The Bear’s Lair: The madness of crowds

Conventional wisdom celebrates cities. It sees the mighty agglomerations of capital and human capital in London, New York, Shanghai and San Francisco/Silicon Valley and celebrates the wealth-producing capabilities of those agglomerations. Yet with today’s low interest rates and high asset prices, the biggest cities also have remarkably high real estate prices, which inflict massive costs on all who live there. Do the arithmetic properly, and many city dwellers would be better off in cheaper, less stressful locations.

There are three economic effects of humanity clustering in cities. There is the positive effect of access to the city’s services, such as restaurants, jobs and the opera. There are the negative effects of high real estate costs, crowding and pollution. And there are the additional “network” positive costs from concentrations of talent, which may in some cases synergize off each other and produce higher output than would be possible alone.

When you have a number of offsetting factors like that, it’s likely that the overall benefit of urbanization increases with the city’s population to a maximum and then declines increasingly steeply as the city’s population increases further. There is very little additional benefit a city can provide beyond about 2 million inhabitants (enough for opera, surely!) and for obvious geographical reasons the commuting time, congestion and real estate costs continue increasing ad infinitum beyond that point.

By 2050, on U.N. projections, two thirds of the world’s population will live in cities, with several of those cities having more than 30 million people. If you can think of any amenity that would be available in a city of 30 million people that is not available in a city of 5 or 10 million people, it’s quite beyond me. Hence the peak in city well-being must be reached somewhere this side of 10 million. I suggest that it is well this side of 10 million, and that two trends, the Internet and soaring real estate prices, are pushing the optimal city size down to a level today little above 1 million, with larger agglomerations being almost universally dysfunctional.

The additional cost of living in cities has soared with real estate prices, which have been fueled by negative real interest rates. Currently, those owning homes in London, Manhattan and San Francisco/Silicon Valley are very contented with the situation; they were able to buy their homes with exceptionally cheap mortgages, maybe even at negative real interest rates, and have seen their investment appreciate steadily in value, with the hiccup of 2007-10 now receding rapidly in the rear view mirror. Yes, the young are having difficulty getting “on the ladder” but the young have always had it tough, and today’s middle aged congratulate themselves on their perspicacity in having been born 20 or 30 years earlier.

Needless to say, this attitude will change when interest rates start rising, and real estate markets suffer their inevitable price reaction. Suddenly people will realize that with the new higher interest rates, even prices 20-30% below their current levels will remain unaffordable to the young, while the middle aged will have seen their housing equity wiped out. Then the true costs of living in gigantic agglomerations will become apparent.

To illustrate the cost disadvantage faced in a major urban center, consider a modest middle class family home of 2,000 square feet/180 square meters, which here in Poughkeepsie will cost you about $200,000, with real estate taxes of about $6,000 annually –a total annual cost of say $22,000, including an allowance of 3% of capital cost for maintenance. In Hackney, by no means the most expensive part of London, indeed a place into which I feared to venture when I lived in that city, those 180 square meters will cost you 6,200 pounds per square meter, according to a recent Halifax survey, for a total cost of 1.12 million pounds or $1.75 million.

Admittedly real estate taxes are a lower proportion of the price in Britain, and maintenance isn’t proportionately more expensive on a higher-priced property of the same size – though London prices and poor work quality probably double its cost – but even so the annual cost of that London property is about $120,000. Given that mortgage costs in London are not tax-deductible, the unfortunate Hackney resident paying a 45% marginal rate of tax has to earn an additional $178,000 before he breaks even against his Poughkeepsie-dwelling cousin.

Needless to say, the Hackney resident gains nothing in quality of life by living there rather than Poughkeepsie. He is much more likely to be mugged or burglarized, he is almost equally far in travel time from the opera, the restaurants are much more expensive and nothing like as good (Poughkeepsie is adjacent to the Culinary Institute of America, with associated spin-off benefits), the local library is poorly stocked, the schools are equally awful, and the shopping is more expensive and no better. Even if he is earning a very handsome income of say $300,000-400,000, the Hackney resident is barely getting by after tax, so living in a big city has given him a miserable lifestyle in spite of his luxuriant earning capacity.

