A Review of Gjerstad and Smith, Part 3

I have been reviewing a couple of Wall Street Journal op-eds (2009, 2010) by Steven Gjerstad and Vernon Smith in the midst of the 2008 crisis that are useful examples of the errant viewpoints that led to the financial crisis.

In Part 1, I argued that the problem with “bubble” models is that they can explain too much. Scholars and policymakers taken in by bubble explanations were driven to support economic crisis because home values had become excessive for supply-side reasons, and so the only way to return to a semblance of normalcy without fixing the supply problem was to create a demand shock big enough to be a crisis.

In Part 2, I pointed to some empirical errors that bubble scholars made because those errors supported their inaccurate model of the housing market.

Here, I will outline some points which may not have been obviously wrong at the time. Following the policy choices of the bubble model has made the supply problem much worse. These outcomes can clarify precisely why and how the bubble model was wrong.

First, here is a comment from the Gjerstad and Smith op-ed about the stability of housing expenditures.

housing expenditures in the U.S. and most of the developed world have historically taken about 30% of household income. If housing prices more than double in a seven-year period without a commensurate increase in income, eventually something has to give. When subprime lending, the interest-only adjustable-rate mortgage (ARM), and the negative-equity option ARM were no longer able to sustain the flow of new buyers, the inevitable crash could no longer be delayed.

This is begging the question. Housing expenditures don’t revert to normal when there is a supply crisis. I mean, maybe eventually we will have displaced every poor family with ties to Los Angeles or New York City out into the rest of the country, so that there aren’t any families left there paying uncomfortably high housing costs in a losing battle to avoid displacement. But, that’ll take more than 7 years.

So, you can see the force of model error in that paragraph. If this is a bubble, then housing expenditures should immediately revert to a stable mean. The collapse of lending markets, then, appears to be a step toward normalcy. If your model is right, this is fine - or at least excusable. If it isn’t….

The popularity of those mortgage products collapsed. In the aftermath of 2008, have housing expenditures reverted to a mean? Not by any measure of either price or rent. Did spending on housing in Los Angeles or New York City revert back toward other regions’? No. Do you expect it to? No? Then why should you have expected it to in 2006?

Much of the April 2009 op-ed summarizes the process of collapse, and notes that the expectations of collapse were preliminary to the actual collapse of home prices. The authors note that by mid-summer 2007, even the AAA-rated tranches of private mortgage securities were trading at a discount, though home prices in aggregate were within a few percentage points of the peak. The steepest declines in home prices followed the loss of confidence.

They write that by the third quarter of 2007, subprime lending was dead. “The liquidity that generated the housing market bubble was evaporating.” Since they have associated liquidity with a bubble, with certainty, this continues to be begging the question. They write:

In one city after another, prices of homes in the low-price tier appreciated the most and then fell the most; prices in the high-priced tier appreciated least and fell the least. The price index graphs for Los Angeles, San Francisco, San Diego and Miami show that in all of these cities, prices in the low-price tier have fallen between 50% and 57%.

Here, I have to note that this is actually wrong. Or, at least overstated. As I have pointed out frequently, including in my recent paper, prices in low-tier housing only increased excessively in cities with severe supply constraints. They collapsed in just about every city. I find this especially troublesome. That collapse in working class Atlanta is massive in scale, and is actually a refutation of the claim.

So much financial suffering has been brushed over in service of confirmation bias and question begging. But, this is common in the literature, with some hand-waving about how reckless lending created overstimulus even in markets with elastic supply. I have never seen a thorough reckoning with the lack of evidence for this. There was generally no building boom in the cities where prices remained moderate. And, I’m not sure if I have seen a single demand-focused paper that acknowledged the sharp and novel tightening in mortgage access after 2008 as a potential reason for the drop in low-tier prices.

Figure 1

The collapse of low-tier lending absolutely devastated places like Atlanta. By 2012, high tier prices in Atlanta and Phoenix were similar to what they had been before 2002. Low tier prices in Atlanta were cut in half, and Phoenix nearly so. Compared to their cycle highs in both cities, prices declined by well over half.

