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- Housing Crisis: A Misidentification
- Byron A Ellis – January 26, 2009
Residential investment consists of the construction of single-family and multi-family dwellings (housing). Residential investment tends to decline in all recessions, including mini recessions. However, yearly investment in housing is a very small portion of the existing housing stock, less than 5 percent; and, it is contingent on the demand for the existing stock of housing.
The demand for housing depends on income and prices. According to economic theory, the lower the price of housing and the greater wealth, the greater is the demand for housing.
The above graph indicates that the price of housing is determined by the interaction of the fixed supply of housing stock, H0, and the demand for housing, DH0; housing prices rise to PH2 when income rises, shifting the demand curve outwards to DH2, and falls to PH1 when income diminishes, shifting the demand curve inwards to DH1.
When increases in income shift the demand curve outwards, DH2, at the prevailing price, PH0, the demand for housing stock increases by H1-H0 and prices increase between PH0 and PH2.
Clearly, the current fall in housing prices is due to an inward shift of the housing demand curve, resulting from a reduction in consumers’ income. Otherwise, lower housing prices would have increased the demand for housing to H1.
However, pundits, some economists, and government officials continue to claim that the economic crisis is due to the housing foreclosures. But, that could not be the case, since the variables affecting demand are income and prices. If income rises (falls), the demand for normal goods increases (decreases). Thus, the drop in housing demand is due to a loss of income.
The National Income Products Accounts (NIPAs) summarize seven accounts that show the composition and distribution of incomes earned in production. The Domestic income and product account treats housing (residential investment) as investment. Residential investment in 2007 is not significantly different from 2002.
The graph below depicts real residential investment for 2002-2007 periods; during this period real residential investment was less than 5.5 percent of gross national product (GDP). Thus, it is difficult to argue that less than 5.5 percent of GDP could cause a worldwide economic crisis. Moreover, mortgage foreclosures are a mere percentage of residential investment.
The economics crisis is due to lack of income. However, injecting money into financial institutions is unlikely to restore consumers' income.
The invasion of Iraq caused the price of crude oil to rise. Higher cost of energy created a significant and rapid shift in wealth. It is this reduction in consumers’ wealth that has adversely affected income, and the demand for goods and services.
If energy cost remains low and government stimulus is targeted to boost efficient domestic manufacturing, the economic recovery will be accelerated. However, if the bulk of the stimulus is used to pay for foreign goods and services, recovery will be long and painful.
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