Fed Study Vindicates Fed

Did inaccurate productivity data cause the housing bust? That's the interesting but tortured conclusion of James A. Kahn, a Yeshiva University economics professor and former vice president of the Federal Reserve Bank of New York, in this study [pdf].

"Productivity Swings and Housing Prices," Kahn's New York Fed paper, assigns "primacy to fundamentals and only a supporting role to bubbles and credit market irregularities." His model shows that productivity shifts correlate well (though not perfectly) to house prices since 1965.

But what Kahn is actually assigning primacy to is the misstating of fundamentals. "Housing market participants were slow to perceive the most recent decline in the rate of productivity growth because the data released through mid-2007 gave little indication of it," Kahn writes. "Subsequent revisions of the data made it clear that productivity had in fact begun to decelerate in 2004."

This is important because Kahn refers repeatedly to the "optimism" productivity gains instilled in buyers and lenders throughout the boom period. To the obvious objection that nobody out there is looking at productivity figures before buying a house, Kahn notes that these are only "estimates of how participants' expectations evolved over time." And it's understandable that if you're doing better professionally you're going to be more ambitious in your purchases. But his argument is that productivity data were overstated at the time, and real gains were much lower than estimated. That is information John Q. Homebuyer would have at his disposal: You don't need to wait for statistics from the Labor Department to know how much you're getting paid for goofing off at work.

Kahn's conclusion:

With the resurgence in productivity that began in 1995, market participants began to see stronger income growth-not from working longer hours or having a second household income, but on a per hour basis. As individuals became more aware that this stronger growth was attributable to technological progress and that it might be sustainable, they grew more optimistic about their future income, and this optimism directly influenced their willingness to pay for housing. Such optimism would likely have been shared by lenders, who viewed mortgages as less risky insofar as income and house prices were growing more rapidly than before.

A decade later, however, signs emerged that the new period of high productivity growth would not be as long-lived as the post-World War II episode, which had lasted more than twenty-five years. As buyers and lenders began to recognize this, the same process that caused prices to rise and credit conditions to ease began to work in reverse. The expected income growth did not materialize and new buyers entering the market were less willing to pay high prices; thus, prices of houses purchased in recent years failed to grow as expected. Foreclosures began to increase as early as 2005, and lenders became more cautious.

More persuasive is Kahn's demonstration that productivity changes can have a "multiplier" effect. Given price-inelastic supply and demand, this means that "in times of above-average economic growth, house prices can grow faster than income (and faster than rents) for periods of many years, even decades."

But there's a big factor left out here: the Fed Funds rate. During the historic period Kahn covers, the Fed Funds rate never went below 3 percent, except once: from October 2001 to May 2005, the exact period of the housing bubble's formation and growth. (It is, of course, back down there now, as part of the Fed's failed effort to revive the economy.) That doesn't prove interest rates were the bubble culprit, and Kahn provides some welcome ideas and nuance. But to say interest rate manipulation had only a supporting role in this decade's real estate madness requires a lot more explaining than Kahn has done here.

Nice try, though.

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