Jan 28, 2019

Were We All Wrong about the Great Recession?

A Macro Musings Transcript
David Beckworth Senior Research Fellow

David Beckworth: Our guest today is Kevin Erdmann. Kevin is the author of a new book titled [Shut Out: How a Housing Shortage Caused the Great Recession and Crippled our Economy] He joins us today to discuss his new book. Kevin, welcome to the show.

While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to macromusings@mercatus.gmu.edu.

Kevin Erdmann: Hi, David. It’s great to be here. 

David Beckworth: All right. Well, fun to have you on. You've got a very provocative new book that's going to reshape the narrative. At least that's your hope and your dream. 

Kevin Erdmann: Yes. Yeah. 

David Beckworth: You're going to change our views and you're here to convince myself and our listeners today that our views about the housing recession are wrong in many ways and you're going to fix them. But before we get into the book, tell me, how did you actually get interested in this topic and what led you to write the book? 

Kevin Erdmann: Yeah. You know, this whole project has been sort of an accident. It's been really a three year process at this point and my first sort of baby steps into it was I was just sort of managing personal investments and whatnot and doing independent research and had some ideas about the home builder market, maybe some tactical investments you could make there back in like 2014, 2015. The original dream of the idea was that oh, there's been this been decline in home ownership, there's probably sort of a regime shift in the market from a homeowner price point to a landlord price point, that as that reverses maybe there were some tactical gains to be made there. 

Kevin Erdmann: So, my original sort of ways of looking at it was, okay, you know, there's going to be some bounce back but since we had all this excess in 2004 and 2005, I need to sort of look at the data and figure out how much of that pendulum swing was just going back to neutral? How much has been an over swing? Just for personal investment strategies. So, I would go look at say, the Survey of Consumer Finance or, you know, any sort of data like that since it's data on home building. So, like Survey of Consumer Finance, I go look and there's nothing. There was no pendulum swing. There was never a shift downward in home buyer incomes or FICO scores. All those measures were pretty level throughout the boom. 

Kevin Erdmann: So, you know, for I don't know six months or a year while I originally maybe planned on spending a month on this and then figuring out what I wanted to do in the market and go from there, but every time I'd look at a new piece of data it would be nothing. There'd be nothing there that was supposed to be there. So, for a long time every few days I'd come down to dinner and tell my wife, "You won't believe this, but home ownership rates were declining during the subprime boom. Isn't that a crazy thing? You know, that doesn't make any sense right?" 

David Beckworth: So, was your wife engaging on this because ... You know, I may get in trouble saying this but I can't always get my wife to get excited about nominal GDP targeting and safe asset problems. Are you telling me your wife really is like, "Really dear?"  

Kevin Erdmann: Well, I think it's sort of come back to bite. She originally had suggested blogging things and by this time I was blogging these ideas. 

David Beckworth: Yeah. 

Kevin Erdmann: So, her original idea was, "He'll tell his blog readers about it and stop bothering me about it." 

David Beckworth: Okay. 

Kevin Erdmann: But eventually it sort of ended up being now I'm in this three year obsession and now she has to hear about it anyway, right? 

David Beckworth: Okay. So, she tolerates you. 

Kevin Erdmann: Yeah. 

David Beckworth: In your ... Okay. 

Kevin Erdmann: Yeah. 

David Beckworth: But continue your story. 

Kevin Erdmann: Yeah, so you know, it was a sort of accident. It was, you know, just this process. Every time I would look at the data, everything was backwards or just non existent from the premises that all the different people arguing about what happened, agreed on these premises and the premises aren't anywhere in the data. 

Kevin Erdmann: So, eventually it just became ... You know, it sort of just ... I accidentally took baby step, baby step, baby step and a year into it here I am with this big pile of data and you know, starting to form a new way of looking at the framework of it and so, you know, at that point I was like, well, I guess this is ... Why am I the guy that found this, right? But here I am, so I guess this is what I'm doing now. 

David Beckworth: Okay. Now, also to complete the story. Scott Sumner, my colleague, my boss here and many of our listeners know, the author of The Money Illusion, he started reading your blog, right? Or posting good riddance. 

Kevin Erdmann: Yes. Yes. 

David Beckworth: Somehow he found you and he found that interesting and then he asked you to write a book about this. Is that how it went or did it go differently? 

Kevin Erdmann: Well, I'd say the book idea sort of ... There was a long time reader of the blog that was supportive of it and sort of encouraged me ... 

David Beckworth: Okay. 

Kevin Erdmann: …to come to Mercatus. 

David Beckworth: Okay. 

Kevin Erdmann: But Scott and I and Tyler had sort of a pre-existing relationship from the blogosphere, right? 

David Beckworth: Okay. 

Kevin Erdmann: Really this whole thing. You know, none of this could've happened before the blogosphere, before ... You know, that I could sit in my loft in my pajamas and download census data, right? Really, that pre-existing relationship had a lot to do with it. You know, that the Market Monetarist sort of idea that there was a recession that came out of Fed policy decisions that was separate from the housing bubble I think sort of was an intellectual foundation that I was standing ... You know, that all made sense to me. So, sort of intellectually I was open to the idea that the story was a little bit different. 

Kevin Erdmann: Then I think just coming from that sort of tactical investor point of view that I had of sort of a trust but verify viewpoint toward efficient markets, I think sort of gave me sort of permission to ... You know, in effect I was approaching this market in the same way I would approach what you would normally only find in a little illiquid micro cap stock where people's perceptions were wrong and you could find mispricing's but when you're doing that, when you're engaged in that sort of work, you have to be very disciplined and 99% of the stuff going on you assume is efficient and you find the little things that look efficient, inefficient but then you have to be very disciplined about, "Look, most of the things that look inefficient really are efficient and it's me that's wrong." Right? That's sort of the process I took down this pathway of, "Okay, that's where the perceptions seem wrong but I really need to confirm this" and I've spend three years trying to prove myself wrong and here I am. You know, I couldn't. I couldn't. 

David Beckworth: Now you have a book called [Shut Out] and how it really was a story of housing shortage that drove the boom and even what we see today. Really what's interesting about your book is it kind of weaves together, and we'll come back to this in more detail, but it weaves together a lot of the discussions today about NIMBYism, the shortage of housing in urban areas. But what your book does, it shows that this story that people are paying attention to today was really part of the story back then as well. But let's go ahead and get into your book and let's begin by kind of getting the executive summary from you and then we'll work out some of the details. But give us the overview of your argument. 

Kevin Erdmann: Yeah. So, what I would say is that, you know, there's this housing shortage problem. You know, I'd say writ large it's basically short of we're in like this new epoch. We're in this new era where there's a new wave of urbanization that's really required just by the state of technology, the state of culture, the state of the economy today. There's, you know, this new post-industrial non-manufacturing based, service-based economy and so at the core of that are the sort of innovative workers in tech fields and finance and they're centered in trade so they're centered in New York City and Boston and San Francisco and LA, and you know, you can say the same thing internationally. There's London and Sydney. You know, all these cities are sort of dealing with this immovable force and unstoppable ... Or what is it? Unstoppable force and immovable object ... 

