Randall Pozdena

William Burke

English

Research Papers in Economics

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November 28, 1980 
Housing: Sacred Cow? 
Some sacred cows wi  II have to be slaugh-
tered in the lean years looming ahead, and 
housing-industry leaders are beginning to re-
alize that they may provide one of  the more 
tempting targets in this regard. Business 
Week, in a recent editorial, putthe problem in 
these terms: "The diversion of capital from 
industry to housing-the primary aim of 
government policy-is one of the reasons 
investment in productive facilities has 
been inadequate." And its prescription was 
forthright: "Wean the housing industry of 
continuing government assistance and make 
it stand on its own feet." 
The genesis of  this viewpoint is a growing 
body of  evidence that inflation and tax pol icy 
have caused an over-allocation of resources 
to the housing sector over the last decade. As 
the nation enters the 1980's with the goal of 
expanding the energy and defense industries 
and "reindustrializing" the economy, the 
pressure to redirect resourcesto these sectors 
will increase. Policies that are designed to 
promote housing activity at the expense of 
other sectors are thus likely to come under 
increasing scrutiny. 
The causes 
The argument that the housing sector was 
overemphasized during the last decade rests 
on a number of factors. First, tax policy treats 
homeownership relatively favorably. Home-
owners can deduct all interest payments from 
taxable income. They also benefit from their 
ability to sell their homes without paying 
capital-gains taxes on the proceeds (provided 
another home is purchased), and to take out 
$100,000 in capital gains afterthe age of 55 
without paying any tax at all. In contrast, 
capital-gains proceeds from financial invest-
. ments (such as stocks and bonds) are taxed, 
albeit favorably relative to wage and salary 
income. 
In addition, homeowners are nottaxed on the 
"implicit" income they enjoy from an invest-
ment in a house in the form of  the services 
that the housing provides them. A $100,000 
investment in bonds, for example, provides 
benefits to the holder ofthe bonds in the form 
of  interest payments, which would be taxable 
as income. The same $100,000 invested in a 
home also provide benefits; but because 
these are in "kind" rather than in cash, they 
are nottaxed. This, too, is a special tax advan-
tage that housing (and other consumer dur-
abies) enjoy. 
The second major  factor affecting the housing 
equation is inflation. During the late 1960's 
and throughoutthe 1970's, inflation has been 
steadily on the rise, and households thus have 
continuously revised upward their expecta-
tions of  future inflation. It has been rational, 
therefore, for households to expect substan-
tial capital gains to accrue to all real assets, 
including housing. 
These two factors have combined to make 
ownership of housing particularly attractive-
for American households. Expectations of 
higher rates of inflation bring visions of large' 
(and tax-free) capital gains, thereby lowering 
the perceived cost of  housing. Of  course 
higher inflation expectations also bring 
some higher costs in the form of higher nom-
inal interest rates as lenders-who expect 
higher inflation too-build in protection for 
themselves in their contract rates. But the 
combination of  deductible interest payments, 
tax-free capital gains and tax-free "implicit" 
housing income more than offsets the direct 
effect of  the higher finance costs. 
The housing rush 
Given the stimulus that tax policy provides 
homeownership in an inflationary era, it is no 
surprise, then, that something likea "housing 
rush" developed during the 1970's. The 
nation produced 17.8 million housing units 
during the 1970's, a substantial 24-percent 
increase over the previous decade's produc-
tion. Although a maturing baby boom also IPcBcdl~rr@\ll  Jhl~s)~1fW~ 
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Opinions expressed in this newsleHet' do not 
necessarilv reflect the views of the rnanagement 
of the Federal Reserve Bank of San  Francisco, 
nor of the Board of GovernlJrS of the Federal 
Reserve Systertl. 
caused the number of individuals of home-
buying age to grow rapidly during  this period, 
by the end of  the decade the number of oc-
cupied housing units per capita was at an 
all-time high. 
In addition, contrary to the relatively minor 
role played by "no-frills" housing, the quali-
