Friday, February 15, 2008

Not a Bubble

Alex Tabarrok of Marginal Revolution has gotten a lot of (mostly dissenting) attention for his argument that there was no housing bubble (hat tip: hmm, I don't even remember, but I'll cite Paul Krugman, Jane Galt Megan McArdle, and Battlepanda, among the many who have pointed to the post). Alex Tabarrok reproduces Shiller's now-famous chart of housing prices over the past 100 years and comments:
The clear implication of the chart is that normal prices are around an index value of 110, the value that reigned for nearly fifty years (circa 1950-1997). So if the massive run-up in house prices since 1997 [culminating at an index value around 200] was a bubble and if the bubble has now been popped we should see a massive drop in prices.

But what has actually happened? House prices have certainly stopped increasing and they have dropped but they have not dropped to anywhere near the historic average. Since the peak in the second quarter of 2006 prices have dropped by about 5% at the national level (third quarter 2007). Prices have fallen more in the hottest markets but the run-up was much larger in those markets as well.

Prices will probably drop some more but personally I don't expect to ever again see index values around 110. Do you?
As Battlepanda points out, "Do you?" is not a very convincing argument unless you already agree with him. But I think I can make it a little bit more convincing:
Prices will probably drop some more, but personally, given the likely effect that an additional 40% drop in home prices would have on the already weak economy, I don't expect that the Fed will allow index values to fall to anywhere near 110 in the foreseeable future. Do you?
Some people will respond with something like, "OK, I don't either, but that doesn't mean it wasn't a bubble; that just means there's a Bernanke put on home prices: there was a bubble, and the Fed is now going to ratify the results of the bubble." But that's not right. The Fed is not actively causing inflation in order to bail out homeowners and their creditors. The vast majority of professional forecasts call for the inflation rate to fall over the next few years. The Fed is just doing its job -- trying to keep inflation at a low but positive rate while maximizing employment subject to that constraint. The ultimate concern of the Fed is to avoid deflation, which becomes a serious risk if the US housing market has a total meltdown. It's very much as if the Fed were passively defending a commodity standard, with the core CPI basket as the commodity.

The ultimate source of the housing boom is the global surplus of savings over investment. That surplus is what pushed global interest rates down and thereby made buying a house more attractive than renting. And that surplus is still with us. If anything, it appears to be getting worse, as US households begin to reject the role of "borrower of last resort." And it is that now aggravated surplus that threatens us with weak aggregate demand and the risk of economic depression in the immediate future -- a risk to which the Fed and other central banks will respond appropriately. Until the world finds something else in which to invest besides American houses, the fundamentals for house prices are strong -- not strong enough, probably, to keep house prices from falling further, but strong enough to keep them well above historically typical levels.

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18 Comments:

Blogger 花枝 said...

So your argument for the continued higher price level of housing have to do with the demand for global savings to go somewhere rather than demand for people to live in enclosed spaces?

Fri Feb 15, 08:33:00 PM EST  
Blogger knzn said...

Pretty much. I'm taking the demand for housing services (i.e. people living in enclosed spaces) as a given. And the direct result is that rents, or owners' equivalent rents, should go up a certain rate, which I'm assuming to be near the rate of inflation, or near zero in real terms. The relationship between rents and house prices depends on the interest rate. (Think about borrowing money to buy a house and then putting it up for rent, or substituting it for the rent you would otherwise pay.) And the interest rate depends on the amount of savings relative to the demand for borrowing. So if there's an excess of savings, interest rates go down, and house prices go up (or rather, in this case, stay up).

Fri Feb 15, 08:46:00 PM EST  
Blogger TStockmann said...

I'm sorry - I think this analysis is faulty. Taking the total cost of ownership (including the presumption of favorable interest rates due to the savings over investment glut) over the total cost of rental (which as a side note also may decline with access to lower rate financing for the investor-owner) should yield a ratio that exceeds one, but would not in itself alter the premium someone looking for housing should be willing to pay to own. All the figures suggest that the ratio changed very much indeed in the years leading up to the current bust, which can largely be attributed to the anticipation of future increaes, one description of a bubble, and these expectations must ultimately be defeated by income constraints. Once the anticipation of increases vanishes, then the premium paid for that anticipation vanishes, causing prices to fall. Even with a "Bernanke-put," - assuming planned inflation maintains the nominal value of housing - it should still fall in absolute terms - i.e., in relation to goods and services that did not see previous run-up's.

I seem to recall you speculated a couple of years back that a real estate slump might have a perverse effect on the owner's equivalent rent in the CPI, that is, by pushing up the demand for rental housing and therefore overstating the change in housing costs. At least in the early stages of the current decline, that has not been the case, partly because of the elasticity of housing demand and mostly because of the ultimate fungibility of recently overinvestment in residential property meant for sale.

Sat Feb 16, 12:23:00 AM EST  
Anonymous Blissex said...

«The ultimate source of the housing boom is the global surplus of savings over investment. That surplus is what pushed global interest rates down and thereby made buying a house more attractive than renting. And that surplus is still with us.»

That surplus has also led to the large and obvious fall in the returns to capital and the consequent huge decrease in the share of national value added going to capital :-).

