Mortgage trends in 2015 Q1

Why can't anything be easy?  2015 1Q Flow of Funds data came out this morning.  I have been hoping for regulatory and market adjustments to allow for more expansion of mortgage expansion, which would help to push home prices back up to intrinsic values and would provide investment demand, pulling interest rates up.  The convergence of interest rates and returns to real estate would earn profit for a position short on bonds and long on housing.

But, real estate loans retained at the banks have stalled in the past month, and while mortgage levels measured by Flow of Funds had stopped declining, they have been level.  This is a little bit surprising to me compared to anecdotal information I'm seeing in the Phoenix area.  It's a sellers market, and households with decent credit seem to be able to mortgage new home purchases.  Home price growth has started to turn up again, but it seems like there is enough activity to trigger more new building and to push mortgage levels up.

In 2015 1Q, mortgage levels actually turned down again.  But, the re-acceleration of home prices, combined with the decline in mortgage levels, caused household real estate equity to jump a full point, from 54.6% to 55.6%.  Before the real estate collapse, equity levels had been ranging between 58% and 60%.  Maybe under the new regulatory and market pressures, equity levels will tend to be higher, so that there isn't anything special about hitting that range.  But, it seems like some sort of signal of healing markets, if only because it would suggest that households would be less encumbered by negative or negligible home equity levels that prevent refinancing and home selling.

I don't have any direct evidence of a connection between foreign capital and these movements, but it does seem fitting that a large part of the decline in 2015 1Q GDP came from a larger trade deficit.  That suggests that there was a surge of foreign capital, which could be the source of price strength in housing without any domestic mortgage growth.

This complicates the housing/treasuries position.  The foreign capital will probably affect prices more than new homebuilding.  If mortgages continue to stagnate, this means that the homebuilder portion of the position will probably have a delayed reaction, and highly leveraged homebuilders like Hovnanian will need to muddle through a few more quarters before there is a positive growth surprise.  On the interest rate side, this has less clear implications than mortgage growth would have had.  New housing value grows the capital base, but I'm not sure of the effect on interest rates.  It wouldn't have as strong of an effect on the investment/savings balance as new building would.  So, I am not sure if interest rates will fall back because of the lack of mortgage growth or if they will remain fairly stable or rise slowly.  The uncertainty has pulled me out of the interest rate position, but I'm afraid that I will watch the potential profits slowly accrue to that position as I watch from the sidelines.

Housing Tax Policy, A Series: Part 38 - The World Record for Reasoning from a Price Change

As I was reading the 1000th account of our supposed pre-crisis over-investment in housing this morning, I realized that this whole chapter must be the most gargantuan example of reasoning from a price change, ever.  It wasn't the level of residential investment that triggered the panic about the housing market.  It was the change that we saw in prices.

I have argued that rising Price/Rent ratios were generally exogenous to the housing market - related to broader trends in interest rates and global capital flows.  Given the change in Price/Rent that we have seen, how would the reaction to the housing boom have changed if there were fewer constraints on housing expansion?  What if, instead of seeing higher rents on a more constrained housing supply we had seen falling rents on a less constrained housing supply?  Residential investment would have been higher, because there would have been more building.  Nominal price increases on homes would have been lower.  And, as a result of all of that extra residential investment, there would be much less moaning today about overinvestment in housing.  Reasoning from a price change leads everyone 180 degrees to the wrong conclusion.


Home Prices were high because Rent Inflation was high

In a previous post, I presented the case that the rise in home prices can be entirely accounted for with (1) the effect of long term discount rates on intrinsic values and (2) the full effect of rising rents on home values.  This is one of several graphs included in that post.

But, I neglected to take the next step in that analysis.  What would the counterfactual be if rent inflation had matched the inflation rate over this time of all the other non-rent elements of core CPI?

Next is a graph of home prices, nationally and in the Case Shiller 10 city index, along with a model of home prices based on long term discount rates, rent levels, and rent inflation rates.  And I have added the modeled national home price level, based on a counterfactual where rent inflation had equaled Core inflation (excluding rent).

How much concern would there have been about overinvestment in housing if home prices had only doubled in 20 years, instead of quadrupling (basically tracking inflation)?

Even the high real estate values that have persisted since the crisis would not have materialized, because the high intrinsic values now are a product of very low long term interest rates that are themselves the product of the collapse of real estate capital markets.


Rent Inflation was high because Residential Fixed Investment was Too Low

The amount of additional residential investment that would have been required in order to reduce rent inflation to levels to this counterfactual level would be a product of the elasticity of housing demand.  The next graph compares real and nominal housing expenditures.  Nominal expenditures have been level since the early 1960s.  (Homeownership rose after the Great Depression until it reached about 63% in the mid-1960s, which is roughly where it has remained since, except for the temporary push up to about 69% in the 2000s.)  Since 1995, when the latest period of rent inflation began, centered around the major coastal metro areas, real housing expenditures have fallen sharply while nominal expenditures remained level, as a proportion of personal consumption expenditures.  The long stability of nominal housing expenditures suggests a unitary elasticity of demand.  This is apparently slightly higher than the typical finding of slightly less than 1.  Households in the problem cities spend about 5% more of their incomes on housing than households in the rest of the country, which also suggests somewhat inelastic demand.  Possibly, national nominal spending on housing over this period increased slightly as a result of added tax benefits to home ownership.  This could explain why slightly inelastic demand hasn't led to a slight decline in nominal spending on housing as real housing expenditures have declined.

Long term elasticity of housing supply is generally found to be very high, which should make persistent rent inflation implausible.  This mystery fits well into the narrative that I am developing that regulatory limits to housing in the large metro areas is the driving factor in persistent rent inflation, and that rent inflation reflects the relative substitutability of real estate outside these areas for the preferred locations where building has been limited.

The average is mis-labeled.  It is for 1962-1995.

