This 18-minute podcast was released Dec. 20, 2019.
“The problem with trying to explain what was the primary causal factor during the ‘40 to ‘60 period was that a lot of things were happening at the same time,” says Don Schlagenhauf, economist at the Federal Reserve Bank of St. Louis. He talks with RC Balaban, digital communications and publications manager at the St. Louis Fed. They discuss Schlagenhauf’s research on the midcentury rise in house prices and home ownership rates and the role of changes in policy, finance, productivity and the purchasers’ income, age and education.
R.C. Balaban: Welcome to Timely Topics, a podcast hosted by the St. Louis Fed. I'm R.C. Balaban, your host for this episode and today we're going to be talking with Don Schlagenhauf, an economist from our Research Division. Don, thank you so much for being here today.
Don Schlagenhauf: Well, thank you for having me.
Balaban: Don, you've recently written a paper co-authored with Carlos Garriga and—
Schlagenhauf: and Matt Chambers.
Balaban: Matt Chambers looking at the house prices and home ownership rates, looking back at the 1940 through 1960 period. What got you interested in this topic?
Schlagenhauf: Well, both of us were very interested in housing, and we had just written a paper about the Great Recession and what happened to housing before the Great Recession. What we looked at was this important fact: During the Great Recession home ownership rates went up 3.7 points, from 64.1 percent to 67.8 percent.
Balaban: So, certainly additional homeowners, but not a large number?
Schlagenhauf: But the impression is it was a boom in housing.
Schlagenhauf: Well, it went up. We also found out prices rise during that same interval, approximately 35%, so we did have a big increase in prices. So, as we studied this, we said, you know, what went on during the Great Depression? What happened between 1940 and 1960? And we just looked at the same facts and we found out the homeownership rate went up 21%.
Balaban: A much larger increase and I believe, if I remember right, most people weren't homeowners at that point and then became a majority after this period.
Schlagenhauf: Yes, yes. So, the home ownership rate went up from 43% to 64% and probably once it hit 64, it was kind of constant until the Great Recession hit. But, before the Great Recession, it was growing a little bit. But, home prices during this period increased 43%.
Balaban: So, an even bigger percentage increase than what we saw coming up?
Schlagenhauf: Exactly. So, we said, well, can we explain this? So, we decided to delve into history. And clearly there were a lot of scholars that said—this is what did it: It was maybe government policy because, between '40 and '60 we had the war and then we rewarded a lot of the veterans with various benefits that allowed them to get into housing.
Balaban: That would be the GI Bill.
Schlagenhauf: The GI Bill. We also had innovations in housing finance, which means the structured mortgage changed a lot. We have things like income went up by a factor of 2.6, so we had a lot of income growth between '40 and '60.
Balaban: So, over this period, people's incomes went up by more than double?
Schlagenhauf: Yeah, they went up. So, you could afford houses. Maybe that was the answer? We had a whole menu of things we wanted to study and see what could explain this.
Balaban: I want to start off with the mortgage structure change first because, my mindset when it comes to a mortgage is, they're just fixed rate mortgages being very common. But, that's not actually the way it was in the period you studied before that.
Schlagenhauf: Between ‘40 and ‘60, mortgage contracts changed a lot, so let's just talk about if you were a homebuyer and you lived in 1940, what was the situation? So, the primary vehicle that you could use to buy a home was very different than the fixed rate mortgages many people use today. They were called balloon contracts.
Schlagenhauf: Well, a balloon contract says you put 20, 40, 50% down. So, a large down payment. And then you have 10 years to pay off that contract. Now, that contract does not generate equity in your house. Like, when you pay for a home today and you have a fixed rate contract, what happens? You pay the lender an interest portion, and you also pay for the fact that you own part of the home now, over time. But in the ‘40s, the primary contract available was this balloon contract which meant that if you didn't have the money to pay it, you had to take out another loan. And you didn't become an owner and generate equity until you owned that home outright.
Balaban: So, you would have a large down payment and then you'd be making—
Schlagenhauf: Interest payments.
Balaban: . . . interest payments and then you'd owe the balance at the end of that loan or you'd have to take out a second one?
Balaban: And, so then, what does the research show? Like, how much of a factor was that in the increase in the home ownership rate and house prices?
Schlagenhauf: What we find is that housing finance probably accounted for between 5 and 7% of the increase in home ownership rate between '40 and '60.
Balaban: So, a notable increase but certainly not explaining the entire range?
Schlagenhauf: Doesn't explain—no, no.
Balaban: And then for house prices?
Schlagenhauf: We had house prices change not a lot. Well, we just put in the different type of mortgage contracts, and then the model says, what happens, right? We only change the mortgage contract, and what we got, there was maybe a 2% increase in prices. So, we didn't get a big increase in prices. Mortgage contracts did not help us explain the big run-up in housing.
Balaban: This would have been around the time that you would have seen the baby boom, the generation we're now referring to as the Baby Boomers. So, how much of a role has the literature said—the demographics have played in the run up in house prices and home ownership?
