Edward L. Glaeser is an economist at Harvard.
Last week’s dismal job figures understandably overshadowed the relatively bright news from the housing markets.
From March to April, the seasonally adjusted Case-Shiller housing index for 20 major markets had its best performance since August 2007, reporting a decline of only 0.89 percent. Four metropolitan areas — Cleveland, Dallas, Denver and Washington — actually experienced price increases. Four other markets — Atlanta, Boston, Chicago and San Francisco — had price declines of less than one half of a percentage point.
Does this mean that the housing market is starting to hit bottom?
Next week, I’ll try to say something about the future. But I wanted first to acknowledge the limits of our knowledge before plunging into perilous prognostication.
One major point of economics is that predicting asset prices is extremely hard, and that goes for housing as well as stocks. Moreover, the last seven years should make everyone wary about predicting housing price changes.
At this point, not only is our foresight limited but our hindsight isn’t exactly 20-20 either. 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 68 percent in nominal terms or 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, and we built hundreds of thousands of additional homes. Our current low levels of construction will continue until we work through all of this extra housing stock.
A number of pundits place the blame for the bubble on the shoulders of the former Federal Reserve chairman, 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. A 100-basis point (1 percentage point) reduction in the inflation-adjusted rate of interest is typically associated with a price increase of less than 5 percent. To get a 50 percent real increase in housing prices, real interest rates would have had to decline by more than 1,000 basis points (10 percentage points), which is not what happened.
Mr. Greenspan’s loose monetary policy may have been a mistake, but low interest rates cannot readily explain what happened to housing prices. 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.
Certainly, there was more subprime lending in markets, like Las Vegas, that had the highest housing price appreciation. 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. After all, subprime mortgages represented a modest share of national mortgages, and prices were also rising quickly for homes bought by low-risk borrowers.
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.
It is proving equally hard to predict where the markets will land. I will return to that topic next week.
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