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• Published in: House Prices and Inflation by John A . T u c c i l l o and K e v i n E . V i l l a n i -- A n U r b a n Institute B o o k published by The U r b a n Institute Press -- W a s h i n g t o n , D . C . , p p . 163-169, 1981. > 3/4/81 T h e H i g h Cost of Trying to H e l p H o u s i n g Remarks by Henry C . Wallich M e m b e r , Board of Governors of the F e d e r a l R e s e r v e System 1 at a conference on house prices and inflation sponsored by H U D and T h e Urban Institute A p r i l 4 , 1980 W h i l e I have not had time really to look very closely at the fine papers contributed for this m e e t i n g , I did get the sense that people are beginning to think in terms of real interest rates after t a x e s . h a v e no idea what a hard concept that is to put a c r o s s . Once You somebody see that, he is not going to be talking about high interest rates very much t h e r e a f t e r . What he m i g h t talk about are rates that are enormously u n c e r t a i n and h a v e a very different effect for different p e o p l e . I do not need to remind you that the real interest rate is after expected i n f l a t i o n , not after current i n f l a t i o n . T h e r e seems to be a peculiar tendency for the interest rate always to keep up pretty much w i t h existing i n f l a t i o n , not just in the United States but in other countries as well. Now w h y isn't it inflation after taxes that the interest rate keeps up with? I do not k n o w , but it does not seem to be the c a s e . M a y b e some research could be done h e r e . A n o t h e r thing I do not need to remind you of is that "after taxes" poses the question "whose taxes?" F o r tax-exempt i n v e s t o r s , most rates h a v e -2- remained m a r g i n a l l y positive as inflation and interest rates have r i s e n . T a x a b l e i n v e s t o r s , for the most p a r t , have negative real rates after t a x . F o r somebody living in New Y o r k in the 70 percent top federal b r a c k e t , plus I think 14 percent New Y o r k State income t a x , and I think 3-1/2 percent city t a x , and all experts can tell us which tax is deductible from w h i c h , a 20 percent interest rate loan for him or her is a flea b i t e . But take a poor constructor w h o s e firm has had no profits for a y e a r , he's h i t with prime plus 3 -- that is a very different a n i m a l . So w h a t w e have is essentially a d i s t r i b u t i o n of impacts of the interest rate that is very u n e v e n . M o n e t a r y policy may be hitting in some places so hard that it goes beyond e n d u r a n c e , before it begins to reach those that are relatively w e l l protected by t a x e s . T h i s is one of the dif- ficulties I see to the concept of real interest rates after t a x . But never- t h e l e s s , I think w e h a v e to hammer away at this concept; o t h e r w i s e , w e are not going to m a k e people understand w h a t the interest rates really mean today. I was impressed by reading the long list of aides to h o u s i n g . W e have d o n e , it seems to m e , things for housing and for the h o u s i n g finance industry that fall into two c a t e g o r i e s . One is of the structural kind w o r k i n g taxes p r i n c i p a l l y , but also through other institutional d e v i c e s . is of a c y c l i c a l k i n d . latter. through T h e other T h e F e d e r a l Reserve has had something to do w i t h the On the structural s i d e , w e have had the tax d e d u c t i o n . Bear in mind that our w a y of treating h o m e owner interest is d i f f e r e n t , I t h i n k , from the practice in other c o u n t r i e s . In other c o u n t r i e s , interest payments are either not d e d u c t i b l e at all or limited to some e x t e n t , as I believe is the case'in C a n a d a , or d e d u c t i b l e only against imputed r e n t , as in G e r m a n y . -3- In this c o u n t r y , we do not charge imputed r e n t , but w e allow full deduction of the i n t e r e s t . T o d a y , the interest rate contains a large infla- tion p r e m i u m , which is really a m o r t i z a t i o n , i . e . , reduction in the real v o l u m e of the d e b t . T h e government has m a d e amortization d e d u c t i b l e , in e f f e c t . No w o n d e r then that people h a v e found it smart to invest in h o m e s . W e have done a number of other t h i n g s , as you k n o w , related to i n s u r a n c e , g u a r a n t e e s , and v a r i o u s government p r o g r a m s . W e constructed a pipeline from the housing finance market into the bond m a r k e t , through Ginnie M a e and other pass-through d e v i c e s . to h o u s i n g . And w h a t have we got? w a y s is not w h a t w e A l l of these have been tremendous aids W e have a set of results that in many anticipated. W e find that the nominal price of h o u s i n g has gone sky h i g h . I say in one of the papers that the real price of h o u s i n g has come down -- I do not quite know how to interpret i t , but evidently the author did not just divide by the C P I . W e have m a d e the real return on home ownership very h i g h . I saw one paper that said we made the m a r g i n a l productivity of investment in housing z e r o . T h e r e evidently has been a tremendous shift from business financing to home f i n a n c i n g . This has been accompanied by a shift in the ownership of wealth from the stockholder to the home o w n e r . T h a t m e a n s , putting it in its crudest t e r m s , redistribution from the producer to the c o n s u m e r . Our productivity gains show t h a t . W e have gone from 3 percent as a general rule to 1 percent if w e are l u c k y . At present of course we are seeing declines in p r o d u c t i v i t y . W e h a v e had other structural results from the strong of h o u s i n g that we did not anticipate and may not l i k e . subsidization There has been a severe drop in the saving