higher than the Eiffel Tower, 20 metres taller than the planned 88-storey Eureka Tower in Melbourne (which billed itself as “the world’s tallest apartment tower” in The Australian Financial Review on 26 September), and 15 metres higher than the AMP Centrepoint Tower in the Sydney CBD (presently the tallest structure in the Southern Hemisphere.)

According to The Australian (23 August), Q1 will have a honeycomb or cellular structure that will enable it to withstand the force of 10 jumbo jets smashed simultaneously against it. There is no indication of the building’s and owners’ ability to resist a bear market; but should a cyclone strike the Gold Coast, winds could sway the top of the skyscraper by up to 0.6 metres and residents would likely notice nothing. That is because the building will have an aerofoil design that enables it to “ride” its moorings imperceptibly. On a clear day, residents of the top half of the building will possess unrestricted views along a 95-kilometre radius (i.e., north to Brisbane and south to Byron Bay, NSW.)

Three years from Q1’s scheduled completion, Sunland says that it has pre-sold more than 400 of the building’s 527 apartments. At prices ranging from $300,000 for a one-bedroom apartment on Level 1 to $8.9m for the penthouse, sales (including one to the Olympic and Commonwealth Games gold medallist, Ian Thorpe, who launched Q1 in Japan after the Pan-Pacific swim championships) thus far total $231m.

Will So Many Be So Wrong?

These are interesting times for people who for the past 12-18 months have been sceptical about the pace, nature and sustentation of economic activity in Australia. Letter 24-25, dated 26 December 2001-26 January 2002, stated that “in many countries, including Australia, Britain, Canada and (especially) the U.S., the boom of the late 1990s sowed the seeds of bust. Australia’s boom ended in 2000 (see Letters 11-12) and signs of bust gathered pace throughout 2001. ... [Our] plans for 2002 are based on the premise that many of the excesses of the 1990s remain unrecognised and therefore unpurged, and that the bust may be extended and sharp.”

Underscoring its dour tone, the Letter 24-25 also stated that a “renewed misallocation of resources ... may manifest itself in 2002 through a ‘recovery.’ Whatever the euphoria it incites in financial circles, such a recovery neither causes economic growth nor creates wealth. Rather, it misdirects Australia’s small and eroding pool of funding and thereby weakens the potential for longer term and sustainable prosperity. During 2002, then, Leithner & Co. will be in no hurry to sing ‘Happy Days Are Here Again.’”

If it is undertaken and completed, Q1 (together with the Darwin to Alice Springs railway) may one day symbolise the misallocation of resources, induced primarily by the Commonwealth Government and Reserve Bank of Australia, which has occurred in Australia since the onset of bust in 2000. According to a report released on 18 September – but, very intriguingly, ignored by the country’s print and broadcast media – economic activity in this country is expected to slow sharply during the second half of 2002. This turn of events raises “questions about Australia’s ability to withstand the weak global economy.”

The Westpac-Melbourne Institute leading index, from which inferences about the pace of economic activity 6-12 months hence are drawn, fell to minus 0.5 in July. The leading index has fallen sharply since peaking at 7.6 in the middle of 2001. Indeed, its latest reading marks the first time since 1994 (with the exception of the sharp decline that coincided with the introduction of the Goods and Services Tax in 2000) that the index has been negative. According to Westpac’s general manager of economics, Mr Bill Evans, “recent readings of the index represent a major test. The general view is that despite a very weak world economy, Australia can continue to grow strongly. [But] the index is pointing to a marked slowdown.”

Why Have They All Been Fooled?

For a primer to value investors on Say’s Law see Thomas Sowell, Classical Economics Reconsidered, repr. ed., Princeton University Press, 1977, ISBN: 0691003580; and Basic Economics: A Citizen’s Guide to the Economy, Basic Books, 2000, ISBN: 046508138X). It reasons from first principles that our forebears mastered towards conclusions that our contemporaries have either forgotten or misconceived. It shows that consumption is not wealth; that consumption destroys rather than produces wealth; and that consumption never needs encouragement by government or anybody else. More generally and all else equal, in other words, an increase of consumption per se does nothing to make a society richer.

These conclusions highlight the egregious and grievous errors of thinking and policy that are presently manifesting themselves in financial markets. In short, he who saves is no less a consumer than he who spends. Indeed, it is savers – and not end-consumers of goods and services – who are a necessary condition for the creation of wealth, maintenance of prosperity and advance of civilisation. It is savers and not consumers who supply the means to produce more raw materials and better tools; and it is savers who ultimately employ more people and train and equip them such that they are more productive. In so doing, savers underwrite a structure of production that brings into being more, better and cheaper food, clothing, housing, transport, medical care and entertainment.

It follows that governments’ many, varied and strenuous attempts to encourage final consumption (whether of motor cars, residential real estate or countless other commodities) merely disrupt and derange savings, intermediate consumption and the structure of production. These policies promote self-indulgent speculation, an obsession with the present and final consumption at the expense of savings, investment, regard to the future and productive intermediate consumption. The perverse and unintended consequence of the obsession with consumption is therefore to dissipate rather than generate wealth.

Chris Leithner


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