Wednesday, January 14, 2015

The complicated role of homeowners in income and production growth

I have been thinking through the relationships between housing, inflation, wages, and economic growth.  My basic narrative is that severe restrictions in mortgage credit from regulatory and market constraints on banks, coming out of the crisis, have crushed access to home ownership.  This has pushed home prices well below their intrinsic value.  There are many implications from this, including low single family home prices, low levels of single family home building, heavy relative all-cash and investor buying, strong growth in multi-unit housing, high rent inflation (Shelter CPI has been around 3%. Trulia is reporting 6% YOY rent inflation.), shrinking home ownership rates, high levels of net capital income to real estate owners, limited monetary expansion through bank credit (crimping both real production of new real estate assets and nominal inflation of existing assets), regressive transfer of income from renters to owners, and downward pressure on real wages (since nominal wage increases are devalued by rent inflation that is a result of the negative supply shock in housing).
Source: Calculated Risk

This last point is one that I would like to think about here, and as I begin writing this, I am not sure if I grasp all of the implications.

Through November
As a starting point, I don't agree with concerns I am seeing about slow wage growth.  Average hourly wages for production & non-supervisory workers have been growing at over 2%, but in December dropped to 1.6%, YOY.  Since this is an outlier compared to recent trends, it is possible that this will be revised up.  And, inflation is also falling precipitously, so real wages in December may not have dropped that much.  In any case, as my graph here suggests, real wage growth has been unusually high in this recession and recovery (which has been part of the problem).  But, my more specific argument here is that real wages are growing faster than even this data implies, because while YOY core CPI inflation is 1.7% (as of November), core minus shelter inflation is only 0.9%.  Shelter inflation is coming from negative supply forces, not positive demand forces, so real wages are increasing at a very healthy pace, once we account for the housing supply issue.  But, this is complicated, and I want to think through this out loud to consider the implications.

Dwarfing the Cantillon Effect

There is some debate over whether there is any significant transfer of value to financial interests who are the first to receive new dollars when the Fed expands the money supply.  Despite it's questionable significance and likely small size, this idea holds some status in the populist economics mind, (usually only noticed during an expanding money supply, but forgotten during monetary contractions when the effect would reverse) along with the notion that monetary expansion is a payoff to Wall Street, pushing equities to unsustainably high levels.

I am not going to unpack the whole issue here, but if loose money caused unsustainably high equity gains, wouldn't the stock market of the 1970's have been going gangbusters?  The reason equities have been rising during periods of monetary expansion is because monetary expansion has been what the economy needs.  The rise has been mostly a product of healed economic wounds and improved expectations.  The fact that so many observers see rising stock prices as a reason to complain about the effects of Fed policy is just one more reason that we are lucky it hasn't been worse than it has.  There is a mood of self-destruction in the air.

But, here, again, housing is different.  Because banks and regulatory constraints are binding, monetary expansion through the credit channel does have direct effects on home prices - but it's complicated.  Since 2007 when the mortgage market froze up, home prices have been held below intrinsic value.  Because returns move inversely to prices, this has countervailing effects.  Rent is more stable than price, so falling prices meant that the returns to home ownership have increased.  In addition, the shortage in housing that this has created has pushed rent inflation higher, making returns to home ownership even higher.  But, these gains are only captured over time, as rents are collected (or implied).  And, since owner-occupiers aren't exactly marking their implied rent to market, this effect among owner-occupiers will tend to have considerable lag as an influence on behavior.  For renters, on the other hand, the hit to real income is felt immediately.  New homeowners feel the effect immediately, because they are marking to market when they engage in a real estate transaction, but this is countered by the home seller who realizes his relative capital loss.  Homeowners who buy new homes might feel some of this positive effect without as many mitigating effects on the selling party, but of course new home building has been very low.  And institutional renters do feel the positive effects of higher rents, which is leading to strong growth in construction for rentals.

