What the prophets of the new housing paradigm don’t discuss, is that real estate markets have experienced similar cycles in the past and that periods described as new paradigms are often followed by periods of distress in real estate markets, including foreclosure sales, bankruptcy and bank failures. The case of Japan’s real estate bubble is instructive. [Full article]
Source link: http://blog.mises.org/2083/housing-too-good-to-be-true/
Housing: Too Good to be True
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I found this article very thought provoking and important, especially since I live in a newly purchased house during this artificial boom. I have constantly brought this up to family, relatives and friends, about the housing bubble and bust, yet I’ve received perplexed looks as if speaking a language they cannot comprehend. Some friends and relatives are in real estate and they constantly tell me that “real estate is the best investment, it’s land, the prices always go up, it’s a sure bet” and point to charts that show the ever increasing price of homes. I try to explain inflation, artificial booms, etc., and I cannot get through.
-Arman
There is some logic to what the realtors say. Land is finite, the population grows, and the government prints more money, so all other things being equal, the price of land will continue to rise.
The problem of course, as Mr. Thornton points out, is that all other things are not equal.
Mark Thornton’s article makes an excellent, central point: housing is in a bubble, which will necessarily reverse. This coming reversal is inevitable, no matter how many realtors shout from the rooftops that land is the best investment. The inevitablity stems from the misallocation of resources inspired by a 1% fed funds rate.
Even if the Fed were to peg the funds rate at 1% forever, the bubble would burst. The reason is that the misallocation of resources generated by the artificially low rate of interest–through endless building of new homes, through profligate consumption (anti-saving)habits encouraged by rising housing prices, and through productive activities “crowded out” by bubble activities–makes people poorer.
This poverty shows up in what Frank Shostak has described as a downward spiral in the “real pool of funding”–the real goods and services that sustain production, that workers consume with their paychecks, and that businesses utilize to manufacture goods. When the real pool of funding declines, production activities that had been profitable–even old-line activities–become less so, or begin to actually lose money. Why? Price relationships change: goods used to sustain production get more expensive, reflecting greater scarcity; producer and capital goods rise in price compared to the revenue prices of whatever they’re used to make.
One consequence is that wage rates decline, because wages are paid from capital, which is contracting. Falling real wage rates make house payments more difficult to discharge. Moreover, the maintenance costs–at least of materials–of all this new housing goes through the roof, reflecting the declining capital base. Falling incomes and profits encourage governments to boost tax rates, futher burdening staggering consumers.
The result is a surfeit of first and second houses that people can not afford, just as Harry Browne explained years ago with his example of the boom in swimming pools, in How You Can Profit From the Coming Devaluation.
Dr. Shostak has explained that the decline in the real pool of funding also creates other important effects. For example,the decline in real wage rates heralds low rates of CPI inflation, because wage earners more and more have to restrict their purchases of what they cannot afford. Further, debt becomes increasingly difficult to service, because incomes and profits fall as the capital base contracts. As debt gets harder to discharge, individuals and firms seek to avoid creating new debt liabilities. The result is that the money supply grows more slowly, even as the inflationaist quacks at the Fed “heroically” seek to expand the monetary base.
To summarize, a declining real pool of funding creates strong headwinds against rising inflation.
This position is very controversial among Austrian economists, because they appreciate and understand that the Fed exists only to inflate. However, if the capital base is contracting, then come what may, the structure of production will get shorter. A shortening structure of production will make capital intentive processes less pprofitable, and labor intensive processes more profitable. True, firms can borrow to pay their workforce, as they change production techniques. But the new hand-to-mouth techniques require less capital and hence less borrowing, for two reasons. First, they cost less (and are less productive)than previous production methods. Second, capital goods utilized to lengthen production are employed to save labor, not for one pay period of from two weeks to 1 year, but for many periods extending over a period of years.
Borrowing to meet a payroll is only needed until profits from the production cycle discharge the operating loan. Borrowing to finance the acquisition of capital goods involves greater sums of money, since the production period financed is much longer.
Thus, it seems likely that the declining real pool of funding will restrain money growth and inflation until the time arrives that stocks and real estate trend lower. At that point, the demand to hold money rises, as it did in Japan, the process intensifies, and risks of a deflation-promoting financial accident become greater.
Arman, your observation reminds me of an episode of The Simpsons where Disco Stu shows an audience a line-graph chart sky-rocketing upwards. The gist of his speech is that this trend could continue and his company would be a good one to invest in. Of course, if you pay close attention to the scale in his diagram, the years are from the late 1970s. Oops.
Mark:
Excellent Article. I recently purchased a house in the San Francisco Bay Area and debated exactly this issue. I do think we have aspects of a housing bubble in the U.S. but at least in California high home prices seem to be driven by political factors.
All of the restrictive growth policies, urban growth boundries, “affordable housing” mandates, permit limits, environmental impacts, have severely limited new construction in California. As a result prices have skyrocketed. Glaser’s recent paper estimated that 90% of the difference between physical construction costs and home prices is caused by land use regulations.