The next graph shows residential fixed investment over time.  When we eliminate the cyclical movements, I think this suggests that expenditures are very sensitive to small changes in residential fixed investment.  From 1962 to 1995, residential fixed investment (shown in the graph) averaged about 7.5% of GDP, and both nominal and real housing expenditures were at about the same level at the end of that period as they had been at the beginning.  From 1947 to 1962, nominal housing expenditures as a portion of PCE skyrocketed from about 11% to about 18%.  During this period, residential fixed investment was only about 1% above the 1962-1995 average.  And, from 1982 to 2007, when real housing expenditures fell, residential investment as a proportion of GDP averaged 7.3%, just 0.2% below the 1962 to 1995 average.  The secular variations in residential investment are smaller than the variations we see through the business cycle.

I have adjusted residential investment to create a counterfactual that would have led to stable real housing expenditures (and stable nominal expenditures, assuming unitary demand elasticity).  For instance, if real housing expenditures decline 0.25% in a given year, the counterfactural residential investment is adjusted upward by 0.25% of the value of residential real estate owned by households.  As the cyclically adjusted stability of residential investment suggest, it would appear to have taken a very small change in total residential investment to counter rent inflation.

Because this problem has been so persistent, it is easy to assume that rent inflation is a natural part of city dynamics.  The many growing metro areas that don't share this characteristic should serve as evidence against this notion.  And, if we look at rent inflation over time, we see behavior that appears to relate to the level of residential investment.  When building was allowed to expand, we did not have persistent rent inflation.  From the beginning of the core inflation series in the late 1950s until the late 1970s, shelter and core inflation generally moved together.  Shelter inflation first moved significantly above core inflation during the building contraction associated with the 1980-1982 recession.  Residential investment failed to move back above the long term average in the ensuing recovery, and so shelter inflation failed to recede back to core inflation levels.  Then, after the 1991 recession, residential fixed investment failed to even reach the long term average until 2003.  And rent inflation has been well above core inflation for most of this period.

The reason that this is even a topic of discussion is because nominal home prices rose to such heights.  Because practically everyone, from populist pundits to skilled economists, is reasoning from a price change, they associate the high home prices with high demand and high residential investment.  But, if only we could have had just a small amount of additional residential investment (focused in the large coastal metro areas, where the natural market supply response has been constrained), home prices would have been tame.  If only residential investment had been higher, nobody would be complaining that it had been too high!


The Substitution of Fixed Investment for Location Value

I made my own error in a recent post where I suggested that urban real estate owners were working against their long term interests by fighting against urban progressives who want to control the housing stock.  I was actually the one being short-sighted in my analysis.  Urban real estate owners do earn excess rents on the artificially high values of their actual properties.  But, they would clearly be better off in absolute dollar terms if they were earning normal returns on their potential properties.

In other words, they would earn much higher profits on their land by financing a 40 story condo building that earned 4% net returns than they earn on the same lot with a couple of duplexes that are currently earning 6% net returns plus 1% annual capital gains from rent inflation.  They are earning excess profit on the land they own, but that land is being prevented from providing the housing stock that it is capable of providing.  It is clearly in their self interest (and our collective interest) for them to develop that land further.

And, I think this adds a subtle twist to the picture of residential fixed investment in the 2000s.  Rent inflation moderated from 2003 to 2005, when residential fixed investment rose.  But, it was still running slightly higher than core inflation.  Why didn't this high level of investment cause rent inflation to fall below core inflation, reverting to lower levels?

The effect of limited building in the cities is that landlords are capturing higher rent for limited housing stock.  If housing wasn't limited, they would be capturing lower rents on expanded housing stock.  So, if housing was allowed to expand in the cities, capital income would be accruing to urban land owners, but it would be accruing to them for providing housing, not for owning an artificially scarce resource.

Now, high rents and limited housing in the cities is pushing households out to the suburbs and exurbs.  One effect of substituting lower value locations for the high value urban locations is that households purchase larger homes.  So, in the constrained context that we have created, fixed residential investment has been inflated.

Residential fixed investment never really rose above the historical range.  But, even the levels it did reach were inflated by our anti-housing metropolitan areas.

If urban development had expanded, households would have favored urban housing where more of their housing expenditures would go to rents on the land.  This is a scenario where capital income would have increased, but as a result of broad improvements in real living standards.  Lower rent on housing would mean that real incomes would be much higher.

May 2015 Employment

Last month, I wrote: "Next month will have to be an outlier for unemployment to come in above 5.2%."  So, my perfect track record remains intact.  It was apparently an outlier.  Right again!

So, what's going on?  I think it's a little bit outlier, a little bit persistence in higher unemployment numbers, and a little bit of a lull in employment growth.

Here is my graph comparing insured unemployment and total unemployment.  For 18 months after the end of 2012, there was a steady trend in the decline of very long duration unemployed workers.  Since July 2014, this decline has slowed, although it continues to have a downward trend.  Since July 2014, the red and dark blue lines show the upper and lower bounds of expected total unemployment, based on a continuation of the previous trend at the lower bound and a complete halt to the decline of very long term unemployment at the upper bound.  This month, that range was from 4.8% to 5.3%.  Total unemployment came in at 5.5%.  So, total unemployment has bumped above the range we would expect, given continued unemployment claims.  This is not a pattern we expect to see.  Here is the graph, smoothed, and going back to the 1970s.  There is a counterclockwise pattern that we see through business cycles.  The trigger for a change in trend at this point in the cycle should be a sharp increase in unemployment claims.  But, before that happens, we would expect to see unemployment insurance claims level out while total unemployment continues to fall.  So, the movement of the last few months is probably anomalous, and I would still expect to see a correction down in the unemployment rate of at least 0.2-0.3%.

This bump up in total unemployment is playing out in the shorter unemployment durations.  One reason for this may be dynamics related to Part Time Employment for Economic Reasons, which is still slightly elevated from what we might consider recovery levels.  (Note: The sharp downward shift in 1994 is a measurement change.)  Not only is total unemployment elevated compared to insured unemployment, but the number of job losers is also elevated compared to insured unemployment.  An elevated level of job losers, compared to insured unemployment, seems to have coincided with periods where there were high levels of part time workers for economic reasons.  This might have to do with less universal unemployment insurance claims by part time workers.  So, it may be continued claims that is the false signal right now.  Or, more specifically, we may be seeing temporary frictions from the normalization of the labor market.

