How the Government Caused Overinvestment in Housing

Conservatives blame poor government policy for causing the housing bubble, while progressives blame the financial industry. While most arguments on the right focus on the government-sponsored enterprises Fannie Mae and Freddie Mac, its stance actually might not need to rely on them. Data indicates that the government's broader efforts to make housing an attractive investment has funneled money away from business and into the housing sector.

This analysis comes from University of Chicago economist Casey Mulligan, via the New York Times Economix blog. He analyzed the value of housing capital, as a measure of profitability, in the U.S. from 1950 to 2000. He calculates it to be average out to 5.7% over the period. Here's his chart:

housing capital mulligan.jpg

It was 6.4% in 2000.

He then did a separate calculation to determine the value of business capital. At 15.3% over the 50-year period, excluding taxes, it was much higher. This implies overinvestment in housing. Mulligan explains:

Business capital has been so profitable to the economy because it is more scarce. It's the law of demand: the less business capital there is, the higher the rate of return that remaining business capital earns because each unit of capital serves more customers. A low profit rate for housing is a symptom of its abundance.

This would seem to imply that prudent investors would be better off investing in business than housing, since business capital is more productive than housing capital. So what happened? The government made housing look like a more attractive investment. Mulligan also calculated profitability with taxes taken into account:

The business-residential profitability gap is almost 10 percent, but our attempts to adjust both profit rates for applicable taxes show that the after-tax profitability gap is zero to five percentage points.

In other words, tax differences sweeten residential real estate investment. They result in it looking nearly as profitable as business investment.

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There are a few things to note about this finding. First, it's important to bear in mind that this was all before the housing bubble; Mulligan's analysis ends in the year 2000. In other words, the overinvestment in housing obviously got much, much, worse in the seven years that followed. This begins to show one reason why so much money flowed to real estate instead of to other investment options.

The second implication is arguably even more important. Business growth in the U.S. during that decade was weaker than it could have been because so much investment was coaxed towards real estate by the government instead of towards other more technology-driven industries. If the U.S. wonders why it's having so much trouble with economic growth now, it can look to the overinvestment in real estate over the past decade, which ultimately resulted in a tragic amount of capital destruction.

Third, this analysis shows the extent to which residential real estate benefits from favorable tax treatment and business suffers from relatively unfavorable tax treatment. If the government wants to figure out how to create jobs, there's its answer. It should reduce the tax benefits provided to real estate and provide them to businesses instead.

Up to now the government has had a dual-rationale for its preference for housing investment. One end it appreciates is promoting homeownership, because it has long (wrongly) viewed owning a home as a part of the American Dream. Second, the housing industry lobby is very powerful, as is evidenced by the ridiculously expensive but politically untouchable mortgage interest deduction. It's time for Washington to challenge this status quo and begin to encourage Americans to put their money in more productive investments that will facilitate stronger long-term economic growth.