Home Ownership, Capitalism, and That Elusive Efficiency Thing

[Note to readers: My new Verdict column, "Elected Dictators? The Limits of What Government Officials Can Do With Their Power," was published this morning.  Although my column below focuses on a very different topic, I encourage everyone to read the Verdict piece as well.]

by Neil H. Buchanan

During and immediately after the Great Recession, politicians and policy analysts understandably spent a great deal of time thinking about mortgages and home ownership.  This obviously made sense, because so much of the financial crisis that nearly pushed the global economy into a second Great Depression -- averted only because the Bush and Obama administrations (and just enough Republicans and Democrats in Congress) actually did the right things and saved the economy with necessary but unpopular bailouts -- was driven by the mortgage market.

My take on the situation was that the crisis had exposed the folly of our obsession with home ownership as part of the American Dream.  My students, like all people in their mid-twenties and later, are bombarded with the idea that a person is not truly a grownup unless and until he or she is married, has a professional job, has children, and owns a house.  This is nonsense, but it is also powerful, and I see young people over and over again making bad financial (and other) decisions in the name of proving that they are adults.

In 2012, I collected twenty-one of my Dorf on Law columns (and one column from the now-defunct Writ) on this topic and put them online in a single document, Owning Versus Renting: Thoughts on Housing Policy, Tax Incentives, and Middle Class Dreams.  In the seven years since then, I have mostly left the topic alone.

At the annual Law & Society meetings earlier this month, however, Professor Danshera Wetherington Cords's presentation included some interesting facts about homeowners' insurance that sparked some thoughts about policies to improve the functioning of the housing market in the U.S.  Those thoughts tie in nicely to the recent political brouhaha about Socialism vs. Capitalism and to the concept of economic efficiency that I have critiqued in my three most recent Dorf on Law columns (here, here, and here).

The bottom line is that our policies related to home ownership demonstrate yet again that there is no "natural" non-government baseline for our laws, and we can have a robust capitalist system under any number of different legal regimes.  The best housing policies are those that would at least reduce the harms inflicted on middle- and lower-income Americans.

The most interesting fact that Professor Cords shared is that the market for homeowners insurance is not working, because large numbers of non-wealthy people have inadequate coverage.  This has become increasingly apparent as the accumulation of climate change-related weather disasters has destroyed more and more homes, at which point the owners discover that their insurance coverage will not allow them to rebuild.

This is especially problematic because so many non-rich people have virtually no other assets but the equity in their houses.  Retirement savings rates are chronically low, and to the extent that middle- and lower-income people have positive net worth at all (most do not), nearly all of their nest eggs take the form of a modest house.

Coming out of the Great Recession, the big lesson was that people could lose their nest eggs if the market turned against them.  Millions of people who had been planning to retire in 2008 and later found themselves with houses that had dropped in value, with no other assets on which they could rely.  Those who had been tempted into the speculative side of the markets, buying houses at inflated prices and counting on the housing bubble to continue to expand, were especially vulnerable.  But even the careful people -- the people who had done everything right and nothing wrong -- were financially ruined.

This motivated much of my writing at the time, as I pointed out that we have a truly bizarre common wisdom about personal finance: always diversify your assets, except for your biggest asset of all.  That is, the same financial advisors who tell people that they should buy a mixed portfolio of stocks, bonds, and other assets -- and that only a crazy person would put all of their money into the stock of a single company -- were telling people to pour money into buying a house.

There is admittedly some logic to this, including the apparent fact that many people need the threat of becoming delinquent on their mortgages to force themselves to save money.  (The monthly payment includes both interest paid to the lender and reduced principal on the loan, increasing the owner's net worth -- that is, saving.)  Even though it is simple as a financial matter to pay rent and then save money, most people seem not to have that discipline, even when they live in markets where renting is cheaper than buying.

There is also, however, a lot of illogic to the idea that people should buy rather than rent.  The most obvious is the conventional wisdom that the mortgage interest deduction (MID) makes owning per se better than renting.  The reality is that the MID and other housing inducements will generally be "priced in" by the market, so that net-of-everything comparisons of the costs of renting and buying will generally (but not always) strongly favor renting as a financial matter.

But that qualifier -- "as a financial matter" -- carries a great deal of weight, because so many people are not thinking solely in financial terms about houses.  A world in which we are being told that home ownership is uniquely virtuous is not one in which people are likely to make cool, rational decisions about owning versus renting.

Professor Cords's point shows that the problem is even more significant, because even if a home-buying decision otherwise makes sense -- and even if a person is lucky enough not to need to sell when the market is going south -- people are not buying adequate insurance to cover their biggest (or only) asset.

A market purist might make two arguments.  First, he would say that the insurers and owners have incentives to make sure that houses are adequately insured, so a supply/demand equilibrium between insurers and insureds should be efficient.  Second, he would say that people who under-insure have only themselves to blame, so if they lose their houses, they deserve that fate.

The extensive literature on "market failure," however, was to a great degree driven by the many ways that insurance does not work like a textbook commodity market.  Perverse behavioral regularities, including the canonical concepts of adverse selection and moral hazard but extending to myopia, wishful thinking, and so on, are rife in insurance markets.  If ever a market was likely not to fulfill the standard assumptions required to conclude that an unregulated market is going to reach an efficient equilibrium, it is an insurance market where the insureds are non-savvy people with few assets.

As I asserted above, this all points to important insights about the current Socialism vs. Capitalism debate that Senator Bernie Sanders has sparked by self-identifying as a democratic socialist.  Senator Elizabeth Warren's response to the "Democrats hate capitalism" trope from Republicans is that she loves capitalism, so much so that she wants it to work better.

That means that Warren is constantly thinking about how to adjust the rules of capitalist markets so that they actually work in a way that can reasonably be called fair, which as an initial matter means leveling the playing field between financial (and other) players and their customers.  Capitalism of the neoliberal sort (after deregulation a la Ronald Reagan, Bill Clinton, and both Georges Bush) nearly destroys itself and everything around it on a regular basis.  Warren wants capitalism to be stable and prosperous.

What would that mean in housing?  At this point, I am no longer convinced that we could or should cut the supposedly "artificial" supports out from under the market for individual home ownership.  Too many people have too much to lose when prices fall, and it is not at all clear that repealing the MID or federal loan guarantees will leave us in a better position.

Why?  Because, for the reasons laid out in my triad of recent columns about economic efficiency, even if we removed all of the so-called distortions in the housing market (and the market for homeowners' insurance), there are so many other imperfections and externalities in other markets that there would be no way to say what the efficient outcomes in the housing and insurance markets might be.  If, say, labor laws allow companies to keep information secret that could affect wages, then people will demand different quantities of housing than they otherwise would, because their incomes are lower than they otherwise would be.

Again, there is no Right Answer to this.  Should public spending projects exist at all?  If they do, should they pay prevailing wages or something else?  Should polluters be forced to bear more of the burden of mitigating the costs that they create?  Should inheritances be disallowed because they were unearned by the recipient?  None of these questions can be answered in only one way, and every answer is going to change the "right" outcome in every other market, including housing and insurance.

In the end, then, being a good capitalist does not involve "letting the market decide," because the market is created by the laws that we write.  We can and should, therefore, decide to adopt laws that would mitigate inequality and especially prevent predation.  As always, capitalism must not only be for the capitalists.