David Friedman on House Prices
My previous post on oil and stock prices naturally leads to the in-between case of houses, which provide immediate services and are a durable asset. Thus, when house prices go down, it’s not as obvious whether this is a good or a bad thing (as opposed to the cases of oil and shares of stock). On the one hand, falling house prices means that housing is more affordable; some people can buy houses who previously couldn’t, and others can afford bigger houses than they previously could. (In the extreme case, intelligent termites who bought houses for food would be ecstatic that the Case-Shiller index keeps falling.)
Of course, the downside to falling prices is that existing owners were counting on their houses as part of their financial wealth. Even if you are planning on living in your current house until the day you die, even so it probably makes you worse off if its market value plummets. This is because you always had the option of selling your house and moving into more humble quarters, if (say) your kid needed an operation, or you get accused of a homicide and need to hire some high-priced attorneys.
For years I have been poking fun at an argument David Friedman (son of Milton) advanced in his books, wherein he claimed that when a person buys a house, then whether prices go way up or way down after the purchase, the new owner benefits either way. Friedman’s case is based on a static model, where the consumer makes one decision–on how to allocate his given income between housing and “everything else”–after seeing the new house price, and then that’s it. In this setup, yes, the consumer can only be helped by a change in house prices. After all, the consumer can always retain his existing house, and so (according to Friedman’s assumptions) changes in price can’t possibly hurt. And indeed, they will in fact help: If house prices go up, then the owner can sell his new home for a gain, move into a slightly smaller house, and then buy more of “everything else” with the leftover money. And if house prices go down, then the consumer can buy fewer units of “everything else,” and use the freed up money to buy a bigger house. Win-win.
There is something fishy with this analysis; I spell out the fallacies in this piece. But for the present post, I want to report an email with David Friedman. With all the mess in the housing market, I wondered if he still clung to his argument. (I.e., why aren’t we all rejoicing that we can now afford more square footage than we could in 2006?) Specifically, I asked him if he had any comments about his argument from years earlier, in light of the current housing debacle. Here is his response, quoted with permission:
Not really. The argument is specifically about people who have bought the house that, if nothing changes, they will want to live in more or less forever. That doesn’t describe all that many people. For that case, the argument is correct–although you need the additional assumption of zero transaction costs to get from “are no worse off” (because they can do what they would have done if prices hadn’t changed–stay in the same house) to “are better off” (because they can now adjust their housing consumption up if prices are lower, down if higher).
But I do find it amusing that when house prices are high, people complain about how high they are, and when they come down, people complain about falling house prices.
One final point: PLEASE PLEASE believe me, that I understand Friedman’s argument. I am not saying that he’s wrong, inside his model. My point is that his model assumes away the very reasons that, in the real world, owners hate it when house prices fall. So it’s not a very useful “counterintuitive” result, since it is only true in an alternate universe. And if you go and read his exposition (in the link above), you’ll see that he made it sound as if real people in the real world were wrong when they complained about falling house prices.
