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Semi-retired blogger Scott Sumner commented on Karl’s post about how the CPI calcuates inflation of owner-occupied housing. So long as he keeps commenting around the econ blogosphere, we can effectively keep him from retirement by hoisting these comments. Here is Scott on Angus, to whom Karl was responding:
I read his argument differently. Reading between the lines, here’s what I think he meant:
1. The Fed doesn’t care about the “cost of living” per se, they care about the price level because supposedly a stable price level produces macroeconomic stability.
2. The price of new homes is an important part of the overall price of goods and services produced in the US.
3. If the Fed stabilizes a price index, that index should include the price of new homes.
4. It’s fine if we have a cost of living index that excludes the price of new homes, just don’t have the Fed target that index.
I don’t see your argument as being inconsistent with what he wrote.
I think Scott’s point here is that there’s a distinction between what should go in a cost-of-living index and what the Fed should target. I’m pretty skeptical of this idea, so I’ll run through some reasons why.
One conceptual problem is that house prices reflect value of the flow of housing services consumed and the investment value of the home. As Karl points out, why should housing investments be counted in a cost-of-living index while other investments are excluded?
A 2005 survey of OECD countries found that 13 out of 31 statistical agencies used the owners-equivalent method for their CPI, and the next most popular method, used by 9, was to just leave owner-occupied housing out. Only two countries, Australia and New Zealand, utilize the acquisition approach, which measures house prices changes the same way you would with non-durable goods. Below is a graph from The Economist of the ratio of house prices to rents from Q1 2000 to Q4 2010 for Australia, the U.S., and New Zealand (the United States is the lowest one at the end, it’s a little hard to tell with the colors).
While the other two countries have thus far avoided a massive crash, they didn’t avoid massive appreciation. You could argue that this just means the changes in prices in these two countries was real and driven by fundamentals. But given these massive differences in the real paths of price-to-rent ratios, what level should the Fed target? How do they distinguish price appreciation drive by real changes in cap rates from pure nominal or speculative inflation? I’m not sure how Australia and New Zealand handle this.
Another problem with the acquisitions approach is that the sale of a home is frequently an exchange between households, and so a sold house is both a cost and a revenue for the household sector. According to the BLS, when statistical agencies use the acquisitions approach they control for this by only looking at home sales to the household sector from other sectors. In practice, this usually amounts to new housing units. This may reflect the cost of new goods and services produced in the U.S., but clearly doesn’t represent a measure of the cost of goods and services being consumed by households. How would the Fed weigh the tradeoff between a price measure that was a true COLI and one that included houses? Say demographics or something else permanentely shifts average cap rates down and thus real house prices up while the cost of living is unchanged. If the Fed tries to tamp the house price inclusive price index down won’t inflation and thus nominal GDP be too low? Of all people I’d expect Scott to worry about this.
Let me end by saying that I am pretty skeptical about the inclusion of house prices as a component of a cost-of-living index. I’m also skeptical about the idea that the Fed should target a non-COLI price level that includes house prices, but less so than in the former, and I’m not strictly closed to the idea.
I’ve long suspected that immigration amnesty would be a boon to housing markets. The idea is that illegal immigrants could be deported and so will be less willing to make the fixed investment of homeownership, and illegal status holds down wages which should also decrease the demand for housing. However I haven’t seen any persuasive studies on this issue. Today I discovered a new paper by Catalina Amuedo-Dorantes and Kusum Mundra that provides some evidence:
A significant homeownership gap still remains between natives and immigrants in most countries. Because of the many advantages of homeownership for immigrants and for the communities where immigrants reside, a variety of countries have tried to implement policies that facilitate immigrant homeownership. Many of these policies hinge on immigrants’ legal status. Yet, owing to data limitations, we still know very little about its impact on immigrant homeownership. We address this gap in the literature and find that legalization raises immigrant homeownership by 20 percentage-points even after accounting for a wide range of individual and family characteristics known to impact housing ownership. This finding underscores the importance of legal status in immigrant assimilation –housing being an important indicator of immigrant adaptation, and the need for further explorations of the impact of amnesties on the housing markets of immigrant-receiving economies.
Note that this does not address the question of whether legalization increases the demand for housing or just the type of housing. For instance, legalization may simply lead illegal renters to buy houses that are identical to the ones they were renting, which aside from potential externalities to homeownership shouldn’t affect prices. This seems unlikely to me, and I’d wager that legalization also increases the demand for housing, and therefore house prices.
I’ve argued frequently that letting in more immigrants is the last best tool we have to help increase house prices, but perhaps legalizing the immigrants we already have would help as well.
UPDATE: MorallyBankrupt provides some excellent thoughts in the comments:
I used to live in Boston. While living there, a few of my friends lived in inexpensive rental apartments where line cooks–often Brazillian–also lived. They used to pack-in pretty tight in those apartments to minimize expenses and maximize remittances. A common theme was that the men would often move out to their own place if and when their wives / girlfriends came into the country or if they formed a family locally.
