Monday, November 30, 2015

Housing, A Series: Part 91 - Blaming "financialization" for economic stagnation gets the causation wrong.

A category of academic work has developed around the idea that "financialization" - a bloating of the finance sector - leads to economic malaise.  I think this sort of idea is built on a misinterpretation that relates to the relationship between housing and low interest rates.

The problem is that home ownership is somewhat unique as a financial security.

Equities tend to have values that are highly variable because the cash flows are highly variable and uncertain.  Bonds tend to have certain cash flows, but changing discount rates.  This causes the face market values of individual bonds with fixed rates to change over the life of the security, but it doesn't systematically change the total amount of borrowing.  If businesses were borrowing $2 trillion when interest rates were 4%, they don't suddenly double their borrowing when rates drop to 2% or halve it when rates rise to 8%.

Homes differ in that home ownership is basically a perpetuity with stable cash flows.  Especially if we consider the aggregate housing stock as a diversified basket of real estate holdings, rents on that basket of holdings will rise roughly with the rate of inflation.  And, the housing stock itself is very stable.  Only a small change in the total real amount of housing outstanding can be effected in a given year.  A perpetuity that grows with inflation is very sensitive to changes in long term real interest rates.  So both the rent cash flows and the stock itself are very stable, and the valuation is very sensitive to changing long term real interest rates.  This means that the total market value of the housing stock is uniquely sensitive to changing long term real interest rates in a way that equities and bonds are not.
Let's imagine a context where the causal factor is some sort of increase in demand for deferred cash flows, or maybe a decline in growth expectations.  These sorts of changes would lead to a falling long term real interest rate.  These causal factors themselves would lead us to expect lower growth ahead.  And the related fall in long term real interest rates would also invariably lead to rising home values.  This is unavoidable.

A measure of aggregate Price/Rent: Source
The idea that home prices are dominated by demand factors as opposed to basic universal tendencies toward intrinsic value as defined by cash flows and discount rates is betrayed by both the experiences of the late 1970s and the present situation.

In the late 1970s, nominal interest rates were very high but real rates were low.  This gives us a window into the relative power of demand vs. supply in home values.  Demand was extremely constrained because households had to qualify for mortgages at double digit interest rates.  On the other hand, low real long term interest rates meant that homes should have higher intrinsic values relative to rent.  And, we see that the supply factor dominated.  The Price/Rent ratio rose sharply in the late 1970s as nominal interest rates soared.  This should be very surprising if you believe that demand dominates.

Home Mortgages, log scale: Source
Likewise, in the current context, rates are low, but mortgage availability has been sharply curtailed, such that total mortgages outstanding have not grown in a decade, and are well below any realistic stable trend.  Yet, because long term real interest rates are very low, Price/Rent has been climbing strongly again.

During periods of slowing growth, real estate values will naturally rise, and given our conventions regarding home ownership, mortgage levels are bound to follow.  But, this is a result of the broader phenomenon, not the cause.

In our current context, this problem is even more pronounced.  The constriction of housing supply in our highly productive cities has caused the cost of housing to rise.  Instead of earning returns on invested capital that increases the available housing stock in valuable locations, urban real estate owners earn capital gains due the economic rents they gain because there are limits to invested capital in housing.  This means that those added housing costs are simply a transfer to rentiers.  The costs reflect nothing of value.  They are a drag on economic progress and equity.

In our current context, I believe that these housing supply problems are the root cause of all of these problems - stagnating economic growth, low interest rates, income inequality.  And the manifestation of these problems is multiplied in home prices, because, not only are housing costs higher as a result of the supply constraint, but the transfer of incomes to real estate owners and the drag on economic growth both cause interest rates to fall, leading to home values that rise as a proportion of the already inflated rent levels.

The core solution is to remove the obstacles to housing expansion in the Closed Access cities.  But, until that happens, economic growth will necessarily translate into higher transfers to real estate owners.  Currently, our mistaken attempt at a solution, which is to dampen credit and nominal expansion, puts a lid on real economic expansion.  Real economic expansion in this context will naturally lead to excessive debt levels and very high real estate values.  We cannot have one without the other.

This is really a conjunction of Krugman's work on path dependent geographic advantage and the work of Douglass North, who recently passed.  Cities like New York City, San Francisco and Silicon Valley, Boston, Seattle, etc. have gathered very highly productive workers into networks built on innovation and reputation in industries like communications technology, bio-tech, and finance.  These networks happened to develop at a time where some combination of factors common in Anglosphere central cities have created severe obstacles to housing expansion.  So, at the same time that these cities provide significant opportunities for highly skilled workers, they also limit access through housing, so that the normal process of migration into centers of opportunity has been closed off.  Krugman's geographic advantages meets North, Wallis, and Weingast's "Limited Access Order".

Normally, limited access order societies are built around stagnant economic systems, where rentiers capture a large portion of a small and stable level of production.  What we have created is a limited access order built around highly innovative, growth oriented, super-achievers.  Instead of having limited access to cultivated land, we have created limited access to the most vibrant forces of innovation and growth ever created.  This urban limited access order creates two classes of rentiers - the classic class of landlords, pocketing the traditional rents on property, and the new class of high skilled laborers.

We see high capital income because of these landlords.  We see high variance of incomes within labor compensation because of these new labor-rentiers, who tap into these highly productive, highly innovative networks.

The housing supply problem is key to both of these issues.  Battling against the financial sector as if it is the cause of this problem is the opposite of what we need to do to solve it.  Now we especially need to support the financial sector, either as a second best solution where it at least supports new housing stock in Open Access cities, or as part of the optimal solution, which would be to support massive housing expansion where it can boost innovation, lower costs, and ultimately reduce these returns to rentiers.  We must support finance in order to shrink it.

The distinction between income to existing capital and income to new capital is key.  Preventing the development of new capital as a reaction to high capital incomes is, at once, rhetorically gratifying and pragmatically futile.

Housing can unify us.

I am hoping to be able to package my version of the housing story for a broader audience.  I think there are reasons for optimism here.  People like Matthew Yglesias share the opinion that housing supply is an important problem.  Today, Paul Krugman also has a blog post that expresses solidarity (HT:EV) on this issue.  It is always tempting to be divisive and partisan.  I think the challenge here will be to be radically empathetic, because I think there is a plurality of intelligent people that can recognize the problem if they don't see it as a challenge to their political identity.

