I don't insure my car. Well, I have liability insurance, but I don't insure the car itself. So if I drive it into a ditch, or it gets stolen, I have to pay to repair or replace it, out of my own pocket.
Why did I take this decision? I could have estimated the probability of it getting stolen, or my driving into a ditch, estimated the cost of repairs or replacement, and done a very complicated calculation of my expected utility with and without insurance, and chosen whichever option gives me the highest expected utility.
But I didn't. Instead I assumed that the market for collision insurance was reasonably efficient, made a couple of judgment calls, and relied on economic theory.
I don't have a clue what the probability is of my driving into a ditch or my car getting stolen. I couldn't even hazard a guess and expect to get it within the right order of magnitude. Or rather, it would take me hours of searching to get a reasonable estimate. I figure my insurance company knows the probability much better than I do.
"Actuarily fair" insurance means that the premium equals the expected payout. So if there is a 1% probability per year of my car getting stolen, and the payout would be $3,000 if it does get stolen, the premium would be $30 per year.
I figure that even if I shopped around, and got the best deal, any insurance I could get would have a higher than actuarily fair premium. The insurance company has to cover its administrative costs. Plus there's the moral hazard problem of people who have insurance against theft taking less care to prevent theft. Plus the adverse selection problem of people who have the higher risk of theft tending to get insurance against theft.
With collision insurance, there's an additional argument against insurance. If I drive into a ditch, the insurance company would have to pay for repairs that would make the car as good as it was before the accident. I would rather have the cash, and either fix the car myself, or just leave a few dents in it. In fact, taking half the cash would still probably leave me better off. The premiums must be more than double what they would be for insurance that would be actuarily fair from my perspective.
My car is probably worth around $3,000. That's much less than 1% of my total wealth (pension plan, house, human capital, etc.). It's peanuts. My utility function is very close to linear over that small a range. Anyone with a linear utility function would be indifferent to taking an actuarily fair bet. My utility function is a lot closer to linear over a $3,000 range than insurance would be close to actuarily fair.
So I don't insure against small losses. I only insure against big losses, where my utility function would be a long way from linear.
I don't do any calculations in deciding whether or not to purchase insurance. I rely on economic theory, plus the assumption that the insurance market is reasonably efficient, except for the inefficiencies I can identify using economic theory.
There's just a chance, of course, that I am totally wrong. Maybe, just maybe, there is some insurance company out there that is willing to offer me premiums that are so low that I would be better off getting theft and collision insurance. But I doubt it. Insurance companies are unlikely to be that stupid, and they have much better data than I do. I trust their judgment of the probabilities more than I do my own.
I don't trust the housing market to be as efficient as the insurance market. Insurance premiums are set by companies that specialise in providing insurance, in competition with other companies, and they have a big incentive to get their estimates right (at least for things like car insurance). They know a lot more than I do. So I don't even try to second-guess the insurance companies on whether insurance premiums are too high or too low. But house prices are set by people like me, or even more ignorant than me. I flatter myself that I can do a better job of estimating whether house prices are too low or too high than most people. So I would compare house prices to the Net Present Value of rents before deciding on whether to buy or rent a house.
But even if I am smarter than the average person buying or selling a house, there's a lot more of them than there are of me. I would be unwise to ignore the "wisdom of crowds" altogether. And while I recognise that other people can be collectively wrong, getting caught up in manias or panics, I have to recognise that i can get caught in the same manias and panics too. I ought to hedge my bets, and rely partly on my own estimates, and partly on what economic theory tells us should happen if the housing market is efficient.
If everybody else were rational, and were doing their own estimates, and if house prices reflected those rational decisions, would it make sense for me to own a house? What sort of people should own a house in equilibrium? Who should be a tenant? Who should own their own home? Who should be a landlord?
First off, it doesn't make sense to say that nobody should own a house, and everybody should rent. Nor does it make sense to say that everybody should own two houses and rent one out. Since every house must be owned by someone, and every family needs a home, in equilibrium the average family should own the average number of homes. One.
The average family should own one home in equilibrium. But there's a strong argument that each family should own one home too. And it should be the home they live in.
As I argued in a previous post, we are born with a short position in housing. We need somewhere to live, and so are born with a liability of the net present value of the rents that we will need to pay. Having a short position is risky. Buying a house is like covering that innate short position. We are insuring ourselves against the risk of rents rising or falling, and making our future utility less uncertain. Buying two houses is like taking a long position in housing. And that's risky too.
And if you own a house, you need a tenant to live in it. The best tenant would be one you know well, who would be reliable in paying you the rent, and who would treat the house as if it were his own. Hmmm. What better tenant than you yourself? Being your own landlord, and own tenant, solves the principal-agent problem between landlord and tenant.
