The Great Divide

I liked this piece in Slate:

http://www.slate.com/id/2170561/nav/tap3/

I was struck by the divide while in San Francisco last weekend (I was there teaching in the Wharton Executive MBA program). One the one hand I talked to a waitress who had moved to California because of its (relatively) high minimum wage and a bartender who was extolling the virtues of an employer who paid $15 per hour before tips. On the other hand, I was at a party where a woman was saying how her mother would find it hard to get by on a nest-egg of $3-4 million. If I were more creative, I could weave these vignettes into a novel about contemporary America.

Cap Rates and the Ten-year Treasury Rate

The current 10 years treasury rate is 5.1 percent; Cap Rates on San Francisco office buildings are running around 5.5 percent.

On the one hand, rents rise, meaning that the expected IRR on a San Francisco office building is higher than 5.5; on the other hand, buildings depreciate and need to be recapitalized, meaning that net stablized net cash flow growth will be less than market rent growth. While office rents in San Francisco rose smartly last year, they had been stagnant for serveral years before, and office buildings always have the potential for substantial vacancy. So would I buy an office building at a 40 basis point spread over Treasuries? I don't think so...

The Savior of Capitalisim, or its End?

Marx argued for the tendency of the rate of profit to fall:

The progressive tendency of the general rate of profit to fall is, therefore, just an expression peculiar to the capitalist mode of production of the progressive development of the social productivity of labour. This does not mean to say that the rate of profit may not fall temporarily for other reasons. But proceeding from the nature of the capitalist mode of production, it is thereby proved logical necessity that in its development the general average rate of surplus-value must express itself in a falling general rate of profit. Since the mass of the employed living labour is continually on the decline as compared to the mass of materialised labour set in motion by it, i.e., to the productively consumed means of production, it follows that the portion of living labour, unpaid and congealed in surplus-value, must also be continually on the decrease compared to the amount of value represented by the invested total capital. Since the ratio of the mass of surplus-value to the value of the invested total capital forms the rate of profit, this rate must constantly fall. - Karl Marx, Capital Volume 3, chapter 13.

At the Wynn Hotel in Macao, the rooms have a copy Wynn magazine, which gives evidence that Marx was wrong about profits. Exhibit A was an advertisement for a pair of $700 Puma sneakers.

I will confess to liking nice things. I am, for examble, the rare Ph.D. economist who likes neckties, and I own way too many of them (my only defence is that I only buy them when they are on sale, but even so). But there are things that are just grotesque in their conspicuousness. It is hard to believe such things are good for social stability.

When agglomeration makes things worse

I have just returned from the Asian Real Estate Society conference in Macao. The conference was very good, as was the food. The small, historic center of Macao, is very beautiful.

But Macao is largely about gambling--the claim is that it has higher gambling revenue than Las Vegas. There are already lots of glitzy casino-hotels. The conference venue was at one of them--the Wynn. Given the construction cost of the place and the posted room rates, it must be the case that it makes its money on the casino.

I have a (small) libertarian streak in me; that streak tells me it is none of my business is people want to blow their money on gambling. I myself go to Santa Anita every other year or so and bet as much as $18 on horse races. But there is a well established literature (http://scholar.google.com/scholar?hl=en&lr=&q=addictive+gambling) that there are gambling addicts--and it is here that there is an agglomeration problem.

Around the casinos of Macao, one finds large numbers of two kinds of retail outlets: pawn shops, and ATM machines. This makes complete business sense--if people need to feed the gambling beast, places that provide money should cluster near casinos. The problem is that it is like putting free booze into the hands of an alcoholic. Even worse is the fact that some casinos have ATM machines on the premises.

I have no illusions about the possibility of eliminating problem gambling, but it might be worthwhile to make it a little less easy to do. Limiting the number of ATM machines and banning pawn shops within a certain radius of a casino might be a start.

Brad Delong on Academic Blogging

The hope of all of us who blog is that we will become smarter, do more useful work, be happier and more productive, and will also impress our deans so they will raise our salaries. The first three hopes are clearly true: Academics who blog think more profound thoughts, have a bigger influence on the world — both the academic and the broader worlds — and are happier for it. Are we more productive in an academic sense? Maybe. We will see when things settle down.
Are our deans impressed? Not so far, but they should be. A lot of a university's long-run success depends on attracting good undergraduates. Undergraduates and their parents are profoundly influenced by the public face of the university. And these days, a thoughtful, intelligent, well-informed Web logger like Juan Cole or Dan Drezner is an important part of a university's public face. Michigan gains in reputation and mindshare from having a Cole on its faculty. Yale loses from not having an equivalent.
A great university has faculty members who do a great many things — teaching undergraduates, teaching graduate students, the many things that are "research," public education, public service, and the turbocharging of the public sphere of information and debate that is a principal reason that governments finance and donors give to universities. Web logs may well be becoming an important part of that last university mission.

You know you're a mortgage geek when...

You are taking a walk with your wife on a beautiful Sunday morning:

You: deep sigh

Wife: what's the matter?

You: just thinking about the subprime market

Wife: geez--from that sigh I thought something was wrong with one of the girls...

A really awful SCOTUS decision

The decision overturning the Seattle and Louisville desegregation plans, plans that used race as a tiebreaker after many other considerations for school assignments, reflected a naiveté about the state of residential segregation in the United States that is appalling.

In Seattle, nearly 60 percent of black households would need to move for the community to be integrated; in Louisville, the percentage is nearly 70 percent. (see http://www.censusscope.org/us/m4520/chart_dissimilarity.html for details, which come from the fine work of Frey and Myers).

Moreover, the best evidence we have is that these patterns of segregation arise from continuing discrimination in the housing market (John Yinger, Marge Turner and Reynolds Farley do the heavy lifting on demonstrating continuing discrimination). Given that SCOTUS has ruled out the ability of school districts to remedy the fact that housing discrimination leads to school segregation, the only way to move forward is to enforce fair housing laws far more rigorously--sending rental agents and Realtors who discriminate to jail for a Paris Hilton type sentence might not be the worst way to start. Not that I expect to see this anytime soon...

At least when people of my generation and older are dead and gone, things should get better. A Pew poll on attitudes toward race shows that Gen Xers are far more enlightened than the rest of us--91 percent think inter-racial dating is OK, while only 77 percent of my generation (boomers) think so (who are those other 23 percent?) . Those older than I are are even less likely to think it is OK.

Why some classes are harder (and better) than others

One excerpt from the profile on Hoffman:

Hoffmann once asked Richardson, who has studied the 1956 Suez crisis in depth, to suggest some relevant readings because he was preparing a lecture that dealt with it. “I recommended five books,” she recalls. “And he read all five!—even though the Suez crisis was only a small piece of the lecture. Stanley takes scholarship and teaching very seriously. He reads an extraordinary amount.”

In true European style, he is also happy to ask his students to do the same, and compiled impressively long reading lists for full-year courses like “War,” which had three lectures per week, plus a section. War and Peace could be the assigned text for just one of those lectures. When asked if that was unreasonable, and if an excerpt from Tolstoy’s magnum opus might not suffice, Hoffmann asked, “Which part of War and Peace summarizes the themes?”

A Nice Profile of Stanley Hoffman

Go here:

http://www.harvardmagazine.com/2007/07/le-professeur.html

Hoffman was among my two very favorite professors in college (my Shakespeare professor, G.B. Evans, was the other) and this article does a nice job of capturing him.

Everyone in my vocation should aspire to be as good as Hoffman, and nearly everyone will fail to do so.

Reading we alluded to in Business Institute today

On college and future success:

http://www.irs.princeton.edu/pubs/pdfs/409.pdf

I have rarely heard such a famous economist be so modest...

From today's Washington Post:

When Edward P. Lazear, chairman of the White House Council of Economic Advisers, broached the idea of limiting the popular mortgage tax deduction, he said he quickly dropped it after Cheney told him it would never fly with Congress. "He's a big timesaver for us in that he takes off the table a lot of things he knows aren't going to go anywhere," Lazear said.

Lazear, who is otherwise known as a fierce advocate for his views, said that he may argue a point with Cheney "for 10 minutes or so" but that in the end he is always convinced. "I can't think of a time when I have thought I was right and the vice president was wrong."

hmmmm...

Why Rent-to-Price ratios vary

I was talking to my colleague Tony Yezer yesterday about measuring rent-to-price ratios for different zip codes for Washington. It got me thinking about why rent-to-price ratios vary so much from place to place.

