Do Bubbles Bother Bernanke?

November 08, 2005

Contact: Karen Conner, (202) 293-5380 x117

November 8, 2005

Do bubbles bother Bernanke?

Study cites recent trends that signal housing bubble

For Immediate Release: November 8, 2005

Contact: Lynn Erskine, 202-293-5380 x115

Washington, DC – Recent trends in the housing market suggest a dangerous housing bubble, rather than a run-up caused by fundamental factors such as higher incomes and population growth, according to a new study by the Center for Economic and Policy Research (CEPR).

The report, "Will a Bursting Bubble Trouble Bernanke? The Evidence for a Housing Bubble," cites three trends in the housing market that suggest an unsustainable increase in house prices: 1) A sharp divergence between house sale prices and rents; 2) An extraordinary jump in the rate of housing construction; and 3) A sharp decline in the savings rate, driven by a housing wealth effect.

Federal Reserve Board chairman nominee, Benjamin Bernanke, has argued that there is no housing bubble and, therefore, no reason for the Fed to take action to address the bubble. Bernanke's approach raises grave risks, since the impact of a bursting housing bubble is likely to be even greater than the collapse of the stock bubble. The collapse of the housing bubble will throw the economy into a recession, and quite likely a severe recession, according to economist Dean Baker, co-author of the report.

"If the Fed chooses to let a housing bubble expand unchecked, the eventual cost to the economy and millions of American families could be enormous," said Baker.

The report, by Dean Baker and David Rosnick, found three housing patterns that are tell-tale signs of a housing bubble:

A sharp divergence between house sale prices and rents. If house sale prices were pushed up by fundamentals in the housing market, it would be expected that rents and house sale prices would rise together — but they are not. The house price index has increased by an unprecedented 51 percentage points more than the rent index since 1997.
A high rate of housing construction. The rate of housing construction over the last three years is more than 40 percent higher than it was in the 17 years prior to the run-up in house prices. This is not caused by the increase in the U.S. population, since the most rapid growth in the number of new households actually took place in the 1970s and early 1980s, when the huge baby boom cohort was first forming their own households.
A sharp decline in the savings rate. If house prices move at approximately the same pace as the overall inflation rate, as was the case prior to 1997, then housing wealth will have little effect on the savings rate. However, in the last eight years, house prices have outpaced the overall rate of inflation. The resulting wealth effect has depressed the savings rate, which has actually turned negative in recent months.

For the full report, click here.

The Center for Economic and Policy Research is an independent, nonpartisan think tank that was established to promote democratic debate on the most important economic and social issues that affect people's lives.