The Shocking Cost of the Housing Boom
Once a year, the Bureau of Economic Analysis (BEA) publishes an estimate of the nation’s “Net Stock of Fixed Assets”. These numbers show the progression of the 2000 – 2007 housing boom, which was artificial and caused by government policy errors. They also make it possible to estimate the cost to the economy of the housing boom and the bust that inevitably followed it. The BEA numbers also point the way out of this mess.
If provided with a stable unit of market value (a stable dollar) and left to its own devices, the economy will allocate capital to the opportunities that provide the greatest real return. This will show up in the BEA numbers as a favorable ratio between GDP and Total Fixed Assets (TFA).
In 1999, each dollar TFA produced $0.379 of GDP. As the housing boom took hold and capital was misallocated from business investment to housing, the GDP/TFA ratio fell steadily, sinking to 0.330 in 2007.
At the same time this was happening, the ratio of Residential Fixed Assets to Total Private Fixed Assets rose steadily, from under 0.500 during the economic boom of the 1990s to a peak of 0.546 in 2005. It then declined somewhat, to 0.535 in 2007. These numbers are unprecedented in the post-war era. The average for the 50 years from 1948 to 1997 was 0.498. The previous post-war high was 0.523, and this was in 1954, when the nation was catching up on housing following the Great Depression, WWII, and the Korean War.
If the artificial housing boom had not occurred, it is reasonable to expect that the fixed asset ratios would have stayed close to their values during the 1990s. If so, by 2007, we would have had about $1.2 trillion less invested in housing and $1.2 trillion more invested in business. Interestingly enough, $1.2 trillion is in the ballpark of current estimates of the write-offs that will ultimately be taken on mortgage loans.
Even more importantly, 2007 GDP would have been about $15.9 trillion rather than $13.8 trillion. And, we would not now be facing a nasty recession.
The best metric for comparing economic scenarios is the “present value to the infinite horizon” of future GDP and Federal revenues. This is the approach used by the Social Security Trustees to calculate the “unfunded obligations” of Social Security and Medicare.
Counting both the GDP lost to misallocation of capital and GDP lost to the recession caused by the inevitable “bust”, the housing boom cost America $284 trillion. Given that the Federal government typically collects 18.5% of GDP in taxes, the Treasury’s share of this is about $52.6 trillion. This is almost nine times the national debt, which is currently about $6.0 trillion.
Stated another way, the housing boom and bust reduced the present value of both future GDP and future Federal revenues by about 17.5%. This is a staggering cost. How did it happen, and what can we do about it now?
Americans are willing to invest capital in business, but business investment is risky. They would rather have a “sure thing”. During 2001 – 2007, policy errors by the Federal Reserve and Congress turned housing speculation into what looked like a “sure thing”.
Starting in 2000, the Federal Reserve began fighting the deflation it had caused in its mistaken efforts to curb “irrational exuberance” in the stock market and the real economy. By late 2003, it had gone from fighting deflation to causing inflation.
When the Fed creates excess liquidity, it has to go somewhere. Since the markets know that the value of the dollar is falling, they will direct the excess liquidity into assets that are perceived to be inflation hedges. Some of the excess liquidity went into commodities, but most of it went into housing. In the process, it commandeered capital that would otherwise have gone into business investment.
At the same time that the Fed started inflating, Fannie Mae and Freddie Mac, under mandate from Congress, began buying and guaranteeing massive amounts of “sub-prime” mortgage assets. From the market’s point of view, this converted risky loans into the equivalent of Treasury bonds—but with higher returns. It also permitted lenders to earn easy profits by originating risky, sub-prime loans and selling them to Fannie and Freddie (and to private investors trying to compete with these entities).
Meanwhile, the Fed’s inflation pulse was causing housing prices to rise. This made investment in housing look like a “sure thing” to both home buyers and mortgage lenders. At the same time, all of the things that Congress had done starting in 1977 to encourage “sub-prime” lending made it possible for people to play the housing game with no financial risk to themselves. People understood that buying a house that they could not afford with no down payment was a game of “heads, I win; tails, somebody else loses”. Also, people with no capital could now speculate in housing, which they could not do in, say, commodities.
The game created by Congress and the Fed made perfect sense for the individuals playing it. They were simply responding to incentives created by government. Unfortunately, the game made no sense for the economy as a whole, and it could not go on forever.
So, how do we dig ourselves out of a $284 trillion economic hole? We do it with economic growth. And how do we get economic growth? We get it with private capital investment. Only private business investment can produce real jobs and real growth. Government programs cannot produce economic growth. If they could, communism would have worked.
The first thing that we must do is to stabilize the dollar. H.R. 6690, which was introduced by Congressman Ted Poe on July 31, would do this by requiring the Fed to stabilize the dollar at a value equal to 1/500th of an ounce of gold. A stable dollar would mean no more bubbles, no more busts, and no more financial panics.
The other thing we need to do is to reduce the tax burden on capital investment. H.R. 6690 would take a step in this direction by permitting “first year expensing” of all capital investment. However, it would be even better to adopt the FairTax, which would replace all Federal income, payroll, and death taxes with a national retail sales tax. The FairTax would not only eliminate all taxes on saving and investment, it would eliminate the huge economic burden of complying with our complex tax code. As a bonus, the FairTax would raise the market value of all existing homes by 10%, or more, while at the same time making housing more affordable than it is now.
The combination of a stable dollar and the FairTax would boost America’s rate of real economic growth to well over 3 percent per year. At growth rates above the interest rate on government debt (which the Social Security Trustees estimate at 2.9%), the present value of future GDP is infinite. The present value of future Federal revenues is also infinite—at any non-zero FairTax rate. This would not only get us out of the financial “hole” created by the housing boom, it would assure America a prosperous future.