Friday, April 15, 2016

Housing: Part 134 - Deprivation Created Wealth

Tyler Cowen has linked to two items recently that are among the countless articles and studies that are at odds with the findings of my current research.

The first item is a link to an upcoming book by Joel Kotkin, where Tyler suggests that higher housing expenses in the cities I call Closed Access cities are somewhat inevitable and that expanded building will only draw in more high income workers.  (1) I reject that claim and (2) even if it is true, it would be an even better reason to build, because it means that the value of density is practically limitless.  Maybe this is step one to Robin Hanson's world of ems living in tightly knitted networks.  On careful reading, I don't think Tyler is saying this is a problem, per se.  He's just saying building won't lower costs.  But, even here, I think it would be quite a jump to argue that greatly expanded building in the Closed Access cities would not benefit the current residents who are being stressed by rising rents.  Even if expansion only led to more rising incomes and rising rents, the increased local market for non-tradable services would surely raise the incomes of current residents, too.  They would likely get some relief from rising incomes, even if rents didn't relent.

The second item is a link to a VoxEU article by Borio, Kharroubi, Upper, and Zampolli that is yet another in a LONG line of articles which take financial expansion as the cause of a boom, and misallocations of capital and labor as a result of that boom, which lead to busts.

I have recently received some great data from Zillow which helps to pull together some more conclusions on these matters.  (THANK YOU, ZILLOW!  One more reason Zillow rocks.  Zillow Data, much of which they publish for free at their website, has been invaluable in my study.)  They sent me data with estimates of total residential real estate market values, by MSA, going back to 1998.  I had been hoping to get something like this to confirm the total effect on national asset values coming out of the Closed Access cities.

Here are the picture pages:

As I suspected, deprivation was the source of much of the increase in real estate values, not demand-side excess.  In this first graph, the US outside the Closed Access and Contagion cities saw a rise of roughly 20% in Property Values / Income from 1998 to 2006.  Over this timeframe, real yields on 30 year TIPS fell from about 4% to about 2% - a tremendous drop for rates that usually are very stable, in a short period of time.  To give an indication of the power of this change, this caused the price of 30 year bonds to rise by 45%.  So, outside the Closed Access and Contagion cities, not only is there no evidence, in the aggregate, of demand-side excess, but there is no evidence of demand-side excess, and the response of home prices to long term real interest rates is tentative.  The market price of real estate in 2005 was very conservative, compared to a discounted cash flow valuation (before taking tax effects into account).

And, as of 2003, even the Contagion cities were in line with the other MSAs and the rest of the country.  Homes in Atlanta, Houston, and Dallas weren't even fetching a higher price relative to incomes, even with the sharply lower interest rates.

In 2003, two shifts began to happen.  Pressure on the GSEs from the Bush administration led to a sharp curtailment of conventional mortgage originations.*  And, population growth shifts downward in the Closed Access cities.

This caused migration strains in the Contagion cities.  But, notice that population growth didn't respond in the Contagion cities, so the Contagion cities began to show some of the symptoms of Closed Access.  (Keep in mind that the Closed Access cities have about 15% of the US population, while the Contagion cities only have about 5%.)  Instead of building more homes, the Contagion cities were forcing home prices to rise enough to induce a second wave of migration from Contagion cities to the rest of the country.  Yet, at the same time, Price/Income levels in the Open Access cities were falling even while real long term interest rates continued to decline.

I know this is a hard sell for a lot of people, but the sudden rise in non-conventional mortgages in 2004 and 2005 was not a product of excess demand.  It was a response to the arbitrary curtailment of conventional loans.  The price movements in the Open Access cities here should be at least as surprising to us as the movements in the other direction in the Closed Access and Contagion cities.  Two trends were pulling in opposite directions in 2003-2005.  Supply constraints in the Closed Access cities were creating a high rent refugee crisis and the high home prices from that effect were from high rents.  And demand constraints from the GSE's were already creating a negative dislocation in the rest of the country.

By 2006, we had killed demand through credit and monetary policy.  This, perversely solved the refugee crisis because an economy with fewer opportunities meant that there was less in-migration into the Closed Access cities to tap into lucrative labor markets.  They weren't so lucrative anymore.

Note what happens after 2006.  The falling relative population in the Closed Access cities levels off, and suddenly population growth in the Contagion cities (here, Riverside, Phoenix, Miami, and Tampa) notches down from their long term trend.  The bust has created a persistent dislocation.