First is expected growth in prices. Places that are losing population (Detroit, Cleveland) will not see prices go up, because they have excess supply of housing, and will for the foreseable future. They must therefore have igh rent-to-price ratio (or low Price-Earning ratios for housing). Places that are gaining population but have no brakes on development will also not see prices go up, because house prices will not rise above replacement cost. For example, when house prices in Dallas go up a little bit, developers rush in to supply the market until prices fall back to construction cost. The only exception are places like the Park Cities, which have excellent schools that are not easily reproducible. Because prices don't go up in Dallas, the rent-to-price ratio is high.

Conversely, San Francisco and Maui are not replacable, so while they are somewhat volatile, the underlying house price trends are upward. As Gyourko, Sinai and Mayer point out, as people in the upper reaches of the income distribution get richer, they outbid each other for these unusual places: they can be viewed as the Monets of real estate. But these places are unusual.

The other thing that can influence rent-to-price ratios is the tax code. Because mortgage interest is deductible, owning is relatively more valuable in places with high federal and state marginal tax rates (i.e., Cailfornia, New York, New Jersey, Maryland). The large place with the highest combined Federal and State Tax Rate is likely San Jose; that with the lowest is El Paso. Sure enough, rent-to-price ratios in San Jose are very low; in El Paso they are very high.

My Hard Drive Failed about a week ago...

On a Sony Vaio PCG-V505EX. I really like the machine, so I am currently making recovery disks (using safe mode) and hoping I can get the thing running again. If anyone has been through this, and managed to recover their system, I would love to hear about it.

Sweeney Todd - London National Theatre Cast

This is how imagine Victorian London--I think Dickens would love it.

Robert Waldmann on Redistribution

This is worth reading (and is relevant to our discussion today in the GW Business Institute).

http://rjwaldmann.blogspot.com/2007/06/possible-efficiency-gains-due-to-taxes.html

Francois Ortalo-Magne is on the front page of the NYT

I just saw yesterday's story, which is about a study Francois did with two Northwestern colleagues on whether houses sold through MLS command a premium over houses sold through FSBOMadison.com, a low fee-for-service Web site for do-it-your-selfers. The answer is, in the case of Madison anyway, no. I saw an early version of this paper (one that only discussed methods, rather than results), and it is extremely well done. It is also noteworthy how generous the MLS in Madison and FSBOMadison.com were in sharing data.

The story is of interest to me for its own sake, but also because I brought Francois to Madison when I was Chair of the Real Estate Department there. It was one of the smartest things I ever did.

Commercial Mortgage Lending and the Macro economy

This is something I wrote some years ago, and have revised a bit. It light of recent events in the commercial lending market, I thought it worth resuscitating.

Mera and Renaud (2000) demonstrate that the phrase “Asian Financial Crisis” was misleading. Green’s (2001) review of the book noted[1]:

[Asian Financial Crisis] suggests homogeneity: that “Asia” is one place, and that the financial crises faced by various countries there in the late 1990s were fundamentally similar. The fact that so many countries that were geographically close faced crises that were temporally close makes it easy to conclude that the crises had common roots.

Nevertheless, real estate did have a role in many of the countries that experienced a crisis, and the size of that role likely explains differences in the relative magnitudes of the crisis. In Japan, crises resulted in part from changing demographics and central bank regulatory and monetary policy, but also because of poor commercial real estate underwriting.

In Taiwan, land prices rose and then stabilized, and never crashed as they did in other Asian Economies. In Hong Kong, land prices fell, but because of the lending system there, which required property investors to use substantial equity funding, real estate had little effect on the overall health of the economy. The Chinese office market became badly overbuilt—especially in Shanghai—but the economy there continues to chug along, at least for now. But in Indonesia and Thailand, poor understanding of real estate fundamentals, along with collapsing currencies, caused real estate markets to fail. In contrast, Korea’s crisis arose largely from an unsustainable system of corporate lending. Real estate likely played a fairly small role in Korea’s crisis, and the country recovered almost immediately. It is worth spending a little time talking about the large real estate crises in Japan, Thailand and Indonesia, as well as the ability of Korea to avoid such a crisis.

Edelstein and Paul (2000) explain the sources of the extraordinary run-up in land prices in Japan in the 1980s, and the government’s response to that crisis. They maintain that the run-up in land prices from 1984 to 1991 was not the product of a speculative bubble, but rather of fundamentals of the Japanese economy. As Mera (2000) points out, Japan managed to survive many challenges to its economy quite well, including the second oil shock and the Plaza accords of 1986, which caused the yen to appreciate substantially and thus rendered Japanese exports less competitive. At the same time that Japanese incomes were rising sharply, interest rates in the country remained quite low. If we think about the Gordon Growth Model, i.e. R = i-g, where R is the capitalization rate, i is the discount rate and g is the growth rate, we would expect rents to be capitalized into high property values.

Moreover, as Edelstein and Paul point out, land in Japan is much scarcer than it is in other places: Japan’s population is a little under half of the United States’, yet its land area is only 4 percent that of the United States, and its habitable land in an even smaller percentage than that. Japan’s population density is thus 25 times larger than the United States’, and its GDP per square mile is 15 times large. Again, this is entirely consistent with Japanese land price levels being substantially higher than in the United States.

The property bust arose, according to both Mera and Edelstein and Paul, because of changing and with government policy.

With respect to fundamentals, we know that the Japanese economy slowed sharply in the 1990s. Part of the reason for this had to do with real estate related problems in the banking system, but part of the reason for this had to do with broader issues facing the Japanese economy. As to the former, Edelstein and Paul note that banks in Japan were allowed to count corporate stock holdings as reserves. This, of course, is the exact opposite of how banking is supposed to operate: reserves are supposed to be assets in which the financial institution has a risk-less position, such as cash and high quality government securities. Instead, Japanese banks counted very risky assets--equity--as reserves. Much of the underlying value of that equity was in the form of real estate, some of which was highly leveraged. Consequently, even a small downward turn in real estate markets had a profound effect on the banking system, which in turn had large repercussions for the financial system as a whole.

Making things worse was the fact that Japanese banks failed to recognize their real estate losses on their balance sheets: non-performing assets effectively drove equity levels in Japanese banks to levels below zero, and consequently created perverse incentives for Japanese bank managers.

At the same time, as the Japanese economy slowed, changes in expectations led to an increase in the underlying capitalization rate for real estate and other assets, and has therefore causes the values of all those assets to decline sharply. The existence of leverage has exacerbated this phenomenon further.

The most spectacular failures in the banking system with respect to real estate: Thailand and Indonesia, and especially Indonesia. Chapters by Bertrand Renaud (on Thailand) and Dominique Fischer (on Indonesia) give us harrowing stories of how poor underwriting, abetted in part by the “unholy alliance” between lenders and developers, can lead to a full fledged financial crisis.

The US has no cause to be smug about this, of course, as it invented the process with the Savings and Loan crisis of the 1980s. Both the Renauld and Fischer stories can be told simply enough: lenders assume rent and property value growth at some extremely high rates, which in turn produces very low capitalization rates. This in turn causes appraisers to assign high values to properties. These high values provide the support lenders need to advance loans, which typically have higher loan-to-value ratios. The high-loan-to-value ratios are justified by the fact that property values “always” rise, and that therefore the equity in the loan will quickly get sufficiently large to discourage default. At the same time, the financial institutions had reason to believe that governments (or NGOs) would prevent them from failing, meaning that the downside risk to the risky loans was attenuated. This led to a classic moral hazard problem, where risk was not appropriately priced.

The problem with this, of course, is that sometimes values and rents stop rising, particularly when building outpaces demand. All that needs to happen is for the real estate sector to grow more rapidly than the economy; at that point, everything can come unglued. And so it did: interruptions in rising rent trajectories caused real estate loans to become delinquent. But then things got even worse. The embryonic financial crisis in Thailand and Indonesia caused foreign, and especially Japanese, capital to flee. This led to currency devaluations. Because real estate loans were often denominated in foreign, rather than home currencies, the debt obligations of borrowers got much larger, which in turn led to more defaults. It was thus the combination of poor underwriting and a lack of understanding of currency risk that contributed to the downfalls of the two economies. In Indonesia, GDP fell by a stunning 15 percent in just one year.

---

[1] Much of the discussion of the Asian financial crisis below closely follows Green (2001).

