The housing market and the case for higher inflation targets

From a VoxEU column today, by me and Joshua Aizenman:

Might more inflation be good for the US and Europe? This column looks at the housing market in the US and argues that, with houses dropping in price, buyers are playing a waiting game. And as buyers keep delaying, the price drops further. Given the importance of property in many economies, the knock-on effects are severe. Yet one way to break this vicious cycle is with inflation.

The eloquent advocacy for moderate inflation at times of peril goes back to Irving Fisher’s seminal paper on the debt deflation:

“In summary, we find that: (1) economic changes include steady trends and unsteady occasional disturbances which act as starters for cyclical oscillations of innumerable kinds; (2) among the many occasional disturbances, are new opportunities to invest, especially because of new inventions; (3) these, with other causes, sometimes conspire to lead to a great volume of over-indebtedness; (4) this, in turn, leads to attempts to liquidate; (5) these, in turn, lead (unless counteracted by reflation) to falling prices or a swelling dollar; (6) the dollar may swell faster than the number of dollars owed shrinks; (7) in that case, liquidation does not really liquidate but actually aggravates the debts, and the depression grows worse instead of better, as indicated by all nine factors; (8) the ways out are either via laissez faire (bankruptcy) or scientific medication (reflation), and reflation might just as well have been applied in the first place.”
Fisher (1933)

This visionary paragraph remains fresh today, particularly at times when the global crisis showed the perils of debt deflation in the US from 2008, and in Europe from 2010. The residential housing market in the US is a prime example of the acidic power of housing deflation.

The key theoretical point is here:

The option-value approach to durable goods implies that housing price deflation and low sales are intertwined. When the odds for housing deflation remain high, households have the incentive to delay purchase, even if they have good access to financing. The zero bound on the nominal interest rate implies that low interest rates may not offset the exposure to capital losses due to expected housing deflation. This configuration may lead to a housing market trap – households engage in a waiting game, delay their purchase, and thereby induce yet faster housing deflation, probably provoking other households to delay their purchase. This in turn pushes more houses to be ‘underwater’, leading to more foreclosures, more fire sales, and so forth.
The social cost of degrading neighbourhoods, where deeper foreclosures reduce the value of other houses, is by now visible in the worst affected states in the US. These dynamics validate the notion of ‘fire-sale externalities’, as well as Fisher’s observation “liquidation does not really liquidate but actually aggravates the debts, and the depression grows worse instead of better.” The laissez faire bankruptcy way of dealing with housing adjustment turned out to be highly inefficient in the US residential market.
This leaves Fisher’s ‘reflation’ option as a viable policy to shorten the painful debt deflation in the US. The logic is simple – moderate inflation for several years would terminate at an earlier juncture the buyer’s ‘waiting game’ in the housing market. Once the deflationary dynamics end, the pent-up demand for houses will be released. The timing game will switch from waiting to ‘rush to buy’. Chances are that this will signal the end of the housing slump, and will invigorate construction.

Our argument applies to certain key countries within the Euro area as much or perhaps even more than it does to the United States. We consider in particular Spain, which as shown in Figure 3 of the VoxEU column has experienced less of an adjustment thus far.
aizenman3.gif

Figure 3: House prices in US and Spain. Source: BIS, Annual Review, 2011.

This argument augments the point that Jeffry Frieden and I have made in our Foreign Policy piece on conditional inflation targeting, and which we will expand upon in a forthcoming Milken Institute Review article. See also other proponents here.

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18 thoughts on “The housing market and the case for higher inflation targets

