8. Houses vs. Cars

CHAPTER

EIGHT

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Houses vs. Cars

It is argued that when one purchases a car on credit, that the buyer is underwater the minute he or she drives the car off the lot. This doesn’t give people the right to walk away from their car loans. Why should a house be any different?

As a rule, car buyers don’t structurally default on car loans. However, if the price of cars fell by half, and a person could buy the same car for half the price and cut their payments in half, there would be plenty of structural defaults on car loans.

Car loans are typically fully amortizing 3 to 7-year loans. The lenders know the collateral depreciates and they make the loan terms to reflect that. Up until the housing crash it was thought that homes only increased in value, and with the government’s help the 30-year loan was born.

The financing rates for cars during the boom (and after) were lower than mortgage rates and the qualification process much easier: Most of the time it happens in a matter of minutes. No one is asked for their tax returns and pay stubs to qualify for an auto loan.

But there was no bubble in the price of cars despite the low financing rates. Cars are consumer goods. Homes, on the other hand, when considered with the land and infrastructure that is required are higher-order goods.

Austrian Business Cycle Theory dictates that people, as they earn money, spend some on consumption and keep some in cash balances, while the rest is saved or invested in capital or production. For most people, this means setting aside a portion of their income by buying stocks, bonds, or bank certificates of deposit or savings accounts.

People determine the amount they wish to put in savings by their time preferences, i.e., the measure of their preference for present, as opposed to future, consumption. The less they prefer consumption in the present, the lower their time preference. The collective time preferences for all savers determine the pure interest rate. Thus, the lower the time preference, the lower the pure rate of interest. This lower time-preference rate leads to greater proportions of investment to consumption, and therefore an extension of the production structure, serving to increase total capital.

Conversely, higher time preferences do the opposite, with high interest rates, truncation of the production structure, and an abatement of capital. The final array of various market interest rates is composed of the pure interest rate plus purchasing power components and the range of entrepreneurial risk factors. But the key component of this equation is the pure interest rate.

When government intervenes to lower interest rates, the effect is the same as if the collective time preferences of the public had fallen. The amount of money available for investment increases, and with this greater supply, interest rates fall. In turn, entrepreneurs respond to what they believe is an increase in savings, or a decrease in time preferences. These entrepreneurs then invest this capital in “higher orders” in the structure of production, which are further from the final consumer. Investment then shifts from consumer goods to capital goods industries. Prices and wages are bid up in these capital goods industries.

This shift to capital goods industries would be fine if people’s time preferences had actually lessened. But this is not the case. As the newly created money quickly permeates from business borrowers to wages, rents, and interest, the recipients of these higher incomes will spend the money in the same proportions of consumption-investment as they did before. Thus, demand quickly turns from capital goods back to consumer goods.

Unfortunately, capital goods producers now have an increased amount of goods for sale and no corresponding increase in demand from their entrepreneurial customers. This wasteful malinvestment is then liquidated, typically termed a crash, bust or crisis, which is the market’s way of purging itself, the first step back to health. The ensuing recession or depression is the market’s adjustment period from the malinvestments back to the normal efficient service of customer demands.

The recovery phase, or recession, will weed out inefficient and unprofitable businesses that were possibly engendered by, or propped up by the money-induced boom. The recovery is also characterized by an increase in the “natural” or pure rate of interest. In other words, time preferences increase, which leads to a fall in the prices of higher-order goods in relation to those of consumer goods.

Homes are higher order goods, not consumer goods as one policy analyst contends who insisted that homes are instead a “durable consumer good.”

While the factory to build cars is a higher-order good, the cars are assembled in a matter of hours.

It is the land that a house sits on plus the entitlements and infrastructure that are required before a house can be instructed that makes it a higher-order good, unlike a car. In a daily article for mises.org I explained:

However, there is more to a house than the sticks, bricks, and gingerbread that people see and buy. The building of homes starts with the purchase of land. And buying land is not like driving over to Best Buy, whipping out your credit card, and buying a big-screen TV. First the developer and his staff look for land to build on because ultimately the builder believes he can sell houses on that land. Consultants are hired to produce soil studies and environmental reports, and to determine the availability of utilities and zoning feasibility. These reports take time to produce and cost money.

If the land appears to be suitable for residential development, the developer will determine what can be paid for the land to make the project profitable, assuming his projections are accurate for the sales prices of his homes. After that, a price is negotiated and escrow is opened. A hot land market will dictate short escrows of 90 to 180 days, whereas in a typical market, escrows of a year or more are not uncommon.

A key factor in how much is offered in price for the land is the interest rate to be paid on the loan used to purchase the parcel. Low interest rates allow the developer to pay higher prices. Low interest rates also allow for the developer to take on more political and development risk. The political risk is the uncertainty that the builder will obtain the zoning necessary to build the number and type of units contemplated when the land was being considered for purchase. In most large urban areas, zoning approvals—which ultimately lead to maps legally describing the building lots that the houses will be constructed on—take months in the best of times; now they often take years.

Horizontal development costs can change dramatically during this process, as city hall may impose improvements that hadn’t been contemplated as well as cost increases caused by increased demand for dirt moving, utility trenching, and street paving. And since most of the costs of developing finished building lots is financed, low interest rates make more projects feasible than high interest rates, not only from a cost standpoint but also from a time standpoint. The interest for development and construction projects is financed—it is borrowed—just like the soft and hard costs associated with the development, thus the lower the interest rate, the longer the project has before it must be converted to a consumer good.

The comparison between cars and houses is not a valid one: it’s comparing apples to not just oranges, but orange trees. Despite easy and cheap financing there was no boom in the price of cars. Nobody bought multiple cars with the idea they could flip them for a quick and easy profit. And although the buyer is underwater the minute he or she drives off the lot, the short amortization schedule in the loan terms aligns the value and loan balance quickly.

Interestingly, the modern terms of car loans are similar to the terms of home loans prior to the federal government’s intervention in the home loan market.