Wednesday, April 22, 2015

Housing Tax Policy, A Series: Part 27 - Free the Housing Market! (Updated)

I have been looking at my Treasury/Housing trade, and in the process uncovered some more data that informs my ongoing discussion of housing.

Here's a graph of new home sales and home prices over time.  Note in this graph how home prices tend to lag home sales.  This supports my general thesis that home prices are sticky, and that much of the speculative activity in the 2000s boom revolved around that.  On my housing position, I had originally expected to be able to value homebuilders, in part, as land speculators.  But, their business and their valuations seem to be much more closely tied to sales volume than price.  I think this is partly because of this price stickiness issue.  The outlet valve for housing when the equilibrium price is moving sharply is the new home builders.  Possibly the laggardly price reaction leads marginal renting households to move to homeownership.  The quantity response moves through the homebuilders.  Then, when the price needs to move down, new home sales plunge and inventories grow.  (I view homes as a sort of long term security.  Rents rise and fall as a function of supply and demand.  But, home prices can move independently of supply and demand, because of the changing discounted value of future expected rents.  I believe that explains most of the price increases we have seen in the past 15 years.)

Edit: This also works well with this description of the business cycle, where I speculated about the inability of the yield curve to remain an unbiased predictor of future rate changes when the yield curve needs to invert.  My hypothesis is that when long term real rates are falling, intrinsic values of homes will rise, because rent and expected rent will be more stable than the fluctuations in long term interest rates that would be causing home values to rise.  So, liquidity is necessary for long term securities to find equilibrium rates.  If a lack of liquidity is a cause for the correction, this mechanism fails.  And, what we see in three of the recessions in the above graph is the quantity of new housing collapsing while the peak in home prices lags.  That makes sense in the context of this business cycle hypothesis.  The lack of liquidity means that there is no nominal demand for new supply.  But, because long term real rates are lower, the prices of the existing stock of homes would still compare favorably to other long term securities.  The level where the yield curve stops inverting would be where there is a balance between the market rate of long term bonds and the availability of liquidity to push home prices up to the non-arb price level.  In this cycle, things got so out of whack that even with short term rates near zero and an upward sloping yield curve, there is still a lack of capital able to push real estate prices up to a level of equilibrium returns relative to treasuries.

We can also see the inevitability of the recession that came out of public misperceptions of housing.  Home sales began plummeting all the way back in early 2006.  Extremely recessionary signals were very clear by then.  But, there was such a misplaced consensus that housing was in the midst of a speculative fervor and that speculators needed to learn that sometimes home prices can decline.  Since home buyers and banks weren't actually being irresponsible, a highly unusual decline of 5% or even 10% in nominal home values didn't lead to much upheaval.  We had to push home prices down by more than 25% to make our point.  The Federal Reserve's estimate of household real estate market values had never declined in value, going back to WW II more than momentarily.  But, we managed to create a 25% drop.  That'll learn 'em!

This is one of the sleights of hand that creates a misperception of the crisis.  Everyone is convinced that the housing boom was created because speculators were convinced that home prices can never fall.  Then, the conventional wisdom says, housing prices did fall, and all of those speculators were proved wrong, and wise people like us were proved right.  But this is deceptive.  That conventional wisdom would have been proven right if home prices had dipped 5% and there would have followed a banking crisis.  But that isn't what happened.  What happened was that banking and housing markets were continuing to muddle along until there was a widespread collapse that included, among other things,  a full 25% drop in home prices.  We do not now, and will not ever - nor should we - have a housing market or a banking industry that perpetually prepares for a 25% downturn in home prices.  Now, you might argue that the huge drop in home values was somehow a product of the housing upheaval itself.  But, now we are in the realm of question begging.  This is a different, much weaker, argument, and must admit to the large influence of tight monetary policies, arguably as far back as 2006, but undeniably as late as 2008.

I get the sense that there is a plurality agreement to the view that the outcome we had was preferable to an outcome where home prices never collapsed, because we needed to learn a lesson.  The fact that this view is so widely held that its proponents can push it without a thorough review of the mitigating evidence does not make it any less destructive or odious.

Every post WWII recession, except for the year 2000 was associated with a brief pause in the growth of real household real estate values, give or take a couple of percentage points.  We had achieved that by the end of 2006.  By the time Bear Stearns had to recapitalize some hedge funds that were exposed to the subprime mortgage market in June 2007, we were well into unprecedented territory.  I have gone over the timeline after that here, here, and here, and of course, there was the Sept. 2008 FOMC meeting after the Lehman failure.

One issue I have noted is that rents were rising through the 2000s, which is strange if sticky prices were pulling more homes onto the market.  But, I think most of what was happening was a transfer of households from renting to owning and from living in multi-unit homes to single unit homes.  As we can see in this graph, multi-unit building was very low during the boom.  So, in total housing supply was still stifled.  I wonder if this is related to the problems of restricted building in the high cost of living cities that tend to have rent controls, zoning regulations, and anti-development sensibilities.  Possibly this graph is sort of showing us two Americas:  The coastal cities which are dominated by multi-unit housing, and where we aren't building much any more, even though there is a huge housing shortfall, and the remaining areas where we lounge in our spacious "McMansions".  Rents are rising much faster in the large cities.  We can see in the graph that the building levels in the 2000s weren't particularly high (especially considering that population has grown over time), but the building was highly concentrated in single family homes.  Even now, when housing has been stifled for so long, vacancies are low, and rents are rising, multi-unit housing starts are not particularly strong.

