The Paper View of the Economy

What distinguishes the Austrian view of macro economics from the Keynesian or Monetarist view is simply the level of focus.  Keynesian and Monetarist views rely on the paper representation of the economy, where the functions of the economy are aggregated and then represented by a series of numbers giving them a bird's eye view of everything.  Low resolution at the points which generate the numbers, but a good broad overview, while Austrians take some (not even a lot in particular) of that granular generator into account. The lack of communication across the schools which have many otherwise similar assumptions and conclusions about economics seems to be because of a modest shift in the underlying assumptions.  A claim under one set of assumptions would sound false and perhaps even ridiculous while being perfectly reasonable under another, its the nature of modeling (yes, what Austrians do is fundamentally modeling).

One issue with the paper view of the economy is the urge to translate it down levels which look like paper representations, but aren't.  Stock prices are a great paper view of a company, if you buy shares of Tesla and three years later those shares are worth 30% more then you can realize a 30% profit.  It doesn't matter if the shares rose because of an increase in sales, or the change of a CEO, or new product lines or a contract with the government.  It also doesn't matter (as long as you weren't leveraged) at the end of the three years if the price jumped 30% in the first year and then was flat, or fell and then rose or rose as a constant rate.  All the changes together, plus all the other changes in the economy, should be reflected in that one price as best the market can tell.  So if you want to follow the value of a company the stock price multiplied by the total shares is all you really need.  

All prices however are not inclusive.  Home prices are a good example of this, if you buy a house to hold in the hopes that property values will rise and let it sit empty for three years and then sell it for 30% more than the initial purchase price you have not made a 30% return on your money.  Why not?  Because as any homeowner knows houses come with carrying costs, you have insurance, taxes and maintenance costs.   You can see this quite clearly when developers buy property with the intention of tearing down existing structures.  They tend to tear down as soon as possible, even if they aren't intending to build immediately, as the taxes and insurance for an empty lot are generally significantly less than for lots with buildings*.

When you make an investment in housing based on expected sale price appreciation the length of time between purchase and sale is important to calculating expected returns.   Scott Sumner wanders into this distinction without noticing it in a recent post on the recent growth oinLas Vegas.

But I argued that these cities were fast growing, and this problem was relatively mild.  In my view the malinvestment is better termed “too early investment”—some houses were built a few years before they were needed.  The Austrian counterargument was that these houses would remain empty for decades, and eventually depreciate sharply (in a physical sense.)  It looks like I was closer to the truth.

Lets look at some basic estimates for carrying costs.  Property taxes plus insurance tend to combine for about 1.5-2.5% of a properties sale vale annually.  Long term interest rates during the last leg of the housing bubble were around 6%.  Estimated carrying costs for a unit would be around 7.5%** without figuring any housing depreciation or maintenance. 

Lets look at house prices

Home prices are currently about 25% off their 2006 peak after a 6 year run up.  So lets say you borrowed money and built a house you expected to sell for $230,000 in 2006, and you expected a 5% profit from it after all yous costs (including any transaction costs and the cost of financing your loan for 1 year while it was built), so your total costs would be around $219,000.  You go to sell now after riding out a huge downswing, your carrying costs have eaten up 88% of the $219,000 which is ~$193,000 in costs over the years (not compounding).  Then you go and sell at today's prices of $185,000.  Your final 'profit' on that project is negative $227,000.  

Ok, but you aren't that dumb, why leave the place empty for 12 years, rent it out and that negative $227,000 will be a reasonable number.  Well Vegas currently has a price to rent ratio of about 20:1, so a house that sells for $185,000 now would rent for about $9,300 a year, over 12 years that would be $112,000, but Vegas had a vacancy rate of around 10% over those last 12 years, pulling that down to $100,000, making your final loss on that $219,000 loan about $127,000**

So actual market returns on Las Vegas construction that was started late in the housing bubble are reasonably calculated at about -58%, and the Las Vegas housing market crash saw about a 60% decline in prices, which is pretty effing amazing projection for a market that was in 'crisis'.  

To justify Sumner's claim that the housing was "to early investment" you have to extrapolate the price trend of the last 6 years another 10-15 years to get to that investment at a break even point. So housing construction in Las Vegas was to early by AT LEAST 25 years, under the best assumptions.  

*There is more to this story as the cost of tearing down carries either interest payments or opportunity cost of that money, so you can see speculators sit on buildings for long periods of time. 

** These numbers understate the case quite a bit, the price to rent ratio is for gross rent, which assumes that utilities are included which then come out of the owners pocket, and it includes nothing for general maintenance and doesn't adjust for the fact that rents in Vegas are higher now than they were over most of the past 12 years.  These more than compensate for lower interest payments that would have come from using the rental into to pay down principle.