Why the housing bulls never made much sense

By Felix Salmon
August 17, 2010
paper which looks at economic research on whether or not there was a housing bubble, and which concludes that "we do not currently have the ability to prevent a bubble from forming or the ability to identify a bubble in real time". Yes, they admit, some smart and prescient economists did say, with complete accuracy, that there was a bubble. But! Other economists weren't convinced! So, never mind, there's nothing we can do.

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Kristopher Gerardi, Christopher Foote, and Paul Willen, of various regional Federal Reserve banks, have a paper which looks at economic research on whether or not there was a housing bubble, and which concludes that “we do not currently have the ability to prevent a bubble from forming or the ability to identify a bubble in real time”. Yes, they admit, some smart and prescient economists did say, with complete accuracy, that there was a bubble. But! Other economists weren’t convinced! So, never mind, there’s nothing we can do.

Tracy Alloway has already dealt with the part of the paper which looks at the housing bears, but for me the part looking at the housing bulls is far more interesting. The paper says that “there were reasonable arguments on both sides” — so what were these reasonable arguments saying that there wasn’t a housing bubble? It turns out that they’re pretty laughable.

The main argument of the housing bulls is also one of the silliest:

If housing was so obviously overvalued, as the pessimists suggested, then investors stood to make huge profits by betting against housing. By doing so, investors would have ensured that house prices would have fallen immediately.

This doesn’t even pass the laugh test. For one thing, there’s an enormous difference between being able to identify a bubble, on the one hand, and being able to profit by betting on it bursting, on the other. Look at stock-market bubbles, which are easy to short: unless you know when they’re going to burst, it’s very hard to make money and very easy to lose money by betting against them. And of course no one knows when any bubble will burst.

But applying this argument to housing bubble makes even less sense, because it’s almost impossible to bet against housing. You might be able to short proxies for the housing market, like real-estate investment trusts or homebuilding stocks. But you can’t short houses themselves. And the handful of people who did manage to make money by shorting the housing market only managed to do so after Wall Street spent a huge amount of time, effort, and money creating credit default swaps on collateralized debt obligations comprising a large number of thin slices of private-label subprime mortgages. Such things didn’t even exist for most of the housing bubble, and even after they were invented they were available only to a very small number of dedicated housing bears.

The paper also quotes what it calls “perhaps the most widely cited evidence against a housing bubble” — a 2005 paper by Himmelberg, Mayer, and Sinai — as saying that “expectations of outsized capital gains appear to play, at best, a very small role in single-family house prices”. That argument is echoed in another paper, by John Quigley, who “claimed that high transactions costs in housing markets would tend to decrease the amount of speculation”.

This is also a silly argument, and it seemed silly at the time: you don’t need speculators to have a housing bubble, and indeed many of us were pretty clear that a large chunk of the housing bubble was not speculative.

On the other hand, it’s downright idiotic to look at rampant house-price appreciation and use it as evidence that there isn’t a housing bubble. But yes, even that argument was trotted out, as part of the thesis that houses weren’t overpriced if you look at the total cost of housing. Get a load of this:


The argument here is that the cost of housing is low, so there isn’t a bubble: houses are priced in line with fundamentals. But a key part of those “fundamentals” is the rate at which house prices are rising! In other words, the faster that house prices are rising, the cheaper houses look. Crazy.

Similarly, other housing bulls looked at “hedonic indices” and the size of homes, concluding that “a significant portion of the house price appreciation measured using the median price and repeat-sales indices was attributable to quality increases” — and therefore that there wasn’t a bubble. But the fact is that if a million-dollar house is unaffordable, it makes no difference how big it is, or how high its quality is. (And I haven’t found anybody saying that the quality of housing stock rose during the bubble in any respect other than sheer square footage.) If house prices are at unsustainable levels, then they will drop, regardless of how many square feet they’re based on.

So my conclusion, after reading the arguments of the housing bulls, is that they were mostly bunk. And there’s even a hint of that in one of the footnotes to the paper, which says that “economists at policy institutions may have shied away from making pessimistic predictions for fear of spooking the markets”. It seems to me that if there wasn’t a bubble, no one was likely to be worried about spooking healthy rising markets.

