Monday, November 15, 2004

The Run-Up in Housing Prices is Not a Bubble

By Hilary Croke

There has been considerable debate recently over the presence of a bubble in the housing market. While there are compelling reasons suggesting an imbalance, there are several factors that indicate a change in fundamentals. Though house prices have undeniably risen in recent years, it is difficult to accurately determine the magnitude given the range of different indexes available from various sources, including the Bureau of Census, Office of Federal Housing Enterprise Oversight (OFHEO) and the Bureau of Labor Statistics (BLS). For example, Chart 1 compares the year-end percent change of the house price index produced by OFHEO with the owners' equivalent of rent on primary residence component of the CPI produced by the BLS. While there are large differences in the construction of the indexes, including how each accounts for changes in the quality of houses over time, both measures indicate that the recent run-up in prices is not unprecedented, though the BLS measure suggests a slightly lower rate.

Chart 1

Demand for housing has increased substantially. Currently, the number of new homes sold is at record levels (Chart 2). Previously, new home sales have been highly cyclical, falling during recessions, along with house prices. However since the early 1990s, new home sales have continued to trend upward. On the supply side, Chart 3 shows that housing inventories remain at low levels, around 4 months supply compared with 12 months in the early 1980s. While this could be explained in part by the increase in population due to immigration, there are several other possible explanations for the increase in demand.

Chart 2 Chart 3

Firstly, the government has introduced initiatives over the past three decades in an effort to boost the rate of home ownership. In addition to tax incentives, the federal mortgage lenders, Fannie Mae and Freddie Mac have been playing an increasingly important role in providing easier access to mortgages for low-income earners. Since the 1970s, the agencies have increased their share of total multi-family debt from around 5% to 23%. More recently, the American Dream Down Payment Act passed in 2003 allows for $200 million annually for down payments and for loans backed by the Federal Housing Authority. The government estimates that these measures will help another 5.5 million families to become homeowners by 2010.

In addition to the increased role of federal mortgage lenders, the private sector has become increasingly competitive in mortgage lending over the past decade. As a result, mortgages have become cheaper and easier to obtain. Along with lower down payments, fees and charges associated with mortgages have dropped dramatically (Chart 4). This has particularly benefited low-income borrowers. Between 1993 and 2000, the number of loans for home purchase to low-income earners nearly doubled.

Chart 4

Thirdly, real estate has become an increasingly attractive investment option. Aside from the traditional reasons, such as the safety of investing in 'bricks and mortar', homes have become a source of finance. Over the past decade, the expansion of the credit market and lower interest rates have made mortgage refinancing increasingly popular. Even as interest rates increased during 1999 and 2000, the volume of applications for mortgage refinancing was four times higher than it was in 1990 (Chart 5).

Chart 5

Lower volatility in the general economy has also encouraged residential investment. Interest rates are lower and less variable compared with previous recessions as shown in Table 1. Personal income growth and the unemployment rate have also become less volatile so that investors are confronted with less uncertainty compared with previous decades.

Table 1: Averages and Variances during NBER-defined Recessions


Recessions (peak to trough)

Unemployment Rate

Real Disposable Personal Income1

Nominal Mortgage Rate2







Nov 73-Mar 75







Jan 80-Jul 80







Jul 81-Nov 82







Jul 90-Mar 91







Mar 01-Nov 01







1 Statistics based on year-end growth rates
2 Federal Home Loan Mortgage Corporation, 30-year fixed rate conventional mortgage.
Sources: National Bureau of Economic Research, Bureau of Labor Statistics, Bureau of Economic Analysis, Federal Reserve Board.

The increase in house prices may also be explained by an increase in housing quality. It is questionable whether the various house price indexes adequately capture changes in housing quality over time. Table 2 shows that over time, new houses have become larger with the median size (in square feet) increasing by around 38% since 1973. In addition, higher spending on residential additions and alterations may be increasing the quality of existing homes (Chart 6).

Table 2: Characteristics of New One-family Houses Completed

(percent distribution)





Median Square feet





4 or more bedrooms





2.5 or more bathrooms





Air Conditioning





Source: Bureau of Census

Chart 6

Finally, several indicators suggest that the increase in home ownership has resulted in lower rental activity. Home ownership is currently at a record rate of 68% (Chart 7). The benefits of home ownership together with easier access to credit has made rental accommodation less attractive. The steady increase in rental vacancy rates shown in Chart 8 may help explain the recent fall in rental prices in some areas.

Chart 7 Chart 8

In summary, while a deceleration in house price inflation is to be expected, a collapse commensurate with previous asset price bubbles is unlikely.

*Hilary Croke works for the Federal Reserve Board. This essay reflects Ms. Croke's view on this issue, not that of the Federal Reserve Board.

You have read the winning essay. Now read Dr. Dean Baker's response:

Housing: Alan Greenspan’s Second Bubble

By Dean Baker*

Survivors of the recent stock market crash should rightly be worried that a sharp drop in housing prices could deliver a second major blow to their retirement dreams. The fact that there has been an unprecedented run-up in home prices over the last eight years creates the possibility for an unprecedented decline in the years ahead - just as the spurt in the NASDAQ at the end of the nineties created the basis for its plunge after March of 2000.

