Home > crisis, economics profession, housing bubble, unemployment > Housing bubbles are not funny

Housing bubbles are not funny

from Dean Baker

The United States has more than 20 million people unemployed, underemployed or out of the workforce altogether because of a burst housing bubble. We also have more than 10 million homeowners who are underwater in their mortgages. And, we have tens of millions of people approaching retirement who have seen most of their life’s savings disappear when plunging house prices eliminated most or all of the equity in their home.

This situation could have been prevented if the government had taken steps to stem the growth of the housing bubble before it reached such dangerous levels. It is incredible that the Bush administration’s economics team failed to see the dangers of the bubble. It is even more remarkable that Alan Greenspan, Ben Bernanke and the Fed ignored the growth of the housing bubble. But even more astounding is the fact that no one in a position of authority has learned any lessons from this disaster.

At the moment, there are housing bubbles in the United Kingdom, Canada, and Australia that are arguably larger, relative to the size of their economies, than the one that collapsed and wrecked the U.S. economy. The basis for saying that house prices in these countries are in a bubble is that there has been a sharp increase in the sale prices of homes that has not been matched by a remotely corresponding increase in rents.

In the case of the U.K., house sale prices increased more than 115 percent in excess of inflation between 1996 and 2010. Over this period, rents pretty much kept even with the overall rate of inflation. In Australia house prices rose by more than 80 percent between the start of 2002 and end of 2009, a period in which rents rose by roughly 30 percent. Canada has a similar story.

The average house price in the U.K. is now almost 60 percent higher than in the U.S. It had been 20 percent lower in the mid-90s. In Canada the average house price is more than 70 percent higher than in the United States. The price of the median house in Australia is more than 225 percent of the median house price in the United States.

Given that wages in the United States are the same or higher than in all three countries, it is difficult to see how this huge gap in house prices can make sense. Furthermore, since rents have not notably outpaced inflation in any of these countries, it does not appear that the price increases are being driven by the fundamentals of the housing market. If there was a serious shortage of housing we should expect it to be showing up in rents as well.

In short, there is good reason to believe that house prices in these countries will not be sustained anywhere near current levels. All three are likely to see the same sort of house price collapse that has wreaked so much havoc on the U.S. economy. It’s impossible to know what will be the triggering event; a rise in interest rates could certainly deflate a bubble quickly.

Alternatively, a sharp increase in supply could eventually swamp demand. A glut of supply was the factor that eventually burst the U.S. bubble. After five years of near-record rates of construction, vacancy rates reached levels never before seen. Once prices began falling, potential buyers and lenders no longer assumed that prices would continue to go up indefinitely and the bubble quickly deflated.

It is fair to assume that a collapsed bubble will have the same sort of devastating impact on the economies of these countries and the lives of their citizens as it has in the United States. Bubbles generate demand in the economy both directly and indirectly. They directly create demand by increasing construction. They indirectly create demand through the wealth effect on consumption. People will consume more when they see the value of their home rise, thereby making homeowners wealthier.

These sources of demand will disappear when a housing bubble bursts. Five years ago, it was standard thinking among economists that the demand generated by a bubble can be easily replaced; anyone who has been paying attention over this period should know that this is not true. There is no easy way to replace the 5-10 percentage points of GDP that is bubble-driven demand. That is why the effects of the downturn in the United States have been so severe.

In addition to the macro story there is also the impact on people’s lives. A housing bubble leads homeowners to believe that they have much more money than is actually the case. Therefore they spend more and save less than would otherwise be the case. When the bubble bursts, reality sets in and homeowners discover that they are now near retirement with almost nothing by way of savings. That cannot be a good situation for a formerly middle class family to find itself in.

For these reasons, governments and central banks should be focused on preventing bubbles before they grow large enough to be so dangerous and disruptive. Central banks in particular are well-situated to take action, since central banks are designed to be less susceptible to short-term political considerations. This means that they can take steps to burst a bubble, which will likely be unpopular.

The tool box for central banks in this regard is extensive. First, clear warnings from a central bank using evidence to document the existence of a bubble will be difficult for actors in the financial sector to ignore. Bank executives will likely be forced to explain why they think the central bank is wrong if they keep lending. In the case of the U.S. bubble, they had no story that passed the laugh test.