Blogging Brooklyn

This is really nice:

http://builtenvironmentblog.blogspot.com/

The only problem is that while he (quite rightly) mentions Peter Lugar's, he doesn't mention Totonno's Pizza in Coney Island. The Pizza is so good it's worth the trip.

Susan Wachter has a mortgage payment index

It is at http://smartermi.genworth.com/mortgage-index.html. It tries to show borrowers how much trouble they can get into if they use Adjustable Rate or Payment-Option mortgages. Simple but useful.

A Nice Paper for GW Business Institute

By Carol Graham, who has done some of the best work on this stuff.

http://www.nd.edu/~adutt/activities/documents/GrahamInequalityAndHappiness2.pdf

Note that as we discussed in class today, Marriage makes people happy, and unemployment makes people REALLY unhappy. All else being equal, people in Venezuela, Honduras and Costa Rica seem to be the happiest in Latin America, while Peruvian, Ecuadorans, and Bolivians are least happy.

You might want to check out the GINI coefficients for these countries (and also try to find what a GINI coefficient is).

Stand-up Economist on Mankiw

http://youtube.com/watch?v=VVp8UGjECt4

One reason to become a parent

I took my daughter Hannah to hear the Philadelphia Orchestra at the Kennedy Center yesterday. We agreed the playing was awesome. But while I found Eschenbach's Brahms 1st fussy, she really liked it a lot, and argued it was consistent with the romantic tradition. I disagree, but it was fun to have the conversation.

George Akerlof's Presidential Address

This is well worth reading:

http://www.aeaweb.org/annual_mtg_papers/2007/0106_1640_0101.pdf

Apparently, a fair number of economists didn't like this, because it states that empirical findings undermine a number of neoclassical totems, such as the Permanent Income Hypothesis. But if we want to be a reality-base profession...

C Students

I think C students can be divided into roughly three types.

The first type sees the universe through a different prism than most of us, and often has wonderful insights that do not translate well to the stylized task of exam writing. I am grateful for these C students.

The second type must deliver pizza and clean bathrooms to pay for tuition, and so has compromised time and energy with which to do school work. I am grateful for these C students as well.

The third type is lazy, arrogant and uncaring. I was thinking about this third type while sitting on the lawn at Wolftrap for Prairie Home Companion the other day. Garrison Kieler was reading hellos to service members in Iraq and Afghanistan from their family members in the audience, and I found myself misting up a bit as I listened. The habits of the third type of C student has placed more than 150,000 young men and women in far more danger than they need to be, and those same habits are keeping them in danger longer than necessary.

When is the bottom of the housing market coming?

I don't know--and neither does anyone else. Here are three things to consider, however:

(1) A good harbinger of the housing market is the months supply measure. When the months supply rises beyond six months, it is hard to make a case for house prices going up anytime soon, unless builders stop building altogether. The reason: it takes about six months to build a house in most markets (i.e., to get from the beginning of the permitting process to the finished product). Thus prices have to fall until the inventory is absorbed.

The good news is that homebuilding has slowed down a lot, and that the months supply measure for new homes fell well below six months in April. The bad news is that the months supply of Existing Home Sales continues to rise, and is currently at 8.4 months. The other bad news (in a sense) is that the Existing Sales number is much less prone to revision than the New Sales number, and reflects actual closed sales, instead of sales contracts. Until the Existing Home Sales months supply number turns around, it is hard to see when the bottom will come.

(2) While the national number is important from a macroeconomic and mortgage securitization standpoint, it is not helpful to buyers in local markets. Some markets have supplies of less than six months, and buyers in these markets, particularly those who are planning to live in one place for awhile, just shouldn't worry about short-term price fluctuations. But other markets have huge supply gluts; in these markets, potential first time homebuyers are better off renting for awhile.

(3) Housing markets have substantial intrametropolitan variation. The detached housing market can be considerably different from the Condo market; housing near transportation lines can retain its value better than housing in far-flung suburbs. Moreover, there are some opportunities in weakness. I was looking at the San Diego MLS listings recently. Houses that would have been out of range for a finance professor a few years ago (i.e., houses with ocean views) are now within range. The principal reason to buy a house is the consumption benefit of the house--when an opportunity arises to obtain a great place to live, it is worth considering. Just don't be naive about it--make sure you plan on living in one place for a long time (in which case resale value doesn't matter so much), that you can afford the place with a fixed rate mortgage, and that you don't mind knowing that its price might go down for awhile before starting back up again.

It's been too long

The past two months have passed too quickly. One week I spent teaching finance in Busan. Korea is a remarkable place. When first I visited in 1992, it was clearly a place on the rise, but also one that retained a large number of very poor people, many of whom lived in very poor housing conditions. I have been back three times since then. The extreme poverty seems pretty much gone now, as its per capita GDP has risen from about 1/4 US and Japanese levels in 1990 to 1/2 US and 2/3 Japanese levels today. At the end of the Korean War, per capita GDP was roughly a dollar a day.

Korea is an exilerating place, because it has come so far so quickly, and as such, is an example for poor countries all over the world. It is hard to know the "secret," though, other than the fact that education has been an important part of the culture for a long time, and Korean parents probably care even more than Montgomery County parents about how well their kids do in school.

The infrastructure in Busan is quite remarkable, with a wonderful metro system, good roads, and one of the most beautiful suspension bridges I have ever seen. (The image below is from Slate). The city is the second largest in Korea, and trying to become the financial services center of the country. But it is still off the beaten path--as a Westerner I felt quite conspicuous.

Casino Royale

Tonight, for the first time, I made myself the drink James Bond creates in Casino Royale:

"Just a moment. Three measures of Gordon’s, one of vodka, half a measure of Kina Lillet. Shake it very well until it’s ice-cold, then add a large slice of lemon-peel. Got it?’”

It is actually very good.

Mortgages and Houses

A few years ago, Alan Greenspan suggested that many households would have been better off financing their houses with adjustable rate mortgages. This is because for many years payments on adjustable rate mortgages were lower than on fixed rate mortgages--so after the fact, Greenspan was correct.

The problem with advising people to use adjustable rate mortgages, however, is that ARMs give households liabilities that have short duration--that is, liabilities whose market value remains close to face value at all times. This is because the rates on ARMs by definition change to meet market rates on a regular basis. Houses, on the other hand, are assets with lots of duration. The services they give to homeowners (shelter and a set of amenities) is pretty much invariant to market conditions. Consequently, house values change with market conditions, such as changing interest rates.

Good financial management practice suggests that to minimize risk, the duration of of assets and liabilities for any institution, including households, should be matched. In the case of houses, this means that households looking to minimize risk should use a fixed rate mortgage to finance their house. There are exceptions--if one buys a house and expects to sell it in five years, a five year ARM makes lots of sense, because the duration of the asset (housing services over five years) and the liability would match.

This is not to say there is anything wrong per se with people getting ARMS, so long as they explicitly understand the risk embedded in them. But a principle I have been pushing for years is that if people can't afford a house with a fixed-rate mortgage, they probably shouldn't buy a house. It is one thing to have the option of the FRM, and then decide to take the risk of the ARM anyway. One of the nice things about the United States is that FRMs are easy to come by--this is not true in most countries around the world. It is something else to be forced into taking a risk in order to buy. Under these circumstances, buying probably isn't worth it.

That said, there is probably too much ink being spilled on the downside of home-owning. The Times this morning had a piece that would make one wonder why anyone should own a house. But it is important to remember that renting is risky too--leases are usually only a year long, which means renters are subject to increases in rent or may even be forced to move every year.

Notice that I have not even mentioned the subprime market in this post. That will be for another day (probably tomorrow).

A few words about urbanization and growth

From a paper I am writing for the World Bank:

Every affluent country in the world is urbanized. Among OECD countries, 77 percent of people live in urban areas, and among World Bank-designated high-income countries, 78 percent of people live in urban areas. The poorest two countries in the OECD, Turkey and Mexico, are 67 percent and 76 percent urbanized, respectively. The least urbanized affluent country, Portugal, is 55 or 59 percent urbanized, depending on source. At the same time, the world’s lowest income countries are generally not urbanized: in 2004, the urbanization rate among the World Bank’s designated low income countries was 31 percent. All of the countries with urbanization rates of less than 20 percent, Burkina Faso, Burundi, Cambodia, Ethiopia, Malawi, Nepal, Papua New Guinea, and Uganda, are low-income countries, all with Gross National Incomes Per Capita of less than $660, and most with GNIs that are substantially lower than that.[1] The correlation between urbanization and PPP Per Capita GDP in 2000 was .70. In short, urbanization accompanies affluence.