David Beckworth: Right. 

Kevin Erdmann: …Problem where these cities suddenly have this tremendous value for those workers. They need to be close to one another to be involved in skunkworks and relationship building and politically we've evolved to a position where locals have so much control over what happens in the rest of the city that we're not building tenements in Manhattan anymore. So, that was probably a swing too far in a direction by today's standards in terms of building, you know, housing that was unhealthy or whatever but the pendulum has sort of swung far in the other direction today at a time where urbanization is really valuable. 

Kevin Erdmann: So, the innovation workers are probably the core of that, but the second part of that is this service economy that sort of comes along for the ride there. You know, so we have this problem throughout the country of people who have say, lost their jobs in the manufacturing sector and a lot of labor immobility that comes from that or that's sort of making that problem worse, right? So, workers are sort of stuck in cities with high unemployment and they're not moving toward places that have more opportunity. Well, the reason that's ... What I think I've found is the reason that that's not happening, and I think there's a lot of agreement and understanding about this, is that they can't move to those cities. You know? Where they would move is they would move to Manhattan or to San Francisco and be a barista or a nurse or a teacher or something, serving these core labor pools of the innovative workers that are sort of the income source in those cities. Right? They're sort of [shut out]. You know, the title of the book, the working title of the book, [Shut Out]. Those service sector workers can't ... 

David Beckworth: They can't afford to move there ... 

Kevin Erdmann: Exactly. 

David Beckworth: Because of the limited supply of housing. 

Kevin Erdmann: Yeah. We call those the non-tradable sectors. Right? 

David Beckworth: Right. 

Kevin Erdmann: You know, by definition those are jobs that have to be close to their customer. That's what keeps them from being bid away to other markets. 

David Beckworth: Right. 

Kevin Erdmann: These local housing policies are the source of obstruction that keeps that transition from happening. Now, I think what ... You know, I think in today's context there's sort of a broad agreement that that's happening. I think the data I found basically says, "Well, you know, everyone seems to also agree that we had millions too many homes in 2005." Well, that's just sort of a weird thing to have to tack onto this problem that we have today, that there's not enough housing and that's the obstruction. 

David Beckworth: Right. 

Kevin Erdmann: So, what I found is there actually has never been too much housing. All along our problem has been a lack of housing, especially in those particular cities. So, once we remove that, to me it's sort of a virus in the national conversation, we remove that virus and then everything makes more sense. Everything actually becomes much more coherent in terms of thinking about the problems that are keeping the economy from being more vibrant over a couple of decades. 

Kevin Erdmann: So, we looked back at say, 2005 ... You know, so Ben Bernanke in 2006, his first meeting at the Fed, he comes away ... You know, in his memoir he talks about how they felt like it was a successful meeting because they'd finally raised interest rates enough to start to sort of pull down residential investment because we had this overhang of supply that everyone thought we had. Well, the year leading up to that meeting, there were probably ... I don't have the numbers off the top of my head but probably 300,000 ... 200,000, 300,000 households that were piling out of those cities, out of New York City, Boston, San Francisco and LA. The cities with the highest income potential in the country. You know, cities that are the sinners of kind of the new prosperity. Hundreds of thousands of households were moving out of those cities for lack of a house. Right? 

Kevin Erdmann: So, they were sort of moving into second best alternatives in other cities but their problem wasn't too much housing. Right? In fact, we'll get into the details later I'm sure, but even in cities like Phoenix at that time, there weren't too many houses when you really look at the details of what's happening. Five or six years later Bernanke is still saying, "You know, well the economic recovery is still moving a little slow because we're still just working off this overhang of supply." So, this sort of ... The mythology that we had too many houses sort of muddied our public policy decisions. It really has been for a decade. You know, we really had a shortage of housing. We've been managing the economy as if we had a surplus and you could imagine how just that mistake itself, when you follow it through one policy decision after another, could itself lead to a crisis situation. Right? 

David Beckworth: Right. 

Kevin Erdmann: This is a huge asset class that we're treating in an upside down, sort of bizarre ... 

David Beckworth: For most people it is the main asset class. 

Kevin Erdmann: Yes. 

David Beckworth: Right? 

Kevin Erdmann: Yes. Yeah, yeah. 

David Beckworth: I mean, for better for worse, housing does make up most of our asset side of household balance sheets. 

Kevin Erdmann: Just to follow up on that ... So, in terms of data, you know, like just one of the basic things that I've looked at is, say, just housing units. You know, these are basic. This is not buried in the bowels of the BEA or the BLS or something. Just go to the Census Bureau and look at housing units per adult or housing units per capita. There was a rise in those measures through, say, the seventies and eighties as household reorganization was sort of happening culturally, but those have been fairly level measures from ... 

David Beckworth: Yeah. So, that's what I want to get into with you now, is the metrics that you present. Your book has a lot of them. So, we'll touch on just a few. But that's ... Kind of your argument is that there was actually a shortage of housing that led to a number of bad policy decisions, misunderstanding that ultimately led us to a great recession and even since then, that the response that's been given has been inadequate. But let's kind of build your argument up for our listeners and let's begin with the one you've just touched on. You know, this is ... You're kind of contesting the claim that there was a supply overhang. So, you go through a number of measures that do this. So, let's work through them. Let's start with housing units per capita or number of homes I guess, or housing stock per person. You mentioned, just mentioned actually that it had been going up in the eighties pretty sharply, right? 

Kevin Erdmann: Yes. 

David Beckworth: And the early to mid 2000's really was an exceptional ... 

Kevin Erdmann: There's a little bit of a rise but there had been quite a bit of a decline during the ... You know, housing starts compared to historical standards were pretty tame through the nineties, so there'd actually been sort of a slow decline. So, we've sort of made up some of that ground. I think partly what led people off the track there is that we tended to concentrate, it seemed like the bubbles in single family housing and that was a lot of the focus. Right? So, the idea was that there was this excess of lending into that market and so whenever you'd see charts and graphs or whatever, it would be single family homes built for sale and that, you know, made ... It was, you know, probably more than 50% growth over a few years in that category and it looks like ... 

David Beckworth: Right. 

Kevin Erdmann: You know, prices are raising at the same time. That looks crazy. It looks like that's ... All these measures, they looked at first glance as if it was ... How could it be anything but a demand bubble? You've got quantity and price going up at the same time. 

David Beckworth: Moving at the same time. Yeah. 

Kevin Erdmann: But over that entire period, you know, there's manufactured homes, there's multiunit housing, there's homes built by owners or homes built by contractors for individuals. There's a lot of kind of ... There's five or six major conduits of new housing units. Most of that growth in single family homes was just market share shift from those other units. So, when you add up all those other units and especially manufactured homes of which don't ... You know, you have to sort of grab from ... 

David Beckworth: What is a manufactured home? 

