Why House Prices Will Continue To Fall

A great article in this past weekend’s Washington Post highlighted many of the major issues affecting the US housing market and most of those issues point to lower house prices.  In particular, the self-reinforcing psychology of price deflation has already set in. And that means prices will continue to fall.

While the government is doing its best to prop up the housing sector and maintain credit growth, most common metrics suggest house prices are still elevated. This artificial prop buys banks time by preventing banks from taking losses and depleting capital while the yield curve is still steep. Yet, investors are coming to the realization that short-term rates will stay near zero percent for a very "extended period" indeed. Perpetual zero (PZ) is having the perverse effect of flattening the yield curve and reducing the carry trade that is benefitting banks. If banks are unable to restore adequate capital to deal with the loan losses that removing the government prop would induce, the next recession will be very painful.

The psychology of deflation in Japan

I first talked about the behavioural psychology of deflation in 2008 when writing about Japan’s housing bust. The  post "A cautionary tale: story from 1994 Japan" relied on Michael Nystrom’s 2006 tale about a Japanese man buying a house amid the mid-1990s Japanese house price deflation to bring the psychology to life.

Michael wrote:

In spite of the booming economy, my uncle, like many Americans today, was shut out of the housing market. Prices always seemed too high, but a pullback never materialized, so he waited until the right time to buy. While he waited, prices spiraled up and away until at last they were hopelessly out of reach. By the time I arrived in 1990, his family was living in a government-owned, rent controlled flat that was, by any standards, small: Two rooms that were each about 12 feet square, a small kitchen and a tiny bath to serve three adults (including his mother) and his two kids…

My uncle thought that he would never ever be able to afford a house in Japan, and that he would live out his dying days in that little rented flat. In his experience, housing prices went only in one direction: up. But by 1992, two years after the Nikkei peaked, something strange began to happen – housing prices started drifting down…

By 1994, housing prices continued to drift lower until some units started to become, with considerable stretching and creative financing, affordable. So that year, by taking out a two generation, 60-year mortgage — with his 16-year old son on the hook for the remaining years that he might not be able to pay — my uncle bought his first home. The family had to scrimp, and both he and my aunt had to work more hours, but they were finally, proud homeowners. And it was a nice house – larger than their old house (but not much), in a nicer neighborhood, and on a higher floor with a view of the treetops. I even helped them move in. It was a happy day. I don’t recall the exact price he paid, but I remember thinking that it sure was a lot! Somewhere north of half a million dollars. Those were the kinds of details were lost on me at that age.

I left Japan in 1994, and didn’t return again for a visit until late 1998. In the intervening 4 years, housing prices had continued to fall, and fall, and fall to the point where my uncle’s house was worth only half of what he had paid for it four years earlier: A couple hundred thousand, up in smoke, just as Japan’s economy was mired in a 13-year slump. But he stuck with his loan, hoping the value will come back. And one day, it just might. So he makes his payments each month faithfully, and when he can no longer make them, his son will take over and pay off the remaining balance. And sometime, in the remaining 48 years on the mortgage, the house may once again be worth more than what is owed on it.

The psychology of deflation hits America

What happened? The psychology of deflation happened. But rather than go into some diatribe of how this works, I will use excerpts of the Washington Post article In struggling housing market, buyers and sellers are out of sync to paint the picture. While reading this, remember that the DC area has been relatively buoyant economically during this crisis compared to other American cities due to federal government largesse. I have highlighted the parts that pertain to deflation psychology.

Jack Donnelly put off selling his Capitol Hill rowhouse for three years until he thought he saw glimmers of life in the housing market this past spring. At $950,000, he said, the red brick Victorian is a "solid deal."

Jackie Wright sees it differently. The row house is one of many homes competing for her attention in uncertain economic times. She’s been looking to buy a home in the District since April but is in no rush to commit, partly because she thinks mortgage interest rates – and prices – could sink even lower.

As with many prospective sellers, Donnelly’s hopes for his rowhouse were forged in the past, before the housing bust, when homeowners assumed that real estate prices would inexorably rise. They expected to reap vast windfalls when their houses sold. But Wright’s eyes are turned to the future. She’s anxious about whether the coming months will bring more gloomy economic news and reluctant to gamble on a major purchase, especially if a flagging market might actually mean better deals ahead.

Notice the disconnect between Donnelly and Wright’s psychology. That’s the interesting thing about this story. The house was bought for $645,000 in 2004. Renovations of $150,000 (including labour) put the all-in cost at about $850,000 to $900,000.  So, why is Donnelly trying to sell the house for nearly a million dollars? In behavioural economics, this is called anchoring. Donnelly’s price point is anchored to the $1 million he expected to receive during the halcyon days of the housing bubble. See Michael Mauboussin on investor psychology for more on this.

Back in 2004, when Donnelly and his new bride, Roxanne, bought the home, they’d paid $645,000. It was a fixer-upper in a transitional neighborhood. And the finances had been a stretch. But with a child on the way, they had been ecstatic to find a place they could afford.

