A Worthwhile Economic Indicator

May 15th, 2010

The April, 2010, issue of Kiplinger’s Personal Finance magazine contains an article that is useful on several levels. “Should You Buy or Rent?” is intended as a primer for readers in the market for a home. It does that job well. It may be worth more, however, for something that its author did not intend – providing a leading economic indicator for our time.

Buy or Rent?

The article’s basic purpose is to dampen the ardor of would-be home buyers attracted by the promise of low prices, low interest rates, and a first-time home-buyer tax credit. The fundamental choice faced by potential home buyers is between owning a home and renting one. Aside from the fact that homeowners pay taxes, insurance, utilities, and repairs in addition to a monthly mortgage payment, there is another significant danger facing the home buyer.

If the home’s value should fall markedly soon after purchase, the homeowner may be “upside down” – that is, owe more than the value of the home. Why should this happen? We are apparently recovering from the worst recession since the 1930s, one triggered by a fall in astronomically-high home prices. If the purchased home is located in an area where prices still haven’t hit rock bottom, the buyer may receive a nasty surprise. This can be hard to judge. A noted stock-market expert once described the practice of judging a market bottom as like “trying to catch a falling knife.” You’re as likely to catch the blade as the handle, resulting in a bad cut.

The criterion suggested by Kiplinger’s is the “price-rent ratio” – a comparison between an area’s median home price and its median annual rent. At the apex of the housing boom in 2005, this ratio had reached 21 for the entire U.S. The historic average is about 15. (The article cites Hessam Nadji, manager of a commercial real-estate brokerage, for these data.) The author recommends renting when this ratio is 18 or higher in your local city or metropolitan area.

The Wide Variance in the Price-Rent Ratio

Many metropolitan areas currently have price-rent ratios of 15 or lower. These include Cleveland, Detroit, Tampa, Indianapolis, Atlanta, Las Vegas, St. Louis, Cincinnati, and Jacksonville. There is even one metro area in California (epicenter of the real-estate bubble) on this list; namely, the Inland Empire metro in the Riverside-San Bernardino area.

Unfortunately, there are still lots of metro areas well above the historic average. The price-rent ratio exceeds 25 for Oakland, San Jose, San Francisco, San Diego, Orange County, Seattle, Salt Lake City, Portland, and Tucson. (Note the over-representation of California on this list.)

A measure of how far home prices have fallen in the last five years is the difference between median mortgage payments and median monthly rents. In 2005, this difference was $745; today it is $181. That certainly suggests that buying has become a viable option in many areas throughout the country. The question is: How does your area stack up in this reckoning?

The Kiplinger’s article collected and aggregated data from several sources, including the Federal Housing Finance Board, the National Association of Realtors, and Reis Inc. Calculating the precise ratio in your area may be time-consuming and difficult. You can get a back-of-the-envelope estimate, however, by surveying several homes and rental units that meet your personal criteria and are comparable in quality. Compare their prices and annual rents and ponder the results.

Business-Cycle Theory, Relative Prices, and the Price-Rent Ratio

The article is not merely useful for would-be home buyers, although that is its stated purpose. The Great Recession of 2007-???? is notable for the prominent role played by real-estate values. According to the economic model guiding current national economic policy – Keynesian economics – this shouldn’t matter much. Keynesians ascribe recessions to a decline in aggregate demand (e.g., spending) and try to cure them through government spending. The motto of longtime Keynesian James Tobin was “spending is spending; it doesn’t matter what you spend the money on.” Nor does it matter particularly where the fall in aggregate demand occurred.

As we are in the process of discovering, Keynesian economics is equally bad at diagnosing recessions and curing them. A better economic model would be one that recognized the role of relative prices in both the beginning and the end of the business cycle. First, lavish money creation by the federal government lowers various interest rates. (This is what happened in the U.S. earlier in this decade.) The lower interest rates divert too much investment into the areas initially receiving the monetary injections. Prices in those sectors are artificially inflated. The words “too much” and “artificially” derive from distortions to supply and demand caused by money creation.

A Leading Economic Indicator

Eventually, the monetary injections end. When relative prices have returned to their pre-recession values – accurately reflecting genuine supply and demand in the affected markets – recovery from the recession can begin. The value of the Kiplinger’s information is that it not only allows us to gauge how far we have already come along the road to recovery, but also how far we may have still to go. The price-rent ratio described in the article is a telling example of a leading economic indicator. In this case, it implies that many areas of the country have more pain to undergo before the embryonic recovery becomes viable.

What can the federal government do to help this readjustment process along? It’s not a matter of doing something overt, but rather refraining from doing anything that would delay the necessary readjustment of relative prices. Holding interest rates artificially low and creating money, which is what the Federal Reserve has been doing ever since 2008, delays the readjustment of relative prices. Distortions in investment are what caused the problem in the first place. Fed policy creates more distortions and keeps home prices artificially high. Fed purchases of mortgage-backed securities, designed to stop the fall in home prices, are another example of distortive policies that hinder recovery rather than help it.

One issue that obsesses investors is the end of recession and the start of recovery. Rather than trying to guess the direction of Federal Reserve policy or awaiting a federal “jobs program,” investors might be better advised to watch the relative prices most directly tied to genuine economic recovery.

Category: Annuities, Contingency Planning, Economic Analysis, Economic News, Home Ownership, Risk | Tags: , , ,

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