Step 1 of the worst case scenario

There are a lot of positives, clearly, in the US economy right now.  We should keep in mind, though, that both bond markets and equity markets are leading indicators.  Things like bank credit and labor markets are lagging indicators.  I suppose trend changes in housing starts are considered a leading indicator.  But, I don't think the boxing referee stops counting until you get off your knees, so housing doesn't really count as an indicator of strength.

Normally, I would be trumpeting the positive slope in the yield curve as an important bullish indicator, but I think this is off the table.  The Fed Funds Rate was raised on December 16, and now I think we have a clear pattern of both long term yields and equity prices dropping.  This is a clear recessionary indicator.  The Fed erred.  The only question at this point, I think, is how much of a contraction we are in store for while they attempt to save face.

I think if they reversed the hike soon and expressed confidence in the economy and a commitment to monetary support, we would see a continuation of the recovery.  But, the longer this goes, the worse it will be.

We could also be saved by mortgage expansion, but after a promising November, closed-end real estate loans at commercial banks have flat-lined again.  There is a broad consensus against supporting mortgage expansion or real estate markets or implementing any public policy that might be seen as supporting stock prices.  That is a context ripe for a contraction.

Source

The first graph here shows the evolution of the yield curve.  It could be that uncertainty combined with the asymmetry caused by the zero lower bound will prevent long rates from falling much lower.  And, the slope of the curve coming off the initial rise is down to about 40 basis points per year.  This is as low as it has been during the entire recovery.  This may be pretty close to the equivalent of an inverted yield curve at this point.

For years in the 1990s and 2000s, in a deflationary context, Japanese 10 year bonds ranged between 1% and 2%.  Ten Year Treasuries are now just over 2%.

Source

In the period where inverted yield curves signaled recessions, the inversion happened with the Fed Funds Rate above at least 5%.  Here is a graph of the Fed Funds Rate and the 10 year Treasury Rate in the 1950s.  Twice we had recessions without inversions.  The Fed Funds Rate topped out at about 3% and 4%.  The 10 year remained about 1/2% above the Fed Funds Rate.

The drop in long term bond yields and the stock market are clear symbols of approaching declines in broad incomes.  This is probably not the best time to have cyclical exposure.

Added: Update from Marcus Nunes, with many graphs.

Housing, A Series: Part 103 - How supply constraints lead to instability

One of the factors in the housing bubble that is difficult to appreciate and difficult to convincingly document is the volatile influence of rent expectations.  Part of the bubble story is the expectation that there cannot be persistent excessive rent inflation because higher rents will induce new supply, eventually bringing down rents and prices.  Since rational homebuyers should anticipate this, home prices that rise above the level justified by current rents, incomes, etc. are a signal of irrationality - a bubble.

Of course, there can't be a sufficient market supply response in places like Silicon Valley, San Francisco, New York City, and Boston.  So, instead of creating a supply response, rising rents and prices in those cities create persistent rent inflation expectations.  This leads to volatility, because the effect of changing expectations on a long-lived real asset are strong.  The difference in the value of rental cash flow 40 years from now with no unusual cash flow growth vs. excess rent inflation of even 1% is large.  In fact, permanent rent inflation of 4% to 5% would basically drive intrinsic home prices to infinity.  Homeowners in the Closed Access cities have to deal with a sort of St. Petersburg paradox:

Question:  How much is a house worth in San Francisco?
Question in Reply: How accommodative will local housing policy in the year 2040 be?

The possibility of sharp regime shifts in policy and the strong influence those future policies have on the values of properties, today, makes the values of those properties very volatile, and it also makes it easy to yell "irrational exuberance" in a crowded buyers' market, because the only way to falsify that claim is to quantify the rational expectation of San Francisco housing policy in the year 2040.

The problem is, you have to have an expectation.  It is unavoidably important to the value of homes in San Francisco.  This is why the scoffing dismissals of San Francisco home buyers who were expecting 10% capital gains every year are slightly off the mark.  The value comes from rent.  And, very small changes in rental growth create huge shifts in property values.  So, what if we reframed this as a question of rent instead of property values?  Would it have been crazy for San Francisco home buyers to expect persistent real rent increases of 2%?  Because that is about all they needed, even at the top of the market, to justify their purchase prices.

You know where buyers don't have to worry about local housing policy in 2040? Dallas, Houston, Atlanta.

So, what is more likely?  That there just happen to be rapacious, short-sighted bankers and gullible borrowers in all the places with constraints on local housing expansion?  Or that constraints on local housing make rational valuations very difficult, very important, and very volatile?  Certainly, pre-paying those future rents by buying the property usually requires the use of credit.  Certainly, some households vulnerable to the uncertainty of rising rents will be more agreeable to some uncertainty in their credit terms.  So, certainly, the extent to which a generous credit market is available will effect the ability of prices to reflect expectations.  The question, then, isn't whether generous credit is responsible for rising real estate prices.  The question is, "Were the expectations implied by those prices reasonable?".

Has anyone even attempted to answer that question?  This is one of the illusions at the heart of the housing market "bubble" narrative.  Prices can rise because of positive demand pressures or negative supply pressures.  Rising mortgage levels are not a sign of rising demand pressures.  They are only a sign of rising prices.  But, it seems that rising mortgage levels have been taken as the sign of demand pressues.  Nobody has asked the important question: "What was the correct price for homes?"  It sure seems like it should be around 3x incomes and mortgage payments should be 28% or less of incomes.  Those rules of thumb have worked most of the time, for a long time.  But, that goes out the window when median renters in places like San Francisco are spending 40% to 50% of incomes on rent.

So, one of the problems I will have as I formalize my findings is that if I have a model that seems to show that expectations were reasonable, skeptics will say, "Who says your model is right?"  And they will have a point.  But show me the model that the consensus is using now!  It looks to me like we've drawn a straight trend line, and when prices moved away from it, we all said, "Ah, ha! It's those rapacious bankers and irrational home buyers."  I ask, what is your model?  A model that can attribute anything it can't explain to irrationality and unsustainable greed, and treat that as a confirmation of the model, explains everything.  It's the ultimate exercise in question begging.


Aaaaannyway.... back to the issue that motivated this post.  The fact that expectations are so powerful creates a real problem for the potential to solve the supply problem.

