Dean Baker
TPMCafé, August 18, 2010

See article on original website

That is the question that millions are no doubt asking after the publication of a new study from the Boston Fed. The study examines the arguments from those warning about the housing bubble, as well as the deniers and the agnostics. It concludes by exonerating the economics profession for failing to see the biggest economic catastrophe in 80 years:

"[T]he state-of-the-art tools of economic science were not capable of predicting with any degree of certainty the collapse of U.S. house prices that started in 2006."

I'm sorry, but this one is really painful. It's bad enough that these highly paid professionals could not see this disaster coming beforehand, but it turns out that even after the Titanic hit the iceberg they still couldn't see a problem in the ship's design.

The highlight of the story from the deniers and agnostics is that if we construct a model that has house prices depending heavily on the interest rate, then the prices of the period 2002-2006 don't appear so out of line. This is especially true if we slip in as part of the equation an expectation that house prices will rise in the future by more than the rate of inflation.

Serious economists cannot take this sort of story seriously. If there is an expectation that house prices will rise more rapidly than inflation, then we are saying that the expectations of rising house prices will justify rising house prices. Can we get a big "duh" from the masses who lack advanced training in economics?

Of course this is the bubble story. If people expect house prices to rise, and they do in fact rise, then we get a higher price to rent ratio. How do we justify the higher price to rent ratio in the next period? We have to expect house prices to rise even more. This works fine, until house prices no longer rise and then our expectations go the other way - and then house prices collapse. This is not a model that supports the case against the bubble. It is a model of a bubble market.

Similarly, the argument that low interest rates justified sky-high house prices also does not explain away the bubble, as I pointed out back in 2002. Historically, house prices had not been very responsive to interest rates, but this could have changed in recent years due to changes in housing finance or other factors.

However, this story should have provided limited comfort to the housing bulls in 2002-2004, since no one expected interest rates to remain so low. In other words, if the high house prices of these bubble years was explained by extraordinarily low interest rates, then the housing bulls should have expected house prices to plummet - just like the bears - once interest rates returned to more normal levels.

Finally, the Boston Fed folks are still trying to hold up one of the silliest stories of the bubble days as a plausible explanation for soaring housing prices. The New York Fed put out a study in 2004 arguing that there actually was no run-up in house prices. This Fed paper claimed that the run-up in prices was an illusion created by a faulty index. The problem was that we were tracking repeat sales of the same homes. However, they claimed that homes were being improved between sales - homeowners were putting in central air-conditioning or building additions - thereby raising the value of their homes. According to the NY Fed paper, these improvements explained the increase in the house price index, not an actual increase in quality adjusted house prices.

This one was easy to dismiss at the time. It was only necessary to look at the data for spending on home repairs and improvements. This information was available in a data series actually cited in the paper. If the improvement story was true, there would have been a sharp increase in the money spent on repairs and renovations relative to the value of the housing stock.

In fact, the data showed the opposite. In the bubble years, homeowners were actually spending slightly less on improvements, relative to the value of their homes, than had been the case in prior decades. However, this detail - which completely destroyed the argument - was not sufficient to keep the Fed from publishing the paper in 2004. Nor was it sufficient to undermine the argument in the eyes of the Boston Fed team in 2010.

It was easy for honest economists to recognize a housing bubble in 2002-2006. A huge break with a hundred year long trend in the largest market in the world is a hard event to miss, even if the vast majority of economists missed it.

If economists can't recognize an $8 trillion housing bubble - even in retrospect--what can they do? That is, except tell us that we need to cut Social Security?