Bill Gross says don't expect double-digit returns anymore

He could very well be right. Part of returns come from inflation, which is currently running at an annual pace of 1.2 percent. If "normal" inflation is 3 percent, a 10 percent return in normal times is equivalent in real terms to 8 percent now. There is nothing necessarily wrong with that.

A modest step toward untangling housing markets

One of the impediments to housing transactions is appraisals. If appraisals (which are backward looking) don't support the offer price of a house, the financing for the house can disappear.

For low down payment deals, this is frustrating, but appropriate. But for deals involving a minimum of 20 percent down, it is hard to see how appraisers have a better sense of value than the potential buyer who is actually putting a lot of money at risk. It may make sense to allow buyers who put 20 percent down, and whose source of funds is well documented, to get a loan even if the appraisal comes in a little low.

At what point will short sales become meaningful to restarting the housing market?

The Washington Post today forecasts 400,000 short sales this year. Lawrence Yun says there will be 2.5 million foreclosures in 2010. So while short sales have have increased substantially, they will still be only about 1/6 the number of foreclosures.

Don't get too excited

Nick Timiraos retweets Brad Hunter: Census numbers: Single family starts up 4.3% (+/- 12.4%) Plus or minus 12.4%!! It's in the fine print of their release!

I actually try my best not too make too big a deal out of any monthly number.

To my macroeconomist friends: if you are going to do urban economics, please read the urban economics literature first.

I saw a paper from a famous macroeconomist a week or so ago that proposed that cities with high incomes relative to house prices produce more utility than those cities with low incomes realtive to house prices. Using this metric, he concluded that Flint was among the five highest utility cities in the US. This might have been a clue that there was something wrong with his utility measure.

The systems of cities literature (see Jan Brueckner's chapter in the Handbook of Urban Economics) and the quality of life literature (see Stuart Gabriel Joe Mattey & William Wascher's RSUE paper) shows that in a country with mobility, utility tends to get equalized across cities, and so that places with high house prices relative to income have more non-housing amenities than places with lower house prices. I can testify to the reasonableness of of this, as while Los Angeles is expensive (as well as congested), I do not find myself tempted to move anywhere else, suggesting that I, at least, derive a great deal of utility from living here (I recognize that lots of people are not so enamored of LA, but enough of us are to keep the price of housing high relative to other places). Other places like LA include New York, London, Paris, Singapore, Tokyo, Hong Kong, Sydney, etc.

This produces an efficient outcome, for if Los Angeles were less expensive, it would be even more congested. On the other hand, St. Louis' cheap house prices should eventually attract people back to it. But it also produces an unfair outcome, because it is very difficult for low income people in Los Angeles to find reasonably priced housing in reasonable locations. Perhaps the goal of housing policy should be to allow everyone to be able to choose the city in which to live, while at the same time distorting the relative prices of cities as little as possible. I am not sure how one does both.

While Arrow showed the impossibility of a well defined ordering of social preferences...

...we tend to act as if there is one anyway. That is, we place a lot of focus on GDP per capita when evaluating economic success. By this measure, the US is, of course, successful. By a slightly different measure from the OECD (go to page 37), average disposable income per household, the US ranks second after Luxembourg among the nations measured. Luxembourg has about the same population of Long Beach, so it is hard to worry too much about it.

But a social welfare function that looks at the lowest decile of income is just as legitimate (or perhaps I should say, illegitimate). By this measure, the US ranks 20th among countries measured, which places it toward the bottom of the OECD pack, with levels similar to Greece and Italy.

On the other hand, the top 40 percent of American household are better off than their counterparts in all other countries (with the exception of Luxembourg), reflecting a great deal of affluence across a large number of people. So where to pick? As Arrow would say, that is really impossible.

When assumptions drive the result

I have spent the past few days at the Wisconsin-St Louis Fed conference on Housing, Urban, Labor and Macroeconomics; it is a third in a series that Morris Davis had organized, and the papers were thought-provoking and well done.

