United States of America: Selected Issues

This Selected Issues paper analyzes the United State’s (U.S.) household savings role in supporting the U.S. recovery; and focuses on the market for single-family housing, and the importance for household balance sheets. It discusses the underfunding of corporate pension plans, macroeconomic, and policy implications; the U.S. fiscal position, and reviews the causes of the fiscal crisis. It examines the impact of energy shocks, energy policy, and the taxation role. It analyzes the growth in linkages between the United States and other G-7 countries, and the regional and bilateral trade links issues.

Abstract

This Selected Issues paper analyzes the United State’s (U.S.) household savings role in supporting the U.S. recovery; and focuses on the market for single-family housing, and the importance for household balance sheets. It discusses the underfunding of corporate pension plans, macroeconomic, and policy implications; the U.S. fiscal position, and reviews the causes of the fiscal crisis. It examines the impact of energy shocks, energy policy, and the taxation role. It analyzes the growth in linkages between the United States and other G-7 countries, and the regional and bilateral trade links issues.

II. Are U.S. House Prices Overvalued?1

1. The recent rapid appreciation of house prices has led to fears that the real estate market is exhibiting signs of a speculative bubble. After remaining flat through the early 1990s, median house prices in the United States have increased at an annual rate of 4¼ percent since 1995, surging by 6 percent in 2002 (Figure 1a). Against the background of the collapse of equity prices, as well as even stronger price increases in other countries, many analysts have suggested that the U.S. housing market may be overvalued.2

Figure 1.
Figure 1.

United States: House Price Trends

Citation: IMF Staff Country Reports 2003, 245; 10.5089/9781451839623.002.A002

2. A collapse in housing prices could have adverse consequences for the economy. For example, the increase in residential wealth has provided valuable support to household balance sheets and consumption growth in recent years.3 With residential housing accounting for roughly a third of household assets, the appreciation of real estate values has offset a considerable portion of stock losses suffered over the past years, and has allowed households to fund consumption by extracting housing equity through mortgage refinancing (Table 1).

Table 1.

Household Balance Sheet Indicators

(In trillions of dollars unless otherwise noted)

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Sources: Federal Reserve, Flow of Funds Accounts of the United States; and Fund staff estimates.

3. In addition, a weakening of the real estate market would adversely affect financial institutions. With wholesale banking business yet to recover from a steep drop in recent years and interest income low, origination and refinancing of mortgages have played an important role in sustaining banking sector profits. Moreover, mortgage-backed securities have become an important asset class for financial institutions, and a shock that affected the market value of these instruments could cause system-wide losses.

4. However, the empirical evidence discounts the possibility of a nation-wide housing bubble. Recent studies indicate that some highly-priced metropolitan markets could be vulnerable to a correction in coming years, but view sharp adjustments as unlikely in the absence of substantial adverse shocks to incomes and labor market conditions. These results are confirmed by empirical tests reported below, which suggest that house prices in the United States are currently within—albeit at the upper end of—a range consistent with economic and demographic fundamentals.

A. House Price Developments: Stylized Facts

5. Real house prices have recently appreciated above long-term trend levels (Figure 1b). Housing prices have gone through two major cycles in the past 30 years, with periods of relatively strong increases in the mid-1970s and mid-1980s. However, subsequent corrections have typically been relatively mild, as illustrated by the observation that nationwide house prices have hardly experienced annual price declines since 1960. The recovery from the last housing bust in the 1980s was initially sluggish, and prices did not return to their long-term trend before 1999. However, the recovery was remarkable in that it was accompanied by strongly surging sales volumes, with the number of transactions exceeding trend by a significant margin (Figure 1c).