We tend to imagine workers having hours cut and then having full time status reinstated.  But, I think we need to be careful about narrative explanations here.  Both labor supply and labor demand have strong influences on the labor market.  (Colloquially, and sometimes academically, we understate the influence of labor supply.)  There is a lot of churn among workers as these markets normalize, and it seems reasonable that some of this exchange between part time and full time could create temporary unemployment from market frictions, even if the causal factor is employment growth that is pulling workers back into the full-time labor market.  In the 1980's, this increased level of unemployment and job losers, relative to insured unemployment, appears to have persisted for several years.  That might be the case again.

JOLTS data appear to continue to show generally positive trends.  This data is a month behind, and a little noisy.  A weighted moving average gives a little faster indication of changing trends, and here Hires and Quits are beginning to show weakness, while Job Openings continues to look very strong.  But, all of these indicators were very strong in late 2014, so it is a little early to call this a problem.

A possible lull in hires might be related to some of the increase in unemployment.  I had expected to see some of the unusually high very short duration unemployment dissipate this month.  But there appears to be a hump of unusual unemployment moving through the durations in the seasonally adjusted data.  On the bright side, very short durations moved back to normal levels this month.  Maybe there has been a temporary hiring lull.

Looking at flows, there has been a decrease in net flows from Unemployed to Employed.  But, flows directly from Not in the Labor Force to Employed continue to be very strong.  In addition, the individual flows all continue to move in positive directions, even though they are at or near full recovery levels.

Any lack of flow out of unemployment into employment appears to be matched by very strong flows back into the labor force and directly into employment.

Wage growth was relatively strong in May.  I only have real wage growth through April (because I use the PCE price index to adjust for inflation).  Wage growth has recently crossed slightly below the long term trend given by the unemployment rate.  But, that should recover slightly this month, once we have inflation numbers.

In total, I think these indicators still point to a healthy labor market and to an unemployment rate that should step down a bit from current levels.  The forces that pushed it from my 5.2% call to the 5.5% print may reflect some persistent headwinds, but I think we should still expect a reversion to a trend in the unemployment rate that is lower than the last couple of months' numbers imply.

National Review Article with Scott Sumner

National Review published an article today by me and Scott Sumner.  For readers coming here from NR, if you are interested in some of the details I have been working on in the housing area, I have about 37 parts of an ongoing series in the calendar links to the right.

Here is a recent post that looks at the drag on real incomes of renting households coming out of the 5 big problem metro areas - New York, San Diego, Los Angeles, San Francisco, and Washington DC.  And here is a follow up rant to that post.

Thanks to Scott and to National Review for generously allowing me to share some of my work.

Am I missing the boat on the Housing/Treasuries trade?

The pullback in the growth of real estate loans at commercial banks has caused me to pause on the short Eurodollar / long homebuilder position.  But other data is causing me to wonder if I am missing the early moves here.

Today, April CoreLogic data continued to point to re-acceleration of growth in home prices.

And, 1Q GDP looks like it points to a recovery in the global capital flows that draw capital into low risk American assets.  I think that net imports are mainly the result of the exchange between developing economies and US corporations, where US firms take on the risk of productive assets abroad, and developing market savers consume the benefits of trust and liquidity provided by Western economies - especially the US.  This leads to net capital inflows into the US, which are funded with net imports into the US.  We buy goods and services, and we sell liquidity and trust in capital.

About half the drop from trend in 1Q GDP growth came from the trade deficit.  We don't measure these liquidity and trust services as production.  Could this foreign capital lead to housing expansion without being reflected in mortgage expansion?  Maybe in the aggregate, at this stage, it can.  In fact, considering that US households are still holding slightly overleveraged real estate, maybe housing price growth has to come from this capital source before leveraged US households begin contributing to the housing recovery.

Housing Tax Policy, A Series: Part 37 - Our perpetual indignation generator

Here's a recent front page story in the Seattle times.  You see, they are proud in Seattle for leading the charge on the $15 per hour minimum wage, because rents have gotten so high that someone working full time at minimum wage levels can't afford to live in most of the apartments in Seattle.

So, demand for apartments in our major cities is high.  In cities that happen to be in "blue" states, where there are more regulatory limits to building, rents have increased.  Demand was increasing and supply was bureaucratically limited.  This meant that new housing consumption was being claimed by higher income households.

(What else could really happen?  The five cities with the lowest rent in the Seattle Times story: Birmingham, Houston, Memphis, Oklahoma City, and Phoenix.  The five hughest: Honolulu, Los Angeles, New York, San Francisco, and Seattle.)

In those high rent cities, the reaction of the locals to these new high income tenants is to put limits on supply.  So rising demand causes rents to rise, which leads these cities to lower supply, which causes rents to rise more.  And, since low income households can't afford rent any more, these cities are starting to raise the minimum wage to unprecedented levels.

The uncontroversial first order effect of these higher minimum wage levels will be a lower quantity of labor demanded.  But, some believe that there will be a mitigating increase in labor demand due to the higher spending of minimum wage workers.  So, what will these workers spend their new higher wages on?  Well, according to those proud advocates in Seattle, they will spend it on rent.

So, now we have again raised demand for housing, which, in this perpetual choose-your-own-adventure saga, takes us back to the beginning of this post.

Meanwhile, real estate owners in blue cities, the beneficiaries of these policies, collect higher rents and capital gains, while a rising cost of living hits low income households the hardest because they spend the most on rent.  And because we haven't been able to force every landlord in every blue city to rent their units for $500 after the local planning commission has managed to make them worth $1,000, this must be the fault of deregulation.  And since there are still some banks willing to issue mortgages on the market value of houses that the planning commission has managed to push from $500,000 to $1,000,000, then this must especially be the fault of banking deregulation.  Thus, the story goes, deregulated markets lead to more income inequality.

