Saturday, April 21, 2018

Welcome the robots.

There is a never ending debate about whether automation will eventually create problematic unemployment.

The same fears have been around since the dawn of the industrial revolution.  If you wanted to suggest to a farmer in 1840 that he and almost everyone he knew would become obsolete, and it would be overwhelmingly for the better, he would have been unpersuaded, if not downright angry.

Likely, he would have hastily demanded an answer to the question, "What in the world would you have us all do to earn a living?"

You could, quite reasonably, have answered, "Well, maybe instead of farming, people could do air ballet for strangers, and, I don't know, sell tickets or something."  Or, just as reasonably, you could have described most of the jobs at Google, or, or many other firms in today's economy.

The farmer would, understandably be non-plussed.  It's not just that you would have a hard time explaining what you meant to him.  It's that there would be no way to get him from point A to point B.  The explanation would have simply been beyond his imagination.

This is what growth means.  It means that things we take for granted are replaced with things we can't imagine.  Luckily, we can imagine air dancing today.  Automation and healthy economic growth will bring new things we can't imagine.  I would like to eventually take for granted the things that today I can't imagine.

It is true that there are jobs because there are needs to be met.  It is also true that there are jobs because there are people looking for needs to meet.  Unemployment is a function of frictions over limited time periods, not of a lack of demands.  This is so clear, it is strange that we have to remind ourselves of it.  Certainly the places where the most broad supply of services are available are not the places where there are more people lacking in available productive activity.  The opposite is clearly more true.  There was a time when this person, looking for needs to meet, would have mostly been looking at a potential set of needs that required leading oxen through a field or some such activity.  Today, that set is large enough to include air dancing.

Should we want change and growth?  To answer yes requires that we cease to rely on our imaginations.  It is an explanation destined to lose, and so we will likely be relitigating it, still, a century from now, when air dancers ask, indignantly, "Well, then, if you invent better holographic robot dancers, what in the world are we supposed to do?"

Wednesday, April 18, 2018

Housing: Part 294 - More doubt about the reckless subprime lending story

Here is the abstract to a paper by Ospina and Uhlig:
We examine the payoff performance, up to the end of 2013, of non-agency residential mortgage-backed securities (RMBS), issued up to 2008. We have created a new and detailed data set on the universe of non-agency residential mortgage backed securities, per carefully assembling source data from Bloomberg and other sources. We compare these payoffs to their ex-ante ratings as well as other characteristics. We establish seven facts. First, the bulk of these securities was rated AAA. Second, AAA securities did ok: on average, their total cumulated losses up to 2013 are 2.3 percent. Third, the subprime AAA-rated segment did particularly well. Fourth, later vintages did worse than earlier vintages, except for subprime AAA securities. Fifth, the bulk of the losses were concentrated on a small share of all securities. Sixth, the misrating for AAA securities was modest. Seventh, controlling for a home price bust, a home price boom was good for the repayment on these securities. Together, these facts provide challenge the conventional narrative, that improper ratings of RMBS were a major factor in the financial crisis of 2008.   (HT: Tyler Cowen)

Arnold Kling disagrees about the conclusion.

Monday, April 16, 2018

Housing: Part 293 - How has Dodd-Frank hurt low tier housing?

I have asserted that Dodd-Frank has been especially damaging to low tier housing markets in the US.

How is this damage inflicted?

First, the data that triggers this conclusion clearly points to specific market segments as the sign of the problem.  Much of Dodd-Frank deals with banking regulations, in general.  If generalized regulations were at work here, then the effect would ripple throughout housing markets, and new entrants would find a way to issue profitable mortgages.  But, starting in the summer of 2010, with the passage of Dodd-Frank, there was a diversion in market values between top tier and bottom tier homes in many cities.  This isn't an effect on lending in general.  It is an effect on lending to homes with lower market values.

Much of the debate about Dodd-Frank revolves around those general regulatory issues.  And, as with all things housing, since there has been an erroneous consensus that bank recklessness caused a bubble followed by an inevitable bust, the premises that the consensus has been built on have defined the debate about Dodd-Frank.  Those premises include the basic presumption that home prices have generally either been correct or too high, and that drops in home prices should be generally regarded as a return to normalcy while rising prices portend danger.  These premises were so strong, that they led everyone to miss a generational defining policy error that has sapped 20% or more of market value from low tier homes in many cities.  So many problems could have been solved by simply allowing that value to be re-attained.

Not only has the peculiar shape of this dislocation gone largely unnoticed, its resolution has been ignored or even actively avoided, as when Fed officials note that rising asset prices create an additional concern for accommodating monetary policy, even as low tier housing markets are so eviscerated that homebuilders can't even fund the purchase of lots to build them on.  (Builders seem to view this as a "shortage" of lots.  Others seem to think builders are just blind to the existence of a market that they were supposedly over-supplying 12 years ago.  All of these problems would go away if we stopped imposing a 20%+ discount on the end product.  But, a 20% increase in home prices would trigger public consternation and a policy response.)

In any case, the generalized regulatory targets of Dodd-Frank have little to do with the damage it has inflicted on working class housing markets.  I think the damage has mostly come through the Consumer Finance Protection Bureau and the regulation of "ability to pay" through the Qualified Mortgage program.  (Here is a sense of the vague liabilities the law imposes.  From the link: "Your lender gets certain legal protections when showing that it made sure you had the ability to repay your loan. Even with these protections, you may still be able to challenge your lender in court if you believe it did not make sure you had the ability to repay your loan.")

CFPB oversight applies to both banks and non-banks.

The problem seems to play out through a combination of higher regulatory requirements and higher costs, together with limits on the amount of fees lenders can charge to help cover those costs (examples 1 , 2 , 3 ).  The correlation of price behavior with Dodd-Frank passage suggests that higher fixed costs have made smaller mortgages difficult to fund.  The "ability to pay" standard may be a primary influence here, or maybe it is simply the cost of establishing the ability to pay that prevents mortgages on smaller properties from being funded.

The rise in homeownership before the crisis had been among young households with high incomes, education, etc.  The decline in homeownership since then has also been focused on both young families and families with lower incomes.  So, the net result of the boom and bust has been to reduce homeownership among households with below median incomes.  Yet, the largest drops in homeownership have been among households under 45 years of age, even if they have high incomes.  The constraint seems to be hitting low tier- and starter home markets, in general.

The drop in lending to lower FICO scores seems to have happened earlier, when the CDO panic happened, the financial crisis hit and the GSEs were taken over.  There isn't any further shift in originations with Dodd-Frank.  There isn't any obvious shift in the rate of delinquency or foreclosure, either.  Yet, there is this shift in pricing behavior that happens coincidentally with the passage of Dodd-Frank.  The effect of Dodd-Frank seems correlated with the market value of the property.  And, this shift in prices should be surprising.  If it hadn't been swamped by the scale of everything else that had happened, it should have led to much public concern.

In a way, I am simply applying the same type of analysis that has been applied to mortgage markets during the boom.  Researchers used changing prices to infer the effect of credit supply.  There were forms of credit which were more flexible than they had been previously.  At about the same time, it seems that prices in low-tier housing markets increased.  It is difficult to attribute price changes to each individual lending decision, so the connection was inferred.

I am doing the same thing here.  There was a shift in public policy - here that had the explicit goal of removing credit access from certain borrowers.  A price shift happened at the same time.  There are mechanisms that could create that shift, mainly in the regulations through the CFPB relating to qualified mortgages.  I am inferring a connection.