The bigger conclusion, of course, is that it’s silly to look to economists to forecast anything at all. Not because they don’t have the tools, but just because it’s always possible to find an economist who’ll believe just about anything. Housing bubbles are normally pretty obvious at the time: there’s one right now in Vancouver, for instance. You can see them in the rise of dozens of huge new glass-clad condo buildings; you can see them in massive price increases; you can see them when mortgage payments are significantly larger than the amount of money you could get renting out the place; and you can see them whenever people start making more money from selling their homes than they do from actually working. The only people who can’t see them, it seems, are economists, realtors, and bankers on Wall Street.


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People will see what they want to see. The Federal Reserve along with Treasury is and has always been a proxy for Wall Street. Wall Street was pulling the strings during the credit boom and is pulling the strings today as we speak. Every single housing program is a back door bailout for the banks. The Federal Reserve is an academic organization, thus they all come from the Neo Classical school of economics. Bubbles don’t exist. These guys still believe in rational, efficient, and deregulated markets. They only talk about re regulation, because that gives them more power not to regulate. Economics has always been a Stalinist regime controlled by the elites. There has been a discussion on any alternatives to the status quo. The Fed knows one thing. Print.

Posted by mhmani | Report as abusive


Generally agree with your conclusion but I think you’ve missed a trick on that paper. I would have thought g t+1 refers to the expected capital gain for any asset of similar risk profile. Its your opportunity cost term. Perhaps if you explained what footnote 18 said that would clear up the confusion.

Posted by Splittorff | Report as abusive

It isn’t enough to have people calling it a bubble. People are calling things bubbles all the time. Don’t you want to know how often bubbles are called that don’t materialize?

And “And of course no one knows when any bubble will burst.” strikes me a as a serious cop out. Wait long enough and the movements of financial markets will provide you with a large negative movement in practically any asset class. If you cannot specify your time period for a bubble popping (even generously specified) you haven’t made a serious prediction.

Posted by OneEyedMan | Report as abusive

Splitoff, the footnote doesn’t help. (As you can check for yourself.) It just says that if prices are expected to fall, then the term is negative. But you can’t have a negative opportunity cost, right? So it must refer to housing specifically. Or that’s how I read it, anyway.

Posted by FelixSalmon | Report as abusive

“And I haven’t found anybody saying that the quality of housing stock rose during the bubble in any respect other than sheer square footage.”

Alyssa Katz’s “Our Lot” has a chapter looking at home building in Sacramento. As the bubble inflated, builders evidently cut corners so they could get houses to market as quickly as possible. Workers were given less time to complete their jobs, and were told to use as few materials as possible to get the house standing. So it’s entirely possible that homes built during the boom were lower quality than their pre-boom counterparts.

Posted by Wilchins | Report as abusive

And, seriously, everyone with a brain knew that there was a bubble. I haven’t seen the data, but I’d be willing to bet a lot of cash on the proposition that there was a sudden rise (and, later, a sudden fall) in the number of mortgage brokers. How can this be considered mysterious, or even really debatable?

Posted by MattF | Report as abusive

Have to disagree with the bubble is Vancouver – it`s population is growing enormously, and much of that growth is from wealthy Asian immigrants/business people. The wealthier parts of the city are like ‘Shang’hai annex’. Many would argue that Shang’hai is in a large housing bubble of its own, I think that comes from an underestimation of how much ‘wealth’ really wants to be there (which is to say if you’re rich and live in China, you want to live either in Hong Kong or Shang’hai). Think of some of the most expensive cities in the world: Moscow, London, New York, Shang’hai… they are places that wealthy people WANT to be; Vancouver is a smaller scale version of those (and a lot prettier too!) Toronto, Calgary.. absolutely they have housing bubbles that are being deflated as we speak – I just don’t think you’ll see anything like that in Vancouver. Some declines here and there, sure, but not 30-50% drop – probably at most 5-10%. And no, I don’t like kool-aid.

