Zoning and "malinvestment"

By Scott Sumner.

"A few days ago, I visited downtown Long Beach. The city of Long Beach is located in LA County, right on the Pacific. It has a population is 456,000 and is fairly expensive. The city should be booming, but instead it seemed sort of depressed. What went wrong?

I saw one fairly new high-rise residential building, but mostly it was just block after block of older low rise commercial and residential buildings, with very little construction underway. There are a few homeless people walking around, although not so many as in LA. Given the high rents and housing prices in coastal California, why isn’t Long Beach experiencing a boom in redevelopment?

I suspect the problem is regulations. California has such strict regulations that it is now extremely expensive to build in California. Thus the state no longer sees the dynamic economic growth it experienced during the second half of the 20th century.  And these regulations are not protecting beautiful old historic neighborhoods; downtown Long Beach is rather bland and unattractive.  A hundred new high-rise residential buildings in DTLB would attract new restaurants and shops, making the city far more attractive.  A few of the poorer residents would have to move a few miles inland, but there would be many more good service jobs to pay their bus fare.

One of the most important economic identities is that saving equals investment (at least at the global level.) So if California stops building housing, what happens to all of the saving that used to go into property development?  

With less investment in real estate, savers have trouble finding people that wish to use their funds.  Thus puts downward pressure on the equilibrium interest rate.  Some might argue that the actual interest rate differs from the equilibrium interest rate due to Fed policy.  But if the Fed is committed to a 2% inflation target, then it must cut its interest rate target when the equilibrium rate declines. Over time, the two rates are generally quite close.

The fall in interest rates does not, by itself, bring saving into equilibrium with investment.  You need potential investors to respond to lower rates by creating more non-residential investment.  Projects that were not profitable at a 5% interest rates become highly profitable at a 1% interest rate.

Most people don’t understand this process.  When they see it play out, they misdiagnose what is actually going on.  I see article after article claiming that the Fed “artificially” lowered interest rates, and that this created “malinvestment” into unproductive projects.  They claim the problem can be fixed by raising interest rates to a level that imposes discipline on investors, a rate that doesn’t allow for low quality investments to be profitable.  That’s wrong.

The US does have a malinvestment problem, but it’s not at all what many pundits assume.  The cause of the malinvestment is zoning and other regulations that make it difficult to build housing.  And housing is not just another sector; it’s a key part of investment.  These bad regulations push saving into areas that are less productive than housing construction, including marginally productive government and corporate investment.

The problem of malinvestment cannot be fixed by having the Fed tweak interest rates; it requires much more fundamental solution.  The only way to fix malinvestment is to remove regulations that prevent developers from building what people really want, which is high quality housing. The Upper East Side of New York was wonderfully transformed in the 1920s, when low-rise buildings were replaced with high-rise residential buildings.  Downtown Long Beach can and should do the same.  But America has lost its ambition, and settled into stagnation.

If you ask most people what stands in the way of them having the sort of lifestyle they wish to have, not many will mention a lack of food or clothing.  Most have adequate cars and TV sets.  Most have a school to send their kid to and some form of health care.  Instead, housing is the one area where lots of people are dissatisfied, where dramatic improvements in living standards are still possible.  But that requires building new housing in locations close to good jobs.  Bandaids such as rent control do not result in a single extra person having housing, and indeed reduce the housing stock in the long run.  More housing is the low hanging fruit to raising living standards.  Fix housing regulation and you go along way toward fixing malinvestment."