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Housing prices: bubble or fundamentals?

Over at MaxSpeak, the state of housing and whether or not it is a bubble is reviewed:


Probably most who read this blog accept that there was a bubble in the US housing market, and that it has come to an end. Some regulars here, notably the notable Dean Baker, were early out the door on the bubble, even beating Robert Shiller to the punch of noting the historically high price-to-income and price-to-rent ratios that were occurring, and replete with forecasts of a recession as the bubble ended (one hit after the end of the high-tech NASDAQ bubble), although this latter prediction has yet to come true.

But there are serious folks out there who deny, or at least question, whether what we have seen has been a speculative bubble. One of the most intelligent and articulate is Jim Hamilton, who runs Econbrowser, where he has put up several such postings, with his co-blogger, Menzie Chinn, most recently arguing that what happened was a combination of fundamental factors, with some bubbling, and a lot of looting through the sub-prime mortgages fiasco. Others questioning the bubble hypothesis have included Edward Glaeser, whose various papers on the matter can be found at the Harvard Institute for Economic Research website (for Glaeser’s in particular), and who stresses the role of increasing land use limits on housing supply around the US, with this even determining patterns of regional economic development.

Hamilton’s argument is that if one looks at the pattern of housing price increases across states in the US, one finds that they mostly went up in economically growing states with declining unemployment. When unemployment rose more recently, it was in states where prices had not risen so much, and those were the states with the most mortgage defaults. Therefore, the price increases reflected fundamentals. The answer to the Baker/Shiller argument about high price-to-income and high price-to-rent ratios is to point to the very low interest rates that were going on in the period, with some other stories (sorry, forget authors and no links, although one paper was out of one of the regional Feds) making this argument explicit about interest rates. And, as we all know, the Chinese have continued to keep the interest rates down, despite some increases.

Hamilton also argued that the lack of a clear and sudden crash in prices after the peak disproves, or at least undercuts, the speculative bubble hypothesis. If prices were rising because people were expecting them to rise, the sefl-fulfilling prophecy aspect of a speculative bubble, then the cessation of rising should remove that prop, and they should crash back to the fundamental. If they do not crash, and except maybe in a few limited condo markets, it does not appear that they have crashed in this episode, then the prices really do reflect the fundamentals, with perhaps Glaeser’s argument lying behind the apparently permanent increase in price-to-income and price-to-rent ratios beyond what can be justified by low interest rates.

I would note that Hamilton’s argument draws upon a deeper argument that he was one of the first to promulgate rigorously, that of the “misspecified fundamental.” This says that even if one sees a price rise relative to income flows one thinks are the fundamental, and even fall, one may not be able to say it was a bubble because agents may have rationally expected the fundamental to rise. When it did not, prices reasonably fell (James D. Hamilton, “On Testing for Self-Fulfilling Speculative Bubbles,” International Economic Review, October 1986, 27(3), pp. 545-552, and for the more theoretical discussion see James D. Hamilton and Charles H. Whiteman, “The Observable Implications of Self-Fulfilling Prophecies,” Journal of Monetary Economics, November 1985, 16(3), pp. 353-373). This misspecified fundamental argument was further developed by Peter Garber his book, Famous First Bubbles. I note three points.

One is that most bubbles, at least those that most people think were bubbles (see Charles Kindleberger’s Manias, Panics, and Crashes, any of its five editions, for a reasonable list, especially in his very useful Appendix B), began wth some “fundamental displacement.” The issue is that the initial upward displacement then keeps going with people speculatively buying out of the hope or expectation of a speculative capital gain. Hamilton et al are correct that it is very hard to separate those two out, but that does not mean that just because there was an initial fundamental displacement, there is therefore no bubble.

Furthermore, some of the more spectacular bubbles do not have a clear displacement. What was it for the 1929 stock market bubble? For that matter, what was it for the recent housing bubble? I guess the skeptics would say the decline in mortgage rates after 9/11, but as near as I can tell it looks more like the end of the high tech stock market bubble when money began flowing into real estate, even though the economic growth rate had slowed down. This would resemble more the relationship between the Mississippi Bubble of 1719-20 in France and the South Sea Bubble in Britain in 1720. Garber has argued that the former might have been justified by someone believing that John Law’s policy innovations were going to bring about a new economic utopia (as he claimed), whereas there was no such story for the latter. It started up after the Mississippi Bubble peaked, and smart “Mississippians,” like Richard Cantillon, shifted their winnings into the new South Sea Bubble. The latter peaked when the former crashed. (I note that Cantillon was the one who introduced the delightful terminology of “fictitious capital,” used by both Adam Smith and Karl Marx in discussing speculative bubbles).

The second point is that the failure of a bubble to immediately crash does not prove that it was not a bubble. This is what happens in theoretical models with homogeneous rational agents, the sort of assumption that Hamilton and Whiteman were making in their paper. But we know the world is not composed solely, or even necessarily predominantly, of such people, and that even smart traders must take into account the behavior of the noise traders in dealing with a market.

In his Appendix B, Kindleberger shows that the majority of bubbles that even crash at all, peak sometime before they crash. Following Hyman Minsky, he labels this period, the “period of financial distress.” I have a paper on this phenomenon available on my website at, coauthored with Mauro Gallegati and Antonio Palestrini, entitled “Heterogeneous Agents and the Period of Financial Distress in Speculative Markets.”

Finally, I note that there are cases where it may be possible to identify a fundamental, although I may agree that this method may not be available for the housing market. This is for closed-end funds that have a net asset value for their underlying assets, which the fund’s value can deviate from. It used to be that one of those ten dollar bills one could pick up from the street was to buy deeply discounted closed-end funds, a strategy that for many years out performed the S&P 500. Buying such funds with high premia was a fool’s errand. An analysis of such premia (and bubbles) on closed-end country funds around 1989-90 is in Ehsan Ahmed, Roger Koppl, J. Barkley Rosser, Jr., and Mark V. White, “Complex bubble persistence in closed-end country funds,” Journal of Economic Behavior and Organization, 1997, 34(1), pp. 19-37.

BTW, although I support reasonable, environmentally sound land use limits, I agree with Glaeser that in some places it is overdone. It should be kept in mind that sometimes such things are done for racist reasons, such as keeping out a sewer interceptor in Anne Arundel County, Maryland, so that minimum lot size zoning can be maintained and there will be no dense housing full of blacks moving in from neighboring Prince George’s County. The original zoning case involving the village of Euclid near Cleveland in 1926, said that cities could do so for “police power,” with the motive then being WASPs wanting to keep out all those minorities, including European ethnics, from their neighborhoods, the same political atmosphere that gave us the restrictive law on immigration in 1924 and the 1925 KKK rally in Washington, the biggest ever held anywhere.

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