6. Price increases appear to reflect a growing demand for higher-quality housing in terms of size, features, and appliances.4 As a result, the median price index for new homes, adjusted for quality improvements, has risen at a considerably slower pace than the unadjusted price, barely exceeding its long-term average in 2002 (see Figure 1b). Price increases in recent years have also been concentrated in the higher end of the real estate market, as reflected in the growing divergence between median house prices and the Office of Federal Housing Enterprise Oversight’s (OFHEO) price index (Figure 1d).5

7. On a regional level, the housing market has exhibited stronger volatility, especially in the West and Northeast (Figure 2). While recent increases in the real value of existing homes in the South and Midwest represent the first sustained strengthening of market conditions in more than two decades, prices in the West are in their third successive upswing over the same period, having emerged from a major downward adjustment in the early 1990s. The real estate market in the Northeast has been even more volatile, showing a sharp upswing in the late 1980s, followed by a spectacular decline through 1995. Higher fluctuations in these two regions—especially in major cities—have been associated with the boom and bust cycles in the new economy and energy sectors in these areas (Table 2).

Table 2.

Real Estate Bull and Bear Markets in Large Metropolitan Areas

(Quarterly house price index, adjusted for CPI inflation)

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Sources: OFHEO; Fund staff calculations (see April 2003 World Economic Outlook).

Appreciation from peak to 2002Q4.

Figure 2.
Figure 2.

Regional House Price Developments

Real median price for existing housing, by census region

Citation: IMF Staff Country Reports 2003, 245; 10.5089/9781451839623.002.A002

B. Fundamentals Supporting Current House Price Levels

8. The strong economic environment of the mid- to late 1990s has helped boost housing demand and prices.6 The combination of strong disposable income growth, low interest rates, and large stock market gains has provided a powerful boost to the financial situation of households:

  • High affordability. House prices appear not particularly out of line relative to disposable household income—which has grown by an annual average rate of 4 percent since 1990—particularly when viewed in quality-adjusted terms (Figure 3a). Indeed, the Housing Affordability Index—which depicts median family income relative to the income needed to buy a median-priced, existing single-family home—has remained at a comfortable level throughout the 1990s (Figure 3b).

  • Manageable debt levels. Declining interest rates have allowed existing homeowners to reduce mortgage payments through refinancing or seek more expensive homes at the same monthly payment. As a result, despite a substantial increase in overall debt, the debt service burden on households has barely increased in recent years (see Table 1). Moreover, financial innovation has allowed households to access home equity more easily, which has contributed to the attractiveness of housing as an investment vehicle and may ease cash-flow problems in an economic downturn.

  • Stock market wealth. Although annual movements of stock values and house prices are generally uncorrelated, medium-term trends in stock and real estate markets appear to move more closely together, particularly during an economic upswing (Figure 3c). This could suggest that the equity gains of recent years have eventually filtered through to the housing market, but the observed co-movement could also be simply a manifestation of a strong underlying economy.7

Figure 3.
Figure 3.

United States: Factors Affecting House Prices

Citation: IMF Staff Country Reports 2003, 245; 10.5089/9781451839623.002.A002

9. Demand also has been reinforced by demographic trends that boosted the number of households. With home ownership rates increasing sharply for individuals in their thirties, the coming of age of the last cohorts of the baby-boom generation may have had a potentially large impact on the housing market (Mankiw and Weil 1989; Figure 3d). Housing demand has also been driven by a decline in average household size and a pickup in immigration.8 The number of households rose by 9.7 million between 1996 and 2002, compared to 9.2 million units added to the housing stock during that period, and the home ownership rate (the share of households owning their own home) reached a record 68 percent in 2002.