Rents have resumed their rise, but since the bust expanded the supply problem to the whole country, now Closed Access residents have rising rents and nowhere to escape to.  As we see in the next graph, Closed Access cities have seen rising incomes over the whole period - much of which is simply routed to landlords.  Most of the country has seen incomes rise at a relatively equal pace.  Except for the Contagion cities, because we killed the construction industry, so for at least 6 or 7 years, we just sucked the life out of those economies for no reason.

The reason we have imposed this problem on them is because of this giant honking error at the center of everyone's point of view on this.  That error is that we have one housing market, and since, in the aggregate, it looked like rising prices and rising housing starts were related, we assumed the exact wrong conclusion - that both of them were caused by too much money.  But this didn't happen anywhere.  It can't happen anywhere.  The reason everyone is so mad at the banks is that we assumed something was happening that would be basically impossible.  So, we explained this incongruity with the idea that banks were massively drawing buyers into homeownership to prop up outrageous home prices.  But the thing we were trying to explain wasn't happening anywhere.

As the next graph shows, the way to make real estate in your city more valuable is to not build.  From 1998 to 2005, real estate in the Closed Access cities increased from 19% of the US total to 24% of the US total.  And they did this by NOT BUILDING.  And the Open Access cities caused their total real estate value to fall from 4.6% to 3.6% of the US total by building like crazy - their population increased from 4.9% to 5.3% during the same time.

The housing "bubble" had nothing to do with homebuilding.  The widespread presumption that misallocation of labor and capital was due to monetary excess is wrong on every count.  None of those things happened.  But, models that use those assumptions look like they are on to something, because they measure falling productivity along with the supposed misallocation.  But, the reason there was misallocation was because of the deprivation.  The reason productivity is low and construction activity appears to be high is because Closed Access policies are preventing workers from accessing highly productive labor markets.  And, since those markets are closed, the houses we can build in other cities require a lot more material inputs for the same amount of value.

So, these studies get the causation backwards and it creates a whole set of false conclusions to argue about that all have the premise wrong.

Looking back at the first graph, the truth of the matter that will be, at some level, the cause of the next recession, is that if we took the fetters off the mortgage market, it would unleash a massive resurgence of pent up real investment.  This would cause interest rates to rise.  But, even if real long term rates recovered back to their 2003-2004 levels, and even if all that new building brought rents back down to previous levels, home prices would still rise by 30% across the board just to pull back to reasonable valuations.

Before that happens there will be gnashing of teeth and general kvetching, and there will be nearly universal calls to kill the housing market again.  We need years of 2 million annual housing starts, and this can only happen with a market in equilibrium, which means much higher housing prices.  And, we aren't about to let that happen.

* This may be hard to believe, given many observers who blame the GSEs for the problem that never happened but that they think happened.  Here is one of my older posts with some details.


  1. Hi Kevin, been following with great interest. Can you expand on your claims that "we had killed demand through credit and monetary policy" and "Pressure on the GSEs from the Bush administration led to a sharp curtailment of conventional mortgage originations"? I read the linked article; while you've convinced me that the levels of low down-payment loans were rational and replacing government-initiated loans, it doesn't mention much about the pressure from government, instead talking about private securities outcompeting government entities.

    Moreover, it seems like your general thesis is "the rising housing prices were not a bubble, instead they were rational market reactions to fundamentals, and we created the crash by misunderstanding this and trying to pop a bubble where there was none." You've changed my mind on the first part: that prices were not a bubble and were justified based on Closed Access and other factors. But what policies were employed that stifled the mortgage market, caused the crash, and are keeping housing starts below equilibrium, as you claim in this post and elsewhere?

    Much appreciated, I know you probably have the explanation somewhere on the blog but it hasn't clicked for me yet. Keep up the great work.

    1. Great questions.

      Maybe this one gets at your 2nd paragraph, a little bit?

