Two Decades of Real Estate Data

Total spending on real estate construction has been rising since 2011. By 2016 it had reached its previous 2006 peak. However, total spending on *residential* real estate construction didn’t reach its previous 2006 peak until November of 2020. The graph below also includes the proportion of residential construction spending (Green). It has been rising since 2009. In and of itself, nothing is good or bad about this figure. We might be spending less on non-residential construction because we are getting better at using less land per unit of good or service produced. Or, it could be that our real investment in future production is falling relative to our current residential consumption.  Regardless, the share of residential construction hasn’t been at this level since 2003.

Importantly, the difference in spending has not been driven by different construction costs. Both residential and non-residential construction costs have moved in tandem since 2010. Therefore, the rise in residential construction spending is not merely nominal – a greater proportion of resources are being consumed by residential construction. Indeed, real residential construction is up about 25% from 2019. The figure below illustrates real residential and nonresidential construction.

That figure requires a double-take.

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Inflation Empirics

Way back in the late 1970s and early 80s, Kydland and Prescott proposed rational expectations theory. This line of research arose, in part, because the Phillips curve ceased to describe reality well. Amid increasing inflation, people began to anticipate higher prices to a relatively correct degree when making labor, supply chain, and pricing decisions. Kydland and Prescott argued that individuals understand the rules of the game or how the world works – at least on average.

An increase in the money supply would increase total national spending, and increase demand for goods. However, firms also experienced increasing revenues and demanded more inputs such as commodities, capital, and intermediate goods. Because there were no greater productivity earlier in the supply chain, price roses. Firms began to understand that greater demand would eventually find its way to causing greater costs. Therefore, firms began raising prices before the cost of resources rose, increasing their willingness to pay for inputs and, ironically, hastening the increase in input prices. As a result, increases in the money supply began having substantial short-run price effects and negligible output effects.

However, assuming that people understand the rules of our economic system and ‘how the world works’ is hard to swallow. It is not at all clear that the typical economist understands monetary theory, much less clear that the typical person has a good understanding. Fortunately, another theory of expectations can help carry some of the load and achieve similar results.

Adaptive Expectations

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Asymmetric Liability, Common Law, & Urbanization

Tort law is interesting. You can argue that someone harmed you, and you can cite almost no legislation in the process. Torte law in the US uses case law – the precedent set by previous rulings in the context of social norms. But, what cases did the early cases cite? They also cited earlier cases and social norms, though we may no longer have a record. The beauty of tort law it allows for changing relative costs in prudence and negligence.

Can you imagine a legislature attempting to codify the appropriate amount of neglect by, say, a painter? The standards would quickly go out of date. The relative cost of resources including labor, communications, materials, and the price differences among competitors of differing quality all change over time. Multiply these factors by 20 and then again by the number of occupations and regions in a country. You will quickly see that legislating the appropriate degree of prudence and neglect through congress is a fool’s errand. The challenge is too complicated and the world changes too quickly. In fact, attempting to legislate definitions for neglect and prudence could even backfire and result in regulatory arbitrage, which occurs when firms comply with de jur rules while avoiding them de facto.*

Externalizing Costs

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Mises’s Bureaucracy, a Recap

My favorite two economists are Ludwig Von Mises and Milton Friedman. They might consider one another from very different schools of thought, though there is reason to think that they are not so different. As an undergraduate student, I liked them both, but I became more empirics-minded in graduate school and as a young assistant professor.

As I progressed through graduate school and conducted empirical research, my opinions and policy prescriptions changed and were refined from what they once were. In graduate school, I didn’t study Austrian Economics, though it was certainly in the water at George Mason University. Recently, as an assistant professor with a few years under my belt, I picked up Bureaucracy (1944) and read it as a matter of leisure.

