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On California

In my last “On California” column, I showed that Orange County housing prices skyrocketed from $200,000 in 1996 to $670,000 in 2004—an increase of 235% over the eight-year period. That compares over the same years to a much milder 60% increase for the U.S. as a whole. I concluded that article by showing that the current mismatch between income and housing prices in Orange County, as well as in California, stems from the spike in housing appreciation that occurred during the period. I left as a mystery how and why it happened.

Now that mystery needs to be solved. During the Golden Age of detective fiction, it was pretty safe to conclude that, “The butler did it!” There’s no butler in our housing price mystery. But if Milton Friedman were around, perhaps in the guise of Hercule Poirot, I’m pretty sure he would exclaim, “The government did it.” Milton, aka “Hercule,” would be right.

Between 1996 and 2004, there was a veritable perfect storm of new government programs and initiatives designed with the noble intent of increasing the home ownership rate. The programs included the Taxpayer Relief Act of 1997, which made capital gains of up to $500,000 for married couples nontaxable. In addition, various laws, especially the Community Reinvestment Act, were enacted to require lenders to lend to borrowers, even if they didn’t meet certain performance-related lending standards. Government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac joined the bandwagon as political pressure was placed on them to allocate more funding to low-income households. Eligibility requirements to conform to Fannie and Freddie’s lending standards, as a result, were loosened.

Another little-known but very important change occurred around 1995, when new standardized underwriting guidelines made it easier and faster to get loan approval. The automatic processing of loans effectively increased the credit box in secondary markets.

I personally believe the most important development that ignited the housing market during the 1996 to 2004 period was the rapidly increasing U.S. trade deficit. That growing deficit, from about $180 billion in 1996 to $700 billion by 2004, led to sharp increases in the demand for mortgage-backed bonds, which were widely thought to be government-backed if they were issued by GSEs, like Fannie and Freddie.

The process went something like this: U.S. oil imports from Saudi Arabia increased between 1996 and 2004. The Saudi Arabians had to invest that inflow of U.S. dollars. What safer way to do that than buy collateralized mortgage bonds issued and “insured” by Fannie Mae?

The perfect storm of policies and programs designed to increase home ownership had its intended impact. The home ownership rate, which hovered in a narrow range of 64% to 66% between 1965 and 1995, rose sharply from 64% in 1996 to 69% by 2004. And with such a sudden increase in home ownership in a relatively short period of time, home prices went through the roof.

But why did housing appreciation go up so much faster in California than in the rest of the U.S.? The policies and programs described above affected the entire nation—not just California.

To answer that question, one needs to understand that the housing market differs from other markets in several important ways. Producing homes is not like producing automobiles. If demand for autos were to spike upward as a result of some government-inspired plan to increase auto ownership, prices would undoubtedly increase for a time but quickly settle back to normal levels as auto production increased. That doesn’t quite happen with housing, since land is needed to provide that good. And in markets where land is in short supply because of building restrictions and costly environmental regulations, such as those in California, housing prices will increase faster as demand increases. Those higher prices, in turn, will tend to remain high, since supply is restricted by costly regulations.

That is more vividly shown in the figure above.

Consider in the figure a situation where there are two housing markets that start off with the same housing stock (So). As demand increases because of government-induced policies, supply will increase. But the increase will be greater where land development is less regulated (SL) than where land is highly regulated (SR).

Notice that as demand shifts from D0 to D1, the resulting equilibrium housing price in a more regulated land market like California (PR) is higher than the equilibrium price in the less regulated market (PL).

It should be noted that the differing quantity and price effects of high versus low regulated markets are made even more extreme in high income areas like Silicon Valley and the coastal regions of Southern California, where housing demand is higher. The upward shift in demand would be even greater than that depicted in the figure, leading to even higher housing prices and fewer homes being built.

So Milton Friedman, as usual, would be right. “The government did it.”

And just as Milton showed so persuasively in “Capitalism and Freedom” and “Free to Choose,” that in spite of the best intentions, a government policy designed to do one thing generally has exactly the opposite effect. In the case of housing, programs designed to increase home ownership eventually worked to decrease it.

As President Trump would tweet, “Sad … very sad.”

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