What Is Wrong with The Housing Market? How Can We Fix It?

By Terry W (Yr 13)

Renowned Founding Father James Wilson once said, “the housing market will get worse before it gets better[1]”. This rationale accurately explicates the current rampant housing frenzy in the United States as housing prices continue to surge. The wounds of the 2008 Great Recession have not fully recovered and another housing crisis appears to loom large over homebuyers. The current housing market plight is far more complex than just a simple demand/supply problem. To delve into the intricacies of why this is, the essay will outline the definition of market failure within the context of the housing market, forming a conceptual yardstick to the main three main issues of the housing market: accessibility, quality, and financialization. Finally, it will propose appropriate solutions and possible modifications to government reforms to help rectify this market failure.

The generic definition of the market failure is the inefficient allocation of goods/services in a free market. But in the context of the housing market, market failure can be characterized as:

i) The failure to meet the minimum standards our society sets for a decent home and the failure to produce an efficient housing[2].

This definition of market failure demonstrates how the housing market fails to satisfy the needs of residents both qualitatively and quantitatively. The housing market comprises of innate qualities that makes it unique among other markets, preventing the imbalance of supply and demand to self-correct and reach a balanced equilibrium position without external support[3]. This makes theorizing about the housing market uneasy but also justifies the need for government intervention to help efficiently allocate houses to homebuyers.

Greater influx of people going home hunting simultaneously curtails the number of available housings. As demonstrated by figure 1, the number of new houses constructed is on a long-term decline – a root cause for the supply shortage. Further compounding this shortfall is the decline in the number of starter homes constructed since the early 1980s: the share of entry-level homes declined by 33% from 1980 to 2019[4]. Accordingly, the US housing shortage has grown from 2.5 million in 2018 to 3.8 million as of 2020[5]. On top of that, the lack of laborers and adequate homebuilding materials are also to blame here, causing the prices of the materials to increase. The rising expense of home construction discourages local government to initiate new homebuilding plans and homebuyers to construct houses[6].

Figure 1: Illustrating an estimation of the total number of houses constructed in the United States that are under 1,400 square feet.

However, zoning has hampered home construction in the country. Zoning is “the municipal regulation that govern how real property can be used within certain geographic zones”[7]. These onerous regulations are heavily used around the country, acting as an artificial barrier to the number of houses that can be legally built. Example of zoning practices are demonstrated in figure 2; areas highlighted in blue are those only used for multi-family housing whereas those that are coloured in pink are only for single-family housing.[8] These exclusionary zoning laws prevent the construction of homes that could accommodate more people, such as duplexes and fourplexes, are prohibited around the country. Even in the multi-family housing zones, municipal laws like height restriction and parking requirements prevent developers from using the allocated land efficiently and effectively, forcing home prices to rise higher than the optimum efficient level. Beyond economic disadvantages that zoning poses, zoning acts as an epicentre for the perpetuation of racial segregation, as it was historically intended. For instance, single-family zoning tends to have a greater white population whereas low single-unit housing has a more diverse population in comparison[9].

Figure 2: Visual representation of Bay Area zoning for residential housing, constituting about 82% of the available residential land in the region.

Even small gradual changes could help alleviate these inequalities and help meet the demand for housing, increasing homeownership rates by curbing skyrocketing rental/home prices[10]. Subsequently, indirect racial segregation could be improved if exclusionary zoning regulations are abrogated, allowing more residential land to be opened for denser and multi-family development. Greater access to housing could mean greater access to good quality education as public-school enrolment is tied specifically to the students’ residential area and funding to the property taxes of the area. With education being another merit good, the increase in the availability of new housing in residential areas could maximize the positive externalities which arise from the increased attainability of good quality education.

Further concerns over inequality are related to the lack of adequate, sufficient homes that cannot be solved just by increasing the overall supply of housing. The characteristics of a good quality home vary and primarily depend on the needs of the homebuyer: for instance, an 881sq.ft home is quite spacious for a single resident but extremely cramped for a family of five. This combined with expensive rent is unreasonable in terms of both cost and quality. Overcrowding is becoming increasingly prevalent as cost-burdened families continue to face difficulty affording necessities, with increasing share of households living with more than one occupant between 2007 and 2017[11]. The crowding effects of housing is a mechanism of social stratification, a major contribution to greater social inequality and mental wellbeing[12]. Although the housing is starting to cool off, the significant expense of the housing still takes up a significant proportion of consumers’ income, especially those of low-income families/individuals.

Figure 3: Diagram showing the welfare loss caused when sufficient housing is inefficiently allocated to consumers[13].

