Should you buy a house?

I spent some time this weekend traipsing around open houses with my sister, who is hoping to someday soon experience the burdens joys of homeownership.

Prices certainly don't seem to be coming down much in my neighborhood, the U Street Corridor. Smallish two-bedroom houses are listed for $595,000 and up. Since the rent on a similar place would be something over half the monthly mortgage payments and taxes, without taking maintenance into account, I think it is fair to say that the market is still pricing in quite a bit of expected capital appreciation in the house.

Is that reasonable? Not too long ago, I saw Suze Orman on television, urging people not to sink money into their 401(k)s, but instead plow that money into a house. A house, almost everyone I know tells me solemnly, is the best investment you can make.

But as Robert Shiller, the Yale economist, has pointed out, this is a very new idea. For most of history, a house was simply a very long-term durable good, which, like cars and refrigerators, began depreciating the day it was finished. Why do we think differently now?

Shiller's argument, which I find pretty compelling, is that we've been deluded by recent history. Since World War II, a number of developments have conspired to boost the prices of homes, giving a large capital gain to those who were lucky enough to own at the time. This has given us the delusion that house prices rise steadily, when in fact, we have virtually certainly exhausted the pricing gains of those happy developments.

The first boost was the invention of the long-term amortizing mortgage. Mortgages used to be short-term loans of perhaps five years, with a whacking great balloon payment due at the end. This started to change in the 1930's, when the government housing administration, trying to preserve homeownership during the Depression, invented the 20-year amortizing loan. That trend really took off in the 1950's, with the invention of the 30-year loan.

People tend to base what they will pay for a house on how big a monthly payment they can afford. Since everyone started getting 30-year loans roughly at once, without a concomitant boost in the supply of housing, the effect was to raise the prices that current homeowners could charge for their properties. This trend is largely played out, however. Though there was a wan attempt at introducing 40-year mortgages at the height of the bubble, the loans were not particularly popular with either lenders or borrowers. It's conceivable that a couple in their late twenties or early thirties is buying a 30-year house, but a 40 year house stretches the imagination too far, and the income expectations into the social security years.

The second trend is the progressive income tax, which really got going seriously in the 1940's. This gave another boost to homeowners, by making it possible for buyers to afford much bigger payments. While this may fluctuate somewhat over the next few years, tax rates seem to be fluctuating within a fairly narrow band, which means that this upward pressure on house prices will also be limited.

The third trend is the changes in inflation and interest rates since World War II. Prior to the 1960's, inflation tended to be fairly stable, meaning that the true cost of your mortgage was fairly predictable. Then inflation started to take off, making existing mortgages very cheap, and new mortgages very expensive. But starting in 1980, the Federal Reserve got tough on inflation. As the Fed's credibility as an inflation fighter grew, lenders stopped demanding such large premia for long-term lending, meaning that the real interest rates on mortgages fell. Since, as discussed above, potential buyers were more worried about payments than prices, that has given a big boost to house prices over the last quarter-century. But that trend, too, is played out. Inflation is set about where it's like to be for the foreseeable future, fluctuating right around 2%. Both mortgage lenders and buyers are calculating the interest rate they will pay on those low inflationary expectations; hence, no future bonus.

Given all that, future price increases should be limited to roughly the local increase in incomes. And since Washington DC is a government town, unless lobbying gets much more lucrative (and employs a lot more people), I find it hard to look forward to the ultra-rapid income growth that is buoying prices in Manhattan.

There is, however, a wild card: the value of land. While most houses are wasting assets, in some localities, land is getting more valuable. Ed Glaeser argues convincingly that this is because Americans have gotten much more effective at blocking denser development. In the old days, the response to increases in the value of land was to build up, or crowd more houses onto the lot. But now local rent-seekers activists have gotten very good at blocking that sort of development, which means that poorer people are forced ever outwards while rich people dominate the city interior. That's why it seems no longer possible for a journalist to go to two parties in one night in New York any more; all my friends are scattering ever-wider in search of affordable housing. Socially, New York is starting too look more and more like London, with friendships balkanized by long commutes.

There is a lot of new condo development in my neighborhood, but most of it seems, to this New Yorker's eye, shockingly low; six or eight stories at most. So it would seem prudent to put the steadily increasing value of land into the home-buying equation.

But even that doesn't mean I should buy, since presumably all the other buyers also think that land will increase in value. Which means that the mean forecast of the increase in the land's value should already be included in the price. If I want to buy a house as an investment (rather than, say, just a hedge against getting evicted again), then I have to believe that the land value will increase by more than what the average buyer thinks it will; in other words, that I am smarter than everyone else, who is being too pessimistic.

The problem is, I don't see an excess of pessimism around me in the housing market; it still seems to be filled with people who think that housing is a better investment than stocks or bonds. So much as I would love to have a place to call my own, I think I'll sit this one out at least a couple more years.