The problem: There aren't enough buyers
Point: Edward Leamer
It's been 3 1/2 years since the housing market peaked at the end of 2005, and we are still nowhere close to normal. Exactly what should be done now is not at all clear. From 2002 to 2005, we happily drank the Kool-Aid mixture of high and rising home prices, high and rising rates of new home construction, and low and falling lending standards. The adjustment to those excesses has come with (surprise!) falling prices, falling building rates and rising lending standards. A symptom of those adjustments is painfully high and rising levels of foreclosures amplified by a high and rising unemployment rate. This is going to slow the recovery.
We have already made a lot of progress on the first two problems: too many homes with excessively high prices. At the bubble's peak, housing starts were at the rate of 2.2 million per year. Using 1.6 million units as the normal annual rate of building, from 2001 until the end of 2006, we built 1.4 million more housing units than we needed.
But the subsequent under-building caused the stock of homes to hit normal levels this past May. At the current building rate of about 500,000 units a year, we are under-building by 1 million units, laying the foundation for the next housing mania. We need to get building rates back up soon.
According to the Federal Housing Finance Agency, home prices in the United States rose by 50% from the second quarter of 2001 to the second quarter of 2007. Through the second quarter of 2009, prices have fallen back by 10%. Is this enough? In answering this question, it is important to keep in mind that the fundamental force behind the rise in all asset prices during the bubble was a global glut of personal saving that drove down real interest rates to very low levels, which are still very much with us now that the 10-year Treasury bond is yielding only 3.5%.
While lower prices are part of the solution, they are also part of the problem. Our much-touted free-market system relies fundamentally on what economists call "downward sloping" demand curves: If the market price falls, sales rise. For homes this is not always the case. Lower prices create the hope and expectation of still lower prices later, and buyers often choose to wait it out to get the best deal. Falling prices cause tighter lending standards because of the elevated risk of default. Thus lower prices create lower sales, and we get overshooting in the downward direction. Clearly it is a good thing to intervene in this price-discovery process, but only if we knew exactly what the prices should be.
Last, we need to think about the lingering effects of incredibly low lending standards. First, I digress to vacancies. The number of vacant units waiting for buyers or renters is huge. Since the end of 2005, the number of housing units classified by the U.S. Census Bureau as "vacant" increased from 15.7 million to 18.7 million. The additional 3 million vacant homes is the equivalent of two normal years' worth of new building.
How does this square with my assessment that the stock of homes returned to normal in May? One answer is that the recession is increasing the number of occupants per home, calling for programs that will encourage renters to buy. Another answer is that we built single-family homes in certain locations when what we needed were multifamily homes in other places. Greatly reduced lending standards allowed a large number of moderate-income Americans to buy homes in so-called exurbs, such as the far reaches of Southern California's Inland Empire. The building that occurred there created homes for a class of buyers that no longer exists because the subprime mortgage market is gone for good. Going forward, these homes will find their best use as rental properties, rented to the very families who now occupy them as owners but don't have the income to do the debt service. In these cases, we don't want to stop the foreclosures. Instead, we should facilitate the change in status of the home from owner-occupant to rental, ideally rented to the same families who live there now.
I think it is very hard to design a fair and effective program that directly targets the foreclosure problem. What we have done so far isn't doing the job. Economist Martin Feldstein’s idea for banks to voluntarily modify loans for troubled borrowers in exchange for recourse lending is intriguing, but the fundamental problem is that there aren't enough buyers. With more buyers we could get stable and rising prices, which would allow lenders to loosen their tight lending standards and bring more buyers back into the market. Stable and rising prices would offer some hope to current owners that they could get back at least some of their investment, and they would be less likely to walk away from their homes.
Our government has been trying to bring buyers back with temporary tax incentives. President Obama's $787-billion stimulus package includes a tax credit for first-time buyers of new or existing homes of 10% of the purchase price or $8,000, whichever is less, on sales that close before Dec. 1. But there are income limits that reduce the effectiveness of this program.
California has offered a tax credit of 10% of the purchase price or $10,000, whichever is less, to new home buyers regardless of income level for homes purchased between March 1, 2009, and March 1, 2010. But the $100-million fund for this program was exhausted in just four months and was used in fewer than 11,000 home transactions. This program is good for the builders, but not so good for the housing market because a new home buyer who is selling an older home is filling one vacancy but creating another.
Let's hope these incentives are enough.
Edward Leamer, a UCLA economics and statistics professor, is director of the UCLA Anderson Forecast.
How Greenspan wanted the boom to go, and how it turned out
Counterpoint: Brad DeLong
Let me start by outlining how the 2000s were supposed to work -- according to former Federal Reserve Chairman Alan Greenspan.
The late 1990s had seen a large technology-led boom that had employed millions of Americans and provided a forced draft that intensified the fire of economic growth. It was accompanied by "irrational exuberance" in the venture capital and stock markets, as investors began to think not just that technological progress in information technology was rapid but that it would be easy for the companies they invested in to turn that technological progress into profits. The first half was true -- technological progress in America's Silicon Valley is still ensuing at an extraordinary rate: I just got a spam e-mail offering to sell me a four-gigabyte USB flash disk for $9.25. In 1987, I paid $900 for a 10-megabyte hard disk.