Detecting and Controlling Housing Bubbles
By Charles Kirchofer, Feb. 20th, 2009
I had originally intended to devote this post to an idea of how to control housing booms and target specifically asset prices that are rising in an economy as an alternative to the blunt (and at times ineffective) tool of interest rate increases. However, upon researching the matter further, I discovered the mere detection of a housing bubble is more difficult than I'd originally thought. Everyone knows that bubbles very often remain unidentified until after they burst. There are always some people shouting warnings, but they are often the ones who had said it would happen every year - when it didn't. All too often, the investment and regulatory communities stop listening to the investor who cried "bubble!"
But then I thought, "geez, I knew it was a bubble... I think." Indeed, Alan Greenspan had even suggested that we might be looking at a bubble. The amount this concerned him was, we know now, not enough to mobilize him to avert a crisis. It's clear that he did not see the true nature of what was coming. Of course, the housing bubble was not the only cause of our current woes, but it was a main contributor to the intermediate causes, or so it would seem (to read more about other intermediate causes, as well as the deep cause, check out our other posts (some of them coming later as Mr. Mohr joins and moves his posts to this blog from my old geocities website). So why didn't regulators step in? Surely a bubble bursting with kind of pow must have been foreseeable?
So I started doing some research. This is what I found:
OK, I know it's a lot of information, so I'll break it down now. Notice the column boom gain/bust loss. The inflation of house prices is staggering, especially when compared to consumer price inflation in the next column. What's even more noticeable is the growth during the boom of the 80s. During the 80s house prices rose by over 189% compared to a rise of just 47.2% in consumer prices in the same period. That's a ratio of more than 4 to 1! This of course ended in the Saving and Loan Crisis of the late 80s and early 90s. As a result, house prices remained stagnant in the early 90s, during which the U.S. also found itself in a recession. By 1993, however, things had recovered. Soon the recession was forgotten. There were small dips in house prices due to the 2000 dotcom crash and the 2002 recession in the wake of the September 11th attacks on the World Trade Center in New York. Otherwise, things were all up hill. Please note that I count the overall rise in house prices only during the boom years. The early 90s, therefore, have been left out. During the 2000 boom years, house prices grew, on average, around 2.6 times as fast as consumer prices. That's quick, but nothing like the rates seen in the '80s. After the brief dip in house prices after the 2002 recession, house prices began to rise yet again. We can see from the ratio, however, that they rose little faster than they did in the 1990s.
Looking at it this way, it is not surprising that many did not realize there was a housing bubble. What you may also notice, however, is that there are very few real "busts." I would hardly call one year where house prices fell only mildly a bust. You'll notice that from 1980 to 2006, house prices never fell for more than one year, and their largest fall in one year (December to December anyway) was 3.9%. It may therefore be more accurate to look at the whole situation from the late 1970s until 2006 as one long, nearly continuous housing boom interrupted by a few short breathers, most notably in the early '90s.
Also of note is the steady fall in household saving rates (not in the table). These peaked in 1981 at somewhere around 12% and fell steadily through 2005, when they even became negative. For comparison, the rate in the 50s and 60s was around 7.5%.
So what's to make of all this? I have already alluded to my opinion (which isn't really anything new): We've witnessed one long, credit-fueled housing boom from the late 1970s until 2006. So what does this mean for regulatory policy?
It means the Federal Reserve and other regulators may have to start reacting to things other than inflation. Looking at the data, however, it's easy to see why they didn't realize this. The "end" of the 80s housing boom resulted in a couple years of housing market stagnation and relatively mild recession. The U.S. economy got through it with little difficulty. The same is even more true of the dotcom crash and the 2002 recession. After all, if the U.S. economy could snap right back into growth again after terrorist attacks on one of its largest financial centers and keep growing right through a war with rising oil prices, they must be doing something right.