Your first reaction to this should be that this weakens my argument, because I am using the same method of inference that I have objected to in the analysis about credit supply during the bubble.  The difference is in the scale of the evidence.  The relative shift in market values is greater, in scale, rate of change, and the number of cities that are affected.  In the handful of cities that did see low tier prices rise relative to high tier prices during the boom, I have presented a counter explanation for the cause.  It is possible, I suppose, that some counter explanation could explain why low tier home prices dropped in most cities after the summer of 2010.  As of today, I don't think there is any analysis published before the passage of Dodd-Frank that establishes a framework that led to an expectation that low tier properties would move roughly in line with high tier prices and then dramatically drop off after the summer of 2010 in cities like Atlanta, Seattle, and Chicago.

There are mysteries here, but if the argument that credit supply caused the housing boom was compelling, then this argument regarding Dodd-Frank seems at least as compelling.

Here are two graphs showing the home price behavior in the "other" cities that I described in the previous post.  (In these graphs, all prices have been indexed to 2000, and the measure is the monthly measure after 2000 of the average price of top quintile zip codes divided by the average price of the bottom quintile of zip codes.  The axis is inverted so that when low tier prices are declining relative to high tier prices, the lines move lower.)  These are cities that didn't generally take part in the housing "bubble".  Prices did rise in some, especially in Washington, Seattle, and Minneapolis, but as you can see in the graph, there wasn't much difference between low- and high-tier prices during the boom.  As I have described elsewhere, that was a phenomenon limited to a few cities where home prices were extremely high.  The only significant diversion between low- and high-tier prices in any of these cities during the boom was in Washington, Philadelphia, and Baltimore, where high-tier prices increased by more than low-tier prices.

In a few of these cities, low-tier prices had begun to drop before Dodd-Frank - Washinton, Detroit, Atlanta, and slightly in a few other cities.  But, the most common pattern here is for low-tier prices to remain within 10% of high-tier prices and then to diverge from high tier prices in 2010, so that after a few years relative high tier prices eventually were 20% to 80% higher than low-tier prices. (A measure equal to 1 means that high and low tier prices had changed by the same amount since 2000.  So, if the measure is 1.2, that means that high-tier prices had increased by 20% more than low-tier prices.)

I don't necessarily have a complete story here.  Maybe there isn't a way to directly connect the higher fixed costs of lending to specific changes in the market.  But, as with so many aspects of the issues I have uncovered, before we even address the gritty details, we should keep in mind how radically off-base the conventional narrative is for most cities.  Low-tier homes didn't explode to some unsustainable value, fed by loose credit, then inevitably collapse.  In most cities, prices across the city moved, more or less, in tandem.  Then, generally after the summer of 2010 - after the recession, after most mortgage delinquencies had happened, after employment began to recover, etc. - low tier prices in most cities experienced a relative valuation shock that was larger than anything which had happened before.

This has surprised me as much as anyone.  The scale of events during the boom and bust led me to miss the significance of Dodd-Frank, also.  Only recently have I noticed how late and how peculiar the home price deviations were in most of the cities that weren't Closed Access or Contagion cities.  And, I don't think this has much to do with the foreclosure crisis.  Many owners in these markets are long-time owners with large amounts of home equity.  So, rather than showing itself in more crisis-like dislocations, this has mostly affected two different markets: (1) older, working class homeowners who have lower net worth because their homes' values have been knocked down, and (2) young, first-time aspirational buyers who have delayed the purchase of their first home.

I think that is partly why this has gone unnoticed.  The effect is mostly on things that have not happened.  Households who haven't purchased a first home.  Households who didn't tap home equity to get through tough times.  Households who didn't move because they either didn't want to sell their undervalued home or they couldn't qualify for a mortgage on a new home.  These are less dramatic changes than foreclosures and failing banks, but they aren't necessarily less damaging to the broad march of economic healing.

PS.  Thanks to Zillow for all of this great price data.

PPS. A new paper from Bordo and Duca that finds a similar effect of Dodd-Frank on lending to small business. (HT: Tyler Cowen)

Saturday, April 14, 2018

Housing: Part 292 - Dodd-Frank was an unprecedented assault on working class homeowners.

I have looked at this from a few different angles already.

I have put together a new measure that helps to focus on the effects of credit collapse on home prices.  I have graphed the relative prices of the median homes in each zip code in the top 20 metro areas.  I split each MSA into 5 quintiles, by median home price.  Then, over time, I compare the relative change in those prices, indexed to the year 2000 (Quintile 5 divided by Quintile 1).

Here, I have taken the average measure for MSAs, which I have divided into three categories:

1) Closed Access cities (NYC, LA, Boston, San Francisco, San Diego).
2) Contagion cities (Miami, Phoenix, Riverside, Tampa).
3) Other cities in the top 20.

As I have discussed earlier, the peculiar rise in low-tier home prices which has been attributed to credit supply is (1) generally limited to the Closed Access cities and (2) happened because high tier prices systematically rise at a slower pace than low tier homes.  It is unlikely, then, that this effect was due to credit access to financially marginal borrowers.  Furthermore, there are an insignificant number of middle class home buyers in the Closed Access cities.  And, there was no relative rise nationally in borrowing among households with less income, education, etc.

We can see that in the graph, here.  I have inverted the y-axis, so that where low tier prices rose relative to high tier prices, the measure rises, and where low tier prices declined relative to high tier prices, the measure declines.  (This is all from the awesome data available at

Here, we can see how the rise in low tier prices was mostly in Closed Access cities during the boom.  Most of the effect in the Contagion cities was in Miami and Riverside, because prices there reached levels where high tier prices begin to level off.  In other cities, on average, low tier prices never rose at a faster pace than high tier prices.

The housing market was then faced with a succession of three credit shocks.

1) The CDO collapse.  The first shock hit private mortgage securitizations.  By scale, these loans were mainly facilitating home purchases by buyers with high incomes buying into Closed Access cities.  So, there was little effect in the other cities.  Even in the Contagion cities, relative prices of low tier homes only really began to decline in 2008.  The private securitization panic mostly hit the Closed Access cities.  (And, in hindsight, prices in these cities are justified by rising rents, and have continued to show strength in the long run, even in tight credit conditions.  Prices across the board have been stronger there.  And, notice that, while low tier prices in the Closed Access cities have retreated from their highs, they remain stronger than low tier prices in other cities.  Low tier home prices in every city have been hammered by credit contraction, but in total, credit contraction didn't hit the Closed Access cities any harder than it hit anywhere else.  That is because the relative rise of low tier prices in the Closed Access cities wasn't the result of credit supply.)

2) GSE Conservatorship.  Credit access was tightened to an extreme at the GSEs (Fannie Mae and Freddie Mac) after they were taken over.  Looking at FICO scores, the GSEs practically closed down lending to the bottom half of the existing market.  The book of business with FICO scores below 740 declined sharply, even in absolute terms.  The drop in Closed Access prices continued, and then leveled off.  The price drop in the low tier markets of Contagion cities accelerated.  And, the relative price drop in low tier markets in other cities started to moderately grow.

3) Dodd-Frank.  In the summer of 2010, with the passage of Dodd-Frank, a clear downshift happens in all of these markets.  In the Closed Access cities, the last bit of a downshift in low tier prices happens.  In the Contagion cities, where low tier prices were beginning to level off after the GSE shock, now reaccelerated downward.  And, now, low tier markets in other cities, which had never risen to high levels, and which had held up relatively well all the way until mid-2010, suddenly down-shifted.

It has taken me a while to fully appreciate the damage that Dodd-Frank did to the net worth of working class families in this country.  Maybe this graph is the best picture I have developed so far of the damage.  It would be difficult to overstate the gratuitous scale of the damage here.  This was the summer of 2010.  The entire country had just crawled through a generation defining financial crisis.  Unemployment was at multi-decade highs, and was beginning to finally decline.  Borrowers were losing their homes by the millions.  And most of the damage of Dodd-Frank was imposed on homes outside the Closed Access and Contagion markets that had made it through the crisis relatively unscathed!