And round and round we go in the circle game.

Housing Tax Policy, A Series: Part 36 - We are the 100%, Housing Edition

As I have been working on the piece about limits to urban housing supply, I have coincidentally come across several articles and posts about the problem.

There was this New Yorker piece, with a very interesting reaction from David Glasner to a reaction from Paul Krugman.

There is also this piece at Medium.com (HT: SSC).

The New Yorker piece is about empty storefronts and old neighborhood retail shops driven out by higher rents.  Some snips (emphasis mine):

“High-rent blight” happens when rising property values, usually understood as a sign of prosperity, start to inflict damage on the city economics that Jane Jacobs wrote about...

If high-rent blight hurts New York’s municipal economy, what, if anything, might be done? Because the problem is tied almost inextricably to the value of New York real estate generally, there are no simple fixes. The #SaveNYC movement and the Small Business Congress NYC advocate the regulation of lease renewal. They support a bill written by the small-business advocate Steve Null that tries to limit rent spikes by making commercial-lease-renewal disputes subject to mandatory mediation and arbitration, like some baseball salaries. Gale Brewer, the Manhattan borough president, supports a different regulation of lease renewals, coupled with zoning rules, that encourages landlords to quit waiting for the jackpot and to start renting. Some, like Moss, want to fine landlords who leave storefronts abandoned, in the hope that they’ll then rent to smaller, quirkier companies instead of Chipotle. There may also be other original solutions to the specific problem of high-rent blight, such as, perhaps, finding ways to let pop-up stores use abandoned spaces on a seasonal basis...

Waits, the owner of the House of Cards & Curiosities, doesn’t endorse any particular solution... But, he said, the tax increases passed on by his landlord have pushed individual businesses like his to the “bursting point.” 

Comments from Krugman:

(I)t’s part of a broader story of big money moving in to desirable neighborhoods, and in the process destroying what makes them desirable...

First, when it comes to things that make urban life better or worse, there is absolutely no reason to have faith in the invisible hand of the market...

Still, we’re now arguably looking at something new, as the really wealthy — domestic malefactors of great wealth, but also oligarchs, princelings, and sheiks — buy up prime real estate and leave it vacant... 

In both of these pieces, supply is not even mentioned.  This is practically the literal definition of beating a dead horse.  Those damnable big city developers just won't make spaces available, no matter how hard we tax them and impose mandates on them.

From the Medium piece, which is by Scott Wiener, a member of the San Francisco Board of Supervisors:

Recently, five of my colleagues on the San Francisco Board of Supervisors proposed a moratorium on privately produced housing in the Mission District, as a response to the undeniable housing crisis confronting our entire city and impacting the Mission with particular intensity. Under the moratorium, no housing development of 5 units or more would be permitted. The only exception would be developments with 100% below market rate subsidized units. Even projects in which half the units are affordable to low or moderate income residents would be banned.

Wiener still supports a laundry list of urban real estate controls.  But, he gets the core problem (emphasis mine):

New residents aren’t moving to the Mission because of new development; rather, they’re moving to the Mission because of the Mission, amazing as it is. People who want to move to the Mission will move there with or without new development. And, without additional housing, they will put more and more pressure on the existing housing stock. Evictions and displacement are the inevitable result of that pressure...

(E)liminating that housing production isn’t going to help anyone, other than existing property owners whose property will become more valuable...

And, yes, in addition to the need for affordable housing, the overall supply of housing matters... Earlier this year, I authored a piece positing that the law of supply and demand applies to housing in San Francisco. While some melodramatically attacked me as channeling the ghost of Ronald Reagan for making that basic point, it really isn’t controversial... Cities that have produced significant new housing — even cities with growing populations — have seen reductions in rents. 

That last link in Wiener's piece suggests that New York City and Washington DC are loosening the clamps on supply.  But, the reaction from Wiener's fellow San Francisco council members doesn't bode well for San Francisco.  The irony is that the position these urban progressives are taking is basically that we can't allow market forces to dictate housing supply because the wrong sorts of people might end up moving in.  Since in today's political landscape, that's an acceptable position to have, as long as it is taken toward Krugman's "malefactors", it is spoken quite plainly - with moral fervor, even.  And, if everyone has to suffer in order to make sure those people don't move in and ruin everything, then that is what we will do.  And, in the meantime, we will try to impose controls on what market supply still remains that make sure as many of the right sorts of people remain as possible.  It's the 21st century bizarro version of white flight.  I guess that's moral progress of some sort.  The complex mesh of San Franciscan regulations are like bizarro versions of the old racist CC&R's.  You can build housing there if the tenants aren't white or if they have an income below a certain amount, or maybe exceptions can be made if the realtor can confirm that potential tenants were visibly moved while contemplating a Cristopher Wool painting.  But, somehow the uncultured rich white people keep coming anyway.

The further irony is that the surest way to be one of Krugman's "malefactors" is to own real estate in a large progressive city with strong "affordable housing" policies.  But that's just the start of the irony.  This looks like a classic Baptist and Bootlegger situation, where moralists are the public face for a policy that benefits rent-seekers.  But, that would mean that Wiener's opponents are secretly supported by real estate moguls.  I doubt that is the case.  These people all seem sincere.  They really seem to want poorer outcomes for the landlords and developers that they are inadvertently benefitting.  And, I suspect that the landlords and developers work sincerely and fervently to overturn these policies.  In their day-to-day work, they are constantly prevented from managing their properties as they see fit.  When they design new properties, they are consistently imposed upon in ways that make viable projects unviable.

