How to Prevent the Next Housing Bubble

Housing bubbles on a national scale like the one that formed several years ago in the U.S. are not particularly common. But it wasn't the first real estate bubble the U.S. has seen, and it may not be the last. Yale economist and housing market guru Robert Shiller provided a quick survey of the history of real estate bubbles a New York Times article on Sunday. He believes that new policy restraints should make another bubble even less likely. Is the economy really safe?

Residential real estate in the U.S. had benefited from overinvestment for a number of years, so what caused it to overheat in the middle of the last decade? Shiller explains the catalyst of a bubble:

Ultimately, bubbles are impossible without extreme public enthusiasm. Opinions about housing seem to change in rather trendy ways, but investor enthusiasm for housing has now been down for more than five years -- a decline that started well before the collapse of the housing bubble in 2007.

In fact, it's irrational exuberance that creates all bubbles. In the late 1990s, it was excitement about dotcoms that led investors to think they could get rich quick by plowing lots of money into tech startups. Their enthusiasm switched to housing several years later, and a new bubble began to form. The housing bubble's effect was more dramatic because real estate is more intertwined in our financial markets than tech stocks were. The housing bubble also captured the interest of people other than investors, as average Americans realized they could flip houses or sell their home for a profit and upgrade.

So when wondering about future housing bubbles, there are really two factors to consider. One is how likely Americans are to get overexcited about housing again. The other is whether policy makers have new ways to calm people down when extreme overinvestment hits.

To be sure, it will likely be some time before people believe again that the residential real estate can broadly achieve wild returns of more than 5% per year. The housing hangover is likely to last for years. Those who got burned by the market are many in number, and they'll be wary about making big bets on real estate for a while.

But as long as housing is widely viewed as an investment that can reap strong returns in some situations, speculation will occur. Once the pain is forgotten -- and it will be eventually -- will regulators manage to avoid another housing market disaster in the future? Shiller appears to hold some hope that recent regulatory changes will do the trick:

In contrast to the 19th century, when the business cycle proceeded without much constraint, we now have the Fed and an active government housing stabilization policy, both of which mitigate the cycle's more extreme effects. And now, the Dodd-Frank law has created a Financial Stability Oversight Council, which is supposed to go even further to prevent instability.

So could these regulators deflate a growing bubble? Perhaps, but these mechanisms could have done so before, too. The Fed could have increased interest rates much sooner to slow the unsustainable growth of mortgages. The Fed -- who then acted as systemic risk regulator, which is now the job of the Financial Stability Oversight Council -- also could have cracked down on wacky mortgage products that helped to overheat the bubble. In that role it also could have required better oversight on mortgage-backed securities.

Why didn't any of this happen? It's actually very politically difficult to slow down an economy in a countercyclical fashion. When the party's going strong, nobody wants to turn off the music and tell everybody to go home. Indeed, the Fed kept the music -- low interest rates -- on at full blast until everyone was already dangerously drunk on the spiked housing punch. How can we be sure that regulators will take bold action in the future when they haven't in the past?

We can't. So instead we should turn back to affecting the first criterion for making a housing bubble happen -- prevent people from perceiving it as an investment that can reap incredible returns. One way to do so would be to eliminate the initial conditions that made the market so conducive to the formation of a bubble.

For example, residential real estate investment should not be distorted by government policy to appear as profitable as business investment. Current federal subsidies like mortgage interest tax deductions and government mortgage guarantees help make housing a comparatively attractive investment. Without those subsidies in place, investors and average Americans would find it much harder to get overexcited about the housing market.

So in a sense, preventing future housing bubbles is really quite easy. All you need to do is make the attractiveness of residential real estate reflect the actual risk and return that would be provided without government support. Then, you don't even have to worry about fickle regulators who might not have the courage to stop a bubble from growing. Investors and average Americans won't get overly excited about a market that becomes as boring as it should be. Of course, stability tends to look a lot more boring than it does exciting.