Second, central banks and other regulatory authorities could use regulatory pressure to limit mortgage issuance. At the peak of the U.S. housing bubble, the largest mortgage issuers practically had neon signs on their buildings advertising fraudulent mortgages. It would not have been hard for the regulators to crack down on abuses, if they had chosen.

Finally, higher interest rates will sink any bubble. If a central bank announced a rate increase and that further hikes will follow until house prices have dropped by 30 percent (or whatever amount seems appropriate) it is likely that the housing market will take the warning very seriously.

There is probably no way at this point to deflate the bubbles in Australia, Canada, and the U.K. without causing considerable pain. It would probably still be better to take steps now than allow for even more people to become caught up in the bubble.

Perhaps more importantly, the public has to demand that central banks put bubble prevention at the top of their agenda. These banks have been ignoring economy-wrecking bubbles everywhere, somehow thinking they have down their job because they kept inflation at 2.0 percent. It’s wonderful that the central banks met their inflation target, but why should anyone give a damn?

See article on original website

  1. July 29, 2012 at 5:59 pm

    and if I know the conservatives, they will say it is the central bankers fault– if we had no central bank and returned to the gold standard (thank you Ron Paul), then the private housing market would have properly allocated resources to house building. [Of course they will also say we need to get rid of Fannie Mae and Freddie Mac who put people into houses that they really shouldn’t have– better they should be living in slum hovels!].

    Nowhere will these conservatives blame the Financial innovations” of “smart” financial innovators to combine a bunch of nonliquid mortgages into a financial derivative that they could claim is liquid. Of course that is an amazing innovation– turning illiquid assets into liquid assets — just as the ancient alchemists claimed to be able to turn lead into gold!

  2. July 29, 2012 at 6:18 pm

    Under the Gold Standard, housing in Britain went through a 40% orice collapse during the Edwardian period. The gold standard was an important cause. In the 1890s, returns to capital overseas were low and consequently there was over-investment in domestic housing. In the Edwardian period, overseas investment became more attractive, and capital flowed out of the UK. Demand also fell as young people emigrated. Rents were not affected. The economy was depressed and unemployment increased. Details in my book, A. Offer, *Property and Politics 1870-1914* (CUP, 1981 [still in print]), ch. 17.

  3. Nell
    July 29, 2012 at 9:53 pm

    In the UK it may have something to do with a shortage in housing maintaining demand, and the way that defaulting householders were treated, via the Mortgage Pre-Action Protocol. The Ministry of Justice reports that

    “The fall [in repossession rates] coincided with lower interest rates, a proactive approach from lenders in managing consumers in financial difficulties, and various interventions, such as introduction of the Mortgage Pre-Action Protocol. Over the last two years, the number of claims has decreased slightly. On a seasonally adjusted basis, there were 16,663 mortgage possession claims issued in the first quarter (January to March) of 2012, five per cent lower than in the fourth quarter of 2011.”

    Again, less repossessions, less houses on the market, less downward pressure on prices. However, some analysts think house prices (which are pretty stagnant) will continue to fall, but very slowly, all things being equal. Of course given the splendid job Osborne is doing running the economy into the ground, this could all change in the coming year.

  4. July 30, 2012 at 10:29 am

    It’s almost unbelievable to anyone but an experienced Georgist like me that the author would correctly blame the housing crisis for the origins of the crisis, but then fail to prescribe the correct solution to the problem: Site Value Reclaim. Without claiming back the value of location – a vlue which came from the commnity, not from anything the landowner did, we will continue to have more Land Bubbles, as we have had about every 18 years, going back hundreds of years to the rise of capitalism in Western Europe. No regulation, agency, appeal to Man’s “better nature” or Cange-agent elected official can fix this, unless we restructure the economy to account for the proper role of Land (maening ALL of nature’s resources in Classical Economics, but in the present case, mostly locational values) in economcs. Treating Land as just another form of capital – when its qualities make it nearly the opposite of Capital – will guarantee more bubbles, crashes, pain and poverty forever.
    OTOH, get this right and we can have smooth economies, with gradually rising living standards for all, an end to vast wealth inequities based solely on rent seeking behavior, new opportunities for true entrepreneurs and workers, and a tiny fraction of the corruption at every level of government. This has been known since Henry George, and even before, going back to biblical times, and is perhaps the most proven economic theory there is in what is otherwise rightly called the “dismal science.”