Here is a table of home valuations, based on a very simple standard financial model of discounted future rent cash flows.  Here I have based it on the present value of 100 years of rent.  These valuations happen to fairly closely match valuations we see in US housing markets.


The left column has "Open Access" assumptions.  These are roughly the median US input values and home price values we see today.  In the mid-1990s, net rent, in nominal dollars, was about $4,000, and median home values were about $100,000.  So, adjusting rent, this also roughly describes the US housing market in the mid-1990s, before the boom. (Net rent is an approximation of rent after expenses, taxes, and depreciation.)

The next column represents base US median "Open Access" home values similar to market conditions in 2005, after real interest rates had declined from the levels of the 1990s.*

The next column represents the effect on price from a sharp rise in rents.

The next column (the middle column) reflects a city with high rents and an expectation that they will continue to rise.  Adjusted for rent inflation since 2005, this column roughly approximates rent, inflation, rates of return, and home prices, at the peak of the boom in 2005, in San Francisco and San Jose.

The next column reflects a city with high rents, high expected rent inflation, and an increase back to higher real long term interest rates.  This reflects the current rent, inflation expectations, and real estate rates of return, and median home price for the San Francisco-San Jose consolidated metro area.

The sharp contraction in mortgage markets has led to a divergence between returns available from home ownership and returns from real treasury bonds.  If those (implied) yields converged again, I think real estate values, given current conditions, in San Francisco, would rise toward the level shown in the middle column.  The middle column reflects a city with the severe building constraints of San Francisco, but with a healthy mortgage market that funds a reasonable level of housing starts, nationwide and pushes prices to non-arbitrage ranges.


OK, So what's the point of my fancy-schmancy table?

Here's the take-away.  Let's start at the column where interest rates have already risen to 4% and the median home in a San Francisco-like city is worth $726,812.  This is similar to today's context.

Let's say that San Francisco solves their housing problem enough to reduce rent expectations, but not enough to reduce actual rents.  This is actually not a natural resting point.  Stable real rents are a reasonable expectation in an open access environment, where the cost of unconstrained new building creates a stable floor under expected future home prices and potential new supply creates a ceiling.  But, there is no equilibrium that would remove volatile future rent expectations while keeping rents in San Francisco at the artificially high levels of today.  But, taking this as a conceptual first step, this alone would reduce home values by about 13%.

But, if San Francisco realistically solved their housing supply problem, we would expect rents to eventually revert back to "Open Access" levels.  This is represented in the last (right hand) column.  I have tried to use relatively conservative assumptions here.  In the high-rent-inflation scenario, I limited real rents in the long-term to double their current levels.  In the mean reversion scenario, I have limited real rents on the downside to a level that is still 50% higher than the US median.  This is about where San Francisco rents were before the 2000s.  So, even the mean reversion scenario leaves San Francisco a very expensive city.  And, even in this scenario, as modeled here, it would take more than 35 years for rents to revert back to that level.

So, if San Francisco credibly solved their housing problem at the abstract policy level, even before tenants actually began to see relative rents declining, home values might decline by 50%.  This is the power of expectations.  I don't see any natural policy resting place between those two extremes of expectations.  And, I don't see how a mitigating policy can counter that.  In fact, that expected 50% decline is based on today's price levels, which I would argue have already cut home values there by about 25%.  So, by undercutting the national mortgage market so sharply that it hasn't expanded in nearly a decade, we have managed to avoid less than half of the potential decline in San Francisco real estate.

The sorts of policy shifts that we have to see in our leading cities in order to take the cap off of our aggregate national growth potential, to reduce income inequality, and to stop the painful segregation of low income households migrating out of those cities and high income households migrating into those cities, will be unavoidably painful.  If, in the meantime, we manage to fix our national credit and monetary policies so that we stop harming potential homeowners in Texas and Georgia, then home prices will generally rise, and eventual solutions in the Closed Access cities will be even more painful.  I don't think those real estate owners generally deserve to be harmed.  They played the hands they were dealt, which included the expectations created by Closed Access policies.  But, I don't see how we avoid it.  And, they certainly won't be getting a lot of sympathy from the broader population.  It's just so easy to claim, in hindsight, that the banks and home buyers were unhinged speculators taking irresponsible bets.  It will be a game of "The bankers did this to us: Round 2.", complete with grainy video footage and Stacy Keach voiceovers.  And even the solution will cause the airwaves to call out, "The system is rigged!"  Volatility will always be blamed on the capitalists.  And, it is true that the price of San Francisco real estate is more volatile than the official price of Venezuelan toilet paper.  But, at least the sound and fury would be coming from necessary solutions and not unnecessary deprivation.  In a complicated world, it's probably the best we can hope for.







* Actually, some of the price levels of the mid-2000s, even at the aggregate national level, reflected some of the rent inflation expectations caused by the Closed Access cities.  Rent inflation and Real Rates of Return have a similar but inverse effect.  So, a 0.3% rent inflation expectation and a 3.3% required Real Rate of Return would lead to a similar valuation.  In either case, a net discount - growth rate of 3%, together with median nominal rent levels at the time of around $6,000, lead to a valuation of just under $200,000, which are all in the ballpark of the measures at the time.

The Lemon Problem as Social Policy

I frequently see assertions that income inequality has risen because workers have less bargaining power than they used to, and the blame for this shift is placed on the decline of private sector unions.  It is good to see some proponents of this assertion beginning to acknowledge that this is not a matter of income distribution between labor vs. capital, but rather a matter of distribution within labor and capital.  The proportion of domestic income to firms, creditors, and proprietors has traced a longstanding flat trend, and as Song, Price, Guvenen, and Bloom (pdf) have found, intra-firm wage inequality appears to have been stable for decades.  I think Mark Thoma seems to recognize this issue here, but one might be forgiven for not realizing that:

Finally, and importantly, workers need to be able to capture the gains from increases in their productivity. Over the last several decades wages have managed to rise with the inflation rate, but they have not risen with productivity.

I believe this is mainly due to differences in bargaining power. When there is an increase in productivity, the gains are up for grabs. Will they go to the owners or the workers? When unions were strong, workers were able to bargain effectively to claim a large fraction of these gains for themselves. But as unions have faded, bargaining power has become increasingly one-sided, and those gains have gone mostly to those at the top of the income distribution.

