This recession, with a weak job market and declining home values, has been especially tough on the middle class. Two of the most valuable assets of middle class households are human capital and residential housing, which are poorly diversified. Financial investments can be spread across many securities so that losses from one investment can be mitigated by gains from others. You can’t trade shares of ownership in your home or human capital to diversify your investment.
Housing has been a poor investment relative to equities since the end of 2006. The most recent Case-Shiller 20-city price index indicates that home values in these cities declined by 32% over the past five years while the Standard and Poor’s 500 index declined by about 5%. To make matters worse property values are closely related to employment and wages in a metro area. Cities hit hard by declining property values have experienced reductions in household wealth, lower consumer spending and falling employment and income.
A simple linear regression of home values on metro area employment (from the BLS) across the 20 Case-Shiller cities indicates that each one percentage point decline in an area’s employment is associated with a 3.2% decline in home values. This significant positive covariance is statistical evidence that buying a home in the city where you work is putting the bulk of your financial eggs in one basket.
There are 8 Case-Shiller cities that have been hit particularly hard by the recession: Atlanta, Cleveland, Detroit, Las Vegas, Los Angeles, Miami Phoenix, and Tampa. The following figure indicates that employment fell by 9% and home values by 44% in these cities between the beginning of 2007 and the end of 2011.
There are another 8 Case-Shiller cities where the recession has been somewhat less severe: Boston, Charlotte, Dallas, Denver, New York, Portland, Seattle, and Washington, DC. The following figure indicates that employment fell by 1.3% and home values by 18% in these cities between the beginning of 2007 and the end of 2011.
For working class households the depth of the recession depends on location, location and location. Job losses are concentrated in cities with the biggest reductions in household wealth due to declining home values. Our tax code, with mortgage interest deductions and capital gains exemptions for owner occupied housing, encouraged the middle class to view their home as a means of accumulating wealth. Decades of policies encouraging investment in residential housing over diversified mutual funds made middle class households especially susceptible to the risk of a housing price bubble.
Although the labor market started to recover over the past two years it is much weaker in cities where many houses are in foreclosure. Job creation has lagged and the labor force is shrinking in cities with distressed real estate markets. Will the just announced $26 billion mortgage foreclosure settlement involving five of the largest mortgage servicers and 49 of 50 state attorneys general help? Critics on the right and left are skeptical. President Obama just unveiled his proposal to offer government assistance to homeowners who are underwater on their mortgage but not in foreclosure. Critics of this plan fear that it could sink the taxpayer backed Federal Housing Administration and delay the inevitable and necessary process of market clearing.
Regardless of how we navigate our way through the current mess serious tax reform should address the home mortgage interest deduction and capital gains taxes on home ownership. These reforms would not just broaden the base and lower marginal tax rates they could make working class households less susceptible to the risk of future housing price bubbles.