Translation/explanation needed

by Chris Bertram on July 11, 2008

One of the benefits of a blog like CT is that non-specialists can always ask specialists to explain stuff. Here’s Martin Wolf, writing in the Financial Times about Britain’s housing bust:

If economists differ on whether house prices are now reasonable, they differ still more on whether a house-price collapse must spell ruin for the economy. A decline in prices brought about by a big boost to supply ought to be beneficial. Even a correction in a bubble should not bring pain: for owner-occupiers, the lower value of their houses is offset by the lower implicit cost of renting them from themselves. [My emphasis] Moreover, the losses of those cashing out of the market are offset by the gains of those buying into it. This is why it is mad to applaud ever-rising prices.

So what on earth does he mean? If I were feeling pain (which I’m not because I’m not going to sell my house any time soon), how would my agonies be offset by a reduction in the implicit cost of something that isn’t actually happening? Enlighten me please.

{ 53 comments }

1

bjk 07.11.08 at 10:48 am

If your renting to yourself, you’re also collecting rent from yourself. So it’s a wash. He’s blowing smoke.

2

thompsaj 07.11.08 at 10:49 am

opportunity cost?

3

thompsaj 07.11.08 at 11:08 am

that is owner-occupiers face the implicit cost of not renting out the house and living under a bridge.

4

Matt 07.11.08 at 11:11 am

My understanding (I should probably just wait for someone who knows this better than I do!) is that the idea is that if you own some house you could do several things with it: 1)Live in it, 2) Sell it, 3) Rent it to someone. Doing 1) is a lot like doing 3) but with yourself as the renter from a neutral perspective. Rents and selling prices are connected but sometimes not perfectly. Supposedly one sign of a bubble is that selling prices are high compared to rents. In such a case you’re getting less value if you hold property and rent it than if you sell it. This applies to a house you own and live in as well- if you hold it and live in it rather than sell it when the price diverges from the rental cost you’re “losing” money. (If you were rational, transaction costs were low, etc. you’d sell your place and rent from someone else to take advantage of the divergence in sale and rental price.) But, if sale prices come down and align more closely with rental prices this “loss” becomes smaller and might even turn into a “gain”. At least that’s how I’ve understood the idea. Since I’d like to be clear on it, too, I’d appreciate it if whatever mistakes I have here would be corrected by people who know better. I’m sure there must be several around!

5

Alex R 07.11.08 at 11:19 am

The implicit cost of rent to an owner/occupier is the rental income that they forgo because they are not renting their property to someone else. What’s a little odd about Wolf’s statement is that one of the features of the housing bubble is that the price-to-rent ratio has departed significantly from the historically usual values — rents have not inflated nearly as much as housing prices.

My guess is that he is using a slightly different definition of implicit rent, some sort of “effective rent” based on the market value of the property. Looked at in this way, then you could consider his statement to be another way to put the common sense notion that once you own a house, it doesn’t matter what happens to the market price as long as any moves you make are to another house of the same value.

6

flapple 07.11.08 at 11:28 am

He is talking about imputed rents

http://en.wikipedia.org/wiki/Imputed_rent

7

Mark Waters 07.11.08 at 11:33 am

The problem with falling house prices for existing owner occupiers is that the “implicit cost of renting” is significantly less than the explicit cost of paying the mortgage.

8

Brett Bellmore 07.11.08 at 12:02 pm

“it doesn’t matter what happens to the market price as long as any moves you make are to another house of the same value.”

But, of course, it does matter, if you refinanced, or borrowed to buy the house in the higher market, because when you sell in the lower market, you might have negative equity, all of which comes due upon selling the house.

9

a 07.11.08 at 12:30 pm

It’s the same thing as saying, so long as you own your house free and clear and you’re not planning to sell it, a bubble or a collapse in a bubble doesn’t impact you. You can reason this in a more sophisticated way as Wolf does, but it’s the same thing.

10

abb1 07.11.08 at 12:33 pm

Imagine that you own a house, you rent it out to someone, and you yourself rent an identical house and pay rent to someone else.

If we assume that the amounts of rent you collect and the rent pay are identical and proportional to the market price of the house, then price of the house becomes irrelevant. The amount of rent you collect and the amount of rent pay bounce up and down, but the balance is always zero.

11

Dave 07.11.08 at 12:59 pm

There are, as above, ways of making the statement make some kind of sense, but explicitly as put, and as relevant to the calculations of normal people [not economists] it is just cock.

