Arnold Kling  

Edward Leamer on Housing and Macro

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He has a new book, which sounds very interesting (but expensive). I've been re-reading his 2007 paper. My comments follow.

Leamer finds that a lot of cyclical variation in the U.S. economy is in residential construction, with some also in automobiles and in other consumer durables. Thus, he argues, we should call it a "consumer cycle" rather than a "business cycle."

A key point that Leamer makes is that you cannot have more housing construction now without having less housing construction later. Thus, if policymakers push housing starts up in one year, they are sowing the seeds of a recession later.

From that perspective, he might view the current recession as an inevitable consequence of the overproduction of housing from 2003-2006. In fact, because that upsurge was so strong, the correction in housing starts will be much longer and deeper than normal. Moreover, there is not much that government policy can do about this necessary correction.

However, it seems to me that if all we had were a housing correction, the economy would have bottomed out already, because most of the drop in housing starts is behind us. Leamer does point out that in a typical recession other sectors, notably business fixed investment, start to decline later in the cycle and keep the recession going. So maybe we are just into that phase.

But I think there is more to it than that. In my view, the main downward driver since last fall has been the stock market collapse. Of course, one wonders how much of that collapse reflects lack of confidence in policy in Washington.

Another point that Leamer makes is that the housing cycle is a volume cycle more than a price cycle. He says that prices are sticky downward, so that transaction volume falls during a housing recession.

This is a longstanding puzzle about the housing market. When there is a decline, home sales collapse, and when there is an expansion home sales increase. In theory the volume of transactions could be independent of the cycle. Volume could be high in a downturn, with prices falling, and volume could be moderate in an upturn, with prices rising.

Leamer does not distinguish between sales volume and construction volume. Even if one can explain why individual home sellers are reluctant to cut prices in a downturn, what matters for GDP is new housing construction. Home builders should not have sticky prices.

Even if prices were flexible, I think there would be a cycle in housing construction. With flexible prices, if demand were to fall, then prices of land and of homes would fall. With prices low relative to construction costs, you would not want to build. It's a Tobin's q story.

We used to think that housing was a big component of cyclical movements in GDP because we thought that housing responded strongly to interest rates. In part, this was due to institutional factors--the way that savings and loans were regulated up to the 1980's, the credit market for housing dried up when interest rates rose.

In the current situation, it was not so much a Fed tightening that wrecked the housing market. It was a speculative bubble that crashed, for the most part because the euphoria was unsustainable.

Overall, I am not sure that past recessions provide any strong lessons for this one. Without looking back at previous recessions, we know that housing was out of balance in recent years, and we know that housing construction has plummeted. That is the easy part of this recession to understand. The hard part to figure out is the dynamics among the financial sector, stock prices, government policy, developments in other countries, and economic activity.

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CATEGORIES: Macroeconomics

COMMENTS (6 to date)
Adam writes:

Leamer's analysis doesn't explain all the convergent phenomena that lead to this recession. As you've pointed out, other contributing factors include, inter alia, the Fed's easy money, "innovations" in banking and finance, and global scale of the economic interactions.

However, Leamer is unique among economists in correctly forecasting a severe recession in 2008 and 2009. Roubini and others also predicted a severe contraction in 2008, but they were also predicting impending doom back in 2005. Hence, Roubini seems more of a broken clock than an accurate analysis. Leamer got the timeframe right and was also roughly correct about the quantitative decline in output.

I'm very impressed. Economists make predictions all the time and are wrong all the time. In contrast, Leamer foresaw a major recession before it happened, based his forecast on careful, standard analysis, and gave policy makers--the Fed--enough time to cushion the blow. Unfortunately, the Fed did nothing even though Bernanke was in the audience when Ed presented his paper.

I'd really like to know: Is Ed Leamer forecasting an upturn in the economy? When and how much?

D. F. Linton writes:

My personal experience is that new home prices are sticky downward. Builders seem first to cut effective prices by granting allowances, providing upgrades, etc. These types of discounts would not show up in price statistics.

If you don't want to buy a copy, a copy is publicly available--at least for now--on Scribd:

(Printable but can not be saved to disk.)

Edward J. Dodson writes:

To more fully understand what triggers cycles, I point Professor Leamer to Ricardo.

Ricardo did not extend his analysis of ground rents to locations in cities or to residential property markets, but he provided keen insights that (for the most part) have been given little attention by modern economics.

What Ricardo understood is that credit acts as an accelerant on the natural tendency of investors to speculate in locations. Far better to use leverage and risk someone else's assets in speculation than one's own. The use of credit by investors in the property markets is normal. What was not normal in this land market cycle were the aggregation of externalities -- most importantly the bypassing of the GSEs as the core secondary market controls over the quality of collateral going into mortgage backed securities. Wall Street packaging of loans and investors looking for high normal rates of return stimulated the production of mortgage loans made without verification of income, employment or even creditworthiness -- often with fraudulent property appraisals. A high percentage of second mortgages were originated under predatory terms with even greater incidences of fraud.