I think that if we can solve this problem, we will find that many of the issues we all disagree about will diminish.  To the extent that these are significant issues, the housing supply problem is at the core of the problems of income inequality, high costs, and middle class stagnation.  The solution to this problem is a symbiosis of removing both our supply-side and our demand-side obstacles.  At the heart of the American competitive advantage is that all of the political factions in American politics have one hand on the ideal of liberalism.  Where we can remove political obstacles to progress and equity, all of those factions can view that change as a victory.  This can be a big tent.  It has to be a big tent if we are going to overcome the forces of inertia and economic misunderstanding.

Friday, November 27, 2015

Housing, A Series: Part 90 - What theoretical basis is there for this?

Reader Andy posted a link to this article in the comments.  It looks like it's part of a series at Bloomberg called "Bubble Watch".  It begins:
Earlier this month, the Boston Fed's Eric Rosengren wondered aloud in a speech to the Portsmouth, Rhode Island, chamber of commerce whether the swelling number of cranes dotting Boston's skyline should be a source of worry. In September, San Francisco's Fed President John Williams voiced similar concerns about U.S. "imbalances" in the form of high asset prices, "especially in real estate."

Some Fed members might be hesitant to drop the "B word" — bubble — but other market observers are being a bit more blunt.
Here are measures of both residential and non-residential private fixed investment.  What could they possibly be talking about?  Why aren't they saying the exact opposite of this?  And, keep in mind, this is Fed officials talking, but "market observers" think the Fed officials should be even more extreme in the position they are taking!  At any point in time before we were struck with this mania, the current level of construction would have been considered deeply depressed.  It's not even questionable.  It's not even close.  Construction is a disaster.

Maybe Boston and San Francisco are especially strong.  And, here I think we are getting to something.  Activity in Boston and San Francisco is near where it was during the boom.  If the boom is what we describe as a "bubble" then in those cities, it probably looks like a bubble.  But, in practically any other city in the country, that level of homebuilding would look like a deep, deep depression.  In this graph of housing permits per capita (San Francisco in blue, Boston in green, US in purple) we can see that going back to the start of the data series for the cities, at their peaks they don't even reach the recession low points for the rest of the country.

Why are these cities now closer to their peak levels than the rest of the country?  One reason is probably because we have hog-tied our single family mortgage markets.  The reason we see all those cranes is because the building we are seeing is multi-unit and commercial building.  Those projects utilize commercial credit sources.  Nobody is looking for predatory lenders there.  You could finance a reasonable property through commercial loans during the boom and you can still finance a reasonable property today with these loans.  That's great, for what it's worth, because that's mostly what we need - a lot of dense residential housing in the Closed Access cities.  The irony is, these officials and market observers that would halt this progress don't even need to worry about it, because these cities aren't capable of approving any more housing than this.  Annualized multi-unit housing permits hit about 400,000 by the end of 2013, and they won't be able to rise much above that.  In the 1970s, believe it or not, we briefly were building more than 1.2 million units in multi-unit structures per year.  Even in the 1980s, we hit 800,000.  We can't do that any more.

Source: Zillow
Because of the conceptual errors everyone made about the housing boom, we think credit led to building and high prices.  But, because these cities have had decades of depression level housing starts, high rents led to high prices, and creative lending was necessary to fund home buying in cities where tenants spend 30% or more of their income on rent.  If we step back and think about it, how can anybody look at this situation and do anything but cheer for more building?  How in the world could anybody look at cities where median rents has risen to 60%, or even 140% above the national median, with much smaller unit sizes, and say that a swelling number of cranes is a source of worry?  What are they afraid of?  These aren't self-dealing developers crafting a secret agenda to keep out new housing competition.  These are people who think they have the best interests of the country in mind, and literally the sight of progress makes them worried.  Fed officials are worried that we are building desperately needed housing stock, and the audience nods in knowing approval.

They seem to simultaneously hold two incompatible ideas.  First, that high prices are a problem, and second that building is a problem because it will lead to a collapse in prices.  In a market with extremely high rent, why do so many people assume that new development is due to irrational investment?  I think, possibly, these cities have been dysfunctional for so long that new supply never even comes close to meeting demand, so when building is strong, rents are still rising for lack of supply, and this coincides with strong earnings growth.  These trends are only correlated because supply is so severely constrained.

And, what is the conceptual model that predicts this process anyway?  Economists seem to nearly unanimously accept this correlation between economic expansion and irrational exuberance in housing markets.  What model predicts that?  (By the way, this hasn't described 80% of the country.)  But in the small portion of the country where home prices and rents have moved up strongly, what economic model says that (1) loose monetary policy will lead to nominal (but not real) increases in housing expenditures, and (2) that home buyers will irrationally bid prices above the fundamental values?  Austrian Business Cycle?  Does everyone believe in the Austrian Business Cycle model now?  Maybe instead of targeting the Fed Funds Rate, the Fed should just set prices for homes in each city.  Apparently they know when those prices are wrong.  Apparently just about all "market observers" know that they are wrong.

Imagine if we could build an extra 300,000 units in the Closed Access cities each year.  We could do that for years, probably indefinitely, without overbuilding.  As I noted in the previous housing post, in these constrained cities, housing demand is inelastic.  When rents rise, households spend more of their incomes on rents.  Closed Access cities only issued 2.8 permits for every 100 residents from 1995 to 2005 while Open Access cities issued 12.5 and the US in aggregate issued 6.6.  This coincided with a migration of about 1% of the US population from the Closed Access cities to the Open Access areas.  Yet total real estate values and rents paid rose in the Closed Access cities and decreased in the Open Access areas.  This new building could add nearly 1% to annual GDP through residential fixed investment.  But, interestingly, it would decrease nominal consumption.  More housing units in these cities will mean lower total rents paid.

If we actually built in these cities, the consequences would be the opposite of what the bubble watchers are worried about.  We would need to loosen the money supply just to keep nominal spending growth level.

