Friday, August 11, 2006


Musings on 'Affordability'

The other day I heard one of my favorite economic commentators, Amelia Tyagi, say that about one-third of Americans live in housing they can’t afford. It gave me pause.

If they can’t afford it, how do they live there?

I think the key issue is the definition of ‘affordable.’

‘Affordable’ has multiple meanings. The most basic, literal meaning is the absolute one: do you have enough money to pay for something or not? By that definition, almost nobody lives in unaffordable housing (and those that do are likely to get evicted in the very near future). But that’s an extreme definition, one that can be stretched so far that it’s effectively meaningless. If I make 40k a year after taxes, can I spend 35k on housing? By the most literal definition, yes. By any reasonable definition, of course not.

A more commonplace definition is a price that someone can pay and still have enough to live at a satisfactory level. Obviously, what is a ‘satisfactory level’ will vary from person to person. (Usually, for housing, it’s defined as something like not spending more than 28-35% of income. On the coasts, many of us are in the 40-50% range, because the alternative is living in slums.) That’s where a term like ‘affordable’ becomes both contentious and helpful.

There are many reasons I’m not a libertarian. One of those is that it’s simply not true that other people’s consumption patterns are none of my concern. Of course they are.

Take housing. When other people are willing to take out (or extend) interest-only and negative-amortization mortgages, they push up the price of houses. If I understand math well enough to know the stupidity of taking out that kind of loan, I will find that my prudence will be punished by my being relegated to neighborhoods I want no part of. Since other people have abandoned traditional (or long-standing legal) restraints, I am forced either to live (comparatively) low on the increasingly-polarized economic scale or to take outsized risk. Neither is reasonable. We used to have strict requirements about credit-worthiness, down payments, and amortization, precisely to prevent the kind of runup in precarious lending (and house prices) that has happened over the last few years.

This is not a new concept. “Sumptuary laws” used to prescribe acceptable maximum prices for all manner of goods and services, on the theory that there is a generally-accepted correct price for any given item. Those have largely gone by the boards over the years, on the (generally) correct theory that the market is smarter than any given legislature. Now, the theory goes, excessive prices will be punished by consumers who will either shop elsewhere or substitute other purchases.

The theory breaks down at the ‘macro’ level, where we use the Fed to control interest rates and money supply – a sort of supply-side sumptuary law. We need the Fed to do that, because left to its own devices, the market tends to go unproductively haywire.

When there was something resembling a viable Democratic party, the grand compromise was to do away with most sumptuary laws, but to enact public policies that tended to lead to a relatively football-shaped income distribution and to provide pretty good public schools in most areas. The compromise, and it was a good one, was that certain basic necessities of life were within the reach of most people, but ‘frills’ were left to the open market. (In some relatively egregious cases, frills were even subject to ‘luxury taxes.’ These have been replaced mostly by ‘sin taxes,’ which are taxes on the luxuries available to the working and middle class.) Since the implosion of the Democratic party (late 1970’s, give or take), we’ve fallen into a pattern of removing just about all restraints on income, consumption, and debt. (Interest rates charged by credit card companies now would have fallen afoul of ‘usury’ laws not long ago. Minimum equity or down-payment requirements for mortgages have been lifted. The minimum wage has been left flat for nearly a decade. The financial-services sector has been deregulated to an unprecedented degree. Guaranteed pensions are going the way of the dodo. Unsurprisingly, the Gini index, which measures economic inequality, is at Gilded Age levels.)

(The exceptions to the deregulation trend – agricultural subsidies and defense contracting – both happen to flow overwhelmingly to red states. An astonishing coincidence. Apparently, risk is only for Democrats.)

If people were the fully rational economic actors that economic theory takes us to be, the trend towards deregulation would be mostly positive. But we’re not. An entire scholarly genre (“behavioral economics”) has developed to explain the various ways that people act counter to the ways economic theory says we’ll act. Salesmen have known this stuff for years: “No Payments for 90 Days!” works because many people falsely assume that the pain of spending restraint in the future will be much less than the pain of spending restraint now. Participation rates in 401(k) plans increase markedly when participation, rather than non-participation, is the ‘default’ setting. People are likelier to attend events when they bought tickets than when they were given tickets, even if the event itself is no more appealing. (That’s called the ‘sunk cost’ fallacy.) These have all been documented in the scholarly literature, but they’re also familiar to anybody who has ever dealt with salesmen. Regulations used to exist to prevent the worst abuses that the predictable human failings would allow. Now, it’s devil take the hindmost.

So we’re remaking a society along the lines of a theory that we know, objectively and empirically, to be false. We’re relying on a rationality that we know not to exist. Why the hell would we do that?


Excellent post!
Dean Dad, thanks for posting this. The issue of what is affordable should be open to more thoughtful discussion. Especially when the individuals and institutions that used to be gatekeepers (banks, mortgage lenders) function less in these roles than in the past. After all, why should they worry? Individuals in the US have a much easier time of racking up debt and a much harder time of shedding it should catastrophic circumstances arise -- the lender doesn't have to be as careful, for their part, that they're lending appropriately.

