Housing: On the Bubble?

Kevin and I have been having an exchange about the housing 'question'. Kevin writes:

I tended to agree with Roach that Modigliani was over-theoretic in dismissing the possibility that housing equity has a bigger impact on spending than financial wealth. Look at the pace of refinancing and its close association with retail sales. The Fed's work on the impact of stock market value on spending suggests it is mostly the wealthy who respond to stock price gains with more spending. So yes, I agree that housing price fluctuation have a big impact on spending. It is mortgage rates, though, that I suspect will have a bigger impact on slowing spending than housing prices. Home prices will respond to higher rates, but probably not in a massive way in the US. Turn-over will slow, keeping prices from fully reflecting a slide in demand in response to higher rates. However, a big chunk of consumption spending in recent years seems to have been driven by falling rates and rising home prices. To that extent, I agree that the housing sector represents a risk, in a negative sort of way, for US consumption. I don't anticipate massive defaults and loss of value. Rather, housing will simply stop contributing much, if anything, to consumption. With wage growth so weak, the loss of housing's contribution to spending will mean below trend growth in consumption for some time, would be my guess.

The Modigliani argument which Kevin is referring to (and which can be found here ) runs as follows:

"I have my doubts. I am suspicious of those studies that find the wealth effect is larger from real estate than equities. Theory tells me it should actually be the opposite. That's because the house in part, produces a consumer good -- housing services, which we consume. When the value of the house I inhabit goes up, its implied rental value increases. But that does not significantly improve my spending power, because my imputed rent has gone up as much. Any wealth effect on individually-owned property must net out the consumption of the service we derive from living in our homes."

Now I would tend to agree with Kevin about this, with the proviso that I would hazard the observation that Modigliano is not being 'over-theoretic', but rather that some of his theoretical assumptions are questionable. Theory should, after all, conform to some known version of reality. (One of the problems with economics is that once someone has been 'blessed' with a nobel, then everyone gets nervous about questioning what they are saying. Right or wrong, I'm afraid I'm not constrained by any such reticence, as those who follow my comments on Mundell and the euro know only too well). Now where Modigliani is obviously right here is in the assumption that if you sell your house then you need to pay a rent on alternative accommodation. This is the 'imputed rent' argument. But there are two additional factors which need to be borne in mind. Firstly, and this is pefectly consistent with the life-cycle model, as we age we tend to trade-down our housing to draw-on savings to maintain a given standard of living. (This is also consistent with an infinite generations kind of assumption, since, as children move on and buy their own home, you could incorporate their imputed rents into the consumption path of the dynasty, and so on, in a Markov chain type process. When we talk about consumption modelling it is important to think about whether we are taking the individual, the household, the dynasty etc as our point of departure).

So in just the same way as the cash we keep in the bank may cover more than one objective, so too may the house we buy. Thus while I have no problem with the idea of 'imputed rent', how you treat that 'rent' analytically does seem to me to be important. This problem is only increased when we consider that many people buy second homes, or buy in order to rent to others. These latter are essentially backing inflation, since such activity normally only makes sense economically if there are clear inflation expectations. In fact the choice between fixed income deposits and property is all about betting on either deflation or inflation. All too often the debate about what to do in Japan conveniently forgets that there is an ageing population with a lot of personal saving held in the form of money on deposit at the bank. This group is politically important (and every day more so!!) and it is clearly also highly inflation averse. Promising to provoke inflation is clearly not going to bring popularity with this constituency. Finally it is also important to note that house prices are effectively determined by a relatively small number of transactions. I don't know what proportion of the US housing stock has either changed hands or been remortgaged since March 2,000, but in Japan during the property boom of the early ninetees the figure was around 7-8%. So I would have to say I agree with kevin, that Roach is right to see the problem as important, and Modigliani is wrong in underestimating its potential.

Now, on the current US position, I largely agree with Kevin. A significant factor has been the fall in interest rates (although I imagine there is also a part which comes from funds generated in the 'flight from equities'). This, as Greenspan has noted, cannot continue with the same pace as before since there is not too much room left to reduce them, and it is this factor that I would be inclined to emphasise over the hypothetical danger of a rise in rates. (Interest rates are especially important in the housing context due to the impact on monthly payments). A rise in rates however , if it were to come, would be a reflection of a more pronounced recovery, and hence, while housing might weaken, other factors (like increased capex) would tend to offset this. So I think the kind of process that Kevin outlines is more consistent with a slowing down in the rate of increase of house prices associated with a weakening in real earnings (resulting from the slack labour market) and a reduction in the rate of reduction of interest rates. However, demographic factors (surprise, surprise) are especially important for this market, and since the ninetees were record years for US immigration and since the 'life-cycle' model of immigration might suggest that many of these immigrants are now established US citizens looking to join the 'property owning democracy' (and here I think the straight 'rational choice' model is right up the spout, our consumption decisions are influenced by the decisions of others) the counter-weight of this process might maintain more bouyancy than would otherwise be expected.

Bottom line, the US housing position is hard to call, we're just going to have to wait and see. Such restraint in opinion is not however in order in the case of the UK and Spain, where I think the evidence for the existence of a bubble is much clearer, and where it is much more a question of take cover, and look out for flying debris. Mind you not everyone is so circumspect about the US position. Take, for example, Ray DeVoe, publisher of the DeVoe Report. He argues that: "Greenspan has maintained that he could do nothing to stop the stock market bubble because bubbles can only be known after they pop. With all due respect, I disagree. Bubbles are obvious to all who want to see them."

Much like the "Tulipmania" in Holland in the 1630s, when the price of tulips shot up by 6,000 percent, stock investors -- speculators -- made tons of money in the late 1990s. Centuries ago, the wealth effect in Holland drove up the price of land and horse-drawn buggies. When the bubble burst, tulip prices crashed by 90 percent in less than a year as the "biggest fool" script played out. Trouble was, everyone believed in the same story: Tulip prices would rise forever and everybody would get rich. Fast forward to 2003. Real estate is booming, thanks to the Fed's manic rate cuts to get the economy back on track. The cost of borrowing is now at a 41-year low. What's happening is that real estate has replaced the stock market as a builder of wealth. Money is flowing into another pot of gold. People have gotten rich from buying homes and they're extracting cash from rising home prices. For the past two years, many economists have warned that home prices may be increasing too rapidly, in the same way that stocks were going through the roof in the late 1990s. The risk is another asset bubble.

The explosion in home prices may be distorting the spending decisions of millions of Americans who have been cashing out at a record pace. Under the "cash out" feature, homeowners refinance mortgages and draw on some of the equity in their houses. The Fed estimates $200 billion in refinancing was processed last year and home equity loans totaled $130 billion. Americans spent half of that refinancing money on consumer goods, which has supported the economy."If interest rates rise and housing prices stabilize or even decline, this contribution to the economy would be significantly lower," DeVoe said. Greenspan insists that a bubble in housing is "unlikely." He has assured Congress that "the types of underlying conditions that create bubbles are very difficult to initiate in the housing market."Says DeVoe: "Well, if he was unable to spot a bubble in stocks until after it popped, he would be equally unlikely to see one in housing."

If the Fed gets it wrong, the economy's long-term health will be at risk. A housing crash may have more serious consequences on the economy than the slump in stocks because consumer confidence, i.e. household wealth, would be directly affected. Worth remembering is that consumer spending accounts for an awesome two-thirds of national economic activity.There's a real risk to the American dream of owning a home. The enriching liquidity that has made home buying so rewarding may morph into impoverishing illiquidity.
Source: Pierre Belec, Reuters News
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