Plus, you won't get into any arguments about what colour paint and wallpaper, or whether to upgrade the insulation or fix the roof, if the tenant and landlord are the same person. All the externalities between landlord and tenant are internalised; all the transactions costs of negotiations between landlord and tenant are eliminated.
And, there's the tax angle. You don't pay income tax on the rents you pay yourself. Nor capital gains on your own home.
It is easy to imagine an equilibrium where every family owns just one home, and lives in it. So how could we explain an equilibrium with tenants and landlords?
Don't say "But some people can't afford to buy a house!". That sort of statement just drives economists crazy. In equilibrium, the price of a house should equal the Net Present Value of the rents minus taxes, repairs, etc. If you can afford the rents, you can afford to buy the house and pay the taxes and repairs etc. Sure, you can't afford to buy too expensive a house; but then you can't afford to rent too expensive a house either. That's got nothing to do with the rent vs. buy decision.
There is however some truth in the "people who can't afford to buy should rent" argument. If you don't have the liquid assets to use as a down-payment, and so have no equity in the house, you don't really own it. You are renting it off the mortgage company. Only it's a tenancy you are locked into. If your income falls, and you want to rent somewhere cheaper, you have to sell the house and repay the mortgage to get out of the tenancy. And if the price of your house falls below the value of the mortgage, so you have negative equity, you have to pay the difference to the mortgage company to get out of the lease.
House prices are uncertain, and your future desired rents are uncertain too. If there's a correlation between falling house prices and your need to downsize, then buying a house is risky. The greater that risk, in proportion to your wealth, the better off you would be as a tenant.
The other people who should rent rather than buy are people who plan to move soon. There are significant transactions costs in selling one house and buying another. Agent's commissions, lawyer's fees, home inspection, taxes, plus the sheer hassle of showing a house and waiting for the right price, may well rise to 10% of the value of the house. (Costs of moving furniture don't count, since renters face those too.) If you move every two years, that reduces the rate of return on owning a house by 5% per year. If interest rates are 5%, that's equivalent to doubling your cost of borrowed funds, or earning 0% on your own funds. People who plan to move soon should rent, not buy.
What other individual characteristics have I missed?
Worthwhile Canadian Initiative 
RSJ:
By the way, I want to commend and thank you for your 11.03 post, which took you some time to write, but really helped me figure out what you had been trying to explain to me earlier.
Here’s where my mind is at the moment:
Each house is different. Each potential owner is different. In equilibrium, each house will be owned by the person who places the highest value on that house (ignoring transactions costs).
The price of each house will reflect the valuation of that house by the person who values it most (or, if houses are sold in English auctions, the price will reflect the valuation of that house by the person who values it the second highest, which is almost the same thing).
People differ in their valuations of a given house for two reasons:
1. (If they are planning to live there) because their preferences differ. (Some would love to live in that house, and others would hate to live there.)
2. because they have different beliefs (about the future price of this and other houses, interest rates, etc.)
To my mind, it is not a problem if house prices reflect the valuations of the individuals with the highest (or second highest) preference for living in that house. That’s exactly as it should be. Prices of consumer goods should reflect the marginal benefit of the consumer, and if each house is unique, and can only be lived in by one person (family), that marginal benefit is the benefit to the person who values it most (or second most) highly.
BUT, it would be a problem if house prices reflected the beliefs of the most optimistic people. We don’t want house prices to reflect “Panglossian” expectations, rather than the average wisdom of crowds. If they did reflect Panglossian expectations, house prices would on average tend to be “too high” relative to fundamentals.
Go back to my alphabetical circular beach model of the fruit market. Only instead of fruit, people are buying fruit trees. An apple tree produces 1 apple per year. The apple will have a price of $25 (assuming English auction). Assume trees live forever, and the rate of interest is 10% forever. If everyone expects future tree prices to stay the same as today, each fruit tree will sell for $250.
Now, suppose half the people expect tree prices to rise by 5% per year, and so value trees at $500 (= $25/0.1-0.05), and the other half expect tree prices to fall by 5% per year, and value trees at X=$25/0.1+0.05.
What happens?
If we assume there is no rental market, and no short sales, so you have to own the tree to eat the fruit, and everyone owns one tree (you have to own the house to live in it), and everyone lives in one house only, half the houses will be priced at $500 (above $250), and half at X (below $250). [And if it weren’t for the accursed difference between geometric and arithmetic averages, the average price would be $250]. Your point would not be valid under the assumption of no rental market.
BUT. If you allow a rental market, but no short sales, then the optimists will own 2 houses each (on average), and the pessimists will own none. And the price of houses will be $500 each.
I think (not 100% sure) that that proves the point you (RSJ) were trying to explain to me.
Wonder (if anyone’s still reading) if this is worth a blog post?
