The Bear’s Lair: Housing’s froth and bubble

Fed Chairman Alan Greenspan referred this week to “froth” in the U.S. housing market; others have debated whether it is a “bubble” at least on the two coasts.  Whether froth or bubble, the secular rise in house prices over the last 5 years has made long term changes in American life, most of them for the worse.

Housing was always the American dream.  When the GIs returned from World War II, their ability through the GI Bill program to obtain mortgage finance created huge demand for low cost housing in the suburbs and created the automobile-dominated American city. No longer was it necessary for middle class families to live in cramped apartments on a busy street; instead they could live in single family homes in suburbia, and commute to work along the new highways.  The result was the rapid decline, not only of 19th Century row house communities, but also of previously stable middle class apartment communities such as Grand Concourse in New York’s Bronx, where relatively new and high class housing stock was abandoned by the suburbanizing middle classes and left to impoverishment and decay.

For fifty years after World War II, everywhere in the United States except in a very few communities such as Manhattan and Silicon Valley, single family homes remained affordable to the middle class.  The mortgage finance companies Fannie Mae and Freddie Mac guaranteed U.S. home mortgages, and together with Wall Street created a liquid secondary market for mortgage backed securities, enriching their shareholders and management immensely by doing so.  In periods of tight money, such as the late 1970s and early 1980s, mortgages became difficult to obtain and affordability for the middle classes became less (because the interest payments on mortgages became so high) but such periods were relatively short, and were always succeeded by renewed availability of mortgages and steadily rising house prices, as population and disposable income increased. 

Land availability became scarce only in a very few communities close to big cities on the East and West Coast; in other areas, house prices were always constrained by the possibility of building new houses on new land, thus once more balancing demand and supply.  Unlike in Europe, planning restrictions remained limited and building land remained readily available, so house prices never exceeded the ability of first time buyers to afford them.

With all these advantages, and the country’s wealth, one would expect home ownership levels in the United States to be exceptionally high by world standards, but this is not the case. In the United States, unlike in most other housing markets, rent controls are scarce, rental laws favor landlords and hence rental housing is readily available at a market determined cost.  U.S. owner occupancy, even after the long boom of 1995-2005, remains below 70% of the housing stock, whereas owner occupancy in Britain, Ireland, Italy and Spain, all poorer countries than the United States, are above that level.  In all four of these countries, the cheap money period after 1995 produced a housing boom similar to that in the United States. In Britain, for example, the Halifax House Price Index for the United Kingdom was up 162 percent over the 10 years to March 2005; that for Greater London was up 212 percent – both a substantial multiple of either overall inflation or the increase in national earnings during those years.

Only Germany of the major European countries has an entirely different system of housing finance, with owner occupancy there being below 50 percent, and mortgages available only with a down-payment of one third of the principal amount. Consequently, home ownership in Germany is limited largely to people over 40, whose careers and lifestyles are well established. German house prices have not inflated as in other countries; indeed, the period since 2000 has seen a slight decline in them.  Furthermore, in relation to German disposable incomes, house prices remain remarkably affordable.

The overall picture is thus clear, but significantly different to that popularly supposed.  In spite of the country’s affluence, home ownership has not historically been uniquely a part of the American Dream; instead, it appears to be more deeply a part of the British, Italian, Irish and Spanish Dreams. On the other hand, very high levels of home ownership are not necessarily a blessing; they lead to periods of rapid appreciation in house prices, and consequently to unaffordable housing for the middle class, in particular for the young, who have not had the good luck to be on the “house price ladder” before. The German housing pattern, lower home ownership and less generous finance, would seem more appropriate to an economy with a high level of job instability and consequent need for frequent home moves.

Seen in this light, the low interest rates, tax-advantaged housing purchase (home mortgage interest is not now tax deductible in most countries) and rapid house price appreciation seen in the United States since 1995 may be a trap.  While allowing effortless capital appreciation and worry-free excess consumption for those already on the housing ladder, it has three economic disadvantages in the long run: 

• Since housing is a cost, high house prices increase the cost of living, maybe not in the official statistics, but most certainly in the percentage of their income consumers must devote to housing, and hence lower their standard of living in other areas. 

