A thought experiment.
It’s Monday morning, and on the drive to work, you realize that you’re low on fuel. At the gas station, you discover that gasoline (petrol) now costs $40 per gallon ($10.56 per liter). That seems bizarre and expensive, so you don’t buy any. You pass that station and find another one, but you find the same high prices. Curious about what’s happening and where you might get a better deal, you call people in other cities and find out that the price of gasoline has gone up enormously overnight, but no one seems to know why. Gas below $35 per gallon cannot be found. Assuming that we’re not in the midst of hyperinflation, which of the following three possibilities seems most likely?
- Income hypothesis: people suddenly have a lot more money. This isn’t inflation or a price hike, but a result of an increase in genuine wealth. The economy has grown several thousand percent overnight.
- Value hypothesis: the real value of gasoline has improved, presumably due to a new technology that can extract substantially more genuine utility out of the fuel. Perhaps 300-mile-per-gallon flying cars have just come online and people are now taking international trips.
- Calamity hypothesis: something bad has happened that has either constricted the supply of gasoline or created a desperate need to consume it, increasing demand. The sudden price hike is a consequence of this.
Most people would choose the third option, and they’d probably be right. Note that, from a broad-based aggregate perspective, the first two options represent “good” possibilities– price increases resulting from desirable circumstances– while the third of these is genuinely bad for society. I’ll get back to that in a second.
For gasoline, people understand this. From a stereotypical American perspective, high gasoline prices are “bad” and represent “the bad guys” (greedy oil CEOs, OPEC) winning. Even moderates like me who believe gas prices should be raised (through taxation) to account for externalized environmental costs are depicted as “radical environmentalists”. People tend to emotionalize and moralize prices: stock prices are “the good guys”– those “short sellers”, in this mythology, are just really bad people– gas prices are “the bad guys”, a strong dollar is God’s will made economics, and no one seems to care too strongly about the other stuff (bonds, metals, interest rates).
I don’t think that any of these exchange-traded commodities deserve a “good guys”/”bad guys” attitude, because investors are free to take positions as they wish. If they believe that oil is “too expensive”, they can buy futures. If they think a publically-traded company is making “too much profit”, they can buy shares. (The evil of corporate America isn’t that companies make too much profit. It’s that the profits they do make often involve externalizing costs, and that they funnel money that should be profit, or put into higher wages, to well-connected non-producing parasites called “executives”.)
There is one price dynamic that has a strong moral component (in terms of its severe effect on peoples’ lives and the environment) and it’s also one where most Americans get “the good guys” wrong. It’s the price of housing. Housing prices represent “the good guys” in the popular econo-mythology, because Americans reflexively associate homeownership with future-orientation and virtue, but I disagree with this stance on the price of housing. People mistakenly believe that the average American homeowner is long on housing (i.e. he benefits if housing prices go up). Wrong. The resale value of his house is improving, but so is the cost of the housing (rental or another purchase) that he will have to pay if he were ever to sell it. A person’s real position on housing is how much housing the person owns, minus the amount that person must consume. In reality, renters are (often involuntarily) in a short position on housing, resident homeowners are flat (i.e. neutral) but become short if they need to buy more housing (e.g. after having children) in the future. In reality, even most single home owners would benefit more from low housing prices and rents than high housing cost levels, because they incur more property taxes and transaction costs. The few who benefit when real estate becomes more expensive are those who least need the help. In sum, the world is net short on real estate prices and rents. If nothing else changes, it’s bad when rents and house prices go up.
If houses become more expensive because of corresponding increases in value, or because incomes increase, the increased cost of housing is an undesirable side effect of an otherwise good thing, and the net change for society is probably positive. These correspond to the first two hypotheses (income and value) that I proposed in the gas-price scenario. I think that these hypotheses explain much of why Americans tend to assume, reflexively, that rising house prices in a given location are a good thing: the assumption is that the location actually is improving, or that the economy is strong (it must be, if people can afford those prices). Rarely is the argument made that the root cause might be undesirable in nature.
An unusual position.