That urbanization accompanies affluence does not, however, mean that urbanization causes affluence. First, it is worth noting that Latin America and the Caribbean are 77 percent urbanized, and the countries in that region are certainly not among the World’s richest (nor are they in general, among the poorest). There are also very poor countries in Africa--Cameroon, Mauritania, and Senegal--that are at least 50 percent urbanized. All of these countries have per capita GNIs of less than $1010.[2] Hence affluence does not necessarily follow urbanization.

One of the most interesting questions in development economics, then, is whether urbanization causes affluence, or whether affluence causes urbanization. Knowing the direction of causation is important, because it will dictate whether policy should encourage urbanization or be neutral with respect to urbanization. Discussion below will outline arguments for both directions.

Principles set forth by Richard Freeman, however, suggests that the evidence is already sufficient to know that policy should not discourage urbanization. Freeman’s three rules of econometrics are: (1) it had better be there in the ordinary-least-squares regression; (2) it had better still be there in the econometrically-sophisticated high-tech instrument procedures; (3) it had better still be there for small technical tweaks to the econometrically-sophisticated procedures. That urbanization has a deleterious effect on affluence is not there in scatter-plots and correlations, and, as we shall see below, is not there in the OLS regressions in the literature.

The fact that there is no evidence that urbanization inhibits development is in itself important. On my visit to Bangladesh in 2004, some officials were convinced that urbanization was shown scientifically to be “immoral,” and wanted to know where to find the work that would prove it to be so. I disappointed them when I was not able to point them to any such work.

---

[1] Afghanistan is likely within this group as well, but there is no good current data on urbanization in the country.

[2] Gabon, a sub-Saharan that is 84 percent urbanized, has a per capita GNI of more than $5000, a very high number for the region. But the primary reason for the high number is the presence of oil.

Taking the log out of our own eye

I admire Brad Delong very much: he is a wonderful blogger and scholar. He also is very tough on the Washington Post. I, on the other hand, consider the Post a treasure, and am grateful to have it on my doorstep every morning. To be sure, the paper has stories that I am not crazy about; it also regularly has stories that are breathtakingly good (such as the recent series by Dana Priest and Anne Hull on Walter Reed).


So let us stipulate that that even the best newspapers have reporters who are not particularly good at their jobs. Unfortunately, universities, even the best of them, have professors who are not particularly good at their jobs. Here at George Washington, we have many wonderful, inspiring teachers. We also have people who should be embarrassed to step into a classroom--people who are unprepared, are indifferent, or worse, haven't kept themselves up to date on their supposed area of expertise. Moreover, unlike reporters, who must meet short deadlines, professors have time to reflect on what they are going to say and do in their classrooms.

Some might argue that comparing George Washington with the Post is not really appropriate: the Post is supposed to be one of the greatest newspapers in the country, while GW is rarely listed as one of the greatest universities. OK. When I was an undergraduate at Harvard, I encountered some really horrible teaching (and of course, truly extraordinary teaching, from Gwynn Evans, James Q. Wilson, Stanley Hoffman, Benjamin Friedman, and my Ec. 10 TA. Jeff Wolcowitz, among others). That was between 1976-1980, so perhaps all the bad teachers are gone now, but based on what Derek Bok and Harry Lewis have been writing lately, I doubt it. I am guessing that even Berkeley has bad teachers.

This is not a plea for reducing the emphasis that universities place on research: many unproductive researchers are bad teachers, and the greatest teachers are often the greatest researchers. Gwynn Evans, my Shakespeare professor, was likely the greatest Shakespeare scholar of his time. During my time teaching at Wisconsin, I discerned a strong positive correlation between research productivity and teacher quality. And no wonder: active researchers know their subjects well, and that rubs off on their ability to explain and enlighten.

Nevertheless, we need to do a better job of quality control for teaching. How exactly we do this without compromising academic freedom is not entirely clear to me. Culture probably matters a lot. When I was a visiting Professor at Wharton, it was striking to me that even those who didn't particularly like teaching considered it important to avoid embarrassing themselves; people generally had too much pride to do anything less than well. More generally, I see too much complacency is our business; many professors are content in the knowledge that American universities are the best in the world, and so don't feel any urgency to change. One of my colleagues here at GW gets upset with me for being too self-flagilating.

I actually feel a great deal of pride in being a professor at a reasonably well-known university--I think that it is among the most rewarding things one can do in life. I think in generally our universities are wonderful. But before we go around removing other institutions' specks, we have some of our own timber to clear.

Best think I have found yet on Youtube

http://www.youtube.com/watch?v=AjnFGk4GTd0

My favorite living pianist playing the most beautiful nine minutes of the 20th Century.

Sub-prime mortgage really are more risky

The Wall Street Journal in the past few days has featured stories about the troubled subprime mortgage industry. There was a particularly telling graph today:

One thing about the graph that leaps out is that under all market conditions, subprime mortgages really are not just riskier and more costly, but substantially riskier and more costly than prime and Alt-A mortgages. While late payments do not necessarily lead to default (most of the time they do not), mortgages with late payment require more servicing, or individual attention, from lenders, and are therefore more expensive.

With the housing market slowing, it is also now more likely that late-payment mortgages will eventually go into default; this is the reason HSBC has had to set aside $10.5 billion reserves for potential sub-prime mortgage losses. To place this in context, HSBC earnings are about $15 billion per year.

Advocates worry that subprime borrowers pay too much for mortgages. While there are doubtless borrowers in the subprime pool who qualify for prime mortgages, and who should be encouraged to use the prime market, as a group, subprime borrowers are riskier. The data from the past few days suggest that it is possible that the mistake some lenders made was not charging too much, but rather not charging enough.

The data also suggest that for many borrowers, the absence of a subprime market would produce an absence of opporuntity for any mortgage.

Great Lyrics Period

Goethe, Erlkönig Original German

English Translation

Wer reitet so spät durch Nacht und Wind? Es ist der Vater mit seinem Kind; Er hat den Knaben wohl in dem Arm, Er faßt ihn sicher, er hält ihn warm. "Mein Sohn, was birgst du so bang dein Gesicht?" "Siehst, Vater, du den nicht? Den Erlenkönig mit Kron und Schweif?" "Mein Sohn, es ist ein Nebelstreif." "Du liebes Kind, komm, geh mit mir! Gar schöne Spiele spiel' ich mit dir; Manch' bunte Blumen sind an dem Strand, Meine Mutter hat manch gülden Gewand." "Mein Vater, mein Vater, und hörest du nicht, Was Erlenkönig mir leise verspricht?" "Sei ruhig, bleibe ruhig, mein Kind; In dürren Blättern säuselt der Wind." "Willst, feiner Knabe, du mit mir gehn? Meine Töchter sollen dich warten schön; Meine Töchter führen den nächtlichen Reihn, Und wiegen und tanzen und singen dich ein." "Mein Vater, mein Vater, und siehst du nicht dort Erlkönigs Töchter am düstern Ort?" "Mein Sohn, mein Sohn, ich seh es genau: Es scheinen die alten Weiden so grau." "Ich liebe dich, mich reizt deine schöne Gestalt; Und bist du nicht willig, so brauch ich Gewalt." "Mein Vater, mein Vater, jetzt faßt er mich an! Erlkönig hat mir ein Leids getan!" Dem Vater grauset's, er reitet geschwind, Er hält in Armen das ächzende Kind, Erreicht den Hof mit Müh' und Not; In seinen Armen das Kind war tot.

Who rides, so late, through night and wind? It is the father with his child. He holds the boy in the crook of his arm He holds him safe, he keeps him warm. "My son, why do you hide your face so anxiously?" "Father, do you not see the Erlking? The Erlking with crown and cloak?" "My son, it's a wisp of fog." "You lovely child, come, go with me! Many a beautiful game I'll play with you; Many colorful flowers are on the shore, My mother has many a golden robe." "My father, my father, can't you hear, What the Erlking quietly promises me?" "Be calm, stay calm, my child; It is the wind rustling in the dry leaves." "Do you want to come with me, fine lad? My daughters shall serve you; My daughters lead the nightly dances And rock you and dance and sing you to sleep." "My father, my father, and can't you see there, The Erlking's daughters in the gloomy place?" "My son, my son, I see it well: It is the old grey willows gleaming." "I love you, your beautiful form entices me; And if you're not willing, I shall use force." "My father, my father, now he takes hold of me! The Erlking has wounded me!" The father shudders; he rides swiftly, Holding in his arms the moaning child. He reaches the yard with fear and dread; In his arms, the child was dead.

