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.