And, compare the home sales graph above to this graph on housing starts.  In addition to the permanent stagnation of muti-unit housing, we can see that single-unit housing has become increasingly institutionalized.  In this graph, even just looking at single-unit housing starts, they were not high compared to previous recovery periods, especially when we factor in the larger population base.  But, home sales were much higher than they had been in previous periods.  Housing starts includes homes built by or for individuals and homes built for rent.  So, I think part of what we are seeing here is the institutionalization of home building where homebuilding corporations handle the increasingly difficult regulatory burdens of housing development.

So, the first graph above reflects at least four factors:

(1) increasing quantities of new single unit homes because of price stickiness in the face of interest rate related price increases.

(2) increasing homeownership among households because of that price stickiness (and probably because of public policies initiated in the 1990s to increase ownership).

(3) regulatory limits to multi-unit housing in high cost cities.

(4) regulatory obstacles that tend to favor tract housing.

Mass misunderstanding of these issues led to a public consensus that demanded a nasty and unnecessary recession, the roots of which go back to 2006.  If we really want to solve the housing problem, we need to reduce regulatory obstacles to building, increase access to mortgages or other methods of home ownership, and stop second-guessing prices.  There has been much ink spilled about the savings glut.  Housing can soak up a lot of capital, but it can't do that if we don't allow for it to be developed.  Ironically, we need a more pro-housing public policy to solve the savings glut problem.  (Not a pro-homeowner policy.  We need to get rid of pro-owner tax subsidies.  As I have said, we need to make it easier for most households to build or own a house, and we should want marginal households to be indifferent to doing just that.)

If we allowed more building, rents would fall.  This should be uncontroversial.  And, rent inflation has been high for some time.  This would have a slight downward effect on home prices.  But, it will only come with housing expansion, mortgage expansion, and probably, initially, significant price increases.  But, I think this might lead to a secondary effect, which could be more controversial, conceptually.  And that is that all that extra housing will serve as a vehicle for capturing the global glut of savings.  This will allow interest rates to revert back toward long term norms, and, ironically, it will lower home prices, because much of the rise in home prices has been related to low long term interest rates.

Our problem wasn't that we had a housing bubble.  Our problem was that housing can serve as a highly useful supply of investment that global savers and baby boomers are desperate for; a combination of market frictions and regulatory burdens have prevented its full development.  Since housing couldn't completely meet this demand through quantity, it met it, in part, through price.  If we allowed this market to function more freely, we would all benefit.  Housing consumers would have much lower rents, and global savers would have higher real interest rates on low risk investments.  Both of these things - low rents and high interest rates - would lower home prices.

Since we collectively got all of this wrong in the 2000s, and continue to get it wrong, home prices soared in the 2000s, and they will continue to rise in the current recovery.  It looks to me like there is a consensus to throttle the recovery again, instead of facilitating the growth of the real housing stock.  That is very unfortunate.

PS. As I post this, I see that David Henderson has shared some comments from Ben Bernanke and others that relate to this issue.


  1. Great blogging as usual, Kevin. I especially like your point about the belief that greedy traders need to learn their lesson, when the reality is that no real estate finance system could or should be set up to tolerate a 30% drop in aggregate real estate value. This was a case of a small surprise plus tight money setting up a major crisis.

    I'm all for working on improving the supply side here (the barriers to construction that you refer to), though I still think the highest priority should be to fix monetary policy (i.e. NGDPLT) which would have protected the larger economy from the financial crisis, and possibly (again, to your point) have averted the financial crisis altogether.



    Kenneth Duda
    Menlo Park, CA

    1. Thanks, Ken. You are absolutely correct. On the other hand, these things are inter-related. If tax subsidies add 10% to home values, rent inflation adds 10%, expected rent inflation adds 10%, and low interest rates due to a lack of real estate investment opportunities adds 10%, you basically get back to 1990s home prices. Eventually, I should be able to take a stab at an unregulated, fully taxed estimated home price index.

      So, we have all of this public policy that pushes home prices up. It pushes them up because prices tend to be pretty efficient within their given framework. Then everyone freaks out about how high they are, as if the price is completely inefficient and investors are just bidding things up, willy nilly. You can model these things out and justify the reason behind the price movements. But, the typical person isn't the marginal investor. The average person might think, "When I could qualify for a mortgage, I went out and bought a home, because obviously that's what you do. There are benefits to owning a home that just don't have anything to do with the numbers." Even financial planners think that. But, they only think that because they have never been the marginal buyer. On the margin, the price relates to the cost of alternatives (or at least it did before 2007). So, people just have an almost complete lack of belief in the rationale behind movements in home prices. They just fall back on their absolutely worthless intuition about nominal prices. It's a classic case of how political beliefs carry no accountability. Even when the belief leads directly to disastrous policy, nobody has to claim responsibility for being wrong. If you don't attribute any informational value to market prices, by what measure would you accept that your preferred policies were detrimental? Ironically, it's in our political lives that we are deeply in need of a lesson, but politics offers no means for learning it.

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