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This old house policy

Our government's approach to housing has grown nonsensical: encourage borrowing to keep homes expensive. It's time to rebuild.

By Edward Glaeser
November 2, 2008
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AT THE HEART of this fall's historic financial crisis lies a steep, nationwide fall in the price of homes. After a wild, bubble-like boom, housing prices have fallen more than 30 percent in some areas, wiping away the wealth of ordinary Americans and bringing some of the nation's biggest financial institutions to the point of insolvency.

For many pundits and politicians, the solution is clear: find some way to keep the price of houses high, whether through new government-subsidized loans or by buying up troubled mortgages. Keeping house prices up has an obvious appeal to home-owning voters. The banking system would certainly benefit if new subsidies actually did shore up the assets that lie at the center of the crisis.

But despite its popular appeal, the notion that the government should try to prop up housing prices with more mortgage subsidies is a mistake. On a practical level, even a huge expenditure of taxpayer money is unlikely to have a meaningful effect on the price of homes. And to the extent that it did work, artificially high house prices will only encourage more new homes to be built, adding to the glut and making the crisis worse.

In a larger sense, the problem lies in the very idea that the government should spend money to keep house prices high - the legacy of an expensive national housing policy that has long outlived its purpose.

Today, there is no more case for artificially boosting housing prices than there is for artificially inflating the price of tea or T-shirts. We need to start treating housing markets not as some sort of ephemeral part of the American dream, but with the same rigorous logic that is used to think about markets for oil or software or orange juice. The goal of housing policy should be not to make prices higher, but to make homes more affordable - and, in so doing, to give people the opportunity to choose housing that fits their needs.

A better response to this crisis would be to define sensible housing goals and to find policies that will actually help us meet them. Rather than increasing the subsidies for borrowing, the government would do better to offer a small, targeted tax benefit to first-time home buyers. Instead of large-scale incentives that divert billions of dollars toward wealthy Americans who borrow to buy bigger homes, we should make housing more affordable by reducing the barriers to building more housing where it's needed.

Housing is special. It is not just a commodity or an investment, but a basic human need. Our homes are the stages on which much of our lives play out. For most Americans, homes are also the primary form of savings, which means that the government has a strong interest in not paying to fuel the borrowing that helped spur this painful boom-bust cycle in the first place.

For 75 years, through both Democratic and Republican administrations, the federal government has aimed to increase homeownership by making it easier for people to borrow money to buy a house. The roots of this approach lie in the New Deal, when the government wanted to boost employment in the construction industry. The public commitment to subsidized lending increased in the Housing Act of 1949, which embraced the objective of "a decent home and a suitable living environment for every American family."

To achieve its goals, the government established Fannie Mae and Freddie Mac, which created a fluid mortgage market by guaranteeing mortgages against default. On an even larger scale, the government provides an immense annual subsidy to mortgage holders in the form of the home mortgage interest deduction - a tremendous tax advantage enjoyed by anyone who borrows money to buy a house and earns enough to make itemization worthwhile. The more you borrow, the more you save in taxes.

These policies helped create a multitrillion-dollar home-lending market, which has helped bring about remarkable improvements in American housing. In 1940, almost 45 percent of American homes lacked complete indoor plumbing. More than 20 percent of homes had more than one person per room. By 1980, less than 3 percent of homes lacked plumbing and less than 5 percent had more than one person per room. Today, the average American has close to 1,000 square feet of living space, more than twice the norm in France or England or Germany. Much of that improvement was driven by rising American incomes rather than government policy. Still, by those measures, federal housing policy at least looks like a success.

But the public subsidy of credit markets has also had a dark side. The tax subsidy does modestly encourage homeownership. But it specifically encourages borrowing to invest in expensive homes, which are risky assets that can crash as well as boom. We had housing bubbles long before the federal government got into the subsidy business, but encouraging homeowners to buy with borrowed money certainly did nothing to moderate extreme price swings.

The past eight years, in which housing prices first doubled and then collapsed, deserve a place in the annals of market mania. In states like Massachusetts, where housing supply is limited, borrowing has kept prices high, which benefits existing homeowners but counterproductively makes homeownership more difficult for ordinary Americans. In states like Nevada, with few regulations and wide-open spaces to build, these policies encourage further construction of more and bigger homes. In the 1940s, it may have made sense to encourage Americans to house their children in larger and better houses. But today, we are essentially spending federal money to encourage people to live in 3,000-square-foot houses instead of 2,500-square-foot houses.

