Tuesday, February 17, 2015

Housing Tax Policy, A Series: Part 7 - The mortgage inflation premium as savings, revisited

I described mortgages as a sort of planned savings program.  The mortgage payment includes an inflation premium.  All else equal, in the typical year, in aggregate, real estate should appreciate by roughly the rate of inflation, which increases the owner's equity.  In addition, a homeowner pays some principal on the mortgage amount.  The homeowner also pays interest on the mortgage.  The real part of the interest is a cost-of-capital payment to the lender.  The inflation premium portion of the interest payment is really another portion of the homeowner's equity accumulation, because the mortgage principal remains fixed in nominal terms, which means that it declines in real terms.

Neither the increase in the home's market value nor the inflation portion of the mortgage payment are generally treated as household savings, which is one reason why much of the data and discourse about household savings is non-informative.

In the early 1980's, effective aggregate mortgage rates hit 10% (7% inflation premium + 3% real) and mortgages amounted to about 30% of GDP.  By the late-1990's, before the housing boom, the effective average mortgage rate was down to 7% (3% inflation premium + 4% real) and mortgages amounted to about 43% of GDP.

In the 1980s, until about 1989, homes were gaining about 7% in nominal value, annually.  But, prices topped out, and for the next decade, nominal home values were stagnant.  Aggregate owner-occupied home values were roughly equal in value to annual GDP during this period, coincidentally.

So, with regard to home owning households that aren't engaged in real estate transactions or active re-leveraging, in the 1980's, households were saving about 9% of GDP each year (7%*30% + 7%).  But, in the 1990's, households were only saving 1.3% of GDP (3%*43% + 0%).  in expected terms, in the 1980's households were saving 2% of GDP (7%*30%) and in the 1990's they were saving 1.3% (3%*43%).  In actual terms, 1980's households were saving 7% and 1990's were not saving anything beyond their principal payments.  (edit: sorry.  My original version double-counted by confusing expected returns with actual returns.)  This was a huge shift in household financial behavior.  And, it happened without any conscious change in savings behavior!

This passive shift in saving behavior should put upward or downward pressure on the level of mortgages.  I believe we can see the basic expected effects of this process in the historical data.  Compared to what we might expect, shifts in mortgage and equity levels are unusually high in the 1980s and 1990s because of tax changes and unusually low in the 2010s because of the liquidity crisis.

This passive saving issue should have a significant effect on monetary policy.  The inflation rate has little effect on lenders.  Their capital base will grow at the real interest rate regardless of inflation.  But, inflation does have a significant effect on homeowner behavior.  This is largely passive savings which households treat as deferred consumption.  As they pay down their mortgages, unless banks reallocate capital into new mortgages or other sectors, there would be a decline in bank credit outstanding.

Because owner-occupied home equity is tax advantaged, there is no tax arbitrage advantage for households to re-leverage.  And the additional equity has very little effect on consumption.  So, in real estate, there is probably a mitigating downward influence on aggregate demand when inflation rates are high.

The same concept can be applied to corporate debt

The inflation premium is a sort of pre-planned savings for corporate debt, too.  In fact, the inflation premium on corporate debt is like the debt equivalent of share buybacks.  In both cases, some portion of nominal earnings is used to repurchase some portion of the claim on future profits, and remaining shareholders have a higher ownership share in the firm's operations, which is manifest through unrealized capital gains.

There is a difference between corporate and real estate debt, though. Whereas owner-occupied real estate confers several tax advantages to the owner, whether ownership is weighted to debt or equity funding, corporations have a clear tax advantage to debt-based funding.  This is especially true in high inflation (high interest rate) contexts.  So, where households would tend to accumulate equity in a passive asset for deferred consumption, corporations would tend to re-leverage as the real level of debt decreases through inflation.

I think we can see this difference in the comparison between the late 1970's and the 2000's.  In both cases, real risk free interest rates were very low and risk premiums were high, which would tend to pull capital out of corporate equities, into real estate and corporate debt.  However, inflation premiums were high in the 1970's and low in the 2000's.  Because of the different effects of the inflation premium, outlined above, this would tend to pull capital into corporate debt in the 1970's.  But, in the 2000's the low inflation would keep corporate interest rates low, reducing the incentive for corporate debt, and leading to more capital being allocated to real estate (both equity and debt) and, to a lesser extent, corporate equity ownership.

Further, because the passive savings from the high inflation premium is so strong, I wonder if the low real rates of the late 1970's were, in large part, caused by the high inflation.  In the 2000's, I have assumed that the low real interest rates were a result of excess savings coming out of demographics and developing economies.  But, as I walk through this topic, I am starting to think that the low real interest rates of the 2000's were exacerbated by tax policies in housing that have pulled so much household capital into real estate and pushed down pre-tax required real rates of return in so much of the single family home market.  (Note how many articles there are complaining about low distribution of stock ownership among households, and how little emphasis is given to housing tax incentives as a cause.  And, how often is the solution redistribution through higher taxes on capital income and high compensation income?  I have posed this question before.  When these taxes induce even more household capital into the tax-preferred deferred consumption of home-ownership, what would be the effect on the breadth of stock ownership and the long term employment and productivity of middle income workers?  Of course, then we will see more articles about how high house prices and low industrial employment are squeezing the middle class.)

At the other end of the business cycle, the 1990's were economically strong - strong wage and capital income.  Low equity risk premiums, falling inflation, and high real interest rates were associated with stagnation in real estate capital levels and a boom in corporate capital, concentrated in equity.  This is just as we should expect.  Note from the graph above that dividend yields were low in both the 1960's and 1990's.  A lot of unnecessary gravitas is usually ascribed to corporate payout ratios.  But, looking at this through a risk-trading paradigm, in those periods, corporate equity would have been attracting capital, and most corporations would find themselves under-allocated to equity compared to the optimal level.  Lowering the payout ratio would be the most efficient way of approaching the optimal allocation.

PS:  There are a lot of ideas floating around here, so I apologize if this series is occasionally scattershot or repetitive.

PPS: I start to wonder if, at some point, some readers start to think something along the lines of, "Well, duh.  He's just talking about what Sanchez and McGillicuddy worked out in their seminal 1995 paper." Or worse, "Uh.  I thought Sanchez and McGillicuddy put an end to this sort of misinformed nonsense with their seminal 1995 paper."  Either way, when you think that, please give me a reading reference in the comments.


  1. Kevin,
    I'm still reading this report but I thought you would find page 18 interesting.

  2. P.S. I see now where Daniel Alpert was promoting a book written a few years earlier, stressing the need for fiscal measures to end austerity. Whereas I believe decentralized (and monetized) marketplaces for time use would solve the labor problem. Still the report was a good read.

    1. Thanks Becky. That was a great study on how complex being wrong can be. He got a nut of truth on slide 18, but the dozen other things he gets wrong keep him from going anywhere with it.

      Thanks for the link. An interesting perusal.

  3. At least his report was easy to read! After disagreeing with Minsky influenced arguments that the economy is inherently unstable, I tried to complete the book by Hyman Minsky, "Stabilizing an Unstable Economy". It turned out to be a much more difficult read than Piketty's "Capital". A lot of Minsky's thinking is flat out opposite of monetarist thought, so when he engaged in a handful of ideological arguments that actually made sense, I could scarcely figure out where they came from!

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