The Myth of Housing as a Source of Wealth Creation

I’ve been watching the housing markets. Home prices are still up 3% year-over-year. That’s not much of a slowdown. Home prices are still increasing at the rate of broader inflation.

Inflation is a very tricky thing because it’s always true that when we have to pay more for one thing, we have less money left to buy other things, and that puts pressure on the prices of those other things, offsetting the increase in inflation in that first thing. When home prices rise, on average people will have less money to spend on other things. They can tap their homes equity by borrowing against it, but that’s just delaying the inevitable because they’ve got to pay back the loan eventually and they will then have less money to spend on other things by the amount of their new higher loan payments. So the consumption benefits are temporary.

It’s only when you build something that other people want that wealth and value is created. Just purely bidding up prices without building anything is only inflationary. If the price of your home goes up for no other reason than because people are now willing to pay more for it than before, then the people who are paying more for it have less money to spend. But if the value increases because you improved your property and in doing so you purchased goods and services, then you added to other peoples’ wealth and that offsets the higher amount people are paying for property.

Homes alone aren’t really a source of wealth creation. That’s a myth. They do nothing to increase the overall productivity of the economy. The only reason we, on average, can own bigger and bigger homes is from a very macroeconomic perspective, we are spending less time and energy on our basic needs and we are having them met much more cheaply than in the past.

People are choosing to spend more on homes because they can. The same goes for healthcare. Economists and market bears like to worry about the rising cost of healthcare. The way they measure this is the average amount people are spending on healthcare and the total size of the industry. But they never consider that perhaps the portion of our healthcare expenses that is relatively discretionary is increasing. In other words, people are paying more for healthcare in part because they are choosing to do so, because they can afford to make that choice, because even at today’s high prices for gasoline and many other commodities, people still have relatively more money to spend on healthcare.

Comments

[Paul Meisel:]

I tend to agree with the point made on housing, except to the extent that as people move up, their previous houses pass on to other buyers, until eventually someone who was living in a substandard situation (with mom, for example) gets a house. Even this really isn't wealth creation except for the builders and remodelers.

However, in health care, I don't agree with the discretionary point. The lion's share of health care spending is through insurance -- the people receiving the service aren't the people paying. Also, many of the largest expenses are not really discretionary -- people typically don't consider treatment for a heart attack, broken bones, or other serious illnesses as a choice but as necessity.

Health care expenses are largely "cost-push" inflation that is not easily managed by consumer substitution.

2006 Aug 18 09:18 AM

[Joseph Queen:]

Your comment "It’s only when you build something that other people want that wealth and value is created. Just purely bidding up prices without building anything is only inflationary." is valid, IN GENERAL, with homes because there is reallly an infinite supply of them.

Want a new house? You just buy some land and build on it.

On the other hand, I tend to disagree with you when it comes to Water Front homes. There is only a finite amount of watefront property.

Want a new waterfront house? if you want a desirable location, there is very little land left.


Granted, the amount of that finite supply varies with region so I can only speak about an area that I know very well and that is the Chesapeake Bay in Maryland.
There is an extremely limited supply of good new land on the water left so existing homes get 'recycled' with an ever increasing cost to do so.

2006 Aug 18 11:32 AM

[Matt Richards:]

I think Mark is not describing inflation correctly. If prices of some things increase and others decrease, that is just a change in the relative value of various products and services, which he correctly notes is due to a finite amount of money being available to buy things. When the government prints too much money, the prices of almost everything go up simultaneously, because you can pay more for one thing, and still have money left over to pay as much or more for other things. Inflation is a general rise in prices due to a decline in the value of the currency. Not all price increases are properly classified as inflation.

2006 Aug 19 10:03 AM

[CrossProfit:]

There seems to be a contradiction in the article. On one hand you correctly state that the construction of new homes or the enhancement of existing properties is the creation of wealth. An increase in price for existing assets is purely inflation related and does not create new wealth. (We agree with this.)

On the other hand you write that because the price for existing real estate assets has increased due to inflation, there is less money for other items. This is deflationary.

Then you state that people have more money in the first place because the cost to meet basics needs is less than in the past – so there is more money for other things!

Let’s separate wealth creation and inflation. We agree with your analysis regarding when and how wealth is created. On the inflation front there are several schools of thought; Keynesian theory (demand inflation/cost inflation/expectation inflation), quality theory and quantity theory.

Without going into great detail, the current increase in real estate prices was caused by an over abundance of liquidity that had to find a place to park. You can call it currency devaluation or a demand to get rid of currency but not a wish to have less money for other items.

In the Keynesian theory model the U.S. economy has just gone through a ‘demand inflation’ period. The demand inflation is based on an increase in the amount of money in circulation in relation to the amount of goods in demand that the economy can readily supply.

Think of demand inflation as having too much money and you don’t know what to do with it. Supply/demand inflation is two people wanting the same item initiating a bidding war. As soon as an additional item is available the later issue is resolved. The former type of inflation continues unless you take away some of that excess money together with mechanism that created the excess in the first place.

If the increase in house pricing was strictly a shortage of supply and assuming there is capacity to build, the housing scenario would end quit differently. Notice how houses in most areas are not returning to previous price levels. There are some specific locations that saw supply/demand price increases and not demand inflation increases. In these areas prices are heading back to their previous price range. Also note that the two are not strictly geographical delimited. There is also a quality factor or class factor that needs to be taken into account.

Many bloggers are confused by the housing data because they are not differentiating between the two. Naturally with the current tightening cycle displacing the demand inflation (less money looking for a place to nest), the supply/demand properties will respond one way and the demand inflation properties another. In order for the demand inflation housing to return to their prior levels a heavy recession is necessary. In order for supply/demand housing to return to their prior level, time and capitalism will do the work.

By no means should one surmise that we are advocating a heavy recession – just explaining economics 101 – this is not an opinion.

CrossProfit.com
www.crossprofit.com

2006 Aug 19 04:29 PM

[Donald Last:]

You cannot judge the real estate market without reference to interest rates. They are the kernel of the problem. It was the steady fall in rates to historic lows which fuelled the real estate boom (global not just US) and it is now the steady rise which is killing it. Real estate is a prime capital asset. Capital assets adjust in value to the changing level of interest rates just like bonds. Its a see-saw: rates up capital values fall - rates down capital values rise. Its as simple as that. Greenspan lowered rates because of the fear of deflation (some say to a needless extreme). Rates are going up because that is now history. New fear is obviously inflation. If inflation is not quelled, rates will go up even further. Bond holders hate inflation so they demand higher returns to compensate. The Fed and the market gives it to them. Builders must hope that inflation levels off and puts a stop to further interest rate hikes.

2006 Aug 22 04:59 PM