• High and rapidly rising house prices produce a large generational inequality; younger consumers find their incomes lower in housing terms than were older ones, and either cannot afford decent housing at all, or must borrow amounts of money that are excessive in terms of their earning capacity, thus leaving them vulnerable to bankruptcy in an economic downturn.  This was particularly clear in Japan in 1985-90, the era of 100-year mortgages. 

• Job mobility is reduced by high home ownership, and unemployment consequently increased.  Selling and buying a house in order to move costs 6 percent of the house’s value in real estate commissions alone, and may be impossible if the housing market in an area is dead or the mortgage is too large in relation to the value of the house. When an area suffers an economic downturn, and consequent job losses, its housing market may also collapse, greatly worsening the hardship for those caught in the catastrophe – ask anyone who owned housing around Youngstown, Ohio in the early 1980s, when the major steel mills in the area closed.

The United States, particularly the two coasts, has never seen a house price boom as extreme as that witnessed since 1995, and house prices are now at record levels in relation to disposable income.  For several years, U.S. consumption and the economy in general have been kept afloat by the steady and accelerating rise in house prices and the easy availability of mortgage refinancing, so that in 2002-04 around $200 billion per annum was added to consumption by this means.  To suppose that this enormous pyramid scheme is cost free is economic illiteracy that only the George W. Bush administration and the Greenspan Fed could perpetrate.

As higher house and commodity prices feed into consumer price inflation in general, the Fed will be forced to put up interest rates more rapidly than it has done so far – even after a year of rises, the Federal Funds rate at 3 percent is still below the inflation rate, on the Gross Domestic product deflator confirmed Friday, of 3.2 percent.  The fallacy that the U.S. economy can continue ad infinitum on the basis of swindling creditors out of some fraction of their purchasing power each year was pretty conclusively exploded in the 1970s. Once interest rates rise above zero in real terms, housing “affordability” will decline catastrophically, and house prices will themselves begin to fall – it’s inevitable; the supply of buyers at any given price level will simply dry up.

At that point, the United States, like Japan in the 1990s, will turn into a gigantic version of 1982-vintage Youngstown, Ohio.  House prices will be dropping, and interest rates rising, so mortgage refinancing “takeout” will no longer be available.  The economy will slow, so jobs will be lost (particularly in the financial services industry, where the huge mortgage banking and consumer banking profits of the last few years will disappear.)  However, consumers will be unable to sell their homes, and unable to move because they cannot sell their homes, while many of them will be further trapped by their mortgages being greater than the value of their homes.  If we all breathed a sigh of relief when the (partial) deflating of the 1997-2000 stock market bubble produced no huge recession, there will be no escape this time.

Going forward, Congress should legislate so that the United States housing market moves close to that of Germany, which by 2010, after several years of social services reforms and the problems of East Germany finally behind it will appear once again a powerful and economically vibrant competitor. Fannie Mae and Freddie Mac should be put out of business (this is likely to happen automatically, because of the losses on their huge home mortgage portfolios.)  Home mortgage interest deductibility should be abolished, and a portion of the additional tax revenues this produces applied to removing the double taxation of dividends, preferably by making them tax-deductible at the corporate level. The “passive income” tax restrictions on rental property income should be removed, to encourage the private property rental market. It may even make sense to impose a “transfer tax” on mortgage debt transactions, to remove the excessive liquidity from the mortgage debt market, and return mortgage lending to the banking system. 

With these changes, over a decade or two, the United States can regain once more what has always been one of its principal competitive advantages, both economically and for its inhabitants’ lifestyles: the availability of cheap high quality housing.

—
(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long ‘90s boom, the proportion of “sell” recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
—
Martin Hutchinson is the author of “Great Conservatives” (Academica Press, 2005)—details can be found on the Web site greatconservatives.com.

Posted by karlmagnus on Monday, May 30, 2005 at 09:55 AM in Economics & Finance,  Social Sciences,  U.S. Politics
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