Tuesday, June 6, 2017

Housing: Part 234 - Liquidity is a Public Good

Reader Chuck Erickson pointed me to this article, which I had missed.  The article engages in the sort of framing that baffles me regarding the housing market.  I think, at the heart of this problem, is a public confusion about the difference between owning a home and utilizing the services of a home (consuming housing services, or making housing expenditures).

I think this confusion comes, in part, from the fact that homeowners do not make regular rental payments to themselves, but all homeowners have expenses for maintenance and upkeep, and many owners make monthly mortgage payments.  The only difference between owner-occupiers and renters is the fact that there is no cash rent payment.  Both owner-occupiers and landlords have upkeep and financing expenses.  But, these represent a fairly complex set of expenses, including depreciation, which owner-occupiers mostly replace with very imperfect heuristics about cash expenses.

This is exacerbated by the fact that ownership carries with it real value.  First, there are the various tax benefits.  But, secondly, there is real value in having ownership control over such a personal asset.  So, the act of taking ownership represents a form of consumption that is separate from renting the property.  The owner-occupier gets value from control, and in this way, buying a home really does represent a different type of consumption from renting - it gets placed in a different mental category.  For many households - those with a settled lifestyle and the means to become owners - renting would be a very poor substitute for owning.  So, financial advisors and families generally tend to balk at the notion that homeownership is a financial decision, similar to investing in something like bonds.

At the personal level, this confusion may work fine.  The fact that financial advisors seem to pretty universally treat homeownership as something different than other financial allocations speaks volumes here.  There must not be that much value for most households to be careful about these distinctions, so we tend not to worry about them that much.

But, the problem is, these distinctions are important when it comes to analyzing macro-level markets.  And, since few people have been bothered to think about these distinctions at a personal level, there is no channel through which these distinctions materialize into macro-level discussions.

So, there is an obvious central factor in housing markets that seems to be easily forgotten:  homeowners are housing suppliers.

The article quotes the National Association of Realtors (NAR): ".... contract activity is fading this spring because significantly weak supply levels are spurring deteriorating affordability conditions."

This is technically true.  But, if we think about the difference between owning and using a home, it's a little more complicated.  The affordability problem right now is wholly and completely a rental problem.  It's a problem from lack of supply that is raising the cost of utilizing housing services.  There is no affordability problem for homeownership.  Practically any house you view at Zillow will have a much higher rental value than a mortgage expense - especially at the low end of the market where home buyers would have marginal credit.  There is absolutely no affordability obstacle to homeownership right now.*

You can spend 40% of your income on rent and Elizabeth Warren isn't going to demand that heads roll, but if you and many of those other renters spend 40% of your incomes on mortgages and then a cyclical downturn leads to defaults on those mortgages, then just turn on C-SPAN and watch out.  There is a natural demand for housing.  We aren't going to force families to live under a bridge to meet some sort of affordability standard.  But we are happy to force them to rent.  We are quite proud of it.  Macroprudence, we call it.  But, there can't be a natural supply of housing if we legally obstruct it - either in real terms in the Closed Access urban planning departments that block actual building, or in nominal terms in the national mortgage market that blocks funding.

There is a source of supply from landlords, which has been quite active.  But, since shifting from owning to renting means that a household loses that control value, and since we rain largesse down on owners, we have two markets - an owner-occupier market, where the demand curve shifts right, and the renter market, where the demand curve shifts left.  And, we have added an additional rightward shift in owner-occupier demand because the obstructed mortgage market means that interest rates are low and true returns to homeownership are kept high.  Owner-occupiers might have higher imputed rents, but they never pay themselves that rent, and they get a boost in the yield of their investment because regulators are keeping the riff-raff out of the ownership market.  In this way, they are kind of like the banana plantation owner without the liquid market.  They have high returns, but those returns can only come from ownership.  They can't be realized as capital gains.  Those who bought when the market was liquid, just before the bust, thus, have capital losses.  (And, of course, the investor buyers get blamed for driving up prices, even though the thing keeping buyers out is clearly the ability to get any mortgage, not the cost of a mortgage that has been offered.)

