California housing subsidy - boon or a curse?

[Rishit Shah]

In a rush? Checkout TLDR below.

I recently came across this article where I read about California's proposed subsidy for housing purchase. https://www.businessinsider.com/california-dream-for-all-program-senate-democrats-new-home-costs-2021-6. The reasoning goes that this is going to help low income families afford a home in a market that is getting ever expensive. But is it actually going to work? Let's take a closer look.

First, we are going to understand what has led to the boom in some of California's most expensive housing markets in the first place. For example, let's consider San Francisco v/s another metro like Chicago. At the time of writing this post, there are roughly 531 homes for sale in San Francisco. The population is roughly 880,000. Simply put, there is 1 home for every 1657 people. On the other hand, let's look at another market like Chicago, IL where prices are more stable. At the time of writing this post, there are a little under 11500 homes for sale v/s a population of 2.71 million people. That is 1 home for 235 people. San Francisco is short of homes by a factor 7 when compared to more stable markets. So essentially, home prices in San Francisco have skyrocketed because of a lack of housing supply.

Now here's where things get interesting. Let's look at how subsidies work in a market like this. Let's consider a $250K studio apartment, the cheapest house I could find at the time of writing this post (check link in reference section). Let's say Joe , Matt and David are 3 people looking to buy a house in the bay area. Joe can afford the mortgage on the $250k, Matt can only afford the mortgage for $200K and David can afford the mortgage for $175k home. The government promises to subsidize 45 percent or $112500. This means the actual cost of housing is now only $137,000. This means now, along with Joe, even David and Matt can afford the house. Great news right? Not so fast. Let us zoom out a little. remember the shortage of supply we just discussed? For all 3 of them, there is still only one house on the market! So what happens now? armed with the new money from the government, Joe Matt and David enter a bidding war. Since Joe can afford the mortgage on $250,000, he still has the higher purchasing power to out bid Matt and David. Since they genuinely want the house and they were looking to spend the relevant affordable amount anyway, they keep bidding until their affordability is reached. Offering and counter offering, David exhausts his bid at $287.5K ($175K he could previously afford + 112500 from government subsidy), Matt at $312,500 and Joe at a whopping $362,500. Clearly, Joe wins the bidding war gets the house. But look what just happened here. Matt and David still don't have a house, and Joe payed $112500 over the asking price, just because he could afford to do so. Looking at this, other are going to realize that they can fetch higher prices on their properties too! So they will all raise the prices of their studios as well, which will eventually bring the asking price to the max affordable price of David and Matt combined with the government subsidy. In the end, the market prices simply went up bu 45% and David and Matt are still left without a home. So who benefit in this? The seller of the house at this moment? For sure. How about Joe? He got the house spending only what he would have spent before out of pocket anyway right? Let's see in the next paragraph how Joe, despite of being in a seemingly neutral position, is actually worst off than he would have been without the subsidy.

Let's say Joe wins the bid at $362,500 and starts living the house. Let's introduce a fourth character seller Jane to our story. Jane just made a whopping $112,500 extra on the house she just sold. Let's say Jane moves in with her partner and does not buy a new house with this money. She choses to invest large parts of her cash (after taxes of course) but because she has so much extra cash on hand, she decides to splurge a little. Let's for the sake of simplicity, say the only thing she can splurge on is restaurants in the town. She starts eating out at restaurants more often to enjoy her money. Just like Jane, many sellers who cashed out on the frenzy have extra cash and decide to splurge on the restaurants. As a result, the lines outside restaurants grow bigger than ever, which causes the prices to rise in face of this new demand. But what about Joe? He has no more money on hand than he would have without the subsidy. But, the price of consumer goods (in our case restaurants) just went up, so Joe can now consume less of it and has a lower standard of living. So if could have afforded to eat out at restaurants earlier once every week, he can no longer do so because of the increased prices. He now has to do it once in 2 weeks. But the restaurant owners got richer because of the demand right? Wrong.

The government just decided to subsidize 45% of a $1.3 trillion market (check the reference section. This is an old link I found but serves well for our example) Let's assume that at any point, 10 percent of this inventory is for sale (no data found on this but any number should work). So, the government would have to spend $130 billion(10 percent of 1.3 trillion) in subsidies for the total transactions in a given year. Since we simplified our economy to have only restaurants, we are going to bring down the spending by a factor of 1000 so the numbers don't look completely absurd. so after this adjustment, the spending is at $130 million. Where is this money going to come from? They certainly can't raise real estate taxes. If they do, now they would even push Joe out of the affordability and worsen the problem. The data will soon show what a huge mistake the subsidy program was. So they decide to start taxing the restaurants. So despite of increased revenue from higher prices, restaurants are no better off than before simply because of higher taxes.

A lot of assumptions were made for simplicity in this article, but the general idea can be simply expanded and applied to a section or entire commodities market. Markets behave in a weird convoluted way in response to intervention so predicting the exact outcome in terms of which commodity will be impacted in what way taxes a more complex analysis. However, the fundamental impacts on each class of people would be the same. The asset owners would end up richer, some of the businesses who are now paying higher taxes would be slightly or not at all better off, and the average person with no assets will end up worst off. In my opinion interventions that act against the basic concepts of supply and demand would in the long run cause more harm than good. What do you think? I would love to know. Post it in the comments below.

TLDR

1) California's housing market is unaffordable for a lot of people because of a lack of housing supply, not because of less money in people's pockets.

2) If the government subsidizes the housing by lets' say 45%, that means there would be more people able to afford the same house. But the supply hasn't gone up. This would result in an all out bidding war. The person who has higher resources (excluding government subsidy) would still be able to out bid the newer buyers who now entered the market. Seeing this, others raise the prices. Eventually, the housing market just went up by 45% and the ones without the house are still left without it. Thus the real estate owners get richer while others are left worst off

3) The money to subsidize this has to come from tax dollars which means higher taxes on local individuals and businesses, leaving them with less capital to invest elsewhere or spend on other consumer goods. In the longer run, a handful benefit while everyone else is left either same or worst off.