In the midst of the crisis, it's understandable that some economists would think that the right response is to try to keep housing prices up by jacking up the federal subsidy for borrowing. Their logic is that lower mortgage rates will energize home buyers and cause housing prices to rise again. This kind of policy - bolstering prices by subsidizing borrowing - is like catnip to politicians, since most American voters are homeowners who would like to see prices go up.

But trying to boost house prices through looser lending is likely to be expensive, ineffective, and create a number of unattractive side effects. Even a massive and expensive government intervention is likely to do no more than prop up house prices by 5 percent - a difference almost imperceptible to the people who need it most, those who have seen their house values drop by 30 percent.

Lending subsidies are likely to be particularly ineffective in the areas that have had the biggest boom-bust cycles, like Las Vegas and Phoenix. In these places, there are neither natural nor man-made limits on building, and, as a result, house prices in these areas stayed close to the cost of construction until 2003. Between 2003 and 2006, these areas experienced a brief, wild price boom. Today, prices in these areas are headed down toward construction costs again. If a housing subsidy did manage to keep prices higher for a time, this would only encourage more overbuilding and a larger housing glut.

Any new subsidy would only increase the cost of our current system, which is already immensely expensive. We still don't know how much restructuring Fannie Mae and Freddie Mac will cost. The mortgage-interest subsidy was estimated to cost the government $74 billion in 2007 alone. Most of that money benefits people with the largest mortgages. The current system, in other words, allocates vast amounts of money to help well-off people bid up the prices of even better-off people's homes.

Instead of continuing the debt-fueled policies that got us where we are, why not rethink our approach to the housing market?

Our current policy takes homeownership itself to be a public good. Our leaders seem to like homeowners. Thomas Jefferson lauded yeoman farmers and George W. Bush admires the ownership society. Homeowners are indeed more likely to vote in local elections or know the name of their congressman; they are also more likely to garden, and own guns.

Yet homeownership is not for everyone. As recent events well illustrate, owning a home comes with large risks, especially for people who aren't planning on living in the same place for a long time. For people who live in multifamily dwellings, the administrative costs of renting can be much lower than dealing with the difficulties of collective ownership. Renting creates more flexibility for people in America's highly mobile workforce. A far more sensible approach to housing would view homeownership as one possible housing option, not a primary public goal.

And even if, as a society, America decides that the social benefits of homeownership are sufficiently strong that ownership should be encouraged, there are much cheaper and more effective ways of doing that than by encouraging people to borrow more money.

For instance, the home mortgage interest deduction could be reduced or even eliminated. Most people who are on the margin between renting and owning have relatively lower incomes. Yet the home mortgage interest deduction targets its benefits to the richest people, who buy the biggest homes. A small targeted subsidy for first-time buyers could encourage homeownership just as effectively as the current system, without encouraging people to borrow vast amounts or to buy larger homes. (Reducing the home mortgage interest deduction doesn't mean that taxes need to go up - we could take the $75 billion that it costs and use that money to reduce other taxes.)

Instead of spending federal money to encourage borrowing and keep prices high, it would make more sense to make housing more affordable by eliminating the artificial restrictions that stymie supply. In other areas of the economy, the government protects consumers by eliminating monopolies and other barriers to competition; our nation's commitment to free markets and free trade reflects our faith that ordinary Americans win when the price of clothing is brought down by imports from China, or when retailers and manufacturers face fewer unnecessary regulations.

In the housing market, prices are artificially inflated by barriers to building new housing in many communities. In dense states like Massachusetts, prices have been kept high by localities that oppose new construction, with large minimum lot sizes, Draconian barriers to subdivisions, and a general hostility to any multifamily housing. If those rules were eased, then housing would become more abundant and affordable.

Today, in the depths of the crisis, it's easy to think that the quickest solution is to keep house prices from falling any further. Certainly, we shouldn't feed the financial panic by deliberately pushing housing prices downward in the midst of a price collapse. But it also doesn't make sense to try to stop the natural return of housing prices to their long-run levels - and to do so for reasons that no longer suit America's housing needs.

Subsidized lending has encouraged millions of Americans to leverage themselves wildly to bet on the housing market. All that betting helped to create the bubble that has now popped. Lending more cheap money would be like a gambler doubling down and hoping for a win next time.

Not everyone needs to be a homeowner. Not everyone needs to live in a McMansion. There's no single solution to the puzzle of housing policy, but one thing is clear: it should be based on good economics, not on an attachment to homeownership, the political appeal of helping homeowners, or the sentimental view that the American dream means owning a big house.

Edward Glaeser is the Glimp Professor of Economics at Harvard and the director of the Rappaport Institute for Greater Boston.

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