Why Did We Divert So Much Capital into Housing?

The other day, Kevin Drum asked a question that a bunch of bloggers have taken a shot at:  Why did so much money flow into housing?  "Why didn't it flow into productive investments instead?  Why did investment in real goods and services suddenly become so much less attractive than housing?"

Several bloggers have taken a crack at this.  Mike Konzcal offers a plausible answer:

One answer to Kevin's question is because of the terrorist attacks on 9/11, and the financial scandals of Enron and Worldcom, bond markets were scared out of their minds that they might be lending to the next Worldcom. Noah Millman has an excellent description of that situation on the ground related to the beginning of the wave of structured finance. Worldcom is early 2002; people are spooked about the next landmine, and housing always seemed like a safe bet for both consumers, and because of some financial innovations and excellent ratings, for investors.

He goes on to add:

Though it may be a rounding error, or it may have some interesting stories in it, I've written before on the idea that demand for housing intersects with a dismantling of the social safety net. To deal with rising health insurance premiums you get a credit card, and to deal with the debt you can borrow against your home - housing equity as the new social contract. In Massachusetts, 60% of all subprime defaults were mortgages that started with a prime mortgage, terms that usually imply something other than consumption smoothing. As for all the talk about the embedded option of getting a tax refund in a mortgage (as your interest can be written off), which is something that should be phased out, the real embedded option in housing is schooling - the option to send your kids to the local public school. As the robustness of educational meritocracy became a hot button issue in the 00s, the value of this embedded option must have skyrocketed. Not to mention gentrification issues, as well as exurbs that were implicitly dependent on cheap gas prices. That's not the whole story of what was going on, but I think it's worth some empirical research.

Because I write a lot about bankruptcy, I've encountered this theory quite a bit.  Because we don't have a social safety net, the reasoning goes, we have credit and easy bankruptcy instead.

From talking to bankruptcy historians like David Skeel, however, I have become very skeptical of this theory.  America's relationship with debt has always been different from that of our European peers, even back when America was the social safety net for Europe's dispossessed.  The American colonies were liberally peppered with people escaping their European creditors.  We also had a lot of small landholders, who borrowed a lot of money to improve their small landholdings.

(Women readers may remember the final book of the Little House on the Prairie series, The First Four Years, during which Almanzo basically bankrupts the family by buying too much equipment on credit in the expectation of bumper crops that don't materialize.  That right there explains more about American bankruptcy laws than any history of our social safety nets.)

American credit markets, and bankruptcy laws, have been exceptionally easy for more than a century.  And when credit is easy, some people get themselves into trouble.

In some ways, I wonder if we aren't looking too hard for an answer.  The fact is, asset markets display bubbles.  They display bubbles without a modern fractional reserve banking system to provide leverage (Tulip mania, South Seas bubble, Albanian ponzi schemes).  They display bubbles without much outright fraud.  (The tech bubble).  They display bubbles in lab experiments where students trade imaginary financial instruments for picayune returns.  Bubbles seem to be a feature of asset markets.   And when the bubbles are in full force, they draw working capital from investments that would ordinarily be attractive, but can't compete with annual returns in excess of 20%.

This certainly isn't the first real estate bubble.  The history of the 19th century is rife with land speculation--and catastrophic collapse.  Before we had the stock market bubble of the 1920s, we had the great Florida Real Estate Bubble, which was the beginning of the state's ascendance to one of the biggest states in the union.  Accounts of the bubble in books like Galbraith's Great Crash or Frederick Lewis Allen's brilliant Only Yesterday, sound eerily similar to the Florida real estate bubble we just lived through.  An excerpt from the latter:

