Startup Cities and the Housing Crisis: The Only Way Out Is Up

Maxwell Tabarrok
Maxwell is an Economics and Math student at the University of Virginia. At UVA his research interests include urban economics, public choice, and the economics of innovation. He has interned for the Cato Institute and the Charter Cities Institute in Washington, D.C, and he hosts a substack blog called Virginica.

The United States is in the midst of a severe housing crisis. Growing populations, increasing incomes, and greater benefits to living in cities are all driving up demand for housing. Simultaneously, the monotonic growth of the zoning code and the ratcheting incentive structure of permitting restrictions are pushing down housing supply. This puts us in a supply-demand double bind where the only thing that is certain is that housing prices will rise, and rise they have. The only way out of this cycle is to start a new one.

The incumbent interests in cities like New York and San Francisco are so entrenched that the battle for housing deregulation is hopeless when fought with politics. Instead, a bundle of new innovations in mass coordination, remote work, and digital currency allow us to sidestep politics and create independent and competitive cities. This bundle of technologies is encapsulated in the Startup City. Private companies, communities of individuals, or even existing governments can contract out sections of land to create areas similar to, but a step above, special economic zones. These cities would have a large degree of economic and political autonomy and would hopefully act as a locus of growth and spillover effects for the host nation and the entire world. These autonomous cities allow communities to coordinate and exit the broken politics of their current home, and choose new ones. This increased ability to exit current cities and choose from a variety of new startups will constrain cities with competition and force all cities, even the incumbent ones, to act as competitive startups.

Before we consider possible solutions to the housing crisis, we must first quantify its causes and effects. Simply put, we are not building enough housing to keep up with demand. In a typical year like 2018, 1.1 million new households are formed, 300,000 homes depreciate to the point of needing replacement, 100,000 second homes are demanded, and around 120,000 homes need to stay vacant at any one time to ensure market liquidity. This added up to an annual demand for 1.6 million houses in 2018. In that same year, only 1.2 million units were actually built, and 2018 saw the highest rate of home building in a decade.

This annual shortfall of homebuilding has compounded over decades and left us millions of homes behind what is demanded. Furthermore, these data are from national surveys which undersell the magnitude of the problem. This is because most of the housing demand is concentrated in a few metropolitan areas where supply is restricted the most. Building 400,000 new homes in Wyoming would close the national gap, but it would do nothing to alleviate the housing shortage facing our most productive and desirable cities.

There are several factors keeping this market from equilibrium. First are restrictions on the location, use, and density of construction in metropolitan areas. Policies like maximum densities, height restrictions, and caps on building permits straightforwardly restrict housing supply from moving in tandem with demand; 20 percent of the variation in metropolitan housing growth can be explained through density regulations, and every extra acre of minimum lot size decreases the number of building permits issued by 50 percent in Boston. A somewhat more indirect cause of housing shortages are restrictions on the supply of construction workers through occupational licensing and immigration restrictions. The number of unfilled construction jobs was higher in 2018 than the post-Great Recession high.

These factors have resulted in record high and increasing prices for the average home. Since 2000, the ratio of home prices to income has increased by more than 30 percent for people living in metro areas. Relatedly, homeownership rates for 25–44 year olds are at their lowest levels in fifty years. These inflated house prices make moving to the most productive labor markets in our country impossible for more people than ever before, greatly slowing income mobility, especially for poor Americans.

These housing supply restrictions also have massive implications for the economic growth of America as a whole. Hsieh and Moretti estimated that if the housing regulations of New York, San Francisco, and San Jose relaxed to the level of the median American city, “the growth rate of aggregate output would increase from 0.795 percent to 1.49 percent per year—an 87 percent increase.” This difference in economic growth, compounded over the period they studied: 1964–2009, would result in 36 percent higher GDP today than what we actually have. That is as big as the current difference in GDP per capita between the United States and the Czech Republic.

If these regulations are so costly, why were they passed in the first place? The answer lies not in the aggregate cost-benefit calculation of land use regulations, but rather in the analysis of who pays the costs and who garners the benefits. The benefits of housing supply restrictions go to a small, clustered group of wealthy people: incumbent homeowners. When supply is restricted, the price of housing goes up and since they own the houses, they get to capture all of that price increase in higher rents, sale prices, and the aesthetic value of their preferred low-density neighborhood. The benefits to this group from extra supply restrictions can easily number in the billions of dollars for big cities like New York with lots of homeowners and very expensive real estate. This group has the ability and the incentive to coordinate and spend a lot of time and money to make sure that housing supply stays restricted. Current homeowners get votes in the decisions of city councils, can afford to show up at zoning board meetings, and fund preferred campaigns. The costs, however, while much larger in aggregate, are spread out among many more people across the entire nation. These are all of the people who might have moved to San Francisco and started a business but couldn’t afford the rent, all of the employers in LA who might have hired more people but couldn’t afford to pay the cost of living, and all of the people who might have stayed in their home in New York but were forced out by rising rents. This group is too disparate to coordinate into cohesive political groups and their per capita costs are not high enough to motivate campaigns to deregulate construction. Even though housing supply restrictions cost trillions of dollars in aggregate, the costs are spread out among hundreds of millions of people, while the benefits are concentrated within a politically active, ultra-visible, and privileged group. This incentive structure is not going away. In fact, it perpetuates itself.

