The problem is that home ownership is somewhat unique as a financial security.
Equities tend to have values that are highly variable because the cash flows are highly variable and uncertain. Bonds tend to have certain cash flows, but changing discount rates. This causes the
Homes differ in that home ownership is basically a perpetuity with stable cash flows. Especially if we consider the aggregate housing stock as a diversified basket of real estate holdings, rents on that basket of holdings will rise roughly with the rate of inflation. And, the housing stock itself is very stable. Only a small change in the total real amount of housing outstanding can be effected in a given year. A perpetuity that grows with inflation is very sensitive to changes in long term real interest rates. So both the rent cash flows and the stock itself are very stable, and the valuation is very sensitive to changing long term real interest rates. This means that the total market value of the housing stock is uniquely sensitive to changing long term real interest rates in a way that equities and bonds are not.
|A measure of aggregate Price/Rent: Source|
In the late 1970s, nominal interest rates were very high but real rates were low. This gives us a window into the relative power of demand vs. supply in home values. Demand was extremely constrained because households had to qualify for mortgages at double digit interest rates. On the other hand, low real long term interest rates meant that homes should have higher intrinsic values relative to rent. And, we see that the supply factor dominated. The Price/Rent ratio rose sharply in the late 1970s as nominal interest rates soared. This should be very surprising if you believe that demand dominates.
|Home Mortgages, log scale: Source|
During periods of slowing growth, real estate values will naturally rise, and given our conventions regarding home ownership, mortgage levels are bound to follow. But, this is a result of the broader phenomenon, not the cause.
In our current context, this problem is even more pronounced. The constriction of housing supply in our highly productive cities has caused the cost of housing to rise. Instead of earning returns on invested capital that increases the available housing stock in valuable locations, urban real estate owners earn capital gains due the economic rents they gain because there are limits to invested capital in housing. This means that those added housing costs are simply a transfer to rentiers. The costs reflect nothing of value. They are a drag on economic progress and equity.
In our current context, I believe that these housing supply problems are the root cause of all of these problems - stagnating economic growth, low interest rates, income inequality. And the manifestation of these problems is multiplied in home prices, because, not only are housing costs higher as a result of the supply constraint, but the transfer of incomes to real estate owners and the drag on economic growth both cause interest rates to fall, leading to home values that rise as a proportion of the already inflated rent levels.
The core solution is to remove the obstacles to housing expansion in the Closed Access cities. But, until that happens, economic growth will necessarily translate into higher transfers to real estate owners. Currently, our mistaken attempt at a solution, which is to dampen credit and nominal expansion, puts a lid on real economic expansion. Real economic expansion in this context will naturally lead to excessive debt levels and very high real estate values. We cannot have one without the other.
This is really a conjunction of Krugman's work on path dependent geographic advantage and the work of Douglass North, who recently passed. Cities like New York City, San Francisco and Silicon Valley, Boston, Seattle, etc. have gathered very highly productive workers into networks built on innovation and reputation in industries like communications technology, bio-tech, and finance. These networks happened to develop at a time where some combination of factors common in Anglosphere central cities have created severe obstacles to housing expansion. So, at the same time that these cities provide significant opportunities for highly skilled workers, they also limit access through housing, so that the normal process of migration into centers of opportunity has been closed off. Krugman's geographic advantages meets North, Wallis, and Weingast's "Limited Access Order".
Normally, limited access order societies are built around stagnant economic systems, where rentiers capture a large portion of a small and stable level of production. What we have created is a limited access order built around highly innovative, growth oriented, super-achievers. Instead of having limited access to cultivated land, we have created limited access to the most vibrant forces of innovation and growth ever created. This urban limited access order creates two classes of rentiers - the classic class of landlords, pocketing the traditional rents on property, and the new class of high skilled laborers.
We see high capital income because of these landlords. We see high variance of incomes within labor compensation because of these new labor-rentiers, who tap into these highly productive, highly innovative networks.
The housing supply problem is key to both of these issues. Battling against the financial sector as if it is the cause of this problem is the opposite of what we need to do to solve it. Now we especially need to support the financial sector, either as a second best solution where it at least supports new housing stock in Open Access cities, or as part of the optimal solution, which would be to support massive housing expansion where it can boost innovation, lower costs, and ultimately reduce these returns to rentiers. We must support finance in order to shrink it.
The distinction between income to existing capital and income to new capital is key. Preventing the development of new capital as a reaction to high capital incomes is, at once, rhetorically gratifying and pragmatically futile.