Arnold Kling  

House Price Behavior

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I am going to react to three things: Nick Rowe talks about the fact that housing transaction volume is higher when prices are rising; Scott Sumner's latest attempted swindle; and the paper by Steven Gjerstad and Vernon L. Smith in What Caused the Financial Crisis. This book, which is a based on this issue of Critical Review, is my choice for the best book of analysis of the financial crisis--by a wide margin.

One point that Gjerstad and Smith make is that bubbles can appear in asset markets but not in ordinary markets for goods and services. That is because with an asset your willingness to buy depends on your expectation for price changes going forward.

Scott tries to twist the labor market data to raise doubts that labor demand was weak prior to 2008. I am sorry, but I am using the same labor market indicators that I used years before the crisis, and I think that the decline in labor demand prior to 2008 is pretty evident. See this post.

Back to the main issue, which is the behavior of house prices. Why do price appreciation, construction, and transaction volume move together? For price appreciation and construction, I would give a Tobin's q answer. That is, when the price of housing rises above replacement cost, you get a lot of new construction. When the price of housing falls below replacement cost, not so much.

For transaction volume, the issue is more difficult. If we take it the housing is an asset, then nominal price stickiness, which is one of the explanations Rowe considers, seems odd. I would not rule it out, but I would look for other explanations first. Here is one possibility:

A lot of transactions volume in the housing market is the so-called "trade-up" market. Some households, when they find that their house has appreciated, decide that they would like to use part of the profits to buy a bigger house.

So then the question is, why is there not a trade-down market, meaning that when household are in houses that have depreciated, they want to sell and buy a smaller house? Iin either case, there will be threshold effects. Because of transaction costs, you need to have accumulated a big change in wealth, income, or household size in order to want to move up, and conversely.

I think that if incomes are rising secularly, the trade-down market will be limited. If you lose some wealth because your house depreciates, you don't trade down, because you have higher income. (Keep in mind that back in the twentieth century, people who bought houses made down payments, so if your house declined in value by 15 percent it was still worth more than the mortgage.)

With secularly rising incomes, a little bit of house price appreciation is enough to get a good trade-up market going. But an equivalent decline in house prices would not create as much trade-down activity.

What I want to suggest is that, because transaction costs are high, it takes a large cumulative price change to make people consider trading up or down. For example, imagine that a homeowner will trade up if the house has gone up 20 percent and will trade down if it has gone down 20 percent. Suppose that the general trend of house prices is a gradual increase. So, after five years, the typical home owner might have a house that is worth 10 percent more--not enough to want to trade up. From this point forward, if the price goes up 10 percent, that homeowner will trade up. But if the price goes down 10 percent, that will put the owner back where he or she started, so there is no reason to trade down, unless prices fall another 20 percent.

I think the story could be stronger if we introduce a secular increase in real income and a positive correlation between income and demand to trade up.

COMMENTS (13 to date)
Phil writes:

Why wouldn't I trade UP if the market went down? I'd rather upgrade from $200K to $400K than from $300K to $600K.

If house prices dropped in half overnight, I'd immediately go out and buy a McMansion.

Justin writes:

I would be shocked if the trade-up/ trade-down thresholds were remotely symmetrical. I would expect that if a homeowner was willing to trade up if the house has appreciated by 20 percent that they would be unwilling to trade down until the house had depreciated by at least twice that. Loss aversion plays a big role-- no one wants to admit that they paid grossly inflated prices so they tend to hold on to the house waiting recovery. And downsizing your home for economic reasons commits the homeowner to at least medium term decreases in their standard of living so it is a much more emotionally wrenching decision than the sort of even money wagers that we use to measure loss aversion. As the bubble expands, people are relatively quicker to ratchet up their housing expectations than they are to ratchet them down when the bubble deflates.

Additionally, there are a couple other explanations that jump to mind.

1) Housing and new jobs are also complementary goods. When the labor market is strong, people are more likely to find opportunities for advancement that either necessitate or allow a move. You get a lot of transaction volume in good years that is based on people moving to take advantage of new job opportunities. In weak labor markets, businesses are unlikely to be looking for labor outside their immediate geographic location.
2) New development should be filling niches that are relatively under-served in the area today (assuming developers are doing their market research correctly). This should naturally lead to transactions that would be lateral moves from a price perspective that allow consumers to reap some other benefit like a larger lot or closer proximity to employers or recreation. If there is excess demand for a particular type of housing, since everyone needs to live somewhere, that implies that people have been forced to purchase substitute goods that would be happy to move to an equally priced home that had what, for them, was a more attractive set of trade-offs. So if there is excess demand for homes on 1 acre lots, a new development that features 1 acre lots will create a number of transactions as homeowners move from other developments. When there is less new development, there are naturally fewer homes coming on the market that would attract the interest of existing homeowners.

