Friday, December 10, 2004


Are Home Prices the Next "Bubble"?

From the New York Fed:

The strong rise in home prices since the mid-1990s has raised concerns over a possible bubble in the housing market and the effect of a sharp price decline on the U.S. economy. This article assesses two measures frequently cited to support a bubble—the rising price-to-income ratio and the declining rent-to-price ratio—and finds the measures to be flawed and the conclusions drawn from them unpersuasive. In particular, the measures do not fully account for the effects of declining nominal mortgage interest rates and fail to use appropriate home price indexes. The authors also estimate a structural model of the housing market and find that aggregate prices are not inconsistent with long-run demand fundamentals. Accordingly, they conclude that market fundamentals are strong enough to explain the recent path of home prices and that no bubble exists. Nevertheless, weakening fundamentals could have an impact on home values on the east and west coasts, where the new housing supply appears to be relatively inelastic. However, prices in these regions have typically been volatile, and previous declines have not had a sizable negative effect on the overall economy.

I think this study overlooks two critical issues:

1. The supply side response to increased demand for housing: Think about it this way: The price of land is the key driver of urban home values. In rural areas, the price of land has not increased significantly. This is because land prices in rural areas are largely determined by the what happens in the agricultural sector. If land prices rise too much, farmers will sell their land. If land prices fall too much, farmers will stop growing crops. In the long run, food prices and rural land prices tend to move together. So what has happened over the past 10 years? As urban land prices have risen, the premium that people pay to live in city centers has increased. Now it may be plausible to argue that as people get richer, they will pay more to live one mile closer to downtown. But the striking feature of today's housing boom is that home prices have surged at a time when real wages have not increased rapidly.

Real estate enthusiasts argue that doesn't necessary imply a bubble, since the amount of urban land is limited. And indeed, this is true: while urban houses can be turned into condos, in general, it is hard to put more housing units in densely populated areas. But this misses the point. Housing prices are set in a broad market. If developers build more houses in suburban areas, this will increase the supply of available housing, and this will depress housing prices everywhere, including in the city center. Why hasn't the supply response been more pronounced? Partly it is because zoning laws in the United States make it difficult for developers to response quickly to shifts in market demand. But make no mistake: the flood of newly built homes will eventually hit the market, and when it does, home owners may be in for quite a surprise.

2. Second, homeowners may be suffering from what economists call 'inflation illusion'. In the early 1980's, when inflation and interest rates were running at nearly 20 percent, anyone who took out even a modest mortgage would end up paying large monthly payments relative to disposable income in the first few years of the mortgage. Of course, in a world where inflation is running at double digit rates, the last mortgage payment that the homeowner would make would only be a small fraction of disposable income (since nominal incomes increase more quickly when inflation is high).

Thus, in a world of high inflation, the real burden of mortgage payments gets pushed towards the first few years of the mortgage, which depresses the demand for housing. As inflation falls, mortgages appear to become more affordable. And of course, one of the things that has driven the housing boom is low inflation combined with very low nominal interest rates. Hence, the particular feature of America's mortgage market, that the value of first month's payment is the same as the last, regardless of underlying inflation, could itself be a reason why the housing market has done so well over the past decade.

Please explain - "If land prices fall too much, farmers will stop growing crops."

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