  1. Ricardo

    Joshua Aizenman wrote:
    The zero bound on the nominal interest rate implies that low interest rates may not offset the exposure to capital losses due to expected housing deflation. This configuration may lead to a housing market trap – households engage in a waiting game, delay their purchase, and thereby induce yet faster housing deflation, probably provoking other households to delay their purchase. This in turn pushes more houses to be ‘underwater’, leading to more foreclosures, more fire sales, and so forth.
    The “housing market trap” in Aizenman’s formulation requires that home purchasers act as speculators. It assumes that homes are purchased for the capital gain rather than as a place to live.
    Anyone who purchases a home looking for a capital gain makes a huge mistake. Homes as depreciable assets losing value over time. In the recent past home prices have increased but the increases were illusion caused by both monetary and fiscal intervention. The illusion revealed itself in 2008 and is still being manifest.
    Aizenman’s call for inflation is a call to recreate the illusion using the same logic as Krugman’s call for a real estate bubble before the 2008 crash.
    Aizenman also notes that “deflation” pushes homes ‘underwater’ and this leads to more foreclosures and fire sales. This is nonsense. If a home purchaser can service the mortage at the time of purchase the purchaser can service the mortgage even if the home is ‘underwater,’ unless there is a decline in income. There is no threat of foreclosure and no need for fire sales due to being ‘underwater.’
    Foreclosures and fire sales are due to changes in the homeowner’s income and their inability to service a loan. Inflation might allow a homeowner to refinance a home but that is assuming that the home can be financed at an interest rate lower than the current interest rate plus refinancing costs, which may or may not be the case.
    It appears that Aizenman assumes that inflation could be isolated to home prices, but then is that really inflation? If inflation, a general price rise, spreads throughout the economy the result would be that a portion of the home owners who are marginally servicing their mortgages would a find themselves forced to choose between paying inflated costs of necessities and making their mortgage payments. A general inflation would actually increase foreclosures and fire sales as these owners on the margin would be unable to service for both the inflation and their mortgage debt.
    This appears to be another example of aggregate analysis done at 10,000 ft. with a policy solution that would add more pain and suffering to the average person.

  2. dwb

    One argument that you often see regarding higher inflation is that it redistributes wealth from savers (really, debt holders) to borrowers. {I dont think with 8.1% unemployment we would get much inflation but lets take this for granted).
    I think that this argument is actually flawed. With so many underwater homes and high unemployment, there is a high propensity to default. Default is a de-facto redistribution of wealth. In fact, to the extent that the household then has lower housing (rental) payments, they have actually captured some gain by defaulting (the difference between the mortgage balance and the PV of the new lower rental payments).
    Mortgage equity withdraw is about 240 Bn per year right now on a stock of lets say 10.2 Tn (just home mortgages, based on fed flow of funds data). Which means that mortgages are already depreciating 2.2%/yr (normal delinquencies at full employment are about 2x normal, so back of the envelope, 1/2 that is “cyclical”).
    lowering cyclical unemployment actually prevents the redistribution thats going on at present (via cyclically-driven defaults, because 70% of underwater homeowners remain current – they generally pay as long as they can afford to).
    I realize that seems a little counterintuitive, but to the extent that a small amount of inflation actually prevents defaults, it actually prevents the wealth redistribution that is already occurring.

  3. aaron

    Building has also not kept up with population growth since the crisis. We’ve actually under-built.
    We have empty homes but somehow have a shortage of supply. The market not clearing is pushing up rents. But not alot of people seem to be willing to buy diffuse properties and take on renter risk.

  4. Steven Kopits

    Reinhart and Rogoff state something to the effect that these periods end with huge bouts of inflation and massive losses of output. (Not hard to be a Ron Paul fan, reading that book. Ideological inclination notwithstanding, “This Time is Different” should be essential reading for the Econbrowser reader.)
    In any event, we might get to an inflationary outcome after all.

  5. RebelEconomist

    Your conclusion is diammetrically wrong. If the authorities respond to post-bust falling house prices by creating inflation, they validate the “safe as houses” folk wisdom, and foster progressively bigger booms, until it becomes difficult to create as much inflation as required to bail out over-extended buyers even with near-zero interest rates. This creates a standoff of another kind, in which sellers hold out in the hope of renewed price rises and under no pressure from interest rate (opportunity) costs, while buyers fear ruin if they do extend themselves as much as necessary and high prices and low interest rates do indeed prove unsustainable. And such a standoff can go on and on, unlike house price deflation, which will eventually reach a point at which prices are so low that the risk of a period of mark-to-market loss is worth taking for the sake of getting on with life. If you want to see what a mess your policy proposal would create, just look at the UK.

  6. dwb

    RebelEconomist
    Thats just more Austrian liquidationist nonsense which shows that you have zero understanding of macroeconomics (booms do not create busts) or the housing market (prices nationwide have dropped 35%) nor the actual underlying causes (poor mortgage finance regulation).
    Here is a paper Beckworth posted on the impact of leaving the gold standard: despite the higher inflation, corporate debt prices went up because of reduced propensity to default.
    http://faculty.chicagobooth.edu/finance/papers/repudiation11.pdf
    as i posted above, a very clinical eye on the impact of inflation on defaults casts strong doubts on who actually benefits from a little inflation. counterintuitively, it can actually be net beneficial to debt holders by reducing the incentive to default (and default definitely redistributes wealth).

