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.

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