In Los Angeles, both low-tier and high-tier prices remained above pre-boom levels because no amount of lending crisis is going to solve the supply problem in Los Angeles that was the true cause of high housing costs.

According to the bubble model, home prices, nationally, had finally been beaten down back to the normal level of 1997. But, this was an average of markets like Los Angeles, which will never be “normal” according to the bubble story, and Atlanta, which was just absolutely torn to shreds by the misguided attempt at normalcy. That’s what the bubble model got us. Tear working class Atlanta to shreds until the aggregate US numbers look normal, and then perrenially blame low interest rates as unprecedented rent inflation pulls those prices back up.

It all really is a harrowing exercise in the strength of confirmation bias. The thing with confirmation bias is that it is so easy. Nothing is easier than not looking deeper when outcomes seem to match your priors, or even when fun house mirror outcomes seem to match your priors.

One aspect of the mistakes here may not have been obvious at the time. Housing supply had never been so constrained that it raised rents in some metropolitan areas so much higher than in others. In 2009, maybe there wasn’t a historical precedent to draw on to understand that high rents can drive price/rent ratios higher. So Gjerstad and Smith made the same mistake that the Financial Crisis Inquiry Commission made about high home prices. The cities they meant to cherry pick as examples of boom and bust - Los Angeles, San Francisco, San Diego and Miami - are exactly the cities you would cherry pick as examples of high and rising rents. The FCIC picked a slightly different set of cherries - LA, New York City, and Miami - but, in both cases, these are the Closed Access cities.* These are the “housing shortage” cherries, and they only appear to be “housing bubble” cherries because the housing bubble model is wrong, or at least is secondary. Figure 2 compares the rent trends, prices, and price/rent trends in those cities.

Figure 2

Figure 2 displays several points of interest. First, US rent inflation (top panel, solid black line) has outpaced other inflation (top panel, dashed black line) during the supply deprived era. This has been especially the case in the cities that lack adequate building (the colored lines in the top panel). Home prices in those cities systematically rise in response to high rents, with positive feedback, so that price/rent ratios in those cities rise.

Price/rent ratios in the housing deprived cities briefly appear to have returned to normal. Of course, we know now that that didn’t last. And, rents in those cities never reverted to the norm. Those price/rent ratios in 2010 were greatly suppressed by the demand shock. Cities with high rents will have high price/rent ratios. And, price/rent ratios rose again where rents were high, which increasingly is everywhere.

This is information that was available in 2009, but one could be excused for not noticing that high price/rent ratios have been primarily caused by high rents. Now, we have hindsight.

As EHT readers know, low tier housing costs are driven higher by supply constraints, and tight lending has not changed this.

The authors write:

When housing prices turned down, many borrowers with low income and few assets other than their slender home equity faced foreclosure. The remaining losses had to be absorbed by the financial system. Consequently, the financial system has suffered a blow unlike anything since the Great Depression, and the source is the weak financial position of the people holding declining assets.

Again, this is a common notion - that the boom was driven by unqualified borrowers and the bust was driven by their inability to pay their mortgages. And, in real time, this may be another factor that we can’t expect to have been understood at the time.

I go into this issue a lot in “Shut Out”. It was one of the first discoveries, 8 years ago, that led me into this accidental project as the housing bubble skeptic. Marginal new homeownership was generally among families with high incomes, the median income of a homeowner in 2005 was higher relative to the median renter than it had been in the 1990s. The new mortgage borrowing was overwhelmingly among families with higher incomes. Even debt-to-income ratios above 40% were generally a development among the families with the highest incomes (Fig 3, left panel). Defaults were largely a lagging factor, driven mostly by deep negative equity combined with a shock like unemployment. For instance, in American Community Survey data that goes back to 2005, the initial drop in mortgaged homeownership in the early bust was among the richest families. In most cities, the decline in mortgaged ownership among median income families, happened after the 2009 op-ed (Fig 3, right panel).