Kevin Erdmann: So, you know, they're sort of ... You know, you could have anything from say, a park model or something that's more like ... You know, building off the recreational vehicle category, toward like more just factory constructed homes that are ... 

David Beckworth: Pre-fabricated. 

Kevin Erdmann: Pre-fabricated and brought to the site and made into a permanent location. 

David Beckworth: Okay. 

Kevin Erdmann: You know, so there's a couple different categories there and they're sort of tracked separately by the Census Bureau. 

David Beckworth: Okay. 

Kevin Erdmann: So, you have to sort of ... To really get the total number of units you have to sort of grab these two different ... 

David Beckworth: Yeah. 

Kevin Erdmann: Yeah. When you add them all together, you know, there's really nothing during that boom period in 2002-2005. We were slightly over the the long term average. In fact, you could even ... If you measure it say, at a per capita basis or something, we didn't really ever ... 

David Beckworth: Yeah, so on a per capita basis it's very clear that there's at most like a little bump. In fact, though, I would describe it, looking at your figures, housing stock per capita, per person, there's a little bump on a road that's going downhill. 

Kevin Erdmann: Yeah. 

David Beckworth: I mean, there's actually a ... 

Kevin Erdmann: Yeah, yeah. 

David Beckworth: The recent few decades has been a decline relative to the eighties. 

Kevin Erdmann: Yeah. 

David Beckworth: But then what you're ... I think the second point you're making here is even if you just look at the absolute number of housing starts, if you don't divide by population, what the mistake was, and I'm guilty of this too, is that we looked at housing starts for single family homes. Even, you know, you're watching CNBC, watching some news channel, the picture they throw up is an individual home. 

Kevin Erdmann: Yeah. 

David Beckworth: The kind of home like I live in. 

Kevin Erdmann: Yeah, yeah. 

David Beckworth: You know, they put that up and you identify. You don't think of like condos, apartments. You know, you're not thinking of multifamily and these other ... So, your point is if you add up all the housing, and I went and looked on FRED and you're absolutely right and your charts show this too, that it really wasn't that unusual, which is kind of, you know, like a mind blowing moment. I had to do a re-take on this of like, "Did Kevin get these numbers right?" 

David Beckworth: But no, one question I had about your housing units per capita was the 1980's. It's a pretty stark change in the trajectory. There's a huge increase in the eighties in the number of homes per person built. One question I had, I was wondering if maybe that's tied to the baby boom or are we past that period? 

Kevin Erdmann: Well, I don't think it's so much the baby ... I think that that shift in the eighties probably had more to do with falling household size ... 

David Beckworth: Oh, okay. 

Kevin Erdmann: Sort of that ... I mean, it had to do with the baby boomer lifestyle change. Right? The divorce rates rose, right, for that period of time. There was sort of more ... 

David Beckworth: Oh, okay. 

Kevin Erdmann: …Maybe single head of household, households. That sort of thing. So, the number of adults per household has been declining and it was probably a pretty strong factor at that point. 

David Beckworth: Okay. Okay. 

Kevin Erdmann: Yeah. So, that's ... 

David Beckworth: Yeah, actually, the more I think about it, the baby boomers would've been several decades before probably in the sixties and seventies when they bought their first homes. 

Kevin Erdmann: Well, they were probably in the market as first time buyers at that time. 

David Beckworth: Some of them then, okay. 

Kevin Erdmann: But, you know, that's why I kind of like the households per adult measure better for that reason because it sort of factors in that but just the number of adults data is a little messier than the population data. So, I like to use both to sort of show… 

David Beckworth: That's right. You did show both in the graph. 

Kevin Erdmann: Yeah. 

David Beckworth: Okay. All right. So, we have these measures that show there wasn't a boom in the quantity relative to population and even in the absolute number. You also show the amount of expenditures in housing or on housing adjusted for inflation and that similarly does not show some kind of alarming growth. Right? 

Kevin Erdmann: Yes. Yeah. Yeah, so that's one of the things ... You know, it's funny when you sort of look at all of this topic from a new framework and you read the other analysis on the housing market, there's a lot of sort of misplaced sort of gravitas overlaid on the analysis. You know, there's a lot of ... For some reason housing is treated as this sort of like nasty form of over consumption. You know, so one of the things that I've looked at ... You know, we really have… there's sort of the education, health care, housing trifecta that's like the three sort of sectors eating the economy. Right? 

David Beckworth: Right. 

Kevin Erdmann: The funny thing is, housing is very sensitive to income. Like over decades in nominal terms, households have ... In terms of rental value households have spent, you know, in GDP I think it's maybe like around 12 percent or something of GDP. You know, if you look at income data it's maybe more like 18 percent but since the say, late seventies to today, that portion of spending is flat in rental terms. Right? 

David Beckworth: Right. 

Kevin Erdmann: But education and health care have, you know, shot up to ... You know, they're taking more and more of our incomes every year. Right? But for some reason when people think about housing they think about keeping up with the Jones's, people are buying houses that are more than what they need and we have this ... 

David Beckworth: The “McMansions”. 

Kevin Erdmann: Yeah. Yeah, we have this like judgmental idea about it but actually for the last 30 years Americans in the aggregate have been ratcheting down their real housing consumption because the rent inflation has been high. Right? So, out of those three categories it's actually the one category that's sort of tethered to ... You know, that we're naturally unwinding our real consumption as a sort of compensation for these other costs. Yeah, so over that period of time, you know, since the mid-eighties, real ... If you compare real consumption of housing in terms of rental value, which I ... To sort of back up a little bit, I think that's one of the really important sort of foundations of looking at all this coherently is to not confuse price and rent. I think rent, we need to reorient ourselves in this sort of analysis towards rent as being the cost of the service of housing. The thing that we build everything else on. Price is more like the price of a bond. It's more like, you know, the decision of allocating capital in a certain way. You know, a lot of the ... 30 percent or 40 percent of the households in the country are renters. The price of their unit is insignificant to them. 

Kevin Erdmann: So, in this BEA data, we're looking at it as in terms of the rental value of the housing stock and since the eighties, every year households ... You know, their real incomes go up two or three percent but their real consumption of housing only goes up one or two percent but then they have an extra percent of rent inflation every year because that's focused in these cities. It's focused in New York City and Boston and San Francisco and LA. So, yeah, in real terms we've been cutting back on housing. We haven't been keeping up with the Jones's at all. In fact, what we're trying to do ... What Americans are trying to do in the aggregate is keep up with the Jones' incomes and the way to keep up with the Jones' incomes is to bid your way into LA or San Francisco and all that income goes to the landlord. 

David Beckworth: Yeah. So, you know, to answer your question why do we think we're keeping up with the Jones's, I mean, part of it is because there is this perception, a wrong perception, which is what you're trying to argue, that housing is ... You know, that these bubbles have occurred and again, your point is more of a supply side constraint. 

Kevin Erdmann: Yeah. 

