What We’ve Learned: Ugly Truths About Housing
By Edward L. Glaeser
With the anniversary of the failure of Lehman Brothers approaching, we asked each of our Daily Economists to explain what we’ve learned from the financial crisis. Here Edward L. Glaeser, an economics professor at Harvard, responds.
One year ago, Lehman Brothers fell and our financial markets teetered at the brink of a precipice. This event looms large in global finance, but it appears less momentous from the perspective of the housing markets.
Housing prices peaked not 12 but 40 months ago in May 2006. After experiencing a staggering 96 nominal percent price increase during the six years before then (72 percent in real dollars), prices started a slow decline. By September 2008, prices had already dropped 22 percent from the peak. Of course, they fell another 12 percent in the six months after Lehman collapsed.
What have we learned from the great housing bubble and crash of the aughts? Most obviously, we have learned that housing prices can be extraordinary volatile. This was less obvious from previous housing cycles.
During the last housing cycle, from 1987 to 1993, the Case-Shiller 10-city index increased by 31 percent between January 1987 (when Case-Shiller data starts) and the peak in March 1990. During the 38-month period before the more recent peak, the 10-city index increased by 55 percent.
But during the recent period, five metropolitan areas (out of 20) experienced price growth above 75 percent; no city experienced such a massive boom during the earlier cycle.
After the earlier peak, the market fell for 42 months before bottoming, with the 10-city decline at about 8 percent in nominal terms, which was closer to 20 percent in real terms. While there are no guarantees against further declines, national housing prices seemed to stop falling in May 2009, exactly three years after the more recent peak. In the current decline, housing prices dropped by 33 percent in nominal terms, or perhaps 38 percent in real terms. A 24 percentage point larger nominal rise in the recent boom was associated with a 25 percentage point greater nominal fall.
So let no one ever again say foolish things like housing prices never fall.
In the current drop, eight of the 20 Case-Shiller areas had housing price drops of 40 percent of more. People who bought with a standard mortgage in the years close to the boom have lost all of the equity in their houses. Buyers and bankers should never again think that an area’s recent price increases are the sign of a strong market where prices have nowhere to go but up. In the long run, price increases are followed by price drops, and special caution, by regulators as well, needs to be taken in booming markets.
In places like Las Vegas and Phoenix, there are no fundamental constraints on building new homes — like a shortage of land or onerous restrictions on construction — and prices in unconstrained areas must eventually find their way back to the construction costs. I once thought that this obvious lack of limits on building meant that such open areas would sit bubbles out, as Dalllas sat out the recent boom and bust, but I was wrong. The logic of supply and demand can be ignored for longer than I thought, but it ultimately reasserts itself.
The second lesson of the housing debacle is that there is extraordinary pain in both housing price busts and booms.
When housing prices soared, ordinary Americans found it increasingly hard to afford a house. I would certainly cheer if Detroit produced a wonder car for $10,000 that could get 50 miles to the gallon and go from 0 to 60 in five seconds. I would also cheer if the housing industry could produce a beautiful and energy efficient 3,000-square-foot home for $100,000. The same logic pushed me to boo when housing became outrageously expensive. During the boom, I hoped that housing prices would stop rising and even decline.
Yet I didn’t understand the terrible impact that declining housing prices would have on our financial sector. While rising housing prices weren’t particularly good for America, declining housing prices were particularly bad for the country. The lesson seems to be that large swings in housing prices, in either direction, can be extremely painful.
The third lesson is that American housing policy has been monumentally foolish.
We have used public resources to encourage ordinary Americans to bet all they could on highly risky housing markets. Fannie Mae and Freddie Mac, the home mortgage interest deduction, even the willingness to bail out financial firms that had lost too much on mortgages, can all be seen as policies that encourage ordinary people to risk it all on real estate.
I had once thought that these policies were misguided, but not terrible. We now know that encouraging buyers and lenders to bet on housing can impose vast costs on the country.
Luckily, no one will ever again think that Fannie and Freddie are independent entities that impose no costs on American taxpayers. I am also tremendously gratified that the government did not engage in a quixotic attempt to buoy the housing market artificially by subsidizing even more leveraged home purchases.
Yet I think that we have not yet fully faced the fact that our tax code encourages people to finance their homes with as much debt as possible, and that our financial regulations abet irresponsible lending.
Now that we have backed away from the abyss, we can consider making much-needed reforms, like reducing the upper cap on the home mortgage interest deduction, that could depress housing prices in the short run, but make future housing bubbles and crashes less likely.