Saturday, January 10, 2009

The Downsides of Widespread Homeownership; Have Americans Overinvested in Housing? Probably


From the Richmond Fed article "House Bias: The Economic Consequences of Subsidizing Homeownership":

The homeownership rate is about 68% now (see chart above). Perhaps the best policy question is no longer why the homeownership rate in the United States is so low. A question that economists might ponder instead is: Why should we want the homeownership rate to be so high?

The Downsides of Widespread Homeownership

1. The current policies produce an economy in which housing investment is generally higher than it would be if government didn’t favor it. Simply put, Americans may have overinvested in housing. And every dollar that is invested in housing stock is a dollar not invested in a more productive use elsewhere. That results in a net reduction in overall economic efficiency.

2. It's not clear that using a home purchase as a primary vehicle for a family’s investment is sound financial advice. Robert Shiller, an economist at Yale University and an expert on national housing markets, has estimated that “from 1890 through 1990, the return on residential real estate was just about zero after inflation.” Throw in the costs of maintenance of the property and it’s easy to see how renting could certainly be cheaper than owning, even if you include the tax advantages. Yet the opportunity cost of those home investments — the foregone investment opportunities elsewhere — go largely unseen.

3. The costs of owning a home go beyond the financial commitments too. Being tied down to a house tends to make people less likely to leave an area in which employment prospects are deteriorating. After all, terminating a lease is much less costly and time-consuming than foreclosing on a house or selling a home, even if the owner breaks even on the transaction. Economists predict this would lead to a decline in “labor mobility,” the ability for people to move to where the jobs are.

4. Homeownership also tends to contribute to adverse political incentives. Incumbent homeowners have an interest in keeping their property values high and have been shown statistically to have a bias in favor of land-use regulations. These restrictions limit the number of houses that can be built in any geographic area and, consequently, keep housing inventory low and property values artificially inflated.

16 Comments:

At 1/10/2009 10:13 AM, Blogger PeakTrader said...

Related comment:

How to Spur an Economic Boom

Once the market is cleared of excess assets and goods, then nominal output (i.e. real output and inflation) will expand. An expansion in nominal output will raise "animal spirits," generating a virtuous cycle of economic growth. The most efficient way to spur an economic boom is a large tax cut, e.g. $2,000 per taxpayer (through a freeze on federal tax collections and an increase in unemployment benefits).

Krugman's slow, inefficient, and unfair plan:
New York Times
The Obama Gap
By PAUL KRUGMAN
Published: January 8, 2009

Bear in mind just how big the U.S. economy is. Given sufficient demand for its output, America would produce more than $30 trillion worth of goods and services over the next two years. But with both consumer spending and business investment plunging, a huge gap is opening up between what the American economy can produce and what it’s able to sell.

Even the C.B.O. says, however, that “economic output over the next two years will average 6.8 percent below its potential.” This translates into $2.1 trillion of lost production. “Our economy could fall $1 trillion short of its full capacity,” declared Mr. Obama on Thursday. Well, he was actually understating things.

To close a gap of more than $2 trillion — possibly a lot more, if the budget office projections turn out to be too optimistic — Mr. Obama offers a $775 billion plan. And that’s not enough.

Now, fiscal stimulus can sometimes have a “multiplier” effect: In addition to the direct effects of, say, investment in infrastructure on demand, there can be a further indirect effect as higher incomes lead to higher consumer spending. Standard estimates suggest that a dollar of public spending raises G.D.P. by around $1.50.

But only about 60 percent of the Obama plan consists of public spending. The rest consists of tax cuts — and many economists are skeptical about how much these tax cuts, especially the tax breaks for business, will actually do to boost spending. (A number of Senate Democrats apparently share these doubts.) Howard Gleckman of the nonpartisan Tax Policy Center summed it up in the title of a recent blog posting: “lots of buck, not much bang.”

The bottom line is that the Obama plan is unlikely to close more than half of the looming output gap, and could easily end up doing less than a third of the job.

