What Caused the Housing Bubble?

Ed Glaeser says that if people were as smart as he is, they would have realized housing price increases were unsustainable and there wouldn’t have been a housing bubble:

In Housing, Even Hindsight Isn’t 20-20, by Edward L. Glaeser: …[Is] the housing market … starting to hit bottom? … One major point of economics is that predicting asset prices is extremely hard… Moreover, the last seven years should make everyone wary about predicting housing price changes. …

The housing price volatility of the last six years has been so extreme that it confounds conventional economic explanations. Over a four-year period — from February 2002 to February 2006 — the Case-Shiller index increased … about 50 percent in constant dollars.

Certainly, those price increases cannot be explained by increases in average income. Income growth was quite modest from 2002 to 2006. Nor can the boom be explained by a dearth of new housing supply. Construction rose dramatically during the boom…

A number of pundits place the blame for the bubble on … Alan Greenspan. They argue that loose monetary policy caused housing prices to rise. While lower interest rates are correlated with higher prices, the relationship is far too weak to explain the price explosion that America experienced. … To get a 50 percent real increase in housing prices, real interest rates would have had to decline by more than …10 percentage points…, which is not what happened. … Real rates actually rose slightly between 2002 and 2006.

While low interest rates, on their own, cannot make sense of the bubble, perhaps the increased availability of credit to subprime borrowers has more explanatory power. … Yet the correlation between housing price growth and subprime lending across markets is as likely to indicate that lenders took more risks in booming markets as that those risks caused markets to boom. …

The most plausible explanations of the bubble require levels of irrationality that are difficult for economists either to accept or explain.

For many years, the creators of the housing index, Chip Case and Robert Shiller, have argued that housing bubbles were fueled by irrationally optimistic beliefs about future housing price appreciation. More recently, Monika Piazzesi and Martin Schneider have documented the rise in optimistic beliefs about housing price appreciation over the recent boom. Using some elegant algebra, they suggest that overly optimistic beliefs could cause a boom even if those beliefs were held by only a small share of the population.

It is hard to argue with this view. The only way that anyone could justify spending bubble-level prices in Las Vegas was by having the incorrect belief that those prices would increase.

I once thought that the Las Vegas housing market was so straightforward (vast amounts of land, no significant regulation) that no one could be deluded into thinking that prices could long diverge from construction costs, but I was wrong. I underestimated the human capacity to think rosy thoughts about the value of a house.

Yet even if ridiculously rosy beliefs are a major part of bubbles, we cannot say that we understand those bubbles until we understand the sources of such beliefs. Economists like to link beliefs to reality, but these views weren’t grounded in sound statistics. The housing boom was a great wildfire that spread from market to market, but it is hard to make sense of its flames. …

I don’t think people believed that housing prices would never, ever go down, what they thought is that housing prices would go up in real terms, on average, over time – that housing was a good long-run investment. They knew there would be variation around that trend, but they expected the variation to be relatively mild, they didn’t expect the severe variation in prices and associated problems that actually occurred.

But as Shiller argues, the belief that real housing prices rise over time is false, the evidence suggests that real housing prices are relatively flat over the long-run. Because people expected prices to rise on average when they should have expected them to remain flat, the correction – the variation in prices – was far larger than anticipated and many homeowners weren’t able to simply ride out the short-run variation like they thought they would be able to do.

But this still leaves a question unanswered. Why did people have this false belief about the long-run trajectory of prices? Shiller explains that this happened because people believed that both land and building materials were becoming relatively more scarce over time, a belief he says is false, but that just pushes the “but why did they believe that” question back one step from housing prices to the prices of land and raw materials.

So let me take a quick stab at an explanation (I’m not pushing this, it’s just a quick thought). People are told (or were at that time) that stock markets are a great long-run investment. If you have the time to ride out the short-run fluctuations you can earn 8% per year. Just dump your money in an index fund that duplicates the market portfolio, and forget about it until many, many years later and you will do fine. Risk adjusted real returns on assets ought to equalize across markets through arbitrage, so shouldn’t housing yield a real return similar to stocks (adjusting for risk)? Shouldn’t there be a real return on housing just like in stock and other asset markets, and if so, doesn’t that mean real prices will rise on average over time? This still requires beliefs about long-run prices at odds with (Shiller’s) evidence though.

One more note. I may be wrong to assert that people thought that housing prices would rise forever. If you know that there is a bubble in an asset market, but you believe you can sell fast enough once the market hits a turning point to still make a profit, or at least not lose much in any case, then you may be willing to make an investment that tries to exploit the short-term surge in prices. But while I think that may apply to stock markets, or other markets where assets can be sold quickly (the belief that is, the reality is quite different when everybody tries to sell at once), I’m not sure this applies to housing where sales can be notoriously slow. But it’s still possible that people would know there is a bubble in housing prices, but still be willing to make an investment because they believe that housing prices would fall so slowly that, if necessary, they could sell their house before taking a loss. It just doesn’t seem to me that this explanation works as well in housing as it does in stock markets.


Originally published at Economist’s View and reproduced here with the author’s permission.

8 Responses to "What Caused the Housing Bubble?"

  1. Anonymous   July 8, 2009 at 1:05 pm

    “But this still leaves a question unanswered. Why did people have this false belief about the long-run trajectory of prices?”The public believed houses were the best investment that most people would ever make because, not only were home prices rising year after year, nearly all the popular financial gurus were telling us so – buy a home now and you’ll be glad you did. Almost every day, the media published articles promoting home ownership. Popular books, such as “Why the Real Estate Boom Will Not Bust – And How You Can Profit From It: How to Build Wealth in Today’s Expanding Real Estate Market” by David Lereah, fanned the flames of housing speculation. Lereah, who made numerous promotional appearances in the media, was Senior vice president and chief economist of the National Association of Realtors, so the public viewed him as a trustworthy authority on real estate. The media bombarded the public every day with real estate propaganda, and it worked astonishingly well – for those who got out at the right time.

