A vital but widely misunderstood aspect of our financial crisis

Summary:  an analysis of the core problem in the US housing market, a problem often ignored by analysts. 

The years from 1929 to 1933 were, for America, a succession of breaking idols and abandoned faiths, some of them the notions of willful children, some deeply ingrained in the character of the nation.
   — The Years of the Locust:  America 1929 – 1932, Vivian Seldes (1933)

The core of the housing crisis is overbuilding, which has created an excess supply of housing units (broadly defined). Today there are roughly 4 – 5 million vacant housing units above historical average rates (as a % all units). For example, the Census Department’s Housing Vacancy Survey shows that 2.8% of owner-occupied units (i.e., not rentals) are vacant, almost 2x the historical average of 1.5%.

These vacant units are a burden to their owners, tieing up capital and costly to maintain.  Whether sold or rented, they drive down prices.  Excess supply is difficult to absorb for high cost and long life goods like housing.  There are no easy fixes, and these vacant homes might vex the market for several years.

Measure to encourage homeownership or home purchases are of marginal effectiveness (e.g., tax breaks, lower interest rates, government aid).  Almost everyone is already living in a “unit”.  For example, at what interest rate would you buy a 2nd (additional) home in your neighborhood for your family to live in?  These programs can increase space occupied by households, helping people move into larger units.  Also, by reducing the cost of living, these programs might encourage some formation of new households by getting adult offspring out of their parents’ homes.

There are two powerful solutions

(1)  Eventually our population will increase to fill these homes.  But slowly.

Our population grows (net new households) from more children leaving home than households disappearing through death.  And net migration into America.  These rates change over time.  Our slowing economy might already be slowing the rate of in-migration.  A recession or political turmoil in Mexico might send floods of people north into America. 

(2)  Not so creative destruction

Many vacant homes will be destroyed, the fast track to fixing this problem.  Empty houses get vandalized, destroyed by the owners (spite or insurance fraud), occupied by squatters or meth labs, or wrecked by the forces of nature.  In regions with net out-migration (e.g., Detroit) homes remain vacant for long periods, often abandoned by their owners (valueless but costly due to taxes and maintenance).  As anyone familiar with the history of the South Bronx knows, empty homes acts as an infectious blight that can devastate larger areas.  After a decade or two, the result can look like Dresden after the bombing in 1945.

Here is one way the government can fix the housing crisis:  buy and destroy homes.  The government did this with food during the Depression, in order to increase food prices (to help farmers).  That was tough on food consumers, just as destroying houses would increase living costs.  Despite what politicians say, that is how most government programs work — aiding one group at the expense of another group (often a much larger but less organized group).

Effects of too many vacant homes

The excess number of vacant homes will exert downward pressure on home prices and rents (in aggregate, vacant homes tend to become rentals).  Prices will stabilize eventually, when they reach a point at which investors will voluntarily accumulate inventory – vacant homes, which they will maintain until they can be sold or rented.  Under normal circumstances there is little housing inventory.  Due to the cost of homes (tied up capital, often financed) and the expense of maintaining them, there is little voluntary inventory.  For example, builders like to have new homes sold prior to completion.

This is one way of calculating a floor price for homes.  I have seen no attempts to determine this number, but it implies a low ultimate price for homes.  Below the equilibrium price calculated by the usual metrics, such as price to rent or home price to income ratios.  That is because too many vacant units is a disequilibrium, preventing normal dynamics from stabilizing the home marketplace.

How did this happen?

There are many reasons.  A combination of speculative activity (the Minsky cycle), excessive subsidies, lax lending, lax regulation of lenders, etc.  Does it matter now?  The crisis itself will force massive changes to home construction, finance, and ownership dynamics.  When things settle down we can look at the resulting situation and discuss reforms.  Until then discussing reforms is building castles in the air.