This was after the crisis.  This was very late in the process.  Consider what we have done.  First, consider the Contagion cities.  This was a double-whammy to the Contagion cities, which had first been overwhelmed by a migration event as households flooded into their cities to escape the high costs of the housing-deprived Closed Access cities.  Then, when that migration event suddenly stopped in 2007 and 2008, their local economies and housing markets were devastated.  This was worsened first by the contraction in GSE lending, and then, after all of that, when homeowners across those cities were sitting on high double digit losses, another shock was leveled on them that pushed low tier prices another 15% lower compared to high tier prices.  So, by 2014, after this series of shocks, low tier home prices had been pushed down by more than 30% compared to high tier prices.  The misinterpretation of these events is so ubiquitous in the American conversation, that I can hear many readers, still, saying to themselves as they read this that this was simply a reversal of the excesses of the boom.  So, I will reiterate: This was a reversal of nothing.  These zip codes had never appreciated significantly more than the higher tier zip codes in their cities.  This was a wealth shock amounting to more than 30% of property values.

As devastating as this was to the Contagion cities, the story in the other cities is even worse.  In many other cities, prices in general had never risen to "bubble" prices.  And, in other cities, low tier home prices had managed to hang on relatively well, even through the first two credit shocks and the financial crisis.  These are markets with stable, low prices, which households with less savings and lower incomes can afford to purchase.  After the passage of Dodd-Frank, low tier housing markets dropped by 13%, relative to high tier markets.  From July 2010 to 2013.

The damage here has been drowned out by the scale of events of the other shocks.  But, imagine that it is 2007 again, and none of these shocks had happened.  Even the naysayers and housing bears would have considered a 13% drop, by itself, to be a cataclysmic event.  And of all of the zip codes in the country, these zip codes would have been at the bottom of the list of places where even the housing bears would have said that this sort of price drop might have happened.

Since public consensus has coalesced so strongly around the issue of banking risk and financial regulation, the conversation about Dodd-Frank has mostly been about its effects on banking stability.  But, in terms of its affects on working class housing markets, its effects have been disastrous.  We may just have well salted the fields or contaminated the drinking water.  Those policies would have been just as justified and just as useful.

It would be hard to conceive of a law whose timing and policy targets were more perverse.

Wednesday, April 11, 2018

March 2018 CPI

This month was a return to the recent norm.  On a month-to-month basis, rent inflation popped up and non-shelter inflation retreated.  But, March 2017 had a very negative reading, so on the year-to-year measure, inflation was almost certain to rise this month.

April 2017 had a pretty low reading too.  So, it still looks to me like we are basically in a holding pattern with shelter inflation above 3% and core non-shelter inflation hanging around 1%.

It still seems like this could, hypothetically, go either way, but the Fed has a hawkish bias, which I still expect to eventually turn things south.  I fear I'm becoming a perma-bear.  I swear I was bullish before.  I was shorting Eurodollars in 2013.

It is possible for things to go on like this for a while - healthy growth and de facto 1% inflation.  But, in an uncertain world, where there is bound to be stochastic movement, I think it's a good bet that the Fed will eventually get too far along and will be slow to pull back.  Slow credit growth, low inflation, and low investment levels suggest there isn't much of a buffer.

But, this has been going on for two years, so even if it happens, I can't really claim that I called it.  It is what it is, regardless.

Tuesday, April 10, 2018

My new policy brief at Mercatus

My new policy brief is up at the Mercatus Center.

Most of the content will look familiar to IW readers, but this is probably the best summary of the basic argument - that undersupply of housing caused the housing bubble.

Here is the take-away:
For a decade, the collapse has been treated as if it was inevitable, and the important question seemed to be, What caused the bubble that led to the collapse? This needs to be flipped around. Given the urban housing shortage, it was rising prices that were inevitable. So the important question is, Why did prices and housing starts collapse even though the supply shortage remains? And why were housing starts still at depression levels in 2011?
The surprising answer to those questions may be that a housing bubble didn’t lead to an inevitable recession. It may be that a moral panic developed about building and lending. The policies the public demanded as a result of that moral panic led to a recession that was largely self-inflicted and unnecessary. They also led to an unnecessary housing depression that continues to this day.

Sunday, April 8, 2018

Lending and the business cycle

Since I think tight mortgage lending has been the key variable holding back more healthy economic expansion, I have been watching some bank lending measures for signals of contraction.  I also think monetary policy is too tight because the Fed is using inflation measures that include a large amount of measured inflation that is due to the non-cash effect of owner-occupied rent inflation.  That high rent inflation is also a result of tight lending, which is keeping housing supply low.

There is an interesting relationship between commercial and industrial lending and the yield curve.

Lending increases during an expansion, with a bit of a lag, so it has parallel movement over time with the yield curve (here, 10 year minus 2 year, inverted).  Commercial and industrial loans tend to grow the most when the yield curve is relatively flat.  Then, when the yield curve inverts, this seems to be correlated with economic contraction and a newly steep yield curve.

But, this relationship has changed recently.  The yield curve remained relatively steep even while C&I lending moved back to expansionary rates of growth.  I suppose this would commonly be explained with the incorrect idea that the Fed has been holding short term rates too low, and that has been the source of the steep yield curve.

I think the more accurate explanation is that when interest rates are low, the zero lower bound causes the yield curve slope to increase, because long term rates begin to act like at the money call options.  There is a sort of premium embedded in future rates.  So, from 2008-2012, the relationship is similar to the typical relationship, but the yield curve is unusually high (lower on the inverted chart).

Until QE3, lending was starting to slow down, and long term rates were declining because economic sentiment was declining.  QE3 turned that around.  The yield curve steepened, and with a bit of a lag, C&I loan growth recovered.

Since then, it appears as if the relationship has reversed.  The yield curve has flattened while C&I loan growth has declined.  The first part of this period is from the end of QE3.  QE3 had boosted growth, so the end of QE3 was somewhat contractionary, but by the end of QE3, the neutral short term interest rate had probably recovered to something close to 0%, whereas it had previously been negative.

Then, the Fed began to raise short term rates.  This has two contrary effects on the yield curve.  The first effect is that it pushes the base rate up from the zero lower bound, which causes the inflated effect on long term rates to decline.  In other words, long term rates start acting more like in the money call options, so the embedded premium is lower.  This flattens the yield curve.

To the extent that the Fed raises rates back above the neutral rate, this also will flatten the yield curve by pulling down economic sentiment.  Both of these things are happening at the same time, which is doubly flattening the yield curve.  One effect is caused by expansionary factors (a rising neutral rate) and the other effect is caused by contractionary factors (a rising policy rate).  So, the question is, what effect is most at work.

And, the fact that C&I lending growth has been declining suggests that monetary tightening has been too strong.  There are many economic measures that seem to be at fairly benign levels, so this hasn't been confirmed by other data, so I have been in sort of wait-and-see mode.  Inflation data also hasn't confirmed either thesis, as both backward looking (non-shelter) inflation and forward looking inflation have been fairly flat, even if backward looking non-shelter inflation has been quite low.

I have had a bias for expecting the bear-reading of this situation to eventually play out, but recent lending has only complicated this, because suddenly, there has been a little bit of a spike in lending, and real estate lending has very slowly been growing for a little while already.  Is this a turnaround to new recovery, or is this a liquidity grab by corporations because nominal revenues are starting to weaken?  There isn't much evidence that things are bad enough to expect that to happen, so I have to wonder if this is part of a turnaround.

The mystery continues.

Tuesday, April 3, 2018

The stock and bond hedge in the Great Moderation

It looks like the cyclical relationship between interest rates and stock market trends was different before the Volker Fed than it has been after the Volker Fed.

