House Prices in Free Fall

The latest house price data (the S&P Case-Shiller index) shows a clear downward trend for the most recent six months, as shown in the graph below:

The next graph shows how this year's data fits in with the long-term trend.  It is clear that the house price bubble, which began in 1997 and peaked in 2006, has not yet finished popping:

How We Got Here

The black stars in the above graph highlight 1951 and 1997, the two years when Congress changed how the capital gains tax applies to home sales.  The first change produced 46 years of wealth accumulation.  The second change produced 9 years of rising house prices and living beyond our means to be followed by about 9 years of belt tightening and economic stagnation.

In 1951, Congress, at the urging of President Truman, instituted the roll-over treatment for taxation of capital gains from home sales, an economically sound treatment of capital gains.  As a result, from 1951 through 1997, whenever a homeowner sold his or her primary residence to buy another residence, the capital gains tax was deferred, not forgiven.  In technical parlance the gain was rolled-over until the new home was sold.  Homeowners would typically build up their equity in one home, sell that home, and then use their savings to make a down payment on a larger home. During that period, there were large changes in interest rates, yet real home prices were quite stable.

In 1997, a foolish Congress, at the urging of a foolish President Bill Clinton, eliminated the capital gain tax on homes sold by most homeowners.  This change immediately stimulated the housing price bubble.  It told speculators that the capital gain that they would earn would be tax free if they bought a house in the expectation of a rise in its market value and sold it at a higher price.  Under the new provision, almost anyone who had lived in a house for 2 years of the past 5 years could sell the house free from capital gains tax.  The new policy encouraged people to gamble on real estate.  They saw that houses were going up in price year after year.  What an easy way to make money! 

Here is how Kenneth Harney (2008) described how the 1997 tax treatment encouraged speculation in a Washington Post article about Congress's 2008 attempt to tighten its provisions:

[Property owners] can claim the exclusion [from capital gains taxation] even if they convert an investment property or vacation house into their principal residence and live there for at least two years. This flexibility has been a boon to many tax-wise owners of multiple houses -- particularly during the bubble years when values doubled in some parts of the country.

Property owners in markets with high appreciation rates could sell their principal residences for hefty profits -- pocketing the first $250,000 or $500,000 tax-free -- and then move into their rental condo or vacation property for a couple of years and repeat the process.

In effect, it was a form of financial alchemy where taxable profits could be magically transmuted into tax-free gains -- at least up to the $250,000 and $500,000 limits.

The housing price bubble had other contributing factors, but Vernon L. Smith, a Nobel Prize winning economist largely due to his study of economic bubbles, held that it was primarily caused by the 1997 legislation.  He pointed out that, at the time it was enacted, the 1997 legislation was quite popular among the industries that were most severely hurt when the bubble burst.  He wrote, sarcastically:

Thank you President Bill Clinton for your 1997 action, applauded by the banks, the realtors and all citizens in search of half-millionaire status from an investment they could understand and self deceptively believe to be low risk; thank you for fueling the mother of all housing bubbles; thank you for enabling so many of us who bought second or third homes, and homes before construction began, which we then sold to someone else who dreamed of riches from owning homes long enough to sell to another fool.

Smith argued that, instead, Congress should have kept the rollover treatment for house sales while switching all other capital gains taxes to the rollover treatment.  Specifically:

More daring than the action to exempt real estate from the capital gains tax -- and in lasting service to the poor -- would have been actions allowing capital gains on all assets to go tax free, provided that the capital was reinvested -- i.e., not consumed, and yes, good citizens, housing counts as consumption.

While house prices were rising, homeowners depleted their savings, leaving them with less money for a future down payment.  Tyler Cowen (2008) described this psychology in a New York Times commentary:

The fundamental problem in the American economy is that, for years, people treated rising asset prices as a substitute for personal savings. The thinking went something like this: As long as your home's value rose every year, you didn't have to set aside so much from your paycheck....

In fact, people did more than stop adding to their personal savings.  They began subtracting from their personal savings.  As documented by Louise Story in the New York Times, bank advertising campaigns encouraged people to consider the rising value of their homes to be income, to be consumed in the present.  They urged homeowners to take out second mortgages on their homes so that they could increase their current consumption and coined the new term "equity access" to replace "second mortgage."  Borrowing on home equity increased steadily.

Where We are Going

In June 2006, house prices peaked as supply increased faster than demand and the housing price bubble stopped expanding.  Starting early in 2009, the Federal Reserve, Congress, and the Obama Administration spent hundreds of billions of dollars trying to keep house prices from falling.  They subsidized first time home buyers, bought mortgage-backed securities, subsidized mortgage buyers, and took other measures.  Apparently, these subsidies only slowed the fall in house prices.

If current trends continue, real house prices (house prices after subtracting inflation) will likely lose about a quarter of their real value over the next 4 years.  If inflation continues at about 2%, this would produce a four year fall in actual house prices of about 4% per year.

It may soon become clear that the Federal Reserve and the federal government wasted hundreds of billions of dollars simply to delay an inevitable fall in housing prices.  Economic historians may compare their policies to the pervasive price subsidies that eventually bankrupted the Soviet government.

What We Need to Learn

You'd think that economists would understand what was happening at the time, but as recently as September 2005, Charles Himmelburg, a senior economist at the New York Federal Reserve, co-authored a NY Fed staff report and an NBER working paper which claimed that there was no housing bubble.  (You really have to read this to believe it.)

The truth is that the expected profit from selling an asset only plays a temporary role in the pricing of an asset.  In the long-run, the value of any asset is the value that the market places on the expected return that it will provide over its life.  As far as stocks and bonds are concerned, the expected return is the expected after-tax dividend or interest.  As far as houses are concerned, the return is the rental value of the home after subtracting real estate taxes.  (See our book, Trading Away Our Future [Ideal Taxes Assn, 2008].)

When President Clinton proposed exempting capital gains taxes on sales of houses, Gene Sperling was the Director of his National Economic Council.  On January 7, President Obama picked him for the same position in his administration. 

But the Democrats are not the only ones who seem never to learn from their mistakes.  Back in 1997, congressional Republicans thought that lowering capital gains taxes encourages investment.  They still think so.

The truth is that lowering capital gains tax rates or exempting capital gains from income taxation encourages speculation and capital consumption, not investment.  On the other hand, switching to the roll-over treatment for capital gains on sales of houses, or stocks and other securities for that matter, encourages wealth accumulation.

The authors maintain a blog at and co-authored the 2008 book Trading Away Our Future: How to Fix Our Government-Driven Trade Deficits and Faulty Tax System Before it's Too Late, published by Ideal Taxes Association.
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