In a recent post, Karl offered a theory as to why house prices are sticky downward. In short, he argues that house is worth less when it is being sold in a neighborhood with a lot of foreclosures than when it is being sold in a neighborhood with few foreclosures. Foreclosure sellers in an empty neighborhood are in effect playing a game of chicken then, where each wants to be the last to sell so that they can sell into a fuller neighborhood.

This is an interesting theory, and I’d venture it’s going on to some extent. I’m pretty sure you could find a way to test it. However, I think nominal rigidity can be found even in areas where foreclosures are relatively low. The literature on foreclosures suggests they have an impact in the neighborhood of 1% on house values within 1/8 of a mile. Given the costs of holding real estate, including the depreciation, maintenance, and lost value of the flow of services, I doubt it would be profitable for banks to play this game very long in areas with few foreclosures. Second, if the current owners are owner-occupiers, then the houses aren’t vacant, so there is no “empty neighborhood” effect. This means some homes must be owned by non-owner occupiers. It seems unlikely to me that in areas with few foreclosed homes and few non-owner-occupied homes you’d observe a lack of nominal stickiness. Nonetheless, I would not be surprised if this effect explained some nominal stickiness.

To understand how stickiness can happen, it helps to conceptualize the housing market as a matching market. Homes and buyers are highly heterogeneous, and there is no “market price” per se. Rather there is a price for a pair of buyers and sellers. This means that a seller can, ceteris paribus, always hold out longer for a buyer with a higher valuation of the house. The question is, why do sellers wait too long sometimes, and why wait longer for better matches when the market is down?

There is some literature on this that provides evidence for few hypothesis. a 1997 AER paper from Genesove and Mayer argue that the issue stems from a sellers desire to sell at a high enough price to get a 20% downpayment on their next home. Consistent with this, they find that sellers with higher LTVs are on the market for a longer time, set a higher asking price, and in the end get a higher price.

A 2001 QJE paper from Mayer and Genesove chalks up some of the problem to loss aversion. Sellers have a nominal number they paid for their house, and they are willing to wait for a possibly non profit maximizing amount of time until a high valuation buyer comes along. They find evidence that sellers with nominal losses have a longer time on the market,  set higher list prices, and attain a higher selling price. They also find evidence that of the LTV effect from the aforementioned paper, although after controlling for nominal loss aversion the LTV effect is less strong.

So what can be down about this? Countercyclical or subsidized downpayment requirements could also be of use. This provides support for those who have argued that a downpayment subsidy should replace the mortgage interest tax deduction.  Encouraging insurance that protects against nominal losses would encourage homeowners to sell sooner. Of course the best policy to fight nominal loss aversion is simply inflation.