They converted the space from apartments into a single-family home and installed central air conditioning. The renovations totaled more than $150,000, not including labor costs, Donnelly said. Three years later, after the tremendous run-up in U.S. housing prices, he decided he wanted to sell it for $1 million.

By then, however, the housing market had begun to sour, and he figured the home couldn’t fetch what he thought it was worth.

"I decided to do the conservative thing, collect rent on this place and wait a couple of years for the housing market to improve," Donnelly said.

See, Donnelly bought another house and moved in there. He should have sold his old house. But he was anchored to the prices of a few years back and so decided to rent it out – which isn’t the conservative thing in the least. The thing is house prices are lower today – even in DC. And this presents a classic negotiating problem. H. Raiifa’s "The art and science of negotiation" sets out a framework based on three sets of data (as quoted by Max Bazerman’s "Judgement in Managerial Decision Making"):

  1. Each party’s alternative to a negotiated agreement (BATNA – Best alternative to a negotiated agreement)
  2. Each party’s set of interests
  3. The relative importance of each party’s interests

In a period of falling house prices, a home buyer’s BATNA is to simply wait. She can rent or stay in her present home. Here’s how the Post puts the conflict.

Hart, the real estate agent, insisted that Donnelly’s house is properly priced. She said five other comparable homes within short walking distance are for sale at similar prices – $900,000 to $974,000. She said others have sold within that range recently.

Donnelly has his doubts.

"Frankly, I don’t know what number makes sense anymore," he said. "It’s not a normal market. . . . Some houses are gone, and some in the same price range are not going. I can’t gauge what’s real and what’s not."

He acknowledged that he’d been thinking of reducing his asking price, lowering his goal for a second time.

In fact, by Saturday he’d dropped the price to $895,000.

And while that may narrow the expectations gap with prospective buyers, it might not be enough. If he fails to attract a buyer soon, Donnelly said, he would take the house off the market, possibly refinance it at lower rates and keep on renting it out.

That would be one more sale that never took place.

Lower home sales presage lower prices

This last sentence is the crux of the article.

In any negotiation, the two parties have a "reservation point" beyond which they will refuse to negotiate and will simply walk away and accept their BATNA. The art of negotiating is finding a price higher than the seller’s reservation price that is also lower than the buyer’s. In a market panic, sellers reduce price quickly because markets are more transparent, the assets transacted assets are fungible, transaction costs are low and volume is high. All of this means a bottom comes more quickly because a seller’s reservation price becomes unanchored very quickly as market prices fall.

In a housing market selloff, markets are more byzantine,  properties are unique, transaction costs are high, and sales are infrequent. This means that, in assessing one’s set of interests and their relative importance, many sellers decide not to transact because their reservation prices are still anchored in bubble psychology.

So the first thing to give way in a housing bust is volume. Lower transaction volume is prelude to lower prices. If volume is falling, you can be sure it has done so because sellers have not lowered their reservation prices and are waiting for prices to rise again. But, of course, if the psychology of deflation has set in for buyers, prices cannot rise. And that means prices and sales volumes drift lower as forced sellers dominate the marketplace.

Moreover, the psychology of price deflation is also the reason markets tend to overshoot to the downside. Buyers are saying, "wow, those prices sure have come down. Maybe they will come down even more. I think I will hold off on buying and see." This type of psychology is self-reinforcing and almost always takes markets below fair value when value players snap up bargains and change the psychology.  In my view, the government can slow but simply will not be able to overcome this dynamic. That means a slow and inexorable decline for house prices.

And since housing usually leads recoveries, that spells a weak recovery and perpetual "extended period" language from the Fed.  Eventually, the U.S. yield curve will flatten as it did in Japan if PZ takes hold. PZ is toxic for banks because when the next recession hits, the central bank cannot lower rates to induce a steep yield curve and bail them out. Therefore, loan losses will have to be taken without the benefit of the carry trade and that spells bankruptcy for the weakest.  This is what happened in Japan and what is likely to happen in the U.S.


Related articles

Housing Woes Bring a New Cry: Let the Market Fall – NY Times

The house price fairy – Worthwhile Canadian Initiative

  1. alicat says

    I am not a financial person, but enjoy very much your insight. Could you explain to me where the money the banks lent to homebuyers (mortgages, HELOCS, etc) came from? Did the banks print this extraordinary amount of money to lend? Thank you, alicat

    1. Edward Harrison says

      See Steve Keen’s writings on this. In his most recent post, he writes:

      Credit Money is created by banks “out of nothing” by the act of giving a borrower purchasing power (a loan of money) in return for recording a liability by that borrower to the bank (a bank debt). This creates new spending power “ab initio” without removing it from other agents. For the mechanics of this process, see my “Roving Cavaliers of Credit” blog entry (click here for the PDF).


      Edward here. Loans create deposits, meaning that bank reserves have almost nothing to do with credit creation. Banks create the money and then go into the interbank market to borrow reserves if they are short of them.