David Beckworth: And that housing really ... I mean, the last point you just made, housing, to the extent it matters, is really a symptom of the deeper underlying problem. This is, you know, the desire to move to a city to get the income but these cities have problems and that's a nice transition into the next part of your work and that is the closed access problem. So, you mentioned New York City, Los Angeles, Boston and San Francisco as the key cities that have this problem. You call them closed access cities. So, tell us about that. What makes them a closed access city? 

Kevin Erdmann: Yeah. So, they have ... You know, if you're casting a wider net you could throw San Diego in there probably, but it's, you know, a little bit ... You know, these four cities are really 95 percent of the issue in terms of the aggregate total value or the aggregate. Eventually if you cast the net wide enough I think Honolulu sort of falls in the ... Has some the same signatures, but every other city in the country, even Seattle and Washington managed to build more than the average number of housing units in their metro areas, and so they don't have these signatures. 

Kevin Erdmann: So, the thing that makes those cities different is, you know, across the board they have much lower rates of housing starts than the average city. You know, really what's happened is, if you think of the drag this puts on an economy, the natural historical sort of moderating feature of a free economy is that migration of jobs and labor, right, to sort of moderate differences between regional areas and that was happening for decades and in a lot ways it's still happening in other parts of the country and other parts of the economy, but because these four cities have cut off, they have basically a cap on their populations in effect, they've actually reversed that flow. So, now we actually have a strong migration pattern of households with lower incomes who are in need of opportunity having to move out of those cities and households with higher incomes moving into those cities. 

Kevin Erdmann: So, what's been a century's long process of moderation has now turned into a process of inequality, of separation, of segregation. Right? By skill and income. So, in these cities you get this very distinct signature where their average incomes are very high and growing, housing starts are very low and then rent inflation every year just keeps ratcheting up and ratcheting up. So, a good portion of those high incomes is simply just routed through wages to the real estate ownership class. 

David Beckworth: So, it's a way of protecting the people who first were there who owned the real estate. It's kind of a rent seeking ... 

Kevin Erdmann: Yeah. Yeah. I mean, I think it sort of happens by accident. I think people, you know, every neighborhood ... 

David Beckworth: Right. 

Kevin Erdmann: …Has always sort of not wanted to change. 

David Beckworth: I mean, that's true for me. Right? I mean, I think all of us kind of naturally want to keep our neighborhood looking nice. 

Kevin Erdmann: Yeah. 

David Beckworth: I mean, it's easy to be critical about the NIMBYism, “not in my backyard” mentality, but I think all of us would be guilty ... It's rational as an individual but as a society collectively it's harmful. 

Kevin Erdmann: Yeah. Yeah. I think that's where, you know, that's the political dilemma, is how to sort of solve that community ... 

David Beckworth: Right. 

Kevin Erdmann: …You know, problem. So, I think it has to be solved. One of the things I go into in the book is sort of the North, Wallis, and Weingast idea of limited access orders versus open access orders. I think that's the real ... In terms of this part of the problem that's the real dilemma, is even they ... You know, they sort of lay out how universal access and free flow of labor and capital and all these things are important to an open society with abundance in economic growth and even they sort of say, "You know, we know what it looks like. We don't know how to make it." In a way, these cities have devolved back into a limited access order and so the local politics are all about getting your part of those rents, extracting your part of the rents and that can be by sort of having a monopoly on real estate ownership, that can be through rent controls so that you get to live in the $4,000 a month unit for only $1,000 a month. Right? So, in that context everyone feels like they have the moral authority to get their part of the fixed pie. 

David Beckworth: Right. 

Kevin Erdmann: And somehow collectively we all have to pull back from that and allow it to be open again, which means everybody sort of makes compromises for the sake of an open society, but how to do that is a tough nut to crack. 

David Beckworth: Yeah. What's interesting is that the problems in these cities are spilling over into other cities, so you got that same NIMBYism. We'll get to that in a minute, but I'd want to mention ... I mean, the point you're raising here is these cities represent kind of the hub of innovation, creative growth, the Enrico Moretti story about there's so much growth. In fact, he argued, and his co-authors, that if you could get full access, GDP would go up by a significant amount. 

Kevin Erdmann: Mm-hmm (affirmative). Yeah. 

David Beckworth: I mean, quite a large amount. The fact that we haven't been able to allow people to move there has really restricted the amount of growth we would otherwise have experienced in the U.S. economy. It might be part of the decline in economic dynamism. All right, so we have these closed access cities and you said you could nudge the definitions, the margins, but for sure we know New York City, Los Angeles, Boston, San Francisco are in the group. Maybe a few other cities. 

Kevin Erdmann: Yeah. Well, I'll tell you. I mean, it really is a significant category, like there's not a lot of gray area. 

David Beckworth: Okay. 

Kevin Erdmann: Seattle and Washington have sort of a bit of a high cost problem. They have some rent inflation but at least so far ... You know, we'll have to see how Seattle deals with it because really they're sort of dealing with the same pressures, but so far, Seattle for instance has built more units than the national average generally over time and they don't have that migration but you don't see low income households flooding out of Seattle to other cities like you see out of the California cities. 

Kevin Erdmann: I think what happens is that they maybe aren't capable of building enough new units to keep rent inflation from being above general inflation but they're able to build enough so that those households on the margin maybe have to move to a less convenient location or maybe a smaller unit but they can remain in the labor market, the Seattle labor market. They don't have to actually leave their entire life there behind. 

David Beckworth: Okay. 

Kevin Erdmann: So, there's a real distinct difference you can see in those four cities. 

David Beckworth: All right. So, those four cities are unique. Then, I don't think you used this term but, you know, the opposite would be an open access city. Right? 

Kevin Erdmann: Yeah. Yeah. 

David Beckworth: So, an open access city and they're very different. I mean, an open access city you have high housing starts or homes are being built, rents and prices are moderate. So, it's more elastic housing supply versus the closed access city you've got very few housing starts and rents and prices are high and inelastic housing supply. 

Kevin Erdmann: Yeah. Yeah. 

David Beckworth: So, the confusion arises, if I understand you correctly, is that we aggregate all these cities together and when we look at a national measure we see some housing starts going up, we see on average prices going up, but it's conflating these two different types of cities. Right? 

Kevin Erdmann: Yeah. Yeah. 

David Beckworth: So, the housing boom, the Shiller indexes, all those things are really kind of masking these very strong differences underneath the aggregate indicator. Is that right? 

Kevin Erdmann: Yeah. Yeah. So, I think that's sort of one of the things I did differently that sort of led to this new viewpoint, is if you look individually and treat each metropolitan area as sort of an individual economic zone that's going to have substitutions within that housing market, and so you sort of treat it as an entity and if you take, you know, say the top 50 metro areas and these closed access cities were outliers in terms of the price change, but if you look at rent, what happened is they were outliers in terms of rent. So, at the national level it looked like price to rent ratios were way out of whack and that was a sign that prices had become unmoored from rents, and so that looked like it was another piece of evidence that fed this credit supply view that credit was behind rising prices. Right? So, it would naturally have to retract but if you actually look at individual ... The difference between metropolitan areas, rent really explains everything. You know, they're outliers first in terms of rent and then where prices are high is where rents are high. I think there was a little bit of a regime shift. You know, up until the mid-nineties a city that had say, a temporary rise in rents might ... You know, you'd have mean reversion. Over time there was no sort of ... There weren't these outliers that developed. Right? 

