Comments on an Article by

Casey Mulligan on the Housing Bubble

Edward J. Dodson

[12 May, 2010, responding to comments by Annie Lowrey of the Washington Independent]

Annie Lowrey wrote:
As long as New York Times Economics contributor and University of Chicago Professor Casey Mulligan continues to insist that the housing bubble was not a bubble, but a "historically unusual housing boom," I will be here to rebut him.

Ed Dodson here:
I also responded at some length to Professor Mulligan's analysis, which I agree is based on a flawed understanding of basic market dynamics and the impact of deregulation of the financial services sector beginning in the 1970s.

Annie Lowrey wrote:
First, he says that Americans needed more room for their stuff, and therefore wanted bigger houses:

"... note that the self-storage industry has more than doubled its share of the national economy since 1995, ..."

Many housing-bubble believers do think that Americans wanted bigger homes. But they believe that easy money and an unrealistic expectation that housing prices would never decline led them to bid up the price on homes irrationally.

Ed Dodson here:
There is a much stronger and deeper factor at work. Reduction in the high marginal tax rates initiated with the Reagan administration added a huge pool of disposable income to households who then looked to real estate (and land, particularly) as part of their overall portfolios. The ability to leverage purchases with low interest credit added fuel to the speculative fire that drove up land prices (which, in turn, drove up property prices, generally). Developers operate under a very basic financial rule: they will acquire land for development only if the market price when completed will be at least four times what the land cost. Thus, if a parcel of land costs $200,000, then the housing unit constructed must yield a total sales price of $800,000 or greater or construction will not go forward. Alternatively, the community might grant the developer an increase in the number of units/acre that can be constructed. However, this often runs into resistance in areas where the predominant housing is single-family detached, where school taxes are already very high and where concerns about more automobile traffic are a factor.

Annie Lowrey wrote:
I'm not sure why Mulligan believes that there is a strong, direct and provable correlation between volume of stuff and price of houses.

Ed Dodson here:
To be sure, homebuyers expect a much longer list of amenities in housing than just a generation ago. However, first-time homebuyers enter ownership in relatively modest single-family detached properties or in townhomes, twins, condominium units or coops. A small but growing number of lower-income households are acquiring deed restricted housing within community land trusts. Of course, there is also a strong resale market for furniture and fixtures.

Annie Lowrey wrote:
Information technology will likely reduce home ownership costs - shrink the "real estate, mortgage industry employees, and other intermediate inputs" and "compensation of employees" pieces of the pie - but for now we cannot be sure exactly when and how much.

Ed Dodson here:
Deregulation and the global credit markets opened the door for a "new economy" that measured wealth not on the basis of the value of goods produced but on the aggregate currency value of transactions. The ability to take on higher and higher levels of mortgage debt (e.g., by the GSEs annually increasing their maximum loan limits to keep transaction volumes increasing in the face of affordability stresses) brought about the explosion in the private placement MBS business generated by the banks and Wall Street without effective risk management (including the risk of organized fraud). Our markets are in desperate need of re-regulation; one immediate measure that should be adopted (but will not, I fear, ever be considered by the Congress) is to prohibit any banking entity that accepts government-insured deposits from making loans for the purchase or refinancing of land value. British economist Fred Harrison has shown that land markets boom and bust on a very regular 18-year cycle. Recessions bring land prices back down to relatively affordable levels but only for a few years before the speculative fever returns -- and lenders forget what happened to them as the last cycle reached its speculative peak.

Annie Lowrey wrote:
Don't forget that a home is built once but typically sold many times, with each sale creating a fee for real estate agents, and many of the sales involving a vacancy period during which no one gets value from the structure.

Ed Dodson here:
Going forward, we face some very unique demographic challenges. Both labor and income mobility in the United States have declined. Income and wealth are more concentrated today than at any time since 1929. Without a dynamic "move up" market based on rising household incomes of renters and owners of starter homes, the overall transaction volume will not support the number of service-providers that have depended on the housing sector for their livelihood. What is clear, on the other hand, is a definite downsizing trend as empty nester baby-boomer seniors migrate back to the cities or to senior housing communities.

Annie Lowrey wrote:
It seems to me that technological innovations that reduced the cost of purchasing a home before 2005 further demonstrate that skyrocketing home prices were irrational and driven by frothy exuberance.

Ed Dodson here:
The economics are rather straightforward, if essentially ignored by almost all analysts within and outside the industry. Every measure that expands the demand side of the housing market will result in rising land prices. Lower down payment requirement, the expanded affordability is capitalized by market forces into higher land prices. Lower interest rates, the same result occurs. Even a general increase in household incomes has the same tendency to drive up land prices.

Annie Lowrey wrote:
And, as always, if Mulligan wishes to argue that the housing bubble was nothing but an efficient housing boom, I am happy to hear him out if he grapples seriously with the issues of low interest rates, no-money-down mortgages, fantastic overbuilding and lax credit.

Ed Dodson here:
And, add to you list the challenge to the belief by those economists who embrace the neoclassical assertion that land is no different than capital when it comes to general equilibrium dynamics. The real world shows clearly that price does not clear land markets. Rising demand for land increasing land hoarding and land speculation (e.g., what is a land banking company other than a pure speculator or buys, holds and sells but never invests in building anything?). Absent an annual rate of taxation on land that comes close to capturing the annual rental value of the location and the supply curve for land leans to the left (at least until there is a market crash and banks are forced to unload half-completed properties at rock bottom prices and write off most of what they loaned for land acquisition costs incurred by the developer).