He doesn't say that gains have gone to firms.  He says they have gone to the "top of the income distribution".  So I think he must be hedging about this issue, but the two sentences before that create a different implication.

I think it is interesting to think about this issue, because, really, what we have in labor markets is a "Lemon Problem".  There are a lot of information asymmetry problems that employers have to deal with in hiring, managing, and promoting workers.  I think we fairly universally recognize that within any given firm, the correlation between individual salaries and individual value added is much less than one.

What if the new trend of some firms with higher profits and higher intra-firm wages than other firms is a sign that some industries have solved some of the lemon problem?  If they have solved the lemon problem, they are able to more precisely match workers to their productivity.  The improved productivity and better worker-job matching would lift firm profits and worker wages.  In labor markets characterized by this shift, the distribution of incomes would steepen, just as a regression line steepens as residual errors are reduced.  Could the firms with lower profits be firms in sectors that haven't solved the lemon problem?

In a way, unions work by reinforcing the lemon problem.  They provide security for workers by shifting their employment risks to predictable elements - away from discretionary, performance-based judgments and toward credentials and seniority.  Other sorts of legislative labor protections also reinforce the lemon problem, by making dismissals more difficult, etc.

But, if we think of the classic "lemon problem" market - used cars - these sorts of solutions would seem strange.  I don't think anybody has ever suggested that the used car lemon problem should be solved by giving used car dealers more negotiating power.  I don't think anyone has ever suggested that we should have laws preventing car dealers from offering return policies.

As you might have guessed if you are an IW regular, I think this is related to housing.  As I have argued, the cities with very high average incomes and very high income inequality tend to be cities with constrained and expensive housing.  There are industries in places like New York City, San Jose and San Francisco which seem to find great value in having a dense population of creative and innovative workers.  That factor is the thing that draws workers into those markets.  I think if those cities solved the housing supply problem, we would see a reduction in those high profits and high wages, because with the influx of more firms and workers to compete, the excess would accrue to consumer surplus.  But, in the meantime, it seems pretty clear that there is a concentration of the firms that are archetypal high profit/high wage firms within these high-rent cities, and it is easy to imagine how the lemon problem plays into these trends.

My impression of Silicon Valley is that there is a culture of collaberation and of project hopping.  The geographic density of the labor pool is important there, because it means creative tech workers take on fewer risks and frictions in matching their value to jobs.  I don't know.  Maybe the economic rents created by the housing supply problem help to make this culture flourish.  Maybe, without the cushion of economic rents provided by the lack of access, firms would be more guarded.

Markets are always searching for solutions to this problem.  The signaling element of education is an important part of this process.  And, solutions to the lemon problem can add economic pressures to vulnerable workers.  Because it is common knowledge that I can't hit 3-pointers like Stephen Curry, I have little chance of even getting a small contract from the Golden State Warriors.  You could say that, as a vulnerable worker, I have less negotiating power than Stephen.  That wouldn't be a very useful way of understanding my plight.  And, it certainly wouldn't be in anyone's interest to add information asymmetries that would make it difficult to find out who was the better basketball player.  It should shock us when policies that are essentially doing that are the best ideas some people have for pulling up low incomes.

I have seen complaints about the difficulty some workers were having in finding new work after they had been receiving long term unemployment insurance.  In that case, a social safety net policy may have alleviated some information asymmetries.  The extended support incentivized some workers to hold out for better options.  This was one of the policy's explicit goals.  But, in the end, the extended length of unemployment may have served as a piece of information valuable enough (even if imperfect) to counter the benefit of a patient job search.  I suppose we can just blame employers for using the information to try to find the best worker-job matches within their firms.  Moral demands that contradict natural and understandable human relations tend to lose over time, but they can do a bit of damage on their way there.

If, as a first step, we all simply approached employer-employee dilemmas as analogous to a trip to the used car lot, maybe we would approach them with the sort of empathy that leads to reasonable and judicious solutions.

Maybe technological progress and a more dynamic labor market naturally lead to more wage inequality.  In that case, we need solutions that don't undermine that dynamism.  But, as a first step, I sure would like to see the cost of living in those dynamic cities come down through housing expansion.  Maybe this is all a misdirection that comes from limited access.  Maybe in an economy with free-flowing capital, consumer surplus is a significant mitigating force to improvements in the matching process of laborers and jobs.  Maybe in an open economy, we wouldn't even have noticed that this would have been a problem.

Housing, A Series: Part 102 - What do our two housing markets tell us about demand?

In yesterday's post, I neglected to mention one implication of our two housing markets.

Much of the country had reasonable home prices throughout the boom period.  According to Zillow, at the end of 1995, the expense of a conventional mortgage on the median home amounted to less than 25% of the median household's income in about 64% of metro areas (MSAs), weighted by population.  At the end of 2004, 52% of cities remained affordable.  By the end of 2005, with rising interest rates, that was down to 40%.  There was a decline, especially in the last months of the boom, but there was still a large area with generally typical home affordability.  And, this proportion is probably higher in the one-third of the country outside of the largest cities.  And these areas of the country were taking in net migration from the more expensive areas.  There are some notable areas of declining population, but these areas include some of the fastest growing cities in the country.

My point here is that, on the margin, these areas that did not have unusually expensive homes were capable of serving as representative marginal housing markets.  These cities are the baseline for measuring demand-side (monetary and credit-influenced) effects on the housing market.  As we should expect from long-standing tendencies in housing markets, trends in rents and price levels were not exceedingly different from the basket of non-shelter goods and services.

Because the price levels of the Closed Access cities are the result of a supply constraint, the higher prices in those cities are not a product of demand-side factors.  They are the measure of substitutability.  The relative prices in these cities reflect the extra value of the properties which are contained in a limited access location relative to the value of a property in an open access location.

That substitutability reflects an inherent comparable value.  Part of that value comes from higher incomes that I believe are themselves a product of the limited access.  So, the ratio of the value of properties in the Closed Access cities to the Open Access cities isn't constant.  It might be affected by economic growth, innovations in certain industries, demographic and population shifts, foreign capital and population flows into the US, and many other factors.  It is probably even affected by the posture of monetary, regulatory, and credit policies.

