Trends and operations in the housing market underpin to a great extent the economic behavior of individuals and markets. This market’s unique economic importance is derived from several key features of the market, including its size, its indispensable character to people and its manners of financing, investment and consumption. It is thus easy to understand why many claim that housing economics underlie the current economic and financial slowdown.
This paper aims to analyze the housing market as a primary indicator for the economy. Moreover, it uses key characteristics of the current situation in the market to explain macroeconomic concepts and theories. Thus, the main body of this paper is structured in accordance to economic reasoning and issues.
The Housing Market and National Product
The housing market contributes to a nation’s economy in several ways. Among the components of Gross National Product (GDP), housing activities represents production of construction-related goods and services, investments and housing services (i.e. renting activities). While the housing sector accounts to 3-10 percent of GDP and Gross National Income GNI and 20-30 percent of all gross fixed capital formation (Angel, 2000), countries differ in the division of housing activities between the government (e.g. through public housing schemes) and the private sector. Thus, it is clear that trends in this market significantly influence any country’s economy.
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When estimating the contribution of the housing market to measurements of national income and added value, economists consider several levels of economic activities: The simplest level of measurement is transactions in the marketplace. These include building and maintenance services, related industries, real-estate services, sales and rental. In addition, the purchase of new housing by households and landlords, known as residential investment, is another critical component of national income.
However, other consumption issues are not made in the marketplace but must be considered as well. For example, once a person bought a house for himself, it would be fundamentally wrong to ignore the economic value of the house. That is, the house still serves as a valuable object, which provides housing to people, although they do not pay any rent for it. In order to consider this value as part of the economy, economists assume an imputed value of rent, as if the owner pays rent for himself. As a result, they prevent a paradoxical situation in which rented houses continue to create value (income for the owner and expense for the tenant), whereas unrented houses have no economic significance.
The current housing market poses a major problem in terms of its underlying value creation. More specifically, excess construction during past years, boosted by fiscal incentives and reach supply in money markets, resulted in high rates of vacant houses. The major reason for that is the fact that the growth in the housing market outpaced the growth in population.
Thus, not only equity investments depreciated due to lower sale and rental prices (the microeconomic equilibrium of demand and supply), but also the drop in growth rates of new tenants compared to creation of new houses has reduced the value of housing as an economic activity. Consequently, the US housing market has put a burden on the US economy. The housing sector has been a constant negative contributor to GDP, way before the outbreak of the financial crises.
Residential Investment and Interest Rate
Changes in interest rate typically bring about an opposite response in the housing market. An increase in the interest rate leads to a decrease in demand for housing and residential investment (Lipsey & Cristal, 2005). This is due to several reasons: (ibid.)
- First, many potential buyers must take out mortgages to finance the investment. Increased interest rates lead to increase in the costs of loans, and hence make housing unaffordable for many people.
- Second, interest rates represent the opportunity cost of investment. Even for people who do not borrow to buy a home, the interest rate measures the opportunity cost of holding their wealth in housing rather than putting it in the bank.
The higher interest rate shifts the demand curve for housing down. This causes the relative price of housing to fall, and the new price make potential investors to avoid residential investment, thus decreasing the supply of houses.
Clearly, the drop in interest rates over the past two years may support the recovery process of the housing market. In order for that to happen, not only interest rates should remain low, but it will be also necessary that investors will perceive lower risk in the market. As in the case of other assets, it is possible that the current low prices, supported with sound fiscal and monetary policies, will bring about a faster recovery in this market than expected.
The Housing Market and Fiscal Policy
Fiscal decisions, in particular tax policies, have a critical influence on the housing market. In an open economy with a strong private housing market, government can encourage the housing market not by public ownership (i.e. direct government investments), but by other means:
- First, by allowing taxpayers to deduct interest on mortgages, the government can offset other trends in the market, and thus to subsidize home ownership and owner-occupied housing. Interestingly, the deduction is based on the nominal mortgage rate, so it is less influential today, because the inflation is rather low.
- Second, taxes on the income from a house (mainly rent), has a capitalization effect, which reduces the value of an asset. For example, a tax on the imputed income from owner-occupied housing depresses the value of houses (Rutherford, 2002). This effect may drive people to rent a house instead on owning it.
- Third, the US government can leverage its current ownership of mortgage companies by shifting some of its welfare expenditure to housing. By allowing in-kind transfers to low income Americans, houses can be occupied and welfare money can be saved through using those assets, which are currently depreciated. A secondary effect of such an action can be lower supply of vacant houses and thus higher price equilibrium in the housing market.
- Forth, the government needs to examine the degree to which it influences the level of risk in the market. Lower risk can be directly related not only to tax, but also to the barriers that are put on the different players. Higher residential investment can be achieved by allowing home builders to function effectively in a competitive and open economy, remove barriers that influence the efficiency of construction activities, and by ensuring regular supply of materials and machinery (Angel, 2000). It is clear, however, that all fiscal policy issues must be dealt with cautiously, in order to prevent the current situation, when too many incentives to the housing market have brought about overbuilding, excess supply, burden on national income arguably underpinned the recent economic and financial crisis.
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Bibliography
Angel, S. (2000). Housing Policy Matters: A Global Analysis. New York: Oxford University Press.
D’amika, K. (2008). Trends in GDP: The Housing Bust Continues, Net Exports Surge. American Institute for Economic Research. Retrieved August 8, 2009 from <http://www.aier.org/research/commentaries/453-trends-in-gdp>
Gärtner, M. (2006). Macroeconomics (2nd edition). Harlow: Pearson Education.
Housingbubblebust.com. (2008). Is the US overbuilt? Retrieved August 8, 2009 from <http://www.housingbubblebust.com/PopHsgRates/Overbuilt.html>
Lipsey, R. G. & Cristal, A. K. Economics (10th edition). New York: Oxford University Press.
Rutherford, D. (2002). Routledge Dictionary of Economics (2nd edition). New York: Routledge