Wednesday, November 21, 2018

Housing: Part 332 - The problem in a picture

I came upon some old data recently that I thought was worth sharing.  Sorry, this isn't updated past 2014 data, but the story hasn't changed that much since then.  Maybe real estate values have recovered another 10% or so, compared to personal income.

Here is the problem.  There are two housing markets in the US.  A closed one and an open one.  The closed market gives you access to the best economic opportunities in NYC, LA, Boston, and San Francisco (Closed Access cities).  It's limited to about 50 million people.  You want in, you gotta pay.

Sources: BEA and Zillow
Here is a graph of total real estate value as a percentage of total personal income.  In 1998, in the Closed Access cities and in the rest of the country, the ratio was about 2:1.

Then, as we entered the post-industrial economic era, competition for access to the Closed Access cities pushed real estate there up to close to 350% of income.  In the rest of the country (which includes the Contagion cities, Seattle, Washington, etc.), it didn't break 250%.  Even that increase can be effectively explained with low long term real interest rates.

By 2014, in the Closed Access cities, it was 248%, while the rest of the country was down to 166%.  Now, this is with very low long term real interest rates, so, if anything, it should be above 250% even outside the Closed Access cities.

Keep this in mind when you read countless articles complaining about affordability.  Homes are more affordable than ever, really, for owners.  It's just that some homes have a premium attached to them that is unrelated to the value of shelter.  Imagine how backwards economic and monetary policy is right now, that it is not unusual to hear people call for or accept contractionary monetary or fiscal policy because home prices are getting too high again, and macroprudential policy is called for.

Also, consider the countless articles and conversations that complain about how we bailed out the banks but left regular households hung out to dry.  You know what really killed those households?  Maybe it was the fact that they lost wealth, on average, that amounted to nearly a year's income.  When real estate value outside the Closed Access cities collapsed from 236% or incomes in 2006 to 157% in 2012, how many of these moral crusaders were demanding more monetary support because home values had clearly fallen too low?

Don't get me wrong.  It isn't the job of the Fed or the government to prop up home prices.  But, it is their job to allow markets to function.  The "bailouts" were only a very poor substitute for reasonable federal macroprudential and monetary policy.  But, any reasonable policy would not have led to such drops in real estate values, especially after 2007.  How many bailout critics would have supported those policies?  That would have created moral hazard.  Right?  Because everyone knew that homes were too expensive.

One more thing about that graph.  It shows less recovery than some other measures of price/income do.  I think the main reason is that normally, price/income is based on the price of the median home compared to the median income.  Since we have been in a decade-long housing depression, the aggregate value of real estate has risen less than the value of individual properties.  This is an important part of what is happening, but it is difficult to understand it with "bubble" thinking.  Bubble thinking presumes that more building is triggered by money and credit, so that more building equals rising values.  That has it backwards.  The red line rose much higher than the blue line precisely because that relationship is very strongly in the opposite direction.

Closed Access real estate rose in value so much because there are not as many new Closed Access homes.  And, even on a national level over time, aggregate real estate value has little to do with the rate of building.  The reason that real estate value has declined along with lower rates of building since 2007 is that credit and monetary policy pushed home values well below the value that could trigger new building in many markets.  The decline in value led to lower rates of building, not the other way around.

The way to reduce things like median price/income levels so that homes become affordable again is to build many, many new homes.  That will have very little effect on the aggregate value of real estate.  In fact, if we do it well enough, it will reduce the aggregate value of real estate.  But, it will be hard to trigger new supply until credit is loosened enough and prices rise enough that more new construction can be justified.

There seem to be many macroeconomic issues that have this strange, contradictory type of causation.  In this case, rising prices cause more building, but more building causes declining prices.  Clearly, more building could cause prices to decline so sharply that more building would cause total value to decline, even after adding new real supply to the housing stock.

Housing prices need to rise so housing prices can fall.


  1. Great post.

    I was surprised at this sentence;

    "But, it will be hard to trigger new supply until credit is loosened enough and prices rise enough that more new construction can be justified."

    In the closed access cities, the problem is more property zoning than the availability of credit.

    That said, it is interesting that this economic recovery has been so sluggish, and that so-called macroprudential policies have prevented endogenous new money from entering the economy (that is, banks create money when they fund a real estate loan).

    Housing markets are beginning to look iffy. Given how sluggish growth has been, a housing slowdown could trigger a recession.

    1. It goes back to my posts last month about Adam Ozimek's post. Prices have recovered in the Closed Access cities, and building rates are at pre-crisis levels there. Places where building is slow are places where credit suppression has kept prices low.