Kevin Erdmann: So, before, say the mid-nineties, if a city sort of became an outlier in terms of rent, it would eventually move back toward the norm and prices at that time didn't reflect an expectation of future rising rents, but as we've entered this period of the immovable force and the unstop ... Or immovable object and unstoppable force where these cities, there's demand for urbanization and these cities won't accommodate it, part of what led to a little bit of that extra price rise in that '95 to 2005 era is now suddenly a San Francisco where the rent inflation for that period is above normal. Nobody's expecting that to revert to the mean. Right? So, now the price of a house in San Francisco not only reflects the rent inflation that's happened for a decade, but now it's almost like buying a growth stock versus a value stock. 

Kevin Erdmann: Now, that house is actually a rent hedge for the rent inflation that everybody knows is going to happen for the next decade. So, it created a little bit of an extra price boost in those cities. So, that's what moves the national price to rent ratio above a norm because there's these few locations where you have this more than one to one reaction. Right? 

David Beckworth: Also, is part of your story though the contagion city? So, your contagion cities are the cities you mentioned, where people moved from New York City from San Francisco because they were looking for cheaper housing but when they get to these cities, these cities are having a hard time keeping up with the influx of folks, so their prices also go up. 

Kevin Erdmann: Yeah. 

David Beckworth: There's also ... 

Kevin Erdmann: Yeah. Yeah. 

David Beckworth: So, when we look at the national indicators and see housing prices take off, the boom in the early to mid 2000's, it's because of the closed access cities, but is it also partly the result of the contagion cities? 

Kevin Erdmann: Yeah. Yeah. So, that's one of the things that I ended up doing. So, talking about these migration patterns and these housing start patterns, you really need ... Everybody is sort of lumped together, the "bubble cities," that includes the Florida cities and Arizona and Nevada and inland California, and sort of lump those together with a closed access city and it was just a bubble story. But in a lot of ways these are mirror images to one another and the closed access cities in terms of just total size are much larger than the LA and San Francisco and New York City are much larger than Phoenix plus Las Vegas plus Riverside, plus Tampa or Miami. So, firstly, just the closed access issue just in terms of absolute numbers is ... 

David Beckworth: By itself... 

Kevin Erdmann: …The largest part of the story. 

David Beckworth: Okay. Yeah. 

Kevin Erdmann: So, what I call the contagion cities, they're the mirror image because when you had these massive outflows of migration during the housing bubble from the closed access cities, what makes Florida and Arizona and Nevada and inland California different from the rest of the country isn't that they had a different credit market really. What makes them different is that they're catching the first wave of that out migration. They're the main net receivers of net migration out of the Atlantic northeast and out of the Pacific Coast. So, they were overwhelmed. 

Kevin Erdmann: For them it was a migration event, a refugee crisis really in a way. So, they were overwhelmed with new households that needed houses. Right? So, as part of that process, you know, say you have an oil boom that's happening, right, it's sort of the similar sort of story. When oil prices jumped to $120 a barrel or whatever, there's always this sort of part of the story that, "Oh, it's the speculators driving up prices." Right? People tend to want to blame speculation. Right? 

Kevin Erdmann: So, sort of the same thing happened in housing, like these other factors were actually creating this boom in those cities and when that sort of boom happens you're going to get a lot of activity. You're going to get a lot of people transitioning in and out of that market because the context has changed. You're going to get people speculating. You know, people that started out as a small time investor and had a quick 40 percent return on investment and they're re-upping into that market. So, you're going to have a lot of speculative activity that goes along with that but that doesn't do anything to tell you what the cause was. Right? That's always going to be there in any market where prices are rising, but when you look at the actual numbers of what was happening ... So, you're in a city like Phoenix, over the course of five or six years their housing permits went up probably 50 percent, at the same time their prices went up to something like 75 percent. Again, it's another thing where any reasonable person looking at that pair of indicators can say that's a demand issue, I know that now, now I can look at other things and know that this is a demand caused problem that's sort of part of the canon now. Like it's ... 

David Beckworth: Right. 

Kevin Erdmann: I don't have to question it. It's like gravity. If other evidence comes to me that contradicts that I can disregard it because this is ... I've decided that now. Right? But if you notice these migration flows, you know, over that time maybe it's 20,000, 25,000 extra units a year that were being built in Phoenix, there were 20,000 or 25,000 extra households moving from coastal California into Phoenix at the time. They were barely keeping up with the demand and the irony is, you know, if you're in Phoenix, it looks like speculation. It looks like you're ... You know, I live in Phoenix. We were laughing about the price of houses at the time and it probably ... You know, there probably were some unsustainable ... You know, you could truly call those cities bubbles in a way because there was probably some snap back that was going to happen but it wasn't a bubble at it's core caused by credit. It was a bubble caused by this mass migration event and the irony is on the margin those households moving in from LA were moving to Phoenix explicitly and clearly to reduce their housing consumption. 

Kevin Erdmann: So, one of the ... You know, I basically say even by 2005 when this migration event's happening in Phoenix looks like it's a bubble and everyone is convinced that this is speculative excess, it's actually a bubble. Again, I say this as a proud resident of Phoenix. It's a bubble. For those marginal buyers it's a bubble and an inferior good. Right? It's people ... It's similar to if ... 

David Beckworth: Second best solution. 

Kevin Erdmann: Yeah. Yeah. 

David Beckworth: Yes. 

Kevin Erdmann: So, it's like if we were a subsistence society, right, and there was a drought and the price of rice went up and everybody's consolidating into rice consumption, right, it's that ... Like that's not something that you tamped up. That's something you stimulate your way out of. Right? 

David Beckworth: Mm-hmm (affirmative). 

Kevin Erdmann: So, you know, you think of that, the family living in LA that they're moving out of a little 1,000 square foot condo that's renting for $3,000 a month, they might be moving into a 3,000 square foot house in Phoenix that's only $1,500 a month. Right? So, even though ... Again, it's like another sort of thing that leads us off the path. It looks like there's a lot of gyps and board and lumber and all sorts of things going to Phoenix, residential investment's actually increasing as a product of this migration. So, again, now residential investment confirms the excess story but that family that just built that 3,000 square foot house in Phoenix was actually making a tremendous downshift in their real housing consumption. 

David Beckworth: Okay. So, the story again is it starts in the closed access cities where there's supply restrictions. There's a boom. There's a sudden rise in prices during this period because they can't meet the demand for housing. That drives up the aggregate picture, but on top of that there's spillover into contagion cities, which also can't meet this demand. 

Kevin Erdmann: Mm-hmm (affirmative). 

David Beckworth: I like the way you frame it. They're refugees. Housing refugees. You know, this image of, "You know, we can't find any homes. Please, help us." You know, so California and Nevada, Arizona, Florida, they're open arms. You have a nice graph in your paper that shows migration flows for the closed access cities and the contagion cities and it's like the mirror image of each other. Right? 

