Building on the Bubble

May 17, 2004

Dean Baker
Houston Chronicle, May 17, 2004

Press Enterprise (Riverside, CA), May 14, 2004
Duluth News-Tribune,
May 17, 2004
Miami Herald
, May 22, 2004
Milwaukee Journal Sentinel
, May 23, 2004
The Pantagraph
(IL), June 20, 2004


Survivors of the recent stock market crash should rightly be worried that a sharp drop in housing prices could deliver a second major blow to their retirement dreams.


The fact that there has been an unprecedented run-up in home prices over the past eight years creates the possibility for an unprecedented decline in the years ahead — just as the spurt in the NASDAQ at the end of the ’90s created the basis for its plunge after March 2000.


The basic facts are striking. According to the government’s House Price Index (HPI), the increase in the sale price of an average house has exceeded the overall rate of inflation by more than 40 percentage points over the past eight years. In the past, house prices had largely kept pace with the overall rate of inflation.


It is important to recognize what this index shows — the HPI tracks the change in price for the same home. This means that the rise in this index is not being driven by better quality homes, it is being driven by homes of the same quality costing more.

This run-up in home prices is not being matched by a comparable increase in rental prices, providing further evidence of a housing bubble.

If there were some underlying factor driving up the demand for housing, then it should lead to comparable increases in home sale prices and rental prices, as it always did in the past. Instead, people are willing to pay more for owning a home, but not in general willing to pay more for rent, at least relative to the rate of inflation.

This suggests a bubble waiting to pop.

While the federal government has played an active role in trying to promote homeownership in recent years, this is not a new policy, and the initiatives of the past decade have not been especially large.

For example, the $200 million annual appropriation for the American Dream Down Payment Act is sufficient to provide $15,000 down payments for 13,000 home buyers, approximately 0.17 percent of the homes purchased each year. This policy is not likely to have much of an effect on the overall housing market.

The secondary market in mortgages has indeed grown in the last 10 years, but it was already huge 20 years ago. Competition has driven down mortgage fees recently, but mortgage fees, like mortgage interest rates, are just now back to their levels of the mid-’60s, not exactly the basis for an unprecedented boom in home prices.

The fact that people are borrowing against their homes at a rapid rate (more than $750 billion in 2003) is more evidence of an unsustainable bubble. The ratio of mortgage debt to home equity is at record highs.

This is especially scary because equity values may be inflated by as much as 30 percent due to the bubble, and the nation’s demographics — with the baby boomers approaching retirement — suggest that many homeowners should have largely paid off their mortgages.

The market is responding to the housing bubble exactly as economics predicts. New homesare being built at record rate, far faster than can be supported by population and income growth.


At the moment, this has mostly affected the rental market, leading to record vacancy rates and falling rental prices. However, as home prices continue to rise, many potential homebuyers will opt to rent, especially when interest rates rise.


And vacant rental units can be put up for sale. The end result will be a loss of $2 trillion to $3 trillion in housing wealth, and a downturn that is even worse than the fallout from the stock market crash.

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