What happens whenever the pool of potential borrowers or homebuyers expands is that market forces capitalize the change in equilibrium into higher land prices. The mortgage lenders responded by a combination of raising maximum loan limits, reducing down payment requirements, extending mortgage terms, creating interest only mortgages, permitting negative amortization and offering ARMs with low "teaser" rates for the first six months or year of the loan.

Those of us in the industry who say all this developing and feared the worst observed that on a higher percentage of property appraisals the land-to-total value ratio skyrocketed in many markets. By the early 2000s, the loans we were purchasing involved financing for more and more land and less and less housing.

Similar problems were operating in the commercial real estate sector. Here, investors ignored current cash flows and entered into bidding contests for properties they expected to flip after a few years to take advantage of rising land prices. Banks accommodated their speculative investments by making poorly underwritten loans and passing on the default risk to investors who purchased CMOs.

What economists ought to immediately understand is that at some point the accumulative financial stress on businesses and residential property owners will bring on a collapse in property markets (with bank failures as collateral damage).

Business profit margins are reduced by rising land acquisition costs (pushed forward to increases in the cost of leasing space in office buildings, retail shopping centers, etc.). So, businesses look for ways to reduce costs of doing business. When business relocations begin and vacancy rates increases, this is a clear indication that a crash in the property market is on the horizon.

In the residential property markets, the end comes when property (i.e., land) prices become too high for first-time homebuyers to enter the market even with the exotic mortgage offerings provided by lenders. The continuation of the cycle depends on the ability to pass on rising land costs to others. By 2004-2005, the capacity of millions of U.S. households to carry housing debt on top of other debt and expenses had reached its maximum. Household incomes were stagnant or declining, household savings had disappeared to many, and interest rates could not be lowered (in part because the U.S. government needed to offer foreign investors some level of return to attract sufficient funds to meet government expenditures).

It is too late to prevent the economic crisis. At best, what governments around the globe will do is mitigate the depth and duration of the depression.

The land market cycle will begin again when businesses see the opportunity to invest (to borrow and invest?) in new capital goods creation and once again generate profitable sales.

Among the numerous reforms we need is regulation that prohibits banks from extending credit for the purchase and/or refinancing of land. This will require investors and homeowners to come up with cash down payments from savings or other sources that do not put the financial system at risk. Removing credit as the accelerant for land speculation will not solve the problem, but it is an important first step.

Greg Ransom writes:

Hayek included "consumer" durables like housing and cars among capital, i.e. non-permanent productive resources. The problem is with Leamer's understanding of capital theory and business cycle theory, not with the expression "business cycle".

You write:

"Leamer finds that a lot of cyclical variation in the U.S. economy is in residential construction, with some also in automobiles and in other consumer durables. Thus, he argues, we should call it a "consumer cycle" rather than a "business cycle." "

arthas writes:

Some comments:
-Housing cycle has not bottomed out. May be u can separate volume and price cycle of which volume cycle is in bottoming out phase whereas the price cycle bottoming out may run for further 2/3 years. Previous house price correction has been long (5/6yrs, Reinhart and Rogoff).House prices being determined by supply side factors than demand of houses, when the price corrections starts, its going to undershot just like when it overshot during the rising phase.
-A distinction needs to be made between housing crisis and the financial crisis though both are related in the current market. The process of healing of balance sheet of financial sector is occuring and this structural restructuring is slow and painful process. (in one firm i knew RMBS/CDO etc structuring team was generating per employee value added of 5 million dollars per year: this is abnormal in normal economy)
-Stockmarket is not the cause of downturn. The stock prices are in some way disconnected from company fundamentals as its a very imperfect market. Right now it is showing lack of investors confidence (just like normal confidence indicators). on a more fundamental level, credit has become more expensive after being over cheap for years (due to liquidity bubble). if creditors ask higher return from firm, equityholders are going to feel the pinch. Thats whats happening.
-most previous economic peaks happened due to changes in structure of economy (railroad, internet) and the following slumps cleared away all the overinvestments and made the boom factor cheap for years to come. think of cheap broadband follwoing the overinvestment in fiber optics during internet bubble or fall of iridium satellites which made china calls cheaper. my question would be: are we in permanent bear cycle for housing? after all, housing is a fundamental need and we saw in all the western economies massive speculation (and overinvestment)in housing. each individual homeowner was a greedy speculator in the last decade. time for creative destruction to wipe out overinvestment in housing so that new industries emerge??

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