Arpit Gupta writes:

Yet Milton Friedman’s arguments against bubbles remains powerful. Why would investors not respond to the addition of crazy money by betting against the bubble? Sure, most investors can’t technically bet against housing, but home owners could choose to rent, there are REITs out there, etc. Why couldn’t rational trading eliminate the mispricing induced by government spending, assuming that the government did intervene in unprecedented amounts before 2002?

I think Arpit is underestimating the difficulty of making negatives bets on housing here. First off, rental markets for single family homes are thin in many areas and the stock of housing there is systematically different than the stock of owner occupied housing. People also do not appear to be strictly indifferent between renting and owning, and transaction costs can be very large.

Even if some homeowners are able to bet against the market, investors not currently owning homes cannot. So you have a market where investors and owners can bid the price up but only owners can bid the price down. It’s not really surprising in this circumstance that when opinions differ about what the relationship between fundamentals and prices should be that a bubble occurs. Without the ability to bet against housing the market essentially becomes an auction where only the highest valuations are observed. When the variance of expected prices among potential market participants increases it’s not surprising that observed prices increase as well, since only those in the high-end of the distribution will be observed.

Another issue is that unlike the market for pork-belly futures, housing markets are dominated by naive investors, e.g. owner-occupied buyers. Given emotional attachments and lack of sophistication about markets is it unsurprising that too many homeowners did not sell but instead held when prices rose above believable levels? In a country with so much owner-occupied housing, investors have a limited ability to affect markets compared to financial markets.

If I had to play homeowner psychoanalyst I would guess that homeowners with a strong preference for homeownership saw cap rates were changing and believed house prices were heading towards a permanently higher plateau that would permanently price them out of homeownership. People who would want to buy houses in the future but were currently renting had this fear as well and rushed into the market. Risk aversion here thus did not lead to selling when prices rose as a simple model might predict. Believable models of how rational households should have behaved in the bubble need to be pretty complex and account for things like this. Not knowing what behavior it prescribes, appeals to rationality here don’t persuade me.