An aside on sumptuary laws -- they worked almost not at all, hence their regular reissuing and the commentary of medieval and Renaissance moralists who bewailed the wasteful decadence of social climbers who defied the laws and went over the top in their movable wealth!
Never thought of it that way. Sometimes the overspending can be the manifestation of rationality. The reason most economic models don't spin out of control is that no-bankruptcy rules are applied. In strategic games where bankruptcy may or may not lead you to be excluded from future economic life, it becomes less clear-cut.

The problem is that on paper, we don't care about an assumption that says "once you lose, all future consumption equals zero". In real life, that means families live under a bridge or stop living period.
Having any type of public safety net (or allowing previously bankrupted people to build a new existence on someone's credit) will severly loosen the restraint people have regarding loans.

This externality effectively gives people a call-option-like payoff on their own wealth, leading to much higher risk-taking, ESPECIALLY if you are closer to the downside.
Unfortunate, yes, but definitely rational.

I tentatively vote for Moral Hazard over Irrationality in this case.
When calculating housing affordability, it is traditional to assume the buyer will use a traditional 30-year fixed mortgage. Combined with the restriction that you mentioned as to not spending more than 35% of gross income, this is how one gets statistics like "only 10% of Californians can afford the median price home" even though if this were true in the more narrow sense of "affordable" the housing market would collapse overnight. It doesn't because , as you mentioned, spending 40-50% of income on your mortgage is not unusual, and there are variable-rate, interest only, and negative-amortization loans with considerably lower payments (at least initially) than a 30-year fixed.

Another aspect of housing prices and exotic loans is that, in the recent past, using a neg-am loan was really not that irrational in an economic sense. Here in LA, for instance, housing prices have doubled in the last 6 years, with yearly appreciation rates routinely exceeding 20%. If you bought a house in LA 3 years ago, say, with any kind of loan whatsoever, and sold it today, you would have made a huge amount of money. Of course, at some point (probably now, actually) housing prices will stop increasing, and people are going to get hurt. The problem is, I think, that the time frame that people seem to use when making decisions is sufficiently short that this type of market bubble really does seem to have been going on forever and hence will go on forever.

In this age of lessening safety nets and increased variability of income in most households (see e.g. the LA Times excellent series on this earlier this year), I think that people are focusing more on investments and asset prices than they did in the past, which is just going to lead to more bubbles. (I think Robert Shiller argues for this in his book, Irrational Exuberance.) Ah, the joys of neoliberalization.
The other aspect to affordability (especially housing) is what alternative is there? That is, we all need somewhere to live. If it's not under a bridge, then the question is how do rental markets compare to purchases. Where I live the rents have remained fairly stagnant for 5+ years, while purchase prices on homes has grown ridiculously (I'm talking 20-30%/year for the same period)... um, except this past year which has seen housing prices flat, or slightly falling. But even at that rate, they are unequivocally unaffordable. Of course, as topometropolis pointed out, if you happened to have "bought" then and were to sell now, you'd realize great gains despite it all.

The comparison however is always between the available options. If I need to live somewhere, it's either rent or buy. If both options exceed my capacity to pay, (say, 50% of my gross income) either the rules will loosen, or the prices will drop. Oddly, the former has seemed the more likely of late, but the latter must come at some point.
I agree that the Democratic Party imploded under Carter, but the process probably began with the McGovern nomination.

Housing prices became unmoored from rationality with the advent of two-income households, which gave those couples much greater bidding power. That started the upward spiral, and forced the two-earner family to be the norm for the middle classes to stay in the middle.

But there is no appropriate alternative. We have emergency price controls on the cost of rental housing in one American city, New York, and the emergency has continued unabated since World War II. The predictable result has been a continuous housing shortage in that market.
I agree with much of what you said, but those same institutions that used to act as "gatekeepers" kept a lot of people from buying homes, or from buying homes in neighborhoods where "they weren't wanted." I don't have much nostalgia for a time when I would have been laughed out of the bank or realty office even though I had a job and a down payment.

And what does it mean to say that you're forced to live in a neighborhood that's undesireable?

What makes a neighborhood desireable, and what not. The what not, on some level is easy: it's dangerous, the schools are lousy, the local utilities don't serve the area well.

But no one in the richest country in the world really should have to live where it's dangerous, or where kids can't get a decent public school education, or where the local utilities (or the Army Corps of Engineers, or FEMA, or whatever) doesn't do the basic job.

That's not just about affordability, or being able to escape to whatever counts as one's suburban bliss.

(Sorry if I sound mean! I've been reading Nickled and Dimed lately!)
I know that in my area, if sufficient money existed to have good schools everywhere housing prices would be lower. We chose to live an a neighborhood with crummy grammer and middle school but good high schools because it was cheaper to send our little one to Catholic school than to buy a house in an area with a good grammer school. We have bipolar prices now, with really high prices in good districts and really low (100-150k less) ones in the rest.
If anon above were right, we would expect to see less of this behavior as the social-safety net got cut away in the 1990s. We didn't.