The vertical marks  note times when short term interest rates began to decline.  Before 1980, this would usually happen after a stock market decline, and the stock market would recover when interest rates began to drop.  During that time, both bonds and stocks were gaining and losing value at the same time.

Since 1980, stocks have generally only started to lose value after interest rates began to decline.  During this period, bonds have gained value when stocks were losing value, so that they have served as hedging instruments.  I expect this to happen again.  There is a chance that in this cycle, stock prices won't give up much, like in the 1990-1992 period, in which case bonds will provide more of a speculative return if there is a general contraction, even though we are close to the zero bound.  A pure speculative position would probably require using something like Fed Funds Rate or Eurodollar futures, because short term notes don't have much price reaction to yields and long term bond yields don't change as much as short term yields.

It would be nice if high asset prices weren't an outcome that is explicitly avoided.  I am not saying high asset prices should be a goal, in and of themselves, by any means, but when the Fed pulled down short term interest rates in the mid-1980s and the mid-1990s, those moderating moves were probably an important part of the Great Moderation, where extended periods of 2%+ real economic growth per worker were only interrupted by minor recessions.

In both cases, the stock market reacted favorably, but both times (1987 and 2000) that was followed by a retreat, so stable economic growth has come to be associated with ill-advised risk-taking and "paper" wealth that leads to economic or market upheaval.

I would much rather live in the late 1990s than the 1970s.  Anyone would.  High inflation in the 1970s suggests that monetary policy actually was too loose then, and stocks hated it.  Workers did, too.  Unemployment was high.

In the 1990s, inflation was low, wages and employment were strong, and stocks like it.  The Greenspan put wasn't a form of monetary over-reach.  It was closer to monetary optimization.

We still have a relatively stable monetary regime, because inflation isn't going to get out of control, and the central bank will eventually provide monetary support during the contraction, but the fear of high asset prices now seems to have us in this de facto policy regime of keeping inflation low enough to target low wages and low asset prices.  I don't see the point of that, but it's where we are.  And, in the meantime, a flattening yield curve should indicate a coming broader contraction, which will signal declining short term interest rates.

I don't necessarily have a thorough explanation for the pre-Volker pattern.  In general it seems that inflation at the time was more pro-cyclical.  A primary feature of the Great Moderation period seems to be that inflation isn't as pro-cyclical.  It remains moderate during expansions.  That is a development for the better.  I wonder if we have become a little bit too afraid of success.  A couple more timely ticks down to avoid an inverted yield curve in 2000 and 2006, as happened in the mid-1990s, and maybe the Great Moderation could have been even Greater.

Maybe there is something about the way markets have evolved (more global corporate revenue bases?) that makes the stock market less of a forward indicator, and the fact that the stock market is bound to influence the monetary stance biases us to a slightly delayed monetary reaction.  Pre-Volker, the economy seemed to swing to sharp highs followed by brief crashes.  The 2007 recession was preceded by several quarters where economic growth slowly ground lower.  To a lesser extent, that was the case in 2000 and 1990.  Prior to that, recessionary shifts in growth tended to happen quickly.  It seems plausible that we have learned to do things pretty well.  We don't have numerous quick contractions anymore.  But there is something keeping us from loosening up when recessionary conditions slowly build.

Of course, the idea that moderation in the 2000s led to a housing bubble only serves to buttress this bias toward disinflationary instability.  I consider those slowing quarters in 2006 and 2007 to be early signs of cyclical miscalculations.  But, most people think the problem was that we didn't invoke that slow growth sooner.  The Moderation won't be Greater until that idea is reversed.

Monday, April 2, 2018

Housing: Part 291 - Learning the wrong lessons

Frequently, Dean Baker has interesting observations, and there are some interesting observations in this post at CEPR.  But, the post caught my attention because it contains a nice example of the wrong lessons of the financial crisis.

Baker is reacting against a columnist who uses stock prices as a measure of national economic well being.  Baker says, "The stock market is not a measure of economic well-being even in principle. It is ostensibly a measure of the value of future corporate profits, nothing more."

This is an unfortunate position, because clearly, economic well being is strongly related to equity valuations, both in cyclical and secular terms.  It's hard to know what the motivation is behind every single move in equity values, and increasingly, equity markets are global, so that equities aren't a pure measure of domestic economic trends.  But, every single unemployment shock is preceded by a decline in equity values.  The drop in equities always comes first.  The wide-spread dismissal of equity valuations as a measure of shifting economic fortunes is an exercise in cutting off one's nose to spite one's face.

It is unfortunate that Baker takes this position, because he has engaged in some good pushback against the idea that labor incomes have stagnated at the hands of some sort of naturally rising level of corporate profits.  Limits to entry are the primary cause of excessively high profits, and Baker has made that case.

Here, I think he is being thrown off by the standard story of the housing bubble.  He asks what would have happened if our wise leaders had explained to the fickle market that "market valuations did not make sense and that prices were likely to fall back to earth".  He writes:
In the first case, Clinton would have been showing that unless stockholders were willing to hold stock for returns that were far smaller than had been the case historically (and were roughly the same as the returns available on government bonds at the time) or future profits rose way faster than anyone economists were projecting, stock prices at the time could not be justified. 
Bush would have been showing how nationwide house prices had diverged from a century long pattern in which they had just kept pace with inflation. He could have also pointed out that this did not appear to be driven by the fundamentals of the housing market since rents continued to rise pretty much in step with inflation and we were seeing record vacancy rates. He also could have talked about the explosion of bad loans, which were widely talked about in the business press even before the collapse of the bubble. 
In both cases, the Lowensteins of the world could have blamed the president for tanking their stock portfolios and they would be right. Their truth telling would have destroyed trillions of dollars in paper wealth and it would have been a very good thing.
It is true that a 20 year investment in the S&P 500 in March 1998 would have barely returned more than an investment in 20 year treasuries.  But, this has come during 20 years with low real and nominal GDP growth.  Hindsight is 20/20, but long term forward returns were not pre-determined.  Even if they were optimistic at the time, equity holders have indeed been held back by real shocks to economic growth since then.  Unanticipated real shocks are almost always more important for equity holders than valuations.  What does it mean that this was only "paper" wealth?  Equity holders at the time expected at least 8% or 9% nominal returns, which is about what they generally expect, and it is about what they would have received if GDP growth over the following 20 years had been normal.

Where does wealth stop being real, and start being "paper"?  When they expect 7% returns? 10%?  Where is the line in the sand where wealth isn't real anymore?  I don't think the evidence suggests that this expectation changes much over time, but what if it did?  Do we really want to base our public economic policies on the idea that any equity prices based on returns under 8% are fake and prices must be tamped down until capital gets a higher return?

There are two ideas that support these ideas about high asset prices coming at labor's expense. (1) That corporate values are based on future operating incomes which come at the expense of labor share of income. and (2) that corporate values are just flying around willy-nilly, unrelated to anything, and when they are up, capital owners get to act wealthier than they are until the crash comes, and then laborers get brought down with them.

Both of these ideas are wrong, and these wrong ideas are both reinforced by factual and conceptual inaccuracies about the housing bubble.

(1) is reinforced by the complaint that labor share of national income has been falling.  But, labor share is falling because rents for housing are rising, not because operating incomes of firms are rising.

(2) is reinforced by the idea that we had a stock market bubble followed by a housing market bubble, and that neither market was justified by the fundamentals.  Readers of this blog know that housing prices were largely justified by the fundamentals, and that a key error that is usually made is to think that prices had nothing to do with rents.  We know that prices have been highly related to rents.  The bubble happened in California, New York, and Boston because rents in those places were rising so sharply.  And, the bubble happened in Arizona, Nevada, and Florida because so many households were moving out of California, New York, and Boston.