This is a big reason why GDP growth has been stalled.  If we don't build homes in the Closed Access cities, owners capture large capital gains, but capital gains are not included in national income, and rents rise sharply, but it is all inflationary.  If we do build homes in the Closed Access areas, owners suffer capital losses, which are not included in national income, we are adding real investment, which boosts national income, and households can live in more real housing that is more than mitigated by rent deflation.

Since we can only build houses in Open Access areas, fixed investment counts toward investment spending, and there is an increase in real housing expenditures in those areas, but this is paired with high rent inflation in the Closed Access cities.  Building in the Closed Access cities would require less fixed investment for each added dollar of real value in the housing stock, because there is much higher inherent location value, and we would be making up for our past errors, with new real rent value added being countered by rent deflation.

Just factoring in the potential benefits of rent deflation, since the mid-1990s, rent inflation has cut about 4% off of real incomes.

But, firms in these cities also capture excess profits and workers capture excess wages because of the limits to competition created by the housing problem.  By reducing the limits to competition, we would also create real and deflationary growth, increased innovation, lower corporate profits, and less wage income inequality.  It would be hard to measure, but these effects might be stronger than the first order effects in the housing sector.

Because we misinterpreted what was happening during the housing boom, our economic policy makers associate new building in these cities with inflation.  But, it is the lack of building in those cities that creates inflation, because demand for structures butts up against the hard cap on potential supply, and something has to give.

This problem has to be solved at the local level.  We can't fix it with accommodative monetary policy.  But, we sure as heck aren't going to fix it by damaging real incomes until we have destroyed marginal demand for Closed Access city housing.  Because, the problem sure as heck isn't going to be fixed by tight monetary policy, and monetary policy has to become destructive enough to damage real incomes before it even looks like it is solving this problem.  That was our policy in 2007, whether we knew it or not. And, eventually, unfortunately, that policy worked.

Wednesday, November 25, 2015


Housing permits per capita aren't lower than the lowest points of the worst recessions since 1960 any more?  What?  Are you people crazy?! You think we can just keep building like this without paying for our greed and over-investment?  Someone needs to put a stop to this.  Close down the greedy banks!  Stop the treasury printing presses!  My goodness, you people are out of control.  You can't be trusted with money - that's for sure.

Tuesday, November 24, 2015

Housing, A Series: Part 89 - Low Interest Rates, the Housing Supply Constraint, and Picketty's Concern

Recently I speculated that the sharp fall in long term real interest rates since the crisis is a product of the housing bust.  After looking at the supply conditions of various cities, this issue now seems to me to be very clear - in fact, obvious.

Here is the supply and demand curve I looked at in the last post.  In a market that allows supply, we should expect demand expansion to feed real housing expansion with very little change in home prices.  Ironically, this is the basis for much of the commentary from people who have been leaders in identifying the housing market as a "bubble".  The idea that high home prices must be temporary because of this supply response is central to the "bubble" story.  This is not controversial.  And, in fact, this is what we see in the majority of the country where housing supply is not severely constricted.

In places where housing is constricted, new demand cannot induce supply through a price mechanism.  So, where housing is constricted, demand leads to rent inflation and asset price inflation.  And, this is what we see in cities where the issuance of new housing permits is low.

Now, let's think about the effect of housing supply conditions on capital markets.  In Houston and Atlanta and most of the non-coastal areas, increased incomes or falling real long term interest rates create real housing expansion.  This requires capital.  Existing homeowners don't experience any capital gains or increased rental cash flows.  But, new homes are very capital intensive.  In conditions where demand comes from easier credit terms or low interest rates, the average household increases their real housing consumption, so the new housing stock that is developed leads to higher rent payments in absolute dollars, because there are more, or better, homes.  But rents on the existing stock tend to go down.  Owning a home in this environment is like owning a floating rate bond.  When rates go down, your cash flows go down.  Since home prices are moderated by the cost of new building, the face value of existing homes remains stable while net rental income declines (adjusted for inflation).

This is what happened in most of the US.  This is how the world works in the model used by economists like Robert Shiller.  And, in these areas, there was no asset price bubble.

The natural outcome of these market forces is to channel capital into our most durable type of investment - housing.  This should naturally push interest rates higher.

But, what happens in housing constrained locations?  There is no use for new capital.  The effect of new demand, either because of the value of the location to potential tenants, or because of increasing incomes, easier credit, or lower long term real interest rates can only be to produce higher incomes to existing owners and to produce capital gains for the existing housing stock.

Any transaction of housing stock in this context is simply a transfer from one owner to another.  So, I'm not sure we need to even think through the complications of mortgage markets and credit creation.  At the end of the day, whether the ownership of a property contains a debt component or not, the level of capital has increased, and income to capital owners has increased.  This is the opposite of what happens in Open Access cities, and it seems to me that this could only lead to a decline in interest rates.  Capital owners would find themselves with a windfall of capital gains and income, and housing which would be a natural recipient of that capital would not be available.  Other potential investments on the margin would be bid to higher prices and lower yields.

This leads to an unstable equilibrium.  Lower yields mean that at given rents, home prices must rise, increasing the incomes and asset values of capital owners, pushing yields yet lower, etc.

This should be obvious.  Freedom of entry is the bedrock of a functional economy and an equitable society.  Where freedom of entry is impaired, income flows to capital owners who are protected from new entrants.

Here is a table of home values, by type of city, from 1995 to 2005.

These are broad estimates, using median home values from Zillow and population from the Census Bureau

The closed access cities represent about 15% of US population.  In 1995, they held 27% of housing stock, by market value.  By 2005, as a result of NOT building they had 39% of housing stock, by market value.  Open Access cities, which built 12% of the homes during that period, despite being home to only 6% of the population saw the total market value of their real estate remain level as a proportion of the total.  This is despite a net migration of approximately 1% of the US population out of the Closed Access cities into the Open Access cities, so that by 2005, they represented 14% and 7% of the US population.  This is what happens when we limit access to a good with inelastic demand.  Our Closed Access cities are the problem Thomas Picketty is writing about.  More and more capital is held by a select and protected class of owners, which leads to a sharp increase in capital/national income and a decrease in yields.  But this is happening because these cities are closed.  This is happening because these cities have eliminated the natural response of a capitalist system.

