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House Prices and Income

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Wednesday, 08 September 2010 04:47

David Leonhardt has an interesting piece on house prices but ends up making a serious logical error. He argues that house prices typically keep pace with income, meaning that they have risen more rapidly than inflation. He bases this assessment on the fact that the portion of income that has been devoted to to housing has remained constant over roughly the last 80 years.

There is a logical problem in this analysis. In principle, the issue is the movement of a the price of a house of the same quality, not the amount that people actually spend on housing. If the price of a house of the same quality rises in step with income, and the share of income devoted to housing remains constant, then this logically implies (i.e. there is no way around the conclusion), that the quality of housing has not increased over this period.

This would mean that the homes that people are buying today are no bigger or better than the homes that people bought 80 years ago. This contradicts an enormous amount of data and common sense. It is unlikely that anyone would seriously argue this case. Therefore, we can conclude that house prices have not kept pace with income growth. 

Comments (18)Add Comment
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written by Wes, September 08, 2010 7:09
Housing is obviously overpriced. Traditional bubble dynamics were at work - belief in the greater fool who will buy it from you a few years down the line. The supply of greater fools eventually ran out... (Stock market, you are next.)
All this alphabet soup of programs and agencies designed to keep housing prices from falling further is worse than useless. Market should be allowed to clear, and sanity should return.
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written by Wes, September 08, 2010 7:44
Good article on the subject:
http://www.bloomberg.com/news/...nto.html
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written by Wes, September 08, 2010 7:48
Ooops... The link got chewed up (why?)
Anyway, I was referring to this:
Subprime 2.0 Is Coming Soon to Suburb Near You: Edward Pinto Bloomberg
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written by izzatzo, September 08, 2010 8:02
From the NYT article, this quote:

If you believe housing resembles a luxury good, then you’ll end up thinking house prices will rise nearly as fast as incomes in the long run and that houses today aren’t terribly overvalued. If housing is a staple, though, prices will rise more slowly — with general inflation, as food tends to.


By extension, this is the same argument used by the rich to justify trickle down economics. At any particular time, while some incomes (and house prices) are much higher than others, over time the high values exchange position with the low values. Therefore what appears to be wealth and income concentration among the same class is instead claimed available to anyone over time and diluted accordingly.

If house prices for a constant quality on average have not kept pace with income growth, then average savings as an asset value and therefore wealth, have declined. Because luxury houses of much higher quality exist within the distribution, they will be used instead to justify a trickle down effect on all houses and corresponding rising asset value.

The bubble was an exaggeration of this effect, successful because wealth income was seemingly expanding concurrent with the consumption of a luxury good.
Is Location a Luxury Good?
written by Bill, September 08, 2010 8:14
I agree 100% with your post.
Question: are there a small number of locations in the US that might rise in value in accordance with income and not just inflation? I'm referring primarily to the land component of value, and probably not to the hard construction costs.
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written by skeptonomist, September 08, 2010 9:04
Leonhardt's piece is somewhat bizarre in presenting house prices as either those of luxury goods or staples, while ignoring the role of houses as investment or speculation (though this is addressed indirectly in the quoted comments). Insofar as houses are an investment or speculation, their prices should be tied to inflation. Of course the demand is also dependent on interest rates, so the Fed can play a major role and it has gotten much more active since the late 60's.
Obviously the late bubble had nothing to do with the intrinsic value of houses or even land as consumer goods, it was a classic asset bubble, which can happen with any commodity (e.g. tulips).
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written by liberal, September 08, 2010 9:09
Bill wrote,
Question: are there a small number of locations in the US that might rise in value in accordance with income and not just inflation?


There's not a small number, but rather a large number. Most urban areas.

I'm referring primarily to the land component of value, and probably not to the hard construction costs.


Dean's a good guy, and helped me not lose my shirt in the dot com and housing bubbles, but like a lot of economists, he doesn't understand the economics of land: namely, that they're not making any more of it, so as you suggest, the value of land (at least in valuable, urban locations) will indeed be bid up with income.
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written by Matt, September 08, 2010 10:29
As liberal points out, the bigger failing of Leonhart is his failure to note the dynamics of the land market in this equation. "Housing" prices describe prices not only for the actual houses, but also the capitalized land rent. Without separating the land component out of the analysis, it's impossible to say anything intelligent about the house prices.
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written by nailey, September 08, 2010 10:32
Before I'd argue any point with "an Economist" I'd ask him why his peers don't demand our principal inflacement measurement be correlated to a population sampling AND how our Economy is EXPECTED to grow from a point that was absurdly inflated by years of leveraged gambling?
House Prices and Income
written by sherparick, September 08, 2010 10:54
Although not quite a logical error, but rather an error that humans are prone to is Leonhardts adoption of "either/or" analysis for determining whether houses are a luxury item or a staple. A house could be part staple, part luxury, with the luxury portion increasing as the price you are willing to pay for it increases.