The macro paper, however, was about whether government can effectively counteract negative shocks to one sector of the economy. To the standard macro model it added a friction where workers had to retrain in the event of a shock to one sector of the economy so as to be able to work in another sector. This is clever and important.

But while the model allowed for frictions, it failed to allow for involuntary unemployment, and so it found that government interventions were ineffective. Well, duh...

Why did Apple give in?

I've rarely been so happy to be wrong as I was yesterday when I heard that Apple had relaxed some of the restrictions it puts on third party software apps for iOS. In case you somehow missed the news, iPhone and iPad apps can now be written in third party languages like Flash and Java. Apple also changed rules that would have made it difficult for outside advertising systems like Google's AdMob to insert ads in iOS apps.

I'd predicted a couple of months ago that Apple probably wouldn't give in on those terms, so it was a surprise -- but a very pleasant one, for a couple of reasons. First, and most important, I think it's good for app developers. The more ways they have to create apps, the more easily they can do business. But speaking as someone who's working on a startup, I was also personally pleased. We're doing a lot of development work in Java, and I'd been worried about the rework if we decided we needed a native client on iOS. Now the problem's solved (or at least it should be by the time we ship).

Although Flash and Java are getting all the attention in the press coverage, Apple's decision also has a huge effect on some smaller companies making development tools. For example, the folks at Runtime Revolution, who make one of my favorite prototyping tools, announced instantly that they'd be supporting iOS (link). And I'll be interested to see if the StyleTap Palm OS emulator will now be able to run on Apple devices that haven't been jailbroken.

This leaves us with the question of why Apple changed its policy. The Wall Street Journal speculated that Apple might have been trying to forestall legal action by the US government (link). The New York Times said it was a competitive response to Android's increasing momentum (link).

I wonder if Apple wasn't also influenced by the Library of Congress' recent ruling that phone companies can't use copyright law to prevent jailbreaking of phones (jailbreaking in this context permits a device to run applications that weren't approved by the manufacturer). Although jailbreaking is rare on iOS today, with the ruling companies were free to start promoting it. Apple may have felt that it was better to loosen up the rules of the App Store, rather than risk a lot of customers bypassing the store entirely.

They're all plausible explanations, and there's no reason why they couldn't all be correct. But I hope there's something deeper going on. As I've written before, when a company reaches a certain level of success, many of the business practices that were foundational to its growth can turn into liabilities. It's kind of like watching a kid grow up -- behavior that's understandable in a 10-year-old ("You got in a fight with Johnny? I'll get the Neosporin.") becomes antisocial in an adult ("You got in a fight with Johnny? You're under arrest.")

Apple has definitely reached that transition point. The aggressive business tactics that were acceptable for scrappy underdog Apple look like bullying and arrogance in industry leader Apple. Companies usually stumble on this transition, because their image of themselves doesn't change to match their altered role. When Microsoft hit it at the end of the 1990s, it responded with denial, aggressiveness, and defiance. The result was years of incredibly distracting litigation. The company has never been the same since.

Has Apple learned from Microsoft's lesson? Understanding Apple's internal decision-making is only slightly easier than understanding North Korea's, so we probably won't know for sure until years from now when somebody retires and writes a memoir. But I hope, for the sake of everyone in the Apple ecosystem, that this is the start of a kinder, gentler Apple.

Assuming it is, here are a few guidelines on how Apple the Leader should behave:

Aim to cripple, not kill. The old Apple routinely reached for the nuclear weapons when threatened by an outside firm. (Remember Power Computing? link) That was OK when Apple's own survival was at risk, but it's bad form for a company that's too big to fail. Instead, your goal is to damage your competitors to the point where they can't threaten your survival, but are still somewhat viable. Remember, dying competitors file antitrust suits; weak competitors are just whiners.