The solution to this problem isn't taxing landlords in California.  Their tenants have inelastic demand for that housing.  The tenants will be paying that tax.  Redistributive taxation will simply feed that unstable equilibrium.  The solution is in Houston and Dallas.  Free entry is the solution.  Dare I say, capitalism is the solution.  Our poorest households have already voted on this matter with their feet.

So, we might say that when low interest rates and credit expansion increased demand for housing, a country dominated by open access would have produced a natural counter-reaction which would have pushed interest rates back up.  Instead, the demand for housing in our most economically dynamic cities was strong enough that these closed access cities became dominant and pushed long term real interest rates down.

Housing imputed yield compared with real long term interest rates.
I have only been talking about the 1995-2005 period so far.  After 2005, the entire country has been a Closed Access country, with regard to new housing.  But, now the limited access is happening through credit markets, so rents are rising throughout the country, but home prices cannot respond.  This still has the effect of pushing down yields in other asset classes, like treasury bonds, but the implied net yield on homes is high.  So, since 2005, there is still an excess of capital that is searching for an investment outlet, and housing now can't be that outlet very well anywhere in the country.  So, home prices are out of equilibrium and owners aren't booking capital gains, but they are still earning higher rents, so we still have an economic context where we are funneling more income to asset owners.  It's just that the prices of one class of assets - houses - don't reflect those cash flows, so the market for selling homes is illiquid.

So, closed access policies in a few cities led to slightly lower long term real interest rates in the 2000s, and national closed access credit policies since 2006 have pushed long term real interest rates even lower.  A valid response to this is that those treasury rates are part of a global market where real long term rates have fallen even in countries without our housing credit problem.  I haven't dug deeply into that issue, but I think it is reasonable to believe a gap of something like $20 trillion in the market value of US real estate, including more than a trillion dollars worth of new homes which have not been built, relative to any reasonable historical trend, could lead to global yield responses.

We might say that low interest rates or lenient credit led to a housing boom which could have been expressed as an expansion of real housing stock, but instead, was expressed as an asset price bubble because of the prevalence of some cities in our economy with closed access housing policies.  But, I don't think that takes the issue to its logical resting point.

Given the prevalence of these closed access cities, and given the economic draw they have due to their geographically captured productive industries, the boom was inevitable.  The fundamental cause of this wasn't the decline in interest rates after the 2000 recession.  The cause was the prevalence of these closed access cities, itself, and the rising rents that this produced.  The housing supply problem created the declining long term real interest rates.  Keep in mind that the problem of closed access housing policies is widespread around the Anglosphere.  Our mortgage problem isn't global, but the closed access problem is - in Sydney, Vancouver, London, etc.

In the US, rent inflation began to rise in 1995.  But, in the late nineties, incomes were rising strongly, so rent remained affordable.  Incomes were rising faster than rents, even with the shortage of housing where we needed it.  And, capital was finding many avenues outside of housing in the tech boom.  In fact, I would argue that the finance and tech sectors share these closed access characteristics with housing, because these limits to access in these cities also limit access to the industries that utilize these highly valuable networks of skilled labor.  So, not only were landlords earning excess rents, but tech firms and finance firms were earning excess profits, and those highly skilled workers were earning excess wages.

But, the hard limit on population in these economic centers puts a cap on how long this can continue.  Eventually, gains will go to the bottleneck in supply, which is housing.  By the 2000s, rent in these cities continued to rise, but incomes moderated.  So, these tensions were building up in the 1990s, but rising incomes meant that ratios of rents and prices to incomes didn't begin to rise until the 2000s.

I submit that the relative costs created by the constraints on housing in the closed access cities had reached their limit by 2005.  Nationally, rent/income ratios topped out at the end of 2004.  If we had pursued monetary and regulatory policies that had allowed housing starts to remain strong, rents would have continued to moderate, and long term real yields would have bottomed out, and possibly risen on their own.  This could only happen naturally with the continued real expansion of the housing stock, even if that had to occur in suboptimal locations.  Instead, we choked off sources of mortgage credit and pushed up interest rates to above their natural levels, until the system of housing finance became dysfunctional and unable to fund a housing market at functional prices.

Instead of recognizing this clear disequilibrium and its relationship between low home prices, high rents, and low new housing starts, many people seem to want to explain this new context by claiming that the huge, outrageous, and now nearly decade-long drop in housing starts was a necessary counterbalance to that relatively minor and short-lived bump above the long-term average rate.

Ironically, what we need to do to reduce these transfers to capital is to bring in more capital.  Build homes.  From 2000 to 2010, population in the Closed Access cities rose 4%, compared to just under 10% for the rest of the country.  This caused their real estate to grow from 27% to 39% of the total US market value.  What if they had grown by 10% or 15%?  That is to say, what if they had increased their real housing stock by 10% or 15%?  Is there any doubt that by 2005, the total value of their housing stock would have been closer to 27% than 39% of the US total?  More capital inflows would lead to lower total capital values.  Is there any doubt that this would lower rents for workers?  Is there any doubt that this would draw in capital and pull up real interest rates?  Is there any doubt that this would lead to more equitable incomes, adjusted for cost?

One pattern that seems to be clear in international economic development is that labor compensation tends to rise as a proportion of national income when capital markets are fair, free to new entry, and stable.  So, we should see these same patterns among Closed Access and Open Access cities.  Closed Access cities should have lower labor compensation and higher capital income.

Matt Rognlie has shown how recent increases in capital income in the West are entirely accounted for by housing.  The intuitively difficult issue here is that, since housing demand is inelastic and housing supply is frequently also inelastic, this increase in rental income comes from declining real housing consumption, relative to other spending.

Fortunately, for my analysis here, the BEA does track incomes by metropolitan area, broken out by Earnings (wages and proprietor incomes); Dividends, Interest, and Rent; and Transfers.

Here are graphs of the proportion of each metropolitan area's income, by type, from 1969 to 2014.  I have included San Jose here as part of the Closed Access cities, which are in shades of red.  Open access cities are in shades of green.

Generally, in the Open Access cities, earnings claim a little more than 5% of total income than they do in the Closed Access cities.  This income generally goes to capital income in the closed access cities.  According to Zillow, median rents in the Closed Access cities have tended to claim from 5% to 15% more of median incomes in Closed Access cities than in Open Access cities, so this very likely represents higher net rental income.

