Categories of Housing Contraction, Part 2
The 2008 Crisis: Pounding a "Normal" Peg into a "Capacity" Hole
In Part 1, I used this figure as a framework for thinking about housing cycles.
After, a “Normal” 20th century, with relatively stable home price trends and cyclical construction activity, the 21st century increasingly is a “Capacity” century. It’s not that demand for housing is increasing. It’s just that the boundary for the “Capacity” Condition keeps moving to the left.
I have shared Figure 2 on social media before. Figure 2 is a pair of charts of rent expenditures as a percentage of GDP, rent inflation relative to general inflation, and changes in real housing expenditures compared to real changes in other expenditures. (In other words, if all prices, including rents, increased by 2%, the rent measure [shown red] would be zero and would be more than zero if rent inflation is more than 2%, and if the average home got 2% nicer, larger, etc. while our clothes, meals, and computers also got 2% nicer, the real housing measure [shown blue] would be zero. It would be positive 1% if homes got 3% better while other things got 2% better.)
You might be forgiven for looking at the top panel and concluding that we spent the last quarter of the 20th century at the top end of the “Normal Condition” because of unrelenting increases in demand for housing. But, as the bottom panel shows, just at the time when rents started taking a persistently larger portion of the national income, rent inflation and real housing growth flipped. Before the 1970s, we built a lot of housing and paid reasonable rents for it. After the 1970s, we created less and less new housing and paid more and more for it.
In other words, the top panel of Figure 2 shows an economy slowly placing itself into the “Capacity” Condition, by increasingly pushing the threshold for “Capacity” Condition to lower rates of production. (By the way, the one recent period of relative growth in real housing consumption in Figure 2, from 2009-2012, is from the decline in GDP related to the Great Recession, not from a hot housing market. In fact, that was a Surplus Condition, which came about in the only way we have ever managed to to create Surplus conditions, by my estimation: by quickly making ourselves poorer.)
Before 2008, the threshold for the “Capacity” Condition was very different from place to place. It was well under 1% annual growth in what I call the Closed Access cities (NYC, LA, San Francisco, Boston, and San Diego). In other places, it was over 3% growth. And, increasingly, as this condition hardened, Americans were, en masse, grasping at normalcy, mostly by moving away from the places that were in the Capacity Condition and to places that were still normal. Since so many Americans were moving away from places that had pitifully low Capacity thresholds, the number of homes being constructed in some other places increased. In some places (I call the Contagion cities), it increased so much that those places entered a Capacity Condition, themselves, even if they still had a relatively generous Capacity threshold. By 2005 and 2006, an unusually high number of residents were moving away even from the Contagion cities because they couldn’t grow fast enough to handle the incoming residents. The Capacity Condition was spreading.
If you think about it, the Capacity Condition isn’t likely to be binding during a recession, or a cyclical contraction in housing. So, of course, the first time we started flirting with Capacity conditions, nationally, it was bound to happen during a cyclical high. There was nothing special about the cycle in the 2000s. In fact, it was quite moderate. The Capacity threshold had moved low enough that a cycle that was much more moderate than any of the mid-20th century cycles started to trigger supply constraints. Looking back at Figure 2, real growth of housing wasn’t even back to growing as quickly as real GDP was. At the peak of the dreaded bubble, adjusting for inflation, housing was still growing more slowly than other types of consumption.
One touchstone in the path to crisis, which I mention in “Building from the Ground Up” is the widely cited paper from noted economist Ed Leamer, “Housing IS the Business Cycle” (pdf). I think the paper is a fantastic guide for monetary policy. And, Leamer presented it to the Fed at Jackson Hole at the end of August 2007! You could title that paper, “Housing IS in the Normal Condition”. The main point of that paper is that housing is cyclically very important, but that it mostly fluctuates through changing production quantities, not changing prices.
The problem that confronted Leamer is that the Normal Condition, which was the condition that had reigned for the 50 years his paper describes, was an increasingly poor framework for understanding the US housing market. Prices only rise significantly when construction activity is constrained.
Leamer and other economists understand this, and throughout the literature, inelastic short term supply is given a nod as a prerequisite for rising prices. And between all that analysis (and, my goodness is there a lot of analysis) and the consensus that it all meant that housing production must have been too high in general, there is just a big fat gaping hole that, to the extent anyone even bothered to acknowledge it, was mostly filled with hand-waving. Or, in hindsight, frequently, the collapse itself is identified as proof of its own inevitability. As if the .007 units/capita builders started in 2005, which was a lower rate than all but a single year of the 1970s, was prima facie, the product of a financial bubble that had produced housing so divorced from our capacity to utilize it that a Surplus Condition was inevitable. There is a shocking lack of analysis of the thing that Leamer correctly identified as the most important thing.
Here is a chart from “Building from the Ground Up” which gives an indication of the state of the housing market when Leamer had the ear of Federal Reserve officials.