Schlagenhauf: Well, there are articles out there written by demographers who argue that the run-up was primarily driven by just changes in the demographic structure in the economy. So, we studied that. We put in what the demographics were in 1940, what the demographics were in 1960, and said, how important was it?
Schlagenhauf: Now, let me embellish it a little bit. What we do know is that there were a lot of people in the age cohort, say 38 to 47, that were buying homes in 1960 in this period.
Schlagenhauf: Why? Because World War II came along and a lot of people had to serve in the war—
Schlagenhauf: . . . they came back from the war and they were a prime home buyer age.
Schlagenhauf: So, there's a lot of feeling by demographers: Game over, that's the explanation. So, that's exactly what we did, we changed the demographics that existed in '40, kept everything the same in 1940, but put in the demographics in our model for 1960 and low and behold, what do we find? Demographics can account for 5 to 8% of the increase in home ownership. But, what about prices?
Schlagenhauf: It can explain about 1 or 2% of the increase in prices. So, you know, there's a contribution of home ownership but maybe not a big contribution or an explanation for why demographics didn't explain the price increase.
Balaban: And then one other one I wanted to cover was just the fact that income rose significantly following the war. So, I believe you said it went it by a factor of about two and a half times, correct?
Balaban: Okay, so it stands to reason that you have more money coming in, people who may not have been able to buy a house before, now can. So, what has the literature said about income going up affecting house price and home ownership?
Schlagenhauf: Certainly. There's literature out there by economists that will argue this is a simple question to answer: It's just, income went up.
Balaban: It's amazing how many of these are simple questions that people can answer, isn't it?
Schlagenhauf: Yeah. However, we looked at our model. And, in fact, we went into more detail, we just didn't put a big income growth in the model and say, what does the model generate? We also know that income depends on education. So, education policies were, after the war, to stimulate more higher education degrees.
So, our model allows workers to have different levels of education. So, we combined both education and just a demand for workers increasing and say, what happens?
Schlagenhauf: And there what we find is that income can range anywhere from a 12% explanation to a 57%. So, the range is quite large.
Balaban: For home ownership or house prices?
Schlagenhauf: For home ownership.
Schlagenhauf: For house prices, we only get between zero and 1%.
Balaban: So, again, we're seeing one of these factors being a run-up in the home ownership rate, but just not explaining very much of the run-up in house prices at all?
Schlagenhauf: You're exactly right.
Balaban: So, what is it that's caused the run-up during this period? It certainly doesn't seem to be these factors; it's certainly not related to house prices going up.
Schlagenhauf: So, that's exactly the question we thought about. What we learned is that, to explain house prices, you've got to think about the fact that houses are constructed in the construction sector with land.
Schlagenhauf: Well, goods are constructed in another sector which economists call "the goods sector" not surprisingly.
Schlagenhauf: And, so our model has these two sectors and we looked at the data, and the amazing thing was that productivity gains in construction, while going up between 1940 and ‘60, paled in comparison to productivity gains in the goods sector. And one of the reasons is during the war there were a lot of innovations that were discovered. So, what did that mean? Those innovations benefited proportionately more—the goods sector—than the construction sector.
And the key was, that not only did productivity go up in both sectors, but the productivity changed in the two sectors. It grew faster in the goods sector than in the housing sector. So, even though housing prices went up, the people in the goods sector, income grew much faster; they could afford these houses.
So, as we worked on this project and we realized there was this relative productivity change, biased toward consumer goods and not housing. When we studied this and put it in the model that was the key to explaining home price increases. The fact that we had one sector being more productive and not having the big price increases, income growing compared to the construction sector. That was the key to being able to explain why we had this big change in prices at the same time the home ownership rate went up.
Balaban: I'm just curious, does it say anything about house size in there? Because, another implication is, if somebody was able to buy a house before but their income has gone up quite a bit, in theory they should be able to buy even bigger houses.
Schlagenhauf: Yeah, our work accounts for that. So, let me give you some background. So, in 1940, homes were smaller. How small? Well, the average home was between 600 and 800 square feet. My apartment right now in St. Louis is 1,000 square feet. So, I have more square footage than the home owner back in 1940, or the average home owner.
Our model generates, for 1940, small houses about that size. So, now we have all these factors that have occurred between ‘40 and ‘60—income, some of them; government policy changed. What were the homes look like in 1960? Well, now the average home grew to 1,000 square feet. So, the model generates there will be an increase in expenditures. Partially, it’s what you said: because of more wealth, more income and they can buy bigger homes. But, the home in 1960 pales in what people are buying in these days. Homes have more land, and homes are much bigger in square footage. I recall my first home when I was just starting out had 2,000 square feet in 1970, so, yeah, homes have increased in size. And that's related to income and some of these other policy effects.
Balaban: So, based on your findings here, what questions came up as you did this research, as you got into the reasons for the run-up in house prices and home ownership rate during this period? What's basically the next line of questioning that comes out of this?