One word:

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Teaching Price Controls (Poorly)

Economics textbooks differ in their treatment of price controls. None of them does a great job, in my opinion. The reason is mostly due to the purpose of textbooks. Despite what you might suspect, most undergraduate textbooks are not used primarily to give students an understanding of the world. They are often used as a bound list of things to know and to create easy test questions. If a textbook has to change the assumptions of a model too much from what the balance of the chapter assumes, then the book fails to make clear what students are supposed to know for the test.

I think that this is the most charitable reason for books’ poor treatment of price controls – even graduate level books. The less charitable reasons include sloppy exposition due to author ignorance or an over-reliance on math. I honestly would have trouble believing these less charitable reasons.

I picked up 5 microeconomics text books and the below graph is typical of how they treat a price ceiling.

The books say that the price ceiling is perfectly enforced. They identify producer surplus (PS) as area C and consumer surplus (CS) as areas A & B. There are very good reasons to differ with these welfare conclusions.

Problem #1

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Fences, Schools, Dryer Lint, & Shower Levers

In game theory, coordination games reflects the benefits of everyone settling on the same rules. Settling on the same rules can avoid a conflict and destructive competition. For example, some rules may be arbitrary, such as on which side of the road we’ll all drive. It doesn’t much matter whether a country’s vehicles drive along the right or left side of the street. As long as everyone is in the same lane, we overwhelmingly benefit from our coordination. The matrix below describes the game.

The above game reflects that whether we agree to drive on the left or on the right is trivial and that the important detail is that we agree on what the rule is. Rules like this are arbitrary. No amount of cost benefit analysis changes the answer. Other coordination rules are seemingly arbitrary, but do have different welfare implications. For example, according to English common law, a farmer was entitled to prohibit a herdsman’s flock from trampling his crops even if the farmland had no fence. Herdsmen were responsible for corralling their flocks or paying damages if they grazed on the farm. With lots of nearby farms, total welfare was higher with a rule of cultivation rights rather than grazing rights.

But the property rights could have been assigned to the herdsman instead. The law could have said that the sheep were free to graze with impunity and that the onus was on the farmer to build fences in order to keep the sheep at bay. In a world where there are a lot of farmers who are very nearby to one another, a small flock of sheep can do a lot of damage. And so, the cost-benefit analysis prescribes that herdsmen bear the cost of restricting the flock rather than the farmer. The matrix that describes this circumstance is below.

The above matrix reflects that agreeing on any rule is better than no rule at all. And, the rule that is selected has societal welfare implications. Choosing the ‘wrong’ rule means that we could get stuck in a rut of lower payoffs because coordinating a change in the rules is hard.


Another way in which the specific rule can be important is by whether it instantiates or works contrary to pre-existing incentives. Before compulsory schooling laws were passed, US states already had very high school attendance rates. Most parents sent their kids to school because it was a good investment. The ages at which children should be required to attend is largely, though not entirely, arbitrary. And wouldn’t you know it, most states applied their compulsory schooling legislation to the age groups for which the vast majority of children were already attending school. Enforcing a law against the natural incentives of human capital investment would have been more costly. The particular ages of compulsory schooling had different welfare implications due to the differing costs of enforcement.

Dryer Lint

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Housing & The Fed’s Reputation

I am not worried about inflation and I’m not worried about the total spending in the economy. As I’ve said previously, total spending is on track with the pre-pandemic trend and, I think, that helped us experience the briefest recession in US history. When output growth declines below trend, we face higher prices or lower incomes. The former causes inflation, the latter causes large-scale defaults. Looking at the historical record, I’m for more concerned about the latter.

I do, however, want to call special attention to the composition of the Fed’s balance sheets. Specifically, its Mortgage Backed Security (MBS) assets. Having learned from the 2008 recession, the Fed was very intent on maintaining a stable and liquid housing market. Purchasing MBS is one way that it maintained that stability. Its total MBS holdings almost doubled from March of 2020 to December of 2021 to $2.6 trillion. Should we be concerned?

