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.


  1. Excellent blogging.

    And maybe you hit upon something.

    Why are federal central bankers so concerned about cranes, when the problem is under supply?

    Answer: the banking industry has extended an enormous amount of loans on property at existing property values. New construction would tend to lower property values by lessening scarcity.

    Good for people and the economy, bad for banks with loans outstanding on property.

    This actually happened in downtown Los Angeles office markets back in the 1980s. There was an epic building boom, oversupply, and buildings where returned to lenders.

    Downtown L.A. commercial office rents have been wonderful ever since--- no inflation since the 1980s.

    Therefore, at least one part of the popular misconception about central bankers is true. Central bankers first think about the banking industry, and then about the larger economy

    1. I would expect to agree, but I think their apathy about home prices nationwide dropping by 1% per month in late 2007 and 2008, and the decade-long stagnation in mortgages outstanding suggest that, if they are secretly protecting bankers, they are doing a terrible job of it.

      Actually, I don't think your scenario is that bad for banks. In the early 1990s, home prices dropped by around 25% in real terms over a period of years, but since inflation was around 4%, nominal home prices were relatively stable, so there wasn't a nominal crisis in home values.

      I think you have struck closer to the truth where you show how overly concerned they are about inflation.

  2. Yes, mild inflation protects both property lenders and borrowers. But the Fed cannot tolerate inflation.

    The FOMC's monomania with inflation was in effect in 2008; reading FOMC minutes is too see the "inflation" hundreds of times on the cusp of the Great Depression.

    Still, regulatory bodies are often captured by the industries that they purport to regulate.

    A Fed official viewing a property construction boom may indeed first worry that lenders will get hurt---not that consumers and the broader society will benefit.

    How else to explain Eric Rosengren's comments?

    Did Rosengren say, "This is great! A building boom! That will help lower property costs!"

    I don't think Rosengren is particularly worried about developers. Nor consumers. That leaves the banks. His constituency, after all.

  3. I think you're onto something regarding the broken mortgage market.

    This may be able to explain the noticeable lack of construction of SFR's in Southern California:

    1. Thanks. Interesting article. Of course, I think a mistake they make is seeing the mortgage market in the 2000s as the aberration instead of seeing the current market as the aberration, which is sort of the problem.

      The credit crisis means that the obstacle to homebuyers isn't really price. It's access to any reasonable mortgage. So, I suspect that the builders don't see much advantage to competing on price. I think equilibrium home prices at today's interest rates should be 30% or more higher than they are. There must be some emergent set of regulators that are keeping new home expansion down until prices reach their natural level. Land owners will have better alternatives until buyers can bid up housing to compete as the best value. Interestingly, even though Price/Rent remains fairly low compared to the peak, it still looks to me like new building, at least in the Phoenix area, is still happening with large homes on very small lots. No back yards. I would expect this to happen if prices were back up where they should be, but it is strange that this seems to be happening even though prices seem low for those who are able to get mortgage funding.