Schlagenhauf: What we would like to think about next is, let's think about the current home ownership rate situation in the United States and what's happening with prices. And we know that prices have gone up a lot in housing since the Great Recession.
So, the question is, here we have a model that's able to answer questions and includes land, includes structures in the formulation, so the question is, can we take this model now to individual cities and see whether this model helps us get insights on what's going on maybe in San Francisco or Seattle and how does it compare with St. Louis? Where we know land is at a much higher premium on the West Coast or on the East Coast than it is the Midwest. How important, really, is that in explaining what's happened to house price movements since the Great Recession? That's one of the things that might be interesting.
Balaban: Sure. So, being able to take a look, because obviously we hear stories about some of these housing markets. I'm not even sure the word "hot" describes it accurately. They're so expensive, prices for houses just seem to be going up considerably. You've got the potential here is to use the model to see why exactly they're so hot.
Schlagenhauf: Not only why they're so hot but there's another dimension. That the question is, what does the model say about rents? Because we know in San Francisco the people are saying we can't afford to live there. We can't buy a house and we can barely afford to live in an apartment. So, does the model generate that behavior? Does it generate a housing price rent ratio for San Francisco when we put the facts in for San Francisco and we run it for St. Louis with the environment in St. Louis? Can we explain the price rent ratio, and how does it vary over parts of the country?
Balaban: What are some takeaways for Joe or Jill Homeowner out there? We're looking at this period where we saw a tremendous increase in home ownership rates and in house prices going up, and of course the natural thought process is, well, what lessons can we learn from that?
Schlagenhauf: Well, I can talk a little bit about my own experience.
Schlagenhauf: So, I got my first job in Phoenix, Arizona, and the salary wasn't very high, I was an assistant professor. Of course, inflation wasn't real high back then, either. And I'm a very conservative type. I go, oh boy, I've got a kid, I'm married, I'm buying my first home and I said, well, I don't want to take any exotic mortgage out. I want to know what my commitments are going to be. And what was critical in my thought of buying a home was that I thought of the economic environment I lived in. What did I know about Phoenix? It was a booming area.
Schlagenhauf: So, I knew I had a job for seven years, so I had some job security for seven years. And I thought, well, I can buy, not a big home, I think it was a little over 2,000 square feet.
Schlagenhauf: So, it wasn't a big home. And what I can do is, I can make my payments and I know if I have to leave Phoenix for some reason, then I should be able to sell it. And I went and bought the home, pretty young in my career, my first year on the job there I bought it. But I knew the market. I knew the market was going up.
Schlagenhauf: I knew that house prices were going to go up, so I felt more secure making the investment, and I knew my job was stable for seven years.
Schlagenhauf: So, given those facts, I bought and it turned out to be a very wise purchase because home prices did go up in seven years. Now, if you take St. Louis, what do we know? Home prices are going up now but will they continue? Historically, they've grown slower than Phoenix.
Schlagenhauf: And I think the data shows now they're slowing now. So, when I see that I have to think about the fact that what type of job do I have? Is it riskier than what I had? If so, you have to factor that in. And it depends on your own risk preferences.
Schlagenhauf: But I think it's important that you not take contracts that were offered prior to the Great Recession where you had these step-ups in payments. That's risky. So, being a conservative type, I prefer fixed rate mortgages. Especially as I'm a first-time buyer because I know what my mortgage commitment is. And you have to factor in: How safe is your income stream?
Schlagenhauf: These are all factors that should be considered seriously that the Great Recession says a lot a people didn't think about seriously, for whatever reason. I think that's the way you should think about buying your first home.
Balaban: Don, what is it about your model, your research, that's different than what's been done previously because this has been something that's been studied considerably over the years?
Schlagenhauf: Yeah, that's a fair question. I think the difference is how we drive everything off a model. Now, I'll explain that in a second. The problem with trying to explain what was the primary causal factor during the ‘40 to ‘60 period was that a lot of things were happening at the same time. So, traditionally, researchers were using traditional regression approaches to try to measure, but they were studying one factor while other factors were changing at the same time. So, what a lot of current, modern macroeconomics does is say, we appreciate regression approaches, they give us information, but we'd like to study a model where people, a variety of different people, model people we'll call them, make decisions based on their income, based on their age, based on their risk preference, there's a whole variety of things. We assume they try to make the very best decisions they can, and we study their home ownership purchasing behavior—but we study it for all different types of people who have different income, different ages. There's a lot of heterogeneity in these models.
Schlagenhauf: We solve the model—we get a solution under a given set of circumstances, say 1940, and then we run the same model with the 1960 circumstances and see if the model can explain what happened in '60, and home ownership rate and prices and what happened in '40 and home ownership rate. If we can, then we have a mouse trap, or a model, that will help us analyze these events. We put one event at a time, solve for a new equilibrium and say, what does the model predict? The importance of such a factor.
Balaban: So, Don, thank you very much for sharing your research with us here today. I really appreciate your time.
Schlagenhauf: Thank you for having me.