I think that amnesty coupled with the ability to extend legal resident status to immediate family (spouses, children) would be a great option. Not only would the units of houses demanded per newly-legal resident probably increase, but the number of residents demanding housing would increase as well. Additional positive effects would be to move (at least some) of the consumption from those remittances into the US.
Finally, establishing residence would allow access to legal, documented earnings which would increase tax-receipts and access to credit, enabling purchases of not only housing, but also durables.
In today’s Philadelphia Inquirer I have an op-ed about how immigration could be used to increase house prices. I’ll put the whole thing below the fold, but it’s also worth noting another recent study that supports the results of the study I cite in my piece. Importantly, this study provides evidence that immigration raises house prices even in housing markets with low price inflation and rent control, and even when the immigration amounts are modest. The impact they find, which is for Switzerland, is that a 1% increase in immigration causes a 2.7% increases in home prices. To my knowledge it is still the case that every study on this issue, which is admittedly few, has found that immigration has a positive impact on house prices.
Here is what I wrote in the Inquirer, with more below the fold:
Amid reports of continuing declines in home prices, it’s safe to say that government policies designed to prop up those prices have failed. More than 14 percent of home mortgages are delinquent or in foreclosure, and 23 percent of homeowners owe more on their homes than they’re worth. At this point, it may seem as if we have to let prices fall until they find a bottom.
But we haven’t yet tried one of the easiest and least costly options for helping the housing market: more immigration.
Over at Economix, Ed Glaeser discusses whether Fannie and Freddie should be privatized, abolished, or kept in government hands. This brings to mind a quick thought experiment: if you’re planning on buying a house, would you be better buying before or after Freddie and Fannie go away? The conclusion I’ll come to is common sense, but it’s worth thinking through it through analytically.
The key issue is what abolishing the GSEs would do to capitalization rates, which are also called cap rates. This is the discount rate that converts a stream of income into an asset value. In the case of housing the cap rate converts the stream of rent, which is what homeowners consume, into house prices. The price of a home is equal to the rent it could generate divided by the cap rate.
Like a discount rate, the cap rate varies by person, since the present value of a flow of housing services depends on, among other things, risk preferences, borrowing costs, and the time value of money. I haven’t seen recent data on this, but from from what I have seen, on average they tend to be in the general neighborhood of 8% for homeowners.
Whether a potential homebuyer will be better off in an post-GSE world depends on what happens to their own cap rate and everyone else’s cap rates. If borrowing costs are less important for you than for the average borrower, then your cap rate won’t be as affected when Freddie and Fannie are abolished and lending terms are more strict. This means your valuation of housing won’t go down as much. Borrowing costs could be low because of high savings, good credit, or a preference for cheap housing services relative to income.
On average, however, cap rates will go way up, as borrowing costs are important considerations for most buyers. If you need to have a 30% down payment, you’re willingness to pay for housing assets will decline greatly. This means house prices will fall. Likewise if mortgage rates increase.
So if you’re cap rate will be less affected by borrowing costs then housing may be more affordable for you in a post Fannie/Freddie world. Keep in mind that investors have cap rates as well, which means even if your cap rate goes up by less than the average homeowners’ you may be priced out of the market by investors who buy and rent housing.
I should emphasize that I’m looking at what happens along one dimension if Fannie and Freddie go away. This is not to suggest that the affects of abolishing them overnight would be modest or desirable. In fact, I believe it would be devastating and would probably make almost everyone worse off.
There was an article last week in the New York Times about economists calling for the government to simply allow house prices fall and reach their bottom, an idea which is gathering more and more support. I think this is a bad idea because the real costs falling home prices are obvious, likely, and severe, while the benefits are vague and speculative.
For starters, as the following chart from Calculated Risk shows, in Q1 2010 there were millions of homeowners who are in a negative equity position. If prices fall another 5%, each of these bars will shift to the left one position. If prices drop 10%, they will shift two.
Lets make the conservative assumption that there are as many people right now in the 0% to +5%, +5% to + 10%, and +10% to +15% bins as there are in the -5% to 0% bin. This means we’ll get another 1.8 million borrowers underwater for each 5% fall in prices. If they fall 15%, that means 5.4 million more.
As you can see though, the numbers of homeowners in each category get larger as they approach zero, going from 1.1, to 1.3, to 1.5, to 1.8 million in the last 4 bins. So it’s likely we’ll actually get upwards of 6 million more homeowners underwater.
In addition, a fall of 15% would push around 1.9 million more homeowners into 50% or more of negative equity, driving this number up to around 6 million. These large increases in total negative equity will drive a wave of foreclosures. The best evidence indicates that foreclosures, in turn, will decrease nearby home values by 1% to 2%, which could exacerbate the foreclosure blights many neighborhoods are already facing.
