Wednesday, April 20, 2016

Housing: Part 137 - Financialization = Closed Access

Another paper on the dangers of financialization.  This one from  Jorda, Schularick and Taylor (2016).  (HT: JH)  This follows the pattern of most research on this topic, placing the cause in credit markets.  But, the cause is the high value of urban density and the inability of modern cities to allow the density that they were designed to create.  The cause is Closed Access policies that lead to high urban housing prices.  Financialization is a result of this, not the cause.  This difference in interpretation leads to conclusions that are diametric.  If financialization is the cause, the problem appears to be financial liberalization, and the solution appears to be to try to reduce the use of credit.  If Closed Access is the cause, the solution is more liberalization - in housing and in credit.  And, ironically, this will lead to a reduction in credit.

From the paper:
Throughout this chapter we use the term “leverage” to denote private credit-to-GDP ratios. Although leverage is often used to designate the ratio of credit to the value of the underlying asset or net-worth, income-leverage is equally important as debt is serviced out of income. Net-worth-leverage is more unstable due to fluctuations in asset prices. For example, at the peak of the U.S. housing boom, ratios of debt to housing values signaled that household leverage was declining just as debt-to-income ratios were exploding (Foote, Gerardi, and Willen 2012). Similarly, corporate balance sheets based on market values may mislead: in 2006–07 overheated asset values indicated robust capital ratios in major banks that were in distress or outright failure a few months later. (pg. 5)
This is because Closed Access is pulling down incomes.  That is why debt/income ratios are low.  It is the income ratio that is out of whack here, not the debt ratio.  The debt/asset ratios were normal before the bust because those assets are claiming more of the future output, because of Closed Access policies.  The fall in capital ratios was due to the unnecessary bust.
Figure 4 shows that the ratio of household mortgage debt to the value of real estate has increased considerably in the United States and the United Kingdom in the past three decades. In the United States mortgage debt to housing value climbed from 28% in 1980 to over 40% in 2013, and in the United Kingdom from slightly more than 10% to 28%. A general upward trend in the second half of the 20th century is also clearly discernible in a number of other countries.  (pg. 11)
I show Figure 4 above.  Actually, in the US, the sharp rise in Loan-Value was because of the bust.  As stated by the authors above, debt-asset ratios have not been high.  They weren't high when the bust hit.  When we remove that sign point from Figure 4, we see that Loan to Value has not particularly been rising since the 1970s.  The other countries in Figure 4 did not have housing busts.

In the span of the last 60 years, the ratio of mortgages to GDP is nearly six times larger; whereas, measured against housing wealth, mortgages have almost tripled. Of course, the reason for this divergence is the accumulation of wealth over the this period, which has more than doubled when measured against GDP. (pg. 14) 
This wealth is based on claims on future limited housing stock.  It is wealth based on limited access.  It is wealth based on a decline in liberalized capital markets.
The change in Exports/GDP and Imports/GDP are both typically procyclical (the correlation is positive) but this effect is more positive with high leverage, and for these variables Imports/GDP shows greater procyclicality (rising from 0.2 to 0.6) than Exports/GDP (rising from 0 to 0.4) throughout the range. This suggests that local leverage levels may hold more powerful influence on the cyclicality of the import demand side than on the export supply side, lending prima facie support for theories that emphasize the impact of financial sector leverage on demand rather than supply channels.  (pg. 45)
This is because Closed Access policies bring economic rents to urban firms and workers.  As economies grow, Closed Access workers collect excess profits from foreign consumers which they spend on imports.  In a way, this is semantic, since the products of these Closed Access workers are sold to foreigners, but many new-economy goods and services are delivered locally, so they are not counted as exports.
At a basic level, our core result — that higher leverage goes hand in hand with less volatility, but more severe tail events — is compatible with the idea that expanding private credit may be safe for small shocks, but dangerous for big shocks.  (pg. 46)
The lower volatility is because as economies grow, a toll is paid to the Closed Access cities, dampening real income growth.  But, this toll is gathered through the ownership of Closed Access housing, which is a sort of high-risk growth-based asset.  It's value is based on the future ratcheting up of Closed Access rents.  So, now, the housing stock has taken on characteristics more like the stock market.  When expectations of future economic growth change, this creates large shifts in equity values.  Now, this same pattern affects Closed Access real estate values.