 
At 1/10/2009 10:44 AM, Blogger ngthagg said...

it’s easy to see how renting could certainly be cheaper than owning

I don't think it's easy to see this at all. The linked article does not include a reference to Shiller unfortunately. But the quote implies that return on residential real estate is based on the full purchase cost of a home.

But the money you pay into a mortgage can not all be considered an investment, because no one is able to direct 100% of that money elsewhere. A certain base amount goes to providing shelter. Suggesting that that money could be better invested is as ridiculous as suggesting you could get a better a rate of return if the money you spent on groceries were put into stocks instead.

I wish the Richmond Fed article were more clear. Without any hard numbers to back it up, it seems to me that housing is a pretty good investment if you consider that the principal is the difference between the monthly mortgage and the monthly rent, but your return is calculated based on the entire monthly payment.

 
At 1/10/2009 10:48 AM, Blogger PeakTrader said...

I disagree with all four points:

1. Without the homebuilding boom (and related goods), U.S. actual output would have been even further below potential output.

2. Data show homeowners have substantially more net wealth than renters (e.g. $150,000 to $4,000).

3. Owning a home restricts mobility. However, more wealth increases mobility.

4. When neighborhoods cannot expand from restrictions, new neighborhoods are created.

The U.S. homebuilding boom was facilitated by "excess" capital, e.g. massive foreign capital inflows, and a record 20 consecutive quarters of double-digit earnings growth by U.S. corporations in the 2000s. Some of that excess capital flowed into the housing market.

 
At 1/10/2009 2:15 PM, Blogger Plamen said...

PeakTrader:

My thoughts on your rebuttals:

1) Potential output is a bogus concept as you use it - with no time frame. The devil is in the details. Most definitions of the term refer to "substantial period of time" - but the difference between a year and 20 years, especially when talking about long-term assets, such as homes, is big.
2) Correlation does not necessarily mean causality. Wealthy people tend to like capital preservation, and thus park a significant portion of their wealth into low-yielding, tax-efficient investments - variable annuities, muni bonds, and yes, homes. Remove the preferential tax treatment, and you'll see some of those investments almost completely abandoned; not so with real estate, but its popularity will surely drop very significantly.
3) True, but it feeds off the previous argument.
4) True, but this argument can be tricky - would you argue that quotas and capital flow restrictions are efficient tools of foreign trade too? "You cannot do business here, because we say so" is certainly a corollary of property rights, and I passionately defend them. However, so is "I can burn my house if I want to", but that does not make mass arson a great idea.

IMHO, the biggest downside of home ownership for the TYPICAL homeowner is the lack of diversification. There are few free lunches out there, but Pareto improvements, such as freer trade (benefits both parties) and portfolio diversification (less risk with no loss of return) are not to be easily passed up.

 
At 1/10/2009 4:31 PM, Blogger PeakTrader said...

Potential output measured as a 10-year moving average shows U.S. actual output has generally been below potential output throughout the 2000s. We've seen U.S. actual output fall further, below potential output, during the housing bust. Homeownership builds wealth through rising home prices and paying-down mortgage debt. Renting doesn't create equity. When the cost of homebuilding is too high in one area, then homebuilding will take place in another area. Typically, homeownership creates a higher standard of living than renting. Everyone has to live somewhere. Can you really diversify that? (when you can afford only one monthly home payment).

 
At 1/10/2009 7:07 PM, Anonymous poor boomer said...

DING DING DING DING

We have a winner!

I've been complaining about this part for years:

"4. Homeownership also tends to contribute to adverse political incentives. Incumbent homeowners have an interest in keeping their property values high and have been shown statistically to have a bias in favor of land-use regulations. These restrictions limit the number of houses that can be built in any geographic area and, consequently, keep housing inventory low and property values artificially inflated."


Since incumbent homeowner protectionsim isn't going away any time in the foreseeable future, what can renters do to protect themselves?

Doesn't this make a case for rent control? If incumbent homeowners can use government to protect their financial interests, why shouldn't incumbent renters do likewise?

 
At 1/10/2009 7:13 PM, Anonymous poor boomer said...