Here’s where I depart from convention. Most people who are well-informed know that high housing costs are an objectively bad thing: the rent really is too damn high. Few would argue, however, that the high rents in Manhattan and Silicon Valley are caused by something intrinsically undesirable, and I will. Most attribute the high prices to the desirability of the locations, or to the high incomes there. Those play a role, but not much of one– not enough to justify costs that are 3 to 10 times baseline. (The median income in Manhattan is not 10 times the national average.) I think that high housing costs. relative to income, almost invariably stem from a bad cause and, at the end of this exposition, I’ll name it. Before that, let’s focus on the recent housing problems observed in New York and Silicon Valley, where rents can easily consume a quarter to a half of a working professional’s income, and buying a family-ready apartment or house is (except for the very wealthy) outright unaffordable. Incomes for working people in these regions are high, but not nearly high enough to justify the prices. Additionally, Manhattan housing costs are rising even in spite of the slow demise of Wall Street bonuses. So the income hypothesis is out. I doubt the value hypothesis as well, because although Manhattan and San Francisco are desirable places to live and will always a command a premium for that, “desirability” factors (other than proximity to income) just don’t change with enough speed or magnitude to justify what happens on the real estate market. For example, the claim that California’s high real estate prices are caused by a “weather premium” is absurd; California had the same weather 20 years ago, when prices were reasonable. Desirability factors are invented to justify price moves observed on the market (“people must really want to live here because <X>”) but are very rarely the actual movers, because objectively desirable places to live (ignoring the difficulty of securing proximity to income, which is what keeps urban real estate expensive) are not uncommon. So what is causing the rents, and the prices, to rise?
Price inelasticity.
Consider the gasoline example. Is $40 per gallon gasoline plausible? Yes. It’s unlikely, but with the right conditions, that could easily happen. Gasoline is an inelastic good, which means that small changes in the available supply will cause large movements in price. Most Americans, if they were asked what the price effect of a 2-percent drop in gasoline (or petroleum) supply would be, would expect a commensurate (2%) increase– possibly 5 or 10 percent on account of “price gouging”. That’s wrong. The price could double. The inelasticity associated with petroleum and related products was observed directly in the 1970s “oil shocks”.
Necessities (such as medicines, addictive drugs, housing, fuel, and food) exhibit this inelasticity. What price inelasticity means is that reducing (or in the case of real estate, damaging) the quantity supplied increases the aggregate price of the total stock, usually at the expense of society. For a model example, consider a city with 1 million housing units for which the market value of living there (as reflected in the rent) is $1,000 per month. If we value each unit at 150 times annual rent, the total real estate value is $150 billion, and we’d expect prices to be around that number. Now, let’s assume that 50,000 units of housing (5 percent) are destroyed in a catastrophe (crime epidemic, rapid urban decay, a natural disaster). What happens? A few people will leave the city, but most won’t, because their jobs will still be there. Many will stay, and will be on the market for a smaller supply of housing. Rents will increase, and given the inelasticity of housing, a likely number is $2,000 per month. Now each housing unit is worth $300,000, and with 950,000 of them, the total real estate value of the city is $285 billion. Did the city magically become a better place to live? Far from it. It became a worse place to live, but real estate became more expensive.
Inelasticity and tight supply explain the “how” of sudden price run-ups. As I’ve alluded, there are three explanations for increases in urban real estate values applying to locations such as New York and Silicon Valley:
1. Income hypothesis: prices are increasing because incomes have improved. Analysis: not sufficient. Over the past 20 years, rents and prices in the leading cities have gone up much faster than income has increased.
2. Value hypothesis: prices are increasing because the value of the real estate (independent of local income changes, discussed above) has gone up. Analysis: very unlikely. Value hypotheses can explain very local variations (new amenities, changes in views, transportation infrastructure, school district changes) but they very rarely apply to large cities– except in the context of a city’s job market (which is a subcase of the income hypothesis). Value hypotheses do not explain the broad-based increase in San Francisco or New York real estate costs.
3. Calamity hypothesis: something bad is happening that is causing the scarcity and thereby driving up the price. Analysis: this is the only remaining hypothesis. So what is happening?
Examining Manhattan, there are several factors that constrict supply. There’s regulatory corruption pushed through by entrenched owners who have nothing better to do than to fight new development (who therefore keep some of the most desirable neighborhoods capped at a ridiculous five-story height limit). Government irresponsibly allows foreign speculators into the market, when New York is long past needing a “six months and one day” law (that makes it illegal or own substantial property without using it for at least 50.1% of the year, thus preventing Third World despots, useless princes, and oil barons from driving up prices). Then there’s the seven-decade old legacy “rent control” system that ties about 1 percent of apartments up (in the context of price inelasticity, a 1-percent supply compromise is a big deal) while allowing people for whom the program was not intended (most present-day rent-control beneficiaries are well-connected, upper-middle-class people, not the working-class New Yorkers the program was intended for) to remain locked in to an arrangement strictly superior than ownership (1947 rents are a lot lower than 2012 maintenance fees). Finally, there are the parentally-funded douchebags working in downright silly unpaid internships while their parents drop $5,000 per month on their spoiled, underachieving kids’ “right” to the “New York experience”. All of these influences are socially negative and compromise supply, and thereby drive up the price of living in New York, but I don’t think any of these represent the main calamity.
