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Home Publications Blogs Beat the Press The NYT Gives Space to Bubble Deniers

The NYT Gives Space to Bubble Deniers

Wednesday, 05 May 2010 10:24

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.


Comments (9)Add Comment
The Fundamental Case That There Was No Bubble
written by Andy Harless, May 05, 2010 6:24
I think there is a pretty strong case that housing prices never rose above fundamental values. To wit:

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.
written by djt, May 05, 2010 7:52
There is a need for risk premium since the value of the house portion of the asset can be destroyed through lack of maintenance. Many tract built homes have a limited life of perhaps 40-50 years and are not built in a way that they can be rehabilitated. Older homes, built of sturdier materials, can last centuries.

A house will not always provide shelter. It requires constant inputs of money to maintain that capacity.
written by djt, May 05, 2010 7:54
Oh, and neighborhoods change and the center of economic activity changes. Who could have guessed that houses in Detroit would one day cost less than the cheapest car one could purchase? That house may provide necessary shelter in the abstract, but in terms of providing necessary shelter to someone who works nearby, it doesn't always do so, even if it did in the past.
The Eggplant That Ate Chicago
written by izzatzo, May 05, 2010 10:40
If there wasn't a housing bubble, someone needs to explain why house prices diverged from rental prices as Baker has explained repeatedly.

Vacancy rates also rose with house prices as rental prices remained on a lower track. If market fundamentals were in effect, excess supply via vacancies would put downward pressure on prices like they do now, instead of continuing upwards as they did then despite the vacancies.

The rising bubble prices stimulated an oversupply of housing which resulted in rising vacancies, which in turn put pressure on rental rates not to rise and follow house prices.

Owners of housing expected supra-normal returns from lenders and future buyers, not renters. Absent the bubble and extra vacancies, fundamentals could have pulled rental rates upwards at the same rate of house prices to reflect increased real relative cost of both, but that's not what happened.

Further, the claim that there was no bubble requires an explanation of how the deep recession was not driven by a huge loss of consumption demand via lost trillions in housing wealth.

If it wasn't from falling house prices as the bubble burst, wonder what it could possibly be? Chicago? That's it, it was eggplants, as in the song, The Eggplant That Ate Chicago. History will eventually show that the Deep Recession was driven by eggplants.
written by Andy Harless, May 05, 2010 11:57
@izzatzo House prices diverged from rental prices because the equilibrium interest rate declined. That's actually quite straightforward. The value of a house is the discounted value of all future rents. If there is a decline in the rate at which those future rents are discounted, then the value of the house rises. If anything, during the "bubble" years, prevailing interest rates overstated the appropriate discount rate (compared to the interest rates we're seeing now), so if anything, house prices during the bubble years were too low relative to rents, based on the fundamentals. But if you look at TIPS yields as a proxy for expected real interest rates, the change that occurred between 2000 and 2005 can explain the change in house prices (relative to rents) that occurred over the same period.

The recession was driven primarily by a collapse of the financial system rather than a loss in housing wealth. But the element of loss in housing wealth, in any case, has nothing to do with house price fundamentals. Bubble or not, homeowners were no wealthier during the boom years than they had been previously: they owned houses; they lived in those houses; they were getting the same housing services. (To put it another way, because everyone needs a place to live, we are all "short" the housing market unless we own an house, and then we are neutral.) Even if they expected high house prices to continue, this did not make them more wealthy and should not have induced them to spend more. Therefore, if consumer spending subsequently collapsed due to a supposed loss of wealth, this was the result of irrational consumer behavior, not irrational house pricing. It's also possible that consumer spending collapsed because of a newly introduced liquidity constraint (the inability to borrow against home equity). That implies nothing about whether houses were fairly valued. (It is not in dispute that house prices have fallen.)
written by Andy Harless, May 06, 2010 12:20
Let me restate my original point a bit differently. At the peak of the housing boom, the US economy was at an equilibrium where desired investment was just sufficient to absorb desired saving. (The economy was near full employment, and there was little evidence of inflationary pressure.) That's when house prices were high. Today the US economy is far out of equilibrium: desired saving is much too high to be absorbed by desired investment at full employment, and there has been clear disinflationary (or deflationary) pressure. If the collapse of house prices brought the US macroeconomy from equilibrium to disequilibrium, how can it be said that the today's housing prices are closer to equilibrium than those that prevailed earlier? (The only way that would make sense is if some other asset price is now far out of equilibrium in the other direction. If you think that house prices have further down to go before they are fairly valued, then you need to specify which asset prices need to go up -- way up -- to the the economy back to equilibrium.)
written by PeonInChief, May 07, 2010 12:02
Another factor is simply that housing prices are sticky on the down, since people try not to sell their houses when prices are falling. Only those who have to sell do so unless they're in the small number of markets where prices aren't falling.
just where was that bubble?
written by David Cay Johnston, May 08, 2010 1:09
"the notorious University of Chicago economist is arguing that there was no housing bubble in the NYT Economix section."

In the news biz we call these fluffs when they are in heds (headlines) and running of track when in the text.

There never was, or could be, a housing bubble IN the NYT Economix blog.

Proper way to render:

"the notorious University of Chicago economist, in the NYT Economix section, is arguing that there was no housing bubble."
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Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.