If you can't think of something nice to say about someone, lie. Apple has thrived on the drama of competition against the evil overlord (go rewatch the "1984" commercial if you want to understand how deeply this is a part of Apple's psyche). This confrontational style has seeped into public communications ranging from Apple's Mac vs. PC commercials to Apple's bitter statements about Adobe a couple of months ago. That all has to stop (and, interestingly, the Mac vs. PC ads already did). For a huge company like Apple, beating up on competitors makes you look like an arrogant bully. Repeat after me: "They're an impressive company, and we respect their accomplishments." It'll feel gross for a while, but you'll get used to it.

Pick your fights. Let go of issues that don't truly threaten your survival. Flash is a perfect example -- although in theory it's threatening, in practice Adobe has shown very little ability to turn it into a major cross-platform app environment. In fact, the whole Flash/Air thing was fading into obscurity until Apple gave it a big boost of publicity by attacking it. Hey, Apple -- you helped old, bureaucratic Adobe position itself as the spunky competitor against your Microsoftian monolith. Was that what you wanted?

The right way to contain the threat from platforms like Flash is to make sure Apple's own platform continues to innovate rapidly, and take better care of developers than anyone else.

Listen carefully. Because your instincts are tuned to the old rebel Apple, you're likely to mis-position yourself frequently while you learn the new rules. Admit to yourself that you have a problem, and manage it proactively. In the era of the Internet, there's no excuse for being blindsided by an issue. Right now you're putting out fires after they become obvious. If you listen carefully, you can respond to an issue before the firestorm builds up.

Occasionally admit you're wrong. People love a powerful person who's willing to admit being wrong. It makes you look humble. The same thing applies to companies. When you realize you need to back down on an issue, don't try to hide the fact. Tell people you listened to them and decided you were wrong. You got halfway there in the statement about the App Store changes: "We have listened to our developers and taken much of their feedback to heart." You should lose the phrase "much of" because it reads as a cheap shot; it implies that some of the things developers said were not worth paying attention to. And what I don't hear yet is the second most difficult three-word phrase to say in the English language: "We were wrong."

It's possible to overdo this sort of thing, of course. You shouldn't be backing down in public more than about twice a year, or you'll look indecisive. Between the store and the iPhone antenna thing, you've now used your quota for 2010. So keep your nose clean for the rest of the year.

Stay on offense. The key to the long-term survival of Apple is innovation and creating new product categories. Once you've stopped thrashing over distractions like antennas and store terms (not to mention federal lawsuits), you can focus more time on creating the next generation iPad, and developing new category products like Apple TV. Those are the things that really matter for your future. The more time you spend on them, the better Apple's prospects. By letting go of your underdog baggage, you give yourself the freedom to make those future products great.

Is it housing or is it Boston?

David Leonhardt's excellent piece on house prices in the New York Times this morning asks a fundamental question about how to think about the future of house prices. If houses are a staple, they are currently overvalued by historical standards; if they are a luxury good, they are not.

Mr. Leonhardt's definition of a luxury good is one with an income elasticity equal to one (i.e., a good where the share of income spent on the good remains constant), whereas technically speaking, luxury goods have income elasticities greater than one (think nice vacations). But the point is still a good one--the income elasticity of demand for housing should tell us a lot about where house prices "should be" right now.

National house prices did follow income closely between 1970 and 2000, while according to Robert Shiller, they grew only by the rate of inflation before that. I wonder if the reason for the change is not that people wanted to spend a constant fraction of their income on housing, but rather that they wanted to spend a constant (or even increasing) fraction of their income on certain cities, such as Boston, New York, San Francisco and Los Angeles. These are all high amenity places, chock full of luxury goods, that have inelastic housing supply. It is possible that housing in, say, Wichita (sorry to the Kansans out there) is a staple, while Santa Barbara is a luxury.

LA commutes? Not so bad.