Epilog

Much of the capital to build these excess homes came from foreign investors.  I doubt they are happy with the results.  Their views — our creditor’s views — on how the process should change might have more weight than ours (the debtors and future borrowers).

In this country we have long considered the Federal Reserve master of its own domain, able to direct and effect our course.  As the rest of the world’s economies emerge we will be forced to consider that our central bank is just one in a global community of central banks.  As that occurs foreign central banks will, rightfully, have more influence and input in our decisions and we will be forced to consider that.

   — Charles Kindleberger, speaking in 2002 to Joshua Rosner of Graham Fisher, as reported in his report of 16 September 2008.  Kindleberger was a historical economist and author of over 30 books. He is best known for his 1978 book Manias, Panics, and Crashes.  Rosner’s summary:  “We are not alone, we are but one player in a global community and right now we are not holding many of the cards.

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Key Treasury Department documents

We cannot plead the “we didn’t know the details in the fine print” excuse. The important details about this massive nationalization have been clearly spelled out for us.  See this page for a current list of Treasury Department documents.

Some FM posts about the current crisis

1. Treasury Secretary Paulson leads us across the Rubicon, 9 September 2008
2. High priority report: a geopolitical sitrep on the financial crisis, 15 September 2008
3. Say good-bye to the old America. Welcome to our new socialist paradise!, 17 September 2008
4. Another voice warning about the nationalization of AIG, 18 September 2008
5. A vital but widely misunderstood aspect of our financial crisis, 18 September 2008
6. A new sitrep, as we move into phase 3 of the financial crisis, 19 September 2008
7. Another step away from our Constitutional system, with applause, 19 September 2008
8. What do we know about the financial crisis? What are the key questions?, 20 September 2008
9. Slowly a few voices are raised about the pending theft of taxpayer money, 21 September 2008
America appoints a Magister Populi to deal with the financial crisis, 21 September 2008
Legal experts discuss if the Paulson Plan is legal, 21 September 2008

For a full listing see the FM reference page about the Financial crisis – what’s happening? how will this end?.

A few of the most important posts warning about this crisis

This crisis has long been forecast by many, including in articles on this site.  Even now that we are in the whirlwind, these provide valuable background material on its causes — and speculation about the results.  Here are some of those posts.

1. A brief note on the US Dollar. Is this like August 1914?, 8 November 2007 — How the current situation is as unstable financially as was Europe geopolitically in early 1914.
2. The post-WWII geopolitical regime is dying. Chapter One, 21 November 2007 — Why the current geopolitical order is unstable, describing the policy choices that brought us here.
3. We have been warned. Death of the post-WWII geopolitical regime, Chapter II, 28 November 2007 — A long list of the warnings we have ignored, from individual experts and major financial institutions (links included).
4. Death of the post-WWII geopolitical regime, III – death by debt, 8 January 2008 – Origins of the long economic expansion from 1982 to 2006; why the down cycle will be so severe.
5. Geopolitical implications of the current economic downturn, 24 January 2008, – How will this recession end?  With re-balancing of the global economy, so that the US goods and services are again competitive.  No more trade deficit, and we can pay out debts.
6. A happy ending to the current economic recession, 12 February 2008 – The political actions which might end this downturn, and their long-term implications.
7. What will America look like after this recession?, 18 March 208  — The recession might change so many things, from the distribution of wealth within the US to the ranking of global powers.
8. The most important story in this week’s newspapers , 22 May 2008 — How solvent is the US government? They report the facts to us every year.
9. Prof Nouriel Roubini describes “The Decline of the American Empire” ,18 August 2008
10. The World’s biggest mess, 22 August 2008 — A brillant ex pat looks at America from across the ocean.
11. “The changing balance of global financial power”, by Brad Setser, 22 August 2008
12. “The Coming US Consumption Bust”, by Nouriel Roubini, 6 September 2008

To see the all posts on this subject, go to the FM reference page about The End of the Post-WWII Geopolitical Regime.