My inelasticity example illustrated a case where a city can become a less desirable place to live (due to a catastrophe that destroys housing) but experience a massive increase in aggregate market value of its real estate, and I’ve shown several examples of this dynamic in the context of New York real estate. Trust-fund hipster losers and alimony socialites who’ve gamed their way into rent control don’t make the city better, but they drive up rents. In these cases and in my model example, value was strictly destroyed, but prices rose and “market value” increased. History shows us that this is the norm with real estate problems. Catastrophes reduce real estate prices if they have income effects, but a catastrophe that leaves the local job market (i.e. the sources of income) intact and doesn’t inflict a broad-based value reduction will increase the market price of real estate, both for renters and buyers. One recent example of this is the what Manhattan’s real estate industry knows as “The 9/11 Boom” in the 2000s. The short-term effect of the terrorist attack reduced real estate prices slightly, but its long-term effect was to increase them substantially over the following years. The intrinsic value of living in Manhattan decreased in the wake of the attack, but speculators (especially outside of New York and the U.S.) anticipated future “supply destruction” (read: more attacks) and bought in order to take advantage of such an occasion should it arise.
However, the post-9/11 real estate boom is over in New York, and wouldn’t affect Silicon Valley, Seattle, or Los Angeles at all. There has to be another cause of this thing. So what is it?
The real cause.
I’m afraid that the answer is both obvious and deeply depressing. Prices are skyrocketing in a handful of “star cities” because the rest of the country is dying. It’s becoming increasingly difficult, if not impossible, to maintain a reliable, middle-class income outside of a small handful of locations. I’ve heard people describe Michigan’s plight as “a one-state recession that has gone on for 30 years”. That “recession” has spilled beyond one region and is now the norm in the United States outside of the star cities.
As I’ve implied in previous posts, the 1930s Depression was caused by (among other things) a drop in agricultural commodity prices in the 1920s, which led to rural poverty. History tends to remember the 1920s as a prosperous boom decade, which it was in the cities. In rural America, it was a time of deprivation and misery. The poverty spread. This was a case of technological advancement (a good thing, but one that requires caution) in food production leading to price drops, poverty of increasing scope, and, eventually, a depression so severe that it became worldwide, encouraged opportunistic totalitarianism, and required government intervention in order to escape it.
What happened to food prices in the 1920s is starting to happen to almost all human labor. People whose labor can be commoditized are losing big, which means that capital (including the social and cultural varieties) is king. This shrinks the middle class, increases the importance of social connections, and admits certain varieties of extortion. One of these is the increasing tuition in educational programs, admissible on account of the connections these provide. Another is the high cost of housing in geographical regions where the dwindling supply of middle-class jobs is concentrated, and it’s the same dynamic: as the middle class gets smaller, anything that grants a chance at a connection to a “safe” person, company, or region becomes dramatically more expensive.
Incomes and job availability are getting better in the star cities (in contrast against the continuing recession experienced by the rest of the country) but the improvement is more than wiped out by the increasing costs of housing. The star cities are getting richer and more taxed (largely by real estate markup) at the same time. Outside of the star cities, real estate costs have stopped rising (and have fallen in many places) but the local economies have done worse, canceling out the benefits. Landlords have successfully run a “heads, I win; tails, you lose” racket against the rest of the world. When their locales do well, they get the excess income that should by rights go to the workers. When their locations do poorly, they lose, but not as much as the working people (who lose their jobs as opposed to mere resale value). This has always been the case; landowners have always had that power (and used it). What has changed is that the disparity between “star cities” and the rest of the country has become vast, and it seems to be accelerating.
Rents and property prices in New York and Silicon Valley aren’t going up because those locales are becoming more desirable. That’s not happening. Since high housing costs lead to environmental degradation, traffic problems, crime and cultural decline, it’s quite likely that the reverse is true. Rather, they’re going up because the rest of the country is getting worse– so much worse that a bunch of former-middle-class migrants have to crowd their way in, making enormous sacrifices in doing so, because good jobs anywhere else are becoming scarce. These migrations (caused by the collapse of desirability in other locations) increase demand for housing and allow rents and prices to rise. That is why the rent is too damn high.
The good news is that there is a visible (if not easy to implement) solution: revitalize locations outside of the star cities. Small business formation (without personal liability, which defeats the purpose of the limited liability corporation– a controversial but necessary innovation) needs to be made viable outside of the star cities. Right now, growth companies are only feasible in a small set of locations, because starting the most innovative businesses will require a rich client (New York, Los Angeles) or a venture capitalist (Silicon Valley) but, as innovative and more progressive mechanisms for funding (such as Kickstarter) emerge, that may change. I hope it does. This extreme geographic concentration of wealth and innovation is far from a desirable or even sensible arrangement, and it makes our rents too damn high. We shouldn’t be satisfied with one Silicon Valley, for example. We should strive to have ten of them.
