Tuesday, July 07, 2009

What caused the housing bubble?

Mark Thoma, the doyen of economics bloggers, asks this question in his latest blog.

His post is occasioned by Edward L. Glaeser´s discussion of the subject, at http://economix.blogs.nytimes.com/2009/07/07/in-housing-even-hindsight-isnt-20-20

Thoma, as always, generously quotes Glaeser, who discussed the possible roles of Alan Greenspan´s loose monetary policy, lower interest rates and increased availability of credit, concluding that the only explanation that makes sense is the "rise in optimistic beliefs about housing price appreciation ....even if those beliefs were held by only a small share of the population....Yet even if ridiculously rosy beliefs are a major part of bubbles, we cannot say that we understand those bubbles until we understand the sources of such beliefs"

Thoma takes on the task of traying to explain the sources of those beliefs, and comments. "I don't think people believed that housing prices would never, ever go down, what they thought is that housing prices would go up in real terms, on average, over time - that housing was a good long-run investment....(though) the belief that real housing prices rise over time is false, the evidence suggests that real housing prices are relatively flat over the long-run. Because people expected prices to rise on average when they should have expected them to remain flat, the correction... was far larger than anticipated and many homeowners weren't able to simply ride out the short-run variation like they thought they would be able to do. But this still leaves a question unanswered. Why did people have this false belief about the long-run trajectory of prices? Shiller explains that this happened because people believed that both land and building materials were becoming relatively more scarce over time, a belief he says is false, but that just pushes the "but why did they believe that" question back one step from housing prices to the prices of land and raw materials.,,,People are told (or were at that time) that stock markets are a great long-run investment. If you have the time to ride out the short-run fluctuations you can earn 8% per year. Just dump your money in an index fund that duplicates the market portfolio, and forget about it until many, many years later and you will do fine. Risk adjusted real returns on assets ought to equalize across markets through arbitrage, so shouldn't housing yield a real return similar to stocks (adjusting for risk)? Shouldn't there be a real return on housing just like in stock and other asset markets, and if so, doesn't that mean real prices will rise on average over time? This still requires beliefs about long-run prices at odds with (Shiller's) evidence though.

"One more note. I may be wrong to assert that people thought that housing prices would rise forever. If you know that there is a bubble in an asset market, but you believe you can sell fast enough once the market hits a turning point to still make a profit, or at least not lose much in any case, then you may be willing to make an investment that tries to exploit the short-term surge in prices. But while I think that may apply to stock markets, or other markets where assets can be sold quickly (the belief that is, the reality is quite different when everybody tries to sell at once), I'm not sure this applies to housing where sales can be notoriously slow. But it's still possible that people would know there is a bubble in housing prices, but still be willing to make an investment because they believe that housing prices would fall so slowly that, if necessary, they could sell their house before taking a loss. It just doesn't seem to me that this explanation works as well in housing as it does in stock markets".

No. And i doubt if most people were financially or economically literate enough to even understand that "Risk adjusted real returns on assets ought to equalize across markets".

But there is a simple explanation of the reason for the housing bubble that seems to me to have been overlooked by both Glaeser and Thoma. what if far more people felt they understood, and therefore felt able to play in, the housing market than in the stocks/funds market? In other words, what if far more people, who were less financially literate, were trading in houses than were trading stocks? Sphere: Related Content

1 comment:

Car Reviews said...

I have read this post and found it very interesting.