So what should regulators react to and how? They should react to a whole myriad of things the Fed has been tracking all along (but not necessarily regulating) in addition to consumer price inflation; like house price inflation, household saving rates, and mortgage down payment requirements. I think the Fed might want to use interest rates to influence saving rates in the future. Saving rates as high as those in the early 80s, when combined with low inflation (unlike the early 80s), may be too high. Conversely, saving rates below 5%, even when inflation is low, might signal problems on the horizon. Much was said in this direction during the '90s and 2000s, but no one reacted because of uncertainty about just what the figures meant. I think now it would be reasonable for the Fed to raise interest rates during times of low inflation (and even fairly slow economic growth) to increase household saving rates if necessary to stop a credit-fueled rise in house prices or even stocks or other investments not counted in the consumer price index (a common measure of inflation). This goes along with my article on global imbalances in saving and borrowing, half of which begins at home (the borrowing part).
The other thing the regulators ought to look at is house price inflation. We've seen that house prices can inflate for decades without causing problems (at least right away). I postulate that house price inflation, despite relatively low consumer price inflation, coupled with declining household savings (certainly becoming critical when they drop below 3 to 5%) is a toxic mix to be steered against. For this (and for other types pf asset price inflation), I would recommend a more precise attack, possibly in addition to higher interest rates, to spur household saving. One possibility would be increased down payment requirements. Down payments averaged over 31% of the price of a home in 1982. From there they dropped steadily until reaching a low of 19.2% in 1994, a level that was again approached in 2007.
But it is perhaps not the average rate that is of greatest concern. So far house prices have not fallen so far that they've caused negative equity on the average. In spite of that, negative equity is occurring with alarming frequency, even if not to the "average" mortgage. Mortgages with no money down are a bad idea, particularly when the toxic mixture I mention above is present. In times when the conditions above are present, I would recommend setting down payment requirements up to as much as 20-30% for all mortgages, not just the average mortgage (and no exceptions or loopholes, which was the main problem recently, not that banks suddenly thought mortgages with no money down were necessarily good). This would serve to slow the inflation of the bubble, as houses become somewhat more difficult to buy. This reduces the incentive for speculation with real estate as well, another cause of many of the headaches. Finally, it would cushion the bursting of any bubble that managed to form by ensuring that any mortgages made are placed on a sound footing and that negative equity is avoided, thereby not providing an incentive for homeowners to just walk away. Of course, as I've mentioned in previous articles, teaser rates and the like should be outlawed (see Mr. Mohr's article on teaser rates for more information (move from old site pending)).
This outline is vague. I also am well aware that over-regulating the market could strangle it, preventing American families that otherwise might be able to buy a home from having one. That would certainly be unfortunate. As I'm not an expert on public economic policy details, I leave this to the experts to hopefully find the right balance. One thing is clear, however, the current balance isn't right.
I had originally intended to devote this post to an idea of how to control housing booms and target specifically asset prices that are rising in an economy as an alternative to the blunt (and at times ineffective) tool of interest rate increases. However, upon researching the matter further, I discovered the mere detection of a housing bubble is more difficult than I'd originally thought. Everyone knows that bubbles very often remain unidentified until after they burst. There are always some people shouting warnings, but they are often the ones who had said it would happen every year - when it didn't. All too often, the investment and regulatory communities stop listening to the investor who cried "bubble!"
But then I thought, "geez, I knew it was a bubble... I think." Indeed, Alan Greenspan had even suggested that we might be looking at a bubble. The amount this concerned him was, we know now, not enough to mobilize him to avert a crisis. It's clear that he did not see the true nature of what was coming. Of course, the housing bubble was not the only cause of our current woes, but it was a main contributor to the intermediate causes, or so it would seem (to read more about other intermediate causes, as well as the deep cause, check out our other posts (some of them coming later as Mr. Mohr joins and moves his posts to this blog from my old geocities website). So why didn't regulators step in? Surely a bubble bursting with kind of pow must have been foreseeable?