There is no systematic difference between Closed Access and Open Access cities in the level of transfer income as a proportion of total income.  For all cities, we can see that while capital income has risen slightly over time, most of the decline in earnings, as a proportion of total income, has been paired with an increase over time in transfer payments.

If we look at changes in these measures over the entire length of the available data, we see that earnings have declined similarly across these cities.  In Closed Access cities, more of that income was claimed by capital.  In Open Access cities, more of that income was claimed by Transfers.

If we look at changes just over the period of time generally associated with the housing boom, trends look somewhat different.  During that period, earnings grew across cities, generally, as a proportion of total incomes.  Transfers declined slightly.  And, the most significant shift during this period was a sharp drop in capital income in Open Access cities.  Building homes is associated with rising wages relative to capital incomes.

I think there are several interesting things to consider here.  The trends in transfer payments seem to be another piece of evidence that our impression of political movements in the US right now is based on a backwards causation.  Maybe red state (Open Access) and blue state (Closed Access) political postures are a product of their contexts, not the cause of them.  The red states have seen rising transfer payments while costs remain low and low income households migrate in.  The blue states have seen stable increases in transfer payments, high costs, and out migration of low income households.  So, Open Access citizens see a functional economy where families moving in tend to rely more on public support, but Closed Access citizens see a dysfunctional economy where families that remain fail to keep ahead of their rising costs, but don't qualify for public support.

But, I think the most difficult factor to think about here is the changing capital income share during the 1995-2005 period, because the characteristics of housing turn our intuitions on their heads.  Why did capital income in the Open Access cities decline so much during the housing boom?  Because, they built a lot of houses.  Because they increased their real housing stock.  This reduced rent expenses.  In the Closed Access cities, capital income was stable during that period.  Why?  Because they didn't build many houses, and real estate owners captured a large amount of rental inflation as growing income.

The hard fact of the matter is that cost-adjusted incomes will rise in Closed Access cities when they start building housing units, and only when they start building housing units.  Until then, the Closed Access cities will have the income distribution of a less developed economy - high income inequality and high capital income.

I see a lot of commentary and man-on-the-street observations in these cities that amounts to, "I feel really strongly about the housing crisis, and I really support attempts to build more housing units.  So, as long as they don't block the views of the existing buildings, as long as they meet a range of demands from local activists, and as long as they build units in the range of rents that seems fair to me that include many units at below-market, I say, build away."  That is the Closed Access policy.  Builders in Phoenix don't have to set aside 30% of their units for below-market rents, and like some sort of perverse magic, market rents in Phoenix somehow are more affordable than below-market rents in San Francisco.

Housing, A Series: Part 88 - Supply, Demand, and Economic Migration

I want to continue on the topic of part 87, but before I do, I think it's worth a reminder, before we get too far down the road of talking about subprime loans and increasing housing demand, of several background issues on this topic.  Thinking through supply and demand dynamics is useful, but I don't want to give the impression that, on an aggregate scale, there is much evidence of demand-side excess of home building.  (Keep in mind, higher quantities demanded by home buyers means higher quantities supplied for home occupiers.  Even if these buyers and occupiers are frequently the same, this issue should not be confused.)

1) Real housing expenditures have been falling since the 1980's as a proportion of total spending, and only briefly moved back up slightly as a result of falling incomes after the crisis.  There was no trend of increased aggregate real housing consumption during the boom.

2) Between 1995 and 2008, year-over-year rent inflation was higher than core inflation every single month (minus one outlier).  Oversupply generally leads to falling prices relative to other goods.

BEA data, Survey of Consumer Finance, and author's calculations
3) Securitizations, in general, including public and private, were stable as a proportion of total mortgages throughout the period.  Until 2004, the decline in Ginnie Mae securitizations, which frequently have low down payments and higher interest rates, more than countered the gain in private subprime loans.  After that, there was a sharp rise in privately securitized mortgages, which was offset by a decline in GSE securitizations.  The prevalence of non-conventional mortgages has little relation to rising prices and none to homeownership rates, which topped out in 2004.

4) The average new homeowner during the boom had household income at least as high as existing homeowners.  There is no correlation between rising homeownership and lower homeowner incomes.

5) The rental values of the homes of average owner-occupiers were stable or declining during the boom, while housing costs for renters were rising over the same period.  This is not what we would expect to see if households were using easy credit to move upmarket.

In any event, demand-side factors were not at the center of the housing market for most of the boom, so what I am talking about here is how this secondary factor may have interacted with the supply issue.

I have been describing the country as having open access housing markets with a few closed access cities.  Here, I want to divide that with a little finer detail.

based on 20% dp, 30 year fixed rate, median income and home
First, we have the Old Economy cities.  These cities generally have low or negative population growth because they have lost their economic draw.  They have low rents and home prices.  There were many subprime loans made in some of these cities, but there is little competition for existing housing stock.  It is probably a bit unfair to put Chicago and Philadelphia in this category.  They both actually seemed to have housing market behavior that we would expect in an unconstrained market with low long term real interest rates - moderately rising home prices and real housing consumption (in terms of rent) without excess rent inflation.  Some of that growth may have been accommodated by relaxed lending.  Mortgage affordability as a proportion of income rose during the boom, but was still in the range of the early 1990s.

As I have pointed out in other posts, the sharp decline in mortgage expense in cities like these, along with sharp declines in housing starts in mid-2006 were already a signal of disequilibrium.

Next are the Open Access cities.  This is where the building happened.  Most of the other 62% of the country that lies outside these 20 largest metro areas has a profile similar to this - low cost, higher than average housing permits, and low price/income.  Phoenix prices rose sharply toward the end of the boom, which I think was related to California out-migration, and this may be attributable in some ways to generous credit markets.  Phoenix still belongs in this group because it has low cost and high growth potential, but actual growth temporarily outpaced potential growth.  Phoenix, along with the inland California cities, Las Vegas, and Florida is a candidate for home prices in the late boom that would be difficult to justify with expected cash flows.  In these limited cases, there is some evidence of positive demand from credit availability leading to prices above obvious fundamental values.