Figure 3

Most of the damage related to neighborhoods with median incomes and below in city after city, like Atlanta in Figure 1, were the result of the removal of mortgage access from those neighborhoods after 2008. Even at the late date of April 2009, most of the damage to households with low incomes and few assets was yet to be inflicted.

In the closing sections of the op-ed, Gjerstad and Smith go into how a housing bust infects the financial system, household wealth and spending in a way that is especially damaging, so that falling home prices are much worse than a bear stock market. And, again, we are back to begging the question, because in their bubble model, all of this goes back to 1997. Our mistake was letting a bubble happen, and once a bubble happens, the feces is already in the water supply.

The important question at that point is, “What if we avoid all of that economic damage by preventing the collapse in home prices?” But, this is verboten if you have a bubble model. Smith made his position clear in an earlier op-ed in the Wall Street Journal in December 2007.

The consumption binge is now over, and there is more than enough blame and souring loans to spread around. Congress, if its members can stop squabbling, wants desperately to sanctify it all with actions sure to launch at some future date the grandmother of all housing and mortgage-market bubbles.

The conditions of 2012, as in Figure 1, were the only conditions that the bubble model could abide. Any other outcome was just beckoning yet a larger bubble to come. It’s turtles begging questions all the way down.

The op-ed closes with:

Why does one crash cause minimal damage to the financial system, so that the economy can pick itself up quickly, while another crash leaves a devastated financial sector in the wreckage? The hypothesis we propose is that a financial crisis that originates in consumer debt, especially consumer debt concentrated at the low end of the wealth and income distribution, can be transmitted quickly and forcefully into the financial system. It appears that we're witnessing the second great consumer debt crash, the end of a massive consumption binge.

J.W. Mason has pointed out that this story of debt fueled consumption by poor households is generally not supported by the facts.

In Part 2, I mentioned Gjerstad and Smith’s selective attempt to conflate asset ownership with consumption, by using home prices instead of rental value to construct consumer price inflation. (Their own adjusted price index showed massive, destabilizing levels of deflation at the time of the op-ed it appeared in, though they did not mention that in the op-ed.) In Smith’s 2007 op-ed, he also had tried to conflate housing construction with consumption. He wrote:

More daring than the action to exempt real estate from the capital gains tax -- and in lasting service to the poor -- would have been actions allowing capital gains on all assets to go tax free, provided that the capital was reinvested -- i.e., not consumed, and yes, good citizens, housing counts as consumption.

Unlike the latest housing bubble, the stock market "excesses" of the 1990s financed thousands of new ventures, some of which found innovative ways to manage the proliferation of new technologies. The result: astonishing, long-term increases in productivity still evident in the most recent quarter.

Adam Smith in his "The Theory of Moral Sentiments" (1759) saw the subtle truth that consumption by the rich has little effect on the welfare of the poor. That's because the income of the rich is largely invested in the tools and knowledge of production, which provide future long-term value for everyone: "The rich only select from the heap what is most precious and agreeable . . . though they mean only their own conveniency . . . [and] . . . the gratification of their own vain and insatiable desires, they divide with the poor the produce of all their improvements."

Expenditures on housing construction are not "improvements" yielding increased productivity and future new wealth to be divided with the poor. They are more akin to satisfying government-subsidized vanity.

Figure 4 compares the percentage growth of mortgages outstanding (blue line) with the number of housing starts. It is hard to know exactly how much mortgages were used to fund consumption. In “Building from the Ground Up” I touch on that question a bit. There was a lot going on, at various scales at different times: mortgages for new homes, to buy existing homes, to borrow from home equity. Again, your presumptions will determine the meaning of those mortgages. The bubble model will say all of that borrowing was unsustainable because, as Smith argues above, even the investment wasn’t investment. The constrained supply model will say that even the borrowing from home equity was simply a side effect of either the harvesting of economic rents from undersupply or of families in the Contagion cities in 2006 and 2007 trying to smooth their cash flow as migration into those cities dried up and local income trends dropped.