12

David in NY 07.11.08 at 1:16 pm

“just cock”

Sounds that way to me, too. But don’t ask us Chris, … er, Professor Bertram, … why don’t you e-mail Wolf? Maybe he’d explain.

13

Stuart 07.11.08 at 1:19 pm

Of course using the same sort of logic you can prove that eating is an economically idiotic activity, as you take something that is worth money and convert it into something that costs you money to have disposed of, so hence everyone should stop eating immediately.

14

abb1 07.11.08 at 1:22 pm

Why, it’s just another (convoluted) way of saying that as long as you happily live in you own house its price doesn’t matter.

15

Barry 07.11.08 at 1:25 pm

Just another econoblatherer on the front page of an allegedly respectable paper, who, in a more just world, would have a career in testing pharmaceuticals or nerve gas or something like that.

16

J Thomas 07.11.08 at 2:14 pm

If you speculate in a market, you might win or lose. In general, for every speculator who loses another speculator gets a bargain. It’s a wash on average, although there are losers.

Ignoring his argument that you ought to feel OK when you’re a loser because somebody else is winning….

If the government bases its policy on keeping speculators from losing when they speculate, where does that lead us? Isn’t it better for government policy to encourage creating wealth that benefits many people?

17

ogmb 07.11.08 at 2:16 pm

Don’t bother with the bolded part. The very next sentence makes it clear we’re in Bloviateland:

Moreover, the losses of those cashing out of the market are offset by the gains of those buying into it.

18

Slocum 07.11.08 at 2:20 pm

As a homeowner, I’ve lost a fair chunk of paper wealth. But for me, the positive side is that my kids, when they’re out of the house, will have a much better chance of actually buying a house in place they grew up (or another desirable place) without having to kill themselves to make the mortgage (or…hit up Mom & Dad for a big down payment).

Unless of course the bubble re-inflates before they’re in the market.

19

Chris Bertram 07.11.08 at 2:41 pm

#18 Amen to that.

20

smaug 07.11.08 at 2:42 pm

Just another econoblatherer on the front page

No. Wolf is describing what economists think. He goes on to offer a different view — the credit crunch is causing pain.

As he says in the next paragraph:

Yet things are not so simple. What matters is why house prices are falling. It is no good having cheaper houses if the reason they are cheaper is that fewer people can afford to buy them because credit is so expensive.

Too much of the “endowment effect” is going on in the US market. We have many people who bought their houses before the bubble but who insist on selling it at near peak-bubble prices. They will refuse to accept an offer of that gives them a nominal appreciation of 6.5% a year over a 10 year period without having made any major improvements to the house.

21

ogmb 07.11.08 at 2:52 pm

Wolf is describing what economists think

Wolf is describing what he thinks economists think.

22

ogmb 07.11.08 at 3:04 pm

It is no good having cheaper houses if the reason they are cheaper is that fewer people can afford to buy them because credit is so expensive.

Actually the obverse is true: It is no good having more expensive houses if the reason they are more expensive is that more people can afford to buy them because credit is unsustainably cheap. The problem with bubbles is not that they end but that they started in the first place.

23

Miracle Max 07.11.08 at 3:07 pm

I think #11 is closest to the mark.

Capital value is a stock, rent is a flow. Even with a perfect price-to-rent ratio, a capital loss is not offset by a reduced negative flow, except in perpetuity (in this case the durable life of the house). Nor does it matter if you own the house free and clear. With a capital loss, if you die in your house the value of your estate to your heirs is reduced.

24

Dave 07.11.08 at 3:08 pm

The problem with bubbles is that we’re already in the first stages of the next one – alternative energy sources. Every day a new hype; last week it was diesel-excreting algae, today it’s paint-on photocells for your windows…

25

Barry 07.11.08 at 3:38 pm

Posted by ogmb: “Don’t bother with the bolded part. The very next sentence makes it clear we’re in Bloviateland:”

(Original article:) “Moreover, the losses of those cashing out of the market are offset by the gains of those buying into it.”

I’m surprised that more right-wing econoscum don’t use that phrase. ‘the loses suffered by people who bought into ____ were totally offset by the gains for the people who sold _____.’