At first, a doubling sounds scary. And, anything with the word ‘trillion’ is also scary. Even the graph below looks a little scary. MBS holdings by the Fed jumped and have continued to increase at about a constant rate. Is the housing market just being supported by government financing? What happens when the Fed decides to exit the market?

Luckily for us, there is precedent for Fed MBS tapering. The graph below is in log units and reflects that a similar acceleration in MBS purchases occurred in 2013. Fed net purchases were practically zero by 2015 and total MBS assets owned by the Fed were even falling by 2018. Do you remember the recession that we had in 2013 when the Fed stopped buying more MBS’s? Wasn’t 2018-2019 a rough time for the economy when the Fed started reducing its MBS holdings? No. We experienced a recession in neither 2013 nor 2018. Financial stress was low and RGDP growth was unexceptional.

Although there was no macroeconomic disruption, what about the residential sector performance during those times? Here is a worrisome proposed chain of causation:

  1. Relative to a heavier MBS balance sheet, the Fed reducing its holdings increases supply on the MBS market.
  2. This means that the return on creating new MBS’s falls (the price rises).
  3. A lower return on MBS’s means that there is less demand from the financial sector for new loans from loan originators.
  4. A tighter secondary market for mortgages decreases the eagerness with which banks lend to individuals.
  5. Fewer loans to individuals puts downward pressure on the demand for houses and on the price of the associated construction materials.

The data fits this story, but without major disruption.

Less eager lenders went hand-in-hand with higher mortgage rates and less residential construction spending. The substitution effect pushed more real-estate lending and spending to the commercial side. Whereas residential spending was almost the same in late 2019 as it was in early 2018, commercial real-estate spending rose 13% over the same time period.

But, importantly in the story, the income effect of a Fed disruption should have been negative, resulting in less total spending and lower construction material prices. And that’s not what happened. Total Construction spending rose and so did construction material prices. Both of these are the opposite of what we would expect if the Fed had caused disruption in the housing construction sector due to its MBS holding changes.   Spending on residential construction fell understandably. But spending on commercial construction and the price of construction materials rose.

My point is that you should not listen to the hysteria.

The Fed has a variety of assets on its balance sheet and it pays special attention to the residential construction sector. Do you think that there is a residential asset bubble? Ok. Now you have to address whether the high prices are due to demand or supply. Do you suspect that the Fed unloading its MBS’s will result a popped bubble and maybe even contagion? It’s ok – you’re allowed to think that. But the most recent example of the Fed doing that didn’t result in either a macroeconomic crisis or substantial disruption in the construction markets.

The Fed has a track record and it has a reputation that serves as valuable information concerning its current and prospective activities. The next time that someone gets hysterical about Fed involvement in the housing sector, ask them what happened last time? Odds are that they don’t know. Maybe that information doesn’t matter for their opinion. You should value their opinion accordingly.

Optimal Policy & Technological Contingency

A person’s optimal choice depends on what they know. To consume more ice cream? Or to consume more alcohol? It depends on what we know about the expected utility across time. If a person thinks that alcohol has few calories, then it is understandable that they would choose to drink rather than eat. The person might be totally wrong, but they are acting optimally contingent on their knowledge about the world. (FWIW, 4oz of ethanol has 262 calories and 4oz of typical ice cream has 228 calories.)

The case is analogous for good government policy. The best policy is contingent on accessing the distribution of knowledge that’s inside of multiple people’s heads. It’s not sensible to assert that a policy is suboptimal if the optimal policy requires knowledge that neither a single individual nor all people together have. Even if the sum of all knowledge does exist, it may not be possible to access it.

Economists like to tell their undergraduate classes that it doesn’t matter who you tax. But that’s contingent on 1) identical compliance costs among buyers and sellers and 2) identical relevant information. If a tax comes as a surprise to the buyer or the seller, then it absolutely matters who is taxed.

