Chapter 6: Cantillon Effects in Skyscrapers

Money makes possible the good things in life: our ability to trade with one another and the ability to form groups to work for beneficial purposes, as well as saving, investing, economic growth, and development. Without some form of money, advanced society would not be possible. However, as we saw in the previous chapters, increases in the supply of money, which mainstream economists now view as indispensable, are really the source of many evils of economic life.

Increases in the supply of money result in higher consumer prices, a process now known as inflation. This means that many people with jobs suffer diminishing purchasing power of their wages over time. Economic historians have long agreed that such inflation is the enemy of labor. Free market monies, such as gold and silver, typically increase in value over time, which is beneficial for wage labor and encourages work and saving, as the purchasing power of wages and savings tends to increase over time.

Increasing the money supply causes an unnatural redistribution of wealth. People who receive the money first become wealthier because they spend the money before prices have risen. People who receive the money later or not at all become poorer because they pay the higher prices. In the case of money coming from the Federal Reserve, the biggest winners are the US government; its large contractors, such as weapons manufacturers, big banks, and Wall Street. As a result, the financial sector of the US economy has grown enormously and economic inequality, measured in terms of income and wealth, has increased dramatically since the United States went completely off the gold standard in 1971. The financial-services sector has grown from about 4 percent of the US economy then to over 8 percent now. Thomas Piketty1 has famously shown that inequality of income and wealth has increased greatly in the United States and elsewhere. However, the entire increase in inequality has come after 1970 and the abolition of the Bretton Woods gold standard. The period beforehand, when we were on the gold standard, is one of increasing equality.

The big losers receive the money after prices have already risen. The losers would include private-sector workers and people on pensions or fixed income — in other words, the labor class. Inflation also harms savers and bond investors, as well as taxpayers who find themselves in higher tax brackets when wages catch up with price inflation. Simply put, paraphrasing Senator Phil Gramm of Texas, the people pulling the wagon are harmed and reduced in number, while the people sitting in the wagon benefit and increase in number.

Finally, inflating the money supply causes the business cycle, and this is the least well-understood aspect of the Fed’s increasing of the money supply. It is not just natural swings in the economy; it is artificial, squanders resources, and ruins lives. This will be illustrated with the case of skyscraper construction.

Inflating the money supply is directly connected to interest rate manipulation. When the Fed buys government bonds from banks, it gives them dollars, which they can reinvest in more government bonds, mortgages, commercial loans, and consumer loans. This process artificially reduces interest rates. It also completes the movement of government bonds from the US Treasury, to the big banks, to the balance sheet of the Fed. It can sit there until it comes due, at which time the Fed can purchase more government bonds. The Fed is required to return any leftover interest income from these bonds to the US Treasury, so this process is the equivalent of an interest-free loan. Also, as monetary expansion turns into price inflation and lowers the value of the dollar, it effectively reduces the value of the national debt, a process referred to as monetizing the national debt. It is a convoluted process, but you can see why those who benefit do not want to reform it. It is quite a racket for the politicians, the big banks, and their highly paid facilitators at the Fed. This is the process that brings about artificial gyrations in interest rates and creates Cantillon effects and business cycles.

The Cantillon effects that we can see in record-breaking skyscrapers are symptomatic of what is going on in the economy; it is just more difficult to point to some particular project or new technology and claim that it is a malinvestment caused by the Federal Reserve and artificially low interest rates. So remember, skyscrapers themselves do not cause business cycles, the Fed does.

Many people consider the skyscraper a form of art, but their construction is essentially a business that must respond to incentives and constraints. Therefore skyscraper construction can be expected to follow closely even small changes in relative prices. In reevaluating the early skyscraper artistically, Ada Louise Huxtable2 noted:

Essentially, the early skyscraper was an economic phenomenon in which business was the engine that drove innovation. The patron was the investment banker and the muse was cost-efficiency. Design was tied to the business equation, and style was secondary to the primary factors of investment and use. … The priorities of the men who put up these buildings were economy, efficiency, size, and speed.