So, everyone works - actively works - against their own long term interests.  Politics is how these social justice advocates work against their long term interests  (or at least their stated goal of having low cost housing).  Markets is how these capitalists would work against their long term interests as regulatory rentiers.  New supply is the only sustainable way that rents and real estate valuations will revert back down to prices that reflect their unencumbered costs.  For this to happen - really the only sustainable way for this to happen - is for new capital to compete with existing capital.  So, total capital will rise, and in absolute terms, there will be more profits.  But returns will be lower, and the "malefactors" will revert back to just investors making an honest market return.  Big city progressives won't allow this to happen because a world where their political control isn't imposed on both production and consumption is, by their definition, a moral failure.  The only way this is distinguishable from old-school social conservatism or sectarianism is that the in-groups and out-groups have been jumbled.  But the outcome demeans everyone, just the same.

Proponents of these supply constraints want exclusivity.  That is what they are calling for, explicitly.  The supply constraint is a first step in achieving that.  But, markets don't create exclusivity in a way that they can control, and exclusivity determined by money seems especially vulgar.  So, painting the households that can afford the artificially scarce housing as "malefactors" is a way to make the manifestation of exclusivity through markets seem more vulgar, giving the preferred forms of exclusivity a patina of moral superiority.  They are saving these neighborhoods.  As the San Francisco supervisor complains regarding Wiener's position, "Let me be clear - not a single affordable housing activist denies the existence of the law of supply and demand...the policies they are pushing aren't referred to by liberals as 'supply and demand' they're called 'free market development' - otherwise known as deregulation."  He understands supply and demand.  He just prefers his own exclusivity to the market's.  And, while no sane observer would include San Franciscan real estate in a list of "deregulated" markets, it must seem that way when you are trying to enforce a strict and peculiar form of exclusivity in a free society.

It's a classic case of the seen vs. the unseen.  The landlord has a building that would cost $10 million to build, and would have units that rent for $1,000 a month.  But, since the city has longstanding barriers to profitable building, it's a $40 million building with units that rent for $4,000 a month, except that the city objects to having $4,000 units, so they force the landlord to rent them for $3,000.  Of course the landlord is upset.  To him, this is clearly a $40 million building.  He might have paid that much for it himself.  And they are forcing him to charge rents below market.  Meanwhile the city is upset at all the greedy landlords who keep jacking up rents.  "That's what faith in free markets gets you," they complain.  And, only rich people can afford $4,000 rent.  The city could have a million units ranging from $1,000 to $10,000, but since they only have half a million units, they rent for at least $4,000, and so only rich people move to the city.  And the city complains, "The rich people are driving up the rents."  "But, you need to build more units," I say.  "That's trickle down economics.  We have added 10,000 units a year, and they just attract more rich people."

Calling for supply is invariably derided as "trickle down" economics.  Normally I would scoff at that.  But, in this case, there really would be a trickle down effect.  These policies have been in place for so long, with such cumulative effect, that it will probably take some time to unwind.  In the Big 5 problem cities - Washington DC, New York City, San Diego, Los Angeles, and San Francisco - cumulative tenant rent has risen by around 40% since 1995.  (Edit: this refers to excess rent inflation that is likely to be a reflection of limited supply.)  And that's for the entire metro areas.  The core cities must be much worse.  New supply wouldn't just cause rents to level off.  We would need to see significant declines for returns on existing properties to return to market levels.  (I say "market levels", but even in 1995 there were unnecessary limits to building in these cities.)

We wouldn't describe market-based housing policies in the rest of the country as "trickle down" because, for the most part, we haven't implemented these damaging supply limitations enough to mess up the market.  So there is plenty of housing of all types for everyone.  Phoenix has many decent apartments for less than $1,000/month.  The progressive housing policies of the big cities have favored rentiers at the expense of renters for decades.  We're not going to work that off immediately.  So, if supply is released, some of those rich villains will probably move in before rents become reasonable again.

These policies are a classic example of politics creating a supply problem and then trying to solve it with a demand solution.  And so - in housing, in education, in health care - we keep chasing less and less relative supply with more and more subsidized dollars, all the while complaining of "malefactors" and the "1%" who are the beneficiaries of these policies.  Time and again, this is our mania.  While this makes us all poorer, it does satisfy the sectarian progressive ambition of our time - maximizing the political dispensation of supply.  (The tide may, thankfully, be moving slowly out on that ambition in primary education.)

But where are the supply-siders that are supposedly such a powerful influence?  Most of the observers I see on the right think the problem is that we have too much money.  This is a monetary bubble we have to pop.  According to the ACS, which goes back to 2005, the median renter in San Francisco saw their nominal income rise from $43,383 to $52,212 from 2005 to 2013 - a whopping 2.5% annual rise.  But $3,600 of that higher nominal income has gone to higher rent - all rent inflation.  Real housing consumption for the median household in San Francisco has been level, or slightly down.  So, after paying for ever more scarce housing, they have seen an annual rise in nominal income of about 1.5%.

But, since the landlord sees the market value of his building rising, observers on the right claim we still are fighting a housing bubble.  We've got too much money!  And we are managing to use all that money to consume less housing every year.  In the words of Jerry Seinfeld, "That's one magic loogie!"  And the solution to this coming from the supposed keepers of the supply side is to cut that nominal income growth even more.  And, it is true, if we cut nominal income enough, property values will fall.  And if that policy "succeeds", just tell yourself you just weren't as wealthy as you thought you were, back when the median household was blowing all those 2.5% income raises on their constantly shrinking home.

There are valid complaints about rent-seeking in agriculture - corn and sugar subsidies, etc.  But, maybe this is the best we can do.  Maybe the lionized farmer has been the mythology keeping us from starving ourselves to death by insisting that for every head of cattle we raise, we have to plant an acre of northern beans for the mandated bean market.  (That's what poor families eat, so we need to make sure it's available.)  And, no, you can't plant beans there, or there, or there.  If you want to plant it there, you'll need to clear it with the planting commission.  Oh, the sandy plot at the back of your lot?  Yes, you have been cleared to plant there, but you'll need to pay a planting tax to do that.  After all, there are some farmers who own prime fields who, for some reason, have become ungodly rich, so we need to start taxing farmers that plant crops, to keep this economic inequality from getting out of hand, especially since beans are now $10 a can, and poor people can barely eat....So, I guess things could be worse.

