Arnold Kling  

Two Stories of House Prices

Order and Disorder... My Mortgage Plan, Continued...

Robert Shiller tells a bubble story.

Real rent has been extremely stable when compared with price. Real rent increased only 4 % from the 1996-IV to 2006-I. The rent figures indicate that there has been virtually no change in the market for housing services, only in the capitalization value of these services into price.

...our expectations data show remarkable confirmation of an essential element of the bubble story: times and places with high home price increases show high expectations of future home price increases.

I would tell a different story. I think that the rise in home prices reflects:

1. The decline in the inflation premium in interest rates. When nominal interest rates are high, payments on mortgages are high, making it hard to buy homes.

2. A general decline in real interest rates. For a long time, real interest rates were high, as realized inflation was low relative to the expectations that were built into nominal rates. Finally, over the past ten years, real rates have come down.

3. A decline in the risk premium for housing. The secondary mortgage market has become more efficient. Moreover, with the use of credit scoring in mortgage underwriting, credit decisions became more accurate (I consider this my personal contribution to social welfare--I pushed very hard for this innovation when I was at Freddie Mac).

4. Transaction costs have fallen. With the use of credit scoring, property valuation databases, and other innovations, the cost of obtaining a mortgage or refinancing a mortgage has fallen sharply. This in turn makes housing a more liquid asset, which lowers the risk premium involved in buying a home.

Having said all that, I can believe that some of the increase in prices over the past several years was over the top. Buyers' expectations probably did get out of hand. But I think that the "irrational exuberance" was more on the lender side than the buyer side. That is, I think that the risk premium got too low, for a variety of reasons, perhaps including excessive confidence in credit scoring.

But my guess is that eventually the home price rise from, say, 1995 to 2007 will turn out to be 90 percent due to a permanently lower risk premium and 10 percent bubble, rather than the other way around.

Thanks to 'Calculated Risk' for the link to the Shiller paper, as well as other papers from the recent Jackson Hole symposium.

My guess is that the symposium created an exaggerated sense of the significance of the subprime kerfluffle. Too many finance/economist types with too little else to talk about.

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The author at Caveat Bettor in a related article titled only 10% of housing appreciation is irrational writes:
    Arnold Kling believes only 10% of housing appreciation is irrational [Tracked on September 5, 2007 10:44 AM]
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Maniakes writes:

I'd expect point 1 to cut the other way. When inflation is high and real housing prices are relatively flat, I'd think buying a house would be smart. Your initial payments are higher, but that's balanced out by inflation eating the value of the principle of the mortgage. You're also locking in a constant nominal housing payment for the next 30 years, while constant real rents would mean rapidly increasing nominal rents.

When inflation is low, the value of locking in your nominal housing payment is much lower, as rents will stay fairly flat as well.

Kimmitt writes:

Speaking as someone who bought a condo five years ago, I have a some difficulty buying either (3) or (4); (3) is really easily gamed and I shudder to think if (4) is true. I dunno.

Matt writes:

His numbers have the real price at 80 points above the nominal, at 100. An 80% rise above inflation (rent) since 1996. So, 90% of that rise for a final 170 index points is permanent price rise, in your view.

Why wouldn't more people rent to take advantage of the new efficiency? I mean, I can get in the same house for much less money, and put the savings into a 30 year account.

Ranjit Mathoda writes:

In 2005 I wrote a pretty detailed analysis of the housing boom and why I thought the risk of a house price drop was increasing with time. Alot of it has to do with how the incentive system of the housing market changed. You can read it here:

floccina writes:

What about regulation of growth. People as varied as Harvard economist Edward Glaeser and Consumer Talk show host Clark Howard claim that slow growth policies have contributed the home price rise by restricting supply.

There is also another seldom mentioned affect; that is that people in America do not want to live in a “Bad neighborhood”. This can cause people to move even if their current house is physically fine – location, location, location. This also makes a house worth more just because it costs more, keeping the riffraff out. I think that more and better police work could help with this. This shows that the relative wealth argument of Democrats cuts both ways. People in the middle might feel bad if they make much less than the rich but IMHO people in the middle would like it even less if the bottom of society where subsidized to the point where they could afford to move into middle level neighborhoods bringing crime and sloppiness with them.

Ron writes:

@Matt: This is one argument I read a lot ("you can rent the same house for less money, so why buy?") but in practice I see little evidence for it. For example, here on the bay area peninsula, there are lots of lower-end condos for rent, but not so many decent higher-end homes. In my city right now there are ~50 4bd/3ba homes for sale, but something like 4-5 similar homes for rent. Similar means same decent street, same amenities, condition, etc. Not "you can buy here in Emerald Hills, or you can rent on Middlefield road."

So, if I want to live in a nice 4 bed, 3 bath home in good condition and on a nice street, and in the city of my choosing, my options are limited. It's not as if I can go find a potential home to purchase, then just wave a wand at it and say "transform into an affordable rental!" In practice, you *can't* find an equivalent pool of rentals vs. purchased homes. Maybe it's different in other areas, but in my neighborhood, that's the reality.

