Marginal Revolution: Was there a Housing Bubble?

Alex Tabarrok looks at the image below and asks the question that dare not speak its name: was there even a housing bubble?


Alex says:

The clear implication of the chart is that normal prices are around an index value of 110, the value that reigned for nearly fifty years (circa 1950-1997). So if the massive run-up in house prices since 1997 was a bubble and if the bubble has now been popped we should see a massive drop in prices.

But what has actually happened? House prices have certainly stopped increasing and they have dropped but they have not dropped to anywhere near the historic average (see chart in the extension). Since the peak in the second quarter of 2006 prices have dropped by about 5% at the national level (third quarter 2007). Prices have fallen more in the hottest markets but the run-up was much larger in those markets as well.

Prices will probably drop some more but personally I don't expect to ever again see index values around 110. Do you? If we don't see the massive drop back to "normal" levels then the run up in prices should be described as a shift to a new equilibrium - much as happened during World War II - see the chart. (It's an important question to ask what changed and why?). In the shift to the new equilibrium there was some mild overshooting, especially due to the subprime over expansion, but fundamentally there was no housing bubble.

What bothers me is that I don't understand why we should have shifted to a new equilibrium. I think I understand the reasons that the equilibrium values shifted between 1940 and 1950:

  1. Developments in rail and construction techniques in the 1910-20 brought huge amounts of land under development, and pushed urban buildings rapidly upward, at a time when population growth was slowing, depressing prices
  2. The Great Depression kept them low
  3. This massive pent up demand translated into a boom in housing demands as incomes recovered
  4. The FHA, and then the Veterans administration, basically introduced an entirely new product: the long term amortizing mortgage. Previously, mortgages had been short-term affairs with balloon payments at the end; five years was a very standard term. The long-term amortizing mortgage, especially when helped along with government subsidies, massively increased the amount a couple could pay for their house.
  5. Housing demand was then sustained by high rates of real economic growth and population growth, which caused housing demand to skyrocket.
  6. Prices leveled off as the automobile brought new land into housing, but since the mortgages kept demand pegged to incomes, they never actually fell
  7. The post-1970 fluctuations are money illusion, responses to changes in nominal interest rates.

I find it hard to name a comparable equilibrium changing development in 1997. I am fairly well convinced Ed Glaeser's argument that high coastal real estate prices are due at least in part to the fact that local interests are increasingly effective at blocking new development. But that's been going on for decades; it didn't suddenly change in 1997. One could argue that this was when credit scoring models started getting much better, making more credit available, and indeed homeownership rates soared--but they soared from 64% to 69%. (By contrast, between 1940 and 1950, they went from 43% to 55%.) Also, it turns out that credit scoring wasn't that much better, as proven by rising default rates.

Alex's theory is supported by the fact that housing is bubbling up all over--the US, in fact, experienced rather modest appreciation. I'm tenatively willing to believe that this represents a real expansion of credit availability--but I still wouldn't buy a house right now without a hefty downpayment to cushion the downside risk.