Yesterday the conversation around Port Phillip Publishing’s coffee machine turned to Pareto’s 80–20 rule. OK. It didn’t exactly just turn there. It’s possible I brought it up.
You see, we’d been talking about booming property prices. Nationally prices are up around 11% since the beginning of the year. But in Sydney they’re up an average of about 16%. And in some areas it’s far more.
This article from news.com.au on Sydney’s light rail extension to its inner west sheds some light on why this is the case.
‘HOMEOWNERS in Sydney’s inner west have hit the lottery as the light rail extension to Dulwich Hill nears completion, with median house prices in some suburbs doubling in less than a year…
‘In January last year, median house prices were sitting on $765,000. Nine months later, that figure had jumped to $1.3 million… Growth was similar in neighbouring Haberfield – with the median house price shooting up from $885,000 in January to $1.9 million by November.’
Those numbers are impressive! If you’d known about this ahead of time, you could have doubled your money in one year. And you could have known about. How? Pareto’s 80–20 rule, of course.
You may have heard of Pareto’s 80–20 Rule. It’s sometimes known as the Pareto principle, or Pareto’s law. In case you’re wondering, as a few of my colleagues around the coffee machine were, it’s named after Italian economist, Vilfredo Pareto, (1848–1923).
It is a common rule of thumb used in many circles that 20% of the causes are always responsible for roughly 80% of the effects. For example, 20% of your time produces 80% of your results. Or 80% of your sales come from 20% of your clients…and so on.
Our modern use of this is attributable to Joseph Juran, a pioneer in quality control. He stumbled across Pareto’s work in 1941, and began to apply the Pareto’s 80–20 rule to his quality management work. And this is the context in which we know the 80–20 rule today. It’s an effective quality management tool. It reminds you to focus on the 20% that really matters.
Today, managers use the 80–20 rule to help them separate what Mr Juran called the ‘vital few’ resources from the ‘useful many’.
But getting back to the big man himself, Pareto’s pioneering study was actually in relation to population and wealth. His very first piece of research found that 20% of the population owned 80% of the land in Italy, and he observed the obvious inequality that followed. He then carried out surveys on a variety of other countries. To his surprise, he found that a similar distribution applied.
Now, the fact that land ownership is concentrated should not have surprised Pareto. And it shouldn’t surprise you, simply because land is economically worthwhile to accumulate — to collect the economic rent. And since only 20% of the people are collecting this rent, this leads to an obvious concentration of wealth.
The key is to be part of the 20% where the wealth is concentrating. And you can do this when you come to an understanding of the economic rent.
Nothing has changed since Pareto’s 1906 study.
Land ownership will concentrate because improvements to infrastructure and services simply increase the economic rent, as with Sydney’s inner-west light rail extension in the above example. And these improvements are largely funded from taxing people’s wages — or by government borrowing from banks, and then taxing people’s wages again to pay back the banks.
Here’s the important point, those that own will pay no extra for improved infrastructure and services. Yes, they still have to pay taxes. However, increasing land prices handsomely offset those taxes. Those who rent effectively pay more. Firstly with increases in rents for improved infrastructure and services. And secondly, they pay more in taxes, as renters don’t have the luxury of collecting back their taxes via higher land prices.
Which side do you want to be on? Use the 80–20 rule to your advantage.
Once you have this understanding, you’ll find the economy has a well-defined repeating structure. And once you know this structure, you can navigate your way through the property cycle, confidently collecting as much of the economic rent as possible. The value of the land simply reflects the nearby services and amenities and general state of the economy. Any improvements in business conditions will only increase the land price. With that in mind, wouldn’t it be handy to know where the economy is headed?
And you can know where the economy is headed. It keeps repeating in the same pattern. The cycle repeats because the underlying structure of the economy, the economic rent, remains untouched.
My colleagues around the coffee machine asked if there wasn’t a way to break this cycle. To minimise this concentration of land ownership. In fact there is. But we’ll leave that discussion for another time.
Schools and mainstream economic texts don’t teach the importance of the economic rent, or Pareto’s discovery that 20% of the population owns 80% of the land.
After the last land-led economic downturn (GFC), the world’s leaders set about reforming the financial system, so such a catastrophe could never happen again. As always the economic rent structure remained untouched, guaranteeing yet another cycle. Also guaranteeing the timing of the next rent-induced bust.
The economic rent is what drives the cycle, and all other economic behaviour follows from that.
Understanding this cycle will make you a better investor.
For The Daily Reckoning