Great Lyrics for Urban Economists

From Talking Heads

Cities
-------

Think of London, a small city

It's dark, dark in the daytime
The people sleep, sleep in the daytime
If they want to, if they want to

CHORUS

I'm checking them out
I'm checking them out
I got it figured out
I got it figured out
There's good points and bad points
Find a city
Find myself a city to live in.

There are a lot of rich people in Birmingham
A lot of ghosts in a lot of houses
Look over there!...A dry ice factory
A good place to get some thinking done

Down el Paso way things get pretty spread out
People got no idea where in the world they are
They go up north and come back south
Still got no idea where in the world they are.
Did I forget to mention, to mention Memphis
Home of Elvis and the ancient greeks
Do I smell? I smell home cooking
It's only the river, it's only the river.

Brad Delong cites AngryBear on Tyler Cowan

http://delong.typepad.com/sdj/2007/01/steven_kyle_thi.html

The issue of income distribution is problematic. We like to think that income is a function of virtue (i.e., hard work, honest dealings, etc.), but the reality is that it is also a function of endowments at time of birth. The most conventional of these endowments is parental wealth, but the most important (at least within the contect of the United States) is the initial store of human capital--that is, talent.

The initial distribution of talent is anything but "fair." Doctors make a good income in part because they work very hard to become Doctors, but if they also tend to be people who were lucky enough to be born pretty smart.

Remarkably, people seem to be more or less OK with the outcomes that the distribution of talent produces--there doesn't seem to be that much resentment of the incomes of Tiger Woods or orthopedic surgeons. But problems do arise and there is resentment when those who work 40 hours a week cannot grasp certain basics--an affordable house, a decent neighborhood, a decent school for their kids, a reasonable commute. It used to be that people without the intellectual acument to go to college could have these things, but they often no longer do.

These are not unreasonable things for working Americans to want, and there is only one way to make sure they have them--some form of income redistribution. There seem to be two acceptable ways to do this politically. The first is to increase the minimum wage. While conventional economic theory predicts that this will lower employment, the most likely outcome of an increase in the minimum wage is that businesses (all of which are subject to the wage floor) will raise their prices to consumers--implicitly tax all of us who consume. Personally, I am fine with that.

The other method for raising living standards for working Americans at the bottom of the income distribution is to get a larger Earned Income Tax Credit. To do this without increasing the fiscal deficit means some of us will have to pay higher taxes. I am fine with that too. My first choice: increase the tax on gasoline. We'll talk more about that soon.

New Orleans (again)

In 1960, New Orleans had 627,000 people and was the largest and perhaps still most important city in the South. It now is smaller than Lexington, Kentucky. Most of the reason for this is, of course, Katrina, but much of the reason is not. New Orleans had already lost around 20 percent of its peak population before Katrina, and as such was very much like unglamorous cities such as Milwaukee, Cincinnati, and Baltimore. So while it didn't lose as much as Buffalo, Pittsburgh, St. Louis and Cleveland, it was hardly putting in an all-star performance, even before Katrina hit.

A question I want to focus on over the next year is why New Orleans--a city I rather love--has evolved (devolved?) as it has. Race certainly has a lot to do with it, but cannot by itself explain the city's fade. Atlanta is a heavily black, southern city that has performed far better--if less charmingly--than its neighbor to the southwest.

Of the course if this year, I will be president of a small association of academics who do what I do--the American Real Estate and Urban Economics Association. I will be giving my presidential address next January in New Orleans. I therefore think that the focus of the address should be about New Orleans. I have a lot of reading to do between now and then; I welcome suggests for reading, people to talk to, and just opinions from well-informed people about the city's history and its future. You may read my preliminary views in the archives.

Thanks for any suggestions or help.

News from a tough real estate market: Metropolitan Detroit

Susan Carter, a Realtor from the Detroit area, writes:

As I thought about ways to best characterize the real estate market in Southeast Michigan in 2006 I looked at last year’s market report…and found I could almost repeat word for word the general market condition comments I made at the end of 2005. The characteristic optimism of Realtors has again been tested by the challenging economic issues facing Michigan AND continued consumer concerns about making major financial commitments. The supply of homes and condos for sale has been high all year and the number of motivated buyers low (especially in the over $250,000 price range)… a condition that can only be sustained for so long without discounted values…basic economics 101. 2006 saw a softening of prices in all areas and price ranges, in some cases up to 12-15 percent of 2004 values. Sellers who simply had to move in 2006 decided there was no point in waiting for a price recovery, especially as we saw the erosion of values tied to supply and demand as the market year progressed. People who wanted to trade up often could not sell their current house or condo, disrupting the typical home ownership cycle….first home, second home, then the keeper until retirement. The current soft real estate market is a complicated issue, one with many factors influencing the fundamentals of supply/demand/pricing, including…
1. Highly motivated sellers: relocation or long term owner sales. When employees are transferred or leave the area for new job opportunities some employers have guaranteed buy-out or sales support programs in place but most do not. At some point in a slow market people without relocation benefits just do not want to own or maintain homes here any longer….and they become the most motivated sellers in town. Owners undercut the market, reducing the list price to below the price of competing homes, to generate offers. When the property sells, the sales price is used to establish market value for future sales. Long time owners with a lot of home equity have started to do the same thing…undercut neighborhood pricing to sell instead of waiting for a market recovery. Buyers have access to sales data and make offers based on the lowest neighborhood price these days as opposed to overbidding in hot markets ten years ago.
2. I have said for the last 5 years that trendy, creative mortgage programs can be good tools when used in the right circumstances…the right buyer and the right home. Many of these programs are based on an assumption of appreciating real estate values, sustained employment and increasing incomes. Unfortunately most lenders do not explain the potential downside of interest only, balloon, adjustable, negative amortization or highly leveraged financing programs…and the impact of job loss or layoffs, which can make refinancing of adjustable or balloon mortgages impossible. Homeowners can be forced to sell if they cannot afford to refinance at current interest rates.
3. Michigan has the highest foreclosure rate per household in the country. Many people bought homes in the last few years counting on a continued robust, appreciating real estate market. Then the local market softened and people could not sell without bringing money they did not have to the closing table. Buyers just stopped making payments and waited for the inevitable. The number of foreclosed homes scares potential purchasers…they think that the bottom has fallen out of the real estate market and the only prudent thing to do is take a wait and see attitude while assessing the direction prices are heading.
4. The media often has banner headlines about the number of unsold homes without looking at the hard facts of real estate sales: there are a lot of reasons a home does not sell besides a weak local economy including a negative equity position that does not allow for price negotiation, changing buyer tastes in terms of style, location and lifestyle, a price that is way out market value range or the overall condition of the home. The power of the press in creating or killing consumer confidence has always amazed me.

While unemployment is high…almost 7 percent in Oakland County…I prefer to focus on the 93 percent of the people in the area who are working and could buy homes if they wanted or needed to. Housing corrections do not last forever and there are indications that consumers are feeling confident about local market conditions and are ready to move back into the housing market in 2007. Literally dozens of people have told me that they are tired of waiting; this will be the year to make a move. Once there is market activity I suspect that prices will rebound within 12-24 months. Our market is unique in that pricing still bears a relationship to actual construction costs. The number of sales tied to speculators is quite low here compared to other parts of the country. It seems to me that people are spooked by perceived loss of home equity…remember the dot.com stock market bust and the huge loss of paper wealth ….but they will not need a lot of encouragement to get back in the housing game if they need more space, want a different location or style of home. Home ownership can be a warm, fuzzy lifestyle benefit, hard to put a price tag on or quantify as strictly an investment.

While I think Susan overstates the power of the press, she is otherwise very much on target as to what is happening in her region. I also appreciate her remarks about exotic mortgage products.

I also think Susan demonstrates something that people don't think about very often when they think about Realtors--that the good ones know their markets exceptionally well, and that it takes a lot of diligence to know markets so well. The is the reason most people who go into the real estate business do not succeed--the median compensation for real estate agents is very low. As is the case in most businesses, long term success in the residential real estate market requires intelligence and hard work. I remember driving down a street in Madison some years ago with a well-known broker from that town, and he could tell me something about every single house on the street.

So how does one choose a good Realtor? When we are buying in Bethesda, we began by going to someone who was a leader in number of listings, a man named Gary Ditto. It turns out he was completely obsessed with the market. Susan seems pretty obsessed too. Go for the obsession.

