Local Address

Bursting the bubble about the causes of the housing bubble

Elizabeth Razzi
Saturday, May 8, 2010

Everybody knows what caused the housing bubble, with its breathtaking, though ephemeral, increase in prices, right? A long run of low mortgage interest rates, loose lending and low (to nonexistent) down payment requirements are the usual culprits cited by experts.

But those factors can be blamed for only a small part of the bubble, according to research published this week by economists Edward L. Glaeser and Joshua Gottlieb of Harvard University and Joseph Gyourko of the Wharton School at the University of Pennsylvania.

They write: "It isn't that low interest rates don't boost housing prices. They do. It isn't that higher mortgage approval rates aren't associated with rising home values. They are. But the impact of these variables, as predicted by economic theory and as estimated empirically over many years, is too small to explain much of the housing market event that we have just experienced."

Glaeser, Gottlieb and Gyourko say those factors can explain only about a 10 percent increase in home prices between 2000 and 2006. That's only one-third of the 30 percent increase in prices (adjusted for inflation) during that period, as measured by the Federal Housing Finance Agency, or the 74 percent increase measured by the Case-Shiller/Standard and Poor's index of prices in 20 large metro areas.

So what is to blame for the bubble? Well, they're not sure. "Using the standard toolkit of the empirical economist, we are unable to offer much of an explanation for what happened," they write.

They don't know what caused the bubble. But they are convinced that low interest rates and loose lending didn't do it. So, they conclude that there's little reason to worry about rising mortgage interest rates. And they feel more secure in suggesting that government policymakers back away from popular programs aimed at reducing the cost of homeownership.

"The relatively modest link between interest rates and housing prices makes us more confident about rethinking those federal housing policies that act primarily by lowering the cost of credit to home buyers, most notably the home mortgage interest deduction," they write.

In particular, they suggest that the $1 million cap on the amount of debt that qualifies for the mortgage interest tax deduction could be lowered to $300,000, which would direct that tax benefit to people in lower income-tax brackets. It "would not dramatically affect most households," they say. (They don't mention it, but that's really a $1.1 million cap on mortgage debt that qualifies for the tax deduction, if you include home equity loans.)

Of course, in markets such as the Washington area, such a limit would affect quite a few households. The median price for homes sold this year in the District (not counting the suburbs) was $354,000. Half of the homes sold for higher prices. Shrinking the mortgage-interest deduction may or may not be your idea of a fair and reasonable policy change. Plenty of people argue that the subsidy disproportionately rewards the more affluent and favors owners over renters. But lowering it would certainly lighten the wallets of many Washington area homeowners.

The three economists also wonder whether state governments might want to smooth out home price volatility by overriding local restrictions on development. They found that home prices were much more volatile in areas such as Boston that have "particularly restrictive" land-use policies compared with areas such as like Houston that have fewer restrictions. But local governments hardly stifled development in Las Vegas, where housing developments sprouted as fast as they could be built, and the housing bust has been among the worst in the country.

Economists have spent the past 70-plus years trying to figure out what caused the Great Depression. They'll probably spend the next 70 analyzing the causes of this decade's devastating boom and bust.

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