I am currently reading a book based on behavioral economics, or what makes people make the decisions they make. So far, I like the book. There is clear empirical evidence of what the author describes as our predictable irrationality in decision making. However, I am at a part in the book where the author has opened the door for a necessity of government intervention, based on ‘failures’ of the free market. Predictably, I am now skeptical…but we’ll see how it ends.
The book questions tenants of traditional economics, price theory, and supply and demand. I question anybody that thinks government action in prices is a good thing. For all our faults, biases, etc., consumers WILL choose what's best for them, and if not...they were at least free to choose.
Take the housing market (please)…
Rather than look at the whole market, I will look at one house in particular. In 2002, the house sold for $220,000. It is now on the market for $299,000. Considering that on average, houses sell for 95% of asking price, it will sell for $284,000. A capital gain of $64,000 for the 2002 buyer. An increase of 29% in the price of the house. If that money is used to buy another house, there are no taxes on the gain (that is not a ‘tax loophole,’ it is a ‘lack of government intervention‘).
What’s wrong with that? It appears as if the investment in the house worked like the American consumer expects it to. So, why am I unhappy with the 29% increase in the investment in the house? Most homeowners don’t have $220,000 for the initial outlay, so the ‘modest’ gain of $64,000 was leveraged by the bank, and really cost the homeowner the down payment, closing costs, fees and interest. While the bank did not realize any of the $64,000, it got the down payment, some of the closing costs, fees and all of the interest - which in the first 10 years, is most of the monthly payment.
If the 2002 buyer had put the $220,000 in an investment that earned a 6% annual rate of return, the money would have become $361,784 (after annual capital gains tax of 15%), an increase of $141,784.
The average annual inflation rate from 2002 to 2012 was 2.50%. At that rate, the house should sell for $380,978 in 2012, an increase of $160,977.
So what is the problem? Why is the house not selling for $361,784 to $380,978? Well, like I pointed out, most homeowners don’t lay out $220,000, they only gave a down payment, closing costs, fees and interest - so the gains are not the same as other investments.
Because, in 2006, similar houses in the neighborhood were selling for over $400,000, when they should have been selling for $268,432 - $268,574...bubble…foreclosures…yadda, yadda, yadda…
It is all relative.
All of us, as consumers, form a price in our head for a good or service that serves as a baseline. It can change over time, but it acts as an anchor. The baseline for me in the above example is not the 2002 selling price of $220,000. The anchor for me is $339,069, the approximate selling price in 2010 (when I moved into the neighborhood), which matched very closely what it should have been, if based on annual inflation.
So, in 2012, if the house is for sale for $339,069 - it is a good buy. But if I were selling the house, I would consider it a loss. And, since you will note, it is in fact 2012, and the house is for sale for $285,000* - that is a “bad” market to sell in.
*You will note, that the current asking price for the house dropped $14,000 from the beginning of the post. That is because - when I checked my facts - THE HOUSE WAS RELISTED!
It is not my house, I am not buying or selling. I’m just living nearby…
A wise man once told me that something is “worth” what somebody is willing to pay for it.
In this market, most houses are worth-less.
Why? What caused the housing bubble to burst? There are several factors, but one of the BIG catalysts was that the government got over-involved. The government opened the door for banks (in come cases opened the door and shoved them through) to loan money to people that could not pay it back. The government then bought the loans from the banks with taxpayer money. Now the government is still trying to fix the problem, by intervening even more.
In this present crisis, I am currently in a losing position, and I am asking the government....please...don't help!