Government’s Role in the Housing Bubble

There are many people who see the housing bubble as primarily a government creation. One tool in that argument that the interest rate deduction we give on taxes, where you can write off the interest you pay on your mortgage on taxes, was a culprit. From The Wall Street Journal:

The idea that home ownership confers special benefits on American society is deeply embedded in our culture—so much so that our national tax policy confers a special benefit of its own on it. Home ownership is granted an advantage over all other forms of ownership in the form of an enormous deduction on the interest payments most individuals incur in financing their homes. Nothing else in the tax code comes anywhere near that deduction in scope or size….

After 2000, the national push toward home ownership intensified in three dimensions, leading to a doubling of housing prices in just five years’ time. First, the Federal Reserve Board’s interest-rate policy drove down the cost of borrowing money to unprecedented lows.

John Makin wants to argue that the housing bubble was inflated because the Federal Reserve decreased interest rates, and because we offer a special tax bonus that allows you to deduct the interest you pay from your taxes. I think Arnold Kling has made this argument. So have a lot of other people on both the left and the right. What I want noted is that these run in opposite directions. In so much as the bubble was inflated by lower interest rates, the tax benefit towards interest on housing should have slowed down the housing bubble.

What? How? Very simple. Let’s say it is Scenario A, 2000, and you want to take out a $200,000 mortgage. The yearly average for the 30-year mortgage rate in 2000 is 8.06%. The accountant you are talking to tells you that your monthly payment will be $1,475.

Suddenly you blink, and it is Scenario B; it is 2004, where the yearly average is 5.841% on a 30-year mortgage. Now your accountant tells you your monthly payment will be $1,175. You tell him “I want to keep my monthly mortgage payment at $1,475; how much housing can I get?” (What’s the new NPV?) He clicks excel and tells you $251,019, and you take out that mortgage. You are willing to pay 25.5% more. (The percent numbers are the same regardless of principal amount.)

Now notice something – your monthly payment is just principal towards mortgage and a tax-deductible interest payment. Since you are making the same payment in each payment, and paying off more principal in each payment, you must be paying less interest in each payment. The housing interest deduction was already in your valuation when you originally wanted the $200K mortgage for the interest you were paying in Scenario A. Now you are getting more house but paying less interest – so that deduction is a net loss in the switch between the scenarios.

So taking the difference between the interest paid in the two scenarios, adding them up every 12 months and multiplying by a third to get an approximate tax benefit, and then discounting at the new interest rate (work here, in google spreadsheet), you are now willing to only pay 21.5% more.

The cool thing is that it probably did stoke up people to leverage more between Scenario A or Scenario B, but that requires some sort of bad mental accounting or behavioral financial mismanagement in order to to make the books proper. Mind you, I think there are good reasons to get rid of the interest rate deduction, and I don’t think it would be very harmful for the economy.

To finish the picture, there was also a tax cut during the Clinton years where sales of houses were not taxed as capital gains anymore. Before they could be taxed at up to 20% like stocks, etc. So I add another piece to the NPV calculation, where principal payments are multiplied by 1.2 in every period and discounted, without adjusting the interest. This feels most generous; it wouldn’t necessarily apply this way to everyone, but I want to make the strongest claim – this, with the interest rate deduction, brings us to an overbid of 29.9%

So in hyper-rational perfect strokes from textbook consumers world, the government intervention at best can justify a housing price jump of 30%. According to the latest Case-Schiller city composite 20 is up 106% during the time period in question. We are going to need more than just blaming the government.

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3 Responses to Government’s Role in the Housing Bubble

  1. Pingback: Fancy Fast Food « Taunter Media

  2. Ted K says:

    Amazing use of numbers as usual Mike. Really. If you apply your gift with numbers to stocks you’re going to be our next Warren Buffet. Get on the gravy train dude. God gave you a gift Mike, hope you use it for more than educating people on your website (although I’m grateful for this site).

  3. sajal says:


    Nice analysis. Thanks,

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