Housing and Inflation

Last year was disastrous for everyone involved in U.S. housing—home builders, the forest industry and other suppliers of building materials, labor, local governmental finance in important forest areas, and above all, potential home buyers who could not muster the necessary down payments or manage the monthly costs.

Residential construction in the United States has been highly cyclical for one hundred years or longer. It also has been seasonally variable, but what follows is based on Bureau of the Census seasonally adjusted and smoothed data, from which the seasonal variations are supposed to be (but are not fully) eliminated. There were marked cycles in residential construction between 1900 and 1950, modified by two world wars and the Great Depression.

Since 1950, eight residential building cycles may be identified. They vary somewhat in length and in amplitude of their swings from high to low and back again, but they have averaged fifty months in length from trough to trough or from peak to peak, and the rise from trough to peak and the fall from peak to trough has averaged between 35 and 40 percent of the peak volume.

Since 1950, the cycles have grown in severity, or at least the two most recent ones have been the most severe of the whole period. Residential building cycle No. 7 began in January 1970; the rate of new building rose for thirty-four months to a peak in October 1972, a rise which was 49 percent of the peak volume; then it fell for twenty-nine months until February 1975, with a decline of 60 percent from the peak. Up to that time, this was the most severe cycle—measured either by length or by amplitude—since 1950.

Record rise, record fall

But cycle No. 8, in which we still seem to be, has been much more severe. It began from a trough in February 1975 and rose for forty-one months to a peak in June 1978, for a rise which was 54 percent of the peak. This rise was a record, both in length and in amount. But the fall since June 1978 has really been breathtaking, and may well continue.

The fall from the peak has twice been interrupted. Briefly in the late spring and early summer of 1979, the rate of new building rose by about 10 percent, but by late summer and early fall 1979 it dropped sharply to new depths. In the spring of 1980 there was another brief rally of nearly 50 percent from the severely depressed levels, but by the end of 1980 and the beginning of 1981, the fall resumed, swiftly and far, to a rate not previously encountered in any month since the end of World War II.

In each of these brief rallies, many observers (including the author) thought the building cycle had ended and a new one had begun. With that recent experience, one is hesitant to suggest that cycle No. 8 indeed did run its course at the end of 1981, though the next year or two may show that it has done so. Unfortunately, the prospects for residential building in 1982 are not bright, and further declines are not impossible. More likely, a long and inconclusive trough may continue. But even if the construction rate turns up in early 1982, the falling phase of cycle No. 8 to the end of 1981 has set new records for length (about forty-four months) and for distance (almost 60 percent down from the peak). A record long rise (forty-one months) and a record long fall (forty-four months) obviously add to a record total cycle length of eighty-five months (or perhaps more), which is approaching double the length of the average cycle. The magnitude of the swing from trough to peak and from peak to assumed trough is also a record breaker, averaging close to 60 percent of the peak number. Thus, by any standard, 1981 was a severely cyclical year for the home-building industry.

Effect of inflation

Inflation has affected housing construction and in turn has been affected by the housing market, including new construction. Under inflationary circumstances—when there is a rise in prices of all goods or services, or a cheapening of the dollar—there is always some flight from money to real property, as consumers correctly understand that their real income and wealth positions are more likely to be maintained by owning property than by holding cash. Under the pressure of general inflation, national average prices of both new and old houses rose rather steadily from the mid-1960s until the end of the 1970s—from under $20,000 as late as 1965 to well over $60,000 by 1979.

The interest rate on new mortgages—less than 10 percent through 1978—seemed high at the time, but it seems moderate by standards of the 1980s, and credit generally was available to households with enough capital for the down payment with enough income to swing the monthly payments. The year-to-year percentage rise in average house prices was greater than the average interest rate on new mortgages, and far higher than the interest rate on older mortgages. Moreover, interest paid is deductible from income in calculating income taxes, thus reducing the bite of the higher interest rates. During those years from 1965 to 1979, the real rate of interest (the apparent rate minus the gain in capital value of the house) was negative: many homeowners and buyers had housing at zero cost. The buyer might have a cash flow problem, since the gain in house value was postponed until sale or until a larger mortgage was taken out, but on an accounting basis, the position of the house buyer was cozy indeed.

Cause of inflation

Naturally enough, millions of households responded to this favorable financial incentive by buying a house, typically assuming a larger mortgage; and many owners who did not sell also took out a larger mortgage in order to spend some of the money generated by rising house prices. Total residential mortgage debt rose from $338 billion in 1970 to almost $1.1 trillion in 1980. This rather closely paralleled the rise in the federal debt, although it started a little lower in 1970 and rose to a little higher level by 1980.