That is not to say that the early skyscrapers were without artistic merit, or that later structures failed to improve artistically; quite the contrary. Nevertheless, post-WWI skyscrapers continued to emphasize profits and technology. The early skyscraper drew from existing technology and was considered an engine of innovation. Even in modern times, design continues to grow and evolve, but for Helmut Jahn,3 the “structural rationale for such a tall structure is technically and economically inescapable.” For Huxtable,4 “Architecture simply doesn’t count. … With pitifully few exceptions in the past, New York’s skyscrapers have never reached for anything but money.” Art, technology, government regulations, and even ego must be considered factors, but the skyscraper is essentially captive to economic forces and motives. Therefore when architects are asked what makes for the super skyscraper, economic forces are considered preeminent. Psychological factors related to ego are created in the credit driven boom.

In this context it is important to remember that changes in the price of land, building materials, and the interest rate will have important implications for skyscraper construction. Changes in the rate of interest have three separate Cantillon effects on skyscrapers. All three effects are reinforcing, and all three effects are interconnected to the transformation of the economy toward more roundabout production processes. When the rate of interest is artificially reduced, all three effects contribute to the desire to build taller structures. The world’s tallest buildings are generally built when the interest rate is reduced substantially below the natural rate for a sustained period of time. In contrast, when the interest rate is forced above the natural rate the economic effects reduce the value of existing structures and the demand for tall buildings. Construction can come to a complete standstill.

The first Cantillon effect is the impact of the rate of interest on the price of land. The most obvious cause of this result is that lower interest rates reduce the opportunity cost of borrowing to buy the land and to build structures. As a result, owners of land and real estate experience an increase in their wealth. This relationship is confirmed by Jeremy Atack and Robert Margo,5 who examined the market for land in New York City during the nineteenth century. Their evidence suggests that land values tended to increase during deflationary periods, when interest rates tend to be low, but less so during inflationary periods, when interest rates tend to be higher because of the inflation premium in interest rates. Paul Cwik6 demonstrates that the interest rate has an impact on the net present value of working capital and longer-lived fixed capital. As a casual observation, when interest rates are artificially low, you tend to see more “land for sale” signs along roads and interstate highways because land prices are higher in general.

A lower rate of interest also tends to increase the value of land, because the interest rate is used by entrepreneurs as a proxy for the discount rate. In evaluating any investment project, entrepreneurs estimate the net present value of a project by looking at the projected income stream from the investment over a long period of time and adjusting it for interest payments over time. The income in the first year does not have to be discounted much at all, that is, just one year’s interest expense, but that same income in year twenty-five has to be discounted by twenty-five years of interest expenses and may be worth nothing in terms of net present value. Net present value of an income stream has to exceed risk-adjusted cost of an investment for the project to be undertaken. High interest rates lead to heavy discounting of income streams, whereas low interest rates lead to less significant discounting, which makes long-term projects seem relatively more profitable.

For example, consider an investment project that is expected to produce $1 million in income above operating costs per year for ten years. In the tenth year of operation, if the discount rate is 4 percent, the calculated net present value of that year’s $1 million net income is $675,000. However if the discount rate is 8 percent then the calculated net present value of that year’s income is only $463,000.

From this we can see that land values rise because lower rates of interest reduce the opportunity cost, or full price, of owning land and drive up the net present value of income streams from using land. Treating the rate of interest as the cause, a reduction in the interest rate will increase the demand for land and result in an increase in land prices. The impact of lower discount rates will tend to favor longer-term investment projects using land, such as skyscrapers.

It has been often said that the three most important things about real estate are location, location, and location. When the rate of interest is falling, the land best suited for the production of the longer-term, more capital-intensive, and more roundabout methods of production will increase in price relative to land better suited for shorter-term, more direct methods of production. As land prices rise, the yield required from any piece of land to make ownership of it profitable must also rise. Combined with a lower cost of capital brought about by a lower rate of interest, land owners will seek to build more-capital-intensive structures, and at the margin, this will cause land to be put to alternative uses.

In the central business district this means more-intensive use of land and thus taller buildings. Higher prices for land reduce the ratio of the per-floor cost of tall vs. short buildings and thus create the incentive to build taller buildings to spread the land cost over a larger number of floors and more leasable space. Thus, higher land prices lead to taller buildings. In my hometown there are a variety of one- and two-story structures currently being demolished to make way for the construction of multifloor structures. These projects are stimulated by artificially low interest rates and the search for yield on investment funds. In this manner, the height aspect of the projects is driven by land prices.