In addition to bemoaning the lack of supply and "affordability" problems, the article blames a shortfall of buildable land in the high priced cities.  You know, those cities where the planning department is just begging developers to come in a create supply, and the builders just shrug and say, "Sorry, there's just no place where we can build."  Those cities.  (It seems like it must be true, though doesn't it?  It seems so plausible.)

The article ends:
Whatever happens, it is apparent that housing dynamics (price and quantity) is not supporting a growing population living in the traditional array of housing arrangements. More unconventional housing arrangements (compared to history) appear to be operational, either by economic choice (housing affordability) or some other combination of reasons.
The answer to this problems is clear, and it has nothing to do with affordability, from an ownership standpoint.  The answer to the problem is that liquidity is a public good, and since we determined to learn all the wrong lessons from the housing boom and bust, we have insisted on imposing a liquidity crisis on ourselves.  This happened in acute form in 2007 and 2008 as credit market dynamics and the money supply were shifted to the point of panic.  And, it has happened since then in mortgage markets in more chronic form as regulatory pressures and federal control of the GSEs has pushed average approved FICO scores up by 40 to 50 points above any previous standard.**

Now, real estate has never been a particularly liquid market, so that the main reason a household would choose to buy instead of renting is how long they intend to stay in the home.  If it is long enough to justify the transaction costs, then generally you should own.  To the extent that there was ever an issue with affordability, it had to do with the fact that leveraged ownership required high cash outlays because mortgages generally require the inflation premium to be paid in cash while homeownership earns its inflation premium as unrealized capital gains over time.  There is a natural savings to ownership because of the control premium and because much of the expense is in the form of depreciation, which allows for some deferred costs.  Because of the confusions mentioned above, this has gotten filtered through public perception as if the affordability problem somehow comes from owning being inherently more expensive than the alternative.  This is just not the case in a low inflation environment, and it certainly isn't the case when implicit returns to homeownership are excessively high because of policies that limit access and liquidity in housing markets, like what we have now.

In effect, what we have done is analogous to closing down the stock exchanges as a matter of public policy.  Equity values would obviously drop like a rock in that scenario.  That is because liquidity is a public good.  Equities are worth more now because liquidity has real value.  We have private and public financial institutions that provide that liquidity, so equity owners demand lower returns on their investments, which means that prices for equities are higher.

Now, imagine if we closed down the stock exchanges and took away that liquidity, and if we were oblivious to the effects of what we had done.  Many people who might own a few shares of Amazon today would be locked out of equity ownership in that context.  We might complain that equity ownership was unaffordable for many people.  It would be.  Even though the market value of Amazon would be lower.

While equity owners would be earning higher profits for their investments, there would be an affordability problem for consumers - those using the services provided by those firms.  Those higher profits would come from higher prices for their goods and services.  There would be an "affordability" problem.  Consumers would be worse off.

We would all simply be worse off in that world.  Except that those who had the wherewithal to make private equity investments in equities would earn much higher returns on their investments while everyone else would be stuck in more accessible securities with lower returns.  (Huh, fixed income returns since the end of the housing boom have been mysteriously low.  What a coincidence.)  As ubiquitous as the complaints about bubbles and hot markets are, I'm afraid we are at a point in history where this would be considered an improvement.  In fact, I think this is basically our problem.

In this analogy, homeowners are like the equity owners, and tenants (both owner-occupiers and renters) are like the customers.  Our confusion about homeownership does such a number on our understanding of the housing market, that the way we talk about housing markets is the equivalent of seeing high prices for corporate goods and services and complaining that there is an affordability problem for shareholders.

The solution to that problem in equities would be to open the stock markets back up.  This would democratize ownership, bring in competition, bring prices on goods and services down, bring profits down, and raise equity prices.  This is what needs to happen in housing.

You want home prices to decline, lets get rid of the tax benefits that amount to a 25% premium on aggregate home values.  Maintaining that regime while we fret about bubbles, about the measly quarter point or so interest rate discount created by the GSEs, and about affordability, is dumb.  The causes of the problem here are right in front of our eyes, and they are not subtle.  We are doing this to ourselves.  And we have been casting blame and fear in all the wrong directions.