26

Witt 07.11.08 at 3:53 pm

This makes no sense to me. When you own a house, there are lots of costs beyond the mortgage. Property taxes are the biggest, but there can also be sewer rent, homeowner’s insurance, mortgage insurance (the kind the bank forces you to get, not the kind you want for yourself). In some municipalities there are yearly fees for getting your trash and recyclables hauled away.

There are upkeep costs — not optional maintenance like painting, but crucial things like fixing broken pipes. There are non-optional things like shoveling snow off your sidewalk (which can cost money if you are not physically able to do it or if you live in a place where you can get fined/ticked for not clearing the way).

Many of these costs are completely invisible to renters, or are inelastic over the course of the lease. If I own a $300K house and am paying $1500/month in mortgage and taxes, not counting the other costs listed above, and the housing market dips so my home is now worth $220K but I’m still paying the same $1500 plus now the school district is raising taxes because they aren’t getting as much revenue as they expected, how does that not make me worse off than if I were renting and not having to pay some/all of those other costs?

Also, the original quotation seems to ignore the overwhelming use of home equity as a safety net — to pay for medical bills, education, spells of unemployment, emergency home repairs, loss of car, even bail or court costs. The cost to a family of not having that equity to draw on can be very dear indeed.

Bah. 11 got it right.

27

novakant 07.11.08 at 4:19 pm

The problem with falling house prices for existing owner occupiers is that the “implicit cost of renting” is significantly less than the explicit cost of paying the mortgage.

I don’t know, at least in London, the rents are totally crazy.

28

bigTom 07.11.08 at 4:21 pm

He may be saying that to the economy in general, a change in the price of any asset is a wash, winners exactly balance out losers. But this is only true to zeroth order, if the price changes, then investment decisions change. And the losers can be a bigger burden to society than the gain of the winners is a boost. Even if a own the house free and clear, and have no intention to ever sell it, some things such as my perceived net worth, my credit rating, my ability to borrow funds in an emergency, are all affected. The ability of the banking economy to loan money into existence has also changed, and this affects the macroeconomy.

29

abb1 07.11.08 at 4:26 pm

23: With a capital loss, if you die in your house the value of your estate to your heirs is reduced.

It depends on the culture and other circumstances. I hear in Europe a house very often stays in the family for many, many generations. When the liquidity is so low, the thing can count as capital about as much as your kidney.

26: …and the housing market dips so my home is now worth $220K but I’m still paying the same $1500…

That doesn’t matter. You are paying the same whether the housing market dips or not. You are paying your debt from way back, it has nothing do to with the current market value of your house, as long as you are happy with it and continue living in it.

30

Dave 07.11.08 at 6:14 pm

I’d just like to say I’m touched, touched, to find so many esteemed colleagues in agreement with me…

31

Ginger Yellow 07.11.08 at 6:14 pm

To be fair, Novakant, those are all the poshest places in London (Lambeth aside). That said, I’m paying a bit over £200 a week for a 1 bed flat in Tower Hamlets.

32

R 07.11.08 at 6:37 pm

I think the grain of sense in this is that falling house prices are less painful to owner-occupiers than to speculators. As long as there aren’t credit problems that lead to foreclosure, if you bought a house because you wanted a house, you still have it — and even if you need to move, you sell your house for less, but you buy the new one for less.

On the other hand, if you bought a house as an alternative to buying stocks or an oil well, you win some, you lose some, but investors are supposed to understand that.

The aspect of the bubble that is really causing pain — and it is hard to see foreclosures of owner-occupied houses as anything but painful — is that the bubble, and the creative financing it engendered, blurred the line between buying a house for the shelter, and buying one to speculate in housing — the loans were only sustainable if the value of the house was growing, so in order to buy a house for the housing you had to bet on the continued increase in house prices.

33

abb1 07.11.08 at 7:07 pm

What is blurred? Assuming a buyer who intends to spend 30 years in the house, and fixed-rate 30-year mortgage, I don’t see any difference whatsoever between paying 6% interest for $400K house two years ago and 8% for the same house priced $300 today.

34

abb1 07.11.08 at 7:13 pm

Well, I suppose you have to also assume that the owner does not accelerate the payments. A lot of assumptions, I agree, but at least they are not too fancy.

35

SamChevre 07.11.08 at 7:15 pm

You’ve got the answer in your question.

If you aren’t planning to sell, the lower value of your home is perfectly offset by the lower implied cost of living there (that’s the lower implicit rent)–thus, you and people like you aren’t feeling any pain. (Contrast this to losing a solely-financial asset, in which case you would feel pain even if you hadn’t planned to sell.)