The bigger problem that Leonhardt does is the excess supply generated by the boom will take addtional time to clear andn that as long as that supply exists, prices will trend lower.
A Flawed Argument
written by Ron Alley, September 08, 2010 11:31
Dean,

Your view puzzles me. You say:
There is a logical problem in this analysis. In principle, the issue is the movement of a the price of a house of the same quality, not the amount that people actually spend on housing.


There is a logical problem in this (ie, your) analysis. What do you mean by "same quality"? "Quality" is not independent of the judgment of the consumer at the time of purchase. Homes surely have increased in size. "Quality" is the determination that economists make. A consumer purchasing a home (whether in the 50's or the 00's) typically would define a "quality" home (with respect to size) as one that, as a minimum, is large enough to provide ample space to shelter each member of the family and his or her possessions. Consumers now have more possessions than they did in the mid 20th century. Consumers today today want larger homes to shelter those possessions. (I have glossed over other elements of "quality" such as electrical service, appliances etc. that also impact the cost of building a "quality" home.)

To make a fair statement about "quality" you must include a reference to the evolving consensus of consumers with respect to "quality". Economists frequently use the "quality" dodge as a tool to construct arguments that understate inflation. An example is the CPI.

I remain convinced that residential real estate should not be viewed as a "good" and is better understood as a personal service. The trend of the residential real estate to follow income is clearly understandable when one views homes a personal service. Similarly, the housing component of the financial bubble becomes more clear and understandable when one views homes as personal services. Consumers naturally tend to buy as much personal services as they as they are, or expect to be, able to afford. The change in consumer income level (as reflected in the paycheck as well as at the re-fi ATM) translated directly and immediately into the collective consensus of consumers on the "quality" of homes, and McMansions became ubiquitous and their builders grew to large, nationwide enterprises. The financial bubble inflated almost all economic activity not just housing.

The financial bubble may have affected housing more than other categories of goods and services, but you are incorrect to assert that the bubble we have experienced is a "housing bubble".

We have experienced a financial bubble and when that financial bubble collapsed employment, wages and wealth took staggering hits. Until we return to middle class income growth (which is not likely to be in the near future) we cannot expect to see an increase in home prices. Because sustained housing growth, like all personal service growth, requires both population growth and wage growth to be sustainable.
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written by diesel, September 08, 2010 12:00
Towards the end, Leonardt does break the package apart into land and building components and argues that the value of land may well, over time, track income while the an aged building obviously does not.

One more aspect to ponder is whether the problem is being considered from the perspective of a person whose job has seen its wages fall relative to those of a carpenter, electrician, plumber etc, or rise. Building trades are still at least partially unionized in some areas or states. Those whose jobs lost union protection over the last thirty years have seen their incomes lag their unionized building-trades buddies. For them home prices have risen relative to their income. Those in the professions whose income has accelerated relative to those of the building trades will see the price of a "basic" home as a smaller proportion of their income. They can well afford the luxury of a deluxe home, just as they buy a Lexus or BMW and not an Accord or Civic.

To continue the analogy, a Civic is, by any standard, a better car than a 70's Comet or Dart, though its cost is proportionally the same relative to median income. The law of diminishing returns would indicate that a Mercedes is not "worth" the extra money compared to a Civic, yet the wealthy buy them anyway because a car, like a home, is also a statement of status and rank. As Veblen has pointed out, to advertise one's wealth one must publicly demonstrate that one can throw away money on frivolous things, a role for which the merely utilitarian doesn't suffice. Bare bones i.e. "adequate housing", are for the lower orders. So, whether the cost of housing tracks income or inflation may depend upon which class you are looking at.
indeed....housing, health, same logic
written by pete, September 08, 2010 3:18
Health care is cheaper too, we just consume more....one might say it has a positive income elasticity....But of course, it is really investing in human capital, not consumption per se such as housing is.
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written by liberal, September 10, 2010 3:04
pete wrote,
Health care is cheaper too, we just consume more...


We consume more, but in terms of actual outcomes, it's not at all clear we're getting that much more for the increased cost.
Commonwealth
written by Jeffery Smith, September 11, 2010 1:27
Not only does our spending for land (including resources, EM spectrum, etc) drive the economy and business cycle, but our failure to recover this flow also creates class. Were we to recover rents, which are socially-generated values, we could lose counterproductive taxes. Were we to share rents, a la Alaska's oil dividend, we could lose addictive subsidies. Instead of working for the economy, finally the economy could work for us.
Quality of living
written by piglet, September 12, 2010 3:53
It would be odd if the share of income people are willing to spend on housing were to decline. After all, the quality of housing determines to a large extent our quality of living given how much time is spent at home and how many crucial activities are performed there. On the contrary, many people (this is true mainly for homeowners) are willing to spend most of their disposable income on making their home more comfortable.
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written by Mladen Adamovic, September 13, 2010 5:39
To figure out where in the world housing is unaffordable and prices might drop in the future, please see http://www.numbeo.com/property-investment/

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Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.

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