PS.  This may be a good post for feedback.  Am I starting to write in a sort of idiosyncratic language that is impossible to follow, or are the concepts above somewhat accessible?

* This isn't true in Closed Access cities.  In those cities, mortgage expenses tend to be higher than rental expenses, especially when you factor in cost of ownership.  That is because Closed Access houses don't just represent the ownership of existing shelter.  Rents there have a growth rate.  These are like buying an early stage growth stock.  Much of the value comes from owning future limited access to a prime location in an increasingly segregated country.  They are long positions in systematic political exclusion.  They are the result of marrying the value of land access as in a banana republic with the liquid markets of a developed economy.  A sort of meritocratic elitism available for sale to the highest bidder.  Heirs to banana plantations are local elites, but in return, they must be in the banana business because their ownership rights are personal, not universal (see North, Wallis & Weingast).  Heirs to Closed Access real estate can sell their little housing services plantations to aspirational young programmers and designers, venture capitalists and investment bankers, and invest their gains in other assets or retire to the mountains somewhere.

** Here's where you tug at your pipe and explain that back in your day, home buyers saved for years first, always put 20% down, walked uphill both ways in the snow, and there were never any financial crises.  And, you knew who you were then.  Girls were girls and men were men.  Mister, we could use a man like Herbert Hoover again.  Didn't need no welfare state.  Everybody pulled his weight.  Gee, our old LaSalle ran great.  Those were the days...  There was probably buildable land in the big cities then too.


  1. > PS. This may be a good post for feedback. Am I starting to
    > write in a sort of idiosyncratic language that is impossible to
    > follow, or are the concepts above somewhat accessible?

    I've been reading your work for so long that I understand almost every word easily. But, I remember having to re-read several times when I was first getting started. I think it's just hard --- it's so easy to confuse housing with homes, to confuse an asset's price with the expense of operating it, to confuse real with nominal. Sometimes I think that at the point you have figured out the right words to use to discuss a problem, you've solved the problem (or the solution follows tautologically from posing the problem in the right terms.)

  2. It's a great article Kevin. Remember though that cronic is spelt with an h as in chronic. :)
    Housing actually is a difficult economy to grasp - as you point out in this article. Part consumption, part investment. There's no question housing inequality is a big source of overall inequality.
    In places with quite inelastic demand, building more may not have much effect for some time I think. (Or should that be elastic?)
    Here in the UK, there are some confounders - it seems that building rates have matched or even exceeded household formation rates - but with rising prices - that seems to be impossible economically, until I suppose you factor in interest rates and mortgage affordability.
    Part of the issue I think is captured by your point about living under bridges. We could build and occupy genuinely cheap affordable housing - but we just don't want to - have you seen your neighhbours!
    Housing is tricky for sure!
    Anyway, keep it up.

    1. Thanks Sean. Like Ken said, it's almost like coming up with the language to describe something is the end result of creating a new way to understand it. But I need to make sure the language I'm using isn't so novel that it becomes a foreign language to new readers. Thanks for the feedback.

  3. Yes, always use the most simple language possible. After decades of financial reporting, I can tell you simple is best.

    For example, you do not use the words "property zoning" in the above post. Why not? Simple and easy to understand.

    Yes, to be sure there are other city codes that could limit supply, such as setback laws, or required parking, stupid affordability inclusion rules etc.

    But in general we are talking restrictive property zoning. So say that. "Some cities have a restricted supply of housing, in general due to tight anti-competitive property zoning."

    Many of us have a way of speaking when we want to explain "the real deal" to intelligent friends. That is often the best way to write too (with some editing).

    If you had some intelligent friends over for drinks, would you speak of "closed access cities and planning departments"?

    Or would you say, "Okay this is how it works. Most if not all neighborhoods in a NY, SF, LA. Boston are zoned to prevent new construction and supply. Guess what? In a good economy, house prices explode. Then, consider the tax benefits of owning. Many upper-income people are all but compelled to buy a house for the tax benefits. Duh, no wonder house prices explode."