That substitutability, or more precisely, the lack of substitutability, was really what fed the arithmetic of the housing bubble.  And, that substitutability is expressed, firstly through rents, and only secondarily through prices.  Monetary and credit policy, aside from being accessible and generous enough to induce reasonable supply (which they clearly are not, now), can't do much to change this relative value.  It would be like using monetary and credit policy to bring down the price of BMW's.  (We never blame the price of BMW's on credit policy, do we?  Since we recognize, intuitively, the notion of substitutability in the auto market, we recognize that, at most, generous credit might lead to more units sold and that monetary policy tends to move all values in tandem.  Nobody would ever argue that we need to tighten credit standards in order to pull the price of BMW's down, and that if Chevrolet prices and production comes down, too, as a side effect, it's just the medicine we have to take to make the category "cars" affordable again.)

As we passed into 2004 and 2005, it looks like economic expansion was increasing the value of those local labor markets and increasing the rental value of those coveted locations.  The relative values of those cities were moving high enough to begin to create some contagion in nearby housing markets.  I really dislike the idea of a "overheating" economy and that we need technocrats to "cool it down" before we overproduce.  That's a dangerous framework, tied in to such other pernicious ideas like that it is the job of the central bank to make sure risk premiums remain high.  But, here we can see how these ideas can seem reasonable.  If you develop real obstacles to creating real economic value that are strong enough, then the economy necessarily becomes a battle for what is available.  It really does become a fixed-pie context.  And, then, all those colloquialisms about the haves vs. the have-nots really do come true.  If you find living in San Francisco personally valuable, then you live in the dog-eat-dog world.  You should want technocrats to "cool down" the economy, and hope you somehow stay warm.

And, since we aren't going to solve these supply-side problems, we solved it with demand.  I don't know, maybe if we had slowed things down slightly, we could have backed migration flows up just enough to reduce the contagion.  But, we slowed things down so much that those Open Access cities which should have been our barometer of demand-side influence switched from being within the range of healthy and normal to being in crisis.  And, if housing markets are any indication, they still are.

Housing, A Series: Part 101 - The Effects of Supply vs. The Effects of Demand

Since there are two distinct housing markets in the US - Closed Access and Open Access - there were two distinct housing booms - the Price Boom and the Starts Boom.  Consumption can change because of changes in supply or demand.  Economic intuition should give us two distinct sets of expectations about a housing market with a negative supply constraint vs. a housing market with a positive demand shock, or expectations we might have about a market with both.

In terms of homeownership vs. renting, the trends across the country were similar.  Here is a graph of homeownership rates in selected states.  So, to the extent that a shift in demand was related to expanded lending to marginal homebuyers, it was a national phenomenon.  (The rise in homeownership rates may have been mostly simply a demographic phenomenon, unrelated to housing supply and demand - simply a transfer of tenants to owner-occupiers as part of normal life-cycle trends.  My preliminary estimate suggests that about half of the growth in homeownership was related to age-demographics.)

Among the largest cities, Phoenix, Dallas, Houston, and Atlanta are the best examples of housing markets with minimal supply frictions.  From 1995 to 2005, Phoenix and Atlanta issued about 16 housing permits per resident and Dallas and Houston issued about 10, compared to a national rate of less than 7.  So, if we want to check our intuition about the effects of a demand shift, these cities should be a good example.

I would expect economic intuition to tell us that more generous credit and low interest rates might lead to a positive shift in demand.  This could lead to higher home prices, but in an efficient housing market, a small price increase would lead to more homebuilding.  More building would increase supply, and rents of existing housing stock would decline as a result of the new supply.  Households would consume more housing at relatively lower rents.  Consumption would increase, but prices and rents would be moderate.

In fact, I don't think my expectation here is particularly controversial.  Sophisticated observers who described the housing boom as an unsustainable bubble did so because they thought supply and prices were lagging due to market frictions, but they expected new supply to eventually bring down rents and prices.  Where I would part ways with the bubble narrative is that I think it is implausible to expect home buying demand to push home prices nearly as far away from intrinsic value as it has been presumed to have done.

But, you don't have to take my word for it.  We have markets which are known to have flexible housing supply.  And, those who have been following this series know what these cities tell us.  During the boom period with strong housing starts, Price/Rent ratios in these cities were level.  (I will address the late price surge in Phoenix later.)

And, likewise, Price/Income was fairly stable, with maybe a slight rise over the period.

So, these areas demonstrate the classic response to demand shifts when markets are efficient and supply can respond.  When demand shifted up, rent inflation declined, housing starts increased,   This conveyed economic benefits to the broad range of households.  The signs of a demand shift are not rising prices.  The signs of a demand shift in homeownership are rising starts, rising real housing expenditures, and, because homeownership creates supply for housing consumption, relative falling rents.

After 2005, housing starts collapsed and prices collapsed, even in the Open Cities.  This can't be the result of an upward shift in supply, because starts were collapsing.  This has to be the result of a downward shift in demand.  This downward shift generally remains in place.

But, in the Open Access cities, the main signal of demand was high housing starts, not high prices.  The source of demand before 2006, in these cities, wasn't so much generous credit as it was migration from the Closed Access cities.  It also so happens that some of the secondary cities that had the most pronounced late-cycle price bubbles, like Phoenix, were cities most exposed to waves of migration from the Closed Access cities.  Phoenix wasn't different from Atlanta or Dallas because it had broader access to private MBS funding.  It was different because it was closer to California.

 Housing starts are dismal in the Closed Access cities, but during the heart of the boom, according to BEA table CA1, population growth was especially stagnant.  At the end of the boom, population flows into the Open Access cities moved higher, and we can see here that the flows into Phoenix, compared to Dallas and Houston, were earlier and stronger.  This doesn't seem like it should have been enough to cause a price spike in Phoenix.  But, for reasons I haven't pinned down, housing permits were not keeping up with demand.  At the new neighborhoods, there were lotteries at the time to apportion new homes to buyers.  Maybe there is some bureaucratic annual maximum of about 0.15% permits/population.  But, it actually looks like, in the midst of this spike, permits began to decline at the end of 2004 in Phoenix, while population, rents, and prices were all spiking.

I would gladly ascribe higher prices to expectations of persistent rent inflation, but, given Phoenix's historical posture of expansion, persistent rent inflation seems unlikely.  Yet, the fact remains that even in this city that seems to be a prime example of speculative disorder, experienced high population inflows, high rent inflation, housing starts stagnating or falling from their normally high levels, and clear real-time constraints on supply.