Why Public Housing is Scorned

I came across this on You-tube:

http://www.youtube.com/watch?v=t29fgA5M7VA

This comes from the film Koyaanisqatsi (a Hopi word meaning life out of balance). From roughly minute 3 to minute 6 of this clip are shots of the notorious St. Louis public housing project Pruitt-Igoe, a subsidized housing project that was so awful, it was never more than 60 percent occupied. The eleven building complex of nearly 3000 units was torn down before it was 20 years old.

In a terrific essay ( http://www.soc.iastate.edu/sapp/PruittIgoe.html), Alexander Von Hoffman argues that even a well-designed Pruitt-Igoe would have been a failure, because St. Louis had been (and in fact continues to be) a dieing city. And so it has; the 4th largest city in the country in 1890 is now not among the top 50.

But Pruitt-Igoe was a representation of the modernist movement at its worst. The buildings were faceless and difficult to cool. Public spaces were neglected and shadowy, and bred crime. The shame is that the complex gave high-rise living for the poor a bad name. High rises can work well, so long as they are well maintained and managed (some of the most desirable places to live in Chicago, Vancouver, Hong Kong and, of course, New York are high rises). More important, the complex lent such a stigma to public housing that it eliminated it as a mechanism to house the poor.

Malpezzi and I have written that the public housing that the US has built has been invariably inefficient as a means for housing low-income people in expensive American cities. This doesn't necessarily mean that it must be so, but the disasters of Pruitt-Igoe and other large scale public housing projects (Cabrini-Green and Robert Taylor Homes in Chicago are almost as notorious) means we might never find differently.

Recruiting for MBAs in the Middle East

I am home from recruiting MBA students in Dubai and Cairo.

Cairo is one of the greatest cities I have ever visited; the architecture, street life, and, oh yes, the antiquities are beyond compare. The people there were exceptionally hospitable, and the streets are safe, if heavily littered. I bought some cool if corny papyrus paintings; the Nefertiti will hang in honor next to my velvet Elvis.

I met great potential students in both Dubai and Cairo, and would love to bring at least a half-dozen from each place to George Washington. The sticking point, in their minds, was getting a student visa. The perception was that getting student visas to the US is too much of a hassle; as a friend of mine at National University of Singapore said to me, the difficulty in getting visas to the US has made recruiting at NUS much easier. Don't get me wrong, NUS is terrific (I have very much enjoyed my two visits there), but I would rather students come here.

My reasons for this are not entirely altruistic. I think having college and graduate students coming to the United States is extremely important to our image in the World. While people in Egypt complained bitterly about US Middle-East foreign policy, they nevertheless wanted to come to America. In the 17 years I have been teaching (has it been that long?), I have seen generation upon generation of international students transformed by their experience in America--and transformed for the better. Once students are here for a few years, they often appreciate America's openness, and generosity, and they embrace American ideals. They can't help but feel better about America's place in the world, even as they continue to oppose US foreign policy. In some small way, this must leave us safer.

A State Department Official in Cairo told me he get could get visas for students accepted at US universities in 3 days. If this is really true, I am optimistic about increasing the flow of students from Morocco to Jordan to Oman into the United States. This would benefit us all.

On my eight day trip, I took one morning off. This is what I saw:

I would say that if you get a chance to see one wonder in your life, this should be it. Astonishing.

Mumbai

I am currently in Mumbai, recruiting MBA students. This is my second trip to this marvelous, vibrant, horrible city. When I walk the streets here, I think about Dickens' London.

The city is remarkably entrepreneurial . There are people selling stuff everywhere, and lots of cottage industry, even in the slums. Kids are going to school here in much larger numbers than 30 years ago, and so literacy has risen dramatically. One sees fashionable shops, and the street along the sea, Marine Drive, could become among the most attractive in the world, comparable to Lake Shore Drive in Chicago.

Yet it is a city of eight million in which 20 percent have no access to toilets; in which the largest slum in the world sits; in which commuter trains run with 4 to 5 times the number of passengers for which they were designed; in which live many pavement dwellers. Many workers do unspeakably difficult tasks--such as breaking up old ships with hammers--for about $2 per day.

Some of the horrors here are a function of the fact that this remains a city that, despite substantial progress, remains extraordinarily poor. But land use policy here makes things worse. Two issues stand out in particular. First, government and quasi government enterprises own vast swatches of land here--the old port is one example. To say this land is underutilized is a severe understatement. Mumbai badly needs to use its developable land--right now land here is as expensive as it is in Montgomery County Maryland, while incomes here are about 1/50th of what they are in Montgomery County.

Second, there is a hostility here to tall buildings. But the Mumbai peninsula, with 150,000 people per square mile, is twice as dense as Manhattan. The only way people can be housed reasonably here is to build up. High rise housing had a bad reputation, I think, because of the ugliness perpetrated in the former Soviet and Soviet-satellite cities. East Berlin was not very attractive (nor was most of the high-rise public housing built in the US). But Hong Kong, Singapore, New York and Chicago demonstrate that high rise housing can be attractive. Shanghai has used high-rise housing to rapidly improve housing conditions there in the past 15 years.

One could talk about a lot of other things Mumbai needs to do to move forward--infrastructure development--including good sidewalks--needs to be on the top of the list. But giving people more room to live might do more than anything else to improve living conditions here.

New President at George Washington!

We have a new president: Steven Knapp, who is currently provost at Johns Hopkins. I was hoping against hope that our new leader would be the provost of a World-class research university, and that is exactly what we got. I am excited.

Too much fun; Weird Al Yankovic - White and Nerdy

Weird Al Yankovic - White and Nerdy

To keep blogger status

I gave a seminar on urban economics today at the George Washington Institute for Public Policy. I learned that to be a true blogger, I must post at least once a month, so here I am.

I am trying to figure out how soft the housing market has gotten. One of the problems--the two best known data sets for looking at house prices--the NAR median house price set and the OFHEO repeat sales index--are moving in opposite directions. The NAR data probably reflect the way the assign regional weights for determining house prices, but there are still cities where the NAR data show price declines, while OFHEO shows increases.

More tomorrow.

Airports and Economic Development

Before the 18th Century, harbors mattered a lot. They allowed trade, and explain why the cities in the current Netherlands became rich, despite the relative lack of natural recourses. In the 19th Century, canals and railroads were important. More recently, highways have mattered a lot--Ed Glaeser has written on how highway spending helps explain differences in urban growth.

But airports may be what harbors once were. I have a recent paper that looks at differences in population and employment growth across metropolitan areas: education matters, climate matters, and airports matter, a lot.

Here is the paper's conclusion:

This paper sought to find a relationship between airport activity and economic development, and it found one. Passenger boardings per capita and passenger originations per capita in the nation’s largest metropolitan areas are powerful predictors of population growth and employment growth. This is the case after a number of controls are put in place, and survives after an attempt to control for simultaneity issues. Beyond statistical significance, the magnitude of the coefficient on boardings per capita indicates that the magnitude of the effect of passenger boardings on these two measures of economic development could be rather large. It might particularly suggest that where airports are constrained by capacity (such as they are in Chicago, Boston, New York and Los Angeles), adding to capacity might well have an important economic development impact. That said, these results do not suggest that every small city should run out and build a large airport.

Of course the results presented here are far from conclusive: they are, perhaps, among the first of their kind (this paper was written contemporaneously with Brueckner 2003), and are therefore subject to far more scrutiny. Nevertheless, their statistical significance is sufficiently strong that it survives a large variety of alternative specifications. The results are also consistent with the findings in Brueckner.

The policy implications of this finding are therefore quite important. The political economy of airports is very much a function of their governance structure. The cost (at least the perceived cost) of airports to members of a community is highly concentrated geographically, while the benefits tend to be diffused throughout the community. Airports are sometimes under the control of local units of government, such as city councils or county boards. When this is the case, representatives whose districts include an airport have a strong incentive to become members of the airport authority. Consequently, decisions about airports can be based on parochial interests, even if the total benefits of the airport to the economy exceed the cost. Should air traffic be a large determinant of economic success, it is entirely possible that the benefits of new or expanded airports exceed costs.

Yet we have observed that in many places (San Francisco, Boston, Milwaukee), interest groups have worked to inhibit runway expansion, while in other places (Chicago), local political squabbles have prevented any number of potentially reasonable plans for expanding airport capacity from going forward in a timely manner. All this suggests that airport policy might best be made regionally, rather than locally. Of course, the regional policy would have to include a scheme for compensating those injured by airport expansion. But if the regional benefits of airport development are large, the costs of fair compensation should be easy to finance.