Why are these foreclosures a problem? Most economically literate readers will be familiar with Bernanke’s famous paper on non-monetary causes of the Great Depression, where he makes the case that an increase in the cost of credit intermediation worsened the Great Depression. In contrast to the argument for how bad things can get when banks fail, few seem to focus on aspect of Bernanke’s paper that focused on defaults and bankruptcies as a mechanism for deepening the depression. In fact Bernanke even discusses the drying up of credit for homeowners as one of the important channels through which the credit system was failing:
Home mortgage lending was another important area of credit activity. In this sphere, private lenders were even more cautious after 1933 than in business lending. They had a reason for conservativism; while business failures fell quite a bit during the recovery, real estate defaults and foreclosures continued high through 1935….
To the extent that the home mortgage market did function in the years immediately following 1933, it was largely due to the direct involvement of the federal government.
Removing the existing government supports for the housing market now will allow this important channel of credit to dry up. As Bernanke recognized, this could worsen and lengthen our recession.
Another problem is that when a buyer defaults they lose a real asset: their credit. As near as I can tell from Googling around, credit scoring agencies have not adjusted their models to decrease the damage that a foreclosures does to your credit score. This seems puzzling to me as economists seem to agree that the huge fall in house prices was largely unpredictable when many of these mortgages were made. Defaulting on a mortgage in 2010, one would think, is not nearly as much of an indicator of lacking creditworthiness as defaulting on a mortgage in, say, 2005.
In any case, when defaults happen a real asset which gives borrowers access to credit goes away and the cumulative creditworthiness of U.S. households falls. In a recession, when borrowing and investing are important means of driving economic activity, this is not a good thing.
I believe the reason that falling home prices are getting support is what Karl calls The Pain Bias. Somehow, falling prices feel like tough love, and it feels like borrowers will be more confident. And it may be the case that another 15% fall in prices will convince people that prices are at a bottom. But along the way to that bottom real economic damage will be done. If that damage is great enough, and hurts economic growth, those rock bottom prices may fall even further.
Calculated Risk tells us the key to fixing the housing market:
The key to the housing market is to absorb the excess inventory. That means more households and fewer new housing units. Luckily housing starts are very low right now, but unfortunately there is very little job growth (and therefore little new household formation).
But job growth is not the only way to get new household formation, as I’ve argued again and again, we have immigration at our disposal. Of course, there are the usual complaints about jobs. But the weakness of this argument can be seen in a new paper Felix Salmon directs us to:
Statistical analysis of state-level data shows that immigrants expand the economy’s productive capacity by stimulating investment and promoting specialization. This produces efficiency gains and boosts income per worker. At the same time, evidence is scant that immigrants diminish the employment opportunities of U.S.-born workers.
It is well understood that the removing capital tariffs and protectionism would increase overall efficiency and incomes. Since immigration restrictions are labor market protectionism we shouldn’t be surprised to see that is has similar positive effects.
Unfortunately, journalists and pundits don’t seem to oppose labor protectionism nearly as much as they oppose capital protectionism. We would see an outcry among op-eds and pundits if we were seeing a worldwide rise in capital protectionism, because they recognize that beggar-thy-neighbor policies make everyone worse off. But no similar reaction has come from the rise in global labor protectionism. Here is how a recent report from the Migration Policy Institute describes the situation:
Confronted with the most severe economic crisis in decades and rising unemployment, governments in locations across the globe embraced a range of policies to suppress the inflow of migrants, encourage their departure, and protect labor markets for native-born workers.
From Malaysia and Thailand to Kazakhstan, Taiwan, Australia, South Korea, and Russia, many governments have sought to restrict access to their labor markets by halting, or at least decreasing, the numbers of work permits for foreigners. Others, such as the United Kingdom, tightened admission requirements. And while the policy focus of many of these countries was on reducing the entry of low-skilled workers, the United States placed restrictions on some companies seeking to bring in the highly skilled.
In addition to the results from Felix above, the wider literature on the issue tells us the quantifiable impact on wages is likely to be minimal compared to the impact on house prices. For instance, research from economist Albert Saiz found
“…a very robust impact on rents and housing prices that is an order of magnitude bigger than the estimates from the wage literature. Immigration inﬂows equal to 1% of a city’s population were associated with increases in average or median housing rents and prices of about 1%.”
Emphasis his. In previous research, Saiz used a classic example of exogenous immigration from the literature and found effects of a similar magnitude. Looking at the Mariel boatlift, a sudden inflow of immigrants from Cuba which increased the population of Miami by 4%, Saiz found that rents in Miami increased 8%. Overall, there appears to be a robust relationship between immigration and housing prices.
Calculated Risk tells us that “Usually housing is a key engine of recovery, especially for jobs. But this time housing is going to follow the economy.” But this is not because of economics, but politics. Instead of waiting around for the labor market to lead housing recovery, let’s use the tools we have to help housing recovery lead.