Housing Tax Policy, A Series: Part 35 - The effect of limitations to building in the coastal cities

I've been using data from the BLS and the American Community Survey (ACS) to try to gauge the relative effect of limits to building in the major cities.  I've been using the 10 cities from the Case-Shiller index as the representative basket (hereafter, "CS10").  This isn't a perfect match for the problem.  Denver, Chicago, and Las Vegas don't exhibit excessively abnormal rent inflation and price levels.  Boston and Miami are worse.  But, New York City, Washington, DC, San Diego, Los Angeles, and San Francisco are in a class by themselves, and they are all on the list of 10.  The Case-Shiller 10 is a pretty good proxy for the cities behind the housing supply problem.  (I don't have full CPI data for Las Vegas and Washington, DC, so some of this analysis is limited to data from the other 8 cities.)


Shelter Inflation reflects a supply problem

As I have looked at housing data and monetary policy over the past several months, I have come to the conclusion that there are two general components of inflation over the past 20 to 30 years.  There is a Shelter component, which is generally high because of supply side issues, and there is Core Inflation minus Shelter, which I think we can use as a proxy for the demand side (monetary policy).  As a rule of thumb, I treat Rent inflation above the Core minus Shelter level as a supply issue.  (I welcome feedback regarding any technical criticism anyone has about this treatment, but please read the series of housing posts first, if you have conceptual criticisms.)

In the mid-1980's, Shelter inflation briefly rose, but this was limited to owner-occupied properties.  I suspect that this largely reflects tax arbitrage in single family homes by homeowners due to the new importance of the mortgage interest tax deduction in the mid-1980's.  Single family homes for rent are subjected to a less favorable tax treatment, so owner-equivalent rent for owners, which reflects pre-tax expenditures, rose.  But, after the brief rise in owner imputed rent, shelter inflation followed core inflation until the mid-1990s.  Since the mid-1990s, shelter inflation has been consistently high (except for the brief post-2008 shock), and it has been highest for renters.

We can see in the Fred graph that since the mid-1980s, multi-unit housing has had very limited growth during recovery periods.  In fact, I have come to believe that this was one of the important factors at play in the housing boom of the 2000s.

Note that total housing starts were not unusually high in the 2000s.  But, limitations to multi-unit building, which are largely occupied by renters, caused rent inflation to rise, and drove households into single family homes.  So, total new units was fairly normal, but all the extra growth had to come through new single family homes.

Home price appreciation was concentrated among the CS10 cities, and I have argued that this reflected rents that were rising especially sharply in those cities.  ACS data, which only covers 2005-2013, gives us some additional detail on this picture, and helps to estimate the scale of the BLS inflation data that goes back to 1982 for many of these cities.  Keep in mind that these data sets cover entire metropolitan areas, including the suburbs, so in some ways, the data showing housing supply problems in these cities understates the problems that are specific to the city centers and to limits on multi-unit housing.

Source

We can see from the first graph, above, that rent inflation was worst during the housing boom, and was especially bad in the 2006-2008 period, after home prices and new building leveled off and began to fall.  During this time, national vacancy rates were somewhat elevated, but they remained low in these high-rent coastal cities.

I think, when we put all of these things together, what we see happening is limited multi-unit building in our metropolitan core cities driving up rents there, pushing households out to the suburbs.  Sticky prices and other frictions in the housing market prevented single family housing growth from fully meeting demand in real time, so rents continued to climb during the housing boom.  Then, beginning in 2006, the Fed began to pull back on the money supply and the mortgage market dried up. Housing supply was already struggling to meet demand, but this new limit to single family home construction completely undermined the market.  Now housing starts collapsed and rent inflation accelerated.

Notice in the Fred graph above that multi-unit housing starts and single unit housing starts had always moved roughly in sync.  But, notice how single unit starts collapsed in early 2006, but multi-unit starts continued apace until the summer of 2008.  Also, note that home vacancies rose in 2006 (even while new building collapsed) but rental vacancies remained level until 2009 (even while building continued).  The money supply and the mortgage market collapse are what led to the housing collapse.  There was still demand for housing, but there was no cash or credit for it any more.

Now, rental vacancies are at new lows, and multi-unit starts have recovered back to pre-recession levels.  But, it's like there is a cap at about 400,000 units per year.  And, in the 20 years during which it looks like there is a 400,000 unit lid on multi-unit housing, we have had persistently high rent inflation.  And this supply problem is coming from our coastal cities.


Rent Inflation among the Case-Shiller 10 and the rest of the country

"Core minus Rent" (CmR) inflation from 1995 to 2013 averaged an estimated 1.8%.  Rent inflation for all households since 1995, in all the areas outside the CS10, has averaged 2.4% - that is 0.6% higher than CmR inflation, suggesting a small housing supply issue.

But, for these 8 cities on average, while CmR inflation was similar to national CmR inflation, at about 1.9%, Rent inflation for all households was 3.2%, and Rent inflation for renters in these cities averaged 3.6%.

The Case-Shiller 10 cities account for 21% of the US population and 31% of residential real estate, by value, but during this period, they were responsible for 55% of the nationwide excess owner-occupier rent and 62% of the nationwide excess renter rent (above the CmR inflation level).*

In the decade before 1995, rent inflation in these cities was no higher than core inflation.  There was a previous period of relatively high shelter inflation, in the 1970s and early 1980s, but I don't have city-specific data for that period.

These cities create a sort of triple-whammy.  Renter inflation has risen more than owner-occupier inflation, these cities have a higher proportion of renters, and rent in these cities tends to claim a higher proportion of household income.

There isn't particularly a reason why these cities need to have perpetual rent inflation.  High density cities aren't that expensive (HT: OB), and many large US cities have grown without unusual rent inflation.

Using rent inflation figures and median rent expenses for the 8 cities with BLS data, I have constructed an estimate of median incomes in a counterfactual world where rent inflation was in line with Core minus Rent inflation since 1995.

