Earlier this month, the Boston Fed's Eric Rosengren wondered aloud in a speech to the Portsmouth, Rhode Island, chamber of commerce whether the swelling number of cranes dotting Boston's skyline should be a source of worry. In September, San Francisco's Fed President John Williams voiced similar concerns about U.S. "imbalances" in the form of high asset prices, "especially in real estate."
Some Fed members might be hesitant to drop the "B word" — bubble — but other market observers are being a bit more blunt.
They seem to simultaneously hold two incompatible ideas. First, that high prices are a problem, and second that building is a problem because it will lead to a collapse in prices. In a market with extremely high rent, why do so many people assume that new development is due to irrational investment? I think, possibly, these cities have been dysfunctional for so long that new supply never even comes close to meeting demand, so when building is strong, rents are still rising for lack of supply, and this coincides with strong earnings growth. These trends are only correlated because supply is so severely constrained.
And, what is the conceptual model that predicts this process anyway? Economists seem to nearly unanimously accept this correlation between economic expansion and irrational exuberance in housing markets. What model predicts that? (By the way, this hasn't described 80% of the country.) But in the small portion of the country where home prices and rents have moved up strongly, what economic model says that (1) loose monetary policy will lead to nominal (but not real) increases in housing expenditures, and (2) that home buyers will irrationally bid prices above the fundamental values? Austrian Business Cycle? Does everyone believe in the Austrian Business Cycle model now? Maybe instead of targeting the Fed Funds Rate, the Fed should just set prices for homes in each city. Apparently they know when those prices are wrong. Apparently just about all "market observers" know that they are wrong.
Imagine if we could build an extra 300,000 units in the Closed Access cities each year. We could do that for years, probably indefinitely, without overbuilding. As I noted in the previous housing post, in these constrained cities, housing demand is inelastic. When rents rise, households spend more of their incomes on rents. Closed Access cities only issued 2.8 permits for every 100 residents from 1995 to 2005 while Open Access cities issued 12.5 and the US in aggregate issued 6.6. This coincided with a migration of about 1% of the US population from the Closed Access cities to the Open Access areas. Yet total real estate values and rents paid rose in the Closed Access cities and decreased in the Open Access areas. This new building could add nearly 1% to annual GDP through residential fixed investment. But, interestingly, it would decrease nominal consumption. More housing units in these cities will mean lower total rents paid.
If we actually built in these cities, the consequences would be the opposite of what the bubble watchers are worried about. We would need to loosen the money supply just to keep nominal spending growth level.
This is a big reason why GDP growth has been stalled. If we don't build homes in the Closed Access cities, owners capture large capital gains, but capital gains are not included in national income, and rents rise sharply, but it is all inflationary. If we do build homes in the Closed Access areas, owners suffer capital losses, which are not included in national income, we are adding real investment, which boosts national income, and households can live in more real housing that is more than mitigated by rent deflation.
Since we can only build houses in Open Access areas, fixed investment counts toward investment spending, and there is an increase in real housing expenditures in those areas, but this is paired with high rent inflation in the Closed Access cities. Building in the Closed Access cities would require less fixed investment for each added dollar of real value in the housing stock, because there is much higher inherent location value, and we would be making up for our past errors, with new real rent value added being countered by rent deflation.
Just factoring in the potential benefits of rent deflation, since the mid-1990s, rent inflation has cut about 4% off of real incomes.
But, firms in these cities also capture excess profits and workers capture excess wages because of the limits to competition created by the housing problem. By reducing the limits to competition, we would also create real and deflationary growth, increased innovation, lower corporate profits, and less wage income inequality. It would be hard to measure, but these effects might be stronger than the first order effects in the housing sector.
Because we misinterpreted what was happening during the housing boom, our economic policy makers associate new building in these cities with inflation. But, it is the lack of building in those cities that creates inflation, because demand for structures butts up against the hard cap on potential supply, and something has to give.
This problem has to be solved at the local level. We can't fix it with accommodative monetary policy. But, we sure as heck aren't going to fix it by damaging real incomes until we have destroyed marginal demand for Closed Access city housing. Because, the problem sure as heck isn't going to be fixed by tight monetary policy, and monetary policy has to become destructive enough to damage real incomes before it even looks like it is solving this problem. That was our policy in 2007, whether we knew it or not. And, eventually, unfortunately, that policy worked.