Wednesday, January 6, 2016

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.

31 comments:

  1. Agreed, but you have to admit, Kevin, that zoning laws force companies to diversify outside of the city. And that is what more of them need to do. If they care about their workers they need to subsidize their high costs or relocate them to less expensive areas. But as long as speculation is driving housing, and Wall Street has its hand in housing, nothing will really work so well. You should be on the left instead of the right, Kevin. Good article.

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    1. I thought most market monetarists were slightly right of center. :)

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    2. I think you missed the point. Speculation doesn't drive housing cost increases, though this is a common misconception. Artificial limitations on supply driven by zoning laws drive prices up. It's basic supply/demand.

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    3. Sorry, speculation is key. You could easily make rules forbidding speculators from owning multiple houses in difficult to access cities. It has been done before. It makes no sense to ruin the cities with an absence of zoning. You do realize, Morgan, that people used to go in buses into Reno and Las Vegas investing in real estate, and pushing prices up. Those were not closed access cities, but they crashed from pure speculation, too.

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    4. Even to the extent that speculation has played a role in driving up housing (and much of Kevin's blog is geared toward arguing it didn't, fairly convincingly), speculation is only profitable when other factors (i.e., supply constraints) are causing consistently increasing housing costs. If housing supply grew as fast as demand, there'd be little point in speculation. You are complaining about a result of the problem, not a cause.

      And basic economics will tell you that banning forms of economic activity is virtually never the most efficient kind of policy.

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    5. Not sure about your argument. Oil cities like Dallas and Houston have unlimited land and have seen speculative booms and busts. They bust when oil busts. It is common knowledge.

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    6. So in other words, speculation isn't causing the booms and busts, fluctuations in oil prices are causing them, no?

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    7. There the speculation has always been in oil. My point was, Mark, that there was unlimited land and that does not stop a speculative mentality based on the price of oil which is also speculative.

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    8. 1995-2015 Median Home Price/Income Ratio:

      Min Max
      1.8 2.7 Houston
      4.3 10.5 San Francisco

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  2. Some interesting ideas in there. Thanks for sharing.

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  3. No. 100! Congratulations.

    Print more money, build more housing.

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    1. No, let fewer people buy houses in closed access cities. Make the houses only for people who want to live there. Do 5 years on and 5 years off.In the 5 years off let no speculators buy houses, only people who intend to live in the houses.

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    2. San Francisco doesn't have a high vacancy rate. Removing speculators could actually increase prices by expanding the liquidity premium. You might be making a quantity demand vs. demand confusion.

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  4. The ideas you have laid out over the last 100 articles have been well articulated. What has always bothered me, is how the "conventional wisdom" refuses to listen and change the narrative. Or what can be written to change a person's mind. I read Bill Mcbride, and he continues to reference "the Bubble." No one has dug into this as deeply as you have. Frankly, any time I read the word bubble; I immediately discount the knowledge of that speaker.

    Keep up the good works!

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    1. Thanks Ben and Chuck.

      Chuck, in a way it's understandable. There are so many deceiving factors, it is very easy to mistake demand problems for supply problems. For instance, people who were in the private mortgage industry are among the most skeptical of my story because they were in the middle of it, and they saw all these low doc loans going through that they hadn't seen before. I can show how these were mostly just being taken from FHA, and how there is no aggregate evidence of buyer incomes declining, and how that happened after homeownership had peaked. But they were there. At the time it was going crazy. Shouldn't their insider experience count for something? Who am I to come waltzing by 10 years later and act like it didn't happen? I would probably feel the same way. And, heck, maybe I'm just so good at fooling myself that I've totally got this wrong in a convincing way. In a way, even though I am convinced by the evidence, I am surprised that anyone has followed me this far, especially since the route was so circuitous in the early posts.

      I might have made a couple of factual errors early on in comments, but looking back, I don't think I made any assertions in posts that have to be taken back totally in light of new evidence. Even where my focus has changed, I think I tended to admit uncertainty in earlier versions of the story. I'm pretty proud of where this has ended up, and feeling pretty lucky that I happened upon something that seems important and which others seem to agree. I think there is a good chance that I will get the story out of the blog and to a wider audience this year. It will be interesting to see if the response is as positive out in the big bad world.

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    2. "...how there is no aggregate evidence of buyer incomes declining, and how that happened after homeownership had peaked."

