May 27, 2019

Thinking Clearly About Housing Affordability

Part One of Kevin Erdmann's Housing Affordability Series
Kevin Erdmann Visiting Fellow

The issue of housing affordability is one of increasing urgency. In the United States and much of the world, the transition to post-industrial economic development has stimulated a surge of demand for urban residency.

However, the US is somewhat unusual among these countries: unlike in other developed nations, US home prices declined sharply after 2007. The average home-price-to-income (“price/income”) ratio fell back to pre-boom levels before slowly beginning to recover again.  In other countries–like Canada, Australia, and the UK–home prices have remained elevated. This might seem like good news for the US, but, in fact, we have uniquely made our housing affordability problem worse.

Housing policies in the US focused on lowering home prices instead of rents. This is the incorrect measure to gauge housing affordability, and policies based on this improper metric have only exacerbated the problem.

This was the case with the Federal Reserve’s response to the housing bubble. In spite of the international character of this problem, the Fed was widely blamed for high home prices.  Transcripts of Fed meetings in 2006 show that they intended to slow down residential investment by hiking interest rates, and that they were generally pleased when they did.  Fed officials such as Richard Fisher publicly blamed Fed policy for the housing bubble and fretted that dropping rates would let speculators off the hook. 

At first, hiking interest rates mainly led to a decline in new home sales.  But eventually, home prices relented. In late 2007 and 2008, the economy crashed, unemployment shot up, and nominal incomes declined while home prices collapsed.

Following this slowdown, there were significant shifts in the American economy and the housing market that didn’t happen in other developed economies.  The private securitization market that had sprung to life in 2004 suddenly seized up in 2007.  The government-sponsored lenders, Fannie Mae and Freddie Mac, were taken into conservatorship in 2008 and have been managed by the federal government since then.

Lending also became much more tightly regulated in the new US market.  For instance, before and during the boom, about three-quarters of new mortgages had gone to borrowers with FICO scores below 760.  (The median FICO score is around 700.)  Since 2008, less than half of new mortgages have gone to those borrowers.  Homeownership rates within each age group below 65 years have fallen well below any levels seen in at least a half century.

Millions of families lost their homes through default and foreclosure.  Most of those defaults happened well after prices had collapsed and after lending had been tightened.  All of these developments happened to a much greater degree in the US than they did in the other major developed economies.

Why was the American experience so poor? One reason was a strong consensus that excessive borrowing pushed prices out of line. Collapsing prices, borrowing, and homebuilding, and eventually incomes and employment were not seen as signs of disarray, but rather returns to normalcy. 

This presumption litters the commentariat.  Here is a recent example from the Financial Times: “The 2008 crash itself didn’t destroy wealth, but rather revealed how much wealth had already been destroyed by poor decisions taken in the boom.”

Prices seemed out of line, so driving prices back down seemed correct.  In fact, during the last half of 2007, post-Fed meeting press releases explicitly referred to rapidly falling home prices as a “correction.”

But curiously, rents have not fallen.  Rent inflation had been persistently above general core inflation for the decade before the financial crisis.  And, since 2012, rents have again persistently risen faster than other prices.

Here is the core analytical error: housing affordability should be measured in terms of rent, but our understanding and policies have erroneously focused on price—to disastrous ends.  From monetary policy to credit policy to regulations on local development, responses to the housing bubble have consistently and explicitly aimed for less residential investment, fewer buyers, and fewer homes.  Limiting the supply of homes has had a predictable effect of increasing rents.

In other words, the problem of affordability, in terms of price, was “solved” after 2007.  Affordability in terms of rent was not.  Understanding the difference between these two measures will be an important factor in correcting the policy errors that led to the crisis and creating better, more equitable, more stable economic outcomes in the future.

I argue in my book, Shut Out, that the housing collapse and the financial crisis were not inevitable.  They weren’t even useful.  In fact, their very purpose was mistaken.  The fundamental measure for housing affordability is rent, not price.  And, trying to bring down prices instead of bringing down rents inevitably will fail on its own terms.  In the long run, prices will be determined by rents anyway.

This series of essays will engage with various influences on price and rent.  Taxation, lending, building costs, and regulations all affect price and rent.  Understanding these effects is essential to understanding how to equitably create access to reasonable shelter for all Americans.

The first step to thinking through these effects is to consider the separate roles of financiers, landlords, and tenants.  Sometimes, a single individual or family will simultaneously play all three roles. Homeowners are, at least in part, playing all three roles.  Housing affordability really only applies to one role – the role of the tenant.  How much does it cost to put a roof over my family’s heads today?

Thinking clearly about these roles is the first step toward thinking clearly about what constitutes affordable housing.  The next few posts will consider the various roles households play in the provision and consumption of housing.

Photo credit: U.S. Air Force photo/Carole Chiles Fuller

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