We had been tickling the top end of the Normal Condition, and localities that had become perpetually in the Capacity Condition were creating distortions within their own markets which were leaking out into other markets. But, by the time Leamer spoke to Fed officials - with a message that housing starts are the key leading indicator of the business cycle - housing starts were sending a deep and worsening signal of coming disaster. By the time Leamer spoke, we had already swung well to the left end of the Normal Condition. By August 2007, we had already overcorrected, and Leamer’s own groundbreaking work created a clear language for seeing that. The solution to the Capacity Condition is to move the Capacity threshold to the right. Lacking that, the second best solution would be to moderate demand just enough to relieve the distortions - to settle at the high end of Normal rather than in the Capacity Condition. We had already moved past that territory some time in 2006.
Leamer said, “To put the point as clearly as possible, what I am advocating is a modified Taylor Rule… in place of Taylor’s output gap, housing starts and the change in housing starts, which together form the best forward-looking indicator of the cycle of which I am aware.”
Imagine saying that, at the point in time highlighted in the figure, armed with a host of historical empirical evidence that every one of those downbursts in housing starts had presaged a recession, and then arguing against stimulus! But, that’s what Leamer did, and I think the reason he did is that nobody at that retreat could have imagined any other conclusion. The Fed, at that point shown in Figure 6, hadn’t even started to lower their target interest rate, and yet were already making emergency loans. Leamer told them that there was “very little possibility that a rate cut would make much of a difference.” The idea that we should tip-toe back into the Normal Condition rather than race headlong to the other, unfortunate extreme of it, was simply not imaginable. (The Fed did start cutting rates, anyway, because they were way behind by that point. But, to offer a sense of the audience Leamer was up against, a year later, Fed voting member Richard Fisher was still making the argument that rate cuts couldn’t make much of a difference! And, the point on the graph that is labeled “2011 Bernanke comment” refers to his memoir where, even in hindsight, he claimed economic growth was still slow because there was still an overhang of excess housing from before 2007.)
Leamer was burdened with the dilemma that he had uncovered something so radically correct that it seemed like it could not possibly be true. His presentation was padded with a lot of the standard behavioral patches that are popular - loose lending was pushing up prices and construction with unsustainable buying; prices in the coming contraction would be buoyed by irrational sellers with sticky reservation prices, etc. Having not noticed the clear fundamental reasons for rising home prices, economists had been busy collecting a list of irrationalities that consumers must have been guilty of. Of course, he was very wrong about home prices being sticky. And the reason he was wrong is that he was compelled to follow the convention of thinking that we had engineered an unsustainable Surplus Condition with a building boom. Ironically, he probably would have been right about subsequent home prices being more stable if the Fed had followed the advice he had discovered but that he couldn’t stomach delivering: that by August 2007, the Fed needed to stimulate the economy enough for housing starts to recover.
“The inevitable effect of the low rates has been an acceleration of the home building clock, transferring building backward in time from 2006-2008 to 2003-2005... The historical record strongly suggests that in 2004 and 2005 we poured the foundation for a recession in 2007 or 2008 led by the collapse in housing we are currently experiencing.”
He didn’t think he was recommending a collapse into a Surplus Condition. He thought we were already in a type of Surplus Condition that, I would argue, doesn’t and can’t exist at the macro level, and if it could, certainly wouldn’t have existed at the time he joined the consensus in asserting it.
To the extent that there had been a cyclical boom in housing, it had already reversed by the time Leamer spoke in the summer of 2007. In “Building from the Ground Up” , I largely blamed the Fed for the early collapse in starts and prices, but as I have built this model, I have shifted my estimation of the effects of tight lending earlier in time. The development of the Surplus Condition in 2008, when we lurched past the left end of the Normal Condition to Surplus, was probably greatly exacerbated by the retraction of mortgage credit. It is arguable that the Fed couldn’t have driven the housing market to such an extreme on its own, if lending norms had remained stable. Eventually, there was a vicious cycle of less lending leading to lower prices leading to defaults leading to lower demand leading to lower prices, etc. etc. The convention has been to blame that vicious cycle on the excesses of the boom and on the imaginary Surplus Condition that had made the collapse seem so inevitable.
This is one reason I think there is little reason to fear a national collapse in the current context. The reason Leamer could believe that prices would generally hold up is because, even in August 2007, after such a deep dive in housing starts, prices were relatively stable. We were still, just by a thread, in the Normal Condition. Cyclical inflation had just completed a full reversal (according to my measures, shown in Figure 4), but nationally, as Leamer pointed out, cyclical reversals in the Normal Condition don’t lead to collapsing prices.
The credit shock was probably a necessary element in the collapse that soon came, and it can’t happen twice. Even many pundits who wouldn’t accept my model will say the same thing through their own language - that we are in safer territory today because borrowers are generally in better shape.
In the next post I will discuss the current context in more detail.