Destroying Value: What Government Does Best

by Sheldon Richman, The Freeman
Oct. 14, 2011

In Cleveland and other American cities homes are being demolished because four years after the housing bust there is nothing better to do with them. Therein lies a lesson in Austrian business cycle theory.

In a world of uncertainty, waste — the destruction of value — is inevitable. Human action, which aims to replace inferior circumstances with superior circumstances, often involves laboring to transform scarce resources from a less useful form to a more useful form. For example, I transform money earned by my labor into raw beef (by using time and gasoline to drive to the supermarket and engaging in exchange), then I transform the raw beef into a medium-well hamburger through the time-consuming process of cooking. If after I eat the hamburger I wish I had done something else with the money and time (say, bought a chicken), I will regret my course of action and feel I'd wasted both. Being able to know the future would have avoided the waste.

We have all devoted time and resources to some project that we later realized was the wrong project. That's the price of imperfect knowledge, which plagues all human beings. If we're lucky, some of the resources that we used might be salvageable and put to other purposes, but the time, effort, and other resources are gone.

The same thing of course occurs in commercial production. An entrepreneur buys inputs and hires labor, thinking the finished product will bring a price that covers costs and yields a competitive return -- only to find that people don't want the product, or not badly enough to pay the anticipated price. The loss represents the destruction of value. That is, the value of the inputs before the transformation took place turned out to be greater than the value of the finished good made from those inputs.

As I say, this happens because our knowledge is imperfect. It's too bad, but perhaps not a tragedy — just a fact of life we learn to live with and seek to minimize. For one thing, it doesn't happen to everybody at once. At any given time, many plans are succeeding.

Distorted Signals

The tragedy occurs when government intervention distorts price signals and induces people en masse unwittingly to make value-destroying plans. That's part of the story told by the Austrian theory of the business cycle. In the present economic case the Federal Reserve's low-interest-rate policy in the early 2000s and several federal agencies' decade-long easy-housing policies induced builders to produce too many houses relative to what the demand would have been without those unsustainable policies. The result was the infamous housing boom and inevitable bust. With housing prices apparently on an unstoppable upward trajectory, and government-backed Fannie Mae and Freddie Mac — not to mention too-big-to-be-allowed-to-fail banks — willing to buy lenders' mortgages no matter how shaky, builders and buyers were found in great abundance. Buying more house than one could afford seemed smart when one could get a low teaser rate on an adjustable-rate mortgage for a low-to-no-down-payment home and expect its price to have risen significantly in six months. When the higher rate kicked in, one could refinance or sell and walk off with the equity.

But when interest rates rose, the bubble burst, and demand plummeted, this smart scheme turned sour. Houses stood unsold, and many people couldn't pay their mortgages, refinance, or sell at a profit. Foreclosures skyrocketed and many people with underwater homes simply disappeared, leaving banks holding a slew of vacant houses that cost money in taxes, code violations, and so on.

As a result, banks now would rather donate the properties to government-created nonprofit land banks and pay for the house demolition than hold them and hope for future sales. This is happening in Cleveland, but the Washington Post reports that similar programs are being discussed elsewhere.

"At the end of August," the Post reports, "the nation's banks, along with Fannie Mae and Freddie Mac, had an inventory of more than 816,000 foreclosed properties on their books waiting for a buyer, according to RealtyTrac. An additional 800,000 are working their way through the foreclosure process."

Value Demolished

How does this relate to the waste identified by the business-cycle theory? To the extent the homes were vacated and allowed to deteriorate because of the process described above, the demolitions represent destruction of value attributable to government. In the absence of the unsustainable bubble-inflating policies, some of those houses wouldn't have been built or in the case of older homes, fewer newly built houses would have competed with them in the real estate market. They would still be occupied and therefore would have been maintained. (There would have been no Great Recession and high unemployment.) Demolition would not have been an attractive alternative.

The tragedy is that because of government policy, demolition is the most attractive alternative. Think of the resources and labor — now seen to have been squandered — that went into making each house. Imagine what products might have been created instead. It's worse than that: Products always have complementary products. (See Steven Horwitz on this point.) A housing boom stimulates the production of related goods and facilities — shopping centers and office parks, for example, but myriad smaller things also. The resources required to make those things also would have gone into other products. Now all those resources, along with much labor and time, are just gone — forever -- because people in government and its central bank thought they knew better how to plan the housing market and the macroeconomy.

It's sad enough that we waste precious resources and labor because we are fallible. It's so much sadder when this happens because government policies lead rational people to make stupid decisions.