Kevin Erdmann: Yeah. 

David Beckworth: It's a very striking graph. So, it's a very convincing story. Let me ask this question though. In the closed access cities, you know, there is this kind of a surge in prices during the early to mid-2000's. So, I was looking at the Shiller case index and there's kind of like a little bit of a surge. It's growing the whole time but is that surge atypical? I mean, is there a reason why it goes up as much as it does during the early to mid-2000's in those key cities? 

Kevin Erdmann: Mm-hmm (affirmative). Yeah. I mean, I think there is a credit aspect to the story here. So, you could see, especially like before the Fed starts raising rates in 2004 there's a brief period of time there where there the subprime boom was happening and the Alt-A was happening sort of starting at the end of 2003. That was especially happening in the California cities. So, during that period you can see a bit of a separation between the Boston, New York City type of market and the LA, San Francisco market and I think a lot of that can be attributed to that private securitization market, which was very heavy in California. 

Kevin Erdmann: So, I think there's a credit portion of the story there but I think the consensus or sort of the general view of the public on this has been that anyone with a pulse could get a mortgage. Right? That's the line you hear all the time. 

David Beckworth: Okay. 

Kevin Erdmann: Really, what was happening was a little bit more subtle. You know, these are markets where if you're a renter you're outside the norm. Right? The risk in those housing markets is inherent in the closed access problem. If you move to LA or San Francisco you're taking on housing risk, full stop. Period. It doesn't matter what you do to supply housing for yourself. You're in a high risk environment. 

David Beckworth: Yeah. 

Kevin Erdmann: So, you know, we don't have agencies in Washington writing rules that you can't spend more than 50% of your income on rent. Right? But we do have agencies that say you can't lend to somebody that's spending more than 40% or 50% on mortgage. Right? So, actually, I would say there was a dislocation in the market before the private securitization market ... 

David Beckworth: Okay. 

Kevin Erdmann: …That was actually keeping prices below what would be a reasonable level in those cities because we regulate one and don't regulate the other. In the data, what you really see happening in those cities is ... You know, it's implausible that households with low incomes that couldn't afford a mortgage could've had any significant effect on those markets. The very small portion of the LA and San Francisco market is owned by people with say, median and below incomes. 

David Beckworth: Right. 

Kevin Erdmann: And to the extent that they own homes, they bought them 20 years ago and they're sitting on capital gains. So, what you actually see happening is those sorts of the Alt-A loans were actually allowing high income households to make a rational decision for themselves between ... You know, they were basically buying those houses as a rent hedge. Now, they were probably spending 50% of their income on the mortgage payment, so documenting their income is not useful. You know, trying to get them into a loan with Fannie and Freddie is not useful, they're not going to meet conventional norms. 

Kevin Erdmann: So, the irony is, it was actually the most qualified borrowers that were feeding that closed access part of the story and then the out migration ... 

David Beckworth: The spillover effects.  

Kevin Erdmann: …Into those other cities is a little more messy. It's a combination of sort of tactical sellers and desperate renters looking to lower their expenses. So, that's a little messier situation but at the core it's credit to qualified borrowers and you can see this like in the Federal Reserve Survey of Consumer Finances toward the ... You know, in that 2004 to 2007 period there was a boost in what you would call, say distressed mortgages. Mortgages that require more than 40% of your income. The entire growth of that problem was in the top two income quintiles. It's because that was the story. It was those households bidding their way into those cities where ... 

David Beckworth: To the better markets. 

Kevin Erdmann: Yeah. Yeah. 

David Beckworth: Yeah. So, the key story again is in these closed access cities there's increased desire to live there because that's where the income growth is, that's where the Enrico Moretti story is being told, the creative class. So, it's a supply constraint. People want to move there but there aren't enough housing. Now, I guess my question would be does this desire to move there really come to a head during this period? I mean, the advent of the internet has really come to fruition after the tech boom, all that over investment in internet, technology, communication technology, so maybe there is this sudden spike in real demand for that kind of living. So, the credit story's just kind of maybe icing on the cake in those cities. 

Kevin Erdmann: Yeah. Yeah. It's sort of along for the ride. You know, I think there were some aspects of that private securitization market that like I said, probably boosted things in LA and San Francisco a little bit, but you know, Fannie and Freddie take a lot of heat for this period but they were highly countercyclical. They lost a lot of market share during that 2004 and 2005 period. So, there were a lot of things happening pushing prices higher and also pushing against prices. In fact, you know, this migration issue is one of the parts of that story. 

Kevin Erdmann: So, you know, one of the things that there's been a lot of focus on is sort of the housing ATM. You know, this idea that ... 

David Beckworth: Pulling equity out of the house. 

Kevin Erdmann: Yeah. Yeah. So, there's this idea that there's this bubble sort of process that prices rise and that encourages households to overspend and buy more and leverage up. So, of course there were some households that were utilizing their newfound home equity for spending. Some of that was definitely going on, although even on that topic I would say the reframing makes a big difference on how you look at that because if you look at it as this unsustainable credit bubble that's destined to collapse then that just looks like people consuming out of something that's fake, that's paper profits. Right? 

David Beckworth: Right. 

Kevin Erdmann: But if those houses are expensive because there's this persistent problem of supply that will continue ... You know, as of today a decade later the relative prices of houses in those cities is just as much above the rest of the country as it was then. So, it's certainly a persistent value in relative terms. 

David Beckworth: Well, housing's a good investment in these cities still. 

Kevin Erdmann: Well, I ... 

David Beckworth: You won't go there. Okay. 

Kevin Erdmann: Yeah. I mean, to me it's a political risk you're taking on. Right? 

David Beckworth: Yeah. 

Kevin Erdmann: But my point is switching our frame, just switching our mental framing of what happened, that this is a persistent issue and not a credit cycle event, even those say, low income households that happen to be homeowners that were using this event to spend out of home equity, effectively they're rentiers. Right? They have newfound wealth that's permanent, and especially the ones that sold their house and moved to Phoenix. That's permanent. Right? 

David Beckworth: Right. 

Kevin Erdmann: They're engaging in just natural consumption smoothing. They have newfound wealth, they'd like to spend some of it today as opposed to in the future because they're wealthier now as a result of it. There's nothing unsustainable about that. Right? Actually, for those new households ... You know, for the ones that sold and new households moved in and have these huge mortgage payments, for them that's not stimulative for them. They have these huge mortgage payments they have to make. The people that sold that home to them and moved to Phoenix or Denver or whatever, they stuck all that money into AAA securities or whatever or they saved it. Right? 

Kevin Erdmann: So, I think one of the aspects is sort of the focus was on all the demand side stuff. The focus was on the housing ATM, the unsustainable borrowing. One of the things we missed, you know, coming out of this migration pattern is in 2004 and 2005 a lot of that migration was tactical, was homeowners sitting in their house in 2004 and 2005, "You know, jeez, this thing's going for $1 million and a half, that's crazy." They may have even thought of it as a bubble but it doesn't really matter what they thought of it. They saw their house, they saw home equity as an unsafe asset class now. Right? So, they're transitioning their portfolio really in a way, out of that asset class. 

