Stabilization of Housing Is Nothing More Than Price Supports

There is consensus among economists that tampering with prices is not an efficient way to run an economy. Price controls that keep the price below what individuals are voluntarily agreeable to contract for, eg., rent control, are widely recognized to be inefficient in that such price controls encourage too much consumption of the subject product, and discourage too little production of the subject commodity. On the flip side, price controls that keep the price above what individuals are willing to pay, eg, price supports for sugar, are widely thought to be an inefficient subsidy through which consumers subsidize producers of sugar.

Economists as ideologically different as Milton Friedman and Paul Samuelson could agree on the mistake of tinkering with the price of wages via the minimum wage. Although Friedman was of course against the minimum wage laws, Samuelson also remarked that there is nothing positive about minimum wage laws as they merely keep someone who wanted to work for two dollars per hour from being able to legally perform such work.

It is thus surprising to find such an accomplished, and normally sensible, economist as Martin Feldstein consistently arguing for the "stabilization" of real estate prices. In a series of articles, "The Problem is Still Falling House Prices", "How to Shore Up America's Housing Market", "How to Save an ‘Underwater' Mortgage", and most recently in the New York Times (October 12) "How to Stop the Drop in Home Values", Feldstein has argued for stabilizing, ie, subsidizing, housing prices to help the economy.

It is surprising that President Reagan's former chief economist would advocate such a large government intervention in the form of price supports. Perhaps not as surprising, his fellow Harvard professor and former Obama Administration official, Lawrence Summers also wrote about "How to stabilize the housing market" (Washington Post, October 24). Unfortunately, neither Feldstein nor Summers has focused on the question of whether basic economic analysis supports this stabilization/subsidy of the housing market.

Wikipedia (under "price supports") offers a concise outline of the classical economists' demonstration that price supports are inefficient; the interested reader should work through the analysis. The basic analysis shows that the total cost to consumers of propping up prices beyond the equilibrium level (which must include the cost to the government of the price supports) exceeds the gain to producers from the price supports; this inefficiency is known as the "dead weight triangle loss." This is standard economic analysis accepted by virtually all economists and is the reason that price supports are widely thought of as so inefficient. Feldstein's and Summers' first year economic students are no doubt taught this.

Note that this demonstration of the inefficiency of price supports does not depend upon the size of market that is being supported; it applies equally to a relatively small price support like sugar or a much larger one like the residential real estate market. What the analysis does show is that the inefficiency of propping up a large market will be much greater than that of propping up a small market.

The Obama administration's form of price supports for housing is included in the stimulus bill, and the tax credits for first time buyers-both designed to prop up the housing market. One may also view the lawsuits blocking foreclosures, and the Fed's policy of artificially low interest and mortgage rates, as indirect forms of price supports for housing which serve to prop up the market above an equilibrium price.

Fortunately, the magnitude of the price supports has not yet reached what Feldstein proposed in the aforementioned Times op ed piece - which is to have the federal government absorb half the cost of writing down mortgages to 110% of market value, let the banks absorb the other half, and require homeowner loans to be recourse. Part of the rationale is that in the huge numbers of Fannie/Freddie loans, the "government would just be paying itself."

There are several problems with this proposal. First, if the mortgages are only written down to 110% of market value, no rational borrower would agree to voluntarily switch to a recourse loan if they are not currently liable. That's the case because this write-down still leaves the mortgage under water. Furthermore, this would substantially increase the $350 billion dollar projected cost of the Feldstein proposal.

Secondly, if the government via Fannie/Freddie loans is already on the hook for the current subsidy for prior foolish loans, there cannot be further stabilization of prices if the government merely officially recognizes its already de facto level of stabilization, ie, subsidy. Thus if the government is "just paying itself", there is no increased stabilization or subsidy.

Third, if his proposal is that the federal government increase the subsidy beyond that currently existing, then the proposal objectionably increases the dead weight loss by requiring consumers absorb both the government costs and the loss of consumer surplus-which we know will surpass the increase in producer surplus by the dead weight loss analysis.

It is instructive to compare the difference in approach and result with our last great housing bubble circa 1990. In that time period, the Resolution Trust Company (and the federal government generally) were not trying to prop up the housing market. The approach was to have the RTC seize defunct savings and loans and auction off their properties as soon as possible. That was "tough love" and traumatic but both the housing market and general economy improved more dramatically than during the current 4 year period-with no end in sight for the housing market or the general economy.