So I started doing some research. This is what I found:
| Sale Price of New US Homes | House price | Boom gain/ | Ratio Houses | |||
| Year (Dec) | Median Price | inflation | Bust loss | CPI inflation | Boom CPI | to CPI boom |
| 1980 | $67,000.00 | 8.9% | 13.52% | |||
| 1981 | $68,400.00 | 2.1% | 10.38% | |||
| 1982 | $71,700.00 | 4.8% | 6.13% | |||
| 1983 | $75,900.00 | 5.9% | 3.21% | |||
| 1984 | $78,300.00 | 3.2% | 4.32% | |||
| 1985 | $87,900.00 | 12.3% | 3.56% | |||
| 1986 | $95,000.00 | 8.1% | 1.86% | |||
| 1987 | $111,800.00 | 17.7% | 3.65% | |||
| 1988 | $121,000.00 | 8.2% | 4.14% | |||
| 1989 | $125,200.00 | 3.5% | 4.82% | |||
| 1990 | $127,000.00 | 1.4% | 189.6% | 5.40% | 4.72% | 4 to 1 |
| 1991 | $122,000.00 | -3.9% | 4.21% | |||
| 1992 | $126,000.00 | 3.3% | 3.01% | |||
| 1993 | $125,000.00 | -0.8% | 2.99% | |||
| 1994 | $135,000.00 | 8.0% | 2.56% | |||
| 1995 | $138,600.00 | 2.7% | 2.83% | |||
| 1996 | $144,900.00 | 4.5% | 2.95% | |||
| 1997 | $145,900.00 | 0.7% | 2.29% | |||
| 1998 | $152,500.00 | 4.5% | 1.56% | |||
| 1999 | $164,800.00 | 8.1% | 2.21% | |||
| 2000 | $162,000.00 | -1.7% | 3.36% | |||
| 2001 | $180,200.00 | 11.2% | 2.85% | |||
| 2002 | $197,600.00 | 9.7% | 58.1% | 1.58% | 2.46% | 2.6 to 1 |
| 2003 | $196,000.00 | -0.8% | 2.28% | |||
| 2004 | $229,600.00 | 17.1% | 2.66% | |||
| 2005 | $238,600.00 | 3.9% | 3.39% | |||
| 2006 | $244,700.00 | 2.6% | 24.8% | 3.23% | 3.09% | 2.7 to 1 |
| 2007 | $227,700.00 | -6.9% | 2.85% | |||
| 2008 | $206,500.00 | -9.3% | -15.6% | 3.84% | ||
| Sources: | http://www.census.gov/const/uspricemon.pdf | |||||
| http://www.measuringworth.com/calculators/inflation | ||||||
OK, I know it's a lot of information, so I'll break it down now. Notice the column boom gain/bust loss. The inflation of house prices is staggering, especially when compared to consumer price inflation in the next column. What's even more noticeable is the growth during the boom of the 80s. During the 80s house prices rose by over 189% compared to a rise of just 47.2% in consumer prices in the same period. That's a ratio of more than 4 to 1! This of course ended in the Saving and Loan Crisis of the late 80s and early 90s. As a result, house prices remained stagnant in the early 90s, during which the U.S. also found itself in a recession. By 1993, however, things had recovered. Soon the recession was forgotten. There were small dips in house prices due to the 2000 dotcom crash and the 2002 recession in the wake of the September 11th attacks on the World Trade Center in New York. Otherwise, things were all up hill. Please note that I count the overall rise in house prices only during the boom years. The early 90s, therefore, have been left out. During the 2000 boom years, house prices grew, on average, around 2.6 times as fast as consumer prices. That's quick, but nothing like the rates seen in the '80s. After the brief dip in house prices after the 2002 recession, house prices began to rise yet again. We can see from the ratio, however, that they rose little faster than they did in the 1990s.
Looking at it this way, it is not surprising that many did not realize there was a housing bubble. What you may also notice, however, is that there are very few real "busts." I would hardly call one year where house prices fell only mildly a bust. You'll notice that from 1980 to 2006, house prices never fell for more than one year, and their largest fall in one year (December to December anyway) was 3.9%. It may therefore be more accurate to look at the whole situation from the late 1970s until 2006 as one long, nearly continuous housing boom interrupted by a few short breathers, most notably in the early '90s.