The people feeling pain are the sellers, and their pain is offset by the buyers’ gain.

36

DaveW 07.11.08 at 7:46 pm

The problem with even if you need to move, you sell your house for less, but you buy the new one for less is that it ignores the effects of leverage on your investment. Take a family that saved for years to accumulate a $50,000 down payment, and bought a $500,000 house with 10% down at the peak of the bubble. Now (ignoring transaction costs) each x% increase in the price of the house gains them 10x% on their investment, but each y% decrease loses them 10y% of their investment. So if housing prices decline only 10% and they have to sell, their investment is completely wiped out. It’s true that they could (in theory) now buy a comparable house for $450,000 instead of $500,000, but they would first need to accumulate a new $45,000 down payment in order to do so. By the time they are able to do so, housing prices may have recovered to the point where they recognize no benefit at all from the temporary decrease.

Taking transaction costs into account makes this effect even stronger: if they have to pay a 6% real estate commission in order to sell, it only takes a 4% decline to wipe out their entire investment.

Leverage is a cute cuddly puppy in a rising market that allows you to realize huge profits from even modest increases in the price of the underlying asset. In a declining market, though, it turns into a ravenous wolf with slathering fangs – that bite.

37

Ben Hyde 07.11.08 at 8:21 pm

I’m loving this imputed rent idea. I’m my own evil landlord! No wait, I’m my own cummy tenant! I should change the locks.

38

bab 07.11.08 at 8:31 pm

28’s take makes most sense to me. Wolf’s clearly talking about an alleged detrimental effect on the economy as a whole, not to any particular person and her respective position on the bubble. Bigtom also correctly points out, however, that the potential aggregating effects that a critical mass of losers can have (particularly regionally) may have a magnified macroeconomic effect.

39

J Thomas 07.11.08 at 8:35 pm

The … bubble, and the creative financing it engendered, blurred the line between buying a house for the shelter, and buying one to speculate in housing—the loans were only sustainable if the value of the house was growing, so in order to buy a house for the housing you had to bet on the continued increase in house prices.

Leverage is a cute cuddly puppy in a rising market that allows you to realize huge profits from even modest increases in the price of the underlying asset. In a declining market, though, it turns into a ravenous wolf with slathering fangs – that bite.

That’s why I’ve rented for the last 10 years. I had no confidence that I’d keep a steady income stream when the downturn came, and I didn’t want to get caught with a house I couldn’t sell in a place I couldn’t afford to live.

That strategy might have lost me money over the long run. It would depend on things I can’t really know about, like buyers. But this year I’m sleeping easier because of it.

40

harry b 07.11.08 at 8:40 pm

dsquared is, regrettably, on holiday. (I gather!)

41

novakant 07.11.08 at 9:25 pm

To be fair, Novakant, those are all the poshest places in London

I don’t know gingeryellow, have you been to Hammersmith, Kilburn, North/West Kensington, Kentish Town or the shabby half of Islington? Posh is different ;).

42

John Quiggin 07.11.08 at 10:33 pm

Matt at #4 is about right. To tread on the dangerous ground of analogy, higher food prices don’t matter to a subsistence farmer since the increased value of their crop is exactly offset by the increased value of the food they are consuming.

You can think of a house as providing a flow of services (shelter, comfort and so on). A landlord sells these services to a tenant, but a homeowner is like a subsistence farmer, both producing and consuming the same services.

So if the house price is just the capitalized value of rental services, a change in the value of the services and in the price of houses should make no difference to homeowners.

But it’s a confusing way of putting the point made worse by the fact (noted by several commenters already) that the market value of houses has gone up much faster than the rental value of the services they provide.

All in all, not the clearest sentence Wolf has written, but the basic point is right. The gains and losses from changing houses prices pretty much cancel out, so there’s no general reason to applaud rising prices or deplore falling prices.

43

Jacob Christensen 07.12.08 at 3:30 am

There was an economist in the audience :-)

Anyway, at the risk of derailing the thread, John’s comment also points to some of the issues which regularly appear on the political agenda with regard to property taxes (at least in Scandinavia). Understanding the logic behind property taxes is beyond most non-economists and politicians have taken to defending the little guy against the wicked economists. As a consequence nobody dares to deal with the effects of the massive rise in house prices in Denmark and Sweden.