    But maybe you are are shrewd.

    You can write in the comments section of "libertarian" blogs about getting rid of property zoning and the home mortgage interest tax deduction. Eventually, your comments will get censored.

    So, maybe some obfuscation is in order.

    1. Well, obviously, the "Closed Access" terminology is the main shorthand that I allow myself. Mostly, I was afraid that where I am trying to be descriptive that I am getting into the habit of using idiosyncratic terms or conceptual models that others wouldn't follow.

      I assume that good writing avoids attributing Machiavellian motives to its readers. At most, I try to limit myself to making sympathetic accusations of self deception.

    2. I'm new to this blog and not an economist, and it is absolutely clear to me (or so it seems) what "Closed Access" means.

  4. Machiavellian?

    Usually I stoop to vulgar Marxism, and accusations of abject cowardice.

    Picky note: It may be bureaucrats in a city planning department would actually like to pencil in a lot more density. But the zoning laws prohibit it. A developer comes in with a plan for high-rise condo, and they have to say "no." So developer goes for variance from the city council.

    So to blame "planning department" may be inaccurate. Blame the laws which prohibit anything above R1 (in CA, single-family detached), or blame the minimum acreage laws.

    I am polishing my bust of Lenin this afternoon.

  5. I like your writing. To the extent that you're concerned, you could add a glossary for beginners.

    This is my favorite line on TV: Gee, our old LaSalle ran great.
    Thanks for using it!

  6. "the act of taking ownership represents a form of consumption that is separate from renting the property"

    Succinct version of my argument against "consumption"-only taxation. Sumner, for all his other merits, drives me a little cray on that one. Control, option-value, status, power, etc. Related to the thrust of your blog, I also see taxation on high incomes and capital gains as an imperfect but important defense against rents.

    1. Among properties that tend to be owner-occupied, that value tends to be capitalized into the price of the property and somewhat factored into rental value, so property taxes do tax that value, I think.

      On your last point, I think this is sort of a version of, "Since there is some cheating in Welfare, we should reduce the social safety net." Why would you use a tax that made no distinction between favored and disfavored forms of income, if what you are trying to mitigate is just the disfavored forms?

      On the other hand, in terms of property, I think your point does apply. Instead of making real estate exempt from capital gains, it is probably the one asset that should especially be taxed on capital gains. In that case, capital losses should be available for refunds, though. I think a libertarian case could be made for socializing some of the gains from upzoning, land development, etc. since these gains are so intertwined with local politics.

  7. Wouldn't you want more welfare spending in a cheat-less circumstance vs a cheat-filled? So yes, absolutely.

    Distinguishing between rent vs earn, especially at the individual level, is really quite difficult. If we have to tax something, let's tax what we think is 50% rent rather than <5% (payroll).

    "socializing the gains from upzoning" brought this to mind:


    I haven't followed the proposal's political fortunes, but I was quite surprised at the thought embedded in the basic formula:

    Tax = .8 * [bonus buildable-sqft] * [local $ of land per buildable-sqft]

  8. I don't understand why these two things logically follow from closing down the stock exchanges:

    While equity owners would be earning higher profits for their investments, there would be an affordability problem for consumers - those using the services provided by those firms. Those higher profits would come from higher prices for their goods and services. There would be an "affordability" problem. Consumers would be worse off.

    If you shut down the market for Amazon stock today I would expect consumer prices to stay the same (financing can't be that important, right?) and I would think the return on the stock would go down just because it would be worth less.

    1. Capital earns higher returns in less liquid markets. We can see this on the margin in American stocks, where smaller firms seem to have persistently higher returns over long periods of time than larger more liquid firms do. And we can see this at the extreme in less developed economies where capital is tightly held by well connected elites. Those assets don't necessarily fetch a high price, but the owners have high incomes, especially compared to laborers.

      A switch to a less liquid regime would entail a capital loss when the regime shifted, but the mirror of that is that the new owners would have higher returns. Going forward, those higher returns would reflect a larger claim on new production by capital owners.

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