  2. Terry says

    I really enjoy your writings but must disagree with the premise of this story. I agree with everything but the analysis that seller in the US housing bubble is motivated by capturing the best price. Their is no attachment to price for them because they have no skin in the game. These are foreclosed properties. The seller is a no-name, no emotion employee who’s job it is to liquidate. The persons in the situation mentioned above are selling the home in DC and are owners of the home and have a vested interest in capturing the most they can from a sale therefor must negotiate a favorable deal. Most of the homes offered for sale today are foreclosures. The buyer is competing with other buyers so the buyer is determining the price. The sellers of these foreclosures will at any price just to clear them out. The “prop” for this market is the investor who will buy when it pencils out.


    1. Edward Harrison says

      Terry, I think you misunderstand my premise. I said at the outset:

      “While the government is doing its best to prop up the housing sector and maintain credit growth, most common metrics suggest house prices are still elevated.”

      This means that in a mean-reverting market, house price inflation will be lower than consumer price inflation in order to get the market back to normal levels of price-to-income or house prices-to-rent. That is the basis of any discussion in the property market: valuation.

      The question is what kind of path will get us there given the government’s desire to keep prices from moving lower. I said:

      “if the psychology of deflation has set in for buyers, prices cannot rise. And that means prices and sales volumes drift lower as forced sellers dominate the marketplace.”

      This means that sellers still anchored to bubble mode will take their homes off the market. The market will then be dominated by those who must sell (foreclosures, divorce, unemployment, moving from one city to another, etc) and this means that prices will go lower even though the government is trying to prevent this – albeit more slowly.

      That is certainly consistent with your comments and recent sales and price data. Am I missing something?

  3. Scott says

    Hi Ed:

    PZ (permanent zero) is a good term if it’s yours. It gets to my last point where lower rates increase existing debt’s real rates, along with the deflationary mindset you lay out here.

    I’m still poking at my existing debt issue though. From theory, I am presuming if the Fed lowers rates, it incentivizes spending for three possible reasons off the top of my head.

    1. Debts that were not validated at higher rates, are now validated, preventing a debt deflation.
    2. New debts and the cost of capital are lower, incentivizing new debts that otherwise would not make sense.
    3. Reducing the cost of holding dollars to the point that it is cheaper to spend than save induces consumer spending.

    I’m still hoping you cover the third point at some time. In a deleveraging cycle, I see the third as counter productive. Debtors, instead of spending, feel deflationary pain so they choose not to spend less in anticipation of lower prices, but to deleverage in anticipation of higher real debt service costs.

    I don’t claim that the Fed actually impacts real rates. I actually think the Fed followed rates down and has not raise rates because the market has set the rate at zero, but if their low rate regime is an attempt to get us to spend, couldn’t PZ actually be counter productive? I’ve seen this argument proposed by whatever Fed chief, but if the “powers that be” act in the name of increasing aggregate demand, lower rates do not seem to be the solution. It appears to me that their only out is to inflate away debt, period. The writedown thesis is doa at this point.

    Michael Pettis shows how an authoritative regime can keep bank spreads artificially high while deposit spreads artificially low for an indefinate amount of time, but we’re not China.


    I cannot shake my inflationary bias.

    I still have to bet on the fact that “it” will not happen here.

    I side with Hussman, who contradicts Marshall in his most recent post. In Marshall’s post on The Big Picture he states:

    “All this is accomplished by accounting entries only, but the main point is that spending creates new net financial assets and taxation drains them.”


    I’m taking issue with the creation of new net financial assets. Hussman states:

    “To clarify once again – I emphatically do not anticipate inflationary pressures until the second half of this decade. As I’ve repeatedly emphasized, the primary driver of inflation – historically and across countries – has been growth in government spending for purposes that do not expand the productive capacity of the economy. It does not matter what form the government liabilities take, because default-free government liabilities and central bank notes are nearly perfect portfolio substitutes (though extreme deficits do tend to be monetized eventually). That said, the seeds of inflation can often remain dormant for years before emerging.”
    https://hussmanfunds.com/wmc/wmc100906.htm (to get this link on his site, you have to replace the URL with the correct dates because his link is wrong)

    So point being, spending is still spending and Marshall’s point that debits and credits are no more may be false. I’m an aggregate demand hater.

    And now to the consequences we have to go to the “ATBC” as outlined by Paul Kasriel, giving credence to the theory,


    and ask ourselves, what price are we paying? Since I say deflation is bad, I feel it, I trust Bernanke will not let “it” happen here, I think Marshall is incorrect about his inflation hypothesis in the long run, and I thing the Austrian theory of the business cycle makes sense. Let us see some ATBC framed analysis on where this mess is going, even if we are five to ten years out and we have another commodity and world boom in the mean time.

    Thanks again.


    1. Edward Harrison says

      Hi Scott,

      PZ was a term I did just invent for this post. Maybe it will catch on because I think this could be where we are headed unless we see some serious money printing.

      We are in a liquidity trap because we have reached the lower bound of interest rates. If you look at a formulaic Taylor rule analysis, interest rates should be negative to induce the kind of stimulative effect you see from monetary policy. So zero rates aren’t going to get the job done.

      Eventually, we’ll see deflation unless we get some massive moves on monetary and fiscal policy. That’s when the debtor’s will start to deleverage in earnest. This all means the next recession will be ugly.

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