The conclusion, in any case, we can come to most confidently is that there has been a negative demand shock since 2005 in the Open Access cities.  Before then, there was either a positive demand shift that was moderated by efficient and elastic supply, or there simply wasn't anything we would describe as a significant positive demand shift.  Housing starts were typically strong in these cities, but they don't look unusual, compared to the 1990s.

In the Closed Access cities, we have clear supply constraints.  So, the question here is, was the boom mostly a reflection of supply constraints, or was it a combination of supply constraints and unsustainable demand pressures?  We know that prices increased to much higher levels in the Closed Access cities than it did in the Open Access cities.  One way we might decide how much of this was influenced by generous lending would be to compare these cities after the bust to the Open Access cities after the bust.  If credit was the fuel, then the removal of that credit should show up as lower prices.  Certainly, during the bust, prices and starts collapsed together, just as in the Open Access cities.  But, in spite of extreme constraints in mortgage credit markets since 2007, where even today total nominal mortgages outstanding has fallen back to 2006 levels, prices have begun to rise.  Rents are rising, too, because supply has especially been constrained since 2005.  So, Price/Income in some of the Closed Access cities are now reaching levels approaching the peak of the boom.

Some might argue that this is due to loose money and QE, but why would QE lead only to nominal expansion in housing and not in broader consumption?  And why only housing in just a few cities?  If the answer to that is that some QE purchases were of MBS, which supported the mortgage market, wouldn't we expect some of that to operate through an expansion of mortgages outstanding?

There was a negative supply constraint, which, beginning as early as 2006, was combined with a negative demand shock.

We should ask ourselves another question.  If this was a credit-fueled bubble, why did housing starts collapse in the cities that didn't have a price bubble?  Why would the subprime buyers in Dallas and Houston, paying 2x - 3x their incomes for homes be the primary source of the collapse instead of the subprime buyers in California paying 10x their incomes?  Why did home prices collapse before rents did and well before defaults did?  (In fact, rents climbed as housing starts collapsed.)

Housing, A Series: Part 100 - One way that income inequality slows economic growth

There are many ways in which local supply constraints in housing reach into many of the sources of concern about today's economy.  I have probably touched on all of these points before, but here I want to pull these ideas together in one post.  Given that this is post 100, please let me know in the comments if you feel like I am becoming repetitious or redundant in these posts, or if this post adds anything to what I have previously discussed.

One theme that I see frequently addressed in the literature is the idea that expansion in the financial sector is a causal factor in subsequent stagnation.  I think this is a specious correlation.  I have argued that low real long term interest rates are predictive of subsequent stagnation and that they are a causal factor in an expanding financial sector.

Further, I have argued that the constraint on homebuilding in our most productive labor markets could actually be a causal factor in the decline of real long term interest rates.  And, even without the effect on interest rates, since in a supply-constrained environment, housing demand becomes inelastic, then constraining housing supply leads to an expansion of nominal real estate values.  So, there is a direct effect of local supply constraints pushing up local real estate values and potentially an indirect effect of lower real long term interest rates resulting from that local effect leading to higher real estate values everywhere.

So, instead of a series of trends that goes: financial expansion -> housing expansion -> overdevelopment -> contraction

I think, in the recent series of events we have something more like: local supply constraints -> nominal housing expansion -> declining interest rates and declining non-real estate investment -> contraction

Income = MSA Median Income as % of US Median

Part of the way that this plays out is that rents in the housing constrained cities go up.  I have documented how the constraints on housing have led to the odd outcome where incomes and rents have both skyrocketed in these few large problem cities.  And, this is the crazy way in which income inequality becomes associated with economic stagnation - another popular topic of our time.

The Closed Access context created by the local housing supply constraints allows firms and workers there to both earn higher incomes.  Closed access means less competition for their services.  The median income in just 5 cities representing about 15% of US population has now jumped to 125% of the national median income.  This is a recent phenomenon.  As housing has taken center stage as the binding constraint, costs in these cities have skyrocketed.  Even as incomes rise, families in these cities struggle - economic growth doesn't even help, because it just leads to higher rents.  All those high incomes go to rent.

So, we see this recent cadre of very high income households, we see rising costs which lower measured real incomes, and we see these families that face economic stress in good times and bad times.

And, just like with all the other conceptual errors we make with this housing issue, we take all these statistics, and we throw them all in the aggregation blender, and it spits out numbers that completely lose the salient part of the information - that this is a localized problem.  And, we see a statistical story that looks like:

income inequality -> desperation borrowing -> unsustainable financial expansion -> contraction

And we fill in the details with a story about how middle class consumption is the key to economic growth, and that income inequality leads to stagnation.  But, this gets it wrong.  First, the borrowing has practically all gone to high income households.  But that borrowing is to buy access to the high income cities.  They bought access by paying the previous residents of those cities a hefty sum for their homes.  And many of those former residents took the cash and retired to Boulder.  The high costs that are pulling down real incomes are just an annuity payment on the sunk cost of Closed Access housing.  These Closed Access cities have imposed a significant cost on the US economy, and to the extent that capital gains on that real estate have been realized and utilized in household economic decisions, those costs have been internalized.  We can fix the future impact of continuing these policies, but the costs that have already been imposed are reflected in the cash transfers to those former owners.  We can't get that back.

That story about inequality and desperation borrowing always struck me as a bit odd, anyway.  How does an economy characterized by desperate middle class borrowing manifest itself in a housing bubble?  In that narrative, the power of predatory lending is carrying a lot of water, and, frankly, even without fully unpacking the counter-narrative I developed about localized housing, it should have struck all of us as comically implausible.

I think the more accurate series of issues here is: local supply constraints -> limited competition among local highly skilled labor in frontier innovative industries -> localized higher profits, wages, and costs -> borrowing to fund access (through local real estate) to those high incomes instead of funding productive investments -> contraction

So, rising inequality is associated with stagnation, but in an upside-down sort of way.  The stagnation comes from the higher incomes, because those higher incomes are only serving as a conduits for economic rents.  This is also probably associated with reduced growth from investment, both because firms in these cities are protected from competition and also because capital is attracted to rent-seeking in these real estate markets instead of to productive endeavors.  I think this explains why practically all the income inequality has come from wage inequality; why wage inequality has practically all come from between firms, not within firms; and why the recent decline in labor share of national income has been paired with rising rental incomes, not rising corporate operating income.  All of this is due to limited access to lucrative labor markets.  The high incomes are a misdirect.