The greater moral hazard problem, however, probably stems form the new bankruptcy laws, which encourage credit companies and banks to make even more questionable loans.
DD wrote:

The theory breaks down at the ‘macro’ level, where we use the Fed to control interest rates and money supply – a sort of supply-side sumptuary law. We need the Fed to do that, because left to its own devices, the market tends to go unproductively haywire.

Associate Dean Economist responsds: Check your premise there. The Fed is the *source* of a lot more "going haywire" than it prevents. Say, for example, the Great Depression, which virtually all parties from every corner of the political universe now agree was to some significant degree the fault of the Fed. Then there's the inflation/stagflation of the 1970s (again, the Fed's fault), not to mention its role in the tech run-up of the 1990s.

The assertion that markets would fail at the macro level in the absence of a central bank is nothing more than that - an assertion.

My friends on the left should be especially concerned about the assumed need for a central bank because most every central bank in the world emerged as a way for governments to finance unpopular wars via inflation and other forms of regulation. It's no coincidence that many major expansions in the US federal government's role in banking occurred at times of war.

Don't folks on the left wonder why we ended the last vestige of the gold standard (and began to suffer from inflation, which disproportionately hurts the poor) at the height of Vietnam, or why the first Federally chartered banks were allowed at the height of the Civil War? And if you go outside of the US, the case is even stronger.

Central banks don't exist because "markets failed" to produce macro stability - they exist because *all* of us would love a printing press in the basement, especially if we had desgins on fighting wars and didn't wish to raise taxes or couldn't find enough bond buyers.

Historical and theoretical references available on request.
Stephen Horwitz and I are completely in agreement on this point. There is no question that the basic purpose of a central bank is to serve as the linchpin of a financial system which is capable of financing wars (though they can be either popular or unpopular) and spreading the cost out over the periods preceding and following the war.

I don't think that it was necessarily Vietnam that took us off the gold standard so much as OPEC; once all of our balance sheets started to dip that far into the red, cheating on the gold standard became too tempting, and something which was great for a half-dozen allies after WWII became exposed as something which ended up being obsolete for a decolonialized world. That said, Vietnam didn't hurt.

The main US-history-based argument in favor of a central bank is in how badly Continental soldiers, who took US bonds as payment, got screwed. If they'd have known that we had a central bank which would have paid them back eventually, they wouldn't have sold those bonds off to speculators at low prices.

That said, we have a system which is based around the rationality of all consumers because we are the descendents of Puritans, and we like to blame the poor for their troubles.
Dangit, I meant Steven. My sincere apologies.
Now we're drifting, but... OPEC didn't take us off the gold standard. Their influence was too late and irrelevant. Nixon closed the gold window 35 years ago this month because too many foreign central banks were exercising their option to redeem Federal Reserve Notes in gold. Why did they have all of those FRNs? Because the Johnson and Nixon administrations used inflation to finance Vietnam and the world market was flooded with dollars. OPEC was irrelevant.

No Vietnam, no inflation. No inflation, no closing of the gold window. No closing, no loss of the last economic check on the power of the federal government to finance unpopular wars via inflation. Imperialism needs an Exchequer, and central banks are the perfect institution to provide those services
It depends on what a person's individual definition of affordable is. For example, when we went looking for a house, we qualified for about 70K more than the house we actually bought. We could have chosen the bigger house with high ceilings and three car garage, but opted instead for the smaller house. This was with the idea that when the kids move out, which they are as they go to college, we could choose to remodel, take the money and travel, or sock it away in retirement accounts. Just as with credit cards, too many people see the credit as a goal and they pay only the minimum amount. Do that for a few years and you find yourself seriously in debt. In the Dallas area, with the crash of telecom after 9/11, techie folks who had formerly recieved six figures salaries and dwelt in cushy suburban giraffe barns buyin the Lexi and other trapping of the noveau riche, found themselves way WAY overextended. Bankruptcies went up, sales went down and people like me picked up bargains. Do I pity them? No, because they knew that a some point loans have to be repaid. If you go into a mortgage with the idea that you need two large salaries to buy a house, then you need to rethink your personal values. The fact is that there are kids straight out of college demanding the same status and quality of housing as people who have worked and saved for thirty years. Everyone starts out somewhere. And people who want the best of everything can sometimes end up with nothing.

Looking at the timing, you're probably right.
I never heard of a connection between central banks and wars. Interesting.

I don't buy the theory that all depressions are caused by central banks. The Fed was established around 1913, but the 1800's were full of nasty downturns. Even the worst Fed skeptic can't blame it for the crash of 1877!

EllenK -- be careful. What you're describing may well be true in the middle of the country, but it's nowhere near true on the coasts. Here, you can pretty much choose between a high-crime, lousy-schools area, or pay through the nose. There really isn't a third option. That's what motivated my post in the first place. There may still be perfectly acceptable, reasonably-priced areas in, say, Ohio, but not on the coasts.
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