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Does a Strong Economy Support Higher Home Prices?

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07/28/2009

Lilburne’s recent article quotes Bernanke, on housing prices:

Well, unquestionably, housing prices are up quite a bit; I think it’s important to note that fundamentals are also very strong. We’ve got a growing economy, jobs, incomes. We’ve got very low mortgage rates. We’ve got demographics supporting housing growth. We’ve got restricted supply in some places. So it’s certainly understandable that prices would go up some. I don’t know whether prices are exactly where they should be, but I think it’s fair to say that much of what’s happened is supported by the strength of the economy.

I dispute that low interest rates are a “fundamental” because Dr. Bernanke has so much to do with setting them; but that is a side point. Do the other conditions in his list really support higher housing prices?

Certainly supply restriction in some places would cause prices to be higher than otherwise. I’ll grant him that much.

But what about population growth, economic growth and higher incomes? Is it so obvious that these factors make housing prices higher that Bernanke doesn’t need to give any further explanation? Does this make any sense?

Economic growth means the production of more goods. As more capital is accumulated labor productivity increases, and more consumer goods can be produced per unit of labor. The purchasing power of labor tends to increase over time with respect to many goods. Why would the increased production of goods not include housing? Simple supply and demand theory tells us that the price of a goods falls when more are produced. Is housing exempt from this?

What if Bernanke had said “Yes, food prices are up quite a bit but that is explained by a growing economy, more jobs, and higher incomes”. Is that logical? Is economic growth consistent with a family being able to afford less and less food each year? Suppose he had said, “Yes the prices of all goods are up quite a bit (and families can afford less of everything than last year) but that is supported by the strength of our growing economy”. Clearly that would be a form of doublespeak.

I can construct a set of assumptions under which Bernanke’s statement might be true. Suppose that in a region where land is scarce and there are building codes that restrict building higher buildings or tear-downs of existing buildings. Then, if people’s incomes rose, it is possible that the prices of existing homes would increase because people would be bidding their higher incomes against a more or less fixed supply. Perhaps these conditions apply in some very tiny countries such as Bermuda, Luxembourg, and Hong Kong.

However, a fly-over of the United States indicates there there is plenty of unused land. Some places have restrictive zoning laws, but others don’t. And during the period when housing prices were in their ascending bubble, new home construction was above trend. If it were sufficiently profitable, even dense urban areas such as Manhattan could become more dense by replacing short buildings with tall buildings.

Another possibility is that as productivity increases, people are choosing to consume more housing – some combination of larger and/or better quality homes.

My point is not that it is impossible for rising incomes and rising home prices to co-exist, only that it requires a very special set of conditions and that, in general, we should expect the opposite. Bernanke’s blithe statement of the obvious at best requires further explanation and is at worst illogical. It is more likely, as Reisman says, that the cause is an expansion of credit.

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