Thursday, February 25, 2010

Lord of the Housing Market

I came home, opened Bloomberg to see the latest financial news, and found out that, President Obama might ban foreclosures. I was more humored by reading this than shocked, the latter being the likely reaction of the average person who might instinctively just be surprised at the blatant exercise of power (and rightfully so).

The reason I found this to be so funny is because banning foreclosures it not very different from setting a price floor on the price of houses. In economics, we know that price fixing of any kind (price ceilings or price floors) always fails. The reason is because there is a market-clearing price for every good and service, so if you artificially set a price that is either above or below the market-clearing price, you end up with either shortages or surpluses. Price floors lead to surpluses.

In this instant, the surplus we are talking about is in individuals who will want to sell their houses at artificially higher prices. The problem is that buyers will not want to buy the houses at artificially higher prices. They would want to buy them at the lower market price, which is of course why this ban is being instituted in the first place (foreclosures would bring housing prices down).

There is not a single episode in history when price fixing has worked. The most recent glaring example (aside from rent control which exists to this day and causes shortages in housing) were the price ceilings on oil during the 1970s. Not surprisingly, this caused oil shortages all over the country. There is no reason to believe that President Obama will be the first individual in the history of mankind to institute price fixing and have it work.

Market prices exist for a reason, which is to efficiently allocate resources throughout the economy. When prices are manipulated because you don't like where they are, it doesn't mean that your manipulation will be a success (unless resource dislocation is defined as successful). If we do actually end up with a ban on foreclosures we can expect it to take longer for the housing market to recover (which will happen only if and when the price fixing is ceased and the market can clear). Not only will buyers be unwilling to buy, banks will also be less willing to lend since they don't have the ability to foreclose (would you make a loan to someone if his default didn't give you the ability to take ownership of his collateral?). Considering what the administration is trying to achieve in this financial crisis (presumably, a resumption in house purchases and a resumption in bank lending) does this sound like the proper way of going about doing so?