Wednesday, May 5, 2010

Was It Really A Bubble?

Copyright, The New York Times Company

Adjusted for inflation, residential property values were still higher at the end of 2009 than 10 years ago. This fact raises the possibility that at least part of the housing boom was an efficient response to market fundamentals.

Inflation-adjusted housing prices and housing construction boomed from 2000 to 2006 and crashed thereafter. Commentators ranging from President Obama to Federal Reserve Chairman Ben S. Bernanke have described that cycle as a “bubble,” by which they mean that, at least in hindsight, the housing price boom was divorced from market fundamentals.

But maybe there was a good, rational reason for housing prices to increase over the last decade.

Let’s consider first what it means to believe that the spike in prices since the late 1990s was unwarranted — the so-called “bubble theory.”

According to the bubble theory, for a while the market was overcome with exuberance, meaning that people were paying much more for housing than changes in incomes, demographics, technology and other basic factors would suggest.

Now that the bubble is behind us, people today should be no more willing to pay to own a house than they were in the late 1990s. (It’s true that population has grown since the 1990s, but population growth is nothing new and should not by itself increase real housing prices. Don’t forget that greater population also means more people available to do construction work.)

Bubble theory also implies that the technology for building homes and providing housing is not very different today from what it was in the late 1990s, and so you couldn’t blame the spike in prices on changing building technologies either. In other words, the bubble theory blames rise in prices on animal spirits, and not on any “legitimate” increase in building costs.

Meanwhile, bubble theorists also say that today America is “overbuilt” as a result of the bubble. With too much housing and no additional demand to be supported by market fundamentals, real housing prices should, according to the bubble theory, be lower today than they were in the late 1990s.

A reasonable estimate, based on bubble theory, is that housing inventory is about 3 or 4 percent above what it would have been without the bubble and without the temptation to overbuild. In order to make these excess homes worth buying, prices need to fall further; economists would generally estimate that an extra 1 percentage point of housing inventory requires a matching 1 percentage point decline in price to make those excess homes look like a good deal.

So if we believe we had 3 or 4 percent more homes than we really needed last year, based on market fundamentals, that means that housing prices would eventually be about 3 or 4 percent below what they were before the bubble, in order to make those extra houses worth purchasing.

I’ve plotted this path out in the blue series in the chart below. It shows the housing price path one might have expected for 2009 and beyond if housing demand had returned to about where it was before the housing boom.

A note: Here housing prices are measured according to the Census Bureau index, which dates back far enough to observe previous cycles, and adjusted for inflation using the Bureau of Economic Analysis’s price index for personal consumption expenditures. The index is normalized so that it is 100 in 1994-97. In other words, a value of “100” for today would mean that inflation-adjusted new home prices are no different today than they were then.

According to the blue series, created using the “bubble theory” premises, real housing prices would be 3 or 4 percent lower now than they were before the housing boom (a value of about 97 for the index) if in fact housing demand were no different, because the “overbuilt” inventory of houses is supposedly 3 or 4 percent greater now than it was then.

This path approximates what some bubble theorists were expecting last year. For example, during the first half of 2009 Professor Robert Shiller (the same Shiller from the Case-Shiller housing price index) forecasted that housing prices would fall further.

Of course, our population continues to grow, so the housing boom’s excess inventory will not last forever as new households form. But this process takes a while, which is why the blue series in the chart shows real housing prices returning to normal (a value of 100 for the index) only slowly after 2010.

Now let’s turn to the black series in the figure, which shows actual housing prices.

Contrary to the blue “bubble theory” series, actual housing prices have risen slightly over the last four quarters, so far remaining well above what they were before the housing boom. Although real housing prices are sharply off their highs, today they appear high by historical standards.

Bubble theorists might say that some unfounded optimism lingers in the market place, and that Professor Shiller was just a little early in predicting that real housing prices will soon be significantly below what they are now.

But another interpretation is that a large fraction of the housing price boom was justified by fundamentals (and next week I’ll consider some of the specific fundamentals that may have permanently increased housing demand in the 2000s). If so, we are probably asking too much of the Federal Reserve and other regulators to accurately disentangle bubbles from fundamentals the next time that asset prices rise.


Greg said...

Amen, Casey Mulligan - Amen.

(Although you're right, you're about to be skewered by a whole bunch of people who haven't really thought about these issues... probably ever. Stand strong)

Maurizio said...

Are you familiar with the idea that interest rates, artificially kept below the market rate, fool entrepreneurs into starting more long-term projects than can be completed with the available amount of savings?

In other words, society as a whole did not accumulate enough savings to sustain the construction of so many projects, so many of them are by necessity doomed to fail, but entrepreneurs don't realize them until it's too late, because they have been misled by the artificially low interest rates into starting them.

That could be taken as a definition of "bubble": the situation in which more projects are started than can be completed with the available amount of saving in a society.

Do you have any comments on this theory?