Monday, June 25, 2007

Housing Market Distortions

Most traditionalist economists believe that markets are always in equilibrium. I believe that markets are almost always out of equilibrium. The questions speculators have to answer correctly are: how much, and in which direction.

Comparing the housing market and the stock market can give a lot of insight into causes of disequilibrium. The stock market can be broken down into stocks that are heavily traded and stocks that are thinly traded. To a large extent the national housing market behaves like a heavily traded stock, but local markets trade more like thinly traded stocks.

Another useful dichotomy: is the trading auction style, or swap style? By swap style I mean the traditional markets as described by Adam Smith: a rational (or at least savvy) person at each end, trading something of value, when there is an elastic supply of the two items (one usually being money) to be traded.

Today there is an almost 10 month supply of unsold houses on the U.S. national market. Two years ago houses more often than not sold the day they were put on the market; houses under construction sold before construction began. Yet the economy is arguably stronger on the whole today that it was two years ago. Anyone who argues that the housing market, or sale prices of housing, is always at equilibrium is saying nothing. They are defining equilibrium to be whatever happens. Same for stock prices.

Suppose you are going to buy something; it could be a stock or a house. As long as the price is rising and continuing to rise it makes sense to buy as soon as possible. Maybe normally you would save up a 20% down to get a good interest rate on a mortgage; but with prices increasing, it makes more economic sense to put 5% down and pay a higher interest rate now, rather than waiting two (or ten) years to save up the down.

The same becomes true when prices are falling. Why buy house now, even if you want it and think it will be a good long term investment, if you think you can buy it for 5% or 10% less if you just wait 6 months?

Rising prices accelerate demand, which in turn makes prices rise more. That is one reason why stock prices and housing prices tend to be out of equilibrium. Falling prices tend to dampen immediate demand, which in turn causes prices to fall more. That is the other main reason prices are usually out of equilibrium. These tendencies are the basis of macroeconomic cycles and of stock market price fluctuations that may last hours, weeks or even years (or, with super-fast computerized program trades, fractions of a second).

Auction systems aggravate these trends, partly because of human psychology and partly because they create a short-term artificial scarcity or surplus. Price swings in thinly traded, illiquid stocks display this.

Buyers in the housing market aren't going to be in a hurry until prices start rising again. The exact turning point won't be obvious, partly because it will take place in different localities at different times. The willingness, and ability, of lenders to finance purchases may stall or accelerate the process of finding a bottom.

But there will be a bottom. Strangely, the longer it takes to reach it, and the deeper the retreat in prices is, the more people will think there is no bottom.


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  3. I'm don't see much here related to "Housing Market Distortions," only a simple explanation of supply and demand.

    You make a valid point about the psychology of increasing or decreasing prices.

    Another analogy is the rapid change in the computer market. For a long time, these marvelous machines looked to be great investments at any price because of the capital value one could produce from the asset.

    Then, a thousand clones spawned a million small manufacturers of cheaper computers with increasing functionality, speed, and reliability. So prices fell rapidly at the same time as PCs got bigger and better. Many tech market analysts say “it’s never a good time to buy a computer, as it will either be obsolete or cheaper in a month or two. True, however, the machines flew off the shelves faster than they could be built.

    Then, a lot of people saw the potential of the rapidly growing market and speculated the stock prices of PC manufacturers and software companies out of any comprehensible range of value reality, thus, bringing about the hyperinflation and subsequent bursting of the “tech bubble.”

    Your article seems to lack significant decaration or analysis of the "distortions" you perceive.

    What are the distortions? Is the housing market distorted by housing demand" Housing price? Over-abundance of unsold homes?

    I believe there is a huge demand for housing in this country, just look at the number of renters and working roommates verses homeowner equity. Plenty of people need housing, which is, in my opinion overpriced due to mortgage funding market distortions that have increased the book value of home prices.