The average one-way LA commute is 29 minutes. This compares with 45 minutes for the UK (the whole country, not just urban areas) and 38 minutes for the EU. A variety of sources suggests that the median commuting time in Japan is greater than 30 minutes and the average is longer (because of skewed data).

European cities are great for vacations, and wealthy people in such cities can live in places that allow them to walk to work. But for average people, LA is a easier place to get around.

Ryan Avent of The Economist gets it right (h/t to Mark Thoma)

He writes:

"...it's simply not true that the administration has rolled out every programme it can think of. Economists with which administration officials are very familiar have proposed measures to deal with the real problem in housing markets: negative equity. Promising policies like mortgage cramdowns and own-to-rent programmes have yet to get a serious look from Washington leaders. But ultimately, a real fix for housing markets must address underwater mortgages. Absent some attempt to deal with negative equity, a rush of buyers into the market will accomplish little; the problem is that underwater homeowners can't afford to sell at prevailing prices. Driving those prices lower won't change that fact.

The truth is that the trouble in housing is not, for the most part, a demand-side issue. The problem is the millions of homeowners stuck in houses they can't afford to sell. These households represent a significant shadow supply of foreclosures-in-waiting. I agree that it would be silly for the administration to try to support housing prices by offering more goodies to potential homebuyers. But it doesn't follow that letting prices go their own way will magically get housing markets moving again."

John Quigley, Alan Blinder (and I for that matter) have been advocating something like a Home Owners Loan Corporation, and/or a debt equity swap for underwater mortgages for some time. We also need to deal with second liens--investors in such liens are holding up renegotiated mortgages because they will get wiped out--which is of course what is supposed to happen when one interest is subordinate to another.

(Thanks to Jim for filling me in on who RA is).

A downpayment factoid

Canada allows 95 percent LTV loans. Borrowers must get mortgage insurance, either from the government or the private sector, if the LTV exceeds 80 percent. Yet 90 day delinquencies there remain under 50 basis points. All home lenders in Canada are subject to strong regulatory oversight.

My favorite Art Goldberger quote

I saw a paper today on heritability and savings. It made me think of my econometrics teacher, Art Goldberger, who once wrote:

Professor Hans Eysenck was so moved by the twin study that he immedi- ately announced to Hodgkinson that it "really tells the [Royal] Commis- sion [on the Distribution of Income and Wealth] that they might as well pack up" (The Times, 13 May 1977). (A powerful intellect was at work. In the same vein, if it were shown that a large proportion of the variance in eyesight were due to genetic causes, then the Royal Commission on the Distribution of Eyeglasses might as well pack up. And if it were shown that most of the variation in rainfall is due to natural causes, then the Royal Commission on the Distribution of Umbrellas could pack up too.)

From "Heritability," Economica, 1979, 46, 327-47.

Do low rates make house prices more volatile?

Over at the FT blog, Cardiff Garcia has a nice summary of three papers that attempt to explain the run-up in house prices before 2007. It particularly approves of the work of my friend and co-author Susan Wachter and Andrew Levitan, who argue that a supply-side credit bubble produced the housing bubble.

As I read the piece, though, I couldn't help but think that while it is unlikely that low interest rates would explain prices, they might explain volatility. When nominal interest rates are low, a small change in price expectations can lead to a large change in prices.

Consider the Gordon Growth model, where Value = dividend/(i-g), where in this case the dividend is the value of living in a house, i is the interest rate and g is the expected growth rate of the dividend. Let everything be real (i.e., not nominal) Consider two worlds: 2 percent real interest rate world and a 4 percent world. Now let expectations about growth vary from negative one percent to positive one percent. In the two percent world, the upside scenario produces three times the value of the downside scenario. In the four percent world, the upside produces 67 percent greater value than the downside. Hence small changes in expectations have a much larger impact in a low interest rate environment than a high interest rate environment. It may be hard to pick this up because expectations are so difficult to measure.

Just a thought.