      Could be true. However, not in certain states, IMO. But even if it were true, people bought too much house during this time. You know why, Kevin? Because there were no underwriters "protecting' the banks because the banks knew they could pawn the loans off to someone else, some naive investor. It was a scam, Kevin. People bought houses they could not afford, way bigger than those they owned or wanted to own in the beginning. Kevin, it is like buying a Ferrari, when you only could afford a Malibu. Your income didn't change, only your desires did. And the banks had never let people do that before. It was a bubble. Sorry.

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  5. Kevin: To be sure, many of your posts are very dense (positive sense of the word). And people have been brainwashed on the "Clinton, CRA, easy-weesy give-away bribe-for-vote loans to urban groups" tale. (Yes, the heavy volume was during the Bush years, no matter).

    The true story, though, is still not too hard to understand: Urban zoning, or even all property zoning, is raising housing costs by creating artificial scarcity. I think you have to stick with that plank for popular consumption.

    I say "all property zoning" as I think many urban areas are ringed by single-family detached, or have in-close sfd enclaves, and many apartments could be built in those locations.

    Of course, then we have places like Ventura and Orange Counties, and even Santa Barbara counties, that have been aggressively zoning out urbanites for generations.

    I have to say this "highest and best use" idea is non-PC from any angle. Take a look at "right-wing" websites. They have hundreds of posts on the evils of the minimum wage (I happen to think there should be no minimum wage). Other than a couple Cato Institute posts, zoning away single-family detached is not a topic that gets any traction.

    Universal "highest and best use" and no zoning? In my neighborhood? We all believe in free enterprise, until we don't.

    We can hope for greater density in places like Manhattan and downtown Los Angeles, They are building in the latter. I see there are needle-towers rising in Manhattan.

    Oddly enough, the place to build residential high-rises is in liberal enclaves. You ain't putting up a tower like that in Newport Beach CA.

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    1. Yes. I think, in organized form, the supply issues are salient, tactile, and backed by a lot of data and personal experience. Once that is established, I think the demand argument sort of falls like a domino, because I'm not sure it has even been made, only asserted, because it didn't seem like it needed to be made, and once that domino falls, the monetary policy domino falls, because if it wasn't a demand boom, why did we need a bust, and why wasn't the bust accompanied by deep declines in rent if we had too many houses. The supply issue is the foundation and the framing for everything. And, in the end I think this narrative creates a sharp reframing of the "trickle down" epithet. Constraints on capital inflow are first and foremost a blow to consumers. Free flow of capital in these housing markets won't trickle down to anybody, in fact it's a bit of a problem because it would create massive capital losses.

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    2. "massive capital losses"

      I guess that means house prices would stabilize or fall in some cities. The guy who bought a $750k shack in Encino would see it decline in value.

      Well, possibly, but even with highest and best use, I think we see supply constraints for many years, as it takes time to build.

      Also, a building boom would be good for the economy, raising incomes, making property more valuable. No one gets hurt in good times (except the psychic incomes of central bankers).

      In addition, if the U.S. would run mild inflation, that would result in homeowners benefitting from owning an increasing amount of equity in their houses.

      Print more money, build more houses.

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    3. This is one of the important implications of my work, I think. And, you're right, inflation will be important. I hope we can have a Fed up to the challenge. In fact, this could be an interesting case where inflation would be a better target than NGDP, because I think in an unconstrained housing market individual homes will rise with inflation, not incomes. Rising incomes will lead to housing stock expansion. So, if we fix the problem, higher inflation will help, regardless of RGDP.

      And the reason this could be a problem is that at this point, it appears to me that a significant portion of property values in coastal California is from rent inflation expectations. That means, if they appear to have fixed the problem, even before actual rents decline, rent inflation expectations should decline, so home prices should decline from like 8-10x income to, say 5-6x income.

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  6. A question on what you say about income inequality in closed vs. open access cities:

    "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."

    This, I think, was the main reason you present for how closed access cities cultivate income inequality.

    However, I would expect that, since a 'closed access' city's policies effectively put a mandatory minimum income required for residency, shouldn't we see less income inequality in these cities? Just as if one has two wealthy countries, and one prohibits immigration of poor people, the one that allows poor immigration will become more 'unequal.' The same I expect happens with cities, though they don't prohibit it outright, just make it impossible for poor people to live there (also, incidentally, a reason I like to bring up why comparing Gini coefficients between countries without taking into account historical immigration patterns doesn't actually tell one about the comparative economic fairness of those countries, but that's another matter).