Dan Weber writes:

Some households, when they find that their house has appreciated, decide that they would like to use part of the profits to buy a bigger house.

I don't see how this works. They are still limited by their mortgage.

Say I buy Small House for $200K, $100K down and $100K mortgage. I start with $100K equity.

Home prices double, so I now have $300K equity and (roughly) $100K mortgage. I am perfectly funded to . . . rebuy the same Small House.

There can be effects from interest rate swings, and how much of the previous mortgage I've paid off. But those aren't relateed to appreciating markets.

A. writes:

Is there any hope in analyzing the empirical data? It looks like anyone can spin whatever story they want. Almost makes you want to become an extreme Austrian and use words like "apodictic"

Nick Rowe writes:

Dunno. Ignoring newly constructed houses; if one person trades up, some other person must trade down. What would cause both to happen more frequently across the whole market at the same time?

MernaMoose writes:

if one person trades up, some other person must trade down

I don't see what makes that necessarily so. Easy to imagine first time buyers moving out of apartments.

Nick Rowe writes:

MernaMoose: but what happened to the people who sold them the house? Where are they living now? In the apartment the first-timers moved out of, presumably. Or they moved to a third house, and the people who used to be living there moved into the apartment.

Jaap writes:

Nick: every year roughly 1% of the population 'trades down' permanently. Next to that, there is new house constuction.

Trading down is also restricted by mortgages/equity. If the mortgage is higher than the price you try to sell the house for, you need to come up with the extra money. A lot of people may not have that.

ed writes:

Dan Webber and Phil are right.

Rising prices should make you less willing and able to trade up, not more.

In Dan's example, consider trading up from the hypothetical 200K house to a 300K house. The mortgage amount would go from 100K to 200K, so payments would double. But after the price rise, upgrading the now 400K house to a now 600K house would make the mortgage go from 100K to 300K, so payments would triple. I think the price rise would make you less likely to upgrade.

joe cushing writes:

I was going to make 2 comments but Phil pretty much nailed the first one. On to number 2.

My home didn't fall by 15%--it fell by more than 50%. My loan was never at that peak value and I paid down about 20% of the loan before I realised I couldn't keep up with the falling prices. Today, I could afford a much nicer home if I didn't have a negitive net worth. As it stands, the only way I can move is to short sale. I'd have no place to go because I can't come up with a down payment and I would have a big hit to my credit score. My only hope is to find a better job and pay down my loan. Then I could really trade up like Phil said.

In the long run, I see falling prices like I see them in any consumer goods market--as a good thing-- but I'm stuck in the short run.

Steve Roth writes:

Makes sense. This especially as people tend to think in nominal dollars -- it's hard to calc inflation in your head. So they'll generally feel like their house has gone up more (or down less) than it has.

One of those obvious examples of humans being systematically irrational in purchase and sale decisions, just as they are in voting decisions -- despite the real cost of that irrationality.

Philo writes:

Your basic mechanism is a wealth effect: if people become richer, they want to move to a more expensive house. But, as Nick Rowe asks, who will sell them such a house (a pre-existing house, not a newly constructed one)? To get more transactions you will need, not just an unusually large number of people getting richer, but a correspondingly large number getting poorer, so that *they* want to trade *down*. But there's no reason for a positive correlation between such a phenomenon and *rising housing prices*.

Scott Wentland writes:

This seems like a simple point, so I must be interpreting you wrong. But, if we're talking about a market house price increase, then a 20% increase in your house's price means that other houses will also be priced higher.

There could be a wealth effect for various behavioral reasons, but if the price of your house goes up 20% and all the other ones go up 20%, then we shouldn't expect much trading up. Your wealth can buy more other stuff, but not more real expenditure on housing necessarily.

In effect, the price change of houses mean that individuals are living in 'more' house.

The same logic applies to inflation: if your income goes up at the rate of inflation, then your real expenditure shouldn't change. Again, I think this is a simple point that you are aware of. But it doesn't fit well with your story. Or does your story not assume rational expectations?

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