Tuesday, January 18, 2005

Trouble At Home: The Housing Bubble

Dean Baker

Dean Baker is economist and co-director at the Center for Economic and Policy Research (CEPR) in Washington, DC.

In the late '90s, the stock market zoomed upwards, with the ratio of stock prices to corporate earnings eventually reaching more than twice its historic level by 2000. While there was no way to explain this run-up in share prices as anything but a speculative bubble, the vast majority of professional economists failed to recognize this bubble and the dangers it posed to the economy. In the fall of 2000, even after the market collapse had already begun, not one of the "Blue Chip" 50 economic forecasters saw a recession coming in 2001. The budget projections at the beginning of 2001 continued to assume solid growth in tax revenue, including capital gains tax revenue.

This history is important in the context of the housing bubble, because people should realize how oblivious the economic "experts" can be to important facts that are right in front of their faces. Very few economists have noted the existence of a housing bubble, nor the potential impact of its collapse on the economy. Nonetheless, it takes no more than simple arithmetic to recognize the nature and size of the problem.

Through the whole post-war period, from 1950 to 1995, the price of homes increased at almost exactly the same rate as the price of other goods and services. While there were areas in which home prices did rise much more rapidly than the overall rate of inflation, these increases were offset by areas in which home prices did not keep pace with inflation, so that for the nation as a whole housing inflation was virtually identical to the overall inflation rate.

This changed in 1995. Since 1995, home sale prices nationwide have risen by more than 44 percent, after adjusting for inflation. This run-up in home prices has not been evenly spread across the nation. Home sales prices in the Pacific region and New England have both increased by 74 percent, after adjusting for inflation. In contrast, inflation adjusted prices rose by 15 percent in the West South Central states and 19 percent in the East South Central states.

This pattern suggests a generalized bubble in housing prices comparable to the bubble in stock prices in the late nineties. The New England and Pacific regions are the NASDAQ in this story—having experienced the largest run-up in prices—but the over-valuation is widespread, with houses in most areas being at least somewhat over-valued.

While some economists, such as Federal Reserve Board Chairman Alan Greenspan, have sought to challenge the housing bubble view, there is little plausibility to their alternative explanations for this run-up in home prices. For example, Greenspan cited immigration, environmental restrictions on building, and growing incomes as factors explaining the housing price boom.

Such explanations are easily dismissed. The impact of immigration is dwarfed by the impact of baby boomers first becoming homeowners in the '80s. Environmental restrictions did not become tighter in the late '90s, with Republicans coming to power both nationally and in many states. Finally, the income growth of the late '90s was healthy (although it has since stopped), but no better than the growth sustained for more than a quarter century after World War II. The more plausible explanation is that, just like Japan in the '80s, the United States has a real estate bubble that fed off its stock bubble.

The final piece of evidence in this story is the pattern of rental prices. Rental prices have always tracked home sale prices. This is due to the fact that, on the demand side, people have the option to rent rather than buy, if prices get out of line. On the supply side, rental housing can be sold off, if house sale prices rise enough relative to rents. Since 1995, rents have risen by just 8 percent adjusted for inflation. Furthermore, in the last two years rents have actually fallen behind inflation, as a record nationwide vacancy rate in rental housing is placing downward pressure on rents.

The impact of a collapse of the housing bubble will be even larger than the impact of the collapse of the stock bubble. Housing wealth is far more evenly distributed than stock wealth, which means that many middle income and even lower income families will be hit by the bursting of the bubble. Tens of millions of families will find that they have far less equity in their homes than they believed. This will be especially hard on families who have borrowed heavily against their homes, particularly those close to retirement. Even with soaring home prices, the ratio of home equity to mortgage debt is at a record low. As a result, millions of families will be hard hit by a sharp drop in home prices, in many cases finding that their mortgage debt exceeds the value of their home.

For the economy as a whole, the collapse of the bubble will almost certainly mean a second recession. Home construction will fall sharply. Even more importantly, consumer borrowing, which was based on the $4 trillion in housing bubble wealth, will plunge. This could lead to a sharp downturn in consumption. In addition, widespread declines in house prices will lead to a surge in mortgage foreclosures, which in turn could lead to a collapse in the secondary market for home mortgages, requiring a government bailout of Fannie Mae and Freddie Mac.

It is impossible to know in advance all of the ramifications of a collapse of the housing bubble (which will likely include the exposure of financial scandals), just as it was impossible to know in advance the full impact of the collapse of the stock bubble. However, it is clear that it will have dire consequences directly for tens of millions of families and for the economy as a whole. It is unfortunate that the country's leadership allowed the bubble to expand to such dangerous levels. We will all have to deal with the consequences of this failure.