Arnold Kling

Housing Bubble

Arnold Kling, Great Questions of Economics
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Dean Baker has a dire warning about a bubble in the U.S. housing market.

In the last seven years home purchase prices have risen nearly 30 percent more than the rate of inflation. This run-up in housing prices has increased housing wealth by more than $2.6 trillion compared to a situation in which home prices had just kept place with inflation. This is an average of more than $35,000 of additional wealth for each of the nationís 73.3 million homeowners. This paper examines whether the increase in home prices can be grounded in fundamental economic factors, or whether it is simply a bubble, similar to the stock market bubble. The paper notes:

1) There has been no clear upward trend in housing costs relative to other items in the post-war period. In general, housing prices move in step with the overall rate of inflation. This means that the recent spurt in housing prices is a departure from the prior history.

Two thirds of the run-up in home prices is attributable to a rise in the price of buying a home relative to the cost of renting a home... This is what would be expected if there is a housing bubble, since it suggests that families are buying homes in large part as an investment rather than primarily as a place to live.

This led some left-wing economists (who seem to have a death wish for the U.S. economy as long as there is a Republican President) to say that this is reminiscent of Japan. It is not. Japan's real estate bubble was most notable in commercial real estate, where it was part of the Japanese house-of-cards financial system.

I should also point out that Baker's analysis is very sensitive to his starting point of seven years ago. That was a point at which rents were high relative to house prices, and some economists (including myself) were arguing that housing was undervalued, particularly relative to common stocks. If most of the increase in house prices relative to rents in the past seven years represents catch-up, then house prices are not yet in a bubble state (although particular markets may be overpriced).

Discussion Question. If home prices fall, how will that affect consumer spending?

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