As the cost of housing increases, people spend a greater proportion of their income on housing so both the potential benefits of supply restrictions and losses from new development to incumbent homeowners become larger, and they become more concentrated and rabid in their defense of land use regulations. Direct financial incentives aside, not in my backyard (NIMBYism), or opposing new construction in cities, is easy. It is supported by status quo bias and fear of change. The logic of NIMBYism also draws from a wellspring of economic misconceptions, like the view that building luxury housing causes prices to go up.  Being a yes in my backyard (YIMBY), on the other hand, requires doing actual research into the effects of housing regulation and the motivation to seek out truth in politics. The ease and incentives of holding their views mean that NIMBYs will always dominate the city councils and planning boards that create these rules. Consequently, for the past seven decades the number of land use regulations has only gone up.

How then, if the political spheres of currently existing cities are closed off to reform, should we extricate ourselves from the arm-bar that housing regulation currently has on our economic growth and mobility?

The Startup City represents the future of innovation in governance, and the eventual solution to the housing crisis. In a world where remote work, cryptocurrency, and mass online coordination allows groups of high productivity workers to move anywhere in the world, cities new and old will have to compete to be open to technology, immigration, and growth. This is already beginning to happen as US cities like Miami and Austin fight to be the promised land for the tech industry exodus from San Francisco.

There are three stages to the Startup City. The first stage has been happening for over a hundred years. It is when a group of very high productivity workers concentrate in cities and start businesses. Recent examples of cities as centers for startups and high productivity technology workers like San Francisco and Boston ring clear. This concentration of high productivity workers creates an atmosphere flowing with new ideas, venture capital, and potential mentors or friends that makes the city more attractive to even more of these workers. A critical mass of city dwellers also creates markets large enough to allow economies of scale and support highly specialized occupations, like software developer, graphic designer, or Broadway performer. These cultural and economic benefits of cities are called agglomeration benefits, and they are the key to understanding the existence and growth of cities.

The second stage, which we are entering now, is when digital technologies like cryptocurrency and remote work free workers from the land and allow them to live anywhere. These technologies are taking the agglomeration benefits of cities and spreading them across the entire globe. Online communication allows people to trade ideas, mentorship, and capital from anywhere on earth. Remote work globalizes the labor market, meaning that highly specialized workers don’t need to live near a city to be near enough to customers that support their work.

Now, mayors act as city CEOs, whether they embrace it or not. More than ever before, cities will have to compete for citizens. Since agglomeration benefits are no longer constrained to cities, poorly managed cities like San Francisco or Jakarta will no longer be able to coast off of the power of their large labor markets and economies of scale. They can pass policies which make their city open to growth and cheap to live in, or they can stay mired in the perverse incentives of traditional city politics. Either way, workers will now be able to vote with their feet; cities that do not keep their citizens will die. On the other side of the same coin, online mass coordination technologies like dominant assurance contracts and crowdfunding will empower workers with collective bargaining powers, allowing tens of thousands of people to move to a place at once. This makes the competitive pressure on cities impossible to ignore.

If the second stage is when cities begin to act as startups, the third stage is when startups begin to act as cities. Private companies can buy land from existing nations or make their own and offer governance-as-a-service on the city level. Private cities have existed for several decades, and they are mostly normal American cities like Irvine, California, or Reston, Virginia. The new technologies that support the startup city, however, will allow new private cities to cater to a global audience, and force them to compete on the global stage. This means that they will have to offer innovative and effective governance, an appealing look and labor market, world-class amenities, and safety to pull people away from existing cities.

This competitive pressure means that the NIMBY ratchet will be self defeating. The demand for housing within cities becomes much more elastic as remote work expands the urban labor market to anywhere with fast internet. This means that restricting supply has a smaller effect on housing prices in the first place. Additionally, NIMBYism may decrease house prices in the long run as progress-minded knowledge workers move to dynamic and growing communities. Many private city projects have already begun.

Próspera, a private city in Honduras, offers the lowest income tax rates in the world, online communication with the government, and a flexible law code where everyone gets insurance based on which set of laws they choose to follow, usually chosen as a package from a list of OECD nations. Culdesac, another private city project, offers a beautifully designed car-free city in Tempe, Arizona, with lots of community space and convenient public transportation. These three stages are all developing simultaneously. As they do, the market for housing and governance will get more and more competitive. Old cities will be forced to reform, and opportunities for new cities will increase, making all cities more open, free, and prosperous.

The housing crisis won’t be solved by electing new city council members in old cities alone. The incentives for incumbent homeowners to restrict the supply of new housing are too strong. The only way to avoid the effects of these incentives is to tear down the barriers to entry for new cities and open the doors to exit for citizens who would like to move. Then, any city which falls prey to concentrated benefits-diffuse costs attacks will see immediate consequences in residents moving out and nomads choosing somewhere else. The technologies of remote work, cryptocurrency, and mass coordination free people from the shackles of the land, and enter every city into a global competition for productive workers. Even now, competitive pressures are beginning to offset the effects of rising demand and NIMBYism, creating better cities for everyone.

Maxwell Tabarrok
Maxwell is an Economics and Math student at the University of Virginia. At UVA his research interests include urban economics, public choice, and the economics of innovation. He has interned for the Cato Institute and the Charter Cities Institute in Washington, D.C, and he hosts a substack blog called Virginica.