by Michael Owen

In his recent blog post, “Defending the First Time Homebuyer Tax Credit,” Carl Milsted recognizes the problems that led to the housing market collapse, while relying on the same faulty reasoning government planners use — an outlook that Austrian economists might describe as “scientism,” the unwarranted analogization of economics to the physical sciences — to support the tax credit. By doing so he arrives at a solution that would just prolong the bubble.

Milsted writes:

"Home prices were too high—once again, no argument here. In fact I was in the market a year and a half ago but quit due to sticker shock. But at least in some markets prices are already down enough, and are threatening to go lower."

But, what is “enough?” How does one identify when home prices, or any price for that matter, have fallen "enough"? Milsted doesn’t tell us exactly what constitutes "enough", but he knows it when he sees it? It appears to be a case of the pretense of knowledge, as Hayek famously termed it. He continues:

"For housing, the simple Adam Smith price model is wrong. Supply and demand curves don't give us the current price. Homes take time to build. Homes are almost always purchased with credit; the home market is highly leveraged. When housing is scarce, prices can skyrocket as people use credit to bid up what is available. Eventually, homes get built, pulling prices down, leaving many early buyers owing more than their homes are worth. Some go bankrupt pulling prices down further, which make ever more homeowners underwater on their payments."

On the contrary, supply and demand do set prices. It makes not a whit of difference how long it took to build a house; this is a sunk time cost that is irrelevant to the current price. Too many houses were built in a Fed/GSE/regulatory-driven speculative bubble. In classic fashion, many of the people who have produced and bought these houses at bubble prices now need to sell them, and have discovered that, surprise!, people cannot afford to buy the houses at prices that would be profitable for said producer/sellers. The market provides the solution: home prices must fall, even unto the point that many would-be sellers cannot cover their debts and must go bankrupt. That's what happens in a recession; mistakes are revealed and the mistaken are punished.

"A highly leveraged market is an underdamped filter. Think of a 1970s vintage American land yacht with worn shock absorbers. Such a car smoothes out bumps initially but bounces afterwards. Leverage allows faster home building when demand is high, but creates the potential for a bigger housing bust after the homes are built. In other words, if the government does nothing about the housing bust, prices will go well below equilibrium."

What is the mass of the housing market, and what is its spring constant and damping coefficient, this physicist wonders? Sadly for scientistic descriptions of the economy, markets, whether "highly leveraged" or not, are not underdamped harmonic oscillators, nor are they '72 Gran Torinos with bad suspensions. Again we see the pretense of knowledge. When does one know when the housing market is overshooting "equilibrium"? How, exactly, do the omniscient technicians within government calculate the correct "damping coefficient" to "critically damp" the housing market to "equilibrium" without excess "oscillations", and having calculated it, how do they apply it? I claim that we will know that housing prices have hit equilibrium only when we note that they have stopped falling and markets are clearing.

"The results of going below equilibrium are not pretty. When prices drop too much, homeowners who need to sell but cannot go bankrupt. When banks get a low price on foreclosures, banks cannot afford to lend – which drives home prices down further yet. Positive feedback abounds."

It's never pretty when artificial economic bubbles burst, but trying to avoid the bursting of the bubble by trying to re-inflate it doesn't make it any prettier; it only shifts the ugliness from those who made relatively more and bigger mistakes to those who have made relatively fewer and smaller ones. Banks can't afford to lend because they are insolvent. They are a part of the problem, not part of the cure.

We have to think about what actually happened. Low interest rates and other government policies channeled a tremendous amount of real resources into the housing sector. That sector was overbuilt. Just this increase in supply alone must necessarily reduce equilibrium housing prices compared to what otherwise would have obtained, all else being equal. To be sure, this was all a mistake. That mistake will be paid for. The question is, by whom? By the people who participated in that mistake, or by people who could actually benefit from it, i.e. the savers, i.e. the unleveraged, who could now actually afford to purchase a house at the real equilibrium price, i.e. a low price? Trying to keep housing prices artificially elevated (i.e. to reflate the bubble) necessarily comes at the expense of those who would otherwise be able to afford houses at a lower price.

Why does Carl Milsted want to punish these people and take away their dream of home ownership? Furthermore, trying to concoct a scheme that will simultaneously keep housing prices artificially high and keep people buying is essentially concocting a scheme whereby you are tricking people into paying too much for houses. This is how we got into trouble in the first place, remember?

"It's all well and good to neener dance and say we shouldn't have had such a leveraged housing market in the first place, but that doesn't solve today's problem. Today's problem will result in government action one way or another. Either the government damps the oscillations caused by over-leverage, or the government will control huge amounts of assets via the bankruptcy courts. Government action is a sunk cost. The only question is which government action is less bad."

Milsted seems to imply, according to this definition, any deployment of sound economic analysis in the effort to avoid policy-manufactured disasters is "neener dancing." But leaving that aside, this paragraph is like a Whitman's Sampler of Fallacies. First of all, avoiding re-inflating the bubble will, in fact, solve today's problem. Just let prices fall to equilibrium. Let the markets clear. Let bankruptcy reassign ownership of assets from the incompetent and over-leveraged to the competent and financially sound. Second, we again have the pretense of knowledge, as if the government has the knowledge or the ability to "dampen" the "oscillations" it caused in the first place. Third, of all the government programs that could come into play, the bankruptcy courts have a clear history of being the least incompetent and corrupt, as the task at hand is at least relatively straightforward; identify the assets, auction them off, pay off the creditors in a generally established order. If it is a choice between bankruptcy courts and economically illiterate politicians making up ad hoc incentives like "First time homebuyer credits" to socially re-engineer the housing markets (i.e. the exact things that got us into the crisis in the first place), I'll take the bankruptcy courts any day, thank you. Fourth, that isn't what the phrase "sunk cost" means.

Sunk costs are costs that cannot be recovered once incurred, like the time and money already spent to build that house that you are now forced to sell; the market clearing price is heartless and cares not for these costs. What Milsted should have stated was something like “Government action is a foregone conclusion,” which sadly is always the case. The question is, do we let the bankruptcy courts clear the field of the sunk costs of the late bubble (i.e. liquidate bad debts and malinvestments), or does the government engage in another round of irrational escalation of commitment, and furiously try to reanimate yesterday’s bubble into tomorrow’s with market distorting gimmicks like homebuyer tax credits? My inner cynic and realist agree on the answer.

"True, propping prices up too much is a very bad option. Prices need to drop enough so owning is competitive with renting."

Again with the pretense of knowledge; I won’t belabor the point.

Milsted acknowledges everything that I've said here is correct:

“Also true: bailing out those who lied to get loans is suboptimal; it rewards bad behavior, creating a moral hazard. Indeed, any action to prop up home prices punishes those who prudently did not buy when prices were too high."

But then it's right back into the world of play-pretend bureaucratic omniscience and omnipotence:

"The first time homebuyer tax credit strikes a nice balance. It helps keep prices from falling too low while compensating the prudent for the lost fire sale opportunity. And as I'll show in a future article, a first time homebuyer tax credit has many other nice features. It is a far better way to encourage home ownership than the long running mortgage deduction. Indeed, I would go so far to recommend we make the credit permanent while eliminating the mortgage deduction."

This is the pretense of knowledge, "compensating" people for tricking them into paying too much for a home with an ad hoc flat housing voucher from Leviathan's tax bureaucracy, and social re-engineering, all rolled up into one market distorting, bubble-reflating brew of unintended consequences that is sure to turn out just as well as the last round.

Michael Owen is a computational fluid dynamics engineer, filthy anarchist, recovering astrophysicist and armchair economist.