This all seems very complicated, but it actually boils down to a simple and obvious basic truth.  Growth comes from the application of new capital to its highest use. Price signals clearly point to housing in these cities as a valuable asset, and local policies prevent capital from being deployed there.  This is basic North, Wallis, and Weingast limited access order stuff.  We now have limited access cities with limited access outcomes.  (To think that this is what has become of the entry ports for countless immigrants - New York and San Francisco were the urban archetypes of Open Access, the pride of accessible American opportunity.  Now residents in the Closed Access cities fight immigration because it drives up rents and complain that only the ultra-rich are moving there.)

This leads to immediate gains for those with access to the constrained assets and losses for everyone else.   In the long run it leads to losses for everyone.

The misdiagnosis of this problem: seeing high cost as a product of excessive monetary expansion or as a more generalized problem of corporate power, leads to proposals to cut monetary expansion or to exact generalized punitive or redistributive policies on corporations.  But, this problem is already leading to generalized deprivation, so heaping more generalized deprivation on either workers or firms only makes matters worse.

Housing, A Series: Part 99 - How widespread is the supply problem?

I have been playing around with Zillow data on a set of 151 metropolitan areas (MSAs), and I decided to double check myself on the extent to which Americans did not experience a pricing bubble in the 2000s.  I have put together histograms of Price/Income, Mortgage Affordability, and Rent Affordability, by city.  For each measure, I have one graph with the count of cities and one graph with the total populations.  For the total populations, I am associating the entire population of each city to its median value.  In reality, each MSA will have a range of values, but accounting for that would require a lot more effort.  This helps us get the basic idea, I think.

These cities represent about 70% of the US population.  I don't currently have direct data on the other 30%, but since it is largely rural, I expect it to have low valuations.  So, including it would mostly add to the lower part of the distributions of these measures.

First, here is Median Price/Income, by city.  Blue bars are 1995, Green are 2005, and Red are 2014.  By city count, we can see that in 1995, the distribution was relatively tight.  Price/Income was under 4x in almost every city, and was under 6x in all cities.  There was a slight shift higher in 2005, with the mode moving up from the 2.7x bin to the 3.0x bin, and a very long right tail developed.  By 2015, the bulk of the distribution had moved most of the way back to 1995 ranges, except for some of the extreme cities at the upper end.

This is the sort of distribution I am thinking about when I say that most Americans did not experience the price boom.  But, I may have been overstating the case, slightly, because the outlier cities tend to be the larger cities, so that if we graph it based on populations, the tail of outliers claims a lot larger part of the country.  There are definitely two stories here - Americans in the hump and Americans in the tail.

Since low real long term interest rates increase the cash value of homes, some of the shift to higher home values should be attributed to interest rates, which have fallen since 1995.

Here is a measure of Mortgage Affordability, which measures the portion of the median family's income needed to make the payments on a conventional 30 year mortgage.  Since the low long term interest rates we have experienced would have a similar effect on the value of a home and the affordability of a mortgage, changes in Mortgage Affordability can give us some insight into the relative causes of home price changes.

The basic distribution of mortgage expenses in 2005 is very similar to 1995 for cities in the hump.  The hump is slightly smaller, because some portion of the cities have moved to the tail.  But, the cities that didn't move to the tail have a similar distribution to cities in 1995.  This suggests to me that the relatively small changes in Price/Income in the hump cities were largely related to falling interest rates.  This is why debt service ratios were relatively stable until very late in the boom.  This measure also has a much larger tail when rendered by population.  So, again, there were many more cities that didn't experience the price boom, but they tended to be smaller cities.  About 1/3 of US population lived in cities where Mortgage Affordability moved outside the 1995 distribution.  The other 2/3 of the country lived in the hump (assuming that the remaining rural areas tended to have hump characteristics).

In 2015, Mortgage Affordability has moved lower than it was in 1995, but with the remnants of the outlier cities remaining.  This is a picture of the basic error I believe we made.  We have moved the hump to the left when our problem was the tail.  We have solved a problem we didn't have while the problem we did have remains.

Next is Rent Affordability.  (A caveat.  I think the Zillow data for this measure includes some linear extrapolation for the earlier time periods, but the estimated levels should be relatively accurate.)  What we see here is a slight march to higher rents in each period, especially from 2005 to 2015, across the distribution.

There isn't so much of a hump & tail shape here, but we can see affordability in some of the larger cities moving away from the norm in 2005 and especially by 2015.  The skew isn't as high here as with the range of home prices.  That is because for the outlier cities, I think the price reflects both the current high rent level and the expectation of persistently high rent inflation.  Note that while the skew has declined in the price and mortgage measures, the outlier rent cities have moved further from the norm in 2015.

This is why I insist that homes now are significantly underpriced.  The Price/Income hump is basically where the hump was in 1995.  But the Rent/Income hump has moved to a much higher level in 2015.  This also reflects our misdiagnosis.  We have hobbled the credit markets that fuel housing supply, so home prices cannot be bid up to their intrinsic values.  The continuing lack of supply has pushed rents relentlessly higher.  I suspect that home prices will need to rise substantially before they induce reasonable levels of housing starts - which at this point needs to be more than 1.5 million units per year for some time to bring these rents down.

With regard to the mismatch of rents and prices, I am referring to the hump - the majority of the country.  The tail cities are expensive because of localized supply constraints, so their correct prices are necessarily more speculative.  And, to the extent that aggregate national numbers are skewed higher by those outlier cities, it distracts us from the clear policy needs of the majority of the country that is capable of building homes, if we can revive our mortgage market.

Housing, A Series: Part 98 - Details on Homeownership

The Survey of Consumer Finances gives us some insight into broad changes in household finances over time.  Homeownership rates, by income levels, is one of the many useful pieces of information it provides.

Way back in the early parts of this series (parts 11, 12, and 14 touch on this issue) I looked at this.  I thought it might be worth a fresh look.

