Modern Monetary Theory (MMT) and Housing Prices
In our prior piece, “U.S. home price growth since 1984: What are its sources and can it continue?”, we explored the drivers of housing prices over the last 36 years and concluded that falling interest rates and inflation have been the main drivers of housing price growth. However, using traditional economic policies, it appears increasingly unlikely that these trends can continue. Due to this reality and other factors such as the anemic wage growth over the past ten years, and the current high levels of unemployment due to the COVID-19 pandemic and recession, a new economic theory has been gaining momentum among policymakers in this country. This new economic theory is called Modern Monetary Theory (MMT) and it has taken the economics field by storm.
In traditional economics, government spending is seen as being like a household budget, where a budget should aim to be balanced and that increased spending in one area must be matched by cuts in another. Therefore, it has been viewed that treasury bonds, that must be bought to fund government deficits, compete for scarce supplies of capital, and drive-up interest rates, which could end up hurting the economy. MMT takes a vastly different viewpoint, as it sees fiscal policy as being similar to monetary policy, in that it is a way to add or subtract money from the economy. In other words, government spending and taxes are simply levers to throttle up or down the economy and do not need to be balanced, even over the long-term. In theory, this means that unlimited deficit spending can be had if metrics such as inflation and interest rates remain at similar rates that they are today.
How does this relate to the housing market though? Let us take a brief look at how MMT, if it continues to gain mainstream status, could affect housing price growth moving forward. Many different factors determine the price for residential real estate. On the demand side there is the amount of money that can be dedicated to real estate expenditures, primarily in the form of income for individuals, and the cost of debt (i.e. interest rates). According to traditional economics, increased deficit spending by governments, especially the federal government, will increase interest rates as the government’s need to finance that debt creates more demand than current supply of capital. Increased interest rates lead to a decline in price growth, as the same dollar of debt service covers a lower starting principal amount at higher interest rates. However, as we see in Figure 1, the opposite has been occurring as the real cost of debt has become substantially cheaper over time, and is now negative. This has also been seen in other countries around the world, such as Japan, which has run large deficits with persistently low inflation. Traditional economists were wrong about this because the United States has a fiat currency, which means that demand for debt is essentially unlimited, so supply of debt in the market can never actually rise to a level that causes interest rates to rise. If this were not the case, MMT would not apply.
We will now explore the second demand side factor of housing price growth, wages and wage growth. Deficit spending by governments creates economic activity in the form of higher income for potential homebuyers, a relatively fixed portion of which people will likely be spent on real estate. As seen in Figure 2, the federal deficit is becoming an increasingly larger portion of annual GDP growth in the United States. If Congress seeks to aggressively work towards balancing the federal budget, like it did early in the last decade, it will cause a rapid fall in GDP, and therefore lead to a fall in incomes that would likely lead to less money being spent on real estate. This of course would lead to a fall in prices in turn.
Another driver of housing price growth has been inflation, which can have a demand and supply effects. On the demand side, when demand for labor or materials is higher than the supply, prices rise. This inflation can be continuous because the supply of money can increase to allow the higher prices. On the supply side, when the supply of money increases, its value decreases. The erosion in the value of each dollar is known as inflation. Rapid inflation is a large concern though, as the Federal Reserve has a stated target of 2%, and based on implied inflation rates from the bond market seen in Figure 1, investors seem confident they can meet this goal moving forward. However, we also see that investors are not worried about the large increase in monetary supply eroding dollar value, as implied inflation still sits slightly below 2%.
While the U.S. currently has a Debt to GDP Ratio at levels only seen at the end of WWII, according to Modern Monetary Theory, the government can continue to power the economy through deficit spending, and that this does not pose a risk of substantially raising interest rates. Additionally, this additional government spending will cause household incomes, and inflation, to rise to moderate levels targeted by the Federal Reserve. Countries with much larger government debt to GDP ratios than the United States, such as Japan, have shown that when a government controls its own currency the amount of debt it can issue is extremely high. Therefore, as the U.S. adopts fiscal policy more resembling MMT, we can reasonably expect the price of residential real estate to be able to continue to climb in the coming years using this framework.
If you are looking to know how macroeconomic conditions and policy will affect your real estate investment decisions, please reach out to us at Hilgard Analytics to see how we can meet your needs!
About the Author
David Rosen, a Real Estate Research Advisor at Hilgard Analytics, has a proven track record of success in the real estate and automotive industries and currently works full-time at Mazda (North America) as a Senior Analyst in the CPO Repurchase Promotions Department. At Mazda, has has become a leader in terms of providing excellent customer service, advising management on various regulatory issues, and vehicle lifecycle management.
David is also the Founding Partner of a real estate investment company specializing in repositioning distressed assets in walkable communities that exist in America’s most underinvested in neighborhoods. He has a lifelong desire to make the cities we live in more equitable and prosperous and has the ability to generate unique insights from his background in data analytics and knowledge of architecture and urban planning.
He holds a Bachelor’s Degree in Finance from California State University, Fullerton and an MBA from the UCLA Anderson School of Management.
