THe Housing Bubble is Deflating
The following is the text of a commentary delivered over WAMC radio by Michael Meeropol on September 1, 2006.
WHAT DOES THE HOUSING BUBBLE MEAN FOR US?[1]
Have you been worrying about being able to afford to buy a house? Or worrying about how long it’s taking you to sell your house? Or worrying that your house has been losing value on the market? Welcome to the world of the housing bubble.
Last week, on Friday and again on Sunday, the New York Times in four separate pieces weighed in on the question.[2] There was unanimous agreement that there is, indeed, a bubble in the value of real estate that has started to deflate but is that bubble in danger of popping?
Let’s start at the beginning. What do we mean by a “bubble in the value of real estate?”
We start with “supply and demand.” The price of housing depends on the supply of newly built homes and those placed on the market by individuals wishing to move. The demand is the desire of those with sufficient income to purchase these homes.[3]
If a price is determined by the interaction of supply and demand with a large number of buyers and sellers (so as to ensure competition), most economists would argue that this market price is the “right” price. So what’s a bubble?
The term “bubble” describes a situation where the price of something rises way out of proportion to its “real value.” So when is a market price not the “right” price but a “bubble” price?
Recall the demand side of supply and demand. Demand includes the ability to purchase (you have to have sufficient income to offer cash or to qualify for a mortgage as in the case of most real estate transactions) coupled with a desire to purchase.
Suppose your desire to purchase is based on the fear that if you don’t buy now, the price will go up so much that you won’t be able to afford to buy later. Suppose your desire to purchase is based on the speculative assumption that no matter how high the price is, it will keep going up and you’ll always be able to sell it at a profit in the future? If enough people believe that prices will continue to go up, then they will pay a high price today in anticipation of having to pay an even higher price tomorrow.[4]
Also, the phenomenal increases in incomes recently achieved by the top 10% of the population allow those individuals to pay rising astronomical prices.[5]
Note, in these cases, demand is based not only on the desire to buy a house to live in it but on those wild expectations of ever increasing prices. This creates a speculation in real estate and the momentum feeds on itself. This can go on for years. Robert Schiller, the man who helped coin the phrase “irrational exuberance” made famous by Alan Greenspan, calculates that this bubble has driven existing home prices to unprecedented heights since 2000.[6]
It is clear, now, that the bubble is contracting. Those wildly optimistic expectations have now been replaced by more realistic ones.
The question is, will prices fall slowly or precipitously – and will the fall affect the entire economy or be restricted just to the real estate industry?
The fear is that as prices fall and construction activity slows, not only will the economy take a hit as construction spending declines, but people will stop taking out home equity loans and thus slow down their personal consumption expenditures. The resulting decline in spending is something we all need to worry about.[7]
Since 2000, the housing bubble has carried the economy – real estate has accounted for 44 percent of all the jobs created.[8] Those who believe the deflation of the bubble will do no harm to the rest of the economy are counting on private business investment to pick up the slack.
But investors need to believe there will be consumers for their increased production and if people carrying big mortgages experience declining home equity and decide to slow down spending, then investors will not invest. The deflating bubble could mean trouble for all of us, not just those who can’t sell their houses.
[1] I would like to acknowledge by debt to Dean Baker, director of the Center for Economic Policy Research for alerting me to the existence of the housing bubble years ago. I urge anyone interested in this issue to check out the CEPR www.cepr.net where there are numerous articles on the housing bubble.