10. The government-sponsored housing enterprises (GSEs) have had an important role in deepening the real estate market and reducing transaction costs. The U.S. mortgage market has become significantly more efficient in the past 10–15 years, owing to the growing use of mortgage-backed securities (MBS), which has facilitated the separation of mortgage origination and investment in mortgages (Colton, 2002; Deep and Domanski, 2002). GSEs such as Fannie Mae and Freddie Mac—which issue the bulk of securitized mortgages—have been the driving force in standardizing the mortgage application process and introducing greater levels of competition to the origination business. Greater uniformity in mortgage applications may have led to improved lending standards by facilitating the development of sophisticated scoring models and reducing the room for unsound lending practices.9 At the same time, these methods reduced costs for mortgage applicants and contributed to improved access to mortgage loans for lower-income households.10

11. According to one study, high real estate valuations in some urban markets reflect zoning restrictions and other land-use controls. Glaeser and Gyourko (2003) found that house prices were in general fairly close to physical construction costs in most of the United States. Moreover, the study showed that divergences between house prices and construction costs—which were limited to a few metropolitan markets—were largely related to measures of zoning strictness, as defined by restrictions on the size and characteristics of houses. By contrast, variables relating to the size of housing lots or population density were not found to have a significant influence on house prices, suggesting that supply factors can play a major role in explaining excessive real estate prices in some major urban centers.

C. Are There Reasons for Concern?

12. In addition to similarities with earlier boom and bust phases (IMF, 2003), concerns over price sustainability in the housing market derive from four sources:

  • Although housing affordability measures are high, some households may be vulnerable to economic shocks if nominal income growth slows. Should the present low inflation environment persist for some time, nominal household income growth would likely fall below the 4 percent average achieved during the 1990s. In this case, the value of both mortgage debt and debt service relative to income would decline relatively slowly, which may leave households vulnerable to income shocks or unemployment (Baker 2002a).11 Under such circumstances, homeowners could be forced to sell (or could be driven into default), increasing the supply of existing houses and driving down prices.

  • An increase in interest rates could similarly affect households’ debt-service capacity, as well as dampen housing demand. As mortgage sizes have generally increased in line with rising house prices, higher interest rates would impose a burden on holders of adjustable-rate mortgages (ARMs) and reduce overall housing affordability. However, the drop in long-term mortgage rates has been accompanied by a decline in the share of ARMs to below 20 percent of newly closed mortgage loans (compared with 30 percent in the 1980s), and the ensuing refinancing wave has also helped increase the average maturity of outstanding mortgage debt.

  • The recent divergence between house prices and rents is seen by some as signaling the need for a market correction (Figure 4). Two recent studies have pointed out that deviations of the house price-rent ratio from its long-term equilibrium are typically not sustained for extended periods (Baker 2002b, Leamer 2002).12 Krainer (2003) finds that the house price-rent ratio currently exceeds its long-term average by 10–15 percent, but he also demonstrates that the ratio would return to this average if rents continued to grow in line with their long-term trend and house prices were flat for a period of two to three years—not an unusually long period of sluggish real estate markets.

  • Lower taxes on real estate capital gains could have led to some greater volatility in the housing market. Housing demand has likely benefited from the 1997 Taxpayer Relief Act, which exempted capital gains of up to $500,000 for married home owners (previously, capital gains taxes could be deferred, but only if a house of equal or greater value was purchased at the same time). Moreover, the tax rate on capital gains was lowered to 20 percent, and first-time home buyers were allowed to withdraw up to $10,000 from individual retirement accounts without penalty. These changes could have contributed to an upward price shift in recent years. Moreover, by facilitating the realization and withdrawal of capital gains in the housing market (e.g., through a shift from ownership to rental accommodation), these tax changes could contribute to greater price volatility in the event of market downturn (Knight and Eakin, 1998).

Figure 4.
Figure 4.

House Price-Rent Ratio

Median existing house price over imputed homeowner rent

Citation: IMF Staff Country Reports 2003, 245; 10.5089/9781451839623.002.A002

D. Empirical Results

13. Recent analyses of house price developments using data for metropolitan statistical areas (MSAs) have found no signs of a nation-wide housing bubble (Burns, 2002; JCHS, 2003; Youngblood, 2003; Zandi, 2002). These papers have all come to the conclusion that price levels in most areas are broadly consistent with increases in personal income, although each study identified a (different) group of MSAs where price levels were found excessive relative to fundamentals. Only some 20 MSAs (out of a total of 250 MSAs) were identified as being excessively priced in more than one of the four papers, however. These 20 markets include the largest metropolitan regions in the United States and may therefore account for a more substantial share of the overall housing market than their number suggests.13 However, deteriorating employment conditions in some of these markets (e.g., around California’s Silicon Valley) have had a limited impact on housing price inflation; indeed, signs of an actual price decline only exist in one MSA so far. This appears broadly consistent with the consensus view that only a relatively large shock to employment and incomes would lead to an actual drop in house prices.