Nationwide, the median home owner would have real income 3.0% higher if we did not have this scarcity in housing.  In non-CS10 areas, median owner real income would be 2.2% higher, and in CS10 cities, it would be 5.3% higher.  Owners do earn this income back, to the extent that they have equity in their homes.  But, in terms of asset values, this income is reflected in unusual capital gains captured by existing home owners.

For renters, the median national renting household would see 7.5% higher real income.  The non-CS10 median renter would have 4.9% higher income and the CS10 median renter would have 12.6% higher income.

This loss of real income is basically paid as capital income to real estate owners, as returns on their unusual capital gains.  Homes in the CS10 cities have cumulative excess rent inflation since 1995 of 27%.  Homes in non-CS10 areas have cumulative excess rent inflation since 1995 of 10%.  The national average is 16%.  In 2013, gross rent paid and imputed for housing amounted to 10.5% of GDI.  So, I would estimate that real estate owners are capturing about 1.4% of GDI from the capital gains they have accumulated due to this imposed scarcity.  This is split roughly in half.  About 0.7% goes to property owners in the CS10 cities and about 0.7% goes to property owners in the rest of the country.


The Effect of Housing Scarcity by Income

I can also use real estate and income data from the Survey of Consumer Finances, the CPI rent inflation data, and BEA data on rent expenses to estimate the effect across incomes.  By this measure, for home owners, housing scarcity claims 1.7% of mean family income, ranging from 1.3% of the top decile to 2.9% of the bottom quintile.

Here the effect on income distribution is muted, because home ownership is not that low in the lowest quintile (37% in 2013), and the lowest quintile has the highest proportion of equity among all income levels (reported at 80% in 2013).  So, most low income home owners are probably older households who have pocketed the capital gains from these 20 years of housing scarcity.

Please give me a link in the comments if anyone knows where I can get data on household income and rent for renting households, by income quintile.  The ACS has some data, but the data I have found is not broken out like the SCF data where I can calculate mean levels of expenditures as a proportion of income.

But, if the median renting household spends more than 30% of their income on rent, the poorest households must reach something around half of their incomes.  That means that the renters who make up 63% of the lowest income quintile probably have real incomes reduced by around 10% because of these housing issues, and renters in the CS10 cities - especially New York, Washington DC, and the California metro areas - might see real income cuts of around 20%.  And that is for entire metro areas.  In the core cities, where the limits on multi-unit housing are most severe, real incomes for the poorest households could have taken an even larger hit, although, for this group, the effect of public subsidies, rent controls, etc., must be complex.

Since high income households spend less on housing and capture some of the gains of ownership, they will only see minor declines in lifetime incomes from this problem.  This could be a major factor in the apparent stagnation of lower incomes.  Actually, I think that this spread in income growth between income quintiles would be in addition to measured increases in income inequality, because these household-specific costs would not be captured by average national inflation statistics.



*This is based on stable nominal expenditures at 2013 levels, so it doesn't include any compounding effects from cities with persistently higher inflation.

Adjusting PE ratios for cash.

Aswath Damodaran uses his extensive database to do, in practice, what I attempted to do, here, in theory:  adjust PE ratios for cash balances.



Here is the key graph, regarding the application of this issue to current valuations.  PE ratios on actual, productive assets are much lower than they appear.



I would take this a step further.  Corporations also have much lower debt levels, and a similar adjustment should also be made regarding debt.  Damodaran addresses this indirectly in his recommendation to use Enterprise Value instead of equity valuations.



Relative PE ratios are much lower than they seem and Equity Premiums are much higher than they seem, when they are adjusted for cash and leverage.  This is especially interesting, given that even unadjusted Equity Premiums have been very high.

If loving finance is wrong...

David Glasner joins the chorus against the finance sector with "Is Finance Parasitic?", mostly with true stories of information asymmetry.  This seems to be a point of view that unites observers from all perspectives.

Think of the international capital flows that I have been looking at lately.  Developing market savers invest in low yield US assets, and US corporations invest in developing economy operations.

This trade is largely facilitated by the liquidity of US equity and debt markets.  Here is my attempt at passing an ideological Turing Test.  Let's look at all the damage finance does through this simple trade.

1) Developing market capital is pulled out of markets that could desperately use it.

2) That capital is parked in Western markets, funding unproductive public debt and inflating real estate values, creating unsustainable asset bubbles.

3) US households binge on this cheap capital, selling their financial futures by borrowing against these bloated assets to spend more than their incomes would allow.

4) Much of this spending goes to imports, so all of this debt goes to killing US jobs and supporting jobs overseas.

5) In the meantime, US firms keep moving operations abroad, selling out the American worker for an addiction to cheap foreign labor.

This is the bubble economy, and it has been facilitated by parasitic finance, who takes its cut at every step in the process.  Does the typical household have higher income because of any of this financial crapulence?  No.  Finance just leaves a trail of debt and excess.

</end of test>

David also references this post with thoughts from Timothy Taylor and Luigi Zingales   These guys are all much smarter, better read, and more reasonable than me.  And, clearly there is as much (maybe more) rent seeking, unfair practices, influence peddling, etc. in finance, as there is in many sectors.  But I am struck by the apparent lack of concern with the difficulty of measuring the social gains of financial activity and the tendency to generalize from specific problems with little concern for scale.

I suspect that a lot of potential readers would read my five steps above without objection.  Isn't that a good description of what is happening?  It's frustrating to me to see so many respectable intellectuals seeming to support the common narrative.  This is a subtle, complex subject, and the subtleties need supporters.

The output of finance frequently can't be measured in spending or production.  Finance is the management of risk.  Sometimes, when finance adds value, it adds value by reducing the denominator in the present value of future cash flows.

When developing market capital flows into the US, driving down interest rates, the owners of that capital earn much lower income on those US assets than US corporations earn on the foreign assets that they purchase in return.  Is the US financial sector actually destroying the potential income of those foreign savers?  If we simply measure the value of finance through the top line income it produces, then the answer is yes.