The second Cantillon effect from lower rates of interest is the impact on the size of firms. A lower cost of capital encourages firms to grow in size and to take advantage of economies of scale, such as the example of the dairy industry in transition. Here, companies that expand based on artificially low interest rates benefit, at least temporarily, at the expense of companies that do not and exit the industry. As part of this larger-scale, more roundabout production process, firms develop central offices or headquarters for their accounting, management, marketing, human resources, and product-development departments. This increases the demand for office space in central business districts. This demand in turn raises rents and encourages the construction of taller office buildings within the central business district.
The phenomenon of firms growing in size and scope in response to artificially low interest rates can be seen in the history of merger-and-acquisition waves. Mergers between two firms occur when both firms believe they can profit from combining their operations. Acquisitions and takeovers occur when one firm believes it can manage the combined assets of the firms in a more profitable manner. Lower interest rates reduce the cost of the capital to buy out investors of the other firm. Mergers and acquisitions have occurred in clusters or waves during periods of low interest rates and easy credit conditions (the boom), and because they often start operating as a united company during the bust, their record of success has not been great.

Saravia7 shows that waves of mergers and acquisitions that have been experienced in the past are consistent with Austrian business cycle theory (ABCT). Not only do low interest rates help finance mergers and especially acquisitions, but the demand for such business deals is a reflection of the “resource crunch” of ABCT as shown in the previous example of the expansion of the advanced computer-chip industry. Ekelund, Ford, and Thornton8 show that when mergers are delayed by government “red tape,” the resulting acquisitions and mergers tend to be unprofitable because they are often completed during an economic downturn. Thornton9 has furthered the discussion of why so many mergers and acquisitions turn out to be miscalculations.

The third Cantillon effect is the impact of interest rates on the technology of constructing record-tall buildings. Record-breaking skyscrapers require innovation and new technology in order to be profitable. Buildings that reach new heights pose numerous engineering and economic problems relating to such issues as building a sufficiently strong foundation, ventilation, heating, cooling, lighting, transportation (e.g., elevators, stairs, and parking), communication, electrical power, plumbing, fire protection, and security systems, as well as wind resistance, structural integrity, and even window cleaning. There are also a host of public issues connected with increases in employment density brought about by tall structures, such as transportation congestion and environmental concerns. For example, Sukkoo Kim10 showed how increases in skyscraper-building and, in particular, improvements in skyscraper technology lead to increases in employment density. Here, advanced technology businesses benefit at the expense of incumbent technology businesses.

Beyond the mere technology it takes to build the world’s tallest building, every vertical beam, tube, cable, pipe, or shaft in a building takes away from leasable space on each floor built, and the more floors in the structure, the greater the required capacity of each system in the building, whether it is plumbing, ventilation, or elevators. So designers, architects, and building contractors cannot simply increase the size of each system to increase capacity. They must come up with new, more efficient systems to reach record heights. Consequently, there is a tremendous desire to innovate with technology in order to conserve on the size of these building systems or to increase the capacity of those systems. Therefore, as the height of construction rises, input suppliers must go back to the drawing board and reinvent themselves, their products, and their production processes.

M. Ali and Kyoung Sun Moon11 describe how designers and engineers have a tremendous need to innovate to conserve on the requirements of building systems. For example, one elevator shaft with a floor size of 2×2 meters would take up the space equivalent of ten efficiency-sized apartments in a hundred-floor building. At standard speeds it would take about ten minutes to get to the top floor of the Burj Khalifa tower, plus the time it took for the elevator to arrive on your floor and any additional stops on the way to your destination. Ames12 reports that KONE Corporation engineers have created a new elevator cable that weighs less than 7 percent of the weight of traditional steel cables, which each weigh over twenty tons for a 400-meter-high building. Obviously, a twenty-ton cable would require an enormous amount of power to operate. Therefore, as building heights rise, technology must be advanced to conserve on the building systems’ footprint.