I once lived in a town where a newcomer who hadn't lived in town for six months organized her fellow homeowners to block approval of a developer's request to build apartments on a large vacant parcel.

After the homeowners succeeded in getting the builder's application denied, they took the next step to downzone the land so that the land was no longer zoned for apartments.

The homeowners were happy, the politicians were happy (because the voters were happy), the developer sued and was paid off to go away, and the renters all lost when the rental supply was artificially kept below demand.

That's life in America.

 
At 1/10/2009 7:19 PM, Anonymous Anonymous said...

Rent control would be counterproductive in the long run. But a tax deduction for rent paid would provide more equal tax treatment.

 
At 1/10/2009 9:49 PM, Anonymous poor boomer said...

A tax deduction for rent wouldn't much help the people who need it most (those with the lowest incomes) because the component of rent attributable to state/local taxes (the only part of rent that could merit a deduction) probably wouldn't be enough to exceed the standard deduction. (Not to mention that even an itemizable deduction wouldn't much help someone in the 10% marginal bracket.)

But there is a sound accounting principle which gets in the way, so it's not going to happen and it would be unrealistic to ask for.

 
At 1/10/2009 9:51 PM, Anonymous poor boomer said...

And yes, rent control would be counterproductive in the long run.

But rent control isn't really about helping "all" renters - only INCUMBENT renters, who would benefit.

The downside of reduced availability would be borne by newcomers, who are harmed by rent control just as newcomer homeowners are harmed by supply control.

 
At 1/11/2009 6:25 AM, Blogger Plamen said...

"Potential output measured as a 10-year moving average shows U.S. actual output has generally been below potential output throughout the 2000s." - You lost me. 10 year moving average of what? Potential output? Either the measure you use went circular, or I am misunderstanding.

"We've seen U.S. actual output fall further, below potential output, during the housing bust." - Not to make the discussion too technical, please look here for Mishkin's look at "what goes into the sausage". Quote: "As I indicated earlier, considerable uncertainty surrounds the measures of potential output derived from any of the approaches I have discussed. In addition, there is also what economists call Knightian uncertainty (named after the famous University of Chicago economist Frank Knight)--the fact that we are not even sure of the appropriate modeling approach to measure potential output. Adding even more to the uncertainty of potential output measures are (1) that the observable data do not always correspond to the data we would like to have to produce measures of potential output and (2) that initial estimates of observable data can subsequently be revised substantially, resulting in a very different picture of what is happening to potential output and the output gap."

"Homeownership builds wealth through rising home prices and paying-down mortgage debt. Renting doesn't create equity." - Only if you assume that mortgage payments are equal to rents, which is generally not the case, even with the tax-preferential treatment of interest. The savings from renting can be invested.

"When the cost of homebuilding is too high in one area, then homebuilding will take place in another area." - True, although this discussion, I think, focused on the cost of home ownership, not home building. Furthermore, the price one pays for a home is very weakly related to the cost to build that home - if anything, for new homes, building cost provides a tentative floor, buit builders routinely sell below cost when they need to free up funds, and way above cost in "hot" areas.

"Typically, homeownership creates a higher standard of living than renting." - True, but in the same way that a BMW creates a better driving experience than a Chevy Cavalier - at what cost? The value proposition should take into account what you pay for what you get.

"Everyone has to live somewhere. Can you really diversify that? (when you can afford only one monthly home payment)." - Again, as above, you assume too many ceteris paribi - rent and mortgage payments are NOT identical (data varies, but from census.gov I get for 2007 median rent $755, and median mortgage $972); renters include disproportionately more "non-earners" (such as college students) for cost-neutral reasons, etc. So, yes, I posit that you can diversify.

 
At 1/11/2009 11:36 AM, Blogger PeakTrader said...

Your link contradicts your own conclusion. Obviously, potential output is measured in a crude way. Yet, optimal growth has been estimated with a high level of confidence. The big problem is the leads and lags of monetary policy, to smooth-out the business cycle, e.g. because of shifts in the foreign exchange market or changes in the velocity of money in the short-run.