I would like to mention, first, that I think there is a bit of false American exceptionalism here.  Usually, I see this when someone cynically paints public homeownership policies as an unwise attempt to force the public into an unsustainable version of a uniquely American dream.  But, according to this Wikipedia article, American homeownership rates are actually pretty low compared to most other countries.  The choice of public policies in this area is a subtle and complicated one, and I would be as happy to see some changes as anyone, but I don't think there is anything particularly American about public or private tendencies to celebrate homeownership.

Here is a graph of homeownership rates, from the SCF, by income quintile (the top quintile is separated into 2 deciles).  What I have pointed out previously is that essentially all of the increase in homeownership during the boom years was among the top 60% of incomes.  There isn't any evidence from the SCF of a surge in low income home buyers.

The next pair of graphs show the change, from 1995 to 2013, in homeownership rates within each income group.  The left graph is for primary residence and the right graph is for non-primary residence.

Since homeownership among the highest income households is already very high, when homeownership rises, we might expect most of the new ownership to happen at lower incomes.  For example, if 100% of the top 40% of households already were owners, then even if marginal new owners were the highest income non-owners, the average new homeowner would have a lower income after the rise in ownership than they had before, even without any downward bias.  Now, it happens that this wasn't the case.  As I outlined in those earlier posts, the income of the average homeowner actually increased during the boom, even with this natural force that should bias the average down as homeownership rises.

In the next pair of graphs, I try to account for this by looking at a new measure.  In this pair of graphs, I measure the change in homeownership in each income quintile over time, as a percentage of the non-owners in 1995.  This doesn't change the accounting for the bottom 40% much, because there just wasn't much net aggregate home buying among those households.  The bust has dropped homeownership among those households.  This has been strongest among the lowest quintile.  I suspect that since homeownership in that quintile appears to be concentrated among retired households with low leverage, much of this drop is the result of households dealing with unemployment, etc., losing their homes, and falling from higher quintiles as a result of the recession.

Among the middle quintile, at the peak, about 20% of the previous non-owners had become owners during the boom.  This has reversed in the bust so that net homeownership in this quintile is back at 1995 levels.

Among the top two quintiles about 30% to 45% of non-owners had become owners by the peak.  This has fallen since then, but in 2013 about 15% to 25% of previous non-owners still were owners.

During the boom, homeownership rose and was slightly skewed toward higher income households, relative to the existing pool of homeowners.  During the bust, homeownership has fallen and has become significantly more skewed toward higher income households.

One response I have seen to findings that subprime loans weren't particularly related to a decline in buyer incomes is that many of them were made to higher income households who were engaged in speculation.  Interestingly, ownership of non-primary residential real estate did rise among the top quintile, but it has generally remained elevated since the bust.  Now, it could be that there has been a transition between high income households that defaulted on non-primary real estate holdings during the bust and opportunistic high income households who have entered the market since then to buy up cheap foreclosures.  So, maybe this group of owners still accounts for some of the defaults.  But, I think it is interesting that we don't see much sign of distress among this group in this data.

MSA Data on Homeownership

Can cities shine any light on this?

Here is a scatterplot comparing homeownership rates and Price/Income levels, by city.  (The data I am using has a discontinuity in 2005.  This is why my charts don't cross that period.  Before that year some of the MSA boundaries are less inclusive, which tends to bring down ownership rates and drive up P/I levels because the urban cores are a larger portion of those MSA's before 2005.  This affects the levels, but it shouldn't affect the trends that much.)

This first pair of graphs shows the movement up in P/I and in homeownership rates from 1995 to 2004, then the move down in both measures since then.  It's hard to learn much from these graphs about the boom, though.  But, it is clear that in all scenarios, high homeownership is strongly correlated with lower price levels.

In the next pair of graphs (for the 1995-2004 boom period and the 2005-2013 bust period) I compare the change in the Homeownership rate for a city to the Price/Income level of the median home in that city at the end of the period.  There is no relationship.  If anything, homeownership increased the most in the cities with the lowest prices.  In the next graph, below, comparing the subsequent change in homeownership to the beginning Price/Income level in 2005, the slope of the regression line is a little steeper.  This is because there were a few cities that did see sharp price swings toward the end of the boom, which subsequently saw sharp drops in prices and homeownership - cities in Florida, Arizona, Nevada, and inland California.  These were generally cities with low to moderate home prices that spiked toward the end of the boom.

In the next pair of graphs, I compare the change in the Homeownership rate for a city to the change in the Price/Income level of the median home in that city over each period.  In the boom period, there is no relationship.  Most cities did not see an extreme rise in Price/Income, and the few that did see an extreme rise in Price/Income did not exhibit a systematic trend in homeownership rates.  Homeownership, at the MSA level, appears to have had nothing to do with the price boom.

In the bust period, we do see some relationship between changing homeownership rates and changing home prices.  In MSAs with falling prices, we also tend to see falling homeownership rates.  For a 1% fall in an MSAs homeownership rate, relative to other MSAs, since 2005, we see a fall in Price/Income of about .05.  Even though the relationship is weak and is not statistically significant, the effect is fairly strong.  Most cities have P/I around 3, so a relative drop of 0.5 in the Price/Income measure for a city with a 10% drop in homeownership compared to a city with no drop is dramatic.

But, the takeaway here is that none of these relationships between cities is statistically significant and to the extent there is any relationship at the inter-city or national aggregate level, it was a bust effect, not a boom effect.  On the margin, this has mostly been a story of high income households buying homes in low priced cities.  The shift of households into ownership was not related to the rise in home prices in the boom.  But, the subsequent collapse of mortgage credit and housing markets did push some households out of their homes.  This corroborates research that has shown that mortgage defaults were strongly related to loss of equity.  These losses were concentrated in secondary cities that tended to be destinations for households moving from the Closed Access cities.  On net, though, what the entire process has led to is Closed Access cities which continue to be very costly, secondary cities that were whipsawed through a boom and a bust, and the majority of the country that never had much of a boom, but has had to endure a decade of curtailed housing starts and mortgage credit.  In this last graph, we can see the endurance of the high cost of a few supply-constrained cities and the relatively normal behavior of most of the others.  These scatterplots compare the median home price in each city from 2005 or 2013 to 1995.  The difference between cities has steepened.  The cities that had P/I ratios below about 2.5 in 1995 are now likely to have lower P/I ratios than they did then, despite very low interest rates.  Those cities didn't need a correction even though some of them built a lot of homes and saw significant increases in homeownership.

