In 2008, I was of the opinion that easy monetary policy cannot explain much of the housing boom. When Professors Krugman and Delong came to agree with me, I immediately realized that I was likely wrong!
Here was my 2008 reasoning:
"Suppose that annual real interest rates were going to be one percentage point (100 basis points) lower for a year. Then the cost of buying a house, holding it for a year, and then selling it would be essentially one percent less. The low one-year interest rate would not affect the selling price at the end of the year because, by assumption, the reduction lasted only for a year and the next buyer will be back to normal interest rates. So the source of benefit from the low rate is that the initial buyer reduces the carrying cost for a year."
Professor DeLong was also part of Cato Issue in which I expressed the opinion above. More than a year later, he expressed the same opinion (without giving me credit, but that's beside the point):
"If you believe that the Fed kept the fed funds rate 2% below its proper Taylor-rule value for 3 years, that has a 6% impact on the price of a long-duration asset like housing. Even with a lot of positive-feedback trading built in, that’s not enough to create a big bubble."
A day later, Professor Krugman picked up on this reasoning, and nodded approvingly to Delong. All of this pointed strongly to the fact that I need to think again about my 2008 conclusion. Here's where I went wrong:
It's true that short term mortgage rates were a bit lower than normal during some of the housing boom. But the "normal" short term mortgage rate would not be the proper benchmark if the housing market really was anticipating the kinds of technical change I was writing about.
I explained how fundamentals -- the real prospects for technical change -- were temporarily pushing up housing prices. Even without subsidies, this process would efficiently raise the probability of a housing price crash, because nobody knew for sure when and how much technical progress would be realized.
But mortgages include a put option: the homeowner can trade in his house keys for the lenders' erasing his payment obligation. And the housing boom I described above (or, for that matter, any process that caused housing prices to rise and increased the probability of a crash) was increasing the value of that put option. Absent subsidies, lenders would not be giving away such a valuable put option so cheaply -- they would have charged more than normal either in the form of higher mortgage rates, higher closing costs, or lower LTVs (when multiple transactions are packaged into one "mortgage", all of these might just show up in "higher mortgage rates").
So even if short term mortgage rates had been "normal", that would have been consistent with a large subsidy, because the unusual housing price dynamics called for extra mortgage charges to reflect the enhanced value of the put option typically included with mortgages.
So anticipated government subsidies to the mortgage market magnified the housing price cycle. Prices would have gone up and come down even without them, but to a lesser magnitude. And the calculation I made in 2008, and Professors DeLong and Krugman reiterated in 2010, understates the housing price impact of those subsidies.
[Note: the elasticity of housing supply also needs to be considered (read more about that here), but that's separate from what Mulligan-DeLong-Krugman said about mortgage rates]
Here was my 2008 reasoning:
"Suppose that annual real interest rates were going to be one percentage point (100 basis points) lower for a year. Then the cost of buying a house, holding it for a year, and then selling it would be essentially one percent less. The low one-year interest rate would not affect the selling price at the end of the year because, by assumption, the reduction lasted only for a year and the next buyer will be back to normal interest rates. So the source of benefit from the low rate is that the initial buyer reduces the carrying cost for a year."
Professor DeLong was also part of Cato Issue in which I expressed the opinion above. More than a year later, he expressed the same opinion (without giving me credit, but that's beside the point):
"If you believe that the Fed kept the fed funds rate 2% below its proper Taylor-rule value for 3 years, that has a 6% impact on the price of a long-duration asset like housing. Even with a lot of positive-feedback trading built in, that’s not enough to create a big bubble."
A day later, Professor Krugman picked up on this reasoning, and nodded approvingly to Delong. All of this pointed strongly to the fact that I need to think again about my 2008 conclusion. Here's where I went wrong:
It's true that short term mortgage rates were a bit lower than normal during some of the housing boom. But the "normal" short term mortgage rate would not be the proper benchmark if the housing market really was anticipating the kinds of technical change I was writing about.
I explained how fundamentals -- the real prospects for technical change -- were temporarily pushing up housing prices. Even without subsidies, this process would efficiently raise the probability of a housing price crash, because nobody knew for sure when and how much technical progress would be realized.
But mortgages include a put option: the homeowner can trade in his house keys for the lenders' erasing his payment obligation. And the housing boom I described above (or, for that matter, any process that caused housing prices to rise and increased the probability of a crash) was increasing the value of that put option. Absent subsidies, lenders would not be giving away such a valuable put option so cheaply -- they would have charged more than normal either in the form of higher mortgage rates, higher closing costs, or lower LTVs (when multiple transactions are packaged into one "mortgage", all of these might just show up in "higher mortgage rates").
So even if short term mortgage rates had been "normal", that would have been consistent with a large subsidy, because the unusual housing price dynamics called for extra mortgage charges to reflect the enhanced value of the put option typically included with mortgages.
So anticipated government subsidies to the mortgage market magnified the housing price cycle. Prices would have gone up and come down even without them, but to a lesser magnitude. And the calculation I made in 2008, and Professors DeLong and Krugman reiterated in 2010, understates the housing price impact of those subsidies.
[Note: the elasticity of housing supply also needs to be considered (read more about that here), but that's separate from what Mulligan-DeLong-Krugman said about mortgage rates]
1 comment:
I agree, I hope we will see a paper soon about this.
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