ratio that I believe you discussed this m o r n i n g , -4- w h i c h may be related to profits on h o u s i n g . There has b e e n , as I s a i d , a drop in investment relative to n e e d , not necessarily relative to G N P and to p r o d u c t i v i t y . There has been a reduction in m o b i l i t y . If you think of the problem of somebody m o v i n g out to C a l i f o r n i a , or even just moving w i t h i n a s t a t e , it involves the sale and financing of a home which is difficult at this t i m e . And w e have been building the wrong kinds of h o m e s . A t a time w h e n w e are down-sizing c a r s , we should also be downsizing h o m e s . B u t , the effort to invest as much as one can in a h o u s e , or more than one h o u s e , leads to an up-sizing that w e cannot afford today. W e have also created social t e n s i o n s . O n e w e d g e that we have driven is between owners of homes and new w o u l d - b e buyers who h a v e a hard time buying a h o m e . w e d g e between owners and r e n t e r s . We have driven a We have created a real financial elite -- that i s , the people who still have these 5 or 6 percent m o r t g a g e s , w h o w i l l not let go of them; even w h e n they sell their h o m e s , they find some wraparound device so that the early m o r t g a g e remains intact. It may be true that the homeowners are house p o o r , as they say; they have allocated too high a portion of their cash flow to their m o r t g a g e payment. H o w e v e r , taking into account their prospective income and pros- pective appreciation of the property -- at least u n t i l now -- they appear to know w h a t they are d o i n g . O n the cyclical s i d e , as I s a i d , w e have also done a number of things to help h o u s i n g . I think it is fair to say that housing was sacrificed a number of times to the needs of cyclical c o n t r o l . this worked is familiar: rising interest rates caused The way disintermediation; this d i s i n t e r m e d i a t i o n caused the crunch in the thrift industry and a -5- downturn in h o u s i n g . T h a t m a d e monetary policy e f f e c t i v e , but in a very undesirable w a y . W e have protected the h o u s i n g industry to some degree against that. F i r s t , there w e r e much bigger flows from the home loan bank board into the m o r t g a g e m a r k e t . T h e n in 1979 w h e n things began to get a little d i f f i c u l t , the money m a r k e t certificates which currently amount to nearly $300 b i l l i o n were c r e a t e d . Other devices have included the 4 - y e a r n o t e . M o r e o v e r , CD's are being i n s u r e d . T h e s e are all devices to stem the financial pressure on thrift i n s t i t u t i o n s , the area of the financial mechanism that generally finances h o u s i n g . T h e s e measures h a v e worked for a w h i l e . learned that they h a v e their c o s t s . But m e a n w h i l e , w e h a v e F i r s t , by eliminating the availability of c o n s t r a i n t , i . e . , the crunch-type e f f e c t , interest rates m u s t be relied u p o n to a greater d e g r e e . T h e r e f o r e , interest rates have had to rise h i g h e r than they would have if the old m e c h a n i s m of crunching the housing industry still had been in e f f e c t . S e c o n d , it is not quite so obvious as it seemed a year ago or s o , that protecting the housing industry against thrift d i s i n t e r m e d i a t i o n , and protecting the thrift institutions against this d i s i n t e r m e d i a t i o n , has done them all as much of a favor as originally i n t e n d e d . had problems resulting from a loss of d e p o s i t s . P r e v i o u s l y , they N o w , their problems are more those of pressure on their s u r p l u s , pressure on their e a r n i n g s . way or a n o t h e r , it is very difficult to protect the thrift industry the needs' of m o n e t a r y r e s t r a i n t . One against H e n c e , w h i l e a great deal has b e e n d o n e , the situation w h i c h emerged at the end is not necessarily better. -6- W e have seen some additional complicated results of trying to protect thrift institutions against monetary r e s t r a i n t . They issue high interest p a p e r , money m a r k e t c e r t i f i c a t e s , u s u a l l y , and then they put the m o n e y into the federal funds market or some other h i g h - y i e l d i n g , short-term assets instead of into m o r t g a g e s . O b v i o u s l y , that does not help the housing industry very m u c h . It is problems of this kind that give one pause in thinking out what the best approach to this situation m i g h t be other t h a n , of c o u r s e , the obvious one that w e ought to try to bring down the i n f l a t i o n . I have said for many years that bringing down the inflation is an absolute m u s t , even at Y a l e , 30 years a g o . B u t , in those d a y s , it was almost impossible to get anything but a laugh w h e n w e said inflation w a s b a d . Inflation was considered probably good -- it stimulated i n v e s t m e n t s , stimulated m e n t , and w h o cared about the cost? There m i g h t be a little redistribution; some l o s t , others gained; but on balance it was a zero sum a g a i n . went on like that for many y e a r s . employ- And, we That point of view was confirmed by the discovery of the Phillips c u r v e , the m o s t disastrous innovation in e c o n o m i c s , I b e l i e v e , that w e have s e e n . It is only quite recently that people are coming around to believe that inflation is b a d . N o w , I do not w a n t to argue that case at all h e r e . As I said b e f o r e , productivity growth has slowed from 3 to 1 percent; I think inflation and the things inflation does are clearly associated with t h a t . T h e u l t i m a t e cost of inflation is both a much lower level and growth path for G N P . I think that is as much of a case as needs to be m a d e . Thank you.
@FedFRASER