To finance housing in the '80s: invest less

High interest rates are public enemy number one wherever US homebuilders and homebuyers gather these days. There is growing pressure on the Federal Reserve to lower the cost of money so that construction jobs are created and Americans' homebuying dreams have a chance of being fulfilled. This deceptively simple solution would be a mistake. Financing new housing in the 1980s will require a more sophisticated three-pronged capital policy: new sources of funds for homebuilders, new saving incentives for homebuyers, and a change in tax incentives for homeowners.

The prime interest rate, which sets the cost of housing money, took a roller-coaster ride in the '70s, peaking early in 1981 at 20 percent. Contractors, who must borrow money at about 2 percentage points above the prime, flinched in the face of such rates. In 1972, when the prime was 5.25 percent, ground was broken for a record 2.4 million homes. In 1981, new housing starts will not exceed 1.1 million. Homebuyers are caught in the same credit crunch. The traditional rule of thumb that a family commit no more than one-quarter of its income to mortgage payments has gone by the board; one-third or more is now the standard.

Shifting more capital into the housing sector in an attempt to reverse these trends could be counterproductive. Until recently, as Anthony Downs of the Brookings Institution has pointed out, Americans put more money into home mortgages than into corporate bonds and commercial and industrial mortgages combined. Since Americans already live in the world's biggest, most well-appointed houses, they should be investing less, not more, in housing. Given the capital needs over the next generation for reindustrialization, the maintenance of social services, and environmental safeguards, the United States economy would be better served following the lead of the West Germans, who are slowly decreasing their investment in housing.

For investment to be redirected without totally stifling the housing industry , homebuilders must have access to some pools of capital, preferably long-term assets such as pension funds, which are now valued at more than $500 billion.

In West Germany, more than 1 million people live in homes built with money controlled by unions. One benefit has been homebuilding geared to the special needs of local communities. In the Emmertsgrund in Heidelberg, for example, a certain portion of the 3,000-unit union-financed development is specifically set aside for low-income people. American unions could apply similar constraints on the use of their pension funds to ensure sufficient construction of rental housing and energy-efficient homes.

While homebuilders need new stable sources of funds, homebuyers need to borrow less and save more. In the speculative housing market of the '70s, Americans abandoned all pretense of saving to buy a home. They bought first, on huge amounts of credit, and saved later through building up equity in their homes. In 1979, Americans saved just 5.6 percent of their disposable income, while West Germans saved 14.5 percent and Japanese put aside 20.1 percent of theirs. Since the West Germans and Japanese saved through bank accounts, their money could be used for productive investments to create jobs and finance economic growth.

West German savings habits are in part due to the bausparkassem savings institutions, which account for more than half of the country's housing finance. Bausparkassenm lend money to prospective homebuyers through savings contracts. Depositors agree to put aside a specified amount at a low interest rate in return for a future mortgage commitment at a guaranteed rate of interest, which in the late '70s was 4.5 to 5 percent. In addition, various government incentives -- premiums over and above the interest rate -- mean a total return on a saver's funds of up to 28 percent per year tax-free, providing a huge inducement for people to save toward the purchase of a house.

Similar programs in the US, or possibly an extension of the one-year life of tax-free savings certificates issued by banks or savings-and-loan associations, would deflate the speculative housing market by channeling money into savings and would slow housing investment in general by encouraging prospective homebuyers to save money. At the same time, lending institutions would have adequate mortgage funds to meet new housing needs.

The third provision of a new capital policy involves reducing the current tax incentives for people to invest in housing. For a homebuyer in the 40 percent bracket, for example, the after-tax interest rate on a 1979 mortgage of 10 percent was 6 percent. Since inflation meant the money the homeowner paid out monthly was declining in value by at least 10 percent a year, the real interest rate was minus 4 percent. Moreover, Americans do not pay taxes on the profits they make as investors by renting their homes to themselves. Under these circumstances, it is little wonder that housing demand was stimulated far in excess of any potential to increase supply, driving up prices for new and existing homes.

In general, tax subsidies are socially useful if they stimulate greater supply, as investment tax credits do in industry. But the deduction of mortgages stimulates demand. Since two out of three American voters benefit from homeownership subsidies, it will be politically impossible to eliminate them totally. However, as a study by the Urban Institute rightly points out, replacing tax deductions with a uniform tax credit would most benefit low- and middle-income households and would eliminate the tax advantages of buying ever more expensive housing. Another approach, one suggested by the Congressional Budget Office in a recent report, would be to limit the deductibility of mortgage interest payments to $5,000.

Reforming the way society finances its housing is bound to clash with the short-term interests of homebuilders and homebuyers. Their demands for cheap money should not, however, take precedence over the country's need for a more productive use of its limited financial resources. The Federal Reserve should have both the political courage to withstand current pressure and the foresight to work with Congress on the design of comprehensive housing finance policies that will lead to more stable housing prices and a stronger economy.