      Maybe this:

      On the GSE's, I don't think I have written on it on the blog. In posts like the one I linked to, I noticed that there was a sharp kink in mortgages held through the GSEs in 2003-2004. I knew it had to be a policy shift, because the change is so sharp.
      But, there wasn't so much an explicit policy shift as there was just bowing to pressure from the Bush administration. I think I saw some of it in All the Devils are Here, and it is covered more in The Fateful History of Fannie Mae. Around 2003, there were trumped up accounting scandals around each one based on complex accounting on long lived risky assets that amounted to next to nothing in total dollars. But, first one, then the other, you can see a shift down in originations as the investigations took place. I now think that this was the first shoe to drop because this pushed a lot of borrowers into private pools where the bond holders took on the default risk, and if I understand the entire set of events correctly, this shift was sharpened because Fannie and Freddie could meet affordable housing goals by buying subprime bonds! A follow-up round of badgering led them to curtail that activity also, which I believe may have been a large step in the liquidity crisis among subprime, but I have more research to do on that. The reporting on it tends to be very sloppy. Journalists tend to impose a grimy moral gravitas on everything the GSEs do, but they are sketchy on the details.
      I never really had a strong opinion about the GSEs. I was probably even a little biased against them before I began this research. But, considering the causal place federal policies will tend to have in systemic liquidity crises, I have come to the conclusion that the default risk on mortgage pools should lay with taxpayers. And, reading histories of the GSEs, people have such a problem dealing with financial agents. As long as there is a private element, there will be a constant threat of arbitrary policy changes. Having them as public entities may be the best we can do until we reach some future utopia where people can act like adults when finance is involved.

    2. And, on the last question, the September-December 2008 Fed policy decisions really were what made a crisis out of a housing bust. And I'm not an expert on the details, but it appears that punitive regulations on banks regarding mortgages since then have prevented banks from expanding mortgages outstanding since then. Mortgage approval standards are far outside any previous norm. Home prices need to rise about 30% higher, by my estimate, to trigger robust new building. Between imposing liabilities on the banks on new mortgage originations and stopping each round of QE before non-mortgage buyers could push prices to where they should be, the housing market has been kept in fetters. Any comparison of GDP now vs. any time before 2006 screams out that this is the difference between the current 2-3% growth and the 3%+ growth that had been more common.

  2. Do you have a single blog post that details which cities fall into which categories?

    1. Good question.

      The categories have shifted a bit as I have developed the thesis. I tend to use the Top 20 MSAs as a template (beyond that, San Jose is an obvious Closed Access city and Las Vegas is a Contagion city).

      Closed Access: NYC, LA, Boston, San Fran., San Diego
      Open Access: Atlanta, Dallas, Houston
      Contagion: Riverside, Phoenix, Tampa, Miami
      Other: Chicago, Philadelphia, Wash. DC, Detroit, Seattle, Minneapolis, St. Louis, Baltimore.

      Obviously, the "Other" category is a bit of a mish-mash. It includes some cities with Closed Access tendencies, but none of them are bad enough to trigger the unusually high incomes and high cost refugee migration patterns that we see from the Closed Access cities.

  3. You hit it out of the park again, but this time with bases loaded.

    Kotkin's story deserves some sort of medal for heroic and willful obtuseness. Where is Yogi Berra when you need him? "Nobody goes there anymore. It's too crowded."

  4. The argument that increased building wouldn't cause a corresponding decline in prices seems odd to me. I get the idea that rich people will just move in and soak up the extra supply, keeping prices from falling, but, last I checked, rich home-buyers don't spontaneously generate the moment new units are built. They come from somewhere, and wherever that somewhere is, there should be a decline in housing prices due to the flight of rich people to the new housing in San Francisco or other closed access city after a lot of building.

    Now, perhaps one might argue that rich people are more mobile than poor people, and that the decline in housing prices in the city from which the rich migrants soaking up the hypothetical new housing in closed access cities wouldn't matter because not many poor people would migrate to those cities to take advantage of the falling prices. I don't buy that though. Recent evidence suggests minimum wage policies even have a noticeable effect on migration patterns of unskilled workers, so I expect that poor San Franciscans will be about as willing to move elsewhere to capitalize on declining home prices there as rich people from elsewhere will be to capitalize on expanded housing supply in San Francisco.

    Also, tot he extent that high income workers do consume all the new housing supply in, say, San Francisco, wouldn't this massive increase in the supply of skilled labor cause the price of skilled labor to fall, and therefore the price of goods and services produced by skilled labor to fall? If Silicon Valley is flooded with skilled labor, software prices go down and everyone's purchasing power goes up. Or for localized goods and services, the purchasing power of San Franciscans goes up thanks to declining wages for skilled workers.