This is made worse by the widespread idea that financialization and credit are the problem.  So, as in the recent recession, policy makers who should be focused on stability instead see instability as a necessary evil in order to reduce credit levels.

Here is another figure from the paper.  Notice what a strong negative relationship there is between Credit/GDP and Investment.  That's because the rise in credit is almost completely due to the Closed Access housing problem.  So, as more savings gets sucked up when high income workers bid up existing homes to access Closed Access labor markets, less savings is available for investment in new capital.

I hope there comes a day where all of these studies are repeated, and wherever "financialization" appears, it is replaced with "capital repression through housing", or more concisely, "Closed Access".  Until then, we have illiberal capital policies, via housing, that are creating poor outcomes and we are fighting them with more illiberal capital policies.  The problem is that prices are information.  They will reflect the underlying reality.  If we don't solve the problem of Closed Access, then the only way that sucking credit out of the economy can change the relative value of those homes is if it damages the entire economy enough to reduce the future value of those labor markets.  This is what we did in 2006-2007.

Since then, we have continued to impose credit market repression, so that now home prices are too low.  Home owners are capturing income at rates above their normal levels, compared to alternative capital income sources, because the hobbled credit market keeps leveraged buyers out of the market.  But, this can't bring rents down.  In fact, it causes rents to rise even faster, because low home prices are preventing new home construction from taking place.

The striking thing is that these urban housing issues are hardly a secret.  The sharp limits on housing expansion where incomes are high is affecting tens of trillions of dollars of capital around the world.  This problem should be clear.

Liberalization is the solution, not the problem.  When even the economic academy can't see this as the core problem of our time, then I fear we are in for some difficult times.  A growth rate a percent or two below trend is probably manageable, though over time is damaging.  But the real downside here is if the social tensions and anger that come from these problems continue to fester, the public outcry will be to double down on repression.  A vicious cycle is the biggest danger.  The ascendance of Sanders and Trump in the current election is a warning about how near this danger is.


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    'Some determined buyers will employ aggressive tactics to get a seller to pick them, Ms. Hill says. She has seen bidders win out by upping the nonrefundable earnest money (usually 1% to 2% of sales price) to as much as $50,000 to $100,000 on a $500,000 to $800,000 home. One buyer paid an additional $20,000 to walk away from an accepted offer, she adds.'

    1. This is one of the surprising conclusions I am coming to concerning the 2003-2006 period. Since everyone attributes rising prices everywhere to excess demand, always, every attempt at capital repression is seen as a victory. So, all the books about the "bubble" are full of facts about how the government undermined the conventional mortgage market, but they are presented as positive developments, with an attitude of "it's about time". But, when you remove that filter from the interpretation, what you see over that period is a relentless series of negative policy shocks to the housing finance market. It is kind of amazing that it held on for as long as it did. In the article we see this sort of thing happening again. Rents are so high in the closed cities that it would be very difficult to buy a home using conventional mortgages, so mortgages are pushed into private securitizations, jumbo loans, etc. Since everything everywhere is excess demand, everyone interpreted the rise of subprime as demand side excess, but really it was a last-gasp stop-gap attempt to simply finance homes in any way, given that the federal government was systematically removing standard financing options and the Closed Access cities were pushing market rents up.

  3. Great post. Kevin, I think you will get a kick out of my latest offering at Historinhas, on bank bailouts are good.

  4. Isn't Trump a real estate developer? And doesn't he support low interest rates? So what's dangerous about Trump?

    1. Well, he and Sanders both seem to tap into broad anti-trade populism. But, I would agree that while Sanders has a specific, relentless pattern of demonization that he seems to get a pass on, Trump is sort of all over the place, and the worst things he says are repeated and exaggerated.

    2. I would not be so reassured about the real estate developer thing - the more politically connected a developer is, the more they may stand to benefit from politicizing the development process to keep out their competition.

    3. Good point Simon. That reminds me of this interesting post at SlateStarCodex: