Adam Tooze on Gridlock in the U.S. Housing Market & Brazil's Elections | Ones and Tooze Ep 262

Hi Cam.

Yeah, I mean, a term which seems to be commonly used by analysts is freezing up or it's frozen. I mean, I think you captured it very well. The mortgage rate, as you say, is over 7%, which is lower than the 7.7 rate that was hit in 2023 when inflation spiked. But the crucial point is that as recently as 2022, you could get a mortgage in the US, the very beginning of 2022, that is, you could get a mortgage for as little as 3%, and during COVID it fell even lower than that. That's a 30-year fixed rate mortgage of, you know, less than 3%. So this is a huge financing shock. An increase in interest rates from three to over 7% is a huge financing shock to what is, as you already hinted, the largest single asset class bar none in the world. You know, we talk a lot about US treasuries on this show because that's a $40 trillion asset pool. American domestic real estate, so housing, is 55 trillion, of which owner-occupied is 48.7 trillion. So this is flat out the single largest element. If you add in commercial real estate, it's 26 trillion. So for the financing costs on a market that large to shift as much as this is a story, you know, that ought to rank alongside the treasury story in terms of its macroeconomic implications indeed, because it impacts households and therefore else and tax consumption. It in some senses is a more direct impact on people's lives. Indeed, another way of describing this is that this is another aspect of the cost of living crisis and conversation that's been going on in American society as it has in so many others in recent years and particularly since COVID. And it's also a K-shaped story. So it's a story about the division within American society at its most elemental level, namely, you know, what do you pay and how do you finance your home? So American mortgages are very peculiar beasts by global standards in that they offer fixed rates for very long periods of time, but with the one-sided advantage to the benefit of the borrower that they can refinance whenever they like, essentially for relatively modest costs, and it's a normal thing to do. And so what happens is that when interest rates fall, people who are well organized financially refinance their mortgages. So currently about 50% of American mortgage holders are locked in on 30-year interest rates which are less than 4%. So incredibly good financing given that the inflation rate in the US is currently ticking along at 3%, right? So half of that population is locked in, and for them to consider moving, they would then have to refinance, presumably if they're moving up the chain, more money at a rate which was not 4% but 7%. So it's incredibly off-putting. But even over the period of the last 12 months, if you had taken out a mortgage 12 months ago, over the lifetime of a 30-year mortgage, your interest costs would be tens, if not hundreds of thousands of dollars lower than they are right now. So you can see why from that side there is a real freezing pressure going on. So what's happening is precisely what you described, namely a contraction of the overall market. A market economist would say, well, you know, the way this works is if demand falls, the price should fall. But the problem with the US housing market right now is that structurally, if you look at households formation as compared to new construction of buildings, there's a deficit, a fairly substantial deficit. And so prices are remaining stuck high. But even at those prices, not many people are actually willing to sell because of the refinancing cost when they move into a new property. And the entire market is in this sort of frozen state. There were periods in the early 2000s during the real estate frenzy before the 2008 crash where house sales were running at the rate equivalent to 7% of households. So real considerable churn. Not all of those, of course, were properties that people lived in, but nevertheless it suggested a very large mobility. That rate is half or less than half that currently. So we really are talking about a kind of deadlock.

Yeah, it's actually almost important to emphasize that, I guess, for people who are not in the United States. I mean, I remember growing up in the US, I was told it was important to get a credit card in order to build a credit score so that you could buy a home later. I mean, like this chain of financial steps that is just kind of taken for granted in the United States is not something that necessarily is even legible elsewhere. But to get back to the specific scenario in the United States right now with the interest rates increasing, I'm curious why that's the case because there's a lot of talk about the Iran war leading to inflation leading to the need for higher interest rates, but this doesn't seem to be an oil story. I mean, the price of oil is steady right now, and yet interest rates are continuing to go up. So is this about a broader growth story in the United States that is sort of producing increased interest rates, sort of overall economic growth, a labor market seems to be picking up. Is that what's going on here?

Yeah, there are a variety of contending stories about these interest rates. This is one of the things that folks maybe outside the financial markets don't appreciate. Something we come back to over and over again on the pod, that the fixed income, so bond issuance, because the mortgages are ultimately refinanced through bonds which are issued by banks, mortgage banks or Fannie Mae and Freddie Mac overwhelmingly, and so this then becomes part of the pool which sits directly alongside US Treasury debt. And what determines those interest rates, those yields, in other words, the relationship between the price that you pay for the bond and the underlying flow of income you derive from it, is determined by this complex array of factors which provide the stuff of endless conversation about the economy much more than, say, chat about how Apple's doing or Nvidia, which is really the stock market story. The macro story is dominated by the questions you've just raised. And so there is, you know, the possibility that this is to do with particular supply shocks and therefore pressure on prices, which one could generalize to a more general story about a tendency in the modern economy to supply shortage which tends to drive prices up. Right? It could be, on the other hand, a growth story, an excess of demand story, which would be AI in the American case with huge volumes of new debt being issued and rapid growth. Then of course there's the fiscal conversation: is the problem ultimately the American government is issuing too much debt? And then there's the drama of the Fed and, you know, who's in charge of the Fed or what we think Fed policy is going to be, and because the Fed has a huge say in the long-run development of long-run interest rates in particular. And all of those kind of drama narratives are out there right now. I think the smart money currently is to say, yes, there's structural pressure from price shocks. Yes, there is also structural pressure from very large government issuance. But the more likely force driving this right now is some sort of story about the relative robustness of the US economy. And that actually is sustaining a lot of economies in an updraft currently. We're not in a deflationary moment by any means. And then furthermore, there has been a substantial shift in the market's assessment of the likely reaction function of the Fed. Last year still, the markets were betting that we would see multiple rate cuts by the Fed to address a slowdown in most of the American economy. Now after the display of bravery by Walsh and the Fed leadership, markets are pricing in two increases in interest rates from the Fed side for the rest of this year. So that's a huge shift. And when you put all of those factors together, you know, some people will say, well, this is really alarming and this may produce instability as hedge fund strategies unwind and we're back to the Treasury market story. But a calmer assessment would simply be, well, this is exactly what you would expect to see interest rates doing in an economy with 3% inflation currently that seems to be running hot and where all of the taps are on. So this is exactly what fixed income markets ought to be doing and mortgages are part of that giant pool. It is the logic of this lock-in effect that generates particular issues and the fact that there has been under-construction of housing, but it's not in and of itself a sign of anything disastrous happening here.