The decline in price that leads to this higher implied return, on the other hand, is felt immediately by many homeowners.  Homeowners with high equity levels may have the same lagged reaction to unrealized capital gains as they do to the high implied return.  But, homeowners that are leveraged or that would be tapping into home equity for cash, would feel this effect immediately.

So, frozen mortgage markets and tight monetary policy have lowered home prices.  This simultaneously creates higher inequality in reported real household incomes, deflationary pressures through the credit channel, and a supply shock felt only by renters.  It's a sort of bizarro Cantillon effect - the economic advantaged gaining income at the expense of the disadvantaged, simply as a result of the change in an asset price because of Fed cash.  Except this is due to a dearth of Fed cash and a decline in asset prices.

If mortgage markets can expand, the direct effect on asset prices (specifically homes) would be much stronger than it is in the regular Cantillon effect.  But, it would lead to a reversal of the problematic effects of the bizarro Cantillon.

Here is a provocative new paper that points to the credit problem as a cause of the employment crisis.

Revisiting my Housing Narrative

Real estate values would be nearly double where they are if credit markets had been functioning.  Some of that value has probably been lost forever because of the depth and length of the downturn.  And, that value would have been roughly divided between the value of new building and the nominal increase in the value of existing real estate.  One reason home prices were so high in the 2000s was because long term interest rates were low.  But, one reason was that we weren't increasing home supply fast enough, so that less of that growth in real estate value was coming from growing supply, and more was coming from price appreciation.  As I mentioned, rent inflation was pretty high throughout the period.  Also, excess returns to real estate, according to the BEA, were high throughout the period - another sign that there were frictions to supply growth.

Monetary policy was so tight in the 2000s that the increase in equity that came from rising prices did not lead to excessive inflation.  The late 1970's is a good example of loose money and high inflation, and during that time real estate market values also increased above trend.  But, as we know, inflation ran between 6% and 12% during that period.  To call the 2000's loose and inflationary, in the absence of consumption inflation is very debatable.  I'm surprised at how confidently this narrative is so widely accepted.  I argue that frictions in home supply were creating a supply shock in the 2000s, which was creating supply-based inflation.  Tight monetary policy was pulling "Core minus Shelter" inflation below 2% for this entire period.  Shelter inflation was above 2% for the entire period.

So, I'm crazy, right?  Well, here is a graph of annual growth in closed end real estate loans.  The trend through 2006 was for more than 11% growth, annually.  What looks more out of line?  The 2000's or the 2008-2014 period?

Here's a graph of the market value of household real estate, with a log scale.  Until 2006, there was a quite stable 8% annual growth rate.  (Again, this is roughly divided between nominal price appreciation and new building.)  Again, I ask.  What looks more out of line?  The 2000's or the 2008-2014 period?  The trend line through 2006, when real estate market values were at about $25 trillion, would now be above $45 trillion.  So, should the burden of proof be on the narrative that says we should be on the 50 year long trend line?  Or, should the burden of proof be on the narrative that says we should have seen a sudden and unprecedented destruction of $20 trillion in household nominal wealth?

Man, it's hard for me to remain civil when I work through all of this stuff and think of SJWs sniveling "The banks did this to us." while they complain about loose money as if it's a "bailout" and constantly remind us how concerned they are about inequality.

A very early sign of recovery in this area appeared today.  This needs confirmation, as it can be a noisy indicator.  A big jump in mortgage applications.  Since interest rates aren't the binding constraint on monetary expansion right now (probably the topic of my next post), mortgage expansion should create a fantastic economic context, regardless of Fed rate decisions this year.  Let's hope.


  1. Here is a start to a reply.

    1. Thanks for taking the time to think through this. You have a good point about 8% indefinite growth. If it isn't sustainable, an exponential trend can get us into problems. In my defense, NGDP growth over that time has been close to 7%. And, the household real estate value trend is about 8%, even if we cut it off at 1997, and assume that the 1997 low point was on trend. Real estate total value annual growth would have had to drop to below 5% to get us to today's values. Maybe we can come up with some reasons why real estate value growth should slow. But, I think it's hard to construct a narrative that explains that falling trend with loose money.

