Reflection on the Housing Boom

An average household needs to earn enough money to be able to afford an average house. A one hundred thousand dollar income family can afford a three to four hundred thousand dollar house. Not much (if any) more than that, and they probably wouldn't want to go any less than that (we always stretch up to the very top of our means). If the average house costs more than the average income we get into trouble.

So what happened was that the prices of houses rose higher than the "average" income. How did house prices get too high? The answer to that question has a lot to do with unwise interest rate cuts from the Fed (which encouraged more people to buy homes) mixed in with very bad and/or lax regulation of the financial markets. But to address the financial crisis, we need to know that the root cause is that house prices got so high that the average household could no longer afford an average house. Once that got out of whack, a "correction" (i.e. decline in home value) was inevitable.

There are two ways to address this. One is to let house prices drop to where an average house is within the means of an average household. The second is to wait around until the income of the average household rises to where they can once again afford an average house. But that's a long-term solution and tough to wait around for while people are being put out of their homes. Letting house prices go on falling is easier, although awful for anyone who owns a home.

Now, a bailout is necessary to keep the financial system from dying under the weight of all that bad debt. But if that plan is focused on keeping house prices from falling, it would kill us, because we would never get there. If we succeeded and kept house prices up, we would remain stuck in this same problem until incomes rose enough to make house prices affordable. And who knows how long that would take, or how much human damage it would cause while waiting for it to happen?

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