ty-as well as the quantity-of  housing was 
on the rise during the last decade. The aver-
age home in 1979 had a greater floor area, 
more bathrooms and bedrooms, and more 
amenities (such as garage space and central 
air conditioning) than a new home in 1970. 
All of this is suggestive of a major shift of real 
resources to the housing sector, a pattern that 
is reflected, too, in credit flows. During the 
1970's, $586 billion flowed 'tnto homefi;.;" 
nancing. This represents an increase in the 
share of mortgages in total flows from an 
average of 19 percent in the 1960's to 
a 20.5-percent share in the 1970's. Sti II, 
government-sponsored institutions played 
a major role here, financing almost one-
fourth of all home mortgages in the 1970's 
(see chart). 
This picture of an inflation and tax-distorted 
boom in the housing sector does not square 
with many people's perspective on the hous-
ing market. Housing leaders are more apt to 
remember the volatility of the industry than 
its substantial growth, because many fortunes 
have been lost in the increasingly wide fluc-
tuations affecting the industry. In the 1973-75 
downturn, and again in the 1978-80 down-
turn, housing starts declined by half or more. 
More fundamentally, many policymakers 
perceive that a dual crisis is developing in 
housing: owner-occupied housing is becom-
ing "unaffordable" and the rental market is 
dwindling. These are very likely surface man-
2. 
----------.-._.-
ifestations, however, of the housing rush 
described above. 
Affordability 
There is no doubt that the purchase price of 
housing has risen relative to other prices in 
recent years. Between 1970 and 1980, the 
price of  a single-family home of  a.given qual-
ity increased at about a 9.3-percent annual 
rate, as compared with a 6.8-percent annual 
rise in overall consumer prices (as measured 
by the deflator for personal-consumption 
expenditures). In addition, this increase in 
real housing prices has been accompanied by 
a sharp rise in mortgage rates. 
On the surface, this combination suggests 
that the costs of homeownership have risen. 
The true cost of  housing,'however, 'indudes: 
not only interest costs (and maintenance, 
taxes, and so on) but also the expected capital 
gains accrual, all after taxes. On this basis, it is 
not at all clear that the cost of housing has 
risen. Indeed, the evidence cited above on 
the increased quantity and quality of housing 
services being consumed suggests that hous-
ing costs have probablyJallen overall during 
the 1970's, despite the rise in prices and 
interest rates. 
The convention of a fixed-payment mortgage 
and a lim  it  on the ratio of  mortgage payments 
to current income, of  course, cause some 
households to experience difficulty qualify-
ing for a loan and taking advantage of these 
lower costs. This problem-called the 
"affordability" constraint-is undoubtedly 
important for many families, particularly 
during periods of  tight money. 
Over  the last decade, however, this constraint 
apparently was not very binding. Homeown-
ership appears to have continued to rise, and 
even first-time buyers (young families) are 
homeowners in increasing proportions. In 
1970, only about 39 percent of households 
with heads under the age of 30 were owner-
occupants; by the middle of  the 1970's, that 
proportion had increased to over 46 percent. $ Billions 
Home Mortgage  Funds 
75 
50 
25 
1965  1970  1975 
The fact that such trends occurred in the face 
of mortgage rates and housing prices that 
were rising faster than income has several 
explanations. First, banks substantially eased 
the terms of  their loan-qualificationtests 
when they broadened the defi n  ition of 
"income" to include the second income of a 
household. Secondly, many households had 
some latitude to "lend to themselves" by 
contributing more of  their savings to housing 
than they otherwise would. Finally, new 
mortgage instruments, such as the graduated 
payment mortgage, may have helped certain 
borrowers to partially overcome the con-
straint imposed by high initial mortgage 
payments. 
Rental housing 
The performance. of  the rental market, para-
doxically, has been consistent with the notion 
of a housing rush. Inflation and tax factors-
in addition to distorting the position of hous-
ing relative to the rest of  the economy-have 
caused distortions within the housing indus-
try. Since some of  the tax advantages enjoyed 
by homeowners are not available to land-
lords (tax-free capital gains, for example), the 
