Friday, January 22, 2016

Housing, A Series: Part 106 - Busts are Bad

One running theme in commentary about the recession is that recessions after financial bubbles are more severe with slower recoveries than recessions with other causes.  One reason is surely because home equity is an important source of capital for new business formation, and households lack access to that capital either because of reduced property values or strained banks.

Now, it seems to me that this is a good reason to especially try to avoid the hard landing of a bust.  But, there seems to be a notion that the arrival of the bust is a necessary preventative.  Bubbles will be even worse if we make them less painful.

But, this doesn't really make any sense, if you think about it.  The bust is the problem.  Let's say we created an economic context with less downside risk.  What if that caused asset prices to reach a higher plateau, because of the way we managed the risk of supposedly overpriced assets?  Would that be a problem?  To the contrary, that is the definition of a developed economy! If I ask you how to tell a developed, fruitful economy apart from an undeveloped, poor economy, by describing their asset markets, your answer would be something like, "The one with less volatility and higher prices, relative to expected earnings, is the developed economy."

Exuberance and high growth expectations will manifest themselves in an equity boom, like the internet boom of the 1990s.  The bust that followed that wasn't so painful, because the pain was mostly felt within equity markets, which are expected to take cyclical downside.  And the exuberance led to investments in tech. infrastructure and creative destruction.

But, financial expansion usually comes through safer assets like bonds, mortgages, and houses.  Growth in these areas is related to low real interest rates.  Low real interest rates is a signal of broad risk aversion, not exuberance.

One response to the plea to avoid a bust is that we will just be creating a larger bubble and, thus, a delayed and larger bust.  But, high home prices and low real interest rates are not a signal of cyclical complacency.  These are low risk, real assets.  Preference for these types of assets is a product of risk aversion.

Here is a graph comparing Home Price/Net Rent to Aswath Damodaran's estimate of the Equity Risk Premium.*  Home prices tend to be high when there is high risk aversion.  Relative home prices were high in the late 1970s when equity prices were low.  Home prices peaked again in the late 1980s, and real home prices fell quite sharply until the late 1990s.  This coincided with a period of low risk aversion and high real long term interest rates.  But, those high long term real interest rates were an emergent phenomenon.  They were a product of low risk aversion.  They weren't a product of a forced increase of short term interest rates.  That wouldn't be an effective way of creating persistently high long term real interest rates, anyway, as we have seen since 2006.

So, in the 1990s, we succeeded at moderating home prices, and we did it by allowing the broader economy to thrive, not by collapsing the broader economy.

So, the idea that nominal support would worsen the bubble is wrong.  If macroeconomic and monetary support had reduced the likelihood of a bust, home prices would have fallen, relative to rents and to other assets.  You pop a housing bubble by growing, not by inducing instability.

Looking at this graph, we have created an incongruity where risk premiums are still high, but home Price/Rent ratios have fallen.  This incongruity has broken the housing supply market.  So, now rents are climbing and those who can establish a position of real estate ownership can accrue the sorts of high rates of income that should be associated with periods of low risk aversion.

The housing "bubble" should have been "popped" by (1) allowing competing supply to enter into valuable housing markets, reducing rents, and (2) supporting a healthy and safe economy so that assets with low cyclical cash flow risks weren't so prized.  The combination of these factors would have had such a moderating influence on real estate values in the costliest cities that a relatively high inflation rate would have been necessary just to mitigate the nominal losses of real estate owners.  But, instead, we did the opposite of this.  We tried to bring the price of real estate down by blunt force.

In the end, we actually did commit the sin that the bubble worriers were concerned about, but in the opposite direction.  Instead of supporting a bubble that would have supposedly led to misallocation of resources to unneeded housing supply which would have eventually led to a collapse in rents and a related price collapse, we imposed a bust, which led to non-allocation of resources (and a clamoring for treasuries) that has led to a significant increase in rents.  Now, home prices remain in check because we continue to enforce an incongruity that prevents capital inflows into housing, so we have sharply rising rents, which call for new supply, but we have removed those avenues of supply.  Instead of supporting an unsustainable bubble that would have led, inevitably, to an even larger bust, we have supported an unsustainable bust that will lead to an even larger "bubble".