  7. Bruce Hall

    “Solve” one problem and create a myriad of others. Think payments on the national debt are difficult with practically zero interest rates? Try it when they go up to 6 or 7 percent. Sure, they were higher before, but the debt load wasn’t.
    And then it is only fair that those 1%-ers like the banks that lent money at low rates get screwed because of some artificially induced inflation.
    Why not skip all of the machinations and have the government declare a 2 for 1 split on the dollar? That gets inflation over with right away and we can all go happily on our way. Right?
    I’m thinking Weimar Republic. Nothing like inflation to solve all of your problems.

  8. Peter N

    One maybe crazy idea is to declare that all fixed rate mortgage rates over 4.5% are reduced to 4.5%. The lenders lose more on the interest rates, but they save on foreclosures and the cost of individual refinancing.
    You’d have to run the numbers, but if this raised prices a bit and reduced the default rate, it might be cheaper than what’s being done now. It’s certainly faster and more effective.

  9. RebelEconomist

    dwb / Peter N
    You may have a point that debt forgiveness reduces the risk of default sufficiently to make the debt worth more, but if that is the case, the lender should be prepared to do this themselves. If they do not, it would be better to ask why not – say because it is administratively complex – and solve that problem, instead of engineering an upward shift in prices generally to validate the price of a handful of misaligned asset prices.
    And even if you could show that it cost the economy less to inflate than to enforce defaults, I would still have my doubts, because of the effect on incentives. For example, what is the point of being a prudent lender if the authorities transform default losses against which you have careful protected yourself into a general inflationary haircut for all lenders?
    It is I think unfortunate that Andrew Mellon gave liquidation a bad name, by advocating the liquidation of even performing loans to farmers etc. What I would advocate is recognition and liquidation of loans with no foreseeable likelihood of recovery, and, in the case of house foreclosures, government intervention to cushion the effect on individual lenders and neighbourhoods.

  10. Buzzcut

    There has been a lot of inflation, just not in housing.
    I’m always looking to refi my mortgage, and rates right now are RIDICULOUS. How about a 30 year fixed for 3.75%? 5/1 ARM for 2.25%?
    But you need to look at the fine print. Those rates are from Wells Fargo, but they’re for 25% down! I’m going to go out on a limb here and say that, because of the deflation in housing, very few people have 25% equity in their homes. I know that it would be very difficult to prove that I do. I might be on the borderline of 25% if I had a very favorable appraiser.
    I suppose that you could pay PMI, but then my real monthly payment is not much lower than what I have now (which, by historical standards is very low, too).
    I guess after all Menzie wrote, I just don’t see how higher inflation gets transmitted into the housing market. I see how it goes into commodities, I see how it goes into currencies, I just don’t see how it goes into the “value” of my house.

  11. tj

    What are the mechanics of housing inflation given that 30 year fixed rate is in the 3′s?
    The ‘problem’ is that lenders have become responsible and now require 20% down.
    Ignoring today’s housing starts, the housing market seems to be improving.
    Scroll to the bottom of this page for a housing market snapshot.
    http://www.mortgagenewsdaily.com/mortgage_rates/

  12. Ricardo

    dwb wrote:
    Thats just more Austrian liquidationist nonsense which shows that you have zero understanding of macroeconomics (booms do not create busts) or the housing market (prices nationwide have dropped 35%) nor the actual underlying causes (poor mortgage finance regulation).
    dwb,
    What you proved by this comment is that you do not understand Austrian economics. Austrian economics does not say that the boom creates the bust. Austrian economics says that artificial stimulus creates an illusionary boom that Keynesians mistake as economic growth.
    The illusion actually misallocates resources by creating malinvestment. The artificial boom (bubble, if you will) is manifest in different sectors of the economy depending on how and where the stimulus enters the economy and how fiscal policy directs the flow.
    Our recent crisis is a perfect example. Fiscal policy errors focused stimulus into the credit markets especially housing and the FED monetary expansion facilitated the error by preventing offsetting declines in prices in other sectors. Home builders and speculators were fooled by the illusion and engaged in massive malinvestment.
    Once the illusion ran its course and became manifest, “deleveraging” of the malinvestment began and no amount of monetary stimulus could turn it around. FED monetary expansion simply pumped up excess bank reserves and the price of hard assets such as commodities and collectables.
    The boom and the bust are manifestations of government monetary and fiscal intervention errors. They do not cause by one another.
    If step outside your bias from academic brainwashing and think about this a little, I think it will help.