Kevin Erdmann: So, during that period there was about two percent a year in the closed access cities of net out migration of homeowners. That's a lot of selling pressure. Right? So, everyone's focused on all these ways that a bubble feeds on itself and sends prices higher, but you know, every year maybe ... I don't know, five or six percent of the housing stock may transact. Well, in those cities, there was a two percent selling pressure of people hiking out of town, taking their gains and getting out of town. That's a huge amount of actually mitigating downward pressure on prices. 

David Beckworth: Let me ask this question then. How does this come to a head when the so called bubble bursts? When things slow down. So, for example, in the contagion cities ... You talked about Phoenix in your paper quite a bit, you kind of zero in on it as a case study of sorts. Why does the migration to Phoenix slow down? If that's what's driving prices. Or what causes it to slow down? Was it the Fed raising interest rates? What was the shock that suddenly now people aren't wanting to move to Phoenix and the housing prices drop? 

Kevin Erdmann: Yeah. Yeah. So, you know, the conventional story is that Phoenix overbuilt, there were way too many houses, they were all bought by people that had no business, couldn't afford their mortgage and so they all started to default then those neighborhoods sort of were undermined and prices collapsed. The story really ... The data tells the opposite story. So, housing starts really ... One thing is that across the country in every city housing starts pretty much start to collapse at about the same time around early 2006, which is about when the Federal Reserve was reaching the highest rate level and the yield curve was inverting. 

Kevin Erdmann: So, whether it's Phoenix or Omaha or Los Angeles, housing starts were already collapsing then and prices stayed pretty level for 18 months or so up til sort of mid to late 2007 just about in every city. The interesting thing is ... So, in a city like Phoenix what you see is housing starts start to collapse. The other thing that happens is again, basically in just about every city in the country way back in 2006, as soon as housing starts start to collapse, rent inflation across the country shoots up. Right? 

Kevin Erdmann: Now, if we had an overabundance of housing and this was a natural process that's a strange thing to see happen. Right? It's a strange thing to see happen in every city at the same time but that's what we see. So, even in Phoenix where we thought there was an oversupply, rent inflation shoots up, housing starts start to decline and what you see is, is in the ... Well, backing up before that, that 2004 and 2005 period really, like I said, was these households basically seeing rate hikes coming, thinking of home equity as something unsafe, they're moving to Phoenix to get out of home equity. Eventually as that process unwinds and sentiment starts turning sour, now people start retracting. So, now that migration pattern starts to wind down even among renters. So, I think even by like 2006, by the end of 2006 especially, what you have are people that were migrating to lower costs now are saying, "You know, I'm getting a little nervous about the economy, we're going to stay in LA, we're going to put up with the rising rents because we're starting to feel nervous about the economy." 

David Beckworth: So, the migration wave came to an end. 

Kevin Erdmann: Yeah. 

David Beckworth: So, it was driving… 

Kevin Erdmann: Yeah. 

David Beckworth: Okay. 

Kevin Erdmann: So, by the end of 2007 what Phoenix lacks isn't tenants. Rent inflation is going high and tenancy vacancies were low in Phoenix until 2008. So, there's no sign in the vacancy. In fact, the funny thing is, in most cities there's never a sign of a vacancy issue in the housing stock. In the few cities that have it it's the contagion cities that had this mass migration of it and it suddenly dried up over a period of a couple years and it's only after the migration dries up that you see sort of that entire sort of local economy fall apart and then vacancy rates are a lagging issue. 

David Beckworth: Okay. So, the initial slow down ... Because, you know my narrative is in 2008 the Fed really made a mistake but the story begins before that because we know housing slows down beginning in 2006 and your story is that this migration wave came to a stop and it came to a stop because you said people's expectations were changing about what was going to happen to the prices. 

Kevin Erdmann: Yeah. 

David Beckworth: My question is, was that change in expectations driven by Fed policy or by something else? 

Kevin Erdmann: You know, I think there's a bit of an avalanche effect here. Right? 

David Beckworth: Okay. 

Kevin Erdmann: So, you know, by the time we get to late 2008 everything's big right? Everything's a crisis and fluctuations everywhere. The stuff that led to that, it starts small. Right? So, you start in spring of 2006 and the Federal Reserve is saying, "Oh good, we've caused residential investment to decline when we actually have a shortage of housing." That's a big mistake but we're still sort of within the boundaries of fixable errors. Right? 

Kevin Erdmann: So, we sort of move along with that idea for a while and then the Federal Reserve trying to sort of comfort everybody starts saying, "Well, you know, you don't have to worry everybody, we've sort of run the numbers and we've decided even if home prices decline by 10 percent or 20 percent the economy's going to be fine. So, don't worry about the housing bust, this is just a natural ... " You know, they used the word ... Even in their press releases they used to word correction, which I harp on a lot, in the follow up book, I harp on a lot like that root word correct. Like this was actually a dislocation and the way we were officially describing it was correct. Right? 

Kevin Erdmann: So, the upside down sort of nature of our policy responses is just clear in that verbiage. But think about the effect that has. So, thinking about that household around the dinner table in LA that says, "Okay, we're selling at the top of the bubble and we're moving to a less expensive city." You know, in financial terms they're having a conversation about ... "You know, we have a large portion of our portfolio in what we thought was a safe asset class, which is home equity and we don't consider that a safe asset class anymore. We're fleeing away from the home equity asset class because we don't trust it anymore." 

Kevin Erdmann: Now the Fed, thinking that they're making us feel more comfortable, says, "Yeah, that asset class could lose 20 percent of its value and we're not going to do a thing about it. We think that's correct. That's a correction." That only feeds the sense that the home equity asset class is unsafe and I think this goes to the topic you talk a lot about, of the safe asset shortage. Right? I think actually the first step of the safe asset shortage was this change in sentiment that sort of happened as rates were rising that suddenly this huge multi-trillion dollar asset class goes from being a safe asset to not being a safe asset. That actually ends up feeding this frenzy for AAA securities in the CDO market. 

Kevin Erdmann: So, at first it was sort of just a little tweak a little bit too far in just basic monetary management, but then there's this sort of sentiment side of it because everyone just assumed that prices were out of whack and so as housing starts were falling to levels that are very recessionary in any other context we thought, "Well, you know, we had too many houses. It's going to take a while for that to catch up." In the meantime we're sort of waiting like, you know, eventually prices are going to have to follow too. Well, the fact that for 18 months that collapse was happening and prices were pretty stable actually, to me, is sort of a confirmation that prices didn't need to fall. The fact that everyone sort of was waiting for that to happen before we could accommodate. 

Kevin Erdmann: You know, the general public conversation or even conversations at the fed at the time were, you know, "We probably should lower rates, but these speculators need to learn their lesson, they need to know that house prices go down sometimes.” Right? 