    In the case open vs. closed cities, it would then appear that closed cities driving poor people into open cities is causing local income inequality in open cities.

    Also, great point on 'predatory lending.' 'Predatory lending' just seems like another way of saying it's a sellers' market when it comes to short term loans, which suggests there are barriers to entry into that market; instead of getting rid of them, however, reformers typically seem to respond by doing the opposite.

    Politics always, without fail, seems to make banking regulation fantastically absurd. Dodd-Frank, for example, simultaneously makes it easier to sue banks for unfair denial of a loan, and also easier to avoid having to pay a loan borrowed on the basis of that the bank should have known better not to give the loan. I wonder if putting banks in a double-bind isn't the purpose of 'reform' though just to punish them. At any rate, whatever banks survive the regulation will only have a tighter grip on their market shares, and even less competition to worry about.

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    1. It is against the law to loan someone money he cannot pay back. Check out the FIRREA Law of 1989. Of course W Bush ignored the law, and pay option arms, lol, happened under his watch. You pay when you feel like, is the terms of that loan, until it isn't.

      I share the MM concern for our descent into low and negative interest rates. There has to be a better way to reflate, than toxic and dangerous loans. The MM boys need to press harder for a solution.

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    2. I think there are a few answers to your first paragraph. First, there do tend to be pockets of very poor neighborhoods with low-value real estate, even in the closed access cities. I consider this briefly in Part 77. This is where gentrification gets a bad name, because the only way to live there with a very low income is to live in a dangerous neighborhood. Also, to some extent households reduce their real housing consumption to compensate, so a household making $60,000 in Dallas lives in a 2,500 sq.ft. single unit while the $60,000 household in San Francisco spends more for an 800 sq. ft. apartment. So, to a certain extent, poor families find a way to remain there, but they spend more on housing, so it still shows up as rent inflation, real estate capital gains, etc. And, meanwhile, at the top end, highly productive workers and wealthy households are attracted to the high cost cities. At some income level, households can afford to live in those cities in housing units that they consider reasonable within the budget level that is comfortable for most households, and households in the limited access work force probably capture more of the rents for themselves because they can find a level of housing consumption that is comfortable without transferring all of the excess income to the landlord. There is some data I have seen that I haven't been able to review yet, but it looks to me like the income distributions in the high cost cities sort of stretch up, so there is still a very low income bottom level, similar to other cities, but the median incomes are much higher and the high end incomes are yet higher, compared to other cities.

      I do agree that migration patterns must be lowering average incomes in low cost areas, making their economic contexts appear worse than they are. I'm not sure how to adjust for that without doing a lot of work.

      Great points on predatory lending and regulation. I agree. I think the importance of barriers to entry is frequently underestimated. A lot of people describe the interest on reserves as a bank giveaway, but if it is a competitive market then they are actually a subsidy to depositors, not banks, and if it isn't a competitive market, then more regulatory constraints aren't going to help.

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    3. Ah, so rent-adjusted income inequality may get worse in closed-access cities, while non-adjusted income inequality gets 'better.' Makes sense; I guess that's a good example why not to trust an uninterpreted statistic.

      One way one might get an idea of the effects of migration could be to compare cities with comparable housing policies and similar income distribution at some date, maybe 20 years ago, but where one city had a lot of poor migration and the other didn't (though it may be a stretch to assume there's data on the proportion of migrants into a city are poor). And see how much income inequality increases in the city which got a lot of migrants. One could do this with a bunch of cities and have a paired data design. Could be possible if there are enough cases like this: poor Los Angelans may move to open access city in West Texas, but never to open access city in northern Nevada, because the weather is so cold up there.

      I think it's hard to argue against paying interest on reserves on fairness, since the banks are after all required to keep the reserves there. If someone told me I had to have X money in a bank account to keep existing, I'd probably expect some interest on it too. But the practical justification, as I understand it, is to give the Fed greater ability to control short term interest rates, right?

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    4. Interest on required returns would be insignificant. It's excess reserves that the Fed is apparently trying to create with ior policy.

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    5. Ok, I have no idea the typical excess to require ratio is; I assume from what you say it's fairly high?

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    6. I think these are the comparable measures:

      https://research.stlouisfed.org/fred2/graph/?g=36wh

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  7. I mention Kevin Erdmann at Historinhas.

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