Saturday, October 25, 2008

Was the Housing Crash Good News for America?

I am not a fan of the blame game. However, regardless of what public policy actions might follow, determining the fundamental cause of the housing price crash is necessary to understand where the economy is headed. Let me give three hypotheses, and demonstrate how each of them affects what we should be forecasting for the future.

  1. Hypothesis F ("F" for future): During the boom the housing market expected (rationally or otherwise) that housing demand would be high in the future. That is, unless housing construction were far above pre-boom rates, there would not be enough housing to satisfy demand in 2007, 2008, 2009 and beyond. Based on the expectation, housing construction proceeded at a furious pace. Once we learned that the future demand wasn't there, we were worse off because those houses couldn't be unbuilt. This ultimately false expectation cost America -- according to my forthcoming (hopefully by Monday at paper "Market Responses to the Panic of 2008" the losses were in the trillions. These losses will cause people to work more and, through that channel, will raise GDP.

  2. Hypothesis P ("P" for present): Suddenly, people no longer found housing to be an important priority. The scenario has some of the losses as with Hypothesis F (and thus the work stimulus), except that GDP may fall to the extent that actual housing/apartment rental rates are lower (recall that part of GDP is the rental value of housing) and this dominates the work stimulus. In the scenario above, actual rental rates do not fall, it's just that people revised their expectations about future rental rates.

  3. Hypothesis G ("G" for government distortion): The boom was caused by a distortion (induced by the government, or otherwise) of capital away from the nonresidential sector. It is good news that the distortion finally ended; the housing price crash is just an indicator that things are getting better. Our economy can use its resources more productively. This may ultimately raise GDP, but through different mechanisms: productivity will be higher, work will be induced by a substitution effect (rather than a wealth effect), and we may even be able to obtain the same government revenue with lower tax rates (recall that the housing sector is a major area for tax avoidance).

The housing rent data tell me that Hypothesis P is not important. Notice from the graph that the inflation-adjusted rents paid by persons living in houses and apartments are essentially as high now as they were during the boom, which themselves were not that high.

I don't yet know which of the remaining hypotheses is more important. I do not get the sense that America is saying "Finally! We can do things more efficiently!" so I have started pursuing the logical implications of Hypothesis F. But I have to start somewhere, and will report back when I have given more thought to G and/or have evidence on its relative importance.

[Update: I haven't made up my mind yet, but in the meantime I recommend Professor João Marcus Marinho Nunes' very nice article on Hypothesis G]


Amicus said...

you really need more data.

What happened in Florida and California, may be different than what happened in Oregon and Ohio. Or elsewhere around the globe.

I have a model that suggests that "pre-crash" value of the housing stock was in line with the growth in PCE and the fall in inflation/interest rates, within 10-15%.

That would suggest that elements of the "crash" are finance-related. Anecdotal evidence suggest that may have been the case in L.A. area, with interest-only loans at artificially low adjustable rates induced price rises per sq. foot.

We also know that some amount of the crash is due to predatory practices, sweeping people clean of their home-equity, to the point that even a small draft would blow them over (the elderly were targeted, in particular, on one report).

In Florida, there seems to have been a genuine, speculative supply overbuild, again, based on anecdotal evidence.

It's worth noting that some markets, like Boston, turned before others, for unknown reasons. Anomalies like that have informational content, perhaps.

Sheng said...
This comment has been removed by the author.
Sheng said...

homeowners unable to pay their mortgages are forced to rent somewhere else, thus may push up rent levels. We have anecdotal evidence on this at least.