The way I would think about this is not through a kind of, you know, piggy bank of money that has to go either to houses or to AI and then say, well, AI is somehow crowding out housing. I, you know, the volume of debt issuance by AI is now large enough to be up there with, say, treasury issuance in certain categories. So it's certainly a big factor, but an awful lot of that is being generated essentially by credit creation within the financial system itself. And so that's the connection, which is that this boom in financed leveraged investment in AI is creating a hot economy to which the Fed then responds by raising interest rates. And so then within the general kind of undulating, quite kind of baggy economy which isn't tightly constrained by a pot of money which has to go one way rather than the other, but is this kind of, you know, expanding kind of liquid balloon kind of structure of credit as the hot bit drags the entire economy forward and the Fed responds to that, the slower moving bits are squeezed. And that is what we are seeing. So the interest rate for the housing market would probably, the equilibrium interest rate will probably be lower than it would be for the AI-driven economy. And so the Fed is caught between one and the other. And we're seeing this very severely in the supply side. So in the construction of everything other than data centers. So data center construction since the end of 2023 has increased at an annualized rate. So if you add up what they do per month and you multiply it by 12, we've seen a $50 billion increase in spending on data center construction and we've seen a $120 billion collapse in the construction of absolutely everything else. And that's exactly what you would expect in this kind of, you know, kind of ooze model of the economy where the bit that's growing fastest is dragging policy into a higher interest rate level which the AI sector can absorb, has to absorb because they're so obsessed with speed. They have to move forward on this. Whereas everyone else in every other bit of the construction economy is just going, well, you know, in due course we'll do that project, but now at 7% plus interest rates is not the moment to do it. That all gets deferred. So I would put it in that kind of way. It's more a macro crowding out, if you like, and it's not even, I don't think, direct competition for workers because the people who build data centers are not the people necessarily that are building housing, but it's an effect by way of the interest rate which is being set to suit the AI economy or slow it down but is squeezing the more fragile bits of the economy.

No, this is why I think frozen or kind of a kind of like a, it's like because frozen implies like low pressure whereas this is a sort of high pressure impass, like gridlock if you like would be a better description. Just to be clear, we are not talking here about a late 2008 overheating bubble type scenario, right? That's not on the cards here. We're talking about a kind of gridlock created by the lock-in effects of the very low mortgage rates in the past. And the supply side issues. And it's very striking, JP Morgan has done research looking at housing markets regionally, right? Rather, because America's huge, 330 million people, lots of different separate housing markets. People are relatively mobile, but not as mobile as they once were. And so each one of these has a separate logic. And to go back to your point, I thought there was very interesting and provocative, like how can one think about housing as industrial policy. Maybe not as industrial policy, but definitely as policy. And there is huge variation between blue states notoriously and red states. This is the whole abundance debate and JP Morgan, which no doubt you know, sides with a vision of abundance which is driven by deregulation and so on, has produced a lot of rather interesting data showing that if you want to see American housing markets which are not in gridlock, where there is in fact rapid movement, where market mechanisms are working, where prices are coming down and the market is reviving, look to the red states where there is very rapid economic growth supporting everything and very, very rapid construction of housing. Notably Florida and Texas. And if you look at those two growth drivers of the, you know, the new South in America or the new new South, there the housing market is not frozen in the same way as it is in the hotspots, say, of California and the United States where you've got these massive lock-in, sorry, California, New York, where you have these massive lock-in effects on the coasts. So this then comes back to this other theme. So, you know, this housing market is fascinating because it's a story about society. It's a story about fixed income. It's a story about macro policy. It's a story about the cost of living. And it's a story about this abundance agenda ultimately, right? Everything is bundled up there. And the red states demonstrate what a minimally regulatory regime, which is a, let's not call it industrial policy, but like a growth regime or a construction regime, looks like. And it does indeed produce the kind of market mechanism of adjustment that you would like to see. But it involves, you know, the building out of strip suburbs, identical buildings, which are clearly not suitable for urban spaces like New York, and run up against local political opposition in California. So that's part of the answer. And emphatically, no, we're not on the cusp of a, you know, an '07-'08 type subprime meltdown. It really is, it's kind of like a gridlock. I think in the end is the best image that's come out of this conversation, better than frozen even, because gridlock implies everyone wants to actually go somewhere but they can't move, and that's a little bit where the American housing market is at, actually.