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The Housing Bust Redux
Jesse Richman, 8/26/2010

When housing numbers were released on Tuesday and Wednesday for July, the picture they painted of the housing market was pretty bleak.  Sales volume tanked, inventory increased.  The only surprising aspect of the associated news stories was that they noted economists had predicted substantially smaller declines.  If we believe that long-run housing prices are shaped by supply (houses on the market) and demand (income and population growth), the recent drop should come as no surprise.

During the housing bubble demand for housing soared, fueled by unrealistic expectations of continued hyper-growth-stock returns from a traditionally stodgy investment that in the long term keeps up with inflation and little more.  Now consumers have learned the error of their ways.  One cannot, as a general thing, predict future changes in asset prices on the basis of previous changes.  Expected future changes in return on investment should already be factored into today’s price.   The belief that housing prices would rocket upwards forever is over, and good riddance.

 Government efforts to support housing prices may well have done more harm than good for the housing crash.  By attempting to stabilize prices at what were (for many cities) still bubble-values, the new home buyer subsidy took on a difficult task.  It succeeded, for a while.  Hundreds of thousands among the more than three million who received the credit would not have purchased a home if not for the government incentive.  Demand increased.  Prices stabilized or turned upward.  However, by encouraging individuals and families to accelerate their home purchases, the tax credit diminished the number of potential buyers in the market today.  Declining prices and falling volume are the natural consequence. 

 One motivation for the tax credit was the fear that investors’ irrational belief in the prognostigatory power of  past changes in asset prices would drive prices too low.   This will probably happen, but it has not yet happened.  Prices remain historically high.  By any realistic metric, they ought to fall further.  The Shiller home price index for the first quarter of 2010 was at 129, well above the long run (1946-1998) average of the inflation-adjusted index at 111.  A nearly twenty-percent nationwide decline is still in the cards.  In markets that have yet to see major declines towards pre-bubble values, declines may be much more severe.  Conversely, a few markets have hit realistic bottoms.

Potential buyers and sellers in the housing market should strive for realism about home values and prices.  In established neighborhoods that have not experienced major positive or negative transformations, this should be surprisingly easy to do.  In the long-run home prices tend to keep up with inflation, but they do not typically exceed inflation.  Therefore, determining a realistic price for a home should begin not with prices last year but with prices more than a decade ago, before the bubble began.  What was this house worth in 1998?  What were comparable houses worth in 1998?  Now adjust for inflation by multiplying that figure by 1.34.  If you buy a house at this price, you can be confident that in the long run your home will tend to maintain its inflation-adjusted value.  If you sell for that price, you can feel confident that you are getting a price that reflects the true long-term value of your home (circa 2005 fantasies notwithstanding).  The housing market will only return to normal when buyers and sellers become realistic about home values, accept their losses, and make deals.  

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  • [An] extensive argument for balanced trade, and a program to achieve balanced trade is presented in Trading Away Our Future, by Raymond Richman, Howard Richman and Jesse Richman. “A minimum standard for ensuring that trade does benefit all is that trade should be relatively in balance.” [Balanced Trade entry]

    Journal of Economic Literature:

  • [Trading Away Our Future] Examines the costs and benefits of U.S. trade and tax policies. Discusses why trade deficits matter; root of the trade deficit; the “ostrich” and “eagles” attitudes; how to balance trade; taxation of capital gains; the real estate tax; the corporate income tax; solving the low savings problem; how to protect one’s assets; and a program for a strong America....

    Atlantic Economic Journal:

  • In Trading Away Our Future   Richman ... advocates the immediate adoption of a set of public policy proposal designed to reduce the trade deficit and increase domestic savings.... the set of public policy proposals is a wake-up call... [February 17, 2009 review by T.H. Cate]