[2] On the OP-ED page, columnist Paul Krugman wrote “Housing Gets Ugly” (New York Times, 8/25/06: A23) in which he asserted that there is now no question that there has been a housing bubble and the only remaining question is whether the deflation will be slow enough to create a “soft landing” or whether the bubble will “pop” leading to a precipitous decline in housing prices which would produce at the very least a “housing led recession.” Two news articles complemented his column that same day. “New-Home Sales and Goods Orders Fall Markedly” (New York Times, 8/25/06: C-3) stated that in July new home sales fell at an annual rate of 4.3%, home sales (all homes) fell below the pace initially predicted and inventories (homes waiting to be sold) “jumped to a 10-year high, pointing to a rapidly cooling housing market.” As if that weren’t enough evidence, the article also reported that “The supply of homes available for sale … rose to 6.5 months, the highest since a 6.8 month supply in November 1995.” The other article described in detail the various “sweeteners” that sellers in the high end market (over $1 million) were adding to their homes in order to sell them without reducing the published price. (“Homes for Sale, By Anxious Owner: Sweetened Deals in a Slow Market” by V. Bajaj and D. Leonhardt, New York Times, 8/25/06: C1). On Sunday, August 27 there was a detailed article about the deflation of the housing bubble asked whether the result will be “A soft landing, a long slump, or a hard crash?” (See D. Leonhardt and V. Bajaj, “Read Between All Those For-Sale Signs” New York Times; Section 4, p. 1)
[3]Technically, supply and demand are a series of price-quantity alternatives in the minds of all the buyers and sellers in any given market. In the case of housing, sellers are all those who might potentially sell their house (in other words supply in the economists sense is not just those homes on the market – the number of homes currently on the market represents some “points” on the total supply curve). However, in the real world, people usually think of the supply of something as the actual number being offered for sale. Those who “demand” housing are those currently in the market to buy housing. Unlike the inventory of houses for sale, this number is harder to estimate. It would require reading the mind of virtually everyone who could afford to buy a house!! Nevertheless, it is often indirectly measured by how long houses stay on the market and what is happening to the price of houses. If homes stay on the market a short period of time and their prices are rising, we can say there is “strong demand” for housing. By contrast, if homes stay on the market a longer period of time and the prices are falling, we say there is “slack demand” or even “falling demand” for housing.
[4]The demand side of the market is obviously based on the incomes of the individuals who might consider purchasing a particular product as well as their tastes and preferences (Americans, for example, have a much greater desire to own their own homes than many Europeans which is why homeownership is so widespread in this country as opposed to equally affluent countries in Europe) and the prices of alternative things they might buy. In addition, expectations of future price movements and future income play a major role, especially in a “big ticket” purchase like a home. (For most Americans it is the largest single purchase they will make in their lifetime.) A rise in positive expectations will increase the number of people willing to buy a house at the current price and even increase the desire of people to buy houses at a higher price than today. This latter phenomenon explains why prices of houses can have risen so rapidly since 2000 and yet the sales of new and existing homes has also risen rapidly.
[5]Most commentators have not focused on this point but it is extremely important. Median incomes have not grown very much. Median real wages have actually not grown at all during the current recovery. (See S. Greenhouse and D. Leonhardt, “Real Wages Fail to Match a Rise in Productivity” New York Times, 8/28, 06: A-1. See the table on p. A-13 for details. “Even for workers in the 90th percentile of earners – making about $80,000 a year – inflation has outpaced their pay increases over the last three years …”) Though much of the earnings of the super-rich come in the form of income from the ownership of property – particularly stocks but including real estate – wages received by the top 10% and 1% of salary and wage recipients have grown much faster than average wages so that the share of wages going to these top groups has also risen significantly. When high income individuals bailed out of the stock market after the stock market bubble burst beginning in June of 2000, many of them chose to invest in real estate which created the white hot “high end” market. This market was featured in a New York Times Magazine story in the Fall of 2005 about the largest company specializing in building what have derisively come to be called “McMansions”. At that time, Robert Toll, the CEO of Toll Brothers argued that the boom would go on forever. He noted that when it comes to supply and demand for housing for millionaires, his company had the supply and the millionaires were creating the