The unsatisfactory provision of housing is inextricably linked with other social factors, like health and productivity. Unsanitary living conditions are the epicentres of contagious diseases – a culprit for the deterioration of people’s living standards, and in some cases, death. Every year, 2 million people need emergency room visits because of asthma from long-time exposure to nitrogen dioxide and smoke - due to poor ventilation and poorly functioning combustion home appliances- and over 2900 people die of house fires due to substandard housing[14]. Substandard housing also affects mental wellbeing. For instance, families that live in substandard conditions express greater levels of distress and higher levels of social isolation due to their reluctance to welcome guests to their homes[15]. In this case, poor housing yields substantial negative externalities, owing to the detrimental spillover effects on third parties, and thus can reduce social welfare. On the other hand, a clean and comfortable looking home design is integral in promoting workers to work from home – a widely popular working route that many employees have embarked on due to the ongoing pandemic. Comparison could be made to the comfortable and spacious working environments that multinational tech giants, like Apple and Google, provide knowing the tremendous external benefits it could have on worker productivity. Figure 3 graphically shows the positive externalities available. A greater consumption of adequate housing could yield higher positive externalities since the marginal social benefit consumption (MSB curve) is greater than the marginal private benefit (MPB curve) at every level of output until it reaches the societal optimum level of output (Qopt). If sufficient housing is under consumed in the economy due to consumers’ inability to afford them, dead-weight welfare loss would result in the economy – indicated by the shaded area.

The under-consumption of sufficient, comfortable housing is not merely a market failure but also a government failure. The implementation of higher taxes and higher interest rates could limit the buying frenzy, and the housing prices thereby. To further improve the quality aspects of housing, the government can set higher building standards and potentially subsidize the construction of higher quality homes. This can allow better quality homes to be produced at a cheaper cost and provide more abodes for workers to potentially relocate to where the most productive jobs are located – an increase in labour mobility[16]. Consequently, greater consumption of this merit good derived from greater variety of housing not only reduces the discrepancies between different socioeconomic status, but also remedies the problems produced from the market failure.

The expense of providing low-interest rates along with easy lending conditions to help stimulate economic growth during the pandemic could have pushed greater amount of money into the housing market, resulting in bidding wars that exacerbate the prevailing non-affordability and quality issues. Financialization refers to ‘structural changes in the housing and financial markets whereby housing is treated as a commodity’[17]. Therefore, the intention in acquiring houses as a means of wealth accumulation and a security for financial instruments diverges from its main social function; that is, to provide a safe abode for living. The tangible danger coupling with the fragility of financialization was experienced in the burst of the 2008 housing bubble, whereby ‘mortgage backed-securities’ created indelible financial catastrophes for both investors and homeowners[18]. To prevent the possibility of further havoc to the economic structure, the government significantly increased the difficulty of acquiring loans through establishing greater restrictions and higher qualifications for specific loans. Despite this, affluent investment corporations like BlackRock exploited this opportunity to amass over trillions of dollars-worth of assets. Accordingly, limited liability companies contributed to 58% of all the housing purchases in the United States by 2015[19]. As Henry Kissinger famously puts it, “whoever controls the money controls the world[20].” Because of their prodigious influence, they prevent those that need a home from purchasing it by unnecessarily depleting the common pool resource.

The nuances behind this complex market structure make housing speculation hard to solve. The heart of the housing problem lies on the mismatch between demand and supply rather than financialization alone[21]. The supply constraint is a government failure; government regulations, like zoning restrictions, make the housing market extremely vulnerable to sudden increase in demand. Hence, the stabilization of the current housing prices could not be achieved simply by easing credit requirements due to restrictions being originally placed on the construction of houses and that properties have become increasingly inelastic. The financialization of demand is the culprit for rising home prices in the short-run, but the planning system’s refusal to respond to the price signals justifies the steady rise in home prices in the long-run. In essence, the plethora problems of the housing market should not be blamed on “commodification” but more so on the shortage of housing, which encourages housing to be seen as a commodity[22]. Equalizing both the supply and demand could, in fact, limit price volatility and maintain stable housing prices. This can address the affordability and quality issues whilst potentially reducing house ownership attractiveness to institutional investors.

It may be more feasible and appropriate to implement supply-side policies rather than proposing policies that deal with the housing market as a demand-side issue, due to the inelastic nature of this supply. For example, if the state and local government of California were to ease the stringent zoning/ordinance regulations or provide more land for home constructions, housing prices would stabilize at the current price or even reduce. Second in importance is the modification to the planning reform to allow for greater social housing. Unlike the housing market in UK, the Palo Alto housing market lacks the provision of public/social housing – every property is privately owned. The introduction of a greater number of efficient small complexes in their region would prevent property values from increasing, but this never took effect in local districts due to homeowners’ fear that new housing could affect their property pricings. If the government chooses to ignore this, the housing supply could potentially catch up with the demand, securing this rights-based entitlement for more people.