  13. dwb

    RebelEconomist

    the lender should be prepared to do this themselves. If they do not, it would be better to ask why not – say because it is administratively complex


    not just administratively complex, but also politically impossible. Various parties have been trying to get the GSEs to write down principal for 3+ years.
    As part of the private mortgage settlement for example, banks were supposed to use some to help homeowners, but states have taken the money to plug coffers instead. New York Times:

    “In Texas, $125 million went straight to the general fund. Missouri will use its $40 million to soften cuts to higher education. Indiana is spending more than half its allotment to pay energy bills for low-income families, while Virginia will use most of its $67 million to help revenue-starved local governments.
    Like California, some other states with outsize problems from the housing bust are spending the money for something other than homeowner relief. Georgia, where home prices are still falling, will use its $99 million to lure companies to the state. “


    Unfortunately, the very decentralized nature of the US means we have 50 different housing markets (laws), and several independent agencies to oversee them, and a dysfunctional congress where it takes 60 senators to pass a law.
    I agree that principal reduction / shared equity would be first best. For GSE mortgages, the Treasury and the FHFA housing regulator DeMarco have been fighting over this for 3 years. Don’t hold your breath.

    I would still have my doubts, because of the effect on incentives. For example, what is the point of being a prudent lender if the authorities transform default losses against which you have careful protected yourself


    you have to distinguish the types of risks lenders are pricing. cyclical unemployment and consequent mortgage delinquencies are far higher than “normal” for prime mortgages and far higher than the 1990 real estate bust. They are the worst since the 1930s. No lender insured themselves against that risk or priced it.
    Keep in mind: no one is advocating attempting to reduce unemployment below the natural rate. To the extent a small amount of inflation reduces cyclical unemployment, there has never been a case when reducing cyclical unemployment has been bad for savers or banks.

  14. random worker

    Amateur anecdote alert:
    I’ve been seriously in the market for 7 months now after spending a couple years observing. It is a very strange market. There are pockets where there is action but in general there is very little movement over time. Homes go “under contract” only to emerge back on the market a month or two later. You can see the spiral from price reductions to short sale to foreclosure on some. But others just hang out there 200, 300, 400 days or more – the owners unwilling to drop the price, the buyers unwilling to pay what they are asking. So for this scenario I think a little inflation might perk things up.
    Then there is the loan process. I have people falling all over themselves to lend me money. Because I dont need a loan!!! I have two relatives who are flat unable to refinance. Period. And wow it would help everyone out a ton if they could. I told the one she’s better off walking away. Banks are valuing all property at fire sale prices.
    I’m closing on a piece of undeveloped coastal land today in an all cash transaction. Try as I might I just could not find any reason to buy an existing home even though that’s what I set out to do. I might have been more help to the economy if the whole sector wasn’t so moribund.
    Regards.

  15. Steven Kopits

    By the way, the casual reading of the housing value chart above is that Spain still has a massive bubble in housing values.
    In other words, the country’s toast. As goes Greece, so goes Spain.

  16. Jeff

    This whole post is filled with dubious logic. If you carefully read Fisher’s article (and are not just looking for an historical authority to appeal to) you’ll see that the key point in his debt-recession is that liquidation can cause a general decline in the the price level–which can also decline for a host of other reasons. In the end deflation is deflation, regardless of the source and the debt-deflation story is just an interesting theory on how we get there.
    With that in mind and after a careful examination of the fact you’ll see that the obsession with a real estate caused recession does nothing with masking the real issues. If you look carefully at figure 3 you’ll see that housing prices started their declines around the beginning of 2006 and fell steadily for years. At yet this had little effect on broader economy. It wasn’t until Late 2008 that the economy really started showing signs of faltering. By then the housing index fell some 30%. After late 2008 it fell maybe another 8%. So Menzie is basically ignoring the first 30% drop and then trying to argue that an 8% drop in housing prices sent the economy in a tailspin. He tries to link the real an nominal with this real option story or this theory of neighborhood blight. Unemployment is not caused by people moving from purchasing to renting. Unemployment is not caused by blight. These tales are nothing more than a distraction that prevents one from getting to the heart of the matter.

  17. anon

    “Might more inflation be good for the US and Europe? This column looks at the housing market in the US and argues that, with houses dropping in price, buyers are playing a waiting game. And as buyers keep delaying, the price drops further. Given the importance of property in many economies, the knock-on effects are severe. Yet one way to break this vicious cycle is with inflation.”
    This effect is not confined to the real estate market: it is readily observable in other asset classes, such as equities. See Glasner D., The Fisher Effect under Deflationary Expectations. One could even argue that it is a special case of the so-called “liquidity trap”.

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