ability of rental housing to "compete" with 
owner-occupancy has been somewhat lim-
ited. As inflation expectations have risen and 
made the cost of  owner-occupied housing 
appear low, therefore, the rental market has 
declined. 
This decline has been manifested in several 
ways. First, the construction of rental property 
has dropped significantly despite large 
Federal subsidies. In 1979, total rental-unit 
construction dropped 20 percent from the 
preceding year-while the number of 
unsubsidized starts fell to only half of 
peak-year volume, and then dropped almost 
by half again in 1980. Second, many existing 
multi-unit properties have been converted to 
condominiums to satisfy homeownership 
demands. In 1979, about 195,000 units were 
converted in this fashion, up substantially 
from earlier years. But a more subtle form of 
conversion has also occurred with a drop in 
3 
1979 
the proportion of  rented single-family homes. 
Between 1970 and 1976 alone, the propor-
tion of single-family homes occupied by 
renters dropped from 19.3 percent to 16.6 
percent. 
Yet these changes must be viewed as a symp-
tom of  the overall rush to housing rather than 
a separate trend. The movement away from 
rental housing, including the conversion of 
rental housing to owner-occupancy status, 
represents a natural consequence of  the mar-
ket's adjustment to the combined impact of 
inflation and tax regulations. 
The future 
Any policy moves to channel resources into 
"reindustrialization" will have to deal with 
the inflation and tax factors that have dis-
torted the economy's natural patterns of 
resource allocation duringthe past decade or 
so. It will be necessary to bring the tax treat-
ment of housing and other investments into 
line if  the distortions in investment patterns 
are not to persist. In addition, the relative tax 
treatment of landlords and owner-occupants 
may have to be reconsidered to address the 
issue of imbalances within the housing  sector. 
Housing may, ironically, enjoy benefits from 
a rationalization of housing and general 
investment policy. The industry'S major  prob-
lem in recent decades has been the volatility 
rather than the nominal level of  activity. Mea-
sures taken to stabilize the relationship be-
tween housi ng and the rest of the economy 
may thereby reduce the heavy costs of  excess 
capacity in this feast-or-famine industry. 
Housing is likely to remain a sacred cow, but 
the beast may actually be healthier with a 
leaner yet more consistent diet in the decade 
ahead. 
Randall Pozdena and William Burke ·J!le:> IO;)SpueJ:I ueS 
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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT 
(Dollar amounts in millions) 
Selected Assets and Liabilities 
large Commercial Banks 
Loans (gross, adjusted) and investments* 
Loans (gross, adjusted) - total# 
Commercial and industrial 
Real estate 
Loans to individuals 
Securities loans 
U.s. Treasury securities* 
Other securities* 
Demand deposits - total# 
Demand deposits - adjusted 
Savings deposits - total 
Time deposits - total# 
Individuals, part. & corp. 
(Large negotiable CD's) 
Weekly Averages 
of Daily Figures 
Member Bank Reserve Position 
Excess Reserves (+ }/Deficiency (-) 
Borrowings 
Net free reserves (  + }/Net borrowed( -) 
* Excludes trading account securities. 
#  Includes items not shown separately. 
Amount 
Outstanding 
11/12/80 
144,133 
122,016 
35,736 
49,217 
23,733 
1,202 
6,687 
15,430 
47,193 
35,273 
29,484 
67,103 
58,180 
26,139 
Weekended 
11/12/80 
n.a. 
95 
n.a. 
Change 
from 
11/5/80 
1,052 
1,034 
58 
100 
- 8 
20 
2 
16 
-1,068 
857 
- 417 
1,226 
1,211 
520 
-
Weekended 
11/5/80 
n.a. 
167 
n.a. 
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Change from 
year ago 
Dollar  Percent 
8,697  6.4 
9,710  8.6 
3,818  12.0 
6,817  16.1 
154  - 0.6 
366  - 23.3 
777  10.4 
236  - 1.5 
1,141  2.5 
2,987  9.3 
481  1.7 
9,431  16.4 
8,897  18.1 
4,674  21.8 
Comparable 
year-ago period 
39 
277 
238 
Editorial comments may be addresseC:I to the editor (William Burke) or to the author ....  Free copies of this 
and other Federal Reserve publications can be obtained by calling or writing the Public Information Section, 
Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120. Phone (415) 544·2184. 

Housing: sacred cow?

http://www.frbsf.org/publications/economics/letter/1980/el80-48.pdf

Housing: sacred cow?

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Research Papers in Economics