The paper is available on the GW Web Site. http://www.gwu.edu/~business/research/workingpapers/Airport%20GW.pdf

A Short Quote in Business Week

http://www.businessweek.com/magazine/content/06_45/b4008063.htm?chan=search

Bridges

Slate today has gorgeous pictures of my favorite bridge--the George Washington Bridge. The bridge is a masterpiece of architecture and engineering, and was completed at the time my father was born. It also helped create suburban New Jersey.

Bridges seem politically unpopular right now--they only seem to get built (or proposed) where they aren't necessary. In my town, for instance, there has not been an additional bridge built across the Potomac in nearly 40 years, despite the fact that the metropolitan area has doubled in size. The lack of bridges has created choke-points in the regional transportation system; choke-points that make people unhappy throughout the region, but that people don't seem to want to do anything about. I would guess that a couple of more bridges from the District into Arlington would easily pass any cost-benefit test, but they flunk the political test.

Perhaps the reason for this is that we built too many ugly bridges. The older bridges across the Potomac--Memorial Bridge, Key Bridge and Chain Bridge--are all quite beautiful. Don't take more word for it--the picture on top is of Key Bridge, the one just below it is Memorial Bridge.

Compare these with the 14th Street Bridge:



It is not hard to understand why people don't want more of these.

But bridges have made lives better for people--they have relieved congestion and, because they open up more urban land for development--reduced housing costs. While some urban planners sniffed that the post World War II suburbs of New Jersey and Long Island and Northern Virgina were banal, they also allowed the emerging middle class the ability to own houses at reasonable cost. These places would not exist in the absence of bridges.

In the Department of Self-Promotion

I am quoted in Robert J. Samuelson's newsweek column.
http://www.msnbc.msn.com/id/15173465/site/newsweek/page/2/

Why I love Keynes

From Brad Delong's blog:

http://delong.typepad.com/sdj/2006/10/the_economic_co.html

Case-Shiller, Ofheo, etc.

This is a really wonky post, but after talking with a reporter today about house price indices, I couldn't help myself. The most commonly cited "constant quality" house price indices come from Case and Shiller, and from the Office of Federal Housing Enterprise oversight. These indices attempt to follow the price of a particular house at a particular place over time. To explain how they work, I will lift from my book with Steve Malpezzi:

Repeat Sales Price Indexes
Repeat sales indexes are estimated by analyzing data where all units have sold at least twice. Such data allow us to annualize the percentage growth in sales prices over time. These are time-series indexes in their pure form. They do not provide information on the value of individual house characteristics or on price levels. They have the advantage of being based on actual transaction prices, and in principle allow us to sidestep the problem of omitted variable bias. However, units that sell are not necessarily representative of all units. Sometimes it's difficult to tell whether a unit retains the same characteristics across time. For example, remodeling could change a house’s characteristics.
The best way to understand how repeat sales indexes work is to look at an example. Figure 2.15 shows a graph of 17 properties that sold twice in the Shorewood Hills neighborhood of Madison, Wisconsin, in the late 1980s and early 1990s. Each property is numbered from 1 to 17, and each property appears twice. The Y-axis is the logarithm of the selling price of the unit.
We can think of the repeat sales estimator as an attempt to measure the average slope of the lines in Figure 2.15, year by year. In a classic paper, Bailey, Muth, and Nourse (1963) illustrated how to compute this using regression methods and a larger sample.
One way to motivate the actual technique used to construct the repeat sales index is to start by reconsidering the hedonic model. Consider a simple semilog hedonic equation
ln P = Xb + b1D1 + b2D2 + b3D3 + b4D4
where P is the value or rent for the unit, and where the vector X includes all the relevant characters, including a constant term; and the time dummies Di represent periods that follow the initial base case period.
The vector X represents a list of housing and neighborhood characteristics that would enter a hedonic equation. The vector D is a series of dummy variables representing the time periods under consideration. These could be months, quarters, or years, depending upon the type of data at hand.
Consider a house, “A,” that sells in periods 2 and 4 (period 0 is the base year). In period 2, we calculate:
ln PA2 = Xb + b1D1 + b2D2 + b3D3 + b4D4
= Xb + b2D2
since D1, D3, and D4 = 0. And of course, by similar reasoning, in period 4:
ln PA4 = Xb+ b4D4
Then, by subtraction, we find:
ln PA4 - ln PA2 = Xb + b4D4 - Xb - b2D2
= b4D4 - b2D2
This is for a representative housing unit that sells twice. Given a sample of such units, we want, in effect, the “average” b4 and b2. (Recall that regression is, in effect, estimating a series of conditional means.) Clearly, by subtraction, the characteristics vector drops out, as do the dummy variables for periods in which no transaction takes place.

Case-Shiller actually does a better job of keeping quality constant than OFHEO, but OFHEO has more coverage (I think). I will explain why in another post.

Long-term interest rates again

This morning's Wall Street Journal reports that long-term interest rates are at their lowest levels in months, with the ten-year Treasury at 4.55 percent. They also note:

Recent data from the Mortgage Bankers Association suggests that some families have taken advantage of a decline in long-term mortgage rates to refinance their mortgages and lock in lower payments. The association's index of mortgage refinancing applications has risen 27% since mid-July, and now stands at its highest level since February.

The MBA has been ahead of the curve in figuring out how the inverted yield curve would affect refinancing. This should help soften price declines in the housing market, particularly in markets away from the coasts.

Nevertheless, yesterday's news on prices and inventories out of NAR was ugly: prices are falling a bit, and inventories are at a high for the decade.

A Key to a Soft Landing in Housing

As I have already mentioned, the Chicago Merc housing futures market is predicting a decline in nominal house prices in several markets over the next year. While the market is still very thinly traded, it likely reflects a prevailing view among many investors and observers of the housing market.

One of the reasons for the softening of in some markets has been the increase in the federal funds rate. Some work in progress among Chris Redfearn, Stuart Gabriel and me is showing that the short end of the yield curve migh have a substantial impact on house prices in many of the coastal cities. The reason: in expensive markets, borrowers slide down to the short end of the yield curve where the cost of borrowing is generally lower. This allows borrowers to buy houses with "affordable" initial payment-to-income ratios.

The problem, of course, is that short term interest rates have been driven up by the Federal Reserve, from one percent in late 2003 to 5.25 percent today. If an Adjustable Rate Mortgage's spread over the fed funds rate is three percent (not usually the way ARMs are calculated, but lets give the example to make a point), and it amorizes over 30 years, the payment on an ARM would rise more than 50 percent per dollar of mortgage balance. This means people who could get into the housing market in a place like Los Angeles before can no longer do so, and it means many people in Los Angeles are facing payment shock. The situation is even worse for those who used "option ARMs" to finance their houses--these products allow people to pay less than the interest they owe on their mortgage every month, meaning that their loan balances are rising over time.

The good news is that long-term fixed rate mortgages, while not at rock bottom rates, remain at very low rates by the standard of the past 25 years: 30 year-fixed rate conforming mortgages last week hast week at an average rate 6.4 percent, according to Freddie Mac's survey. This means the ARM borrowers can refinance out of their ARM into a fixed rate product that is pretty reasonable. This should place a floor under house prices, particularly in an economy where unemployment is pretty low.

I think the early part of the '00s should have taught an important lesson to homebuyers--if they can't afford a house with a 30 year fixed-rate mortgage, they probably shouldn't buy a house. That is not to say the ARM isn't a good product--it is, if households use it as part of a portfolio strategy. For instance, is someone knows she is only going to live in a city for five years, it is perfectly reasonable for her to borrower with a 5/1 ARM, where the rate is fixed for only five years. Her liability, the mortgage, now matches her asset, the house, where she expects to live for five years. But when people use ARMs--especially option ARMS--to make payment-to-income ratios acceptable for a limited period of time, they are liekly looking for trouble.

America the Spacious

While those of us who live on the Eastern seaboard of the United States feel hemmed in, the fact is that by World urban standards, we have a lot of space.

One of my favorite websites is http://alain-bertaud.com/. Alain has a wonderful gathering of information on urban environments around the world. Among his many great graphs, a particularly revealing one is the one to the left: it gives average urban densities for large cities around the world.