demand. In answer to a question about why he was so optimistic about the luxury home market, he told the University of Pennsylvania Law School Alumni Magazine: “I don’t see any reason for it not to continue to be a good market. The doomsayers are predicting that there will be an implosion that will come from the recognition that the market is just floating on air and not sustainable and that it’s going to wreak havoc on the economy. I think that’s a lot of bull. I think housing price escalation will continue. It won’t be as fast as it’s been in some markets but it’s not going to be as slow as it was. The creation of wealth has been phenomenal. Families making $100,000 or more have grown six times faster than the general population. The population has grown by 80 million in the last 30 years. (Yet) we’re building fewer homes on average this decade than we did in the 1970s. So with this tremendous growth in population, tremendous growth in wealth and slackening supply, you get a great imbalance, and when supply dwindles and demand grows what gives is price.” (See http://www.law.upenn.edu/alumnijournal/fall2005/alumni_briefs/page03.html) However, on August 22, 2006 we discover from Business Week online that:
“Luxury home builder Toll Brothers Inc. said Tuesday [August 22] that its third-quarter profits fell by 19 percent as the housing-market malaise weighed on sales and caused the company to abandon some building locations. The Horsham, Pa.-based company also cut its earnings estimate for the full year, signaling that it doesn't expect the housing market to stabilize soon. Investors have given up on flipping properties for a quick profit and builders have slashed prices to move homes, especially on the luxury end.Robert Toll, chairman and chief executive, told analysts during a conference call that he doesn't yet see signs of improvement nationwide. ‘I don't see a turnaround in any of the markets,’ he said. ‘I don't see any forming a bottom’."
(http://www.businessweek.com/ap/financialnews/D8JLMKV80.htm?sub=apn_home_up%26chan=db). In other words, despite Mr. Toll’s assertions last October, the demand at that time was in fact “floating on air” – the hot air of unrealizable speculation – a classic case of a bubble.
[6]Shiller is a Professor of Economics at Yale University and he was briefing Alan Greenspan in December, 1996 about the danger of a stock market bubble. He described the markets at that time as “irrational” and two days later Greenspan shocked the stock market by using the term “irrational exuberance”in a speech delivered before the American Enterprise Institute. [See Robert Shiller, Irrational Exuberance (Princeton, Princeton University Press, 2005): 1 and the endnote on 231] Unfortunately, in order to reduce the danger of a market slump in response to his statement, Greenspan began to backtrack and for the rest of the 1990s was actually a cheerleader for the stock market gains, refusing to support, for example, the raising of margin requirements on the sale of stock to calm down the speculative mania that ultimately led to the dot-com bust. Shiller’s book Irrational Exuberance was initially published in 2000 and fortuitously it came out just as the stock market peaked and began to slide. In 2005 he published a second edition in which he wrote a new chapter focusing on the real estate bubble. (See Ibid: 13)
[7]Much of the mortgage refinancing since 2001 has been a result of lower interest rates. But often what comes with it is a utilization of the equity built up in a home as a result of the rise in its sale price to increase current consumption. If home prices stop rising, then people will not be able to re-finance and turn their accumulated equity into current consumption. We can see how this has affected consumer behavior by measuring consumption outlays (personal consumption expenditures plus interest payments and transfer payments to other individuals) against disposable personal income. For most of the decade of the 1990s, the ratio was between 93 and 95% but in the last three years of the 20th century as a result of the stock market boom, many people felt secure enough to increase their personal consumption expenditures so that in many cases it exceeded their current incomes. This is an example of what economists call the “wealth effect,” the idea that if the stock you own goes up in value you don’t have to save as much so you can consume all of your current income and even increase your indebtedness. This led to personal outlays over 96% in the last three years of the 20th century. The same principle is on display during the early years of the 21st century when people see the values of their houses increase and they therefore borrow that equity and spend it. The ratio of personal outlays to disposable personal income was above 97% for the first years of the decade and over 100% (leading to a negative personal savings rate) in 2005. [See Economic Report of the President, 2006: 318]
Unfortunately, when the value of housing stops rising and interest rates rise so that refinancing is no longer attractive, that increase in consumption virtually stops. That is what is beginning to happen now (Fall, 2006).
[8] See D. Leonhardt and V. Bajaj, “Read Between All Those For-Sale Signs” New York Times; August 27, 2006: Section 4, p. 1.