    So, the supply benefit has to come in somewhere. If not from cheaper housing, than from lower prices due to increase in the supply of skilled labor, right?

    1. Yes. I agree. It's a sort of weird Giffen Good argument - it's an upward sloping demand curve, but instead of rising prices leading to rising quantities, the argument is that rising quantities lead to rising prices. The only way I see it making sense is if the benefits of density and networking among these high income in-migrants are improved so much by the new housing that the cities are just worth more. But, if that is the case, then it is all the more reason to build.

      But, to make that argument, I think one would have to extend the argument to say that rising rents in the past 20 years were unrelated to supply elasticity, and that just seems completely at odds with the facts to me.

    2. "The only way I see it making sense is if the benefits of density and networking among these high income in-migrants are improved so much by the new housing that the cities are just worth more. But, if that is the case, then it is all the more reason to build."--Kevin


      Evidently, people like density. Probably, density evolves more consumer-business choices and options.

      More restaurants, museums, education opportunities, theaters, potential friends, clubs, potential business connections. There are very few chess clubs in rural Oklahoma. If you love chess, then maybe you want to live in Brooklyn (though the Internet changes some things). Go to a zoo? Botanical garden? You must live in an urban area.

      Of course, the solution is not to have government decide development, but rather free development of unzoned land. No zoning.

      There is a role for government in city infrastructure.. Infrastructure is needed to support density. Obviously, toilets have to flush, and mass transit is a thorny issue. Density requires excellent mass transit. Otherwise you get the West Coast city problem, of choked roads and anti-growth backlash, compounding the problem of sacred single-family neighborhoods.

      City parks are probably another necessity, though they could be privately operated.

    3. Yep. It will be interesting to see how the continuing evolution of Uber, self driving cars, etc. affects this. They could facilitate larger commutes, or they could end up creating an emergent replacement for public transit that is too dynamic for urban governments to swallow up. Maybe we will end up with a persistently functional private transit system that facilitates density, if these cities will ever let density happen.

    4. Are all economists totalitarian in their thinking Kevin? I mean, the control that government could have over mass transit when there is no other choice other than self driving cars would be terrible.

  5. I guess, since it seems half of the world dreams of living in Manhattan, that density does increase demand. So the more people that live in a place, the more other people want to live in that place. You're right though, that's not really a problem at all; just means the value is coming from somewhere other than declining home prices in that city.

    Benjamin Cole
    "Of course, the solution is not to have government decide development, but rather free development of unzoned land. No zoning."
    True, one can't help but notice how many of the very features of urban areas you mention seem to sprout up in the very areas where they aren't 'supposed to' due to zoning. In the midwest, old nearly abandoned industrial districts get converted into trendy neighborhoods with thriving restaurant districts and zoos and aquariums and whatnot. Zoning makes the dynamic repurposig of land a lot more difficult. I think some rust belt cities have allowed their industrial centers to get repurposed because they're struggling so much that they would never say no to any sort of development, but it would be nice if, as a rule, developing weren't so restricted and stratified from one part of the city or metro area to the next.

    1. I know Ben will remind us that the problem is widespread, but to me, there are issues with zoning and urban planning that are arguable, even if they tend to err on the side of being too obstructionists - especially in the Closed Access cities. But the two things that really irk me about the Closed Access city politics are (1) these places were built for density. To deny them that is offensive. and (2) many of the complaints basically boil down to "just price" onanism. The market price of every single new unit that could possibly be built in the San Francisco MSA is offensive to them, so they block them - on the grounds of the price being wrong. Thomas Aquinas died in 1274. It's probably due time to update their moral philosophy.

      The irony is that the only reason any modern housing unit could ever rent for less than $1,000, or whatever reasonable price we might be benchmarking to, is because a couple centuries of open access economic policies have allowed innovations to emerge that have pushed the costs of building them down to prices that human beings in a state of nature wouldn't even comprehend because they are so low. The low prices they are benchmarking to, which causes them such offense when new developments are proposed, are only something they can imagine precisely because the very policies they oppose have been in place long enough to create them.

      Politics is where people demean themselves.

  6. You have a point, Kevin, about the curtailment of conventional loans. However, they were curtailed for many because people could not afford the 20 percent down. Oh, and by the way, we are slow growth forever. Check out these Christopher Phelan quotes from the article I just wrote:

  7. Kevin--

    For all I know, if we had free markets and highest and best use in land development Southern California might be a huge medium-rise metropolis. Fine by me, if that is what the market and consumers wanted.