44

dsquared 07.12.08 at 3:30 am

I’m back! Although rendered otiose by John’s #42. It’s the “Housing Is Not Net Wealth” argument; technically flawless and convincing to roughly nobody.

The reason why housing *feels* like net wealth is that it’s just about the only way that a private individual can get meaningful amounts of leverage on an investment; if you’ve bought a house with a mortgage then you’re in the position of a subsistence farmer who has to pay a tithe in cash and suddenly the nominal value of your house does actually matter quite a lot (to you, that is; these things all even out at the level of the whole economy).

45

Jacob Christensen 07.12.08 at 3:31 am

(I desperately need an edit function here or maybe a better brain – I was not implying that John was derailing the thread but that I risked doing so by mentioning taxation…)

46

mq 07.12.08 at 4:05 am

Wolf was making a good point, in that thinking about it helps you understand some of the real sources of the problem here. As several people have said, starting with Brett Bellmore way up in comment 8, the problem is leverage. A house is the major investment asset for most people, and most still owe money on it. Recent purchasers can easily end up with negative equity.

Think of a bailout plan where the banks agreed to reduce mortgage values to the current value of the house and then were fully reimbursed by government. That would have inflationary effects on the overall economy (not to mention a lot of moral hazard for the future), but the homeowners would no longer be worse off. The issue is all the speculative debt that was accumulated during the bubble, even by ordinary homeowners. People were forced to be speculators in this bubble.

47

J Thomas 07.12.08 at 2:33 pm

People were forced to be speculators in this bubble.

“The only way to win is not to play.”

If we could find the people who intentionally designed this system to drain wealth from the middle classes, maybe we could hang them from lampposts and feel a little better about it all.

48

Alex 07.13.08 at 11:09 am

44: It’s also popular because it’s the only way you can force your kids to transfer wealth to you while you’re still in a condition to enjoy it.

49

Ginger Yellow 07.13.08 at 12:20 pm

“I don’t know gingeryellow, have you been to Hammersmith, Kilburn, North/West Kensington, Kentish Town or the shabby half of Islington? Posh is different ;).”

Yes. I lived in Kentish Town for two years. It’s plenty posh compared to the vast majority of East London or South London, which are conspicuously absent from the list. I have mates in Kilburn, Hammersmith and the “shabby half” of Islington, and while they’re not Knightsbridge, they’re not Hackney either. That’s not to say there aren’t pockets of deprivation in all those places, for sure, but they’re very gentrified compared to lots of London.

50

Marc 07.14.08 at 9:22 am

This is definitely a posh list. The only postcodes south of the river are Lambeth, Battersea and Richmond x2 (for those of you not in London: dodgy-but-extremely-central, posh, posh, posh). Half of London lives south of the river, but you only list 4 postcodes, and 3 are posh?

51

Jack 07.14.08 at 11:42 am

Even Hackney is not Hackney these days.

I think Wolf might have said what he meant more clearly if he had just said that the price of your house doesn’t matter until you move and even then your loss is somene else’s gain. Pretty accurate but economists aren’t usually quite so insouciant about redistribution, the first part isn’t quite true and gets less true the further prices fall and similarly while house prices are not net wealth, it’s not clear to me that the swings exactly match the roundabouts.

abb1, $400k @ 6% is more expensive than $300k @ 8% because the future payments cost more. For example trying to pay off your mortgage before retirement is harder.

52

paul 07.16.08 at 2:34 pm

I think that this isn’t really about the effect of the lower imputed rent on the individual homeowners but is rather an example of the mindless aggregation that a certain class of economists practice whenever there’s some disruptive economic shift. Think of the way that apologists for a certain kind of global trade regime argue that lower prices for imports compensate for the pain inflicted by job losses, even though the losses and benefits largely go to very different people.

If rents had in fact been going up in step with home prices, this argument would at least be internally consistent.

53

uptown 07.16.08 at 10:20 pm

OK, let’s put it this way –

If you own a house, the value that you sell it at is the real value of the house. Estimates based on prices at other times don’t count, for anything.

If you bought a house during a period of higher prices, but sold another at the same time – it’s a wash. You gained some on the house you sold but may lose some when you next move.

If you were a first time home buyer and overpayed because of the bubble, time and lower interest rates are your friends. Of course, if you couldn’t afford the payments (like many in the USA), you still can’t afford the payments and there are no more suckers left in the pyramid scheme to buy your overpriced piece of crap.

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