WHAT DOES THE HOUSING BUBBLE MEAN FOR US?[1]
Have you been worrying about being able to afford to buy a house? Or worrying about how long it’s taking you to sell your house? Or worrying that your house has been losing value on the market? Welcome to the world of the housing bubble.
Last week, on Friday and again on Sunday, the New York Times in four separate pieces weighed in on the question.[2] There was unanimous agreement that there is, indeed, a bubble in the value of real estate that has started to deflate but is that bubble in danger of popping?
Let’s start at the beginning. What do we mean by a “bubble in the value of real estate?”
We start with “supply and demand.” The price of housing depends on the supply of newly built homes and those placed on the market by individuals wishing to move. The demand is the desire of those with sufficient income to purchase these homes.[3]
If a price is determined by the interaction of supply and demand with a large number of buyers and sellers (so as to ensure competition), most economists would argue that this market price is the “right” price. So what’s a bubble?
The term “bubble” describes a situation where the price of something rises way out of proportion to its “real value.” So when is a market price not the “right” price but a “bubble” price?
Recall the demand side of supply and demand. Demand includes the ability to purchase (you have to have sufficient income to offer cash or to qualify for a mortgage as in the case of most real estate transactions) coupled with a desire to purchase.
Suppose your desire to purchase is based on the fear that if you don’t buy now, the price will go up so much that you won’t be able to afford to buy later. Suppose your desire to purchase is based on the speculative assumption that no matter how high the price is, it will keep going up and you’ll always be able to sell it at a profit in the future? If enough people believe that prices will continue to go up, then they will pay a high price today in anticipation of having to pay an even higher price tomorrow.[4]
Also, the phenomenal increases in incomes recently achieved by the top 10% of the population allow those individuals to pay rising astronomical prices.[5]
Note, in these cases, demand is based not only on the desire to buy a house to live in it but on those wild expectations of ever increasing prices. This creates a speculation in real estate and the momentum feeds on itself. This can go on for years. Robert Schiller, the man who helped coin the phrase “irrational exuberance” made famous by Alan Greenspan, calculates that this bubble has driven existing home prices to unprecedented heights since 2000.[6]
It is clear, now, that the bubble is contracting. Those wildly optimistic expectations have now been replaced by more realistic ones.
The question is, will prices fall slowly or precipitously – and will the fall affect the entire economy or be restricted just to the real estate industry?
The fear is that as prices fall and construction activity slows, not only will the economy take a hit as construction spending declines, but people will stop taking out home equity loans and thus slow down their personal consumption expenditures. The resulting decline in spending is something we all need to worry about.[7]
Since 2000, the housing bubble has carried the economy – real estate has accounted for 44 percent of all the jobs created.[8] Those who believe the deflation of the bubble will do no harm to the rest of the economy are counting on private business investment to pick up the slack.
But investors need to believe there will be consumers for their increased production and if people carrying big mortgages experience declining home equity and decide to slow down spending, then investors will not invest. The deflating bubble could mean trouble for all of us, not just those who can’t sell their houses.
[1] I would like to acknowledge by debt to Dean Baker, director of the Center for Economic Policy Research for alerting me to the existence of the housing bubble years ago. I urge anyone interested in this issue to check out the CEPR www.cepr.net where there are numerous articles on the housing bubble.
