Property and Banking in Latvia’s Economic Future
Michael Hudson
WHEN Latvia regained its independence in 1991, its citizens received an economic asset that immediately made them one of the world’s wealthiest populations. They got title of ownership free and clear to their homes and the land where they lived.
This enormous transfer of wealth was achieved peacefully. While the privatization was by no means egalitarian, in housing, at least, it achieved the classic aim of providing families with their own home and basic means of self-support. Today, some 90 percent of Latvians own their homes – a remarkably proportion high by world standards. (About two-thirds of American and British families own their homes, and this usually is considered to be a high ratio.) Real estate remains by far the major asset on Latvia’s balance sheet, and land is the single largest element. This hardly is surprising. The same is true for every economy, including that of the United States.
Turning to the West for models of how best to become a market economy, most Latvians expected the nation’s resources to be used more productively, raising living standards and creating a rich economy. But little detailed analysis occurred with regard to just which market structures would be best for Latvia and its particular economic conditions. As in Russia, the use of vouchers did not prevent managers from getting their businesses as personal assets. Many state-owned properties, infrastructure, land and going concerns were privatized without really popularizing stock ownership or giving the Latvian government a meaningful share of the value being transferred.
Instead of being modernized with progressive U.S.-style laws, tax structures and public policy regulation, Latvian industry was largely dismantled during the early and mid-1990s, surviving best as real estate developments such as the Gipsa Fabrika project. This is a common problem with former members of the former Soviet Union, and also reflects the worldwide trend toward property and debt bubbles. The question is, how far should Latvia go along this path?
Latvia’s financial system interfaces mainly with the wealthiest quarter of the population. As in most other countries, the bulk of debt takes the form of property mortgages. (In America and Britain, about 70 percent of bank loans are mortgages.) Some three-quarters of the population have no bank loans, a remarkably high proportion. Interest charges amount to less than 3 percent of GDP, compared to over 7 percent in the United States. Along with widespread home ownership, this is a major factor buoying Latvia’s economy today.
Fortunately, Latvia’s property loans to date tend to be relatively short-term (5, 10 or 15 years), compared to 30 years and even longer in the United States. U.S. banks have loosened their lending standards in order to make larger loans affordable by including less amortization in their monthly carrying charges. Most Latvian mortgage loans also are still relatively small (less than 30,000 euros), and hence remain affordable and within the typical guideline of not exceeding 30 percent of the borrower’s income.
The question is, where are present trends leading? The balance sheet for many Latvians ostensibly is improving as prices for housing and office buildings in central Riga are approaching those in other European and North American cities experiencing bubbles. Most people view high prices for homes and office space as a sign of wealth. But they are best thought of as an overhead charge. Economies with high housing costs are less competitive, compared to those with lower housing costs and lower tax overhead. Property bubbles thus are inflationary – and this threatens post-industrial service economies in particular.
Property bubbles develop when two conditions apply – conditions that cannot last. First, nearly everybody expects prices to keep on rising. Second, the carrying charge of a property exceeds the income it can generate.
When everybody expects prices to keep on rising, buyers stop caring about current price, and look only at how rapidly property prices may rise, compared to the rate of interest they must pay. This is the speculator’s mentality. It is widespread in Latvia today.
The second condition – when interest and other carrying charges of a property exceed the income it generates – means that properties have to be held at a loss. Owners and prospective buyers are willing to absorb this loss only because they expect the price gain to exceed their operating loss, making the game worthwhile. This too is the case in Latvia today. But rosy price expectations already are beginning to disappear in neighboring Estonia, whose property bubble started a few years before Latvia’s. Speculators and recent investors are questioning whether it really pays to hold or buy property and subsidize their tenants.
All property bubbles are financial bubbles. They nearly always are promoted by government policy – especially tax policy. Latvia’s high employment taxes are a concealed subsidy for property. In Latvia this subsidy goes far beyond the levels normal in most countries, and threatens to deter industrial as well as service-sector employment.
The classic fiscal principle is to tax “free lunches” and capital gains, not enterprise and earned income (wages and profits). Latvia’s present high taxes on employment and income are driving many young men and women to emigrate to find work. Such taxes on labor and enterprise are inflationary costs – but this is not the case with taxes levied on property, because a property’s income and tax-paying ability are determined by the marketplace. Low property taxes simply leave more property income available to be pledged to banks for larger loans to buyers.
To slow the rise in property prices, the U.S. Federal Reserve Board recently has moved to deter overly easy bank lending. The problem with loading down property with higher debts to bid up property prices is that this leaves less income available for spending on domestic goods and services, and hence slows the rate of domestic economic expansion. Latvia shares this problem, as do all countries for that matter.