Or, maybe, Western financial institutions are providing value that surpasses that apparent loss of income, and this is one factor that attracts that capital to Western securities.

When US firms buy foreign productive assets in markets with high local risks, even if those assets don't produce more than they would under local ownership, their nominal values may rise due to the fact that they are pulled into a diversified asset base of a corporation traded in sophisticated and liquid financial markets.  So, there is no increase in production, but American corporations capture increases in nominal asset values due to diversification and liquidity.  American finance, just moving stuff around on paper to create fake paper profits.  Right?

Or, put another way, the owners of those foreign assets are now demanding fewer profits for each dollar of productive assets, and capital inflows into those markets will push up the future wages of local workers as a result.

This is conceptually very difficult to understand.  Even if financially literate intellectuals put on a full on offensive effort toward public education on this issue, it would be a tough assignment.  But, in a world where misplaced concerns about trade deficits and asset bubbles keep steering public policy in damaging directions, it's disappointing to see these concerns supported.

One specific reaction I have to the Glasner piece is regarding his paragraph about active trading.

In earlier posts, I have observed that a lot of what the financial industry does is not really productive of net benefits to society, the gains of some coming at the expense of others. This insight was developed by Jack Hirshleifer in his classic 1971 paper “The Private and Social Value of Information and the Reward to Inventive Activity.” Financial trading to a large extent involves nothing but the exchange of existing assets, real or financial, and the profit made by one trader is largely at the expense of the other party to the trade. Because the potential gain to one side of the transaction exceeds the net gain to society, there is a substantial incentive to devote resources to gaining any small, and transient informational advantage that can help a trader buy or sell at the right time, making a profit at the expense of another. The social benefit from these valuable, but minimal and transitory, informational advantages is far less than the value of the resources devoted to obtaining those informational advantages. Thus, much of what the financial sector is doing just drains resources from the rest of society, resource that could be put to far better and more productive use in other sectors of the economy.

It seems to me that he is doing a rhetorical flip-flop here.  It seems as though he is counting the gains of the winning trader as gains to finance and the losses to the losing trader as social losses.  But, isn't it more accurate to say that, if active trading is a zero-sum game, and passive investing on average earns higher returns, that all the gains are social?  The active investors who are making markets more efficient capture none of the gains of their efforts.  In fact, after costs, they lose. But, the benefits clearly accrue to the passive investor and to consumers who enjoy the products of newly funded firms.

Did Apple, Microsoft, Google, Amazon, etc. just spring from our passive conscience?  Aren't we taking for granted that the internet economy sprang from the American VC industry?  I suspect there are some subtle rhetorical biases going on here, where we separate active asset management into categories.  Where it was highly socially beneficial, as with Apple, the result is (1) huge gains to some traders and (2) unseen consumer surplus.  So, we count the trading gains as a sort of unearned income that leads to economic inequality.  Where it failed, the result is (1) losses to some traders and (2) missed potential consumer surplus.  So, we count the losses as a sort of outcome of information asymmetry - finance luring unsuspecting savers in with false tales of potential gains, pocketing the trading fees in a heads-I-win, tails-you-lose parlor game.

In the model in the Hirshleifer paper that Glasner links to, markets are assumed to be perfect.  So, active trading doesn't add any social value in a model that assumes away the social value of active trading..  And, we make a different category for describing capital that creates permanent changes in productive capacity.  When we describe these activities as earning rents off of "private information", it's easy to underestimate how ethereal information is.  Until the singularity comes, things like "foresight", "intuition", and "courage" are scarce kinds of information.  We are much more willing to credit people who created PC's in their garages with creating a new world than we are willing to credit the people who bankrolled them.  It seems ok that the tinkerer got rich.  He was out there working days and nights, getting his hands dirty, doing real work - innovating.  The financier behind him just got lucky, and her gains are parasitic - rents from private information.

Partly what is going on here is the Ant & the Grasshopper problem.  Is someone who invests savings with the assistance of a financial advisor a consumer of the finance sector or a part of the finance sector?  I think what people tend to do is move the agents around, depending on their place in the narrative.  So, there is a narrative that investors trade too much and are overconfident about active investing.  In this narrative, the financial intermediary plays the part of the finance sector and the saver is a customer - outside of finance.  So, overtrading is a cost finance imposes on others.

But, what if the narrative is that corporations have some sort of monopolistic power and profits keep climbing while wages stagnate?  In this narrative, the saver is a part of finance.  They are accruing gains on their investments at the expense of others.

Finance is parasitic because we define it as parasitic.  And the definition is fluid and self-contradicting where it needs to be.

In any system that is too complex to easily understand, we have a tendency to import our biases as a satisfying source of explanation.  Parasitic financiers are an ancient source of explanatory satisfaction.  I think we would do better to check ourselves.  It is very important for us to undermine and correct specific areas of corruption and influence peddling in an area as important and difficult as finance.  But, a comment like, "a lot of what the financial industry does is not really productive of net benefits to society." which is sort of vaguely defensible while feeding corrosive social misunderstandings, is sort of a rhetorical parasite feeding on our existing biases.  I'm not sure this points us in the right direction.

"Mood affiliation" is very tempting here.  I want to make it clear, the point of this isn't to make a category - "finance" - and to form two teams of arguing advocates and opponents.  My point is that finance, in the current public context, contains (1) a lot of highly regulated, complex, and politically charged activities that are ripe for rent-seeking and abuse by providers and (2) a lot of complex and politically charged activities that are very beneficial - crucial, even - to a world of progress and abundance, and whose benefits are subtle, difficult to measure, and frequently at odds with our dreadful intuitions.  Confusing activities in group number 2 with those in group number 1 is inevitable, because emergent phenomena are too complicated to understand.  This confusion is usually met with mass approval, because of our rotten intuitions and the moral dissonance we feel about deferred consumption - the ant.  Avoiding this confusion may be one of the most important and difficult tasks public intellectuals can undertake.