Interest Rates, or Optimism about Interest Rates?

Professor White showed that one-year real interest rates were low during the housing boom.  That’s a good starting point because, if the Fed can affect anything real, it is the short-term interest rate.  Now let’s use that information to demonstrate that the impact on housing prices is minimal.

Since I will demonstrate that the housing-price impact is small, I will assume that the supply of housing is fixed; an elastic supply of housing would only reduce the price impact below what I calculate here.

Each house in place today produces services for a number of years.  To a good approximation, we can assume that each house lasts forever, except that it depreciates exponentially (but slowly).  The market value of the house is the present value of those services.  Low interest rates can raise housing prices (although not much), because future services are discounted less.

Suppose that annual real interest rates were going to be one percentage point (100 basis points) lower for a year.  Then the cost of buying a house, holding it for a year, and then selling it would be essentially one percent less.  The low one-year interest rate would not affect the selling price at the end of the year because, by assumption, the reduction lasted only for a year and the next buyer will be back to normal interest rates.  So the source of benefit from the low rate is that the initial buyer reduces the carrying cost for a year.

A 100-basis-point-lower interest rate for one year would justify paying about $202,000 for a house that would ultimately be worth $200,000.  A 100-basis-point-lower interest rate for two years would raise purchase prices by about two percent. (Actually, it would be less, because of the discounting of the second year, not to mention the supply response.)  A 200-basis-point reduction for two years would raise purchase prices by less than four percent, etc.

Thus, interest-rate reductions for a short horizon do raise housing prices, but not much by the standards of this recent housing boom when housing prices were tens of percentage points higher (according to Case-Shiller, practically 100 percent higher).  A house that would ultimately be worth $200,000 was actually selling for something in the neighborhood of $300,000.

Perhaps Professor White would argue that market participants expected short term interest rates to remain low for much longer than a couple of years.  If so, he is on shaky ground.  First, such a claim is at odds with long-term interest-rate data. As I indicated in my article, long-term mortgage rates were not low during the housing boom.  It’s not hard to find commentary from those years recognizing the low short-term rates were not expected to last.

Second, such a claim gets closer to my hypothesis: that it was optimism that raised housing prices, not much of anything tangible during the boom.  Whether it was optimism about future interest rates, future tastes, or future technology is more of a quibble.

Also from This Issue

Lead Essay

  • What Really Happened? by Lawrence H. White

    In the first of this month’s four accounts of the causes of the financial crisis, Lawrence H. White, the F.A. Hayek Professor of Economic History at the University of Missouri, St. Louis, makes his case. White argues that the housing boom and bust, and the resulting meltdown of financial markets, cannot have been the result of a laissez-faire monetary and financial system, since we never had one. Nor can deregulation have been the cause, since the most recent relevant deregulation has probably helped contain the turmoil. While admitting that “private miscalculation and imprudence made matters worse,” White argues that “to explain industry-wide errors we need to identify policy distortions capable of having industry-wide effects.” He points to two such distorting sets of policies: the overexpansion of the money supply by the Fed, and government mandates and subsidies to write riskier mortgages.

Response Essays

  • Adam Smith Was Right about Corporate CEOs’ Incentives absent Effective Regulation by William K. Black

    In our second anatomy of the financial crisis, William K. Black, associate professor of economics and law at the University of Missouri, Kansas City, says that key to the crisis was perverse compensation schemes that put the incentives of executives at odds with the interests of creditors and shareholders. Drawing on his concept of “control fraud,” Black argues that a failure of regulation encouraged executives to meet short-term earnings goals and to capture large bonuses by encouraging fraudulent mortgages – even when it could be foreseen that this might lead to the destruction of the firm. “When we do not regulate or supervise financial markets we, de facto, decriminalize control fraud. The regulators are the cops on the beat against control fraud – and control fraud causes greater financial losses than all other forms of property crime combined,” Black writes. Fannie and Freddie cannot have been the culprits, Black argues, because they were guilty of less mortgage control fraud than their fully private counterparts. “ ‘Modern finance’ has failed the market test,” Black concludes. “Its policies optimize the environment for control fraud and create perverse dynamics that create recurrent financial crises.”

  • Fundamental Origins of the Housing Boom and Bust by Casey B. Mulligan

    The housing boom and bust stands behind the financial turmoil of 2008. Therefore, in our third analysis of the financial crisis, University of Chicago economist Casey B. Mulligan explores various hypotheses about its underlying causes. Was it changes in tastes and technology? Public policy? Investor “exuberance”? Mulligan describes some of the empirical tests that would be needed to settle the question, and argues that at least part of the answer is already clear. Most of the housing boom, Mulligan finds, was based in expectations about the future, rather than in demand, supply, or subsidies during the boom. Mulligan says that additional empirical tests – especially about the aggregate wealth effects of the boom and bust – would help us form a more educated guess about whether boom expectations were based more to changes in tastes, changes in technology, or exuberance. But those tests have not been done, and therefore, Mulligan concludes we cannot yet reliably predict the future economic damage from the housing boom and bust, or formulate beneficial financial industry regulation.

  • Liquidity, Default, Risk by J. Bradford DeLong

    Our fourth and final anatomist, J. Bradford DeLong, notes that “in the past two years the wealth that is the global capital stock has fallen in value from $80 trillion to $60 trillion,” and lays out five reasons why this value might fluctuate. “Savings has not fallen through the floor. We have had no little or no bad news about resource constraints, technological opportunities, or political arrangements.” Therefore, DeLong says, we’re left with changes in the discounts for liquidity, default, and risk. The housing crash has increased default risk significantly, but central banks have actually pumped up liquidity. Almost the entire drop of the value of global capital, DeLong argues, comes from an “increase in the perceived riskiness … of income from capital.” The problem, DeLong says, is that “our models for why the risk discount has taken such a huge upward leap in the past year and a half are little better than simple handwaving and just-so stories. Our current financial crisis remains largely a mystery: a $2 trillion impulse in lost value of securitized mortgages has set in motion a financial accelerator that we do not understand at any deep level that has led to ten times the total losses in financial wealth of the impulse.” However, DeLong is confident that Larry White’s story – focusing on the money supply and government policy to encourage bad home loans – cannot be the right one.

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