Sunday, March 21, 2004

More on housing

Regular readers of this site may have noticed that I am a little obsessed with the economics of housing. In this good post by Brad DeLong, he notes that the rise in asset prices has increased consumption by present home owners (because they are richer), but does not seem to have decreased consumption amongst future home owners (because they will have to pay more to get a house and are therefore poorer). The question is why?

The first thing to note is that implicit in Brad's argument is the fact that everyone who does not own a home is, in fact, short housing. By contrast, not owning a stock leaves you neutral to that stock's performance. If you own a house, and the price rises, your new wealth is exactly offset by the extra you will have to pay if you buy another home. A renter, however, has to pay a higher rent without any offsetting boost in wealth.

As for Brad's question on why housing seems to have boosted consumption so much, I have a few ideas:

1) While housing prices have risen, the effect is limited to a few very hot markets, such as Boston, California, and New York. However, rents in these markets have not matched the increase in real estate value. This means that renters are not having their consumption reduced through paying higher prices *now*, while home owners are enjoying higher consumption through their equity appreciation.

2) The above is not sustainable. Either rents will rise back inline with prices, and thus reduce consumption by renters, or prices will fall back inline with rents, and thus reduce consumption by owners who suddenly find themselves with more house than they can really afford.

My big question is how long-term fixed rate mortgages factor into all of this. When interest rates rise, along with inflation, the cost of financing home purchases will rise just as the real cost of debt (the mortgage) will start to get eroded. This seems to work mostly in favor of owners. I think that the way people think about buying a house demonstrates that folks are (incorrectly) looking at the purchase from a nominal cashflow perspective, so I would expect to see a rapid drop in demand when interest rates start rising. What I'm not sure about is whether this will occur at the same time as an increase in supply as over-extended home owners find themselves with more house than they really want/can afford. And what will happen to mortgage lenders with lots of long term, fixed, low interest debt on their books?


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