So while I thought that there were aspects of a monetary cause to a housing bubble it seemed like my local housing market had more to do with restricting the supply of new homes (something you note is not happening in Auburn). Then I looked at the political reality of California and asked: were housing policies likely to get worse, or better. My guess is worse.
As long as CA continues to limit supply more and more, I see a lower downside to any bubble correction here. I hope I’m right!
Good article.
Ben
Ben,
I hope you are right too. But I suspect you are wrong. Absent the extremely low interest rates, do you believe that the limits on new construction you see in California would result in skyrocketing prices, or would they instead cause people to leave California?
The fact is, that many home buyers in California have bought with very little equity on the theory that prices will continue to rise. But once interest rates rise, what will cause housing prices to rise as well? At that point, won’t people who need to buy a house, have no choice but to move elsewhere? And won’t that bring prices lower? Is it realistic to think that living in California is so much preferable to living elsewhere that people will continie to pay higher and higher costs to do so?
It’s one thing to have higher than average prices to live in a place like Manhattan, where business opportunities are so much better than elsewhere that it can justify what to most people are ridiculously high prices. But does living in California allow you to be so much more productive that you can justify the high real estate costs?
If you want to look at real big nasty bubbles you have to find a market where the supply is relatively restricted or “inelastic”. [You can even get "natural bubbles" in such cases as tulips and llamas.] California has restricted housing for the benefit of incumbant homeowners for a long time and thus has created an artificial version of Manhatten and Tokyo. In places with restricted supply is where you see the biggest price swings. Ceteris Paribus, we would expect to see the biggest falls in $ terms in these markets.
On the other hand, the long term trend is up due to persistent monetary inflation. [My guess is that the real cost of building homes is lower today than 25-50-75 years ago.] And land values should keep up with inflation and growth–if not beat it–so if you don’t buy at the top and have a fixed-rate 30-year mortgage and a solid family income base things may not work out too bad if the overall economy doesn’t get whacked. And if (when) price inflation really does go on a bender your house could still turn out to be a good investment. If you bought a few years ago and prices are up more than 100% you have a pretty good cushion if you haven’t extracted equity.
For more on traditional investment philosophy see:
http://www.lewrockwell.com/thornton/thornton12.html
Mark
Very interesting, well-researched and argued. I have made a number of observations that agree with the article;
a) Friends selling homes within hours of listing, at or above listed price ($400K+);
b) Suddenly, there are a lot of “For Rent” signs on single-family homes and small commercial properties, and;
c) An explosion (5000 + new homes)of homebuilding in my town (Southern NJ near Philadelphia), with attendant infrastructure spending (3 new and 2 enlarged schools), and a 30% tax increase.
I just got married, and we are thinking of renting out my wife’s house and living in mine. This article has me considering whether we should just sell one of the houses,bank the money, and buy distressed properties when the bubble deflates.
Definitely food for thought.
This is an excellent article! My wife and I are in our early 30′s, and are experiencing first-hand the disastrous effects of the Fed’s and Fannie Mae’s low-rate and easy-credit policies.
We had to move out of Austin, Texas just to find affordable housing. California and New York were out of the question. Believe me — like all young families I know, the income-to-housing ratio is one of the MOST important factors in our search for a place to live, and it is getting harder and harder to find anything remotely affordable.
As I see it, these policies are more than just election-year manipulation by Greenspan. It is yet another mechanism by which the government foists burdens on the young and productive at the expense of their favored consituency. Artificially low interest rates are just another form of wealth-transfer; it just is a little more sneaky than, say, outright confiscation by taxation (which they do too, of course).
In May, I wrote a short piece that touches on many of the same issues. See http://www.georgegaskell.com. The host of Libertarian Jackass also kindly put it on his website (it is sort of a Generation X version of the Mises Blog…)
http://libertarianjackass.blogspot.com/archives/2004_05_01_libertarianjackass_archive.html#108496445009082627
Interesting discussion – lots of good points. My wife and I live in a neighborhood in Brooklyn where housing costs are also superheated. We are interested in multi-unit investment properties in Brooklyn or Manhattan, but are concerned we may be purchasing at the top of the market. A decline in rents or occupancy in a market so restricted seems unlikely, but declining wages or employment can push overvalued properties into the red.
Peter raises an interesting point. The high cost of real estate is a deterrent to living in NYC, but so far has failed to shrink population. More people want to live here than leave – apparently no matter how outrageous the apartments cost. Peter is right in that higher costs of housing will drive some to seek greener pastures, but for many, living in California or New York is desirable enough that the extra cost is worth it. If it weren’t the demand wouldn’t be so high.
Ben raises a good point as well: how much of the bubble in NYC or California is caused by monetary manipulation, and how much is caused by other restrictions upon supply such as zoning or geographical limitations. The island of Manhattan, for instance, isn’t getting any bigger. Will market cycles drive prices down in places where demand will outpace supply for the forseeable future? I’m betting they will, but only slightly. People come to New York every day to make it big in one way or another and will always provide demand.
Some multi-unit or commercial properties in New York operate on the “Bigger Fool” theory: buy a property that is cash-flow negative, fund it for a couple of years and then sell it at an enormous profit to some bigger fool, who also feels the property will continue to appreciate. Whether this is foolish or not, I cannot say, but it’s certainly expensive.