To conclude, the conundrum of the current housing market does not just rest upon rising housing prices, but more so on it being a market failure. Solutions incorporating the use of higher income tax alongside rising interest rates only partially solve the housing problem but fails to address the supply constraint of adequate housing, unable to fix the detriments brought by said failures in the long run.[23]. Putting greater strain behind this is financialization, exploiting the land ordinances alongside regulations to profit off property. Hence, the American right in owning a good quality, comfortable, and affordable home may be too distant at this moment.

Author’s Note:

Unless specified otherwise, the phrase “housing market” mainly applies to the housing market in Palo Alto San Francisco. Furthermore, the statistics used in the essay could be a bit obsolete, meaning that these datapoints may not be an accurate representation of the current market trends.

[1] “James Wilson Quotes,” BrainyQuote (Xplore), accessed June 28, 2022, https://www.brainyquote.com/quotes/james_wilson_406098. [2] Ian Harris, “London Housing Market - London.gov.uk,” Market failure and the London housing market (Greater London Authority, May 2003), https://www.london.gov.uk/sites/default/files/london_housing_market.pdf, 1. [3] Ibid [4] Sam Khater, Len Kiefer, and Venkataramana Yanamandra, “Housing Supply: A Growing Deficit,” Freddie Mac, May 7, 2021, https://www.freddiemac.com/research/insight/20210507-housing-supply. [5] Ibid [6] “Millennial Demand Helps Stoke the Housing Boom,” The Economist (The Economist Newspaper, March 23, 2020), https://www.economist.com/finance-and-economics/2022/03/26/millennial-demand-helps-stoke-the-housing-boom. [7] Will Kenton, “Zoning Definition,” Investopedia (Investopedia, April 6, 2022), https://www.investopedia.com/terms/z/zoning.asp. [8] (Menendian, Gambhir and French, et al. 2020) [9] Stephen Menendian, Samir Gambhir, and Arthur Gailes, “Racial Segregation in the San Francisco Bay Area, Part 5,” Othering & Belonging Institute, August 11, 2020, https://belonging.berkeley.edu/racial-segregation-san-francisco-bay-area-part-5. [10] Jerusalem Demsas, “Covid-19 Caused a Recession. so Why Did the Housing Market Boom?,” Vox (Vox, February 5, 2021), https://www.vox.com/22264268/covid-19-housing-insecurity-housing-prices-mortgage-rates-pandemic-zoning-supply-demand. [11] Claudia D. Solari, “America's Housing Is Getting More Crowded. How Will That Affect Children?,” Urban Institute, April 24, 2019, https://www.urban.org/urban-wire/americas-housing-getting-more-crowded-how-will-affect-children. [12]Claudia D Solari and Robert D Mare, “Housing Crowding Effects on Children's Wellbeing,” Social science research (U.S. National Library of Medicine, March 2012), https://www.ncbi.nlm.nih.gov/pmc/articles/PMC3805127/. [13] Paul Hoang, Sean Wray, and Tanusankar Chakraborty, Economics for the IB Diploma Programme (London: Hodder Education, 2020), 146. [14] James Krieger and Donna L Higgins, “Housing and Health: Time Again for Public Health Action,” American journal of public health (© American Journal of Public Health 2002, May 2002), https://www.ncbi.nlm.nih.gov/pmc/articles/PMC1447157/. [15] Ibid [16] “Home Ownership Is the West's Biggest Economic-Policy Mistake,” The Economist (The Economist Newspaper, 2020), https://www.economist.com/leaders/2020/01/16/home-ownership-is-the-wests-biggest-economic-policy-mistake. [17] Dallas Rogers Senior Lecturer and Emma Power Senior Research Fellow, “Explainer: The Financialisation of Housing and What Can Be Done about It,” The Conversation, March 10, 2022, https://theconversation.com/explainer-the-financialisation-of-housing-and-what-can-be-done-about-it-73767. [18] Prakhar Singh, “Financialization of the Housing Market,” Medium (Medium, April 3, 2019), https://medium.com/@prakharr_singh/financialization-of-the-housing-market-8b81033eb13c. [19] Ibid [20] “A Quote by Henry Kissinger,” Goodreads (Goodreads), accessed June 15, 2022, https://www.goodreads.com/quotes/1236134-who-controls-money-control-the-world. [21] Anthony Breach, “Why Financialisation Is Not Causing the Housing Crisis,” Centre for Cities, July 3, 2019, https://www.centreforcities.org/blog/why-financialisation-is-not-causing-the-housing-crisis/. [22] Ibid [23] “Why Financialisation Is Not Causing the Housing Crisis,” Centre for Cities (The Economist, July 3, 2019), https://www.centreforcities.org/blog/why-financialisation-is-not-causing-the-housing-crisis/.