The post-housing-bubble narrative has been that the unsustainability of prices was obvious ex ante, and so we should be able to call them in the future. This to me seems to be a bit of hindsight bias, but it is always difficult to make a case that claims which turn out to be ex post false were nevertheless ex ante reasonable. Kristopher Gerardi, Christopher Foote, and Paul Willen have a new paper out that I’ve been waiting for someone to write. They go through pre-collapse claims of the housing pessimists, optimists, and agnostics, and evaluate not just who was write and wrong but which beliefs where obviously right and which were debatable. This is a fun and accessible paper starring a well-known cast of characters, with prominent roles for Paul Krugman, Dean Baker, and Robert Shiller, and a quick cameo by The Economist, Calculated Risk, and John Cassidy. I strongly recommend it.
Rereading the cases of the optimists and the agnostics should be a reminder to those who claim to have identified the bubble, and also argue for the identifiability of future bubbles, with a high degree of confidence. The burden of proof on those making those claims is to argue convincingly against, for instance, Himmelberg, Mayer, and Sinai who argue that you can’t just look at price to rent ratios, but must consider changes in the user-cost of housing.
Even more prominent than the housing optimists are the housing agnostics. Rosen and Haines argued that the academic consensus on the issue was that the relationship between prices and fundamentals was sound, and that overpriced markets, if they existed at all, were limited. The authors find that the beliefs of agnostics can be summarized in this quotation from Davis, Lenhart, and Martin:
If the rent-price ratio were to rise from its level at the end of 2006 up to about its historical average value of 5 percent by mid-2012, house prices might fall by 3 percent per year, depending on rent growth over the period.
There is a tendency to call anyone who bought a home during the late stages of the bubble “irrational”, because prices were obviously unsustainable. But as the authors point out, the consensus of economists gave no indication that this was the case, and so behaving as if it wasn’t was quite reasonable for non-experts. Of course, pointing out that current prices were justified by fundamentals does not rationalize a 120% LTV negative amortization mortgage.
To those who simply point to lower lending standards as sufficient proof for a bubble, the authors offer this:
Did lax lending standards shift out the demand curve for new homes and raise house prices, or did higher house prices reduce the chance of future loan losses, thereby encouraging lenders to relax their standards? Economists will debate this issue for some time. For our part, we simply point out that an in-depth study of lending standards would have been of little help to an economist trying to learn whether the early-to-mid 2000s increase in house prices was sustainable. If one economist argued that lax standards were fueling an unsustainable surge in house prices, another could have responded that reducing credit constraints generally brings asset prices closer to fundamental values, not farther away.
I believe the case for humility about the obviousness and knowability of bubbles is underappreciated. Many, I’m sure, will simply point to the pre-bubble agnostic consensus of economists as more evidence that economists are rational expectations obsessed, over-mathematized fools who don’t know what they’re doing. I think they would benefit from a close reading of this paper.
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Tuesday ~ August 17th, 2010 at 12:57 pm
Andy Harless
I’m still not convinced, even in retrospect, that there was a housing bubble. Asset prices needed to rise (and now need to rise even more) in order to balance saving and investment at full employment. Rising house prices were a normal part of this process. Arguably, the fundamental value of housing (based on full employment, given prevailing world saving propensities) is higher than prices were even at the peak. It’s unlikely now, given the liquidity trap, credit constraints, and bad monetary policy (which apparently isn’t nearly bad enough to satisfy the preferences of the general population), that house prices will get anywhere near that fundamental. But these conditions were not anticipated (not even by most of the housing bears) in 2005-2006. Krugman might have convinced me if he had said that the housing boom wasn’t sustainable because we were falling into a liquidity trap — but that’s not what he said.
Tuesday ~ August 17th, 2010 at 2:08 pm
Lord
I would focus on debt service and income. We often heard during this time of how people were becoming more optimistic about future incomes or prices, but that was a red flag if anything since rising incomes are inflation to the Fed and prices based on price expectations are the definition of a bubble. In part, higher prices were justified by lower long rates, in part, they were not because so much funding was at short and teaser rates without the incomes to support them. The ambiguity arises in how much these represented permanently lower rates and how much temporarily lower rates, but as the point of the episode was to keep rates higher than they would otherwise have been, the end will be when they are lower than anyone conceived possible and when most of these bad investments have been turned into good ones.
Tuesday ~ August 17th, 2010 at 2:32 pm
Ted
I’m generally skeptical of people who claim to spot bubbles, but I must admit the housing bubble was extremely obvious in real-time – or at least it should have raised strong suspicions on everyone radar.
Since 1890 average housing prices have never much exceeded $120,000 (in inflation-adjusted 2006 dollars). It seems, at a minimum, odd that we would then see average prices not just exceed $120,000, but skyrocket to above $200,000. Not to mention, this massive increase occurred over an extremely small amount of time – with no obvious change in underlying fundamentals (though of course some of it was fundamentals). Take the post-WWII housing boom. It was obvious what was going on in that housing buildup – and accordingly we didn’t see a bubble. In the 2000s, there was no significant change in fundamentals that would seem to justify that. In fact, real wages were mostly stagnating and growth was fairly sluggish.
This is not to say that this is in any way definitive evidence a bubble was happening. But at a minimum it should give you strong pause to wonder what is going on. That’s why I do think it’s fair to say some people really did call the bubble. They saw massive increases in housing prices over an extremely short period of time with no seeming underlying cause.
Also, it’s important to note that we know the housing prices do not follow a random walk and the arbitrage conditions do not seem to hold. So, we know the efficient market hypothesis does not hold in the housing market so returns are possibly forecastable.
Wednesday ~ August 18th, 2010 at 11:20 pm
db
The housing bubble was obvious. The problem is that for the people who saw it, it was obvious as early as 2002-2004. If you bet on a bubble that early you would have gone broke waiting for the bottom to drop out.