14. These studies are supplemented by the estimation of a housing market model that allows for the interaction of supply and demand effects. The model consists of two equations, which were estimated jointly using a three-stage least squares approach:

pD=αD+γDs+βDxD+iδD,idi+εDpS=αS+γSs+βSxS+iδS,idi+εS

with D and S representing demand and supply, respectively. Endogenous variables included real house prices (pD = pS) and the number of homes sold (s). The model was specified separately for new and existing home prices.14 Explanatory variables were chosen as follows:

  • On the supply side, xS initially included construction costs, the housing stock, and home ownership levels. The latter two variables proved insignificant and were replaced by a time trend in the new house price model (to broadly capture quality improvements); and by average household size in the model for existing home prices (reflecting a relative supply shrinkage caused by an aging population). The di are dummies for U.S. Census regions.

  • On the demand side, xD included real disposable income, the real mortgage rate, the unemployment rate (a measure for income uncertainty), financial wealth, and a variable representing the age structure of the U.S. population. The last two variables were dropped, however, due to insignificance in both specifications.

15. The results suggest that recent price increases are largely explained by economic fundamentals (Table 3). As expected, the income variable was strongly significant, with a marginal income coefficient of 0.7 and 0.5 for new and existing homes, respectively. These coefficients are broadly consistent with results in the existing literature, while also suggesting that new houses are viewed as luxurious, at least relative to older houses.15 The estimates indicate that house prices are mostly in line with underlying variables, especially in the Midwest and South (Figure 5). In the West and Northeast, house prices are somewhat above model predictions, with a gap between actual and predicted values of 15–25 percent in the West and somewhat smaller in the Northeast.

Table 3.

Results of Three-Stage Least Squares Regression for House Prices

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Figure 5.
Figure 5.

Model Prediction of New Home Prices

(Logarithm of median price, not adjusted for quality)

Citation: IMF Staff Country Reports 2003, 245; 10.5089/9781451839623.002.A002

Source: Staff Estimates.

References

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  • Baker, D., 2002a, “The Housing Affordability Index: A Case of Economic Malpractice”, Center for Economic and Policy Research Issue Brief, Washington, D.C.

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  • Baker, D., 2002b, “The Run-Up in House Prices: Is It Real or Is It Another Bubble?,Center for Economic and Policy Research, Washington, D.C.

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  • Burns, J., 2002, “The Housing Cycle Barometer”, www.housingzone.com (June 26, 2002).

  • Colton, K.W., 2002, “Housing Finance in the United States: The Transformation of the U.S. Housing Finance System,Harvard University Joint Center for Housing Studies Discussion Paper No. W02–5.

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  • Deep, A., and D. Domanski, 2002, “Housing Markets and Economic Growth: Lessons from the U.S. Refinancing Boom,Bank for International Settlements Quarterly Review (September).

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  • Gallin, J., 2002, “The Long-Run Relationship Between House Prices and Income: Evidence from Local Housing Markets,Board of Governors of the Federal Reserve System, Finance and Economics Discussion Series No. 2003–17, Washington, D.C.

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  • Glaeser, E.L., and J. Gyourko, 2003, “The Impact of Building Restrictions on Housing Affordability,Federal Reserve Bank of New York Economic Policy Review (June).

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  • IMF (International Monetary Fund), 2003, World Economic Outlook (April).

  • JCHS (Joint Center for Housing Studies), 2003, The State of the Nation’s Housing 2003, Boston: Harvard University.