Note that the bust we imposed doesn't even fit the bubble narrative.  Bubble worriers claimed that high prices (low implied yields) would lead to oversupply, which would drop rent cash flows, and subsequent home prices would have to fall as a result.  But, if we thought that there was some lag preventing lower rents from pulling down home prices, we should have implemented policies that reduced that lag and brought down rents sooner.  Instead, we imposed policies that have created high yields to housing, that only made rent cash flows go higher.  Even if the 2005 housing market could be characterized as a bubble, the bust which has led so many observers to take a victory lap looks nothing like the bust that they supposed would solve the problem.

A cure for the boom needn't have had any significant side effects, but the bubble poppers cheer the imposition of side effects without bothering to create a cure.  They think the side effects are the cure.

Consider the possibility that, not only were the concerns of the bubble worriers misplaced, but that there wasn't much of a demand-side bubble at all.  Think of the series of costs we have imposed on American households.
  • We have limited entry into our most productive industries, so that many families had to move into very expensive cities in order to tap into high income careers.
  • In order to hedge against the rising rents in those cities, those families had to pay very high prices, relative to their incomes, in order to insure stable future housing with homeownership.
  • Then, we suffocated credit markets and the nominal economy until the values of those homes collapsed, creating an illiquid market for them - trapping them in their homes and leaving some of them with significant capital losses.
  • Then, we pushed against nominal growth so hard that many of those families faced unemployment.
  • Now, they couldn't sell their homes to move to new job opportunities, because their home values had collapsed, and they couldn't tap home equity in order to muddle through hard times, because the mortgage credit market had collapsed.
  • When they eventually lost their houses, they had to move into new homes with high and rising rents.
  • And, now, after all of this, because of inflation that is only even moderately high because of the ever-increasing rents we have saddled them with, the Federal Reserve is trying to slow down nominal economic growth as if their rent is rising because they have too much money.
One starts to wonder if the only reason we haven't suffered a plague of locusts is because we lack the technical ability to create it.

 * I think net rent is the proper measure to use here, because it is the relevant relative measure to returns from other asset classes.  But, Price/Gross rent should give a similar signal, and as we can see in this graph, it does not present a relationship that is as strong.  The difference is that Price/Gross Rent wasn't so high in the late 1970s.  It looks like this is because the BEA's measure of consumption of capital was high in the late 1970s.  That caused my measure of net rent (which is net of consumption of capital) to be low, and the lower value of the denominator makes my measure of Price/Net Rent higher.  I'm not sure why the measure of consumption of capital is the difference that causes the net rent measure to confirm my thesis better.  So, there could be something I am not accounting for here.


  1. Excellent post. Another sign the bubble-istas were clueless is this. The mantra is 2007 was practically 100% that the bubble would pop when interest rates ROSE due to all the high LTV ARM loans. As we know, "interest rates" did not rise in 2008 or any time since. (I use the scare quotes because those words are so nebulous as to be close to meaningless)

  2. Interest rates rose or people feared they would rise when the ARM's were adjusted. They knew what was coming.

    I have a question, Kevin that I posted on another blog:

    “The Nikkei got a boost after an aide to Prime Minister Shinzo Abe said Thursday that “conditions for additional easing have fallen into place,” according to The Wall Street Journal. The Bank of Japan will meet on Jan. 28-29, and some expect the central bank’s asset-purchasing program could be increased.”

    It is legal for the BOJ to purchase non financial assets like REITS. It is an experiment worth looking at, however, it is illegal for the Fed to do the same. However, the Fed has decided to fund the highway bill, at the request of congress.

    The BOJ buys long bonds which is a dead market. Wonder how banks make money lending if mortgages are tied to bond yields?

    Maybe central banks should just stop buying bonds and just by assets or just fund projects.