And, Baker is correct that the press had many stories of bad loans before the collapse of the bubble, but empirically, defaults were triggered by falling prices, which first hit households with high incomes and only much later hit households that were default risks for economic reasons.

This notion that asset prices were unmoored from fundamentals is largely a product of fallacies.  So, it is true that equity holders would have been right to blame the president for tanking their portfolios.  It is Baker that is wrong that this would be a "very good thing."  Baker is hardly alone in this position.  And, really, do we need to know any more than that to understand why the American economy has been running on three cyclinders for the past decade?

Home prices are inflated because of monopolistic legal barriers to new homes, and we resolve to make them unaffordable by removing the means for purchasing them until those prices relent.  It turns out that important factors for making homes affordable include being employed, receiving growing wages, and having a healthy banking system.

One last comment I would make is that there are two different things going on here.  The stock market bubble was based on optimism about the economy in general.  But, the housing bubble was based on monopoly rents going to holders of capital.  Yet, Baker says that in both cases, valuations were outside historical norms and didn't make sense.

Housing prices did make sense because of legislated monopoly of real estate owners in the "Closed Access" coastal metropolises.  Baker should recognize that as clearly as anyone, but there is no voice within his earshot correcting the errors that have built up around the explanations of the bubble.

So, just like the country's opinion leaders went whistling past the graveyard in 2007 when house prices started to collapse, we will do it again this time when nominal incomes start to stagnate, until the right lessons are learned.

Friday, March 23, 2018

Housing: Part 290 - Migration and credit markets

After making yesterday's post, I saw this tweet from Jed Kolko: "America's dense urban counties grew in 2017 at their slowest rate since 2007." with the following chart:

This is one of many recent sources that have been noting developing migration patterns.  Here is another (HT: Jason Schrock)

Earlier, I had developed the opinion that if you have Closed Access cities, then a housing "bubble" would develop regardless of the condition of credit markets.  The bubble was just a product of Closed Access and economic growth.

But, much of the surge of Closed Access out-migration in 2002-2006 was from homeowners tactically selling their properties.  So, I have come around to the idea that the "bubble" was triggered, to a certain extent, by flexible lending markets, which allowed households with high incomes to buy Closed Access homes at prices that were high enough to induce that selling and accelerate the inevitable Closed Access segregation process.

I still think that was the case.  But, it is interesting that as the new economic expansion ages and strengthens, that migration pattern is developing again without the help of an active mortgage market.

Closed Access means that economic opportunity is associated with stress - fighting over a fixed pie.  The high housing costs of the Closed Access cities aren't the product of frenzy and speculation.  They are signs of a painful and unsatisfying battle for access.  People don't like that.  And, when the economy is strong enough to substitute away from that, people choose to substitute.  Closed Access means that households tend to make trade-offs so that they are less productive in order to avoid that stress.

Here is an article (HT: ChargerCarl) that takes a fairly productive stance on supply from a progressive point of view.  From the article:
There’s a “multiplier effect”: Every tech job creates 1.3 other jobs. There are 105,000 low-income households in San Francisco, and despite how expensive it is to live here, they somehow persist. Asked why they stay, even when it would be far more affordable not to, Egan gives a one-word answer: “Jobs.”
Surely, in a safe, growing, stable economy, that answer becomes a less persuasive reason to stay.

So, even without an active mortgage market, the national segregation continues, where workers that can leverage the productive value of those cities push in and the bulk of workers must avoid those cities or move away from them.  Since flexible mortgages aren't as available now, this works through rental markets instead of homeowner markets.

The 2000s mortgage market is widely described as predatory, but really, it was just providing one more tool for households to deal with Closed Access.  That's why it led to a disruptive migration event, because Closed Access has created a lot of pent up stress, and those tools were accelerating the methods households were using to deal with that stress.  So, rent inflation in 2004-2005 was moderate, but today rent inflation is high, because rent inflation is a key indicator of that stress, and mortgage markets in 2004-2005 were relieving it.  In 2005, highly skilled workers could hedge their rent risk by buying Closed Access homes and Closed Access home owners could capture their ill-gotten gains and move on.

Now, since we have limited the availability of credit to many households, this process operates more like a pre-capitalist society or banana republic.  The class of owners can't capitalize their monopoly rents as easily, so they must earn them over time, by using or renting the property.  So, the new investment banker or tech wiz moving into town has to bid up the rent of a service sector worker until they move away rather than bidding up the price of some retired couple's home who then move to Boulder or Phoenix or something.

The mortgage boom did end up creating stress in places like Phoenix because it accelerated that transition, but at its base, it was relieving stress by creating new alternatives for dealing with these latent monopolistic markets and providing means for ownership of those assets to shift.  It just relieved those stresses so effectively that it created new stresses from the high rate of change.

Thursday, March 22, 2018

Housing: Part 289 - The "Credit Bubble" and housing expansion

The mortgage boom in the 2000s was mostly facilitating purchases by qualified borrowers - mostly young professionals with high incomes.  The drop in homeownership since the bust has also been concentrated among those households.

The story of what actually happened was that mortgage lenders had found reasonable ways to lend to young, qualified borrowers with loans that had to be outside conventional norms, because housing markets in Closed Access cities are outside conventional norms.  That pushed prices in Closed Access cities up to levels that reasonably reflected the high rents that come from a persistent shortage of housing.  That triggered tactical selling by existing homeowners.  The aggregate effect of this activity was to lower the population of Closed Access cities as young households with high incomes were able to secure a more generous amount of housing in cities where the total amount of housing is relatively fixed.  That led to depopulation and out-migration.  The out-migration overwhelmed a few cities, like Phoenix and Las Vegas, and caused prices in those cities to spike.

Here are a couple of charts that marginally add to that story, both measuring population growth per new housing permit.

Nationally, we can see that, in terms of this measure, the housing boom was generally a return to normalcy after a decade of reduced housing permits.  The rate of new building during the 2000s was similar to the rate of building that occurred throughout the 1970s and 1980s.

Starting in 1989, there is housing permit data, by metro area.  In the more recent graph, we can see the story I described above.  Closed Access building had been repressed for years.  Throughout the 1990s, the number of new residents outpaced the number of new homes relative to national norms.  Residents were packing into the existing housing stock.  From the late 1990s to 2007, Closed Access households were able to expand their consumption of housing.  By 2005 and 2006, populations in those cities were actually decreasing.  These were generally well-off borrowers making initial steps toward expanding their real housing consumption toward something somewhat normal.

By this measure, if there was anyplace in the US that was overbuilding, it was the Closed Access cities.  But, obviously, they have never come close to overbuilding.  In fact, this apparent surge in homes was actually a surge of migration away from the Closed Access cities.

Much of that surge went to the Contagion cities, and the Contagion cities increased their building in response to it.  That surge in building also has been taken as a sure sign of overbuilding, even though it barely met the need for housing demanded by the new residents.

But, the Contagion cities generally have more population growth per housing permit than the US does in general.  There was a slight downshift in that measure during the boom, parallel with the rest of the country, but new residents per new home in the Contagion cities never dipped below the national average.

Wednesday, March 21, 2018

February 2018 CPI

Sorry, I'm a little late with this month's inflation update.

In February, both shelter and non-shelter inflation were basically on target.  The annual rate of inflation for both continues to move sideways, with shelter inflation above 3% and non-shelter core inflation below 1%.

Shelter inflation is receding a little bit, which is strange, since housing starts continue to be below the level required to maintain a stable supply.  This could be something cyclical, or maybe it is a sign that housing is leaving the phase of disequilibrium and the American underclass is slowly moving to the new equilibrium where their real housing consumption will be lower than it used to be.  Higher rents for less housing, which leads to a long term decline in real housing consumption until it settles back at a reasonable nominal portion of household budgets.