  2. Guest   July 8, 2009 at 6:16 pm

    Aside from Pump and Dump, since 1997 there has been a powerful incentive to pile into real estate: the change to allow up to $500,000 of capital gains to remain tax-free. This also coincided with the beginning of the housing bubble.

  3. Green Man   July 10, 2009 at 7:20 am

    Very important topic – we absolutely need to understand what happened so that it can be prevented from ever happening again. My analysis is the following: my brother, who is a veteran residential & commercial certified appraiser, told me just after the S&L mortgage crisis that the RE industry had laid low long enough for regulators to go back to sleep and was restarting the RE price inflation collusion machine. Here is how the machine works. All parties to a real estate transaction have an interest in a “successful” deal, so there is collusive pressure to “make it happen”. When one party orders the possible deal breaking appraisal, they get to choose the appraiser who will perform it. Like investment banks shopping for the least onerous regulators, the RE industry shops for the appraisers who will give them the values they need. In fact, some appraisal orders actually come in with a post-it note with the target appraisal price attached. The understanding is: give us our deal making values consistently or we won’t do business with you anymore. So, the system of checks & balances becomes non-existant in the real world of conflicts of interest, and when everyone is playing with OPM (other people’s money) then the process rapidly inflates prices until the bubble eventually bursts. How do appraisers deliver such inflated valuations over time? Simple. Consider a deal for a property 10 miles inland from prime waterfront properties. The appraiser simply took 3 waterfront property “comparables” and made some slight downward adjustments to get a valuation that just happened to work perfectly. Now, other deals in the target area will use that sale as a comparable and the price inflation bubble expands a little more. Folks, human business behavior is not nuclear physics. A system with real checks & balances is easy to create & enforce if we really want honesty, transparency and sustainability. The reality, however, is that marketmakers want the appearance of due process but the actuality of financial control. Thus the near collapse of our industrial sector due to Globalism has left our poorly regulated real estate/financial services sector as the “growth sector” where need & greed can feed. And they have been gorging themselves on decades of asset accumulation by hard-working people by simply shuffling paper around and taking a cut on every dirty deal that came around. Hey, “everybody’s doing it”… “gotta make hay while the sun is shining”… “it’s not gonna be MY problem when the sh*t hits the fan.” Well guess what? It’s everybody’s problem when the sh*t finally hits the fan.

  4. SpecialK   July 10, 2009 at 7:55 am

    Limited rationality, the cost of information and agency problems.Or to put it differently, sorry economists and fiancial experts but no one was or wanted to listen to you. Who did they listen to? See below.Actual buyers and sellers didn’t “have” the data or process it well. They weren’t using your models, even when they could avail themselves of the data. Its costly, they aren’t economists or market statisticians. Joe Public doesn’t read official statistics, much less have a valuation model that extends beyond extrapolating “what happened” in the markets she was (infrequently) involved in. (And this ain’t Joe Six Pack we are talking about. Its also, Joe the lawyer, Joe the doctor, Joe the accountant, even Joe the personal financial advisor!)Plus the now endlessly rehearsed “physcological biases” about how we believe what we “wish” to believe by selecting the “evidence”Where did most people’s “evidence” and “model” come from? From the realtor community of course. These ” experts” had every incentive to perpetuate the “story” of how well everyone would do because they had done so well in the “past”. It all seemed so (locally) rational, and besides, as a realtor you had every incentive to rehearse this model and validate it based on what had happened most recently.Its ironic that the biggest personal asset market on the planet lacks minimal transparency, lacks mechanisms to mitigate agency misalignments and completely lacks “financial education” for its customers!

  5. old gringo   July 10, 2009 at 9:54 am

    I really thought that I was witnessing the rise of a new middle class in Nevada, Arizona & New Mexico.

  6. Anonymous   July 10, 2009 at 3:25 pm

    “But this still leaves a question unanswered. Why did people have this false belief about the long-run trajectory of prices?”Which in turn leaves the question, “Why did people supposedly think black tulip bulbs were worth thousands of todays dollars and would appreciate in the tulip mania?”Because it’s elementary, my dear Watson, that particularly in a mania people act like cliff jumping, lemming ***holes.

  7. Guest   July 11, 2009 at 10:42 pm

    As usual, making excuses for Greenspan. And no mention of the moral hazard created by Fannie/Freddie courtesy of Barnie F., who’s at it again. I expect better here.

  8. Gordon Cannoles, CPA   July 12, 2009 at 8:22 am

    The housing bubble is much easier explained by loose mortgage lending standards, buyer speculation, and out right buyer and mortgage lending fraud. Buyers were put into mortgages that could never be paid back. Fueled by Wall Street’s willingness to buy the mortgages and bury the almost worthless loans in securities. The rest is history. No one nailed it down better than Kyle Bass of Dallas when he observed the widdening gap between the median wage and median home prices. Cash flow is the one variable that never changes. Cash in has to equal cash out, or somebody does not get paid. Place the blame where you wish, everybody in the real estate and securities food chain has blood on there hands.The only resaon the problem did not get out of hand in Texas is because mortgage brokers are licensed and regulated. The management of Texas financial institutions also remembered the roaring 80’s of real estate, the following collapse of the residential and commerical real estate markets, and the Resolution Trust.It is hard to believe almost no one in a postion of leadership, at any level, learned anything from this experience.Greed always trumps reason.