    Oh, by the way, the big banks did a form of NGDP targeting in rich neighborhoods. They permitted those that defaulted to live there free, so the prices would not crash in those neighborhoods. So, even in crash cities like Reno and Las Vegas, there were people living over 5 years in houses where the mortgage was not being paid.

    Of course, the average Joe was not afforded such a break. The banks didn’t care that the prices dropped in his neighborhood because they had big clients ready with credit lines to go in and pay cash at rock bottom prices on thousands of homes. So, they got the houses they wanted back through foreclosure and credit to their wealthy clients.
    So, the question is, based on what the big banks did in the above statement, can NGDP targeting possibly be fair?

    Now, I realize that this isn't quite the same as NGDP, but it is a little like it. By not evicting the people, the banks appeared to keep the money supply stable because the prices remained stable.

    1. Sorry, Gary. I don't have time to respond to you any more. As I said before, if your point of view is correct, I will probably be the last person on earth to realize it. That's a risk I'm willing to take. In the meantime, I don't see any point in engaging with you. I generally have maintained a policy against censorship, so I am leaving your comments up, but you should generally not expect replies from me. And, I would prefer if others let it go, too. I welcome criticism. That is the value of the comments for me. But, unless it is criticism on the margin, coming from a point of view that understands or accepts the subtle truths of price theory, there really is no point in commenting here.

  3. Sorry, no criticism from me. I think this post, and the finale about locusts, is right on.

    We have met the enemy, and he is us.

  4. Whatever, Kevin. Lots of friendly MMers around. Just you and Scott are the exceptions. Perhaps you think that gets your story out, but ultimately it doesn't. And besides, the banksters will game NGDP even if it makes perfect sense. And I believe it does as a tool for observation. Whether it makes sense as a tool for implementation with all the dishonest banksters in the world is another matter. I wish you well.

  5. Kevin:

    Below is a comment, by George Selgin (who I like), on my post on Zombie Economics at Historinhas.

    Alack and alas, even George Selgin thinks there was a housing overbuilding boom etc.

    "Benjamin, this is not a fair post, for all kinds of reasons, but mainly because many of the criticisms you offer are quite unrelated to the claims actually made in Thornton’s paper.

    For example, when Thornton claims that QE may have resulted in some unsustainable asset price developments, you observe that there were booms and busts before QE–as if Thornton’s statement amounted to a denial of that fact!

    When addressing Thornton claims that QE has unduly influenced the behavior of commodity prices, you criticize, not what he actually says, but what you “think he wants to say.”

    You assume that the fact that corporate profits have been “soaring” somehow contradicts Thornton’s concerns about equity prices being excessively high. (Certainly it is now evident that such profits are no guarantee against a major correction.)

    You treat the fact that housing starts are still below their level during the last boom as clear proof that Thornton is crazy to imagine that QE has provided excessive stimulus to the housing industry–as if forgetting about all the overbuilding that the last boom entailed.

    But most of all, you are too intent on attacking “right wing inflation hawks,” and so, instead of addressing Thornton’s actual arguments about the origins and consequences of QE, you make him stand-in for your favorite bĂȘte noire, and then criticize the bĂȘte noire."

    1. I think very highly of George's work. I have had a couple of exchanges with him, in which I think he probably considered me a bit batty. He is one person whose reaction to my work, if I can get it in front of him in a complete form, I will be interested to see.

  6. Kevin:
    Well, I have to answer Selgin, and I will defer to your work, and he will likely see my answer. I plan another blog post with his name in title, so....
    Like you, I think Selgin is an interesting thinker and, in my experience, a nice guy...

    The ubiquity of property zoning makes your arguments powerful. The fact that zoning is local has obscured their national economic ramifications....

    1. Thanks, Ben. I'm working on getting this into an organized form of publication so people like George might see the whole complex hypothesis in one piece. I think there are a lot of clear thinkers like him who will approach it with enough skepticism to keep them from spending an afternoon digging through some blog figuring it out, but presented with the full thesis, might begin to consider the point of view.