The extra costs imposed by big cities make them uncompetitive, not just at the individual level but at the corporate level. Companies, especially those with modest-skill employees, have to pay their staff vast wages to allow them to live within commuting distance of their work. London Underground, for example, is subjected to frequent strikes because its staff, fully unionized and receiving an excellent blue-collar stipend, nevertheless do not get paid the 75,000 pounds ($115,000) calculated by pundits as necessary to sustain a modest standard of living in that city.

At the corporate level, the best example of this is Uber, essentially a taxi service with some frills attached, valued by Silicon Valley for some unexplained reason at $51 billion, even though it is currently said to be losing $200-400 million a year (the unpublished numbers vary according to the source). Uber is currently planning a new 420,000 square foot headquarters in the Mission Bay area of San Francisco, one of the city’s fanciest districts. Uber management explained that as the company was born and grew up in San Francisco, its headquarters had to be there, in spite of the city’s sky-high real estate costs. In its new headquarters, Uber employees will doubtless be treated with the pampering that Silicon Valley and San Francisco yuppies have come to expect.

That’s all very well, but consider Uber’s cost base compared with that of its competitors. Joe’s Taxi Service operates out of a metal hut in the South Bronx, admittedly urban but not a high rent district; it has a large parking lot with some repair facilities next to a strip club. Joe’s employees have access to a coffee machine, which produces some of the worst coffee in the New York metropolitan area, for which they must pay. The chain link fence around the property protects Joe’s admittedly tough employees from the local criminal gangs, and reduces the danger level for them slightly below the level to which Uber employees are subjected in the drug-crazed-hippie-infested streets of San Francisco.

In other words, Joe’s taxi service provides the same necessary facilities for operating the business as does Uber – at about one hundredth the cost per employee. Only one element of Joe’s capital investment is similar to Uber’s – in the highly restrictive state sponsored rip-off of New York City taxi medallions. Little wonder that Uber loses money, and will continue doing so. Meanwhile Joe is picketing City Hall, furious at the venture-capital-subsidized competition.

Given that the number of Russian billionaire oligarchs is finite – and not increasing, given the current sad state of Russia’s economy – the number of people who can reasonably afford to pay London’s outrageous real estate costs without ruining their lifestyle is very limited, and will become more so once the market bubble pops and they realize house prices can go down as well as up.

Given that the supply of idiot venture capital money prepared to capitalize hopeless loss-makers in the multi-billions is also finite, the excess costs of operating in one of the world’s most expensive cities will eventually catch up with Uber and the other Silicon Valley giants, and they will discover the joys of relocation to a less expensive urban nexus. Even Tesla, the ultimate billionaire vanity project, had the sense to locate its battery gigafactory outside Silicon Valley in low-cost if corrupt Nevada.

It’s not as if most of the agglomeration in mega-cities is today necessary. Whereas fifty years ago large-scale production had to happen in factories, with physical goods moving down a production line, these days most such production happens in emerging markets. Foxconn’s factories with 300,000 employees may be fair-sized cities in themselves, but they are located in the lowest-cost areas in which minimal housing is available, not in the big cities. In the West, remote working is increasingly feasible, and these days it’s even possible for management to see what level of effort remote workers are contributing. As for interaction, conference calls with video facilities make it almost completely seamless. The company which sets up in Silicon Suburb or Silicon Field will have a huge cost advantage over that in Silicon Valley, and will have little difficulty finding and attracting top employees, providing attractive local facilities are available.

The glorification of big cities by many commentators is at best romantic tosh; the vast majority of major advances in human history have happened in communities that were at most medium sized towns by modern standards. (No, intellect is not proportionate to population; otherwise, where are today’s 2,000 Shakespeares?) In the next downturn, inhabitants of London, New York and San Francisco and investors in companies operating in those overpriced locations will find this out the hard way.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)