Looking forward, one of the problems is that Latvia never has introduced strong consumer protection such as a “truth-in-lending” law that spells out the risks that borrowers take on. At present, bank customers are not informed of how much interest they may be required to pay over the course of adjustable-rate mortgage loans. An increase in interest rates could sharply raise their monthly mortgage burden. For fully mortgaged properties, this would lead to defaults and foreclosures. Also, some foreign-exchange risk exists with regard to the terms on which Latvia will enter the European monetary system.
Some bank loans call for highly onerous penalties for late payment – charges that many other countries have deemed to be usurious. Most Latvians are subject to harsher loan terms than the parents of country’s major banks extend to the citizens of their own countries. Latvians deserve better consumer protection approaching what U.S. bank customers enjoy.
Many nations are tightening bank regulations to slow their property bubbles and achieve a “soft landing” when the bubble bursts, as it always does. One way to do this is to require buyers to make higher down payments, especially for commercial and absentee owners. The United States long ago established penalties for banks that over-extend credit without proper regard for the debtor’s ability to pay back the loan. New York State’s “law of fraudulent conveyance,” for instance, goes so far as to state that if a creditor makes a loan without having any idea of just how the debtor can reasonably repay it, the debt is nullified. Latvia and other countries need to be vigilant with laws and regulatory procedures that induce its banks to lend responsibly, so that they bear some of the risk rather than passing it all onto their debtors.
Latvia has a great advantage that most other countries do not. The tax rate is set nationally, not locally. This means that the nation can pursue a “revenue neutral” policy, so that the overall tax take remains the same, but taxes are shifted from “bad” to “good” or “neutral” taxes. This would be a great help in preventing property-price inflation and labor-tax inflation.
The first such pre-emptive tax should be on “capital gains.” Most of these asset-price gains actually are real-estate gains, which reflect the inflation of land prices. As American realtors express this principle, property prices are determined by three factors – location, location, and location. As Latvia’s prosperity increases – and as cities spend more money to upgrade the quality of their services – prices increase for favorable sites. This creates a “free lunch” for owners as their property rises in market price, enabling them to “make money in their sleep,” as John Stuart Mill put matters. Inasmuch as the national economy helps create the increase in property valuations, the property sector deserves to recapture this windfall.
This “value recapture” principle is especially important for properties whose prices are increased by improved transportation, port development or other public expenditures. A windfall tax on such gains requires an up-to-date land-value map to be created. In the United States such maps deter fraud and establish appropriate land-tax rates for every city and county by re-assessing market valuations every year or so. This practice reflects the view that as largest economic asset, land is the natural fiscal resource.
Until such a map is created, free of political interference, Latvia should consider the classic transition policy of leasing rather than selling land that still remains in the public domain. This would help ensure transparency. It is the policy that made Hong Kong so wealthy – and in many ways Hong Kong’s entrepot economy resembles that of Latvia. As is well known – and as Russian experience indicates with an exclamation point – it takes at least ten years to establish reasonable market values for property.
Creating a land-value map as the basis for property taxation would help. At first glance the Euro system’s requirement that countries run only small deficits imposes onerous conditions on Latvia and other countries that require heavy public infrastructure spending to modernize their economies. But Latvia has a fairly easy way to finance this spending without running a budget deficit. It can issue bonds to finance public infrastructure, to be paid off out of a windfall tax imposed on the added property valuations created by this public investment.
In London, for example, extension of the Jubilee Tube line cost over £10 billion, but the new subway stations increased property valuations along the route by an even larger amount. The city is now proposing to finance future transport expenditures by issuing bonds that would be paid off out of a windfall tax levied on the rise in property values that this spending creates.
One problem that politicians often bring up with regard to a land tax is how it will affect pensioners and low-income families who live in neighborhoods where prices have risen dramatically. Property speculators and large investors often try to hide behind this “retiree problem” in order to avoid having their own property taxed. The problem is by no means so dominant that it should deter taxing the land’s rising rental value.
To put this problem in perspective, the first thing to realize is that low-income families that find themselves living on properties worth, say, half a million lats, are in a very, very fortunate position. Their property is worth more than they could save up over many years of work. For families that wish to remain on such high-priced land, a number of solutions offer themselves. One is to let normal property taxes accrue on the land, up to its assessed value, for a period of ten years or so – but not to actually be collected until the transition time is over, or until the property is sold, or – at a limit – until the death of the present retirees. Another reasonable proposal would be to defer or phase in taxes on, say, two thousand square meters of living area, but to tax the remainder at normal rates. (It should go without saying that such “special case” tax policies would require effective penalties for breach of law or fraudulent attempts to circumvent them.)
These policies would help control property prices, lower Latvia’s pace of inflation and avoid national budget deficits. The property tax would act as a progressive tax on wealth, and would help bring Latvia into line with the economic philosophy of most other Western countries. Most important, it would shift taxes off employment and tangible capital investment, encouraging enterprise while making the economy more competitive.