Tuesday, January 14, 2014

Rising house prices are a bad sign

How prices have risen significantly in the recent years. Naive economists claim that this is a sign of recovery. There are two primary reasons for increases in housing prices, or any price for that matter. Prices increase if there is a decrease in supply or increase in demand.

New housing starts have been picking up pace recently based on data from the National Association of Home Builders. And with the large stock of homes built during the housing boom that still need to be sold, it would seem to be unlikely that rising prices are due to a decrease in supply.

Since we know it is most likely an increase in demand that explains rising house prices, is this not evidence of a recovery? Surely people buying homes is a sign of recovery. However, the US median real income is falling. From this fact alone we know that there is no recovery. We can also know that the increase in home purchases is not by middle income home buyers purchasing new homes. They could not afford these homes.

Home purchases are due to investors. We know this because of the stagnant incomes and that a large number of purchases were in cash. With stagnant incomes and low savings rate, regular Americans are in no position to purchase homes with cash.

This means that rising house prices are an asset bubble.

But things get worse. Rising house prices make it harder for middle class Americans to purchase homes. The wealth effect leads to excess consuming by home owners who feel richer do to the higher home values. This leads to borrowing against the home equity. With stagnant incomes, home owners will not be able to pay back these new loans. When interest rates begin to rise, these homeowners will be in a world of hurt.

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