Next are what I am calling here the "Closing Access" cities.  The Florida cities and Riverside are a sort of wild card.  They tend to be characterized by very high population growth and low median household incomes.  They, like Phoenix, could have some price appreciation that was inflated somewhat by generous credit markets.  But the rest of the cities in this group are closed access cities in their infancy.  They have limited housing policies, which has pushed rents above the comfort zone, but for the most part, households have been able to counter that by reducing their real housing consumption - paying the same rent as they would in open access cities, but settling for a smaller or less convenient unit.

This combination of high rent inflation and household housing budget adjustments means that rent expense tends to be low in these cities, but home prices have been climbing.  I would identify this as a supply issue, because those high home prices are justified by expected future rent inflation.  And, low real long term interest rates would have an especially strong effect on home prices in these cities because the expected persistence of rent inflation means that the value of homes in these cities is more dependent on far-future growth rates in rents.  It also means they are more susceptible to sharp downturns because of changing growth rates, whether in rent inflation or in the expected income of future tenants.

Finally we have the Closed Access Cities.  These cities have housing supply problems that are so bad that future rent inflation will be facilitated by migration out of the city.  Despite having 15% of US population, and generally high incomes, these cities only accounted for 6% of housing unit permits from 1995 to 2005.

Before the bust, in Open Access and Old Economy cities, rent claimed around 25% of the typical household's income, and this translated into Price/Income ratios of around 3x-4x, which is roughly the high end of the long-term range of home prices where there is no expected unusual rent inflation.  Since the slight rise in home prices was a product of lower long term discount rates, not supply constraints, both rent affordability and mortgage affordability were low (with Phoenix as a brief exception).

In Closing Access cities, rent claimed around 25% of the typical household's income, and this translated into Price/Income ratios of around 5x-6x during the boom.  This is because future rent inflation of a given housing unit will claim a higher proportion of a given household's future income in a city with restricted housing expansion.  This is reflected in today's price, but not in today's rent.  Rent affordability was low, but since home prices were affected by both low discount rates and expected rent inflation, mortgage affordability was not low.

In Closed Access cities, rent claimed around 30-40% of income and Price/Income ratios were up to 11x.  Both rent affordability and mortgage affordability were high.  In these cities, rent affordability could not be mitigated by future reductions in real housing expenditures nor by rising rent as a portion of income.  So, in Closing Access cities, home prices reflect future rent inflation that will be imposed on the present occupants.  In the Closed Access cities, home prices reflect higher rents imposed on future occupants with higher incomes than the current occupants.  Without that migration, these price levels would be unsustainable.  Median mortgage payments on a conventional loan reached 55% to 70% of median incomes in the coastal California cities.  In 2005, aggregate national mortgage affordability was at about the same level that it had been in the late 1980s.  But this was divided between 3/4 of the country where mortgages were as affordable or more affordable than they had been in the late 1980s and 1/4 of the country where mortgage affordability was driven by these supply issues to be far outside any previous range.

I have shown how even though incomes in these cities have grown abnormally, most if not all of that growth has been claimed by rent.  The only way to avoid the ratcheting of higher rents without moving is to try to become an owner-occupier.  Imagine the cash flow demands of that position.  Of course these households were looking for creative financing.  The problem is that the unsustainability of their residency in these closed cities was already embedded in the price of homes, so the only choice was to either move away or use creative mortgage terms to pull down the cost of buying.  These prices were efficient.  A lot has been made of survey information where buyers expected home price appreciation of 10% or more.  This is just one of many oddities that came out of our mania regarding the housing boom.  Since when do we use surveys as a measure of price efficiency?  Do analysts issue a sell opinion on Apple Computer because they interview retail buyers and find that many of them buy Apple based on na├»ve brand affinity?  No.  They do a discounted cash flow analysis and compare their valuation to the market price.  If we do that with aggregate home values, across these cities we find that home values were justifiable with moderate rent inflation of about 1-2% above core inflation.  Can anybody claim that this is an unreasonable expectation for coastal California real estate?  Ten years past the peak, I'd say it looks too conservative.

If we look at this supply and demand chart for housing, we can see what sort of behavior we would predict in each market from a rightward shift in the demand curve, either due to falling real long term interest rates or due to more lenient lending terms.  These factors would allow a household to bid up the price of homes without increasing their cash outflows.  We should expect low real long term rates to be fully accounted for in the marginal price, because they would change the intrinsic value of the home broadly across the market.  Lenient lending terms would have a smaller and less ubiquitous affect on home prices because these create more risk, so the individual risk profiles of each household would create idiosyncratic demand reactions.

Previously, I have used this chart to think about housing consumption (rent).  Here, I have tweaked it to think about home buying.  On the x-axis, the proxy for quantity is the real rental value of the home.  The y-axis is the price of the home.  One thing to keep in mind when thinking through these scenarios is that rising housing consumption in real terms means that households are building new housing stock.  This does not affect existing home prices.  Only inflationary increases in rent affect home prices, both by increasing existing cash flows from rent and by increasing expected trends in future cash flows.

In an Open Access city, a small increase in home prices will trigger more supply, so in open access cities, a rightward shift in demand would lead to rising, non-inflationary rent/income, level mortgage affordability, and slightly rising prices.  This is what we see in those cities.  Note, elasticity of demand doesn't make much difference here.  It is the elasticity of supply that creates these general responses.

In "Closing Access" cities, real rents would rise more moderately, triggering some rent inflation, and home prices would rise more sharply, partly because of the increase in real rents shown on the graph, but additionally because of rent inflation.  Again, this is what we see.

In Closed Access cities, among existing tenants, rent would already be maximized, so a rightward shift in demand would not increase housing consumption, in terms of real rent.  In fact it couldn't, because supply is inelastic.  But, lower rates and lenient terms would feed the bidding war for existing housing.  So, in these cities, rents would rise moderately.  This would be inflationary, not real.  And prices would rise more acutely because households in these cities would be more willing to use lenient lending terms to remain in the city.  So, prices would rise due to both the effect of persistent rent inflation and due to the effect of lower mortgage payments increasing the potential purchase price of buyers.  Since supply is inelastic, in these cities, the demand shift will flow strongly into home prices.