There was nothing languorous about the atmosphere of tropical Miami during that memorable summer and autumn of 1925. The whole city had become one frenzied real-estate exchange. There were said to be 2,000 real-estate offices and 25,000 agents marketing house-lots or acreage. The shirt-sleeved crowds hurrying to and fro under the widely advertised Florida sun talked of binders and options and water-frontages and hundred-thousand-dollar profits; the city fathers had been forced to pass an ordinance forbidding the sale of property in the street, or even the showing of a map, to prevent inordinate traffic congestion. The warm air vibrated with the clatter of riveters, for the steel skeletons of skyscrapers were rising to give Miami a skyline appropriate to its metropolitan destiny. Motor-busses roared down Flagler Street, carrying "prospects" on free trips to watch dredges and steam-shovels converting the outlying mangrove swamps and the sandbars of the Bay of Biscayne into gorgeous Venetian cities for the American homemakers and pleasure-seekers of the future. ...Hotels were overcrowded. People were sleeping wherever they could lay their heads, in station waiting-rooms or in automobiles. The railroads had been forced to place an embargo on imperishable freight in order to avert the danger of famine; building materials were now being imported by water and the harbor bristled with shipping. Fresh vegetables were a rarity, the public utilities of the city were trying desperately to meet the suddenly multiplied demand for electricity and gas and telephone service, and there were recurrent shortages of ice.

How Miami grew! In 1920 its population had been only 30,000. According to the state census of 1925 it had jumped to 75,000 -- and probably if one had counted the newcomers of the succeeding months and Miami's share of the visitors who swarmed down to Florida from the North in one of the mightiest popular migrations of all time, the figure would have been nearer 150,000. ...

Everybody was making money on land, prices were climbing to incredible heights, and those who came to scoff remained to speculate.

Nor was Miami alone booming. The whole strip of coast line from Palm Beach southward was being developed into an American Riviera; for sixty-odd miles it was being rapidly staked out into fifty-foot lots. The fever had spread to Tampa, Sarasota, St. Petersburg, and other cities and towns on the West Coast. People were scrambling for lots along Lake Okeechobee, about Sanford, all through the state; even in Jacksonville, near its northern limit, the "Believers in Jacksonville" were planning a campaign which would bring their city its due in growth and riches.

. . .

But by New Year's Day of 1926 the suspicion was beginning to insinuate itself into the minds of the merrymakers that new buyers of land were no longer so plentiful as they had been in September and October, that a good many of those who held binders were exceedingly anxious to dispose of their stake ... The influx of winter visitors had not been quite up to expectations. Perhaps the boom was due for a "healthy breathing-time."

As a matter of fact, it was due for a good deal more than that. It began obviously to collapse in the spring and summer of 1926. People who held binders and had failed to get rid of them were defaulting right and left on their payments. ...There were cases in which the land not only came back to the original owner, but came back burdened with taxes and assessments which amounted to more than the cash he had received for it; and furthermore he found his land blighted with a half-completed development.

Just as it began to be clear that a wholesale deflation was inevitable, hurricanes showed what a Soothing Tropic Wind could do when it got a running start from the West Indies.

The Florida real estate bubble was amplified by the rivers of gold pouring into America from Europe.  In our own decade, we have Asian central banks and Asian savers pouring their capital into our markets.  When central banks buy dollars, they don't want to park them by taking a flyer on a tech stock; they invest in some form of fixed income security, aka debt.  That led to an expansion of credit markets.

Given that house prices are basically set by the size of the monthly payment that buyers can afford, rather than some deeper notion of intrinsic value, it's hardly surprising that looser credit caused house prices to rise--nor that, in the wake of WorldCom, the recent history of steady appreciation in American real estate led naive buyers and lenders to think that housing was "safe".  The ingredients of a bubble are always, to some extent, sui generis, but they have a common theme:  the price of something starts going up in a way that deludes investors into thinking they've found a sure thing. 

So I don't think the problem is some intrinsic lack of investment opportunities in the United States.  Rather, I think that markets sometimes miscalculate.  In the long run, however, the bubbles burst, and people's appetite for speculative bets on asset price appreciation abates.  Unfortunately, we're usually left with a hell of a hangover when it happens.