In the late '90s, U.S. actual output generally exceeded potential output. Throughout the 2000s, U.S. actual output was generally below potential output. However, in the 2000s, the global economy overproduced. It was appropriate U.S. monetary and fiscal policies raised U.S. actual output towards potential output, although that caused the global economy to overproduce even more. Consequently, the U.S. was near optimization, while the rest of the world produced at a suboptimal rate, to a large degree.

 
At 1/11/2009 3:17 PM, Blogger PeakTrader said...

Link to the CBO method of estimating potential output is below:

CBO's Method for Estimating Potential Output: An Update

"CBO's current method for estimating potential output offers a combination of transparency and computational ease. It also produces accurate results relative to forecasts by the Administration and the Blue Chip survey of private economic forecasters. However, CBO staff continue to evaluate alternatives and may modify that method when evidence points to a superior approach."

https://www.cbo.gov/doc.cfm?index=3020&type=0

 
At 1/11/2009 3:37 PM, Blogger Plamen said...

This comment has been removed by the author.

 
At 1/11/2009 3:43 PM, Blogger Plamen said...

"In the late '90s, U.S. actual output generally exceeded potential output."

Please, define potential output as you use it. Standard definitions involve a growth/employment rate that does not lead to inflation. Inflation in the 90's did not increase (data from bls.gov, but in a servlet), in fact it was remarkably stable by historical standards. Therefore either your statement above is wrong, or you use a different definition of potential output.

All I am trying to point out is that the concepts of potential output gap are a redressed Phillips curve. This "curve", as we know, does not stay very static, and does not even shift in a predictable manner, and thus is not really a curve, but a scatter plot and a Rorschach test for one's attitude towards gov't spending.

I'd be interested to see links on the optimal growth estimates you mention.

Thanks, and a good rest of the weekend!

 
At 1/11/2009 5:05 PM, Blogger PeakTrader said...

Plamen, I think, you're spending too much time on potential output and not enough time on actual output. Potential output is sustainable real growth consistant with price stability. It's well-known, in the U.S., roughly 2.5% real growth is potential output. However, I stated above nominal output is also important to generate "animal spirits." Here's what Bill Gross of Pimco has to say:

Jan '07 partial interview:

Bloomberg's Tom Keene: "Bill [Gross], your note every month is always interesting. This last one is one of my favorites. As you know, I'm a big fan of nominal GDP - this, folks, is real GDP plus inflation. It's the 'animal spirits' that's out there. You say be careful, Bill Gross. It looks real good to me, Bill. I see 6% year-over-year nominal. You say that's going to end?"

Pimco's Bill Gross: "I think almost assuredly, because of oil prices. I'm not suggesting it end because of real growth going down - that's the Goldilocks scenario in which we have 2% plus or minus real growth. With oil prices doing what they're doing - if they hold in the $55 range - gosh, we're going to see CPI prints y-o-y over the next three or four months of 0.5% or 1.0% and that means nominal GDP is down in the 3% range. "Ultimately, the inflation component affects the real growth component. To the extend that you have nominal GDP - in my forecast 3 to 3.5%, that's really not enough growth in terms of the economy itself to support asset prices at existing levels. And so, declining assets prices ultimately factor into eventually lower real growth. But that's not for mid-2007 but perhaps for later in the year."

Tom Keene: "When we look at six months of low nominal GDP, is that enough to link directly into the 'animal spirits" of the business investment component of GDP - the "animal spirits" of business men and women?"

Bill Gross: "Well sure it is. When you realize that the average cost of debt in the bond market - and therefore in the economy and this includes mortgages - it is about 5.5%. If you can only grow your wealth and service that debt at 3.5% rate, then that has serious implications. When you go back to 1965, Merrill [Lynch] did this study - in terms of asset prices during periods of time when nominal growth grew less than 4%. Risk assets have been negative in terms of their appreciation and actually bonds have done pretty well. The question becomes why hasn't that happened yet, and I think we're simply in a period of time where there are leads and lags that are much like the leads and lags of Federal Reserve policy."

 

Post a Comment

Links to this post:

Create a Link

<< Home