Housing Bubbles: Past and Future
More than two years have passed since the housing bubble began to deflate, but analysts continue to argue over the nature of the bubble, and its causes. The consensus is still that the bubble was caused by a loosening of lending standards and easy credit. Insists one analyst, “During the credit boom, if you had a pulse, that’s pretty much all you needed. You didn’t have to prove your income. You didn’t have to show much of your debt. It was just detached from reality. That’s all over.” Other analysts, however, aren’t content with this explanation and have developed counter theories.
A recent paper by a former vice president of the New York Federal Reserve Bank, for example, challenges this consensus and argues instead that changes in labor productivity was a primary impetus behind the rise in housing prices. “Consumers thought that because they were working harder starting in the mid-1990s, their paychecks would follow suit, encouraging them to pay high prices for housing, the study found.” This naive optimism was evidently shared by the banks, which were quick to extend credit with fewer strings attached. By extension, the bursting of the housing bubble could be theoretically be attributed to the fact that incomes ultimately did not keep pace with rising productivity.
The paper attempts to preempt its critics by asserting that, Productivity growth is especially well suited for a model of aggregate house prices. Many of the other fundamentals that affect housing prices—demographic factors, density (the availability of land per capita), interest rates, taxes, and local government regulations affecting new construction—can vary widely across regions…Productivity growth, by contrast…exhibits precisely the kinds of unexpected but long-lasting changes that have the potential to influence the forward-looking price of an asset like housing.”
Perhaps the key to predicting a housing recovery, then, lies in understanding not only expectations for productivity growth, but also the extent to which changes in productivity will flow through to paychecks. Based on the chart below, the latter is somewhat irrelevant since forecasts for productivity growth have fallen dramatically since the recession began.
Robert Shiller, the Yale economist and one of the creators of the eponymous Case-Shiller Housing Index, is also looking towards the future: “There could be another bubble in housing, once the excess inventory is worked off. ‘This is not my more probable scenario [but] people have gotten very speculative in their attitudes toward housing.’ ” In his mind, then, it’s neither a question of productivity nor of income expectations, but instead of price expectations. In other words, if people believe housing prices are undervalued, prices will rise simply by virtue of this belief. Granted, this notion of (under)value must be rooted in economics, but the point stands that if for whatever reason people believe prices will rise, and have the ability (i.e. credit) to exploit this belief, then the rise in prices will become self-fulfilling.