In any event, for owners who finance aggressively or leverage their cash flows, the ledge is narrow. One strong wind and a few will fall creating more motivated sellers. But how much decline can we expect when the buyers are already there with cash in hand? I agree with Mark in that I feel that maintaining equity and financing conservatively is a good hedge against any sort of market correction. All of this is conjecture, however; no one can see the future. Hearing the opinions of so many with an understanding of Austrian economics is certainly helpful though. And enjoyable.
Aaron
I myself am indulging in “geo-economic arbitrage” – I live in a relatively low-cost area (far southwestern NJ), and work principally in the NYC metro region. So I don’t compete in the NYC housing market. But now the cost where I live is slowly but surely rising…
Can anyone explain or link me to an article describing the mechanisms by which the Fed lowers interest rates? I have heard the argument that because there is a market for debt instruments, the Fed cannot, in fact, artificially lower interest rates.
I know there are two mechanisms at work: (1) Fannie Mae and Freddie Mac, which guarantee a buyer for low interest mortgages; (2) Asian and Middle Eastern central banks, which purchase Treasuries at high prices to keep yields down.
Any others?
Doug,
The Fed cannot raise interest rates above the money market rate, but they can sure lower it to zero if they want. (This is the case of modern Japan, which has a zero percent short term lending rate.) To get a piece of this newly-created (counterfeited) money; however, you have to go to the bank and take out a loan to get your hands on some of this counterfeited money. The Fed puts a limit on how much they will counterfeit because they require that 10% of the money that is lent out is from other people’s savings (real money). So it is a combination of savers and the governments “looseness” with the interest rate that determines the inflation rate.
The savings rate at a bank will never exceed the lending rate or else you could just take out a massive loan and put it into savings to make money. So the savings interest rate will be low, meaning that people will save less. (Japan’s savings rate went from a high of 14% to 3%.)If the savings rate goes to zero, people may not bother to put their money in the bank. This limits the growth of the “money supply”.
The market for debt instruments (especially treasures) does not effect how much money the Fed can print up.
Debt instruments are how the government finances a large part of its operations. If the interest rates are too low presumably no one will buy treasuries; however, emerging markets such as China buy US treasuries in spite of the low interest rates to build credibility for their own currencies and because their governments have more influence from their exporters than their consumers. There is no reason that the government needs to be in debt and theoretically the Central Bank is independent and should not care about the solvency of the rest of the government. Besides governments are fickle and may not honor their treasury bonds. A government in debt appreciates low interest rates just like any other debtor.
Steven,
I now recall some comments by Gary North, who pointed out that the price of credit, like everything else, obeys the law of supply and demand. As credit increases, its price (i.e., interest) will drop. What I would like to pin down are the mechanisms by which the supply of credit is increased.
The supply of credit can increase if people save more of their incomes and deposit their savings with financial institutions, who in turn, lend it out to borrowers. Borrowers who pay off their debts without reborrowing also free up credit. The Federal Reserve increases the supply of credit by purchasing Treasury bonds/notes from banks who then have more money to lend into the market. Note too, that the more they purchase, the greater demand for Treasuries, the higher the price of Treasuries, and thus the lower the interest rate return on Treasuries.
Mark’s explanation is certainly illuminating.
But, if you are looking for the simplest mechanism of control that the Fed has on interest rates, just look at the effect that the Fed’s very existence has on the lending market.
The Fed was sold to the American people as being the “lender of last resort” for other banks. That meant that any bank that needed a source of financing could always find one, thereby (supposedly) solving the cash-flow “problem” that sometimes caused bank failures in the pre-Fed era. (I say “problem” in quotes, because this situation wasn’t really a problem at all. If a bank was failing and couldn’t raise cash by getting a loan somewhere else, that was a sound market decision. It also encouraged banks to avoid making bad loans. Would you lend money to an irresponsible person who had made bad financial decisions and was on the verge of bankruptcy? No, and neither would a private bank!) A central bank like the Fed (which doesn’t operate according to the market) could bail out almost any bank, no matter how over-extended. Naturally, this encourages more risky loans.
But a more most significant effect is that the Fed sets the market rate! How could a private bank ever lend money at a rate that is lower than what the Fed offers? How can a private bank compete with a government-subsidized institution? The Fed isn’t bothered with such pesky concerns as what it can afford to charge for interest. It can afford anything (even zero), because it can always confiscate whatever it wants through the federal income tax (it is no accident that the Fed and the income tax were both passed in 1913.)
So nowadays, private banks borrow from the Fed, and then lend that money out to borrowers at a slighly higher rate, and make a profit on the spread. That’s why the Fed’s lending rate is called the “prime.” As a result, the going rate in the lending market can ONLY be prime-plus-the-spread. In effect, the lending market now walks in lock-step, as opposed to the free market system where each bank sets interest rates according to market forces.
All,
Thank you very much for your comments. Very helpful.
I sometimes wonder if the Federal Reserve and the Treasury Department even bother with double-entry accounting in their transactions with each other.
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