    • July 30, 2012 at 10:56 am

      Scott Baker – you were lucky not to get moderated out for your comments – I said the same thing on this thread and got chopped. It is almost as if the real desire of those who claim to be concerned about the problem is that it should never be solved. Doesn’t bother me, I have no children to worry about and have a nice income from rents. I would be one of the few people who would be worse off under LVT and get the best of all worlds by living in a socialist country with good public services and a little bit of LVT.

  5. July 30, 2012 at 11:10 am

    Scott, it doesn’t surprise me at all. I spoke to Dean recently at a conference in London where he poo-pooed my suggestion that those who accurately predicted the financial crisis have to be given some credit when they suggest solutions. From the floor I spoke of Fred Harrison’s Boom Bust House Prices, Banking and the Depression of 2010, and the much earlier Power in the Land, both of which precisely predicted the peak of the UK house price bubble many years in advance.

    There is a very simple way to stop house price bubbles, which unlike stockmarket bubbles affect the real economy and real peoples’ lives since shelter is a basic human need. The solution, of course, is the collection of all land rent for public benefit.

    • July 30, 2012 at 10:11 pm

      Which, when you look at it, Carol, would amount to the nation owning our debt and the interest we pay on our mortgages etc turning into land tax available for expenditure on public services. I’m not sure that would be as effective at stopping housing price bubbles as going back to the post-WWII 2-1/2 times one-person’s-income based limit on borrowing. Also, it would interfere with the endowment of NGO charities already performing public services, though on the whole it would be a lot better than we have now. But since money is created out of nothing, why not just start again by giving everyone a sufficient tax/interest/rent/profit-independent income and requiring them to earn it via public service? Don’t just say that wouldn’t work. Ask what would be the necessary conditions to make it work, and what would be involved in trying to provide them. One condition, surely, is that money created out of nothing for stock market gambling doesn’t end up blowing bubbles in the real economy.

      • July 31, 2012 at 6:45 am

        Mortgage interest = Rent.

        Mostly rent of land. If all of it was collected as public revenue in the first instance, then the selling price of land would be zero. Houses would change hands for the value of the buildings, and with them would go the liability to pay the land value tax as a condition of the validity of the land title. This tax might be very low in a place like, say, Sunderland, but very high in South Kensington, reflecting the higher value of the land in the desirable London location.

        If existing taxes were replaced by this tax, then, first, there could be no more land price bubbles, and second, the potential revenue would be high enough to provide all citizens with an unconditional basic income.

        But it is not going to happen any time soon. The old socialist/Marxist models need to fade into oblivion and now there is the neoliberal menace to be fought.

    • July 31, 2012 at 6:38 am

      The refusal to acknowledge that the housing bubble was in reality a credit-fuelled land price bubble is one reason why the problem is apparently intractable and will happen again, probably around 2028. That said, the neoliberal project is in full flow. It will give rise to unprecedented social unrest which will be put down with force unprecedented in peacetime situations. The Judge Dredd society is coming.

    • July 31, 2012 at 11:28 am

      I do not see why it is hard to prevent housing bubbles. 100% capital gains tax on profits from any sale should do it, surely?

  6. robert r locke
    July 31, 2012 at 5:30 am

    The contributors do not say if the bubble has occurred everywhere. I don’t believe it has in Germany, because the government stops speculators from buying land and buildings and selling them quickly unimproved at a big profit. In my town, I could not sell the house I bought without paying a hefty tax for ten years after purchase. That ruins the property market for speculation, but it forced me to stay and go into business in order to get a return on my investment. Tough on me but better for the community than the hit and run speculations in which outsiders engage, which creates bubbles. .

    • July 31, 2012 at 6:46 am

      What you have described produces roughly the right effect but is not the best way, or even the right way, to go about it.

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