      The next graph brings GDP into the denominator, which I think adds unnecessary complication to this specific discussion. There are decent reasons why equity/GDP might have been growing at this time, which I have gone into on other posts. We might also ask why hasn't GDP been growing more. And, the two graphs together, which say that real estate total values have been on trend (until they dropped), and GDP has been below trend, again fit better into a tight money bust story than a loose money boom story.

      A couple of my recent posts have gone into the issue of how real estate equity and debt would both rise, relative to GDP, when real interest rates are very low.

      The third graph is only with regard to 5+ unit starts. I apologize for not labeling it clearly. It was just there to show the recent strength in that particular market segment. I can see how my lazy presentation would be confusing.

      My evidence for a supply shock doesn't rest so much on building quantities. It rests on the fact that rent inflation has been high throughout most of this period. We would expect rents to decline if homes were oversupplied.

      I agree that household size has given an unsustainable boost to household formation, and that we should expect the quantity of new homes built to remain low relative to previous recoveries. Although, I will admit that, while homeowner vacancy rates remained level until after 2006, rental vacancies did rise as early as 2002.

    2. Oops. The last sentence should be in the paragraph before.

    3. I guess I cant reply directly to your reply. I will take equal (at least) blame for misreading the graph and intention- I was rushing at the end of that post (a flaw of mine).

      "In my defense, NGDP growth over that time has been close to 7"- However NGDP growth from 85-05 was more along the lines of 5.5%. Unless TIPS spreads implied much higher expected inflation than we actually got that 8% was going to be unstable, and during the commonly accepted "bubble" period you had higher than average growth rates with average to below average nGDP growth. Even if you a placing blame on low nGDP growth there is still clearly an unsustainable trend that has to be corrected.

      In terms of rent increases- they failed to keep up with price increases (I might be stepping in it here as I haven't ever looked at methodologies for P/R ratios so some blind faith that they are reasonable) with Price to Rent ratios increasing by 50%. We can also come up with some solid reasons for rents increasing as prices increase. The two strongest are- opportunity cost of holding onto a rental unit and not just realizing gains in terms of higher prices and the cost of financing for investment properties usually includes higher down payments, so rental owners benefit less from lower interest rates than homeowners.

    4. Also I agree that there were probably supply issues, but I don't see them as the dominant factor.

    5. I will go part way with you. The implementation of pro-housing tax policy probably led to increased housing investment. But, most of that would have played out by the 1990s. It meant the total value of real estate was higher in the 2000s, but I don't think it had that much to do with growth levels in the 2000s. If you don't like my story, though, that is definitely one beam in the bridge from my narrative to another narrative.

      Rents were increasing relative to other non-housing prices. In other words, rent increases were not just a monetary phenomenon, but must have reflected a supply/demand balance. Price/Rent ratios were higher because of lower real interest rates, which increased intrinsic values, and broader access to home ownership, which allowed economic rents to be bid down.

      I prefer to begin analysis of homeownership by thinking of home values as an all-cash investment. There are ways that mortgages might effect market prices, but those are tweaks from the all-cash intrinsic value. Low long term real interest rates increase intrinsic values for occupiers and rental owners.

      The issue of real estate total market value increasing relative to GDP is related to the same issues that have brought down interest rates. Homes and bonds had the same reaction. The difference is that bonds tend to be framed in terms of yield and homes in terms of price.

    6. Regarding tax breaks, it is worth keeping in mind that property taxes are a pretty steep mitigating factor. The problems with real estate tax breaks are that they lead to uneven market between occupiers and rental owners. But, if real estate was taxed at the same level as other assets, it might actually rise in value, compared to the status quo.

    7. here is part two

  2. Great stuff Kevin. Do we know what residential real estate prices did in 2014?

    I've seen some anecdotal stuff around Chicago to suggest maybe a 10% increase.

    1. This thought ties into your characterization of houses as TIPS perpetuities and the breathtaking drop in long-term TIPS yields since the end of 2013.