David Beckworth: So, the original error was that the fed raised rates too much early on, which began to raise questions in these homeowners minds and it kind of created a snowball effect and then by the time we get to 2008, which is the story that I usually tell and Scott Sumner would tell, was the Fed, you know, greatly amplified matters, made them worse. 

Kevin Erdmann: Yeah. 

David Beckworth: So, you would put the original sin back in 2006? 

Kevin Erdmann: I would. So, yeah. I would ... 

David Beckworth: Okay. 

Kevin Erdmann: Say. I mean, maybe I shouldn't say this out loud but, you know, the Market Monetarist view is sort of that the Fed caused the recession and it didn't have anything to do with the housing bust. I would say the Fed caused the housing bust, right, and then ... 

David Beckworth: Which then fed into a broader crisis. 

Kevin Erdmann: Yeah. Yeah, so ... But you know, even by late 2007 it was all very ... I think, you know, had they sort of kept rates a little lower in 2006, we would've never had, maybe never even had a recession and we would all be sitting here having a conversation today about whose fault it is that home prices are still so high ... 

David Beckworth: Yeah. 

Kevin Erdmann: And we would've taken for granted that we'd had nice good economic growth for the last 10 years and we'd be looking about who to blame for housing prices. 

David Beckworth: It'd be a very different world. 

Kevin Erdmann: Yeah. So, but you know, even by late 2007 that's all fixable but it would've taken a total ... The fed would've been pilloried for it. Right? The entire public would've been upset at them for letting speculators off the hook. 

David Beckworth: Right. Bailing out housing and people made bad decisions. 

Kevin Erdmann: Yeah, yeah. So, it's sort of a model risk thing. If your model's wrong, right, when the bust happens you take that as confirmation. You know, if your bubble says we have to have a contraction, that that's necessary, then when the contraction happens you take that as confirmation but the contraction was actually a result of model risk. We had the model wrong. 

David Beckworth: Yeah. So, in the time we have left just a couple of observations and a final question. My observation is your story, which seems fairly compelling and you present lots of data to support it and I encourage our listeners to get the book, but the observation I want to make is that this story of financial imbalances of excesses was simply wrong, I mean, we talked earlier about this really undermines the Austrian business cycle interpretation of the early to mid 2000's ... There's a bunch of malinvestment that occurred and this would say, "No, no, no. That completely wrong." But also just not even Austrian but just kind of this general narrative of these excesses, financial imbalances. What your analysis shows is that that's completely wrong, that this is really a supply side story, a misreading of the data. I think, you know, in addition to what you show for that period, seems to me and this is where my question comes in, that what we're talking about today is kind of confirmation of what you are saying happened back then. The fact that people on the left and the right are talking about zoning restrictions, NIMBYism, the lack of labor dynamism, the decline in labor mobility to these big high income earning cities is really just a continuation of this trend that you say actually was going on back then. 

Kevin Erdmann: Yeah. Yeah. 

David Beckworth: Okay. 

Kevin Erdmann: Yeah, so one of the things that I find in the data, for instance, is in inflation data at the peak of what we call the bubble in late 2005 ... So, you know, for the last 20 plus years rent inflation has been consistently above core inflation. So, most ... You know, a good part, maybe close to half of what's been measured, core inflation has been from shelter inflation. It was only toward the end of 2005 that shelter inflation and the non-shelter part of core inflation both sort of converged at 2 percent. So, at the top of what we were calling a bubble was actually the only period of time in the last 20 years that we actually achieved a sort of normalcy in the second best world where you can't build the houses that you'd like to have in the coastal metropolises, our second best alternative if we're going to have a vibrant, growing economy, whether it's nominal or real doesn't really matter. Any economic growth will lead to a bidding war to get access to the economic potential of those cities. 

Kevin Erdmann: So, you know, there's a lot of talk about the bubble economy and that's all put on the Fed, it's all put on the banks that they're feeding this bubble, all the assets are overpriced because they keep feeding a bubble. The source of the bubble is that there's an inevitable bidding war for assets that give you access to those cities and until we solve that problem that's the sign of actually an economy that's running normal in the second best state. So, what we've been doing is trying to avoid running an economy in the second best state because we're afraid of the bubble that's inevitable in that context. 

David Beckworth: So, we're running in the third best state. 

Kevin Erdmann: Yeah. Or fourth. 

David Beckworth: Or fourth, depends where … 

Kevin Erdmann: Yeah. So, you know, that urban housing problem is that ... You know, that's a tough nut to crack and I don't know how we do ... That's a complicated ... 

David Beckworth: That is the key problem though. 

Kevin Erdmann: That's the key problem but the easy thing that comes… Once you take this framework into mind, you know, if we can get a regime shift in the framework we use to see this period, the easy problem to solve is let's just stop beating ourselves up over it to avoid the signal of a bubble, you know, of a second best economy. 

David Beckworth: Right. 

Kevin Erdmann: You know, we see it. The funny thing is, all the conversations in the United States are sort of built on American exceptionalism in terms of the causes of these problems. The subprime crisis and banking deregulation and the GSEs, but the hilarious thing is, the countries most like us all around the country, Australia and Canada and Great Britain, you know, all these sort of other Anglosphere countries, they actually have more or less been running along in that second best economy. They avoided the deepest parts of the crisis. They didn't have as much of a rise in unemployment and the foreclosure crisis and they have "bubble economies" that people keep trying to blame on their local credit markets. Right? 

David Beckworth: Right. 

Kevin Erdmann: They're actually doing it right. If you can't fix the context of these …  

David Beckworth: Right. So, they are doing the best that can be done in a second best world where you have these supply side constraints. So, like you mentioned Australia, UK, all these places around the world that have "housing bubbles" are really just the fundamental response to a second best world. 

Kevin Erdmann: Yeah. 

David Beckworth: So, they all have to address this issue, this local housing supply issue. That's the ultimate solution, but you're right. So, you know, let me ... I'll just end on this note. I'm looking at right now in front of me a measure, a graph of global house prices in different countries and they all have these booms. A lot of them have them. New Zealand, Australia, Britain, Canada, and what's unique about United States is we're the only one that engineered a sustained decline in housing prices. 

Kevin Erdmann: Yeah. 

David Beckworth: So, we are exceptional. We are, you know, American exceptionalism. We are practicing it, but it's a problem that's more fundamental than monetary policy, than the credit excesses and all those things need to be done right but at the end of the day we need to address the housing supply issue. So, with that, our time is up. Our guest today has been Kevin Erdmann. Kevin, thank you so much for coming on the show. 

Kevin Erdmann: Yeah, thank you David. It's been a pleasure. 

David Beckworth: Macro Musings is produced by the Mercatus Center at George Mason University. If you haven't already, please subscribe via iTunes or your favorite podcast app and while you're there please consider rating us and leaving a review. This helps other thoughtful people like you find the podcast. Thanks for listening. 

Photo credit: Kemberly Groue/US Air Force

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