Or, possibly, even without a robust homebuilding market to facilitate it, a strong economy is again leading households to move away from Closed Access cities.  Economic strength would allow them to more confidently make the tradeoff between gross income and cost of living.  One product of higher quit rates might be that more workers quit their jobs in LA to move to Phoenix or Dallas.  In 2005, there was an outflow of both renters and homeowners.  The flow of homeowners was facilitated by generous lending and high prices on their existing homes.  But, the flow of renters would not be as sensitive to housing markets, so that flow might now be strong because of economic confidence.  This data comes with a lag, though.

Tuesday, March 20, 2018

Housing: Part 288 - A tale of two bursting bubbles

Housing bubbles may be about to burst in both Canada and Australia.  It appears as though Canada is following the American model and doing it the wrong way while Australia may be doing it the right way.

In Canada, there doesn't seem to have been much of a supply response.  (See here, here, and here.)  The central bank is raising rates and tightening lending regulations.  Here, Bloomberg uses my least favorite word - "Canada’s biggest housing market has been correcting".  Here, they interview Steve Eisman of "The Big Short" fame, who also uses the word.

This is "correct".  It is something to be accepted - even cheered.  Sucking cash out of the economy will achieve this end.  And, now, "Canadians Using Real Estate To Secure More Debt Reaches New Growth Record"  Why are Canadians tapping credit lines?  Presumably because they need cash.  But, if Canadian officials create cash, that will mess up the correction.  And, Canadians using debt to get cash is just one more sign of their recklessness - exactly the reason they need some discipline.

This all looks like it is heading down the road the US took in 2006-2008.

The bubble in Australia might also be bursting.  But, there, it appears to be mostly for the right reasons.


Here are housing starts in New South Wales (Sydney) and Victoria (Melbourne).  Both have increased approvals of new units to highs not seen in decades, if ever.  Sydney is double the level of a few years ago.

And, rent inflation, which had been generally high since 2007 has finally trended back toward the general level of price inflation.

So, it appears that Australia might be popping the bubble by creating supply.  Prices have only just begun to stabilize, so only time will tell.

Australia has implemented some demand side policies, but the central bank isn't raising interest rates, and the demand side policies don't seem that significant to me.

But, I suspect that if both bubbles pop, both will be generally attributed to "corrections" in demand.

PS: I forgot to add this article from "Better Dwelling", a Canadian housing news site, titled, "Canada Didn’t Skip The Great Recession, We Delayed It. Here’s The Chart", which closes with:
Now the Bank of Canada has two options, they can continue to expand the supply or start to shrink it. Continuing the expansion, i.e. keeping rates low, will cause further asset inflation with a minimal contribution to the GDP. If they raise rates, the supply will shrink, likely triggering a recession. People fear the consequences of a recession, but it actually addresses a very useful purpose. It corrects misallocation of capital, whether human or financial. Our ten year experiment of trying to avoid correcting the misallocation, has only made it worse.
The reason capital is "misallocated" is because monopolistic power of existing homeowners allows them to capture economic rents from the productive economy.  This is the case whether Canada enters a recession or not.  Certainly, Canada can reduce the size of that transfer by hamstringing its economy.  That's what the US did.  But, it doesn't actually work in the long run.  Home sellers and home equity borrowers do capture more of the economy's current production by tapping the value of their real estate assets for spending.  This is a form of consumption smoothing, which utilized the market value of those assets.  But, in the end, those market values are a product of high rents.  The transfer of economic rents to real estate owners happens over time as the rent on their properties rises above replacement value.  Recessions do nothing to stop that.  In fact, we can see that the recession in the US made it worse.  After a brief period of chaos, rent inflation has risen again.  And, we can see from the wild swings in Closed Access migration that economic contraction led households to remain in Closed Access cities in order to have access to higher incomes.  The expansion from 2002 to 2006 was allowing Americans to escape those high rents by moving away from the Closed Access cities.

The social and psychological forces that lead to consensus calls for economic contraction and even panic are fascinating.  But, it really is strange when you take a step back from it.  I hope that eventually we will come to a place of understanding where these intuitions are mostly seen as errors in human nature.  Instead of imposing "discipline" on the market by indulging these intuitions, we must discipline the intuitions.

Sunday, March 18, 2018

Housing: Part 287 - Closed Access and Gentrification

There are many things that housing obstructionists in Closed Access cities say that make sense in a Closed Access context but don't make sense in an Open Access context.  One of the ways that normal economic intuitions frequently fail is that people have a really hard time thinking about second order effects in complex economic spheres, and also people tend to think in terms of power, so that they tend to make inferences that depend on monopolistic assumptions in markets that are competitive.  So, the sorts of things that Closed Access obstructionists say match the poor economic intuitions that people tend to have about competitive markets, and so those things don't naturally meet with rhetorical opposition where they should.

The sorts of things I'm talking about are claims about how allowing more units to be built will raise rents, or claims about how since luxury units are more profitable, they are the only type of unit developers will build, etc.  These sorts of things may be sort of true in some places in Closed Access cities, because those cities have turned housing into a monopolistic asset, but they aren't remotely true in other cities.

I don't think there is enough pushback on those sorts of claims because our poor economic intuitions prevent most people from realizing how wrong they are.  An example outside of housing where intuitions fail us is, say, in grocery stores.  Food has gotten progressively cheaper over decades and generations.  Yet, in cases where, say, cans of soup over time have changed from a standard size of 12 oz. to 10.5 oz, in my experience, many or most people will chalk that up to some sort of conspiracy among food producers to trick us into paying the same amount for a smaller size.  Or, to take another example, I hear people complain that when oil prices rise, gas station prices rise immediately with them, but when oil prices fall, it seems like it takes a while for gas station prices to fall.  This is always stated as if gas station owners simply use this trick to increase their profits above some normal, reasonable level, using a trick to pocket a little extra.

People will commonly intuit a monopolistic conspiracy, even regarding a business whose primary distinguishing feature is a large, illuminated street-side sign with a price that changes daily.  In the same way, someone living in a place where entry-level apartment buildings are going up all over the place can hear that developers only invest in luxury units because those units are more profitable, and yet not naturally notice what a strange thing that is to say.

This is all a long-winded way of getting around to an idea that occurred to me.  I wondered if gentrification pressures might be stronger in Closed Access cities than they are in other cities.  They clearly are stronger, simply because Closed Access forces current residents to have to move away.  But, specifically, what I mean is that since location and social amenities are a more important factor in Closed Access rents, then when a neighborhood is developing and moving "up market", that might have a stronger effect on local rents in Closed Access cities than in other cities.

What caused me to think about this is that I realized the notion that an improving neighborhood would be bad for existing tenants is mainly a Closed Access problem.  In Phoenix, I think most people are naturally happy to see their neighborhoods improve.  Even in a place like Chicago, this mostly seems to be true.  The reason is that rents in most cities mostly reflect the cost of building.  There are some locational premiums having to do with commute times, etc.  And, other factors, such as the value of nearby units or the types of neighbors one has, don't account for that much of a difference in rents.

In a place like Dallas, at the zip code level, except for some rarified areas, rents just don't rise that far above the cost of building, so changes in neighborhood character don't affect rents that much.  In cities like that, tenants have the normal way of reacting to changing neighborhood character.  They like living in a neighborhood that is "moving up" and they don't like living in a neighborhood that is in decline.  (Of course, class, race, and other factors are in play there, and these perceptions aren't always fair.)

But, in a city where demand for housing from potential new tenants is less elastic than the demand for housing from existing tenants, because existing tenants have income limitations, then maybe rents do systematically rise at a rate that is so unfavorable to existing tenants that it reverses the normal reaction.

