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From Kelo With Love: Revisiting Kelo’s Flawed Economics and Vacuous Constitutionalism

The recent announcement that two California counties are considering using the eminent domain power of the Fifth Amendment to seize underwater mortgages from their owners provides a useful opportunity to revisit the Supreme Court’s extraordinarily wrong-headed decision in Kelo v. City of New London, one of the most publicly-maligned decisions in recent Supreme Court history.

Events post-Kelo have confirmed what was evident at the time: that defining “public use” so broadly to permit politicians to seize private property from one person and give it to another is misguided.  Indeed, by unleashing politicians and special interest factions to use the political process for their own purposes Kelo turns the Constitution on its head.

Subsequent events since Kelo have confirmed its critics’ worst fears.  First, because of Kelo’s lack of a coherent rationale it also lacks a coherent limiting principle.  Second, Kelo fails to understand the nature of politics and why constitutional restraints on government are important and thus essentially puts the foxes in charge of guarding the chicken coop.  Third, the subsequent history of Ms. Kelo’s property in New London again shows the dangers of government central planning of economic development and provides a cautionary note about the wisdom of accepting “pie in the sky” theories of economic development.

Kelo’s Flawed Economics

Economists have justified the power of the government to take private property for public use by pointing to the potential hold-out power that can undermine efficient assembly of property in order to provide public goods.  For example, assume that the government wants to build a highway across the state.  In order to do so, the government will need to acquire land or an easement from the multiple owners of contiguous lots that run across the state.  But this creates a potential hold-out problem: because the project can go forth only if all landowners consent, each landowner has a sort of monopoly power to act strategically to demand a price above what they typically would accept.  This potential arises because combining the land creates economic rents: assuming that the highway project is a valuable project, the value of the combined land together exceeds the sum of the individual parcels of land separately.  This provides an incentive for each landowner to seek not only the value of her own land but also to try to appropriate some of those economic rents to herself as a condition for selling.  But each landowner has the identical incentive, thus this would produce a series of highly-strategic bilateral bargaining as each individual tries to appropriate as much to themselves as possible.  This strategic bargaining could lead to a dissipation of the overall rents of the project perhaps even resulting in destruction of the economic value itself.  The justification for the eminent domain power is to overcome these hold-outs and enable government projects to go forth.

Note that I leave aside here many of the practical responses to the traditional justification of the hold-out power, such as the fact that it will rarely be the case that people will actually have a hold-out power: for example, there will usually be several particular locations for building a road or school.  I also leave aside other possible responses, such as the use of secret purchasers and the like, such as Disney famously did in assembling the multiple land parcels to build Disneyworld.  All of these practical responses are important and significantly weaken the justification for the eminent domain power generally.  But here I want to focus on the more difficult challenge: explaining why Kelo is flawed as a purely theoretical matter, leaving aside these practical responses.

Some economists have argued that the justification of forcing potential hold-outs to sell to the government applies with equal force to private transactions, such as the need for Wal-Mart to assemble land in order to build a new Superstore.  Just as the government needs to assemble multiple parcels to build a school, it is argued, Wal-Mart needs to assemble multiple parcels in order to build a Superstore.  The identical hold-out problem is present, it is argued, thus it is appropriate to use the eminent domain power in the latter situation as much as the former.

But this is where the analogy breaks down.  For while the hold-out power is real, there is an equally real mirror image to the hold-out power: subjective value.  Consider the following example.  I am the proud owner of an autographed photograph that depicts what is unarguably the single most important moment in American history: Franco Harris’s Immaculate Reception that miraculously ended the 1972 AFC playoff game between the Pittsburgh Steelers and Oakland Raiders, propelling the Steelers to their 1970s football dynasty.  I received the picture as a gift several years ago, so this particular photo has idiosyncratic significance to me that exceeds the retail price of the picture.

Suppose that the market price of my photo is $89 and someone offers me $100, yet I refuse to sell.  So he ups the offer to $110, yet I still refuse to sell and demand a still higher price.  “Zywicki is holding out!” insists my hypothetical purchaser.  He is demanding a premium just to extract a price above the market price.  As a result, he insists, this is a situation that is ripe for invoking the power of government to take my photo and give it to him—i.e., to move the property to a purportedly higher-valued use.

And it is true that I am insisting on an above-market price.  But does that mean I am illegitimately “holding-out” such that the government should take my property and give it to someone else?  No.  How do we know this?  Because although the event it depicts is singular, autographed pictures of the event are not; in fact, similar pictures list on eBay for approximately $89.  Thus, although I would like to hold-out for an above-market price I cannot do so because there are ready substitutes on the private market.

Note, however, that it is impossible to observe directly whether the refusal to sell reflects an effort to legitimately protect one’s subjective value or illegitimately to hold-out to extract economic rents.  But the presence of market alternatives allows us to determine indirectly that I am not illegitimately holding-out but that my expression of my willingness to sell only at a much higher price (say $250) illustrates a sincere expression of deep subjective value that exceeds the market price.  Thus, taking the property and giving to someone else would actually decrease economic welfare.  This passing observation, however, is crucially important: it provides the fundamental reminder as to why as a matter of policy we should have a very strong presumption in favor of private ordering and allocating resources through private ownership and voluntary exchange, rather than centrally-planned coercive transfers by government.  Because some degree of subjective value or subjective cost will frequently be present, private value will often exceed market value.  It is only through observing actual exchanges made in private markets that we can know for sure the value placed on various things—the presence of a voluntarily exchange evidences what we cannot observe directly, namely that the parties to the exchange place differential value on the items subject to the exchange.