“Other people call that the “money market”. I don’t. With n goods including the medium of exchange, there are n-1 markets. ”
If you need a car, or want to get rid of a car, you go to the car market. In this market, cars are bought and sold for money.
Suppose you need money. What do you do? You have two options. The first is to be seller in one of the other markets. If that is the only option in your model, then then the sum of excess demands need not be zero, because people will violate their budget constraints (e.g. money proceeds from sales in the n-1 markets will not equal money proceeds on purchases in the n-1 markets, neither in aggregate, nor at the level of the individual agent).
The second option is to go to the money market, or the financial market, in which people incur financial liabilities in exchange for the medium of exchange, or they use the medium of exchange to purchase financial liabilities.
Now you are in both an exchange and credit-based economy. In this case, money in = money out for each agent and for the economy as a whole, as any money not spent is by definition used to acquire a financial asset (money itself is a financial asset, the liability of the central bank).
Are you ignoring this market, or do you view this as just another market like the market for cars? One in which the thing bought and sold is a future income stream?
If you do include this market, then you need to be aware that supply and demand work differently in this market, as the “price” of money does not reflect the quantity of money demanded, but of expectations of return. The marginal eagerness of a borrower to borrow will not set the price, and neither will the marginal eagerness of a lender to lend. The price will be set by the mean expectation of return, or how much the market as a whole thinks the promise is worth. It is not always the case that more promises to pay means that the market thinks each promise is worth less (expectations could be good). Neither is it the case that fewer promises to pay mean that each promise is worth more (expectations could be be poor). So all of a sudden expectations about the future enter into the picture when you are in a prediction market, and when the future looks bleak, the desire to borrow decreases and the desire to save increases, leading to a disequilibrium. Falling yields do not fix this disequilibrium, but reflect the poor expectations.
Agree or disagree?
RSJ: “Are you ignoring this market, or do you view this as just another market like the market for cars? One in which the thing bought and sold is a future income stream?”
It’s just another market. The market for bonds. A bonds is a promise to pay future money. (I use the word “bond” more loosely than those who trade them).
“…supply and demand work differently in this market, as the “price” of money does not reflect the quantity of money demanded, but of expectations of return.”
I have massive semantic problems with what you say here:
1. When I say “the price of money” I mean the reciprocal of the price(s) of all the goods that the medium of exchange (money) can buy. 1/CPI would be a first approximation. You presumably mean the rate of interest? Or some reciprocal of the price of bonds?
2. When I say “the quantity of money demanded” I mean the stock of medium of exchange that people wish to hold. You presumably mean the flow of bonds that people want to sell?
So let me translate what you say into my language:
‘…The rate of interest does not reflect the supply (and demand?) of bonds, but expectations of return.’
I would say that expectations of return shift the supply and/or demand curves for bonds, and that those shifts in the supply and/or demand curves in turn affect the rate of interest.
And I would re-state your last sentence as:
‘ Falling bond yields DO fix this disequilibrium, AND ALSO reflect the poor expectations. Unfortunately the falling bond yields may sometimes cause an increase in the demand to hold the medium of exchange (an increased demand for money), and this can cause macroeconomic problems, like a general glut.’
What if there is more than one medium of exchange?
What if most entities consider currency, demand deposits (actually currency denominated debt), and “money market deposits” (actually currency denominated debt) to be fungible?
Nick’s post said: “‘ Falling bond yields DO fix this disequilibrium, AND ALSO reflect the poor expectations. Unfortunately the falling bond yields may sometimes cause an increase in the demand to hold the medium of exchange (an increased demand for money), and this can cause macroeconomic problems, like a general glut.'”
What if poor expectations cause bond yields to go up because of currency denominated debt defaults?
Small comment on dental and car insurance:
Dental and eyeglasses insurance are not insurance in the usual sense of the word, i.e. paying a small amount of money to cover off a low probability but financially catastrophic event. In fact they are group savings plans administered by insurance companies.
Car insurance: Consumer Reports has long pointed out that automobile insurance for physical damage to one’s own car is not worthwhile when the value of the car is low. In that case you are better off self-insuring.
What happens when home ownership turns into home “rentership”?
From:
http://latimesblogs.latimes.com/money_co/2009/12/foreclosures-california-foreclosureradar.html
“Fontana resident Harold Sumpter, 72, is one of those borrowers who is behind on a mortgage because of a job loss. Sumpter said that since he lost his job as a general contractor for Toyota earlier this year he has struggled to pay the $897 monthly payment. He is two months behind on his mortgage, though he said he would probably be able to cull together the payment for December.
Making the payments is difficult because he and his wife make only about $1,900 a month combined with their Social Security benefits, and their household expenses roughly total $2,500, including the mortgage, Sumpter said.
“I have been current for years,” he said. “Just in the last few months, I haven’t been able to come up with the money.””
I’d like to know why this person is not retired with the mortgage paid off.