More Hot Air for the Home Ownership Bubble

Tuesday, October 27, 2009

Mark A. Calabria, director of financial regulation studiesmcalabria@cato.org:

Rather than seeing the financial and mortgage crisis as the result of a housing bubble, Washington continues to believe it was the correction in house prices that was the problem. The politically obvious and simple solution: blow lots of hot air back into that bubble. Sadly, this is another "solution" that looks great in the short run, but is costly in the long run.

The proponents of the tax credit believe we need to replace the decline in speculative demand for housing...with yes, new speculative demand for housing. This analysis could not be more flawed. The tax credit largely acts to keep housing prices from falling further. However, that is how markets are supposed to clear in an environment of excess supply. If there's too much housing, the way to address that is to allow housing prices to fall, which attracts buyers back into the market.

We should also recognize that the tax credit does not help the buyer—it helps the seller, by allowing the seller to charge that much more for the price of the home.

Perhaps the worst impact of this policy is that it encourages the continued building of homes, only adding to the over-supply, which itself will protract and extend the recession. Witness the recent news that housing starts in the U.S. just hit a nine-month high. While these levels are still low in historic terms, and housing inventories are declining, we still have an excess of housing. The damage done by creating a false floor to housing prices is that builders don't respond to inventory, they respond to prices, and as long as there is a positive gap between prices and construction costs, builders will build. The tax credit only serves to widen that gap between prices and construction costs.

The central flaw in the thinking behind the tax credit proposal is its assumption that we need to re-inflate the housing bubble. The previous level of housing demand, from say 2003 to 2006, was not driven by fundamentals. There had to be a correction in the housing market. Our choices are to either absorb that correction quickly and move on, or to prolong that correction, maybe even making it worse, by trying to create a false floor to the market.

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