Our house is worth much more than it was five years ago, according to an article in Sunday’s Pioneer Press. Yippee! My wife and I are richer than before.
Your house probably is worth more, too. Nor are we alone. The story noted that house prices have risen in virtually all parts of the Twin Cities. Moreover, house prices have risen across much of the United States. Increasing housing values are making our whole country richer.
Wrong.
This is what philosophers call a “fallacy of composition” — assuming that what is true for one individual inherently is true for a larger group. One classic example of this fallacy is watching a basketball game. If I stand up, I can see more of the action than if I stay seated. Therefore, if everyone stands up, everyone has a better view.
That is obviously wrong. It is also an error to assume that increases in the values of most houses are good news for the whole nation just because the increase in the value of one house is good for its owner. Rather than good news, widespread, substantial increases in house values could indicate a problem: too much money sloshing around the economy.
Misperceptions about whether rising house prices are good or bad news stem in part from what economists call “monetary illusion.” People mistake the “money economy” for the “real economy.” Only the latter really matters.
We don’t eat money, it doesn’t clothe us, and it doesn’t shelter us from even mild Minnesota winters. Food, clothing and houses do meet these needs. Money is only a cultural artifact, something that societies have created that facilitates the saving and exchange of real value.
An increase in the amount of money floating around the economy, without a commensurate increase in the production of real goods and services, does not make society any better off. People might look at newspaper articles or tax statements, however, and be confused. In their confusion, they might make choices that turn out to be bad ones. If many others make similar decisions, the outcome can be collectively bad for society as a whole.
The U.S. economy is growing. As part of that growth, we’ve built more houses in the last five years than we have demolished. More, and perhaps better, housing thus is available to meet our needs than we had in 1999.
We do not, however, have 94 percent more housing, the factor by which houses in my neighborhood increased in price. While the value of housing in the monetary economy increased substantially, it has grown much less in the real economy.
If real housing to meet people’s need for shelter grew only marginally, why did its monetary value grow so much more? There are a number of possible explanations.
First of all, home prices in a specific area can rise because that location has become a more attractive place to live. Perhaps the climate and amenities are perceived as better than in other places. Perhaps more jobs are available. Los Angeles-area housing prices rose dramatically in the early 1980s as defense industry employment there boomed. When defense procurement tanked later in the decade, prices in that metro area collapsed. Now they are again rising strongly.
This explains some of the increase in Twin Cities house prices, which have risen more than in the rest of the state and more than the national average. The Minneapolis-St. Paul area apparently is a desirable place to live.
But, while home prices have risen more here than on average, residential real estate prices across the nation as a whole grew substantially faster than the economy as a whole and faster than disposable personal income. The “moving to a better location” explanation cannot explain nationwide increases.
It could be that consumer preferences changed so that people wish to spend more on securing a desirable house and less on clothing, autos or recreation. This occurred three decades ago when baby boomers started to marry and have children en masse. It might explain a portion of recent increases.
The most likely cause, however, is the easy credit available for the past four years. The Federal Reserve has increased the money supply since January 2001 to keep interest rates low. While Fed laxness has the greatest effect on short-term interest rates, a larger money supply can bulge out in many places.
Beginning economics students learn that too-rapid monetary expansion can lead to inflation. There is no reason, however, that easy money need affect prices of all the items measured in tabulating the Consumer Price Index. As Japan demonstrated two decades ago, excessive money growth can funnel into stock and real estate prices while leaving little mark on consumer prices as a whole.
That probably accounts for much of what we have experienced here in the United States. Historically low mortgage rates have increased demand for houses. Whether we have created an unsustainable bubble is a matter of debate. Future economic historians, however, are unlikely to single out the monetary party at the dawn of this century as one that had no economic hangover whatsoever.
© 2005 Edward Lotterman
Chanarambie Consulting, Inc.