The revival of cities and the urban land premium

Henri De Groot, Gerard Marlet, Coen Teulings, Wouter Vermeulen

Only a few decades ago many talked about the ‘death of cities’. Today, many cities have emerged as hubs of economic activity. This column argues such a phenomenon is due to spill-overs and agglomeration of human capital. The popularity of certain cities is explained by their attractiveness for innovative enterprises and high-educated top talent. But since locations where top talent clusters are scarce, land rents on these locations are high.

End of the ‘death of cities’

Forty years ago, a large squatting movement was taking hold of the city centre of Amsterdam. This was not so much an expression of left-wing radicalism, as much as the desolation of the city. After 25 years of population decline, many vacant buildings had no better use. At around the same time, New York’s Times Square hosted mainly sex shops. There simply was no alternative use for the available floor space. It was an era in which people talked about ‘the death of cities’. What use did it have for modern mankind to agglomerate in heavily congested cities, when telephone and fax made long-distance communication so easy as to render physical proximity seemingly irrelevant? These stories are just two examples of a major turn-around in the prospects of cities over the past four decades, so vividly reported in Edward Glaeser’s (2011) ‘Triumph of the City’. Amsterdam’s squatting movement squandered as the demand for housing and office space soared. Times Square has nowadays become the vibrant centre of NYC’s theatre district.

Explaining the reversal of fortune

What explains this unexpected reversal of fortunes? Why have cities emerged as hubs of economic activity in this era in which the internet seems to be the ‘cul-de-sac’ of physical distance? That is the question we ask in our new book ‘Cities and the Urban Land Premium’. Several authors point in the same direction, namely spill-overs and the agglomeration of human capital. Gennaioli et al. (2014) show how within countries, human capital clusters in a small number of regions. The premium in regional GDP per capita is 20% and more per year increase of the mean education level in a region. This return is far above any reasonable estimate of the private return to human capital. Desmet and Rossi-Hansberg (2008) focus on the role of general purpose technologies. In the 1920s and 1930s, that was electricity. Since 1990 it is information technology. In both periods, industries that could benefit most from these general purpose technologies moved to the city to facilitate the diffusion of new ideas. The growth of human capital has been key to the economic miracle of the 20th century, but the fruits of this capital could only be harvested when great minds and well educated people clustered together in cities. The rise of the city and the knowledge economy are therefore intimately related.

Where knowledge spill-overs play a crucial role in the modern economy, locations where top talent clusters are scarce and hence land rents on these locations are high. Surprisingly, the social return to human capital gets paid out in the form of high land rents in cities.

In the Netherlands, both Amsterdam and Rotterdam lost 25% of their population between 1960 and 1980. Amsterdam managed to re-emerge as a focal point for the higher educated, while Rotterdam still struggles, similar to the difference in fates of Boston and Detroit in the US.

The paradox is that the agglomeration of higher educated in particular cities leaves large parts of the country almost empty across all OECD countries, while land becomes scarce at particular hotspots.

Hence, land rents take an increasing share of GDP. This is because in the provision of housing services, the elasticity of substitution between land and construction is less than one (see Teulings et al. 2015 for the Netherlands, and Albouy and Ehrlich 2012 for the US). The increase in land rents in the city therefore more than offsets the decrease in the countryside. Agglomeration benefits driven by knowledge spill-overs are therefore one of the main explanations for the increasing share of housing in many developed countries’ capital stock as reported in Thomas Piketty’s (2014) ‘Capital in the 21st Century’, next to the downward trend in the real rates of return (see the debate on Secular Stagnation).

Externalities and rents

Knowledge spill-overs imply that cities are a focal point of location-driven externalities. Land rents are the expression of these externalities. A location’s rent is high not because of the characteristics of the location itself, but because of what happens at locations in their direct proximity. This is a clear example of an externality, the value of your property depends on the actions taking by the owners of neighbouring property. These externalities provide a textbook argument for developing public policy at the level of the city and why a Henry George tax on the value of land is most efficient. In fact, the total land rent differential of a city can be shown to be an excellent instrument for the valuation of externalities generated by a city. They also allow a valuation of the contribution of public transport services. In the Netherlands, we show that these externalities account for approximately 3% of Dutch GDP.

As history has shown (see, for example, what happened to Detroit or the decline in the population of Amsterdam and Rotterdam referred to above), current successes provide no guarantees for the future. This is what Gibrat’s law tells us, growth is independent of current size. Future growth is therefore largely independent of past success. The chances for policymakers that try to row against the tide are small. A successful policy requires to ‘go with the flow’. Large investments in infrastructure in a declining city do not satisfy any real demand but lead to large financial burdens for the local population, making these cities even less attractive. However, policy can make a difference in growing cities. In order to remain on the short list of hot spots, policymakers in these cities have two margins to work on.

First, the city has to be attractive for innovative entrepreneurs and enterprises to locate their business.

Second, the city has to be an attractive choice for high-educated top talent as a place to live in.

Land rents provide an excellent instrument for analysing which of these factors matters most. When job availability matters most for the land rents, then the first margin is the most important determinant of urban success. When consumption amenities matter most, then offering an attractive living environment for higher educated is the key to success.

This is exactly the analysis that we do in Cities and the Urban Land Premium. Even in a small country such as the Netherlands, land rents for residential real estate differ dramatically, from 17€ per square meter in the north-eastern part of the country close to the German border, to 3,500€ per square meter in Amsterdam’s canal zone district. On average, the contributions of job availability and consumption amenities in explaining this variation are about equal. Both explain about 35% of the land rent differential. However, these shares are only averages. The distribution of consumption amenities is extremely skewed. When focussing on Amsterdam, by far the most successful city in the Netherlands, consumption amenities play a far more important role in explaining its success than does job availability. In particular, its monumental canal zone and its vibrant cultural life give the city a leading edge in attracting top talent, both from within as well as from outside the Netherlands. This conclusion is collaborated by the evidence on wages – regional wage differentials are rather small. Amsterdam’s consumption amenities are a good reason for people to accept high rents that have to be paid for living in this city. Entrepreneurs do not have to pay high wages to offset them.

References

Albouy D and G Ehrlich (2012), “Metropolitan land values and housing productivity”, NBER working paper 18110, Cambridge MA.

Desmet K and E Rossi-Hansberg (2008), “Spatial growth and industry age”, Journal of Economic Theory, 144, 2477-2502.

Gennaioli N, R La Porta, F Lopez-de-Silanes, and A Shleifer (2014), “Human capital and regional development”, Quartely Journal of Economics, 128, 105-164.

Glaeser, E (2005), “Reinventing Boston: 1640-2003”, Journal of Economic Geography, 5, 119-153.

Glaeser, E (2011), Triumph of the city; How our greatest invention makes us richer, smarter, greener, healthier, and happier, Macmillan, London.

de Groot, H, G Marlet, C Teulings, and W Vermeulen (2015), Cities and the Urban Land Premium, Edward Elgar, Cheltenham.

Piketty, T (2014), Capital in the Twenty-First Century, Belknap Press, Cambridge, MA.

Teulings, C, I Ossokina, and H de Groot (2014), “Welfare benefits of agglomeration and worker heterogeneity”, CEPR Discussion Paper 10216, London.