Thursday, December 6, 2007

how to not grow the pie

the US over the last 7 years or so has experienced significant growth in wealth unrelated to any increase in productivity or production.

we got richer through asset appreciation. specifically, our largest asset. our homes appreciated like gangbusters. they set new all-time highs relative to incomes in every major city for several years in a row.

the important part in that statement was "relative to incomes." this means that every city in the US became more expensive to live in. it happened in every city, so no special factors can explain it.

simply put, people lost their shirts in the internet bubble and decided to put their money in something safe, the Fed made credit cheap, loans became easier to get, prices increased, lenders used the recent history of high appreciation to justify making loans easier to get, people saw a history of rising prices and wanted some of the action so they were willing to pay more, the Economist called it a dangerous bubble and declared it would soon pop.

wash, rinse, repeat. for five to seven years, depending on the city. in many markets, prices doubled or more relative to incomes.

the thing about housing is that, relative to incomes, pricing basically hadn't changed for 80 years. this makes sense because a middle-class neighborhood is pretty much always going to be a middle-class neighborhood where people make middle-class money. so, how is it now that people should be paying twice as much today as 5 years ago?

they aren't. people couldn't possibly afford to do that. they saw an investment opportunity that justified the risk associated with weird loans with low intro payments, no cash down, etc and they jumped in head first.

now that these weird loans are resetting to their regular rates and the houses haven't appreciated their way to glorious wealth, people are screaming bloody murder and insisting the gov't do something to help, because (surprise surprise) they can't afford the payments that the evil loan officer forced on them. foreclosed houses help drag the market down, forcing more people into the unenviable situation of owing more on the house than the house is worth and knowing that the house will continue to lose value. some of these people decide to cut their losses and give the house back to the lender. this further depreciates the market. a bit of a vicious cycle.

this is a big deal, some people are losing imaginary wealth at an alarming rate. the average house in California lost 10% of its value last year. if the average house cost $500k, that is $50k in money gone from what is meant to be a very stable investment.

this kind of loss of wealth has the ability to derail the economy a fair bit. nobody knows quite how much, but quite a lot, probably. the gov't wants to help, but can't possibly. they have proposed a deal that is nearly finalized, but it can only slow the process down. to suggest otherwise is to claim that housing in every major city will permanently be more expensive relative to incomes without any change in circumstances whatsoever. maybe one or two cities have had areas with changes in demographics where formerly working-class neighborhoods are now middle-class, but everything else can only revert to the previous median.

prices will return to their normal levels relative to incomes. this is a pain, a rather big pain for many, but it is the unavoidable result of misplaced trust, greed, and lack of foresight.

it will slow our economic growth for a while, it has caused a couple of banks to fail, it may force more than a few boomers to stick it out at work for a few extra years because they were counting on their house to fund some of their retirement, it has damaged our currency, and it should cause all of us to be extra skeptical of "experts" that consistently support the industry that pays their salary.

ideally, we will learn from this bubble and the Fed reserve will take action to reduce the severity of the next one in exactly the same way that they didn't do for this one or the one before it. i'm not holding my breath. the Fed seems to like growth, sustainable or otherwise.

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