Housing prices are falling because fundamentally the price of housing became unaffordable. The stream of expected household income necessary to repay the loans exceeded the capacity of household budgets. It is that simple – there is no sense in paying $3,000 a month in mortgage payments on property with the rental equivalent of $1,000. To be sure, a homeowner could justify such a purchase as long as they thought they were guaranteed a 15% annual risk free return. But who, other than realtors and mortgage brokers, remain under that delusion?
Similarly, I find programs that purport to “help” homeowners by reducing their mortgage payments of questionable value. Lowering your mortgage payment to 38% of income might sound like a good deal – but if you have no equity, you do not really own anything. You are just a renter by another name. So if your final mortgage payment significantly exceeds the rental equivalent, has the government really made you better off? And if, as I suspect, homeowner bailouts will not stem price declines, the program recipient could soon find themselves with negative equity again in a matter of months. If you really wanted to help underwater homeowners, you would bring their payments in line with the rental equivalent. I suspect this would be extremely costly.
That housing prices will ultimately return to some conventional relationship with incomes does NOT imply that the government has no role in supporting the housing market. The government’s role is simple: to take actions that ensure that persons who can afford a mortgage remain able to do so. The Federal Reserve and Treasury need programs that allow creditworthy borrowers access to credit. This justifies the takeover of the GSEs, and even justifies pouring billions of dollars into them to ensure that the family earning $60k a year is able to get the mortgage for a $200k home.
The problem for housing prices, of course, is that two years ago that same family could purchase a $400k home. Unless policy is expanded to encourage such loans, then the supply of funds is no longer available to support $400k homes. If policy is redirected toward such a goal, then the government, and ultimately the taxpayer, will take on additional credit risk in one form or another. There will be pressure to use the GSEs in this fashion. Consider this proposal, via the WSJ:
As part of an industry proposal called “Fix Housing First,” builders are asking Congress for a tax credit of up to $22,000 on houses bought over the next year and an interest rate buy-down that would reduce rates on new, 30-year fixed mortgages to 2.99% for houses bought through June 30, 2009. The proposal could cost up to $268 billion, according to the National Association of Home Builders, though the group may scale it back.
Thirty year money costs the US Treasury 4.2%, so obviously the taxpayers is expected to make up the difference. I suspect this proposal would cost vastly more than $268 billion, as it would ultimately be expanded to refinancing as well. Why shouldn’t those of us who want to stay in our homes be on the same terms? Moreover, can anyone imagine that the government could end such a program? Might as well hope for the mortgage interest tax deduction to be eliminated. I can see that a guarantee of ultra-low interest rates would support the housing market, but I don’t see how the resulting massive unfunded liability could be supported with anything less than outright monetization of deficit spending.
In a similar vein, we are seeing increasing interest in support consumer access to credit. Treasury Secretary Henry Paulson today announced that TARP is no longer about troubled assets:
Second, the important markets for securitizing credit outside of the banking system also need support. Approximately 40 percent of U.S. consumer credit is provided through securitization of credit card receivables, auto loans and student loans and similar products. This market, which is vital for lending and growth, has for all practical purposes ground to a halt. Addressing these two priorities will have powerful impacts on the overall financial system, the strength of our financial institutions and the availability of consumer credit.
Again, policy should rightfully focus on maintaining credit to the creditworthy. But we should draw the line at encouraging lenders to make risky loans. The Federal Reserve has the right idea:
At this critical time, it is imperative that all banking organizations and their regulators work together to ensure that the needs of creditworthy borrowers are met. As discussed below, to support this objective, consistent with safety and soundness principles and existing supervisory standards, each individual banking organization needs to ensure the adequacy of its capital base, engage in appropriate loss mitigation strategies and foreclosure prevention, and reassess the incentive implications of its compensation policies.
Unfortunately, I suspect such jawboning will have little impact. With consumers already overextended, the room for rapid credit growth is simply limited. Moreover, with economic activity deteriorating and unemployment rising, the number of creditworthy borrowers is falling. This comes on top of the deleveraging already underway in the financial sector. The Fed and Treasury are able to do little but prevent the banking system from outright collapse.
Simply put, policies focused on housing and consumer spending are a black hole for spending – this summer’s short-lived stimulus package is a case in point. Policymakers need to come clean with the American public: Future patterns of growth will simply be less dependent on consumer spending. We are entering a period of structural adjustment, and it will be painful. We spent decades pretending that the relentless focus on producing nontradable goods and relying on a ballooning current account deficit to hide our lack of productive capacity was an appropriate policy approach. But ultimately, those policies have failed us, with stagnant income growth for median income families and the deepest recession since the 1980’s (or even worse).
This admission, however, in no way, shape, or form means policy options are limited. The admission simply defines your policy. In the short term, policy can cushion the transition by expanding the social safety net. In the medium term, if consumption is falling, and private investment is unable to compensate, then the federal authority should fill the gap. There is no shortage of sectors of the economy that offer opportunities for investment. In so many ways, we are running on the fumes of the infrastructure investment made by the last generation. Roads, bridges, channels, etc. – you name it, there is an opportunity. Or human capital, via education? Should the federal government finally step up and fund unfunded mandates? And by all means, continue efforts to reform health care, including the development of nationwide, portable medical records tracking. Reasonable policymakers free from ideological constraints can develop a host of potential projects without relying on bridges to nowhere. You can even extend the argument to supporting Detroit – if current management and boards are swept clean.
Can we afford these policies? For the moment, yes. I did not believe this in the first half of the year, as I though the global economy was running too hot to support substantial stimulus without an inflationary offset. That is no longer the case. If we reach a point we can’t finance the spending, financial markets will tell us. All policymakers have to do is listen and adapt. And I think it is much more likely that we can afford investment spending that yields productive assets rather than taking on the risk of refinancing the housing market at less than the cost of funds. Indeed, I think relentless focus on housing prices will lead to rash policies that could only be inflationary in the long run. After all, the key to supporting housing prices is simply to inflate nominal incomes.
In short, policymakers need to envision an economy in the future that is distinctly different from the past. Relying on the housing market to propel growth is a failed policy. Relentless upward leveraging to support consumer spending was not sustainable. Accept the failure, and move on.
Originally published on November 13, 2008 at Economist’s View and reproduced here with the author’s permission.