Here, I have graphed the rent per square foot for every zip code, in order from lowest to highest, for several metro areas.  And, as one might expect, rent per square foot is pretty stable throughout the metro area in Phoenix, Dallas, and Chicago.  It runs 80 cents to $1 in most of Phoenix and Dallas.  Slightly higher in Chicago.  With a few zip codes at the top where rents are much higher.

Interestingly, the pattern in Boston and LA is not that different.  In those cities, most zip codes have similar rents/square foot.  It is just that the entire metro area has inflated rental values.  The difference is that in Boston and LA, there are more areas with relatively higher rents/sq. foot, and the jump from the typical zip code rent to the level of top tier rents is higher.  So, we can see that, on the margin, in some small portion of neighborhoods that might be transitioning from low-tier to high-tier because of peculiar localized development, there might be some areas where rents are especially rising.  But, for the typical zip code, adding some new units along a mass transit corridor that might be targeted at a high tier demographic, probably isn't going to raise rents for locals by 40%.

On the other hand, if the existing units have some sort of rent control, then marginal increases in local rents could displace some tenants if landlords sell into a strong sellers market.  So, in a couple of ways, there might be especially strong localized pressure on rents in Boston and LA, but it doesn't seem to be the case, metro-wide.

In San Francisco, the pressure does appear to be metro-wide.  Rent/sq. foot is quite variable throughout the metro area.  Presumably, the housing shortage there is so severe, and prices are so far from basic cost of construction, that local character and amenities do have a strong effect on rents in most parts of the city.

Sunday, March 4, 2018

Housing: Part 286 - Upside Down CAPM and the Housing Bubble

One of the over-riding themes and lessons about the housing bubble was the realization that we weren't as wealthy as we thought we were.  That we drove up the prices of American assets with debt and then took out more debt using that inflated collateral in a doomed attempt to live beyond our means.

I have discovered that all of that was wrong.  The truth is really more the opposite of that.  We have hung a weight around our collective economic neck, consisting of restricted ownership that requires transfer payments to the politically protected owners.  Home prices during the bubble were a reflection of the value of their restricted ownership.  Debt was a product of attempts to buy those restricted assets.  And debt-fueled consumption was mainly consumption smoothing by the owners of those assets, who could liquidate their real estate by sale or through credit, to consume today from their future claims on ownership.

An idea central to the conventional story is the idea that debt and leverage can be used to increase the total market value of asset classes, and thus creates a sort of false growth.

Part of the foundation of the Upside Down CAPM idea I have been developing is that this is largely false.  It comes from thinking of borrowing from the perspective of a consumer.  But, thinking in terms of a national balance sheet, it is more accurate to think of the nation's assets as the anchor - the left side of the national balance sheet.  The right side of the balance sheet shows us how ownership is divided - between creditors and equity owners.  It is more accurate to think of rising debt generally as a shift in ownership between equity and creditors, with a stable amount of assets.  Debt levels are a pretty slow moving animal, and I like to point out that the frothy markets of the late 1990s happened through rising equity values and rising growth expectations.  Interest rates at the time were high because there was a bias then for equity ownership to have a claim on that growth.  Creditors weren't bidding down interest rates in an effort to avoid risk.  They wanted risk.  And savers looking for risk want to be equity holders, not creditors.

So, how does this hold up if we look at the housing bubble?

This first graph is a graph that has been an emblem of the American spending problem.  Debt keeps rising relative to incomes.  This is unsustainable, it would seem.  Households were dealing with stagnant incomes and they were borrowing in order to keep afloat.

The first problem with that story is that the borrowing was heaviest among the households with the highest incomes.  They represent the vast majority of borrowing and they also represented most of the new borrowing during the bubble, in absolute dollars.

The conventional thinking about this shifts upon this evidence to say that, well, the debt was used to bid up housing in a frenzied bubble, so while the evidence that the bubble was built on lending to households with low incomes may not hold up, the use of debt to push up home prices still sits at the middle of the story.

Of course, I have written, ad nauseam, about how the debt was mostly funding access to Closed Access labor markets, and that rising rents explain rising prices better than credit.  But, what about those crazy high debt levels?  How can I explain that away?  Households taking on new debt amounting to half a year's income, over the course of a single decade?

But, that graph shouldn't bother us because of what's on it.  That graph should bother us because of what's not on it.  We should view the economy as a complete balance sheet, where debt is just one form of ownership.  This is a partial picture.*  Debt is the least important part of the balance sheet.

In this next graph, debt is the yellow line.  In thinking about household net worth, I want to walk through these items one step at a time.  All measures are as a percentage of disposable personal income.

Step 1: Blue Line
Step one is the value of all financial assets.  This is stocks and bonds, etc.  Not housing.  This is the value of capital held by households, except for housing.

Step 2: Red Line
In Step two, we subtract debt from the total value of financial assets.  This is how we should think about household balance sheets.  The blue line is the total (non-housing) balance sheet and the ownership is divided between debt and "equity".  (Some of the "equity" may be in the form of fixed income securities, but here, those are assets on the left side of the balance sheet.  In terms of the household's balance sheet, those are part of the household's net worth, similar to a corporations equity, or market capitalization.)

Step 3: Black Line
Most household debt is used to buy real estate.  In step 3 we add the value of real estate to the total.  If we assume for the sake of simplicity that all household debt is secured by real property (most is), then we can roughly think of the distance between the blue line and the black line as the value of household equity in their real estate.  The distance between the blue line and the red line is the value of real estate funded by debt.

Since debt has already been subtracted from the total, the black line represents American households' total net worth.**

I apologize that I have made this a bit more complicated than it needs to be.  It would make more sense to add up the real estate and financial assets and then subtract the debt from that.  You would still end up at the black line as a measure of household net worth.  But, gross household asset ownership would be at a line higher than the black line, representing the total amount of assets, before accounting for debt.  I have done this because I want to make a point.

Let's look at 2005 with the full perspective of American household balance sheets.  The credit bubble story says that we were borrowing from foreigners in a housing bubble, where that borrowing was propping up the value of that real estate.  If an American household borrowed from foreign savers to bid up the housing stock, then that would leave the blue line where it was, it would lower the red line, and it would raise the black line.

So, let's not give American households any credit for the value of those homes.  Take a look at 2005 to 2007.  In terms of gross financial assets, without housing, American households were in a better financial position than at any time in recent history - roughly on par with the peak of the internet bubble.

You might respond that this is an average and that there is gross inequality.  But, remember, the borrowers were households with high incomes.

You might respond that the stock market was still in a bubble, but PE ratios were under 20x and declining.  Bond rates were at cycle highs (so that valuations were low).

Now, subtract all that debt that Americans used to buy those homes.  The red line.  Even after subtracting debt worth 130% of disposable income, American balance sheets were as healthy as any time in modern history, except for a brief time during the internet bubble.

And, I have been arguing that the CDO boom at the end of the housing bubble was actually the beginning of the bust - part of the shift out of home equity because sentiment was already changing - even though American balance sheets were in great shape.  Notice that household net worth (the black line) was level from late 2005 to late 2007.  But, outside of housing (the blue and red lines), household balance sheets were still growing strongly.  Again, give Americans no credit for their real estate, but saddle them with the mortgage debt.  Even after that, from late 2005 to late 2007, when housing starts were collapsing and the Fed hiked the target rate to 5.25%, American balance sheets were expanding - even relative to incomes.

This is especially the time when American households were supposedly loading up on debt to live beyond their means, and now that home values had stopped rising, the end was supposedly inevitably near.  If we think about the equity and mortgage components of real estate, then, during this time, the distance between the red line and black line shrunk.  In other words, total real estate value was shrinking as a portion of household incomes.  And the equity portion was shrinking while the debt portion was rising.