[2] On the OP-ED page, columnist Paul Krugman wrote “Housing Gets Ugly” (New York Times, 8/25/06: A23) in which he asserted that there is now no question that there has been a housing bubble and the only remaining question is whether the deflation will be slow enough to create a “soft landing” or whether the bubble will “pop” leading to a precipitous decline in housing prices which would produce at the very least a “housing led recession.” Two news articles complemented his column that same day. “New-Home Sales and Goods Orders Fall Markedly” (New York Times, 8/25/06: C-3) stated that in July new home sales fell at an annual rate of 4.3%, home sales (all homes) fell below the pace initially predicted and inventories (homes waiting to be sold) “jumped to a 10-year high, pointing to a rapidly cooling housing market.” As if that weren’t enough evidence, the article also reported that “The supply of homes available for sale … rose to 6.5 months, the highest since a 6.8 month supply in November 1995.” The other article described in detail the various “sweeteners” that sellers in the high end market (over $1 million) were adding to their homes in order to sell them without reducing the published price. (“Homes for Sale, By Anxious Owner: Sweetened Deals in a Slow Market” by V. Bajaj and D. Leonhardt, New York Times, 8/25/06: C1). On Sunday, August 27 there was a detailed article about the deflation of the housing bubble asked whether the result will be “A soft landing, a long slump, or a hard crash?” (See D. Leonhardt and V. Bajaj, “Read Between All Those For-Sale Signs” New York Times; Section 4, p. 1)
[3]Technically, supply and demand are a series of price-quantity alternatives in the minds of all the buyers and sellers in any given market. In the case of housing, sellers are all those who might potentially sell their house (in other words supply in the economists sense is not just those homes on the market – the number of homes currently on the market represents some “points” on the total supply curve). However, in the real world, people usually think of the supply of something as the actual number being offered for sale. Those who “demand” housing are those currently in the market to buy housing. Unlike the inventory of houses for sale, this number is harder to estimate. It would require reading the mind of virtually everyone who could afford to buy a house!! Nevertheless, it is often indirectly measured by how long houses stay on the market and what is happening to the price of houses. If homes stay on the market a short period of time and their prices are rising, we can say there is “strong demand” for housing. By contrast, if homes stay on the market a longer period of time and the prices are falling, we say there is “slack demand” or even “falling demand” for housing.
[4]The demand side of the market is obviously based on the incomes of the individuals who might consider purchasing a particular product as well as their tastes and preferences (Americans, for example, have a much greater desire to own their own homes than many Europeans which is why homeownership is so widespread in this country as opposed to equally affluent countries in Europe) and the prices of alternative things they might buy. In addition, expectations of future price movements and future income play a major role, especially in a “big ticket” purchase like a home. (For most Americans it is the largest single purchase they will make in their lifetime.) A rise in positive expectations will increase the number of people willing to buy a house at the current price and even increase the desire of people to buy houses at a higher price than today. This latter phenomenon explains why prices of houses can have risen so rapidly since 2000 and yet the sales of new and existing homes has also risen rapidly.
[5]Most commentators have not focused on this point but it is extremely important. Median incomes have not grown very much. Median real wages have actually not grown at all during the current recovery. (See S. Greenhouse and D. Leonhardt, “Real Wages Fail to Match a Rise in Productivity” New York Times, 8/28, 06: A-1. See the table on p. A-13 for details. “Even for workers in the 90th percentile of earners – making about $80,000 a year – inflation has outpaced their pay increases over the last three years …”) Though much of the earnings of the super-rich come in the form of income from the ownership of property – particularly stocks but including real estate – wages received by the top 10% and 1% of salary and wage recipients have grown much faster than average wages so that the share of wages going to these top groups has also risen significantly. When high income individuals bailed out of the stock market after the stock market bubble burst beginning in June of 2000, many of them chose to invest in real estate which created the white hot “high end” market. This market was featured in a New York Times Magazine story in the Fall of 2005 about the largest company specializing in building what have derisively come to be called “McMansions”. At that time, Robert Toll, the CEO of Toll Brothers argued that the boom would go on forever. He noted that when it comes to supply and demand for housing for millionaires, his company had the supply and the millionaires were creating the demand. In answer to a