How does this relate to private economic development takings in Kelo?  The proper question to focus on is not on trying to measure the alleged value of the economic development directly or the plausibility of a claim of subjective value directly, but rather whether any effort to assert a hold-out power is plausible.  Was the hold-out power plausible in Kelo?  One thinks not.  Unlike the highway or school, which arguably must be built in a particular geographic location (although as noted above, this argument may be overstated, but I accept it for purposes of argument here), no such argument applies to building a new office building in downtown New London.  There is no intrinsic reason why that particular geographic location must be used.  The office building need not be built on the river in New London or even in New London itself.  For that matter it need not be constructed in Connecticut or even the United States.  Thus at the time the decision was being made where to locate Pfizer’s new corporate headquarters there are numerous market substitutes for the particular location chosen.  Where there are multiple market substitutes available, the hold-out power dissipates.

What creates the alleged hold-out power in most situations (such as in Kelo) is not anything geographically unique, but rather the presence of government tax breaks and subsidies for the private company.  At that point building in other cities is, in fact, not as valuable of a substitute for the proffered property.  Thus, the preferential government treatment creates a sort of “artificial scarcity” by making the particular parcel more valuable than others.  But this sort of value is purely redistributive, not efficient: governments are competing for relative advantage but it is purely positional, not efficiency-enhancing.  So there is no good economic reason to do this.

There may be one unique situation where the analysis might be more complicated.  This could be in the situation where a firm is seeking to expand its current operations into a neighboring area rather than to build new operations.  In such circumstances there may be economic rents associated with building from the existing footprint, rather than creating a separate facility or relocating the entire facility elsewhere.  As a result, neighboring properties could conceivably have a similar hold-out power.  How frequently this is the case and how valuable the potential rents might be from doing so are empirical questions.  An optimal rule might permit a taking in this extremely narrow situation.  If these situations are sufficiently rare, however, adopting a bright-line rule that prohibits private-to-private transfers (rather than essentially permitting all private-to-private transactions, as in Kelo) may nevertheless be optimal.

Regardless of whether private-to-private transfers should be always prohibited, one thing is clear: that the use of the Takings power to take underwater mortgages is an absurd claim completely disconnected from the underlying rationale of the takings power.  If there is any public purpose to taking the claims of individual underwater mortgage owners—a dubious claim in itself—any benefit is individual as well in that any purported benefit flows from each marginal mortgage that supposedly averts foreclosure.  There is no property assemblage problem or any hold-out problem by mortgage holders.  Nevertheless, Kelo’s approach of rubber-stamping political decisions provides a foundation for taking even in that situation.  Choosing between a rule that either prohibits all private-to-private takings or permits them all, the error costs of the latter are likely to be much higher than the former.

Kelo’s Political Economy

But Kelo is flawed in a second way that reinforces the preference for market transactions instead of political transfers.  Reading Justice Stevens’s opinion for the Court, one is struck by the naïve view of the political process that he presents.  He implies that the political process in that case resembles that of your ninth-grade civics teacher.  In reality, of course, the political process bears minimal resemblance to this naïve view of politics.

In fact, as shown in subsequent reporting, the use of the eminent domain power in the Kelo case itself illustrates the worst of how the political process actually works when it comes to the use of the political process by large, wealthy, politically-connected land developers.  Pfizer orchestrated the process from the outset and the political process itself was largely a rubber-stamp for the purportedly public deliberation that followed.

In Federalist 10 Madison noted that the greatest danger is the use of the political process by majorities to plunder the property rights of others.  Indeed, the politically opportunistic use of the eminent domain power to seize underwater mortgages is reminiscent of the debtor-friendly political pandering under the Articles of Confederation that prompted the adoption of the Constitution—including the Takings Clause—in the first place.  The Supreme Court’s refusal to consider the political economy of how private-to-private transfers could be abused simply ignores these lessons.

Government as Central Planner

Finally, it should not go without mention that today the land taken from Ms. Kelo and other residents in New London remains a barren, undeveloped garbage dump.  Pfizer has announced that not only has it abandoned its plans to develop the seized land but that it is closing its existing operations and moving all 1,400 jobs to its facility in Groton, CT.  As for Ms. Kelo’s property and the others seized by the government for the redevelopment program, the land remains vacant and overgrown with weeds and was designated a dump site for debris following Hurricane Irene last year.  No plans to actually develop the land appear to be imminent.

Conclusion

Constitutions exist to restrain the democratic process.  The purpose of a constitution is to tether the political process through rules that restrain democratic processes.  Politicians and politically-powerful interest groups will often plead for exceptions from these rules—to suspend the rights of criminal defendants or freedom of speech.  Yet we recognize the danger of loosening the leash because of the mischief that can result.

The Framers understood that the tendency of politicians and special interests to seek to use the power of government to transfer property to themselves was perhaps the most tempting use of government of all.  Via Kelo, however, the Supreme Court has turned this on its head, empowering politicians to buy votes by taking property rights.  The lack of a coherent rationale in Kelo—indeed, the inability to understand the nature of constitutional government itself—has opened the Pandora’s box of political favor-seeking through the abuse of the eminent domain power as seen in California today

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