The basic facts are striking. According to the government's House Price Index (HPI), the increase in the sale price of an average house has exceeded the overall rate of inflation by more than 40 percentage points over the last eight years. In the past, house prices had largely kept pace with the overall rate of inflation.

It important to recognize what this index shows - the HPI tracks the change in price for the same home. This means that the rise in this index is not being driven by better quality homes, it is being driven by homes of the same quality costing more.

Also, it is important to remember that the HPI is measuring housing sale prices. The Bureau of Labor Statistics has an index that measures the rental prices of owner occupied housing. The fact that this rental index has not risen anywhere near as rapidly as the HPI (and is now rising less rapidly than the overall rate of inflation), is convincing evidence that there is a housing bubble. If there were some underlying factor driving up the demand for housing, then it should lead to comparable increases in home sale prices and rental prices, as it always did in the past. Instead, people are willing to pay more for owning a home, but not in general willing to pay more for rent, at least relative to rate of inflation. This suggests a bubble waiting to pop.

While the federal government has played an active in role in trying to promote homeownership in recent years, this is not a new policy, and the initiatives of the last decade have not been especially large. For example, the $200 million annual appropriation provided for in the American Dream Down Payment Act, will be sufficient to provide $15,000 down payments for 13,000 home buyers each year, approximately 0.17 percent of the homes purchased annually. This policy is not likely to have much of an impact on the overall housing market.

The secondary market in mortgages has indeed grown in the last ten years, but this market was already huge twenty years ago. Furthermore, competition may have been successful in driving mortgage fees down over the last twenty years, but the full chart (CHART 4) from Ms. Croke's column would show that mortgage fees, like mortgage interest rates, have just now fallen back to their levels of the mid-sixties, not exactly the basis for an unprecedented boom in home prices.

It is questionable whether the economy has become less volatile as claimed; the recent slump has produced the most prolonged period of job loss since the Great Depression. However, it is reasonable to believe that homeownership would be more valuable in a period of great volatility, since the safety of homeownership might be seen as especially appealing if stocks and other assets pose great risks.

The fact that people are borrowing against their homes at a rapid rate (more than $750 billion in 2003) is more evidence of an unsustainable bubble. The ratio of mortgage debt to home equity is at record highs. This fact is especially scary given that equity values may be inflated by as much as 20 to 30 percent as a result of the housing bubble, and that the nation's demographics (with the baby boomers approaching retirement) suggest that many homeowners should have largely paid off their mortgages.

The market is responding to the housing bubble exactly as economic theory would predict. New homes are being built at record rate, far faster than can be supported by population and income growth. At the moment, this has mostly affected the rental market, leading to record vacancy rates and falling rental prices. However, as home prices continue to rise, many potential homebuyers will opt to rent, especially when interest rates rise. And vacant rental units can be put up for sale. The end result will be a loss of $2 to $3 trillion in housing wealth, and a downturn that is even worse than the fallout from the stock market crash.

Dean Baker is an Economist and Co-Director of the Center for Economic and Policy Research (CEPR) in Washington, DC.

And More...

Why Is the Run-up in Housing Prices Not a Bubble?

There is no precedent for the nationwide run-up in home prices over the last eight years -- 35 percentage points in excess of inflation. Neither the great boom of the sixties, nor the demographic surge created by the baby boomers forming their own households in the seventies and eighties, led to any substantial increase in home prices, adjusting for overall inflation.

Economists who claim that that there is no housing bubble - that the run-up is explained by fundamentals - cite several factors:

1) increasing population due to immigration,
2) limited supplies of urban land
3) environmental restrictions on building
4) growing incomes of homebuyers

The problem with these explanations is that none of them are new to the bubble period - if these factors explain the current run-up in home prices, then they should have also led to rising real home prices in prior decades, when many of the factors (e.g. rising incomes) would have played a larger role in pushing up home prices. Furthermore, rental prices have not kept pace with home prices. The rate of inflation in rental prices is now slowing, and in some bubble areas (e.g. San Francisco and Seattle) rental prices are actually falling. No one has yet produced a remotely plausible explanation of how fundamental factors can lead to a run-up in home sale prices, but not in rental prices.

Bubbles inevitably burst, and the cost of the bursting of the housing bubble, like the cost of the bursting of the stock bubble, will be enormous. It will destroy much of the savings of tens of millions of families and almost certainly throw the economy into a second recession.

While it took nothing more than simple arithmetic to recognize the existence of the stock bubble in 1998-2000 [], virtually all of the nation's leading economists ignored the stock bubble. The nation's top policy makers designed economic policy as though the bubble did not exist and came up with implausible stories to explain the unprecedented surge in stock prices. This failure led millions to lose their retirement savings and was the immediate cause of the 2001 recession. They seem determined to repeat this mistake with the housing bubble.


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