Recent news reports reawakened discussion of whether there is a housing price bubble in the United States.
Anecdotal evidence of widespread home price increases is easy to find. In March, the median home price in Los Angeles County was 29 percent higher than a year earlier. For Virginia suburbs of Washington, D.C., the annual increase was 23 percent, just above Baltimore’s 20 percent. Here in the Twin Cities, the annual increase was a more modest 7.1 percent.
Are such price increases good news or bad news? And what effect, if any, might mounting evidence of dramatic housing cost increases have on national policies? These questions say something about how people react to economic news and what economists still do not understand about monetary policy effects.
Little concern gets expressed when housing prices go up, in marked contrast to what happens when food or gasoline prices jump. This is because, for many households, a home is not only a durable physical good that provides shelter, but it also is an investment. Moreover, only a small fraction of families buy new homes in any particular period.
When gasoline or food prices go up, most households effectively have less ability to buy other things. When housing prices increase, only those actually buying a house feel the same effect. Even within this group, the reduced-income effect is strong only for those buying their first residence.
Existing homeowners moving to a different one face higher prices on the buying side, but also receive more when selling their property.
Thus, the immediate pain of more expensive housing is felt by only a small minority. This may be severe, however.
Families who have scrimped for years to reach a financial position where they might finally achieve home ownership see their dream evaporate.
Many other households, however, feel better off because of an increase on the asset side of their balance sheets. Particularly for those who do not have a lot of equity in their homes, a modest bump in home prices can bring dramatic increases in apparent net worth.
When housing price increases accompany — or are caused by — low mortgage rates, families standing pat in an existing residence are likely to have refinanced, and thus have more surplus disposable income than before.
All this means that many families view housing price increases as good news rather than bad. If the number of people who feel better off exceeds those who consider themselves worse off, society as a whole must benefit from higher prices, right?
Not necessarily. If you get beyond the obscuring veil of money to the underlying real economy of resources, goods and services, it is clear that housing prices can increase without there necessarily being any increase in the amount of housing or in other goods and services. If society does not meet more of its needs, it is not any better off.
Consider a hypothetical country of 1,000 households. There are 1,000 owner-occupied homes, each with an average value of $100,000. Housing prices are stable. No new homes are built and no old ones demolished. Each year, 50 existing houses change hands. The national money supply is $20 million.
Then the central bank increases the money supply by 5 percent in one year to keep interest rates low. For some reason, none of that extra money goes to increases in prices of ordinary goods and services. All of it somehow funnels into housing markets. Fifty houses come on the market that would normally sell for $5 million. But with a million extra dollars in the money supply, there is $6 million available. The houses sell for $120,000 instead of the usual $100,000.
The news that housing prices are up 20 percent hits the newspapers and the other 950 households all assume that the value of their houses has increased by a similar proportion. The total market value of housing is now $120 million instead of $100 million.
There are no more houses available and the houses are not improved. Real output of goods and services has not changed. The consumer price index changes only slightly since its formula reflects the fact that only 50 households have higher mortgage payments. The society is not better off in any way, but most people think they are richer.
This is, of course, an artificial, highly unrealistic example. But the lesson is important. Unlike in introductory economics courses, where the dangers of excessive money growth are limited to consumer prices, real-world money supply expansion can pop up in different places.
The experience of Japan from 1982-1992 demonstrated that excessive monetary growth — i.e., artificially low interest rates — can funnel into huge increases in the prices of real estate and corporate stocks despite little increase in consumer inflation. Japan is still recovering from the aftermath of tragically bad monetary policy.
We are far from where Japan was 15 years ago. We are far from any crisis engendered by a collapsing bubble.
But a decade or two from now, economists may well fault the Greenspan-led Fed for keeping interest rates low too long while home prices grew inordinately.
© 2004 Edward Lotterman
Chanarambie Consulting, Inc.