  • Knight, J.R., and C.F. Eakin, 1998, “A New Look at the Home Ownership Decision,Real Estate Issues (Summer).

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  • Meen, G., 2002, “The Time-Series Behavior of House Prices: A Transatlantic Divide?,Journal of Housing Economics, Vol. 11, No. 1, pp. 123.

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  • Youngblood, M.D., 2003, “Is There a Bubble in Housing? New Evidence from 210 Housing Markets,GMAC RFC Securities.

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1

Prepared by Martin Mühleisen and Martin Kaufman.

2

Concerns also exist regarding the commercial real estate market—where increasing vacancy rates have led to questions about the possible exposure of financial institutions—and to some extent the market for multi-family housing. However, this chapter focuses exclusively on the market for single-family housing, which is of wider macroeconomic relevance owing to its size and importance for household balance sheets.

3

See the accompanying chapter on household saving in this Selected Issues paper.

4

For example, the median square footage of new single-family houses has increased by 11 percent over the past decade (to 2,114 sq. ft. in 2002), and the share of new houses with warm-air furnaces as primary heating source has risen 6 percentage points (to 71 percent) over the same period.

5

OFHEO’s price index includes geometric weights based on transaction amounts and therefore gives a larger weight to higher priced houses. Both the median price and OFHEO index are adjusted for quality, although the OFHEO index covers only repeat sales of existing houses with mortgages of conforming size. The two series have moved closely together in the past, and have only recently begun to diverge.

7

The relationship between equity values and house prices is not a priori well defined. During a rise in equity markets, housing demand could either strengthen if households maintained a balanced asset portfolio; or weaken if households sought to shift out of housing and into stocks.

8

The number of legal immigrants to the United States averaged 900,000 per year in the 1990s—compared to an average of 730,000 in the 1980s—and census estimates also indicate a rising inflow of illegal immigrants.

9

Mortgage holders may also have benefited from the GSEs holding a large portfolio of securitized mortgages on-balance sheet. Since GSE purchases of MBSs are financed using the GSEs’ triple-A rating, this may have at least partially reduced costs to borrowers. This benefit is illustrated by the positive spread between mortgages of conforming size (which are eligible for GSE mortgage pools) and noneligible “jumbo” loans.

10

Transaction costs for new mortgages have on average declined from 250 basis points of the loan amount in 1985 to below 50 basis points in 2002.

11

For example, it is assumed that a household today allocates 25 percent of its disposable income to make payments on a new 30-year fixed mortgage at 6 percent interest. If nominal incomes grow by 4 percent per year, mortgage payments account for only 19.8 percent of income by 2008, compared to 22.2 percent under 2 percent nominal growth. After 10 years, the proportions are 15.6 percent and 19.7 percent, respectively.

12

Similar to the stock price-earnings ratio, an increase in the house-price rent ratio would suggest that house price levels may not be justified by the discounted stream of future rent or imputed rent income.

13

These markets are located in the states of California, Colorado, Florida, Massachusetts, New Jersey, New York, Washington, and the District of Columbia. Together, these states account for about 25 percent of the single-housing stock in the United States.

14

Regressions using prices adjusted for quality improvements failed to produce satisfactory results.

15

As discussed in Gallin (2003), it is hard to identify the statistical properties of house price models, since relatively slow price adjustments in the real estate market imply that the power of tests for co-integration remains rather low. Such a cointegrating vector was found in the model for new house prices, but none could be found for existing home prices, making the estimated coefficients as well as their statistical significance difficult to interpret.

United States: Selected Issues
Author: International Monetary Fund
  • View in gallery

    United States: House Price Trends

  • View in gallery

    Regional House Price Developments

    Real median price for existing housing, by census region

  • View in gallery

    United States: Factors Affecting House Prices

  • View in gallery

    House Price-Rent Ratio

    Median existing house price over imputed homeowner rent

  • View in gallery

    Model Prediction of New Home Prices

    (Logarithm of median price, not adjusted for quality)