This is exacerbated by the resulting migration.  High income workers with skills that can be leveraged in these cities have less elastic demand for housing in these cities than existing occupants, so as demand shifts rightward, existing occupants are out-bid for housing as these high income in-migrants become more able to afford homes at imputed rents above levels that the existing tenants can afford.  So, incomes in the city rise.  This would not cause rent/income levels to rise, but it would cause high rent inflation, leading to high home prices, leading to high mortgage costs for the existing occupants.

And, again, this is what we see in those cities: moderate increases in rent/income (no higher, really, than in any of the other types of cities during the boom years), but high rent inflation, and very high prices and mortgage/income ratios.  Here, the elasticity of demand also has little effect on real housing consumption.  The real housing stock is stagnant.  Demand can't raise real rents, so it causes rent inflation.*

So, yes, both low real long term interest rates (which are a market phenomenon, not a Federal Reserve phenomenon) and lenient lending terms can increase demand for home ownership.  But, the effect of that demand is completely dependent on supply.  Where there are no supply constraints, we see classic econ 101 - rents on the existing housing stock decline and real housing consumption increases.  Where there are supply constraints, rent inflation and prices rise.  If California and New York City had Texas housing policies, this period would have been characterized by broad-based economic improvement instead of economic stress.

Here we can see how rent inflation behaved in Open and Closed Access cities from 1995 to 2005.  (San Francisco has some idiosyncratic movement because of its exposure to the internet boom and bust, so that it has high average rent inflation for the entire period, but low inflation during the 2000s.)  This is the signature of strong demand in different supply contexts.  After 2005, demand has been limited by access to credit, not by equilibrium cash flows.  So, tenants are bidding up rents, which has led to similar rent inflation in all types of cities, since the hobbled mortgage market can't provide funding for a price response that would trigger real housing expansion.

The Open Access cities should have been our measure of demand.  There was no increase in mortgage costs in those cities (excepting Phoenix, briefly), but there has been a sharp decline in mortgage costs relative to income since 2006.  A demand bubble never led to unjustifiably high home prices (outside of possibly a few cities, briefly, that amount to a small portion of the aggregate), but a demand bust has led to unjustifiably low home prices since 2006.  We cannot solve the supply problem by creating liquidity crises.  The only way we can pull down home prices in Closed Access cities is to pull down real incomes.  That has been our implicit national policy since 2006.  I would like to try a new policy.

*Rent inflation is understated in these cities, because what little housing stock expansion there is gets valued as if its market value is its real value.  But, really, its market value is an inflated value.  If supply were allowed in these cities, we would expect to see sharp deflation in the rents on those new properties.  If supply were allowed in Dallas, we wouldn't expect sharp rent deflation because, well, supply is already allowed, and the rents there represent unconstrained value already.  This would be hard to measure for many reasons.  One reason is that actual costs in the Closed Access cities are inflated because where builders can manage to build, there are excess profits available, relative to raw building costs.  The gap is filled with costs created by city bureaucracies and by generous labor agreements, as we see in New York City where new building policies are bundled with demands from local craft unions.  This is one of many ways where the economic rents created by limiting the entry of new labor into the high wage competitive sectors in these cities gets transferred to workers in other sectors.  These are the types of rent extraction that are nominally sticky downward and tend to hasten a city's descent when competition reduces the profits of the industries that made the economic rents possible.  When Google starts shifting the core of its value-added operations to Austin, or when Computer Science grads from US colleges start moving to Seoul to begin their careers, shorting Case-Shiller San Francisco futures will probably be quite lucrative, because there is a long way to fall, and no clear ways to avoid the ensuing dislocations.

Monday, November 23, 2015

Automatic Destabilizers

Timothy Taylor has a typically reasonable and interesting post at Conversable Economist today about counter-cyclical federal budget policies - policies that create federal budget deficits during downturns and surpluses during expansions.

There are some issues that I would take with this framing by looking at this with Scott Sumner's monetary offset point of view and also with Arnold Kling's "patterns of sustainable specialization and trade".  First, it seems that many of the effects of deficit spending can be better achieved through monetary policy.  Second, to the extent that counter-cyclical policy is based on temporary spending increases, it seems like these may frequently be an impediment to the adjustments that will pull us into future expansion rather than an aid.

But, leaving all that aside, with regard to automatic stabilizers - ways in which the budget naturally goes into deficit during a downturn - I think there may be more here than meets the eye - or less, as it were.  Here is a graph posted by Taylor, showing automatic stabilizers on the revenue side:

The fall in national income leads to proportionately larger falls in federal revenues.

But, we need to keep in mind what happens in a typical downturn.  Equity holders earn profit by exposing themselves to cyclical fluctuations.  This means that when national income begins to fall, equity is the first victim - the canary in the coalmine, if you will.  So, corporate profits are a relatively small portion of national income, but they are a large portion of the variance in incomes as we move through the business cycle.  Here is a graph comparing corporate profits to labor compensation. (They are on different scales to show proportional changes, because labor compensation is a much larger portion of national income.)  A decline in corporate income, relative to labor compensation is a leading indicator of a coming contraction.

So, what we are really seeing in the automatic stabilizer of federal revenues is the excess volatility of corporate profits.  Corporate assets are forced by competitive pressures to target, via both operating and financial leverage, expected revenue levels.  When there is a shock to national spending, the disequilibrium created by the mismatch of this leverage with actual revenues pushes profits down sharply as a proportion of revenues.

Here is a graph of domestic corporate taxes as a proportion of national income.  Comparing this to Taylor's graph, we can see that most of the change in federal revenues is coming from changing corporate taxes.  This isn't really a stabilizer, because firms are still paying the same tax rates.  Taxes are simply falling with revenues.  The automatic stabilizer isn't measuring a decline in the federal tax burden on corporations.  It is simply measuring the outsized negative economic shock that corporations absorb because of nominal instability.

But, it's actually worse than that.  Here is a graph comparing the effective corporate tax rate (red) to the domestic corporate profit share of domestic income (green).  What we see is that the tax rate is actually highest when profits hit their cyclical lows, and then drops as the economy recovers.  I expect that much of this has to do with the non-deductibility of losses.  In the early part of the contraction, when profits are falling, some corporations take losses which lead to a drop in total corporate profits, but not a drop in total corporate taxes.  Tax rates rise.  Then, as recovery takes hold, corporations can start claiming tax deductions on those losses against their subsequent profits, so effective tax rates in the earliest part of the recovery are especially low.

The non-deductibility of corporate losses is pro-cyclical fiscal policy.  At the beginning of economic contractions, when the incentives for investment and the stability of corporate incomes are most important, our effective corporate tax rates are arranged to rise to cyclical peaks.  Then, after trends have recovered and the process of new expansion is in place, corporate tax rates are arranged to fall to cyclical lows.

We don't have automatic stabilizers.  We have automatic destabilizers.

Friday, November 20, 2015

Update of October 2015 Economic Indicators (Amended)

I've been more focused on the housing issue lately, so I haven't kept up with other economic updates.

Here are my inflation measures.  As we come up to an expected rise in the Fed Funds Rate, the pattern seems pretty stable.  Year-over-year "Core minus Shelter" inflation at about 1%, and Shelter inflation rising along with economic recovery, as production gets funneled to real estate owners.  We have decided that building more houses is out of the question, so we have to handicap national income as much as we are handicapping housing expansion in order to prevent that transfer.  The national debate is over whether to use monetary policy or fiscal policy to hold our heads underwater until the bubbles go away.  I guess the monetarists have won this round.

Since housing demand is inelastic when supply is constrained, especially in the short run, negative income shocks will probably drive non-shelter inflation down farther than shelter inflation, unless we decide to push it so far that we create another foreclosure crisis.  Last time, though, housing starts were strong on the national scale, so when the self flagellation began there was a shift in marginal housing supply downward and there were many middle income families with recently originated mortgages.  In 2006, households at first bid up the rents on the stagnating housing stock until the mortgage default wave hit and households couldn't even sustain payments for the housing stock we still had.  But, this time, there has been neither a housing expansion nor a mortgage expansion, so I don't see how we can trigger a foreclosure crisis this time.  Does that mean that at the point where monetary policy begins to shrink spending that "Core minus shelter" inflation will collapse while shelter inflation jumps?  Did shelter inflation finally fall in 2007 because of defaults or because households began to make long term budget adjustments?  Since tenant inflation remained high, I think defaults was the trigger.  Since rent expenditures are already high, signaling that households already have inelastic housing demand, it seems as though we might expect rent inflation to rise again.  If rent inflation ends up at 5% and "Core minus Shelter" inflation declines to 0%, how will the Fed react to that.  I would be going long on Eurodollar futures (betting on falling forward interest rates) like crazy if it looks like that will happen.  My only misgiving is that political positions are vulnerable to regime shifts, and if the Fed came to their senses and reversed course, long fixed income positions could take a quick, deep hit.  The risk of nominal contraction is probably already priced into forward rate contracts, which is why the yield curve is so much less steep than it usually is at this point in a recovery.

Here are some charts from the just released household credit report from the New York Fed.  Mortgages outstanding rose, which is encouraging.  I had hoped to see more momentum by now, though.  I'm not sure if this is enough to overcome any monetary headwinds.  This is annualized growth of about 7%, and appears to be coming largely from outside the commercial banks.

The other charts here highlight the severe repression of mortgage credit we have seen since 2007.  It is mindboggling that supposedly serious people are talking about credit bubbles and macroprudential risks in this context.

Other Agencies = GSE's
I would like to compare this originations graph to a graph of mortgages outstanding, by holder.  Note that there was a sharp decline in originations at the end of 2003, across FICO scores, but mainly at the top.  Notice how there was a sharp discontinuity at the end of 2003 among the GSE pools.  There was clearly a policy shift at the end of 2003 that sharply cut into access to conventional loans.  The discontinuity points to a policy shift, not a market trend.  This pushed potential borrowers into the private non-conventional mortgage market.  Note that there was a tremendous increase in mortgages held by private pools during this period, but there was no increase at all in originations for low FICO scores.  The rise in subprime loans after 2003 has absolutely nothing to do with an increase in mortgage originations among high risk borrowers.  As with all of these housing boom issues, this was a supply problem.  The GSE's pulled back on the supply of real estate credit.

I have half seriously suggested that the GSE's and the mortgage originators that feed them should be socialized.  If they basically just push papers based on bureaucratic rule sets and then securitize the loans, whose main risk is basically currency risk, of which the Federal government is the monopoly supplier, and if management of that currency will then involve lender-of-last-resort financing of those institutions, then the administration and the risk of the process might as well be public.  There is no value being added by the private sector.  But, here we can see how a fully privatized system would be better, because private markets don't usually lead to sharp, immediate, and arbitrary trend changes based on policy postures.  An ownership system based on nominal long term fixed mortgages probably isn't sustainable with a discretionary fiat currency, though.  Privatization would be more feasible in something like an NGDP targeting monetary regime, though.

One minor bright spot is that mortgage originations have been growing - but this growth is entirely among FICO scores above 780.  If your FICO score is less than that, you don't have to worry about predatory lenders tricking you into building a home.  You're welcome.

Note that this pattern does not apply to auto loans.  I occasionally hear of fears about the auto loan market, too.  Maybe we will eventually decide that transportation is as gluttonous as shelter and we will limit this to FICO scores above 780, too.  One asset class at a time, though, folks.

On the employment front, I also think there are early signs of slowing growth.  Flows into and out of unemployment continue to have good trends.  But, flows between employment and "not in the labor force" now have flattened for several months, and the net flow out of the labor force has widened.  This suggests that opportunistic marginal labor transitions have stopped expanding.  Similar trend shifts happened in early 2001 and early 2007.

Looking at unemployment durations, it looks like improvements at the long end of durations have also leveled off.

This looks to me like exactly the sort of place in an extended recovery where the difference between a stingy monetary policy and an accommodative policy can make a big difference.  If the yield curve flattens when the Fed Funds Rate rises, look out below.

On the positive side, unemployment insurance still has a good trend, even though it is already at low levels.

Added: Hm.  I am more optimistic after seeing the weekly H.8 report on bank assets.  I guess I missed this last week.  This is quite a pop in closed end real estate loans.  I have been watching for this to happen for several months.  With the recent strength in other measures of mortgage growth, if we see a continuation of a new higher trend here, this could be good.  I think this is the single most important factor to watch with regard to economic growth in the near term.