The Housing Market And The Case For Higher Inflation Targets

From a VoxEU column today, by me and Joshua Aizenman:

Might more inflation be good for the US and Europe? This column looks at the housing market in the US and argues that, with houses dropping in price, buyers are playing a waiting game. And as buyers keep delaying, the price drops further. Given the importance of property in many economies, the knock-on effects are severe. Yet one way to break this vicious cycle is with inflation.

The eloquent advocacy for moderate inflation at times of peril goes back to Irving Fisher’s seminal paper on the debt deflation:

“In summary, we find that: (1) economic changes include steady trends and unsteady occasional disturbances which act as starters for cyclical oscillations of innumerable kinds; (2) among the many occasional disturbances, are new opportunities to invest, especially because of new inventions; (3) these, with other causes, sometimes conspire to lead to a great volume of over-indebtedness; (4) this, in turn, leads to attempts to liquidate; (5) these, in turn, lead (unless counteracted by reflation) to falling prices or a swelling dollar; (6) the dollar may swell faster than the number of dollars owed shrinks; (7) in that case, liquidation does not really liquidate but actually aggravates the debts, and the depression grows worse instead of better, as indicated by all nine factors; (8) the ways out are either via laissez faire (bankruptcy) or scientific medication (reflation), and reflation might just as well have been applied in the first place.” Fisher (1933)

This visionary paragraph remains fresh today, particularly at times when the global crisis showed the perils of debt deflation in the US from 2008, and in Europe from 2010. The residential housing market in the US is a prime example of the acidic power of housing deflation.

The key theoretical point is here:

The option-value approach to durable goods implies that housing price deflation and low sales are intertwined. When the odds for housing deflation remain high, households have the incentive to delay purchase, even if they have good access to financing. The zero bound on the nominal interest rate implies that low interest rates may not offset the exposure to capital losses due to expected housing deflation. This configuration may lead to a housing market trap – households engage in a waiting game, delay their purchase, and thereby induce yet faster housing deflation, probably provoking other households to delay their purchase. This in turn pushes more houses to be ‘underwater’, leading to more foreclosures, more fire sales, and so forth.

The social cost of degrading neighbourhoods, where deeper foreclosures reduce the value of other houses, is by now visible in the worst affected states in the US. These dynamics validate the notion of ‘fire-sale externalities’, as well as Fisher’s observation “liquidation does not really liquidate but actually aggravates the debts, and the depression grows worse instead of better.” The laissez faire bankruptcy way of dealing with housing adjustment turned out to be highly inefficient in the US residential market.

This leaves Fisher’s ‘reflation’ option as a viable policy to shorten the painful debt deflation in the US. The logic is simple – moderate inflation for several years would terminate at an earlier juncture the buyer’s ‘waiting game’ in the housing market. Once the deflationary dynamics end, the pent-up demand for houses will be released. The timing game will switch from waiting to ‘rush to buy’. Chances are that this will signal the end of the housing slump, and will invigorate construction.

Our argument applies to certain key countries within the Euro area as much or perhaps even more than it does to the United States. We consider in particular Spain, which as shown in Figure 3 of the VoxEU column has experienced less of an adjustment thus far.

chartFigure 3: House prices in US and Spain. Source: BIS, Annual Review, 2011.

This argument augments the point that Jeffry Frieden and I have made in our Foreign Policy piece on conditional inflation targeting, and which we will expand upon in a forthcoming Milken Institute Review article. See also other proponents here.

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