Note that American cities are in red: the densest of this, of course, is New York. But New York is less dense than European cities, and is much less dense than Asian and African cities. My home city of Washington is practically rural compared with most large cities around the world. But then, I am sure that someone from Mumbai would consider suburban Maryland and Virginia to be the countryside.

One of the reasons American cities have so little density is that the United States has a lot of land (only about five percent of which is developed) ; another reason is that the US is a rich country, and rich people buy more stuff, including land. But these reasons are only part of the story. More to come....

Jon Stewart on Social Foment

We saw Jon Stewart at Merriweather Post Pavillion last night. He articuated well why many of us can't get organized about expressing our frustration at policy and policy makers. The rallying cry of "be reasonable" somehow does not have an inspirational ring to it.

Credit to Francois Ortalo-Magne

It occurs to me that I might never have come up with the idea in the previous post had it not been for a conversation I had with Francois Ortalo-Magne at an NBER conference around a month ago. Francois pointed out the selectivity problem in Levitt's work.

Do Real Estate Brokers Shirk?

Steve Levitt is an incredibly smart guy (he has a Clark Medal, the prize for best economist under 40, to prove it) and, according to the people I know who know him, a very nice guy. Freakonomics is fun to read, and I liked it enough to use it for a seminar I taught last summer.

A reason the book is so much fun is that it is provocative, and challenges us to think about things from perspectives we had not before considered. It asks why drug dealers live with their mothers; whether Roe v Wade was responsible for the falling crime rate in the 1990s; whether Sumo Wrestlers cheat; and whether real estate agents shirk.

Levitt sets up the real estate agent-house seller relationship as a classical principal-agent problem: the agent is like anyone else: he has an incentive to do as little work as possible in exchange for as much commission as possible. Therefore, Levitt conjectures that real estate agents have an incentive to get sellers to take the first offer they receive from buyers. Because commissions are based on the entire price of the house, the fact of a sale gives agents a large benefit. If the seller refuses an offer, the agent has to do more work, but gets very little added compensation. For example, if there is a $490,000 offer on a house that could ultimately sell for $500,000, and the agent gets a 1.5 percent cut, from the standpoint of the agent, the benefit of waiting is only $150. The agent will almost certainly have to do a lot more work for the $150, and so has an incentive to encourage the buyer to take the $490k.

This would be a powerful argument for an incentive problem if agents were playing a one-shot game. But they are not--they are playing a repeated game. Agents rely on listings to make money, and listings come from referrals. Agents--good ones anyway--have an incentive to make sellers very happy, because happy sellers drive future business.

So now let's get to the evidence that Levitt provides to show that agents shirk: he shows that agents leave their own houses on the market longer and sell them for higher prices than the houses that they sell for others. This is an interesting fact, but is not necessarily explained by agents' shirking. Rather, it could be that the houses agents own themselves are different in unobserved characteristics from the houses that they sell to others. Or it could be that agents are different as human beings--they are more risk taking, and more entrepreneurial. For all we know, sellers ignore the advice of their agents and sell more quickly than they should, because they are relieved at the prospect of a sale and don't care so much about the marginal benefit they would get for waiting. In order to disentangle this, we would need to know something about the unobserved characteristics of people who become real estate agents--and of people who don't.

Full disclosure: while I was writing my dissertation in the late 1980s, I worked doing research for the Wisconsin Realtors Association. I had fun while I was there. Believe me, the Realtors are different with respect to their attitude toward risk taking from the rest of us.

Ofheo House Price Index Flattens

See http://www.ofheo.gov/media/pdf/2q06hpi.pdf. House prices rose only 1.17 percent in the second quarter, according to the index. This is an increase that more or less keeps pace with inflation.

The Ofheo house price index is not, however, completely representative of the housing market. Ofheo tracks prices on houses financed by Fannie Mae and Freddie Mac; Fannie and Freddie may only finance "conforming" loans, which are in 2006 defined as loans whose value is less than 417,000. This limit shuts Fannie and Freddie off from large parts of the California, Boston, New York and Washington housing markets; consequently, should these large markets go into the tank, their impact on the index will be muted.

The Case, Shiller, Weiss (http://www2.standardandpoors.com/servlet/Satellite?pagename=sp/Page/PressSpecialCoveragePg&c=sp_speccoverage&cid=1143857726920&r=1&l=EN&b=4index ) doesn't have this issue; nor, presumably, do the indexes that one can find in Zillow. The CSW Composite Index for 10 cities was completely flat in June.

A Paper on Market Reaction to 9/11 by Kallberg, Liu and Pasquariello

I really like this paper:

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=716721

Abstract:

This study analyzes how three groups of market participants - insiders, analysts, and investors - revised their expected returns on New York Real Estate Investment Trusts (REITs) in response to the catastrophic events of September 11, 2001. The attack on the WTC represents a unique experimental setting to evaluate financial markets' reaction to external shocks for several reasons. First, these events, of a totally unanticipated and unprecedented nature, could not have been built into the market's expectations; hence, market participants had to learn something new rather than just recalibrate their expectations on past occurrences. Second, unlike other studies of market reactions, the impact of the terrorist attacks on REIT returns was ambiguous, since it was uncertain if the effect of reduced supply of office space in New York would outweigh the impact of the negative shocks to the local and national economy on its demand. Finally, the period of market closure that followed 9/11 gave these players ample opportunity to reassess their expectations. Our analysis reveals that, on the day when markets reopened, REITs with significant exposure to the New York area outperformed a broad REIT office index by 4.1%. However, we find that, according to several metrics of real market behavior, this anticipated superior performance of New York office properties did not materialize. Consistent with notions of market efficiency, we find that insiders were the first to lower their expectations (99.9% of their trades in REITs with New York exposure were sales in the month following 9/11), followed by analysts (the vast majority of them revised downward their expectations of NY REIT performance in the first weeks of November 2001), and finally market prices adjusted to reflect the underlying real market behavior; indeed, abnormal REIT returns had disappeared by mid November 2001.

While the paper is principally about information diffusion, it also presents some very nice data on the resiliency of the New York employment market in the wake of 9/11. New York's refusal to be cowed may be the greatest victory we have had over Al-Qaeda. But that refusal also speaks volumes about why New York became a great city in the first place.

The Chicago Merc Housing Futures Market

Chip Case and Robert Shiller have created a housing futures market for 10 US cities, along with a composite of those cities, that trades on the Chicago Mercantile exchange. If it works, it will allow homeowners to diversify some of their risk, and presumably make the market more liquid.

Owners who have lots of of home equity are long in the housing market. This may be fine, but it also may be that their length in housing means that they are not as diversified into other assets as they may wish. The CME index can help.

Here is how it works. Suppose you own a house in Washington, D.C. The most recent index value for Washington is from June, and is 250.39. The next futures contract is for November, and currently has a price of 247.8. If you take a short position for November, you have the right to sell the Washington index at 247.8 per unit. If the value of your house us perfectly correlated with the index, you can completey immunize yourself from swings in the market, outside of the difference between the June index and November price. If the price falls below 247.8, the profit on your short position will offset the loss in house value; if the price rises above the 247.8, your house offsets the loss on your short position. All of this assumes that there are no tax implications, but even with taxes, the index enables homeowners to at least partially hedge their risk.

All of this should actually make houses more valuable, because it should increase liquidity in the housing market. There remain some issues--chief among them is the lack of a true spot market in housing, because of the lag in the time between when a house receives an offer and when it actually settles. I'll discuss this further in another post. I will also discuss what the futures markets are saying about the future of house prices, and the implications for the own-rent decision.

A discussion on the Income Distirbution

From Brad Delong's Blog:

http://delong.typepad.com/sdj/2006/09/making_em_feel_.html

The first comment from readers seems on target to me. If we wish to encourage innovation, but discourage "spiteful" consumption, then using a luxury tax, instead of a more progressive income tax, makes sense. But does this mean that people would have to pay a tax for going to Greg Mankiw's high tuition university, but not pay that tax for going to Brad Delong's low-tuition university?

Some Reading for Friday's Commercial Real Estate "bootcamp" at GW.

Here are a first set of readings. More readings and commentary will be coming shortly.

http://www.irei.com/uploads/marketresearch/65/marketResearchFile/SORetail_Mkt_Inv_Opp7-06.pdf
http://www.irei.com/uploads/marketresearch/35/marketResearchFile/Pru_USQuarterly_July%2006.pdf

http://www.irei.com/uploads/marketresearch/10/marketResearchFile/RealEstateCapRates.pdf