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.