New CEPR Paper Looks at the Factors Leading Up To the Recent Instability of the Housing and Stock Markets 

For Immediate Release: August 9, 2007
Contact: Alan Barber (202) 293-5380 x115

Washington DC: The Center for Economic and Policy Research released a report today examining the factors that have led to the recent instability in financial markets, specifically the housing bubble and the recent run-up in stock prices. 

“The housing bubble was recognizable, but as was the case with the stock bubble, those who focused their analysis on fundamentals were largely ignored in the media and in policy circles”, says Dean Baker, author of “Midsummer Meltdown: Prospects for the Stock and Housing Markets.”

The fundamentals in both the stock and housing market showed that both markets were seriously over-valued. Yet this fact was rarely noted by economists or reported by the media.

In the case of the stock bubble, as late as December of 2000, after the market had already begun to deflate, the economists sampled in the Philadelphia Federal Reserve Board’s Livingston Survey still expected strong growth and new record highs in the stock market. In the case of the housing bubble, the most widely cited expert was David Lereah, the chief economist of the National Association of Realtors and the author of Why the Real Estate Boom Will Not Bust and How You Can Profit From It.

Baker shows that, as a long-term trend, house sale prices have moved at roughly the same pace as the overall rate of inflation until 1995. Since 1995, house prices have risen by more than 70 percent after adjusting for inflation. This has created $8 trillion in housing bubble wealth. The run-up in house prices has led to a predictable oversupply of housing; an oversupply far beyond anything the country has ever experienced, with the inventory of unsold new homes 70 percent above its previous record and the number of vacant ownership units nearly twice the previous peak.

The correction of the housing bubble is likely to throw the economy into a recession and quite possibly a very severe recession. Housing construction will have to decline much further to restore inventories to normal levels. The loss of up to $8 trillion in housing bubble wealth will lead to a sharp contraction in consumption, as the saving rate rises back to more normal levels. In addition, the exuberance around the housing market has again caused the stock market to become over-valued relative to long-term trends, which implies a large drop in the stock market as the housing bubble unwinds.

Baker argues that the failure of economists and the media to pay attention to fundamentals in the stock and housing market has allowed for these bubbles to grow to dangerous levels. The collapse of these bubbles will have very serous consequences for the economy and for tens of millions of families, whose major financial asset is a substantially overvalued house.

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