Existing Homes Plunged 27%… How Could this Happen?

The AP reports today that sales of existing homes plunged 27 percent, despite the lowest mortgage interest rates in history. How could this happen?

Part of the Obama stimulus package was a tax credit for homeowners who purchased homes within a stated time frame. The credit has now expired. Economic theory predicted the program would be a failure on its own terms and it was.

Housing is a durable good and the stimulus in effect was a one-time income transfer program. What does economics tell us that individuals do with transitory additions to income? They save most of it. Because of the way this particular program was structured, the saved in the form of a durable good, that is, housing.

No permanent demand for housing was created by the program. The accelerated purchase of homes had to come at the expense of future sales. Instead of stimulating the demand for housing in the future, the program depressed it. Thus it was a failure on its own stated terms.

What of the other part of the story: declining home sales despite low mortgage rates? The demand for housing finance is a derived demand. If the demand for housing is depressed, so too will be the demand for housing finance. Hence, mortgage interest rates will fall.

The AP writer was apparently perplexed by this because he has made an elementary mistake. He confused demand and the quantity demanded. The reporter can be forgiven confusion on this point, but not so Obama’s economic advisers.

About Gerald P. O'Driscoll 16 Articles

Affiliation: Cato Institute

Gerald O’Driscoll is a widely quoted expert on banking and monetary policy. Previously the director of the Center for International Trade and Economics at the Heritage Foundation, O’Driscoll was senior editor of the annual Index of Economic Freedom, co-published by Heritage and The Wall Street Journal. He has also served as vice president and director of policy analysis at Citigroup, and vice president and economic advisor at the Federal Reserve Bank of Dallas. He has also served as staff director of the Congressionally mandated Meltzer Commission on international financial institutions.

He is widely published widely in leading publications, including The Wall Street Journal. He has appeared on national radio and television, including Fox Business News, CNBC and Bloomberg. With a dozen years experience as a university professor, O’Driscoll speaks regularly at academic conferences and universities.

O’Driscoll holds a B.A. in Economics from Fordham University, and an M.A. and Ph.D. in economics from UCLA.

Visit: Jerry O’Driscoll's Page

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