Tuesday, April 4, 2017

Housing: Part 218 - Closed Access real estate is now a cyclical signal

I've been seeing this sort of article recently (HT: JW), about rents or prices dropping at the top end of the housing market.

I think this is one of the potentially useful tactical concepts that can come out of a new understanding of the housing bubble.  This also happened in the bubble.  The first shift in housing markets, in the Closed Access cities in 2006, was a downshift at the top end.  An exodus from home equity had been happening for years before mortgage markets collapsed in late 2007.  For more than a year before mortgage markets collapsed, there had been a fairly conventional decline in home prices that was concentrated at the top tier markets in cities where prices had risen.

That was the correction.  It was minor, local, and focused at the top and in equity (not credit).  Everything that happened after private securitization markets collapsed was a public policy choice that had little to do with the bubble.

The collapse in home equity in 2006 and 2007 was the product of a flight to safety.  Public opinion and public policy has the benefit of being able to impose itself on the country regardless of how obtuse it is, and so, two years after markets had turned to defensiveness, our consensus public policy choice was to teach the supposedly reckless market a lesson and really create a panic.  Nothing is more pro-cyclical than public sentiment strong enough to impose itself.

idiosyncraticwhisk.blogspot.com  2017
Each dot = one zip code. (Source: Zillow Data)  x-axis: log home prices, y-axis: annual log price change
selected western US Closed Access and Contagion cities shown

...Anyway, back to 2006.  Across cities, it was the top end that led the initial contraction.  One explanation for this is that Closed Access real estate has become sort of like a growth stock.  The value of Closed Access real estate is its protected claim on future economic productivity.  This is manifest through expected long term rent inflation in those cities.  So, Closed Access real estate prices are more exposed to long term real growth rates.

The bubble-monger mentality that has been created by Closed Access consequences leads to this pro-cyclical public policy.  Just as the stock market is an early indicator of economic and employment trends, now Closed Access housing is also an early indicator.  But, we can't utilize these indicators for stabilizing public policy because this will be seen as protecting Wall Street or protecting real estate speculators.  Especially now in real estate, these early downshifts are treated as the inevitable collapse of an overheated market, and they are generally welcomed.

I don't think the ingredients are there for a disaster like we saw in 2008 and 2009, but we are still destined to walk right into a contraction while patting ourselves on the backs for it.

If these contractions were based on a permanent shift toward more building in the Closed Access cities, first, we would need to see housing starts far above what they are - at least double - and, second, the first reaction to that regime shift would be a collapse in Closed Access home prices, because they would lose their claim on exclusion.  This would be considered disruptive, so there would be a plurality of forces in Closed Access cities that would come together to ensure continued exclusivity - for the sake of local stability.  Limited access governance begets limited access governance.  Even North, Wallis, and Weingast don't have a prescription on how to reverse this.

But, on the national level, didn't a plurality of forces demand instability? Yes.  The problem is that we have a shortage of (local) supply, and (national) credit markets are mostly a passive effect of this.  But, we mistakenly have thought that we have too much credit, creating too much supply.  So, we tend to err on the side of limiting supply, which can avoid short term local disruptions at the local level, with the cost of long term national exclusion, and we err on the side of limiting credit, which creates short term national disruptions.

The disruptions we would see locally from solving the Closed Access problem would be at a completely different scale than what we are seeing.  They would be on the scale, to the downside, of the price appreciation we saw in the 2000s.  These small scale declines, I think, are more of a sign of marginal cyclical shifts in expectations.  National expected income is declining because of cyclical shifts downward, which means there are fewer rents to claim from exclusion.  This hits Closed Access real estate values.

There seems to be a difference between now and 2006.  In 2006, rents were rising as prices began to contract.  That is because the exodus from home equity happened first and housing starts were already sharply falling.  This cycle is different because there hasn't been as much panic about a housing bubble, and housing starts, while weak, aren't collapsing.  So, there appears to be some softness in rents, too (although this isn't showing up in the CPI data yet*).  But, if that softness in rent was considered permanent, rather than cyclical, Closed Access price contractions would be extreme.

* There can be a lag in rent inflation in the CPI.  It will be interesting to see if CPI rent begins to slow down.  Will that remove inflation pressure, causing the Fed to stop monetary tightening?  The road ahead is interesting.  I'm getting tired of being unclear about it.  It seems like this has been the case for some time.


  1. Will that remove inflation pressure, causing the Fed to stop monetary tightening?---KE

    I get the feeling the Fed will hike rates, institutional momentum in place.

    Recession or just slow growth?

    The scary thing is if recession, then the Fed needs to go to QE fast...but they won't. And helicopter drops are not even an option.

  2. Will that remove inflation pressure, causing the Fed to stop monetary tightening?---KE

    I get the feeling the Fed will hike rates, institutional momentum in place.

    Recession or just slow growth?

    The scary thing is if recession, then the Fed needs to go to QE fast...but they won't. And helicopter drops are not even an option.

  3. Seems to me you're making a large assumption about which direction the supply shock runs. What if the pre-1990s period is the anomaly and represented an abnormal positive supply shock? It may be that supply-constraints in desirable markets are actually normal, not a negative supply shock. It would certainly seem consistent with many other cities around the world lending support to the notion that it is not some "inefficiency" that will be corrected anytime soon. In my opinion, central banks should be qutie certain about the temporary nature of supply shocks before they adjust monetary policy to account for them.

    1. This is a good point. The rhetorical treatment of these urban constraints as unnatural or unnecessary does loom large in my narrative, so the question arises, what difference does it make? What if these constraints were natural? Wouldn't we have all the same effects?

      First, I think in either case, the way this would play out is that existing real assets would be gaining income from sunk costs, so that what is being measured as economic growth would really just be a growing transfer of rents. This also effects inflation rates in a way that causes general inflation to be higher because of rising rents. So, the reasons for running slightly positive inflation would now require target inflation that is higher than normal, because wage inflation might hit zero while rent inflation is still pushing core CPI to 1% or higher. This is especially problematic since most rental income is imputed. Much of the inflation in core CPI right now has nothing to do with cash.

      But, further, I think the fact that these constraints are political does make a difference. That is because for these urban real estate markets to clear, there have to be fees and taxes imposed on new development, obstructions that are simply waste, and various other costs that are imposed on developers. If they weren't, these cities would be overrun with developers and real estate owners with plans for expansion. When something does get built, it is treated as if $x of real value has been added to the capital stock. But, really, most of that value is waste and deadweight loss, and the extra income that justifies it is simply the transfer of economic rents through exclusion. At a fundamental level, these are inflationary effects that differ from a natural constraint. If the constraint was natural, instead of engaging in wasteful rent-seeking, there would be an application of capital toward increasing the carrying capacity of those cities. That has a different effect on an economy than paying a bunch of lawyers to shuffle papers for 6 years to satisfy a bunch of local opposition to free entry.