Diagnosis and Cure
by David Stanowski
27 July 2008
Many people who live and work in the City of Galveston are painfully aware of the anemic state of the local economy. They don't need an economic study to convince them that something is wrong, because they struggle to make a living every day! The simplest way to actually measure what they are experiencing is by using the Median Household Income. The latest available data (2005) showed that Galveston's Median Household Income of $30,500 was 28% below that for the State of Texas ($42,139).
This article may be the first to attempt to pinpoint exactly why the local MHI is so far below the State average, and suggest a course of action to begin the process of raising it.
In the 1870's, Galveston had one of the highest per capita incomes in the world. 100 years later, it had become one of the poorest cities in the U.S. What happened?
The decline of the City began when the Houston Ship Channel opened, in 1915, because the new port, in Houston, began to "lure" traffic away from the Port of Galveston. By 1940, something at the Port had changed so dramatically that a transfer of ownership from its private owners to the City government was believed to be the best course of action.
It shouldn't be surprising that the decline of the economic engine that had built a wealthy city, lead to the decline of that City, but why had the Port been so important to the success of the local economy, and why haven't souvenir shops, restaurants, bars, beach houses, and condos been able to replace it? The answer lies in how effectively "capital" is utilized in each of these "enterprises".
What is Capital?
The definition of what capital actually is and what role it plays in an economy can become very complex, but a rather simple explanation should be sufficient to understand the changing role of capital in this city.
Capital can be categorized in one of three ways: human, physical, and monetary. Human capital is each person's knowledge, skills, creativity, and ability to innovate. Physical capital refers to the tools people use to do their jobs more efficiently, as well as infrastructure such as bridges, damns, houses, and roads. Monetary capital is the amount of current income that is not spent, i.e. savings, which may be held as excess output, or cash, gold, stocks, bonds, and other investments.
In simple societies, long before the birth of modern capitalism and monetary systems, people progressed beyond the most primitive hunter-gatherer stages by using their human capital to learn how to hunt and gather more efficiently. They also crafted tools and weapons (physical capital) to help improve their "harvest". If they used the first two kinds of capital successfully, they would accumulate excess game, plants, tools, and weapons that became their monetary capital for trading. Even in those times, it was recognized that the only way for individuals and societies to see their income and wealth grow was through the formation and wise use of capital.
Today, most people realize that a man with a stick can dig fewer holes than a man with a shovel, and a man with a backhoe can dig many more holes than either one of them. Therefore, if the most effective physical capital is available to a man whose job it is to dig holes, the man's income will rise. If the man increases his human capital by improving his skill in digging holes, his income will rise even further.
Therefore, the ONLY way for an individual to increase his income is to increase the physical capital that he uses to do his job, or to increase his human capital (skill at doing the job). If he increases both types of capital, his income will rise even more. Moving from an individual to a collective process, if many of the residents of a particular city can increase their human capital, and/or the physical capital, used to do their jobs, the income of the whole city will rise!
The story of a city with below average Median Household Income is the story of a city with below average human capital, below average physical capital, and/or the mis-allocation of capital. This is the story of the City of Galveston for the last 50 years.
Mis-allocation of Capital:
In a free market, capital does not remain mis-allocated for long. People make mistakes when they decide where to employ their capital, but after awhile, they see better opportunities, and move it to other investments. However, a true free market has not existed for a long time, in this country, due to the efforts of special-interest groups to re-direct capital into areas where it would not normally go.
The most significant example of the mis-allocation of capital began right after WWII. The stock of housing was unable to grow throughout the long Depression, and was unable to do so during the War, so the late 1940's saw a large pent up demand for housing hit the market. Opportunists from a wide variety of real-estate interests began all-out lobbying efforts to convince the federal government to make residential real estate a top national priority; and they have been very successful!
Over the past six decades, the federal government has supported the residential-real-estate industry through legislation and regulations. It created many agencies that are dedicated to subsidizing their cost of capital like Fannie Mae, Freddie Mac, Ginnie Mae, HUD, and the VA. It also altered the tax code to include income-tax deductions for property taxes and interest paid, on residential real estate, as well as lowering or eliminating capital gains taxes for many real estate transactions.
In recent years, special tax rebates for developers such as TIRZs and PIDs were created at the state and local government level that further expanded the incentives for capital to flow away from productive enterprises, and into residential real estate.
The current housing bubble was fueled by new "innovative" ways to loan money to people who had little chance of paying it back, because everyone from the mortgage brokers to the investment banks, that securitzed the loans, got a nice piece of the action for handling the capital while the federal government ignored these fraudulent transactions.
The mis-allocation of capital during this housing bubble has already left the country with a legacy of 18.6 million vacant houses! The number should easily reach at least 20 million by next year. If each of these houses has an average value of $200,000, there will be $4 TRILLION worth of capital trapped in these empty houses that could be providing the tools to make American workers more productive! (Bloomberg on vacant houses)
When the history of the financial decline of the U.S. is finally written, the massive mis-allocation of scarce capital into unproductive residential real estate should play a very prominent role in the story. Many people think that this use of capital has advanced the social condition of the country, but now they are asking where all of our jobs have gone. They forgot that you have to have a job, BEFORE you can buy a house. Many jobs have disappeared, because so much capital is tied up in residential real estate!
The Uses of Capital:
Another way to look at this issue is to construct a hierarchy of how different enterprises utilize capital; a kind of capital "food chain". At the top of the list will be industries where an added increment of human or physical capital will increase incomes the most, and at the bottom will be the enterprises where added capital will increase incomes the least. The following list is incomplete, and somewhat subjective and arbitrary, but it should be accurate enough to make the point.
Capital "Food Chain":
1. Intellectual Property
2. Manufacturing of technological devices and components
3. Internet-based information and commerce
4. Manufacturing of household items
5. Transportation and distribution centers
9. Commercial real estate
10. Residential real estate
It should be obvious that a person who develops a ground-breaking idea (Intellectual Property), through the use of their human capital, may increase their income by millions of dollars, while those who work for this individual usually benefit handsomely, too. That is why IP is at the top of the list.
Moving down the list, it should be noted that a retail store usually requires a significant investment in a building and inventory, but the employees normally do not need to have above-average human capital (skills), or need much physical capital to do their jobs. That is why the owner is usually the only one who earns above-average income, due to his capital investment.
Finally, when someone has a home built, it does create jobs for a few skilled workers, but after they finish, the home does not operate as a business for the homeowner. Building a home means that large amounts of capital have to be allocated into a "consumer purchase" as opposed to an operating business. There are no owners or employees who benefit from this undertaking once the house is built.
It can certainly be argued that each and every family needs some kind of housing unit to live in whether it is a single-family home or in multi-family configuration, but as people want to spend more and more on their housing, less is available to create better-paying jobs by employing the investment as physical capital in businesses.
In a free society, no one should have the right to tell people where they can spend their money, but it should be noted that because the government subsidizes the cost of capital for residential real estate, they are actively helping to suppress income growth, and to send jobs offshore! Americans should wake up and demand an end to this practice!
Uses of Capital in Galveston:
19th-Century history makes it clear that the "investment interests" saw Galveston as a risky place for large-scale industrial investments, due to the threat of hurricanes. That meant that the Founders understood very clearly that THE PLACE, on this Island, to use capital to create high incomes was at the Port. It worked very well for them until they failed to respond and adapt to maintain their share of the shipping business, as Houston became the dominant port.
Ever since the Port was taken over by the City, it must be assumed that it has not been run as efficiently as it could have been under private ownership, and it has probably been starved for capital for decades. As the Port of Houston has looked for more and more capacity, in recent years, Galveston was unprepared to take up the slack. If the Port had sufficient capital, it would be jammed from one end of the channel to the other, and Pelican Island would have been fully developed years ago!
The failure to re-privatize the Port (which is a transportation and distribution center), or at least find ways to raise private capital has cost this city dearly! While Galveston's most significant opportunity, at the top end of the capital "food chain", has been limping along, starved for capital, the City concentrated on steering capital to the very bottom of the food chain: residential real estate! An "investment" where it is almost impossible to employ capital so that it permanently increases incomes!
Of course, on the other side of the ledger, the creation of human capital in this city has suffered greatly as the residents look to GISD as the main resource. This is a problem that may take many years to correct, but it is also time to look for alternative ways to increase the human capital in this city!
When the Galveston economy is examined in terms of the capital available to the City, and the allocation of that capital, the reason for the below average Median Household Income should be fairly obvious. The solution is simple in concept, but much more difficult and complex to execute. It could take many years of effort to bring this city back to parity with the state. However, that is no reason not to begin the effort now, and at least start moving in the right direction.
The City government, the residents, and local institutions must work together to find new ways to increase our human capital, to raise new financial capital, and to allocate that capital to the high end of the "food chain". The efforts of the GEDP to create new-business incubators, and bio-tech start ups are right on target, but need to be supplemented by other initiatives.
A Galveston venture capital fund would be such a device. This fund could target industries that can create higher incomes, and should require that the principals live on the Island. This would force them to keep their incomes in the City, but a long-term solution has to found to address the local problems that send some of the people who currently earn good incomes, in Galveston, fleeing across the Causeway in search of a place to live. Often, they do so because of the poor school system and/or the high crime rate.
One of the most critical needs for capital is at the Port. It is the dominate institution on the Island that is positioned to employ capital in ways to create higher-paying jobs. However, it isn't proper to try to raise that capital with municipal bonds, by pledging the property of the residents as collateral, so some sort of privatization process must be employed.
The need to re-allocate the use of capital, in the City, should not be construed as an attempt to exclude any further residential real estate development; it just needs to be given a much lower priority. Since the 1980 census, residential real estate development has used a large percentage of the capital available to the City. This period has seen a decline in population, a decline in the number of jobs, a decline in retail sales per capita, a decline in cargo handled by the Port, and stagnant growth in Median Household Income. This should be sufficient proof that residential real estate development does not and cannot raise incomes, or boost the economy.
The mis-allocation of capital into residential real estate is a national problem. Galveston is probably unique only because it neglected to find ways to invest in highly-productive enterprises, in addition to real estate. Local government officials and economic leaders should have seen this problem years ago, and made attempts to re-direct local capital flows.
Unfortunately, many of them have been satisfied to act as if residential real estate development is one of our only options, as they tout the "blessings" of collecting more property tax. The high-priced developments of recent years have driven up prices all over the Island which raises everyone's property tax burden. Higher property tax collections do little to benefit anyone except those employed by the City.
Concentrating local efforts on enterprises that can make the best use of capital will help everyone including enterprises further down the list. For example, even without any direct effort to improve the local retail industry, if other businesses help to raise the Median Household Income to the state average, that would generate an additional $11,639 per household, per year, to spend in local retail stores. That would be an enormous boost just by itself!
It is high time to move beyond the conventional studies of the local economy, and convene a conference on capital formation and allocation. That is our only hope!
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