But, as Figure 4 makes clear, mortgage borrowing tracks very strongly with residential investment and home building. Mortgage trends are, largely, investment trends. All three of these op-eds were posted well into a collapse in any case.

Readers of EHT are familiar with the deep error in that last Smith excerpt. Filtering is everything in housing. The most important factor that makes housing affordable for poor families in a city is that over many years, ample homes are built for rich families. Homes of any kind really. There may be no better example in all of economics where consumption yesterday and today by rich families is associated with consumer surplus for poor families. Find an affordable city (which is hard to do these days). Find a random working class home, and figure out who built that home or lived in it 60 years ago. If the city is affordable, that home was almost certainly built for a family of a higher relative socio-economic status than the current residents.

And, again, we are left begging questions. If you think housing markets are perennially in a brief normal condition interrupted by bubbles, then housing is generally in a state of overstimulation or oversupply. In that condition, of course new housing isn’t productive.

I frequently share real vs inflationary rental expenditures charts. Since housing has been in a constant state of undersupply for decades now, it is in the opposite condition. Demand for housing is inelastic. That is why families are willing to pay more to avoid displacement where homes are in short supply. So, for every 1% that housing investment falls short, there is more than 1% of rent inflation. More than 1% of housing expenditures are being converted from consumer surplus to economic rents. In this state, more than 100% of new residential investment flows to consumer surplus. All else equal, each new home reduces total nominal expenditures on housing. This is especially true in the most expensive cities that desperately need housing. Few investments could more dependably serve poor families than residential investment.

But, even if you don’t want to go that far with me, the contention that housing isn’t productive because it is consumption rather than investment is confused. All investment is related to consumption! We aren’t building these big new microchip factories just to appreciate the architecture. The point of those factories is so that we can consume the chips!

It is reductive to pretend that every homebuyer is simply matching their investment with consumption, so that the transaction is misconstrued as purely a consumptive act. The fact that owner and consumer are frequently aligned is not particularly important to the broader point. People that don’t buy homes aren’t generally living under a rock. The act of buying is an act of investment. And, in the aggregate, where the buying activity leads to new homes, it is absolutely an investment. We don’t only count microchip factories as investment when people don’t consume the chips! Quite the contrary, it is only investment when they do!

And, even if you don’t buy that explanation, the simple logistics of homeownership is that you buy or invest in a home that is forever, or at least is as long as it depreciates before becoming unusable. But, the owner only consumes it a day at a time. Twisting homeownership in the aggregate into a cumulative act of consumption is just wrong. The only way to buy a home that you will live in tomorrow is to provide a home for your family or some other family for decades to come.

Again, it’s another turtle begging questions, when, in 2010, the streets are lined with foreclosures and the bubble scholar confirms their priors about unneeded houses. But, again, the answers to those questions, 15 years later, abound. American working class families face unprecedented rent inflation. And, for anyone interested in noticing, it will be hard not to notice that this condition was well ensconced well before the 2005 housing boom.

The challenge for us in 2023, where these problems are more clear than ever, is to leave behind the mistakes of the previous generation of scholars and policymakers - to solve these longstanding problems without the albatross of tempting and erroneous models around our necks. I don’t know how much of this post Jerome Powell would agree with, but at least he has set the table for potential growth coming out of the Covid recession and hasn’t saddled us with a new collapse in housing construction. But, the worst excesses of mortgage regulation after 2008 remain in place. I have come to associate that problem with much more American economic pain than the Closed Access land use regulations have caused. A better Fed and better urban land use regulations both seem to have tailwinds. Maybe mortgage access can eventually join the ride. And, when they do, I recommend taking your “bubble” models out behind the woodshed. Or, at best, tie them up real tight and only let them whisper to you occasionally through a crack in the door, because they can grab you and scream at you until you can hear nothing else. And, we don’t need to do this any more.

Part 4 is here.

*I have traditionally put Miami in the category of “Contagion city”, but of all the major metropolitan areas that I don’t include normally in the “Closed Access” category with NYC, LA, San Francisco, Boston, and San Diego, it is probably the most “Closed”.