Most economists agree that a rising federal debt is one factor in inflation, but rising residential mortgage debt has been less noticed in the professional and popular literature, though it may reasonably be argued that its effect on inflation is just as serious. The great expansion in residential mortgage debt constituted a massive transfer (over $300 billion in 1980 prices) of real capital from lenders to borrowers. The expectation of continued inflation was a further factor in rising house prices; by 1979, it appears that about $10,000 of the U.S. average house price of about $60,000 was in response to the expectation of continued inflation.

Rising house prices contributed directly to inflationary forces. First of all, housing costs in the Consumer Price Index (CPI) are based in part on rates paid for new mortgages, and the rising CPI, in turn, is used to adjust wages in many union contracts, with wages in nonunion occupations often following closely, and to adjust Social Security and other retirement payments. As wages rose, costs naturally also rose, with the effect of higher housing prices and higher mortgage payments being translated into still higher prices for consumer products. Multipliers work upward in prices as well as in total economic activity.

Rising house prices and mortgages contributed directly to inflation in other ways. In part, the increased prices and mortgages were simply a transfer of money (and purchasing power) from one household to another, and to this extent were not inflationary. But to some extent they also constituted "new money." As the new mortgages were sold to investment corporations, the larger sums became the basis for expanded lending by the primary lenders, and so on, round and round; the recipients of the higher house prices and of the larger mortgages used part of the funds so received to finance additional purchases of other consumption goods. Money, in effect, was created without goods added to the same extent—the classic characteristic of inflation.

Countereffects

Although inflation tended to increase house prices and residential mortgages, other developments arising out of inflation had contrary or dampening effects. As the rate of interest on new mortgages shot up in late 1980 and through most of 1981, partly as a result of the Federal Reserve Board's efforts to control inflation through credit restrictions, the cost of borrowing for house purchases rose sharply.

Even at the higher interest rates, residential mortgage credit for long-term, fixed-interest rates was not available in unlimited amounts. These credit restrictions sharply inhibited further increases in house prices and greatly reduced the marketability of houses: the time required for a house sale increased greatly, or concessions had to be made on price, or special credit arrangements were necessary, or some combination of these was required if either old or new houses were to sell.

For the first time since the rate of inflation rose during the Vietnam war, the rise in house prices was less than the rate of inflation; in other words, the real price of houses fell slightly. Moreover, doubt was sowed about the future trend in house prices. The apparent $10,000 addition to the average house price at the end of 1979, in expectation of continued inflation, declined to about $4,000 by the end of 1980 and almost surely shrank some more in 1981. Housing no longer seemed such a good buy or such a good hedge against inflation, even for those who could swing the financing, and, of course, large numbers of households lacked the capital and the income for house purchase.

Continuing decline

A declining rate of residential construction has obvious effects. Construction firms suffer a loss of income, and some go broke or withdraw from the business; their employment of workers directly or through specialized subcontractors declines; consumption and prices of lumber, plywood, paper, and other forest products, and of other building materials, fall off, and employment in the production of these materials also shrinks. All of these declines in employment affect local economies, so that in turn service businesses and workers of many kinds are adversely affected; and these economic effects get translated into reduced income and other taxes and into higher government costs for unemployment relief and even for welfare. While these effects are national in scope, they fall with particular severity on some important forest product regions.

The Pacific Northwest generally, and the state of Oregon in particular, have been hard hit. Oregon's constitution requires the state to balance its budget over two-year periods. Substantial reductions in appropriations and, consequently, in services have been made up to the end of 1981, but further reductions in appropriations or increases in taxes, or both, will be required if the state is to meet its legal commitment for budget balancing during the biennium. A substantial part of the increased unemployment, reduced revenues, and higher governmental costs results from the reduced level of residential construction nationally. Colleges and universities, to cite but one example, already have suffered serious funding cuts, and worse lies ahead. The ramifications of a depressed national residential construction industry are many and severe.

Short-term, long-term effects

The problems of the residential construction industry—and of everyone associated in any way with it—fall into two general categories. For the short term—the next one to three years—the basic problem is to increase the level of new construction, from the general level of 900,000 units to 1.5 to 2 million units, and to finance the sale of the new structures in some way that will not set off further inflation in the price of existing structures. If the rate of new construction could be increased greatly, this would solve most of the severe problems. For the long term—meaning more than three years, and extending infinitely—the basic problem is to stabilize the rate of new residential construction or at least to reduce substantially the magnitude of the swings in such construction.

Cyclical instability in residential construction is costly to the nation: average annual costs, on whomever they may fall, are on the order of $50 billion because of cyclical instability alone. When businesses must expand and contract as if on a yoyo string, the real costs to society are high. The key to stability in residential construction seems to lie in separating the means of financing sales of new houses from those for financing sales of older houses, to stabilize the one without inflating the other. While reducing the real costs of housing requires action on many fronts, the most important single step would be to stabilize the rate of new construction. If that were achieved, great economies would arise from operations of the private economy, aside from further steps by government at any level.