The run-up in home prices: a bubble - The Market Failures Issue

Challenge, Nov-Dec, 2002 by Dean Baker

IN THE LATE 1980s, JAPAN EXPERIENCED A SIMULTANEOUS BUBBLE in its stock market arid its real estate market. The collapse of these bubbles has derailed its economy for more than a decade. A similar collapse in the United States, coupled with a poor policy response, could have similar consequences here.

The recent plunge in stock prices has finally forced most policy analysts and economists to acknowledge that the stock market had a bubble at its 1998-2000 peaks. Similarly, the recent fall in the dollar has increased the recognition that the dollar, too, was overvalued. The economy has yet to deal with all the disruptions created by the deflation of these two bubbles. This process will take some time, and the correction in the value of the dollar is still far from complete. However, the economy has now developed a third bubble, the collapse of which also poses a serious danger to the economy.

That third bubble is in the housing market. Since 1995, home sale prices have risen far more rapidly than the overall rate of inflation. Over this seven-year period, home sale prices have risen by more than 47 percent in nominal terms, an amount that is nearly 30 percent above the overall rate of inflation. (1) This run-up in housing prices has translated into an additional $2.7 trillion in housing wealth, more than $35,000 for an average homeowner, compared to home sale prices' having only kept pace with the overall rate of inflation. (2)

This increase in housing prices has had important short-term consequences for the economy Most immediately, it has helped to sustain housing sales and construction of new homes, as many families purchase homes at least partly in the belief that their price will continue to outpace inflation in the future. Housing sales have remained at or near record levels throughout the recent recession. High housing prices have also fostered consumer spending generally As several recent studies have shown, households view the value of their homes as an important source of wealth for the future (e.g., Case et al. 2001; Dynan and Maki 2001; Maki and Palumbo 2001). When they see home values climb, they feel less need to save for the future. In addition, increases in home values allow households to directly increase their consumption by borrowing against their increased equity. Partly as a result of this run-up in housing prices, consumption has stayed high and savings rates have remained near record lows, even as the declinin g stock market has substantially reduced the wealth of tens of millions of families.

While the short-term effects of a housing bubble appear very beneficial--as was the case with the stock bubble and the dollar bubble--the long-term effects from its eventual deflation can be extremely harmful, both to the economy as a whole and to tens of millions of families that will see much of their equity disappear unexpectedly. The economy will lose an important source of demand as housing construction plummets and the wealth effect goes into reverse. This outcome will slow an economy already reeling from the effects of the collapse of the stock bubble. The loss of housing equity will be yet another blow to baby boomers on the edge of retirement, many of whom just endured large losses in the stock market.

Unfortunately, most of the nation's political and economic leadership remained oblivious to the dangers of the stock market and dollar bubbles until they began to deflate. This failure created the basis for the economic uncertainty the country currently faces. The problems created by the deflation of the stock market and dollar bubbles will be aggravated further by the deflation of the housing bubble. This process will prove even more painful if the housing bubble is allowed to expand still further before collapsing.

The first section of this paper examines the evidence that housing market is in fact experiencing a bubble. It shows that the 1990s have seen a run-up in housing prices that is without precedent in the post--World War II era. The second section points out some of the likely implications of housing prices' returning to more normal levels. The third section briefly examines the economy's near-term prospects, given the likely collapse of the housing bubble. A brief conclusion follows.

The Evidence for a Housing Bubble

While there is no dispute that housing prices have vastly outpaced the inflation rate over the last seven years, it is possible that higher housing prices reflect shifts in underlying fundamentals, which have led people to place increased value on home ownership. This is precisely what Federal Reserve Board Chairman Alan Greenspan argued in recent testimony before the Congress ("Fed Chief" 2002). This section examines the evidence for such a shift in fundamentals.

Before looking at the data, it is worth noting that very similar arguments concerning shifts in fundamentals were made by those who believed that the stock prices at the peak of the bubble were justified, or that the high dollar could be maintained in spite of soaring current-account deficits. Many prominent economists, including Mr. Greenspan, put forward such arguments. In the wake of the recent declines in the stock market and the dollar, these arguments appear much less credible than they might have two or three years ago.