In the midst of our recent economic crisis, the US federal government’s interventionist policies have again redeployed finite resources in contravention to market forces. Consumers and many custom builders have been pushing for better quality, sustainable, energy efficient construction. Unfortunately these market forces have been overcome by government intervention. The government has incentives for first time homebuyers who typically purchase cheaper starter homes. As a result almost all new construction is being undertaken by large tract builders who specialize in cheap housing. This end of the market is very price sensitive leading these builders to continued with larger designs that sacrifice quality for size.

Contrary to the belief of the US Congress, capital cannot be created by printing money or authorizing programs intended to create jobs. In a free market capital is deployed efficiently to areas with the best returns. When the government intervenes, it may skew the use of resources to less efficient enterprises. History provides us with numerous examples, but we do not have to look far back to see one of the best.

The deep recession we are experiencing resulted in large part from government interference in the housing market. The American dream has become the American nightmare. Successive governments, both Democrat and Republican, since the Great Depression have done everything they can to encourage privately owned housing. Government bureaucracies like the Federal Housing Administration and government sponsored, now government owned, entities like Fannie Mae and Freddie Mac artificially created a market for low interest loans to high risk customers. In a perfect storm, the Federal Reserve artificially depressed interest rates for a short-term economic boost.

Without artificially low rates and low credit standards, it is unlikely that the production of homes would have risen from 1.6M in 2001 to almost 2.1M by 2005. Post deflation the housing starts fell to 554,000 in 2009. At the beginning of the expansion, the Federal Funds Rate in January 2001 stood at 6%. When housing peaked the rate had been lowered to 1%. Not only did the volume of construction increase during that time, but the size of homes increase dramatically as did the price. Consumers were encouraged by lenders to purchase the largest home they could afford to take advantage of a once in a lifetime opportunity. Capital that might otherwise have been used in other areas of the economy was deployed in housing at artificially low rates. The result was catastrophic.

The same government is again intervening through first-time homebuyer tax credits. Coupled with low interest FHA loans having 3% down payments, they are creating some of the previously existing conditions. In addition to risking another bubble, the tax credits funded by all taxpaying Americans are being funneled to large corporate builders that specialize in low-end housing. This is evidenced by the fall in the median sales price in 2009 to $209,000 from a high of $262,000 in 2007.

Some of the larger builders have developed smaller plans, but they have mostly done so to meet the lower price points that the government influenced market demanded. They are not increasing the quality, sustainability or energy efficiency of their new homes. Though not all large home construction has stopped, only the truly wealthy, who tend to build better constructed homes, are still building. Homes of this quality usually include energy efficient systems and last much longer; both qualities of sustainable construction. Much has been written about “McMansion” homes, but generally homes in this market are not included. That is discussion for another day.

While tract home builders dominate the starter home segment, custom builders control the large home market. The real battle will be for the “move up market”. This market will determine the character of American housing for the foreseeable future. Move up consumers will chose between low quality, lower-cost homes built by large corporate builders and high quality, higher-cost homes built by small custom builders. Given the same available dollar for construction, the tradeoff is size for quality.

Assuming market forces determine lending limits, the average price of homes in the move up segment will likely remain much lower than previously experienced. At the peak the move up segment ranged easily into the $1M plus range. Those who grew accustom to the quality of higher priced homes will not likely abandon their affinity for hardwood floors, commercial-grade appliances, custom cabinets and granite tops. To match those features with a lower total budget, consumers will need to build smaller, high quality homes. The skill set to build these homes lies with the custom builder.

If Americans are truly interested reducing dependence on foreign energy and increasing sustainability in the housing market, we will need to decide to build smaller homes to offset the higher cost of quality construction. While it is possible that tract builders may chose to build smaller, their main advantage currently is delivering large size for a low price. Their organizations are not set up to deal with the custom aspects that would make their housing sustainable or more energy efficient. Through builder association programs custom builders have become much more educated in energy efficient, sustainable building to go along with their inherent quality.

The question now is whether the government will continue to incent consumers to continue a behavior pattern contrary to free market forces. If all new construction continues in the low end of the market, it will drive many of the remaining custom builders from the market. Already the number of builders belonging to professional organizations like the National Association of Home Builders has been drastically reduced. Most small custom builders are surviving only through remodel work, but if the market continues much longer many will likely move to other work. Rebuilding the knowledge base and expertise may take years and impact the overall quality negatively for year to come.