Also of note is the steady fall in household saving rates (not in the table). These peaked in 1981 at somewhere around 12% and fell steadily through 2005, when they even became negative. For comparison, the rate in the 50s and 60s was around 7.5%.
So what's to make of all this? I have already alluded to my opinion (which isn't really anything new): We've witnessed one long, credit-fueled housing boom from the late 1970s until 2006. So what does this mean for regulatory policy?
It means the Federal Reserve and other regulators may have to start reacting to things other than inflation. Looking at the data, however, it's easy to see why they didn't realize this. The "end" of the 80s housing boom resulted in a couple years of housing market stagnation and relatively mild recession. The U.S. economy got through it with little difficulty. The same is even more true of the dotcom crash and the 2002 recession. After all, if the U.S. economy could snap right back into growth again after terrorist attacks on one of its largest financial centers and keep growing right through a war with rising oil prices, they must be doing something right.
So what should regulators react to and how? They should react to a whole myriad of things the Fed has been tracking all along (but not necessarily regulating) in addition to consumer price inflation; like house price inflation, household saving rates, and mortgage down payment requirements. I think the Fed might want to use interest rates to influence saving rates in the future. Saving rates as high as those in the early 80s, when combined with low inflation (unlike the early 80s), may be too high. Conversely, saving rates below 5%, even when inflation is low, might signal problems on the horizon. Much was said in this direction during the '90s and 2000s, but no one reacted because of uncertainty about just what the figures meant. I think now it would be reasonable for the Fed to raise interest rates during times of low inflation (and even fairly slow economic growth) to increase household saving rates if necessary to stop a credit-fueled rise in house prices or even stocks or other investments not counted in the consumer price index (a common measure of inflation). This goes along with my article on global imbalances in saving and borrowing, half of which begins at home (the borrowing part).
The other thing the regulators ought to look at is house price inflation. We've seen that house prices can inflate for decades without causing problems (at least right away). I postulate that house price inflation, despite relatively low consumer price inflation, coupled with declining household savings (certainly becoming critical when they drop below 3 to 5%) is a toxic mix to be steered against. For this (and for other types pf asset price inflation), I would recommend a more precise attack, possibly in addition to higher interest rates, to spur household saving. One possibility would be increased down payment requirements. Down payments averaged over 31% of the price of a home in 1982. From there they dropped steadily until reaching a low of 19.2% in 1994, a level that was again approached in 2007.
But it is perhaps not the average rate that is of greatest concern. So far house prices have not fallen so far that they've caused negative equity on the average. In spite of that, negative equity is occurring with alarming frequency, even if not to the "average" mortgage. Mortgages with no money down are a bad idea, particularly when the toxic mixture I mention above is present. In times when the conditions above are present, I would recommend setting down payment requirements up to as much as 20-30% for all mortgages, not just the average mortgage (and no exceptions or loopholes, which was the main problem recently, not that banks suddenly thought mortgages with no money down were necessarily good). This would serve to slow the inflation of the bubble, as houses become somewhat more difficult to buy. This reduces the incentive for speculation with real estate as well, another cause of many of the headaches. Finally, it would cushion the bursting of any bubble that managed to form by ensuring that any mortgages made are placed on a sound footing and that negative equity is avoided, thereby not providing an incentive for homeowners to just walk away. Of course, as I've mentioned in previous articles, teaser rates and the like should be outlawed (see Mr. Mohr's article on teaser rates for more information (move from old site pending)).
This outline is vague. I also am well aware that over-regulating the market could strangle it, preventing American families that otherwise might be able to buy a home from having one. That would certainly be unfortunate. As I'm not an expert on public economic policy details, I leave this to the experts to hopefully find the right balance. One thing is clear, however, the current balance isn't right.
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