What would happen if, as so many people are hoping, home prices were to go up dramatically again as they did in the early 2000s? Would such a change really benefit society?
People who most ardently desire this are homeowners who are underwater on their mortgages, who took out mortgages at the peak of the boom and now find that their homes are worth less than they owe on them. They would just feel relieved to get out of the red as soon as possible.
But should they really be wishing for this, if they were to take into account all the effects and their humane concerns for all people?
In my new book Finance and the Good Society I argue that we should be hoping for better financial arrangements, a democratised and humanised financial capitalism, not for some price increase. We should be hoping for prices that are formed in markets in which all people participate with realistic expectations, prices that reflect contracts that treat everyone fairly and that reward good behaviour.
Thinking that large home price increases would be a good thing seems very widespread. But the effects of any such future price boom would not be so clearly beneficial, and would depend on the causes of the price increase and the financial arrangements that were made for them. The issues are much more complex than most people seem to imagine.
Note that in the latest bubble home prices in the US and the UK rose rapidly relative to the cost of renting. It was not a rental boom. It was thus financial in origin, not caused by a rise in the real scarcity value of housing services that people want to consume. It was instead a change in the investment demand for ownership of a claim on a stable flow of rents.
Before we can answer what would be the effects of large future home price increases relative to rents, we would have to ask why those increases would be happening. Let us consider why they increased the last time, in the early 2000s. The reasons are basically the same in both the US and the UK.
Price increases were related to a loosening of credit standards and weakening of the banking system due to complacency about the possibility of price falls. The result has been serious trouble in the banking sector, and the necessity for government bailouts.
Home price increases were also related to unrestrained and unrealistic public expectations for future price increases. In a survey of homebuyers in four US cities that Karl Case and I carried out in 2004, at the peak of the housing expectations, we found that the (trimmed) mean home price increase expected for the succeeding 10 years was 12.6 per cent a year. Maybe our respondents didn’t quite understand what they were implying: that would mean more than a tripling of home prices in the succeeding 10 years from an already high level.
At the least, home buyers must have thought they would make a ton of money: those who borrowed 90 per cent of the money to buy their house in effect saw their investment levered up 10 to one, and so these high expected price increases would be magnified 10-fold for their investment. No wonder people felt so pleased with the boom while it lasted.
Already eight of those 10 years have passed, and the actual rate of increase in US nominal home prices on average for the eight years was minus 3.6 per cent a year. Long-term public expectations were way off. And yet, even in the fact of this evidence, expectations have come down only slowly and gradually. Expectations for annualised 10-year price increases dropped to 5.6 per cent a year by 2011, though that is still high: it would imply a doubling of home prices in about a dozen years.
So, the price increases the last time were brought on by some massively unrealistic expectations. This means that people made costly mistakes, and not just the mistake of a bad investment in homes. People under such delusions and feeling rich may not have taken necessary steps to maintain their human capital, their skills and job readiness, for instance. Their complacency about their presumed future wealth may also have meant that they did not save for the future in other forms. It means that people may have missed other investments that might have provided better for them. It even means that people may not have been supportive of taxes paid for government infrastructure investments that might have better supported the economy.
If that kind of thinking were again the reason for a price increase, it would not be a good thing. It might even bring about another crisis eventually, and the home price increases we might see tomorrow would be only temporary. There is nothing good about that.
Even people who are living with underwater mortgages may not really benefit much from a home price increase. If it is like the last one, the increase may not last for long, and the bubble will burst again before they sell the property.
So, if one wishes for substantial price increases, enough to bring out everyone who is underwater, one would have to be wishing that somehow price increases could rise for a different reason than last time.
A more likely way such price increases could happen in the future is if governments were to give massive subsidies to real estate consumption while at the same time enforcing rigid zoning requirements to prevent a supply response from the construction industry to the higher prices. That would create an artificial shortage of housing, and that could have a more permanent impact on housing, since it would produce a rent increase as well as a price increase. But is an artificial shortage of housing any good?
Opinions on that might depend, for example, on children. Assuming one cares about one’s children, then if one has more than one child one can’t just bequeath one’s own house. A price increase will make one worse off, since one will have to help out the other child or children to buy a house in an expensive market. And maybe one even cares about other people, beyond one’s own children.
The real things that we should hope for are rather more technical-financial, far more esoteric than the level of home prices that people so naturally fixate on.
We should hope for some remedy for a sort of collective-action problem that is preventing mortgage financiers from providing workouts, or restructuring, to underwater homeowners. The problem is that, since so few anticipated the decline in home prices, securitised mortgages spread responsibility for mortgage workouts over very many mortgage investors, who now can’t get together to agree on workouts for underwater homeowners, even when the workouts are in the mutual interest of both mortgage lenders and home owners.
This collective-action problem is exacerbated since mortgage servicers are typically left with the responsibility of pursuing workouts, but, in the original mortgage servicing contracts, had no direct financial incentive to do such workouts. We have to find some legal remedy for this problem – if we do, that would be great news.
We should also hope for some fundamental change in our mortgage institutions so that the problem that got us into this housing crisis will not be repeated. In my book I talk about new types of privately issued mortgage that would go a long way towards preventing the kind of financial crisis we have just been through. I have proposed a continuous workout mortgage that has a pre-planned and continually adjusted workout written into the original mortgage contract. Issuers of such mortgages would be in effect selling insurance on home price declines as part of their mortgage package.
I and my UK colleagues, M Shahid Ebrahim of the Bangor Business School, Mark B Shackleton at Lancaster University and Rafal M Wojakowski, also at Lancaster University, have shown how these mortgages should be priced to yield a normal profit for private issuers. By creating such mortgages, issuers would be bringing the financial theory of risk management to the broader public, thereby helping to democratise finance.
We should also hope for better liquid markets for home price risk that would provide price discovery for future home prices, and a hedging vehicle to help mortgage originators to better kinds of mortgages without overburdening themselves with home price risk. That would be more good news.
Ultimately, what we really should be hoping for is not home price increases but democratisation and humanisation of the financial infrastructure. Such improvements are unambiguously good, and are things we can make happen. It need not be just a hope.
Robert Shiller is professor of economics and finance at Yale University. His newly updated free-to-the-public online Open-Yale introductory finance course elaborates on themes in his new book ‘Finance and the Good Society’ (Princeton 2012)