Lead Story… Pretty much any adult with a rudimentary degree of financial knowledge is aware of the impact that interest rates have on housing. Lower rates make monthly payments cheaper and higher rates make monthly payments more expensive on a relative basis. Since nearly all homes are financed, rates impact buyer demand and prices rise and fall accordingly.
What’s far less understood is the impact that housing costs have on interest rates. Let me explain: the cost of shelter is basically a necessary evil. Houses are not a particularly dynamic economic investment yet still represent the largest “asset” that most people own. Every dollar spent on housing is a dollar that is not recycled back into the economy via consumption or investment in growing businesses that create jobs. This means that excess dollars spent on housing are a drag on the economy, leading to lower growth and, in turn lower interest rates.
The conventional wisdom is that rising housing costs should lead to higher inflation. However, this has proven to not always be the case, especially in recent years. As housing (either renting or owning) becomes more expensive without incomes rising a commensurate amount, it causes capital to be diverted away from more productive parts of the economy. This effectively limits economic growth, slowing inflation and keeping interest rates lower than they would otherwise be. An interesting counterfactual to this is the run up to the housing crash in 2008. In the mid 2000s, the HELOC floodgates opened, and people were allowed to extract equity from their homes at record amounts. A large portion of that money found it’s way back into the economy via increased consumption which stimulated economic growth for a period of time and led to higher interest rates. Of course this was unsustainable and the economy came crashing down in a heap when the market turned, leaving a giant mess of negative equity.
Conor Dougherty of the NY Times touched upon the negative economic impact of high housing costs in a story late last week about the hypothetical economic benefit of falling home prices if the US were to suddenly adopt Tokyo’s development policies (emphasis mine):
So let’s carry on with this hypothetical. Say we opened the floodgate of development. What kind of effects could we expect? The economy would grow, and by a lot. According to a recent paper by the economists Chang-Tai Hsieh, from the University of Chicago’s Booth School of Business, and Enrico Moretti, from the University of California, Berkeley, local land-use regulations reduce the United States’ economic output by as much as $1.5 trillion a year, or about 10 percent lower than it could be.
That is a theoretical figure that includes easy-to-see things like increased sales of building materials and more jobs for construction workers. Most of the increase, however, would come from more abstract gains like increased wages for people who are willing to move from an economically distressed city to a faster-growing economy elsewhere, but are currently unable to because housing is too expensive.
That giant sucking sound that you hear $1.5 trillion a year that is swallowed up by housing costs, keeping it from making it to more productive parts of the economy. Dougherty continues (emphasis mine):
Moreover, it’s likely that lower home prices would encourage workers to move farther and more often in search of job opportunities. The impact on mobility could be huge, as the $1.5 trillion figure shows.
There was a time, a few decades ago, when the cost of living did not vary all that much from city to city. Since then, as places like New York, San Francisco and Seattle have been hit with skyrocketing rents and home prices, the regional disparity in housing costs has altered how Americans of different incomes pursue opportunity.
Back when home prices were more even from place to place, people with different levels of education and income tended to flock to the same types of high-wage places, according to research by Daniel Shoag, a professor of public policy at Harvard, and Peter Ganong of the University of Chicago.
Today, people with less education tend to go where housing is cheap, like Las Vegas, while college-educated workers with skills that are in demand still go to places where wages are high, like the Bay Area.
That’s because lower-income people have little to gain by going to California’s coastal cities. Wages might be higher, but as the state’s poverty figures show, a better paycheck doesn’t help if it’s swallowed by rent. The loss of mobility makes income inequality worse, because lower-wage workers are effectively locked out of exactly those places where wages and the demand for workers are greatest.
Given the above, it should be no surprise that interest rates are incredibly low (although they have increased a bit recently) at a time when high housing costs in our most productive cities are constraining economic mobility. Unfortunately, there does not seem to be much of a will to do anything about it in the regions where the affordability issue is worst. Low interest rates do help to push home prices higher. However, those same higher home prices in turn help to push down interest rates by constraining economic growth. The debate about affordable housing would be better informed if more people recognized this.
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Chart of the Day
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