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 (here)

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.