Posted by CDN_finance | Report as abusive

Canada in general is not in a housing bubble… over the last decade, compound growth in US house prices was in double digits (as measured by S&P Case/Shiller index) whereas in Canada it was in the mid single digits (more here http://takloo.wordpress.com/category/rea l-estate/)

What is unsustainable is the 20% rise in house prices from 2009 bottom… this has started to deflate – read yesterday’s news release – and will last for the rest of this year & well in to next year but nowhere near bubble proportions

Posted by takloo | Report as abusive

Suppose it were debatable; it quacks like a bubble, but there are a number of people who insist that it’s not. If you tighten credit requirements for getting a mortgage, and there was no bubble — it was fundamentally driven — you might delay the proper pricing of housing by a couple of years, and make some young people save up a while longer before they can buy a home. If it turns out there was a bubble, you take a lot of the air out of it immediately, before it gets bigger, and you reduce the ramifications, even on a size-for-size basis, by taking out the domino debt component. Even if you’re sufficiently married to efficient markets to think we can’t tell what’s a bubble in a reliable way, how about when a lot of people think there is, we disallow 3% down mortgages for a couple years?

Posted by dWj | Report as abusive

Nearly everyone knew that it was a bubble, especially after just experiencing the dot com bubble. The problem was that too many people were making too much money by riding the bubble. Realtors were starry eyed about the vast profits they were making, and ordinary schmucks were flipping houses and doing cash-out refi’s without regard to their liability for that debt when the bubble pops. And the dynamics of all bubbles tend to be pretty similar. Bubbles tend to inflate the fastest right before they pop, and this one did too. The subprime debacle was small in relative terms to the whole housing market, but it did finally pop the bubble, since much of the incremental demand was from subprime at the end.

Posted by Andrewp111 | Report as abusive

I think you are too charitable to the housing bulls. They are assuming the EMH and noting that it rules out a bubble. This is circular reasoning.

The first argument is that there can never be a bubble of any kind. It is known to be false. The assumption that there are some sophisticated investors does not imply that prices correspond to the EMH. Claims to that effect were never based on formal models and Campbell and Kyle proved that they were false decades ago.

The fact that, given transaction costs, attempting to make money by speculating on houses is stupid, doesn’t mean that people didn’t do it (demonstrably people did). The bull is assuming rationality. No one claimed that the housing bubble was a rational bubble.

The hedonic price index argument is plainly nonsense. The Case-Shiller index is based on repeated sales of the same house. The average price of houses is not a correct hedonic price index. The price index which everyone uses is a correct hedonic price index. The bull is full of B.S. and doesn’t know a basic fact.

Also it certainly was possible to short housing throughout the bubble. That was the point of making furtures on the Case-Shiller index an asset on the Chicago Commodities Exchange (Shiller made exactly the argument that it is important that it be possible to short housing dozens or hundreds of times).

Basically the bulls’ argument is that if we assume that asset markets are efficient, then we conclude that asset markets are efficient. They don’t make a case against a particular claim that there was an irrational bubble — they assume that there can be no such thing.

Posted by robertwaldmann | Report as abusive

You make some interesting points but the year ahead expected capital variable or factor is not a crazy concept, rather it is the stuff of bubbles and quite rational behaviour. Purchasers expecting substantial price appreciation believe that the current price is cheap relative to their expectations. This is not crazy even though their expectation may prove to be irrational.

You state that Vancouver is currently in a housing bubble but I respectfully differ. Prices are currently declining following a sizable rebound from their recession low of Jan-2009. Your evidence of high-rise condo construction is insufficent to reach such a conclusion. Rents for newly constructed buildings are almost always lower than mortgage payments – no surprise here — otherwise builders/developers would build market rental buildings for their own account and that is not happening in Vancouver.

Yes, when taxi drivers talk about how much money they have made in the housing market it probably is a bubble but that is not what I hear from cabbies these days.

The housing market is well researched and documented as an inefficient market for a number of reasons and to expect otherwise is irrational.

Posted by hpastrick | Report as abusive