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Casey Mulligan is on the loose again. The notorious University of Chicago economist is arguing that there was no housing bubble in the NYT Economix section. The centerpiece of his argument is that inflation-adjusted house prices have not returned to their pre-bubble level. This means that the price rise must be driven by the fundamentals of the housing market rather than an irrational bubble.
It's hard to know where to begin on this one. I guess the first point would be that he is using the wrong series to find anything about the bubble. He is using the new house price series from the Census Bureau. This series controls for neither quality nor location. If the price of all homes doubled, but the price of new homes built further from city centers remained the same, this index would show no increase in prices. This is why almost everyone in this debate uses one of the repeat sales indices, such as the FHFA House Price Index or the Case Shiller national housing index.
Of course the good part of the story is that Mulligan's case would hold even more strongly with these indices (they are further above their pre-bubble level), but it is important that we at least look at the right picture. The NY Fed put out a paper back in 2004 claiming that there was no bubble, the only problem was that people like me were using the wrong price index.
But, let's get back to the issue at hand. House prices have certainly not deflated to their pre-bubble level. They are about 15-20 percent higher in real terms. Why is this the case?
I would point out three factors that may have escaped Professor Mulligan's attention. First, until last Friday the government had an $8,000 first time homebuyers tax credit. This is a bit less than 5 percent of the median house price. Even at the University of Chicago an $8,000 tax credit would be expected to have an upward effect on house prices.
The second factor is that we have had extraordinarily low mortgage interest rates. The weakness of the economy and the Fed's policy of buying $1.25 trillion in mortgage-backed securities pushed the 30-year mortgage rate below 5.0 percent. Interest rates are at their lowest levels since the early 50s. Again, even at the University of Chicago, low interest rates would be expected to have a positive effect on house prices. We might see a different picture if interest rates creep up to near 6.0 percent over the next year, as they are widely expected to do.
The third factor unusual affecting house prices in the last year was the expanded role of the Federal Housing Authority (FHA). The FHA guaranteed almost 30 percent of purchase mortgages in 2009. Many of these homebuyers would not have been able to get a mortgage without the government's support. Again, even at the University of Chicago they probably think that government guarantees for mortgages will have a positive effect on house prices. It is worth noting that the FHA is rapidly cutting back its role because it lost lots of money and is now below its minimum capital requirement.
Finally, real house prices are falling -- currently at a rate of between 0.5-1.0 percent a month. Economists generally do not expect to see instantaneous price adjustments, so it should not be surprising if it takes another year or two for house prices to get to a stable level, once the bubble has fully deflated. (Over-correction is a real risk.)
So, if anyone thought that the housing bubble would immediately deflate and bring prices back to their fundamental level -- in spite of massive efforts by the government to prop up prices -- then Professor Mulligan has the evidence to show that they were wrong. But for everyone else, this piece is probably not very enlightening.
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1. The equilibrium interest rate is the one that equates saving with investment at full employment.
2. Clearly no non-negative interest rate will do that, so the equilibrium interest rate is negative. (You can object that this situation will change in the future, but looking at Japan's experience, I'm not convinced that's the case.)
3. When the interest rate becomes negative, the value of long-lived assets goes to infinity.
4. Houses are such an asset. (You can quibble about depreciation if you want, but I doubt the depreciation of houses happens quickly enough to make the difference -- and the land underneath is truly a virtually infinitely-lived asset.)
5. There is no need to apply a risk premium, because, in terms of real utility, houses are the safest of assets. Even with T-bills, there is reinvestment risk, but a house will always provide necessary shelter, no matter what happens to asset prices or asset returns.
All this is not to say that house prices will actually rise again soon. But under the circumstances, I object to the notion that we can establish some finite fundamental value that implies they were overvalued during the so-called bubble. And I particularly object to the idea that their fundamental value can be assessed based on historical value benchmarks. That error -- looking at historical data without modeling why the data behave the way they do and why the future might be different -- is precisely the one that sub-prime investors made.