I believe this is a big factor in buying vs. renting, and one that doesn't seem to get addressed in most analyses.

So what would explain the meteoric rise in house prices in the late 1970s, or the late 1980s where the average prices climbed at 6-8% annually?

1977-1979 was a much more intense appreciation in home prices than what was experienced from 2004-2006.

Data from and

Barkley Rosser writes:

Let me see, with all the recent crashings in the global financial markets due to the sub-prime mess, and the ongoing declines in housing prices in many parts of the US, do you really want to hold to this claim that the risk premium in housing is down, or more precisely, will stay down or should have gone down?

Lord writes:

Real rents rose even as everyone that could buy did says that they will be increasing faster from here on out and any excess in housing will likely only moderate this tendency.

brilliant writes:

Hi Arnold:

Bold posts -- I like them. I certainly could not argue that:
1) The recent housing price appreciation is rational due to increased efficiencies (not bubbles) in financing
2) The subprime problems that killed a couple of hedge funds don't count as a bubble, as the new system really is less risky
3) Taxpayers should bear the brunt of 20% of any fallout in non-over leveraged homebuyers purchasing reasonably priced homes, that have doubled in five years.

Incidently, I have a hot internet stock you might be interested in -- I'll offer you *fantastic* financing.

JW writes:

[Comment deleted for supplying false email address. Email the to request restoring this comment. A valid email address is a requirement to post comments on EconLog.--Econlib Ed.]

Kurt9 writes:

My responses to Arnold's points:

Comment #1: low interest rates mean lower morgage payments for any given price of house. This would mean that you can buy, say, a $350,000 house for the same monthly morgage that you could for a $200,000 house 10 years ago. However, the housing prices have gone up way higher than this in the last 3-4 years (I know, because I was looking at houses earlier this year and I got qualified for a loan).

Comment #2: Decline in real interest rates. Greenspan introduced hedonic and other BS factors into the CPI starting in 1994. This resulting in unreported inflation that does not show up in the official CPI. He did this in order to get away with flooding the economy with cheap money (which is ALL he has ever done in his entire career as FED chairman). The markets will, sooner or later, catch on to this trick with the long term result of higher interest rates. If anything, the inflation premium in the interest rates will go up in the future.

Comment #3: This is certainly true as compared to the early 90's, but not so compared to the 80's and before. Credit requirments for loans were tightened rather profoundly following the S&L mess of the early 90's. However, the sub-prime lending industry was created to get around this. Also, the only way this factor would increase the price of housing is if it allowed many more people to qualify for morgages than otherwise would. This affect would be seen mainly in the sub-prime lending area.

Comment #4: It is true that transaction costs have fallen. However, the only way this could boost housing prices is if this allowed more people to qualify for home loans (increase the demand for housing) than otherwise would. Other than the subprime lending, I see no basis for believing that this has occurred.

I think its a bubble.

Paul Ramsey writes:

As an architect, not an economist, I have a few comments on issues absent from any of your discussions:

1. Over the last ten years, the cost of construction has skyrocketed!
A house I designed eight years ago, bid out at $117 sf. Today, the same house would be over $300 sf. National magazines showing construction cost show the same increase, nationwide. Most of the increase is due to price increases in basic construction materials such as lumber, concrete, steel, drywall, plywood, pvc piping and copper.

In areas where there is demand for housing, this increase will be reflected in higher prices because the replacement cost is now much higher.

2. No Growth and other alarmist policies have greatly restricted supply in many desireable areas and many deep blue cities.
In LA County, where I live, officially over the last 16 years there was new housing built for 400,000 people, (not adjusting for those many housing units demolished to make new ones) for a County that grew officially 800,000.(not counting illegals which there are millions) Thus a severe housing shortage occurred where perhaps over a million people, mostly illegals, are today living in tenement like conditions.

C. These same alarmist policies have made construction much more costly, risky and time consuming.

Back in the day, housing was designed in a few weeks, planchecked in a few weeks and construction started. No mas!
Simple houses now take years to design and permit because of new regulations. Worse yet, now many simply cannot be built at all because of little poison pills buried in our wonderful new ordinances. Three quarters of the clients who came to me within the last year, I had to inform that their projects probably could not be permitted.

Risk is scary high. Only the well heeled developers need apply.
Used to be a developer could acquire, build and sell easily within the same housing cycle. Now during acquisition because of the long time to permit, it is difficult to tell what financial environment you are going to be selling in.

All these issues taken together, have to increase the cost of housing significantly.

So now, Chairman Bernacke seems to be implying there has been irrational buying exurberance that needs to be fixed by a good old fashioned credit crunch, throwing millions of people into the ditch just for the hell of it.

I think not. Seems to me, that herr Chairman is way out of his depth. Tight money cannot solve multi-layer supply problems created by over- regulation.

Paul Ramsey

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