Another example of this type of technological effect is in heating and cooling systems for especially tall skyscrapers. Record-breaking skyscrapers require a tremendous capacity for heating and cooling; and traditionally, hot and cool air or water would have to be pumped long distances, which is both inefficient and requires a great deal of space for all the ductwork and plumbing. A recent solution to this problem is a system called variable-refrigerant-flow zoning and split-ductless systems. Instead of massive amounts of air or water transported throughout a building, only the refrigerant — for example, Freon — is moved to each zone. It is transported in small copper tubing rather than bulky ductwork or water pipes, which take up horizontal space between each floor as well as vertical space. Each zone can have its own temperature, and the flow of refrigerant is variable according to the needs, rather than just on and off. The total amount of equipment is less, it is easier to maintain, and it is said to be 25 percent more energy efficient. Surely this is a great invention, but one that would not have come along as early as it did in the age of the mega-skyscraper. In other words, enormous amounts of resources were expended to obtain small gains in efficiency due to the artificially high demand to build very tall skyscrapers. When the next economic crisis comes, the demand for these advanced technologies could collapse because either no one is building such skyscrapers or they are only building much smaller buildings.

Construction systems must also be reinvented to tackle new record-breaking construction projects. For example, pumping concrete higher to build taller structures requires innovation in concrete-pumping technology; the same can be said for cranes and moving laborers to and from their worksite on the building. Again, in the economic crisis that follows, these systems and all the capital combinations that support them could either go unused or used at greatly diminished levels.

All three Cantillon effects resulting from lower rates of interest are interrelated and reinforcing. All three are generally recognized by people involved in the construction of large office buildings including architects, bankers, contractors, design specialists, engineers, entrepreneurs, government regulators, often the tenants themselves, and finance specialists such as bond dealers.

Higher interest rates discourage the construction of taller buildings and of construction in general because capital is scarcer and land is less in demand and available at lower prices. Higher interest rates also create financial difficulties for the owners of existing structures because of the decreased demand for office space and condos. Companies engaged in construction and their suppliers face a decrease in the demand for their services, the impact of which falls hardest on those firms that specialize in the production of the tallest buildings and the suppliers of the specialized construction systems and building systems for ultrahigh construction.

In other words, the technologies and industrial capacities that were induced by the artificially low interest rates are now greatly incapacitated and mostly idle. The buildings themselves are likely to have excess capacity, with too few tenants and lower-than-expected leasing rates.

The interest rate is what makes the construction business, in part, such a speculative business. Homebuilders build spec houses and face the risk of finding a buyer at a profitable price. Developers build speculative office buildings, which in contrast to many corporate headquarters are investments that rely on an uncertain flow of rental income. Separating the winners from the losers is not so much a matter of greed as it is a matter of time and calculation. Skyscraper expert Carol Willis explained the difference between normal times and boom times:

In normal times, when costs of land, materials, and construction are predictable, developers use well-tested formulas to estimate the economics of a project. These calculations are based on the concept of the capitalization of net income. This value takes into account the net income for thirty or forty years. … [T]he conventional market formulas and the concept of economic height were widely known and followed in the industry. Most speculative building was not risky, but reserved in its calculations and highly responsive to market desires.13

All of these normal calculations that help ensure profit and avoid loss are not, however, reliable during the boom phase of the business cycle.

In booms, the so-called rational basis of land values is disregarded, and the answer to the question “What is the value of land?” becomes “Whatever someone is willing to pay.” Some speculators estimate value on new assumptions of higher rents; others simply plan to turn a property for a quick profit. … But due to the cyclical character of the real estate industry, the timing of a project is crucial to its success, and the amount a property reaps in rents or sale depends on when in a cycle it is completed or comes onto the market.14

Building the world’s tallest building has been a matter of particularly bad timing by entrepreneurs, and even if they were able to successfully steal away enough tenants from the remaining pool of renters, the economic problem for society is that valuable resources are lost in the process of constructing buildings that are bad investments and underutilized. See, Patric Hendershott and Edward Kane,15 who estimated that there was more than $130 billion wasted in the commercial construction boom of the 1980s. The Empire State Building was nicknamed the Empty State Building because of its high vacancy rates until after World War II.