State Religion & Public Education

Don Boudreaux's quotation of the day was especially good yesterday.  "(It) is from page 92 of the 1978 collection, edited by Eric Mack, of Auberon Herbert’s essays, The Right and Wrong of Compulsion by the State; specifically, it’s from Herbert’s March 1884 Porthnigtly Review essay 'A Politician in Sight of Heaven'”:

You may use your own reason when you say that compulsory education, or compulsory temperance, is good for certain people, and proceed to carry it out; but in so acting you disallow the existence of reason in those whom you compel.  You have placed them in a lower rank to yourself, you retaining and using your reason, they being disenfranchised of it.

I sometimes think that, if I am a fundamentalist about anything, it is the basic public consensus of the American experiment, with the Bill of Rights as a central document.  One of the oddities of the American consensus, though, is the strong statement in the Bill of Rights against a state religion, paired with the consensus that has developed since then in support of compulsory education.  These are analogous issues.  In fact, it seems to me that in the broad history of humanity, they would not have even been considered analogous.  They would have been considered restatements of the same issue.

And, in fact, they really still are the same issue.  Education has become the religion of the modern secular world.  Education, or science, is certainly where we have public debates about what our national ideals are, today.  In today's society, few will care how you rate the three persons of the trinity, or what your detailed beliefs about the Eucharist are, but you better be ready to defend your position on climate change, the effect gun laws have on crime, or the demands society places on women.  And, we don't fight about how our propaganda gets disseminated from the pulpit to the pews.  We fight about how it gets disseminated from the white board to the school desks.

In a free society, what exactly "education" even is is difficult to define, in much the same way that religion is.  Is it going to the right services?  Earning the right credentials? Knowing the correct things?  Having a thirst for spiritual or material wisdom and intelligence?  Is either one about living well in the world, or is it about having a depth of spirit?

Education is our religion, and so we have taken an end-around past our own ideal.  We have imposed state religion/education on ourselves, even as we stand united in opposition to it.  In that mess of potential definitions and goals for education and religion, public compulsion has the same types of effects, pro and con, in both manifestations of the issue.

I don't hear these problems being aired out in the public debate over education policy, so we keep pushing more and more support on our state religion, with predictable downsides.  Ironically, not only are these downsides that we all explicitly understand, but we only understand them because we learned about them while we sat in our state churches (schools) learning about the Bill of Rights and how it has protected us from state religion.

I have seen this meme:

The same thing could be said about state religion, maybe replacing "stupid" with "immoral".  None of us would find this meme convincing if we made that minor change.  And, generally the reasons that it would not be convincing would also apply to public compulsory schooling.  State religion, where it is treated as socially important, is a great recipe for moral stagnation and sectarian moral featherbedding.  We shake our heads at countries that have powerful state religions who respond to moral stagnation and division by redoubling their commitment to it.

And, further, I think the way in which past problems with public education have been framed around the idea of desegregation takes the focus away from this problem.  Desegregation was mostly a way to try to trick dominant groups into managing a functional school system for marginal groups.  But, the problems of segregation were secondary problems.  They weren't the cause.  Segregation was effective because education was compulsory, because there were truancy laws and accreditation rules that forced marginalized groups of children into failing institutions.  The idea that public education is the unquestionable vessel for escaping that legacy strikes me as..... well, questionable.  And, the idea that education can be imposed on people is...well....stupid.

The sad thing is that with regard to religion, America is the prime historical example of people, freed from the religious controls of their homelands, engaging in a frenzy of religious experimentation and fervor.  Would that we might trust ourselves enough to have such a frenzy of education.  And what does it say about our respect for our fellow Americans that some of us think a knock on the door from the truancy officer is the only thing keeping us from "living in a country with a bunch of stupid people."?

IW in 2015

Housing, housing, housing.  I'm not even going to compile the list of posts.  Just go to the monthly archive on the right margin and work your way back.  At the rate it's going, I might have another 100 posts in the series by the end of 2016.  If I had more time to compile data, I probably would already have another 50.

Of the housing posts, the most popular were:
Part 77: Housing is defining politics and the repercussions are dreadful
Part 8 - The crisis didn't happen the way you think it happened
Dr. Shiller, heal thyself
Part 88 - Supply, Demand, and Economic Migration
Part 1 - I was wrong. The mortgage deduction is just the tip of the iceberg.

Back then, this was mostly just an idle curiosity about taxes and home values.  I have, unfortunately had to leave some of the early questions unanswered as I discovered new avenues for research that have been more salient. Part 2 isn't nearly as popular.  I suspect a lot of people have read some of the later stuff, decided they should go back and start from the beginning, and after part 1, thought, "Shit, this is boring." 

Part 51 - Housing and Strong Form IMH
Part 85 - Housing Prices were sustainable because of migration
Part 76 - There are two Americas.
Part 65 - Reasoning from a Daisy Chain
Part 78 - The Intractability of economic stagnation with a supply constraint
Part 33 - Higher Home Prices can lead to Larger Homes


Other financial/economic posts that were popular included:
We Are the 100% (August)
We are the 100%... (February)
The huge potential value of NGDP Level Targeting, a CAPM and Risk Trading perspective


Other Nonsense:
Keystone pipeline: politics is not about policy


Some conceptual posts that I like, but didn't get as many clicks as the posts above:
A brief rant on monetary policy
Just a minute, honey. Someone on the internet is wrong.
The Problem with Corporate Social Responsibility
Institutions, individuals, and American Politics (aka: Progressivism becomes Conservatism)
Our discomfort with reward from risk leads us astray
If loving finance is wrong...
My National Review article, with Scott Sumner
Higher Asset Prices are not a Wall Street giveaway
Wages, profit, overtime pay, and "rights"
The residual claimant is equity (cyclically) and labor (secularly) and Residual Claimants, Pt. 2
The Minimum Wage, Sunk Costs, Returns, and Capital
Freedom of Entry is Huge
Random thoughts about capital income
Some Perspective on Housing Starts and More perspective on housing starts
Projecting Instability
Why are low interest rates such a mystery? and a Follow Up
Automatic Destabilizers
Real Economic Growth is What Moves Equity Prices
Hindsight is 20/200