A Failure of Capitalism (IV): More on Bubbles

by Richard A. Posner

The housing bubble is so central to our current economic troubles, and such a mysterious phenomenon from an economic standpoint, that I want to elaborate on my brief remarks in the previous entry.

A few figures: At the beginning of 2000, the federal funds or overnight rate--the short-term interest rate that the Federal Reserve focuses on influencing through its purchase and sale of Treasury bonds--was 5.45 percent. Though short term, this rate influences long-term rates, because it is the rate at which banks borrow from each other, and the more (less) they borrow ,the more (less) they are able to lend to their customers; and the more (less) they lend, the lower (higher) their interest rates are. Also at the beginning of January 2000, the average interest rate for the standard 30-year fixed-monthly-payment mortgage was 8.21 percent.

By December 2003, when the overnight rate had fallen below 1 percent, the mortgage rate had fallen to 5.88 percent and housing prices had risen (since the beginning of 2000) by 42 percent. The overnight rate than gradually rose, to 5.26 percent in July 2007, by which time the mortgage interest rate had risen to 6.7 percent, yet housing prices had continued to increase and were more than 80 percent above their 2000 level. After that both interest rates, and housing prices, began to decline.

If low interest rates drive up housing prices, high interest rates should (and eventually do), drive them down. Yet we have just seen that housing prices continued rising after interest rates started to rise. Moreover, a leading housing economist, Edward Glaeser, has pointed out to me that, on the basis of studies of the responsiveness of housing prices to interest rates in other periods, it is unlikely that the fall in mortgage interest rates during the early 2000s accounted for more than 20 percent of the increase in housing prices.

What I think we are seeing in the numbers is the classic bubble phenomenon, a phenomenon that has been observed in a variety of markets in a variety of countries for centuries. The low interest rates of the early 2000s pushed up housing prices both directly and indirectly. Directly by reducing the cost of housing debt--and housing as I mentioned in my last entry is bought mainly with debt. Indirectly by pushing up the value of common stocks. The low interest rates, as I said, caused asset-price inflation. Common stock is an asset, and was affected by the inflation. As the market value of people's savings, increasingly concentrated in common stock (whether in brokerage accounts, retirement accounts, college savings plans, or health savings plans), rose, people felt (and were, for the time being anyway) wealthier, and this increased their demand for houses--for owning rather than renting, or for owning a bigger or fancier house than their present house. And banks, including mortgage banks, being able to borrow capital at low rates, for lending, were eager to encourage borrowing by relaxing their credit standards. So people who could not have qualified for a mortgage at any interest rate earlier were now able to borrow at affordable rates.

Once house prices started rising, moreover--and here is the bubble phenomenon at its purest--the increase acquired momentum. An increase in the price of an asset, after that increase has continued for a significant time, creates a belief that the asset is a good value. One sees other people bidding up the price of houses and assumes they know something that perhaps one does not. And when officials and economists, and not just brokers and bankers, say that housing prices are rising because of "fundamental" changes in demand and supply that are likely to continue, the belief that a house is a good value, even though it costs a good deal more than it would have cost just a year or two ago, is fortified. There is nothing irrational about such a belief, or about action on it, though there is always a risk that the apparent increase in value will turn out to be a bubble phenomenon.

That seems to be what happened, and the basic fault lies with the Federal Reserve in having pushed interest rates too far down, and kept them too far down for too long, during the early 2000s, and with the dismantling of regulatory controls that had formerly reduced the incentive and ability of banks to lend into a bubble.