However, it is not the entrepreneur’s formula that is at fault, but a system-wide failure that has occurred periodically throughout the twentieth century and before, and is known as the business cycle. Hoyt16 found the building cycle was a “motion of a definite order” lasting eighteen years, on average, from peak to peak. Willis raised the key issue as it relates to skyscrapers:

Indeed, a key question about cycles is, if their pattern is so predictable, why don’t people foresee the inevitable bust? This conundrum can perhaps be answered by looking more closely at the dynamics of speculation and at a typical skyscraper development.

Hoyt suggested that the cycle is long enough for people to forget the lessons of the previous cycle and thus not be able to apply it to the next cycle. However, the building cycle is much more volatile and unpredictable than this eighteen-year average would suggest. Together with the impact of local economic conditions and government intervention, the combination of factors blurs any usefulness of the simple knowledge that business cycles exist and have an average duration. Indeed, the people who experience one business cycle are often not even the same as the people who experience the next cycle. As Willis noted:

After the collapse of an inflated market, it is easy to look back on the grave errors of judgment that preceded a crash; yet the basic indicators of the twenties economy seemed to promise unimpeded growth. Pent-up demand for office space after World War I, the expanding numbers of the white-collar workforce, and the increasing per-person average for office space all fueled the building industry. Each year, the summaries of annual construction figures reported record numbers.17

Willis did correctly identify that “easy financing underlie[s] all booms,” but this does not answer her conundrum, because easy financing and low interest rates are also at the heart of genuine economic growth. The entrepreneur’s problem is that profit calculations cannot show for sure whether interest rates will remain low and projects will succeed (i.e., economic growth), or rates will rise and projects will fail (i.e., the business cycle). Furthermore, it should be made clear that in ABCT, low interest rates and “easy financing” are terms defined not on the basis of their magnitudes, but in relation to their natural rates, which of course are not calculable outside of a free market.

1Thomas Piketty, Capital in the Twenty-First Century (Cambridge, MA: Harvard University Press, 2014).
2Ada Louise Huxtable, The Tall Building Artistically Reconsidered: The Search for a Skyscraper Style (Berkeley: University of California Press, 1992).
3Quoted in ibid., p. 117.
4Ibid., p. 105.
5Jeremy Atack, and Robert A. Margo, “‘Location, Location, Location!’ The Market for Vacant Urban Land: New York 1835–1900.” NBER Historical Paper 91, National Bureau of Economic Research (Cambridge, MA, August, 1996).
6Paul Cwik, “Austrian Business Cycle Theory: Corporate Finance Point of View,” Quarterly Journal of Austrian Economics 11, no. 1 (2008): 60–68.
7Jimmy A. Saravia, “Merger Waves and the Austrian Business Cycle Theory,” Quarterly Journal of Austrian Economics 17, no. 2 (Summer 2014): 179–96.
8Robert B. Ekelund, George Ford, and Mark Thornton, “The Measurement of Merger Delay in Regulated and Restructuring Industries,” Applied Economics Letters 8, no. 8 (2001): 535–37.
9Mark Thornton, “Review of The Synergy Trap: How Companies Lose the Acquisition Game, by Mark L. Sirower,” Quarterly Journal of Austrian Economics 2, no. 1 (Spring 1999): 85–86.
10Sukkoo Kim, “The Reconstruction of the American Urban Landscape in the Twentieth Century,” NBER Working Paper 8857, National Bureau of Economic Research (Cambridge, MA, April 2002).
11M. Ali, and Kyoung Sun Moon, “Structural Developments in Tall Building: Current Trends and Future Prospects,” Architectural Science Review 50, no. 3 (September 2007): 205–23.
12Nick Ames, “Elevator Installation Prep Begins at Kingdom Tower,” ConstructionWeekOnline.com, May 10, 2015.
13Carol Willis, Form Follows Finance: Skyscrapers and Skylines in New York and Chicago (New York: Princeton Architectural Press, 1995), p. 157.
14Ibid., pp. 157–58.
15Patric H. Hendershott, and Edward J. Kane, “Causes and Consequences of the 1980s Commercial Construction Boom,” Journal of Applied Corporate Finance 5, no. 1 (Spring 1992): 68.
16Homer Hoyt, One Hundred Years of Land Values in Chicago: The Relationship of the Growth of Chicago to the Rise in Its Land Values, 1830–1933 (Chicago: University of Chicago Press, 1933).
17Willis, Form Follows Finance, p. 159.