question about why he was so optimistic about the luxury home market, he told the University of Pennsylvania Law School Alumni Magazine: “I don’t see any reason for it not to continue to be a good market. The doomsayers are predicting that there will be an implosion that will come from the recognition that the market is just floating on air and not sustainable and that it’s going to wreak havoc on the economy. I think that’s a lot of bull. I think housing price escalation will continue. It won’t be as fast as it’s been in some markets but it’s not going to be as slow as it was. The creation of wealth has been phenomenal. Families making $100,000 or more have grown six times faster than the general population. The population has grown by 80 million in the last 30 years. (Yet) we’re building fewer homes on average this decade than we did in the 1970s. So with this tremendous growth in population, tremendous growth in wealth and slackening supply, you get a great imbalance, and when supply dwindles and demand grows what gives is price.” (See http://www.law.upenn.edu/alumnijournal/fall2005/alumni_briefs/page03.html) However, on August 22, 2006 we discover from Business Week online that:
“Luxury home builder Toll Brothers Inc. said Tuesday [August 22] that its third-quarter profits fell by 19 percent as the housing-market malaise weighed on sales and caused the company to abandon some building locations. The Horsham, Pa.-based company also cut its earnings estimate for the full year, signaling that it doesn't expect the housing market to stabilize soon. Investors have given up on flipping properties for a quick profit and builders have slashed prices to move homes, especially on the luxury end.Robert Toll, chairman and chief executive, told analysts during a conference call that he doesn't yet see signs of improvement nationwide. ‘I don't see a turnaround in any of the markets,’ he said. ‘I don't see any forming a bottom’."
(http://www.businessweek.com/ap/financialnews/D8JLMKV80.htm?sub=apn_home_up%26chan=db). In other words, despite Mr. Toll’s assertions last October, the demand at that time was in fact “floating on air” – the hot air of unrealizable speculation – a classic case of a bubble.
[6]Shiller is a Professor of Economics at Yale University and he was briefing Alan Greenspan in December, 1996 about the danger of a stock market bubble. He described the markets at that time as “irrational” and two days later Greenspan shocked the stock market by using the term “irrational exuberance”in a speech delivered before the American Enterprise Institute. [See Robert Shiller, Irrational Exuberance (Princeton, Princeton University Press, 2005): 1 and the endnote on 231] Unfortunately, in order to reduce the danger of a market slump in response to his statement, Greenspan began to backtrack and for the rest of the 1990s was actually a cheerleader for the stock market gains, refusing to support, for example, the raising of margin requirements on the sale of stock to calm down the speculative mania that ultimately led to the dot-com bust. Shiller’s book Irrational Exuberance was initially published in 2000 and fortuitously it came out just as the stock market peaked and began to slide. In 2005 he published a second edition in which he wrote a new chapter focusing on the real estate bubble. (See Ibid: 13)
[7]Much of the mortgage refinancing since 2001 has been a result of lower interest rates. But often what comes with it is a utilization of the equity built up in a home as a result of the rise in its sale price to increase current consumption. If home prices stop rising, then people will not be able to re-finance and turn their accumulated equity into current consumption. We can see how this has affected consumer behavior by measuring consumption outlays (personal consumption expenditures plus interest payments and transfer payments to other individuals) against disposable personal income. For most of the decade of the 1990s, the ratio was between 93 and 95% but in the last three years of the 20th century as a result of the stock market boom, many people felt secure enough to increase their personal consumption expenditures so that in many cases it exceeded their current incomes. This is an example of what economists call the “wealth effect,” the idea that if the stock you own goes up in value you don’t have to save as much so you can consume all of your current income and even increase your indebtedness. This led to personal outlays over 96% in the last three years of the 20th century. The same principle is on display during the early years of the 21st century when people see the values of their houses increase and they therefore borrow that equity and spend it. The ratio of personal outlays to disposable personal income was above 97% for the first years of the decade and over 100% (leading to a negative personal savings rate) in 2005. [See Economic Report of the President, 2006: 318]
Unfortunately, when the value of housing stops rising and interest rates rise so that refinancing is no longer attractive, that increase in consumption virtually stops. That is what is beginning to happen now (Fall, 2006).
[8] See D. Leonhardt and V. Bajaj, “Read Between All Those For-Sale Signs” New York Times; August 27, 2006: Section 4, p. 1.
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