Perhaps KNZN you are forgetting the big other story (or two) of the past 10-20 years, and your neoclassical attitude shows through,..

The big two stories of the past 10-20 years are the enormous increase in the workers-to-capital ratio, which has driven profit rates to prodigious highs, and a much smaller increase in the savings pool, mostly fueled by Chinese savers.

To which add the determination of anglo-saxon country governments to drive up financial rents as financial rentiers have become very important to the political process.

Sat Feb 16, 03:54:00 AM EST  
Blogger knzn said...

TStockmann, I don't understand what you're saying. When the ratio of total cost of ownership to total cost of rental is low, a lot of people want to buy houses, and prices go up. That ratio got extremely low in 2002 because of low interest rates, and prices rose rapidly over the ensuing years. The ratio got too high by 2006, and the demand for houses began to falter. That was an overshoot. To some extent the demand for houses was affected by a false expectation that prices would keep rising. Prices certainly deviated from the fundamental; call it a bubble if you want, but I don't think prices got too far away from the fundamental.

Now the ratio is getting lower again, and to the extent that people are still able to get mortgages, buying a house should be attractive, except for the fact that people now expect prices to come down. The market is probably going to overshoot on the downside, just as it overshot on the upside.

Of course the availability of mortgages is also a factor, and that has clearly declined, so in a sense the fundamental itself has shifted downward compared to where it was a couple of years ago. But even so, with interest rates this low, the price at which owning a house as opposed to renting becomes worthwhile financially is significantly higher now than it was in the late 90s, and when the dust settles, we should expect actual house prices to remain higher than they were then.

Sat Feb 16, 05:47:00 AM EST  
Blogger TStockmann said...

I think this paper is useful:

http://www.federalreserve.gov/pubs/feds/2006/200629/200629pap.pdf

"Our fourth result is that real interest rates and real housing premia play roughly equal roles in determining
trends and variances in housing valuations. For example, changes to real rates account for about 40 percent
Decomposition of Rent-Price Ratio 24
of the downward trend in the national log rent-price ratio from 1975 to 2005; housing premia account for
about 50 percent. The housing premium plays a relatively more important role from 1997 onward, and can
explain about 65 percent of the recent run-up of house prices relative to rents."

Sat Feb 16, 11:42:00 AM EST  
Blogger knzn said...

Regarding the paper (which I read last year), I have a couple of points:

(1) If you accept their methodology, changes in real interest rates account for 38% of the trend change in the log rent-price ratio since 1997, which is a lot more than 0% and would imply that, at current interest rates, house prices should be significantly higher than they were in 1997 if the same proportion applies going forward (unless you think the housing premium is going to be significantly larger than it was in 1997).

(2) I have a problem with the way they measure real interest rates, using the historical time series properties to calculate an EPV. They find the EPV only going down to about 3% this decade, which, if it were true, would mean that the people buying 30-year bonds at market yields were just being stupid.

They acknowledge in the paper that there is a potential issue: "Obviously, if the dynamics of real interest rates are systematically different than those of the first-order auto-regressive model, our analysis will be inappropriate. In particular, our modeling framework assumes that real interest rates have a constant unconditional mean. This assumption is important in light of the rather low value of the real interest rate near the end of the sample period. If there has been a structural break in the level of the real 10-year Treasury, then our forecast model is mis-specified." And they find (unsurprisingly) in the sensitivity analysis at the end of the paper that a greater persistence of real interest rates would imply a very different result, with real interest rates accounting (in their extreme sensitivity test) for more than 100% of the trend changes in the log rent-price ratio since 1997.

I find their AR(1) particularly suspect because the sample only goes back to 1975. If you take the late 1970s as your base case for what happens when real interest rates are low, you will expect to find dramatic mean reversion, but the 1970s were very different from the 2000s (as the experience of the past 3 years shows -- in that real interest rates have now actually fallen from where they were in 2005). The late 70s were characterized by very high inflation rates that ultimately required a dramatic tightening of monetary policy to be brought down. The 2000s have been characterized by low core inflation rates, and the risks of deflation have never been too far off. In particular, I think if the sample extended back to the 1950s and 60s, they would find that low real interest rates are a lot more persistent.

Sat Feb 16, 12:30:00 PM EST  
Anonymous Michael Cain said...

Two questions:

How much of the "savings" is from real income, and how much is from credit created by the central banks?

Why are there no attractive investment opportunities? Businesses can't offer anything with better returns than mortgages?

Sat Feb 16, 03:49:00 PM EST  
Blogger knzn said...

The savings are "real" in that surplus countries have been sending real goods and services to the US (and other deficit countries), but much of the saving is actually being done by central banks. The question of what would happen if central banks weren't doing so is complicated and controversial (and I may address it in a future post). The saving might happen anyway, or it might not.

There are a lot of opportunities that investors find attractive, just not enough to use up all the world's savings. But it's largely a matter of perceptions and time-varying risk preferences (or a matter of "animal spirits," Keynes would have said). This decade people just haven't been very enthusiastic about the marginal investment opportunities (except in China, maybe, but China has a ridiculously high savings rate and doesn't need foreign investment), whereas in the 90s they were perhaps too enthusiastic.

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