The Bennett Newsletter
“Accept nothing” was one of my teaching admonitions. Students should remain sceptical of what is taught, and test the known evidence rigorously. I was reminded of this when considering a column on Monday.
There were many comments on the Welfare Working Group’s conclusions. I wanted to read the Report and test its evidence. It was not on the Institute of Policy’s website, and calls to Paula Bennett’s office were not returned.
How can policy be adequately discussed on the basis of press releases? Surely a press release should have a link to the main report so that the public can reach its own conclusions.
I enjoy reading reports and carefully note the terms of reference, and then begin reviewing the evidence, questioning the assumptions, methodology, bibliography, evidence and statistics and the coherence of the conclusions. I wanted to participate in the debate, but will not without evidence.
My academic philosophy is that the function of universities is to teach “creative destruction”. This means that lecturers should try to explain the established position on an issue, and then suggest how recent research may be challenging this. One might encourage students to re-examine evidence or present a new dialectic that would challenge the established version.
The US housing story is a case study for “accept nothing”. My perception is that housing was a bubble caused by factors such as Government wanting a population of home owners, a financial industry keen to profit, and many millions of buyers getting increasing exuberant about prices. Prices increased and affordability declined, especially for people with poor credit ratings who took out sub-prime mortgages. When the market crashed, prices deteriorated and new construction also seized. This “bubble theory” assumes that house prices rose for no fundamental reason.
Bubble Questioned
The evidence for a bubble seems overwhelming. All the more reason to question it! Casey Mulligan (University of Chicago) asserts that part of the construction boom served a legitimate economic purpose. In asserting that fundamentals were involved, I suspect he is fighting a rear-guard action for mainstream economists who deny bubbles because markets are self-correcting.
The boom resulted in an inventory only 3%-4% above previous decade trends so perhaps there were sound supply and demand reasons. True, there was a slight excess in supply and maybe some were built in the wrong location, but most of the houses will prove desirable and presumably not “leaky”.
Mulligan says that the population grew less than the increased housing stock. Demand came from an unexpected quarter: “stuff”. Using data from the Bureau of Economic Analysis, from 1995-2005 ownership of furnishings and appliances increased by an average of 4.5% per person per year, which is above the trend set in previous years of 2.2% a year. The rate for recreational goods was 9.1% p.a., much greater than 5.4% of the previous period.
This increase in “stuff” is collaborated by demand in the self-storage industry which doubled the number of employees after 1995.
This argument that the boom was partly driven by the need to accommodate “stuff” may be valid. However, I feel that fashion and maintaining status was an important factor.
I am continually surprised by the size and elaboration of new houses, with amazing kitchens and entertainment areas that get little use. But Thorstein Veblen “The Theory of the Leisure Class” (1899) exposed a century ago the US lifestyle of conspicuous consumption and ostentatious waste.
Economists suggest that cash flow is an important determinant of house prices. Other things being equal, homes sell for the present value of the cash flow. So did cash flows increase in the boom? Mulligan thinks not as rents inflated less than housing prices.
He proposes that the majority of the boom derived from “market expectations” about the future, rather than something that happened to demand before 2006. Although Mulligan gives links, these do not amplify what he means by market expectations. Economic theory on this topic is largely based on interest rate yield curves, while the layman might explain “expectations” as the market signalling incremental increases in the future.
Mulligan is anxious to associate the boom with advances in IT. He believes that presently a number of third parties get an income from other people’s houses. These include real estate, mortgage industry, repair people etc. IT could shrink this income. Houses can be bought on line after virtual tours, and mortgage screening can be speeded up. IT can potentially reduce the cost of owning and managing homes.
The “fundamentals” school also contests the “bubble” theory on the grounds that, adjusted for inflation, property values now are higher than ten years ago. A bubble burst would leave house prices lower because the market had encouraged house over-supply (as Robert Schiller does). But actual housing demand is 10% higher than 1996-8 and high by historical standards. I think the case desperate and under-whelming.
What caused the boom and bust?
Between April 2000 and April 2006, US house prices rose by 71%; and between April 2006 and April 2009 they fell by 36%. This massive convulsion is not thoroughly understood.
The “established position” stresses easy credit, low interest rates, high loan-to-value ratios and permissive approval of mortgages. While these are valid, they do not in themselves explain fully the great convulsion. Treasury interest rates declined steadily, but were they sufficient to explain the price rise?
Work by Edward Glaeser of Harvard reviews real data and concludes that a fall of one percent in interest rates leads to an 8% increase in house prices. But economic theory suggests that a one percent fall in interest rates could cause house prices to increase by as much as 24%.
Glaeser tried a simple modification of allowing random change in interest rates to allow for people to buy when interest rates are low and sell when they are high. With a couple of tweaks, the model and reality converge on a 1% fall leading to an 8% rise.
As interest rates fell by 1.2%, 1996-2006 prices should have risen by about 10% rather than the 40%+ achieved. As interest rates have plunged since 2008, low real rates cannot explain the post boom plunge either. What can?
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