Household balance sheets were healthy, but they had lost faith in housing markets, and they were disinvesting in home equity.  They still had plenty of net assets, and those net assets, seeking safety that no longer seemed available in home equity, they funded things like MBSs and then CDOs.  If, on net, that activity was the result of a global savings glut, then non-real estate net worth would have been declining.  But, on net, American net worth was rising.

When we only looked at the debt component, we missed all of this.  Part of that debt component is due to the Closed Access problem, that some urban real estate contains a capitalized claim on future political exclusion.  But, when we only focus on the level of debt over time, we miss the broader important factor.  Who borrows?  Rich people borrow. (See chart above.)

The reason debt has increased is because American balance sheets are healthy.  The reason there was a frenzy for AAA securities in 2006 and 2007 was because Americans were wealthier than they had ever been and they were scared about the housing market.  The most expensive housing markets, by far, were markets that we now know, with a decade's hindsight, were not destined for a bust.  Prices in the most expensive cities have performed as well as anywhere.  Yet, even in 2004 and 2005, homeowners were selling out of those markets and moving to other cities in large numbers - disinvesting in equity.

Were households borrowing out of home equity in order to consume?  Many surely were.  To the extent that they were, household net worth would have declined.

Today, American net worth as a percentage of disposable income is well into record levels by all of these measures.

* Oddly this selectivity is...selective.  For some reason, when talking about capital's claim on national income, economists seem to always use corporate profits - ignoring the part of corporate operating profits claimed by creditors.  When talking about household balance sheets, economists seem to only look at debt and ignore equity.  In both cases, the partial view is not very useful.

** There are also a small amount of non-financial assets amounting to about a quarter or a half of disposable income over time, so total net worth is slightly higher, but I have left that out for simplicity here.

Thursday, March 1, 2018

Henry George and Affordable Housing

Philip Bess has an article in American Affairs about the benefits of a land value tax (LVT), which was the idea that led to the fame of 19th century thinker Henry George.  There are a lot of interesting thoughts on urban development in the article, and I generally agree with the points made.

Reading the article triggered some thoughts regarding the land tax and housing affordability.  One of George's conclusions, which Bess refers to, is that having a near 100% land tax (which, effectively, is confiscation of unimproved land, but not the improvements and structures, by the government) would prevent speculative bubbles and would improve housing affordability by removing speculative value from the property.  Here is an interesting description, from the article, of how land ownership would look under a comprehensive LVT:
Land speculation would be impossible because only the use of land would have economic value. In turn, though, an LVT would also benefit land titleholders who would not pay tax on improvements to their land or productive activities undertaken thereon. And why would anyone sell land? One would not sell land to make a profit from the sale (which would not be possible), but rather to relieve oneself of a tax liability. That which one cannot or will not use one cannot own save for a fee. “Ownership” of land extends no further than an entitlement to the use of land, and that which an “owner” cannot use he must pay for or “sell” to someone else. “Buying” and “selling” land under a single tax regime therefore assume slightly different meanings than in ordinary discourse because what is really transferred is a land liability equal to land value—a liability virtually no one would accept if they did not plan to use the land.
George focuses on land banking and speculative ownership which is based on expectations of capital gains.   Here, I think my recent work on the housing bubble might add food for thought to this topic.  The point I have frequently made about analysis of the bubble is that there is a sense of attribution error in human nature deep enough to infect the academy. ("I bought a house in Phoenix in 2005 because I was tired of having my rent jacked up every year in LA, but I had to overpay for it because there were thousands of greedy speculators in the market at the time.")  I rarely see homebuyer expectations framed in terms of the present value of future rents.  Usually, especially during the bubble, they were framed in terms of expectations of future home prices.  Removing rental income from the mental framing of home values causes us to exaggerate the effect of speculation as a process unmoored from intrinsic present values.  I think this is the case regarding the idea that a LVT would eliminate land speculation or price volatility.

First, in terms of affordability, I would like to point out that ownership, first and foremost, is a rent hedge.  A Georgist tax would be a pretty harsh Darwinian imposition on homeowners.  California has Prop. 13 because rising home prices meant that older owners with limited incomes were faced with rising property taxes.  A Georgist LVT would impose that tax at a maximum level.  There would be no rent hedge.  It would be the antithesis of tenants rights.  If you couldn't pay the rising tax on a valuable property, you would have to move out.  George sees this as an advantage, and there are benefits to it.

One benefit would be, as a second order effect, that more housing development would be induced because developers would outbid less productive owners and build more improvements on the land, which they could profit from.  So, maybe where current building restrictions are the cause of high prices, this would solve the affordability problem, and little old ladies wouldn't be faced with rising taxes in the first place.

But, the first order effect would be to remove an important source of stability that is fundamental to ownership in our current system.

So, back to my point about speculation and price volatility, if price volatility is unmoored from the fundamentals, then it would be reduced.  However, if price volatility is related to fundamentals (the rental value of a home) then it would not.

Imagine an owner in an untaxed system vs. one in a system with 100% LVT.  Let's say the structure is worth $200,000 and the land is worth $200,000.  It has an annual rental value (after expenses) of $20,000 - $10,000 from the structure, $10,000 from the land.

Untaxed, a buyer pays $400,000 cash and there are no further transactions.  Under the LVT, a buyer pays $200,000 plus an annual $10,000 tax.  We might  imagine that they invest their other $200,000 in a long term fixed income security that pays $10,000 annually.  So, for the buyer, the transaction is essentially the same.  They need $400,000 to own the house.

Now, what if there is a market expectation that the land rental value will grow by 2% annually because of its location?  All the numbers above are the same, but in year two, the tax would be $10,200 instead of $10,000.  So, now, in order to perpetually control the property, the buyer would need enough savings to pay the initial $10,000 tax, and to grow by 2% each year.  So, the buyer would need to pay $200,000 for the house and save $280,000 to cover the taxes.  So, the total "price" would be $480,000.

Now, since rising rent is a liability for the owner, owners would still want to hedge that risk, just like they do today.  So, we might imagine that banks would offer a service.  They might develop a security that they sell, sort of like an annuity.  They would say, "Pay us a set amount, and we promise to make the LVT payments on a property in perpetuity."  So, now, the buyer would go to the bank, pay them $400,000.  The buyer would own the home and the bank would handle the LVT, so the owner would have no further expenses.

And, if the local housing market became valuable, and there was an expectation that land values would rise 2% annually, the bank would still sell the same security, but they would require a payment of $480,000.  And, if someone wanted to buy the property, they would have to purchase that annuity from the current owner, also at $480,000.  If we think of speculators betting on future rental value rather than betting on short term price increases they expect to reverse (presumably after they sell), then there is no difference in that changing value.

(edit: Changing interest rates would also affect the value, just as they do today.  And, of course, we could further imagine that buyers fund their initial payment for the annuity by getting a loan with a 30 year fixed amortization.)

(edit #2: Upon further thought, even unmoored speculation could happen with those annuities.  So, maybe my distinction between fundamental and unmoored speculation isn't that important.  Everything would basically be the same, except that since the government has taken a long position in the land, which it doesn't have in the untaxed version, for these instruments to work, the bank has to have a short position on the land, which is what the promise to pay the tax is, which it doesn't have in the untaxed version of the story.)

So, we can imagine that, to the extent that home values reflect capitalized future rental value, there really is no difference between the taxed and the untaxed market.  I differ from George on these two points.  (1) I think he, like most observers do, overestimates the significance of unmoored speculation on home prices, and (2) by removing a device for capitalizing future rental values, he can imagine that the value doesn't exist.  But, future rent or tax changes have an effect on current owners whether we imagine that they can hedge them or not.