    I disagree with the premise that some regions or cities can socialistically zone out density but not other regions.

    If density naturally occurs, I suspect mass transit is needed. If the roads are swamped with Uber drivers or people driving themselves, the roads are still swamped.

    I 100% agree the best thing Los Angeles could do for "poor people" is to allow unlimited construction of luxury housing.

    1. We disagree less than the impression I've given you, I think. The zoning issues throughout California and New England are clearly too restrictive, since they are blocking basic economically induced migration patterns.

      I would refer to Michael Munger's Euvoluntary Exchange standard. The measure of how bad the policies are is how far local costs are from the unencumbered potential cost of new units. This is clearly at an extreme in the core cities where studio apartments rent for thousands of dollars. It is bad even in suburban California and New England. That's true.

      But, the reason I don't ascribe this problem to "zoning" in general is that there are some zoning rules in most cities. If someone builds a golf community in Phoenix, I don't begrudge them preventing someone from buying up five lots along the 18th fairway to build tenements. Sure, there are classist issues, etc., that come up. But, the fact that these sorts of minor controls are in place doesn't keep Phoenix from having plentiful affordable housing.

      The reason California is so bad is because you get these outrageous sorts of region-wide or city-wide limits, like no units higher than 25 feet over a whole city. San Francisco and Washington DC both have crazy height restrictions in place. Sure, there are homeowners associations behind some of them, Dallas has homeowners associations. What Dallas doesn't have is preservationists, environmentalists, and generalized anti-market activists that can concoct these overarching restrictive covenants. I think that politics in general is ruled much more by the unintended consequences from illiberal enforcers than by self-interested ideologues. Prohibition was implemented by people with the best interests of the country in mind. These crazy minimum wage rules coming into place aren't being secretly backed by shadowy cabals of black market employers who gain from rising unemployment. They are backed by sincere innocents.

      The problem is since we tend to assume that terrible policies are imposed by evil people, it makes it even harder for us to believe that we are behind terrible policies. The ethical foundations behind the political will to impose density restrictions around Silicon Valley is very shallow. I don't think it is really that important to many people that there aren't 10 story condo buildings throughout the region. It's just that the benign foundation of their support for the status quo is so removed from the massive economic damage it does, they simply can't believe they are responsible for the problem.

      Get rid of all the shallow political involvement, and the self-interest of developers will easily overwhelm the self-interest of the present owners.

  8. I think the support of building restrictions has a lot more to do with common notions of communal ownership rather than any political sentiment. People implicitly believe they have some ownership over their neighborhoods or cities, a sentiment vindicated by the fact that where and what gets built around them impacts the value of their own property. People also tend to think that their view of the bay belongs to them, and therefore they get a say in whether I high rise that will block that view gets built.

    It's a hard sentiment to combat.. Granted, it would sound absurd if a Ferrari owner thought he had a right to stop Ferrari from manufacturing more cars of the model he owns because it would devalue his car, but maybe more people would think that way if most of their wealth was in their cars and moving them from one spot to another were far more difficult.

    1. That is certainly plausible. But, I'm not convinced. I have no doubt that if 3 million San Franciscans moved to Phoenix and started voting, our housing market would go to crap....come to think of it, 3 million San Franciscans are moving to Phoenix.....

      Anyway, here is Wikipedia on Rent Control:
      "Modern rent controls were first adopted in response to WWII-era shortages, or following Richard Nixon's 1971 wage and price controls. They remain in effect or have been reintroduced in some cities with large tenant populations, such as New York City, San Francisco, Los Angeles, Washington, D.C., and Oakland, California. Many smaller communities also have rent control, notably the California cities of Santa Monica, Berkeley, and West Hollywood,[2] along with many small towns in New Jersey. In recent years, rent control in some cities, such as Boston and Cambridge, Massachusetts, has been ended by state referenda.[3]

      New York State has had the longest history of rent controls, since 1943."

      The correlation between rent control and future housing problems is roughly 105%, with a 5% margin of error. There are many competing claims in a city, and some of those will be obstructionist or conservative. But, the straw that always breaks the camel's back and pushes a city into disastrous dysfunction is when people start applying "just price" ethics to housing.