When I was in 1st grade in North Carolina, my class went on a field trip to a Christmas tree farm. We learned a bunch about maintaining the farm and we got to choose a pumpkin to take home. At the end of our visit we took turns perusing the gift shop. My mother had generously given me a dollar to spend  and I was eager to spend it (I rarely had money to spend). Unfortunately, even in the early mid-90s, most of the things in the shop cost more than $1. So, I settled on purchasing some beef jerky that cost 99 cents.

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The Justice Dividend

While I was listening to The New Bazaar and enjoying an episode with Tim Harford, I was reminded that economists don’t just have the job of understanding the world. We have a responsibility to our fellow man of keeping fallacy and economic misunderstanding at bay (a Sisyphean task).  That doesn’t mean that we just teach economic theory. We can and should advocate for good economic policy ideas and try to think up some policy alternatives that fit our political climate.

Here I was sitting, being grumpy at the US Federal deficit, when an idea came to me. I am full of ideas. Especially unpopular ones. So, I especially like ideas that make political sense to me given that the political parties care about their policy values and re-election. Asserting that people in congress actually care about policy apart from re-election is kind of a pie-in-the-sky assertion. But, here we go none the less.

Mancur Olson liked to emphasize the role of concentrated benefits and diffused costs in political decision making. Economists point to it and explain the billion-dollar federal subsidies that go to interest groups. A favorite example is Sugar subsidies. As of 2018 there were $4 billion in subsidies and sugar growers earned $200k on average. The typical family of four pays about $50 more in subsidies each year as a result. The additional tax burden of higher sugar prices is also relatively small. Therefore, says the economist, the few sugar beet and sugar cane farmers have a large incentive to ensure the subsidy’s survival while others pay a relatively small cost to maintain it. That small cost means that there is little money saved and little gain for any individual who might try to fight the applicable legislation.

That’s the standard story. But it’s so much worse than a story of concentrated benefits and diffused costs. The laity don’t know how the world works in two important ways. First, many people will simply say that they are happy to protect American producers for an additional $50 per year. That’s a small price to pay for ensuring the employment and production of our fellow Americans, they say. An economist might reply, in a manner that so automatic that it appears smug, that that $50 would instead go to producers of other goods and that our economy would be more productive if the sugar-producing resources were diverted elsewhere. This is Bastiat’s seen and unseen. Honestly, I suspect that neither economists nor non-economists can adopt the idea without a little bit of faith.

Secondly, people don’t know what causes a particular price to change. Hayek painted this characteristic as a feature of the price system. We are able to communicate information about value and scarcity without evaluating the values of others or the actual quantity of an available resource. However, lacking causal knowledge of prices makes for some bad policies. Say that the subsidies and protections subsided and the price of US sugar declined. The consumer would likely not know anything about the subsidies in the first place, much less that they were rescinded. Further, the world is a complicated place and people are apt to thank/blame irrelevant causes otherwise (corporate greed, anyone?).

When economists blame concentrated benefits and diffused costs, they often assume that there is perfect information. THERE ISN’T. People don’t know how the world works well enough to predict with confidence what will happen in an alternate version of reality without subsidies. Nor do they understand the particular determinants of prices in our current world. Half the battle is a lack of knowledge about the functioning of the world – not just that the costs and benefits fail to provide a strong enough incentive for legislative change.

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Happy New Year!

Did you notice that social media had much less traffic and activity today? It seems like even less than on Christmas.

I was instantly sick about all of the emails that went out early in the COVID times from companies that said that “we’re in this together”. Frankly – no we weren’t. Lots of people dissented and still do today.

To a great degree, we share a great deal in common. If you didn’t work today, then you probably spent time with family and friends – it’s a relatively secular holiday. Even if you did work, you probably resented it a little.

But, we do share common experiences otherwise. Make sure that you get home safely tonight. Maybe check-in on your friends in the morning. Be sure to reflect on your life from the past year. Plan like you have many years in front of you and live like you have a single day in front of you.

Happy new year everyone from !