Chapter 20: The Economics of Housing Bubbles

[This chapter originally appeared as “The Economics of Housing Bubbles,” in Housing America: Building Out of a Crisis, edited by Randall G. Holcombe and Benjamin Powell (New Brunswick, NJ: Transactions Publishers, 2009), pp. 237–62. Reprinted with permission from the publisher.]

Nothing better illustrates government failure and the housing crisis than the housing bubble. While the housing bubble is being created by government, homes become increasingly expensive and beyond the economic reach of first-time home buyers. Then as interest rates rise and housing prices fall, many home buyers find themselves with bad investments that they can no longer afford. What started as a grand federal-government effort to improve homeownership for all Americans through a policy of “easy money” will have unintended consequences that will leave many Americans economically scarred for the rest of their lives. An easy-money policy involves the central bank (the Fed) setting low interest rates and expanding the money supply so that it is easier to get credit (loans), and it also involves government-sponsored credit organizations such as Fannie Mae and Freddie Mac that make getting home mortgages easier.

When an economic bubble pops, many people are harmed economically. In the case of a housing bubble, this will be especially true of homeowners, particularly new homeowners who buy homes during the peak phase of the housing bubble. However, the harm also consists of unemployment of labor and a loss of value to owners of capital, particularly in housing-related industries. At the individual level many people are forced into bankruptcy. On the macroeconomic level the bursting of the housing bubble can send the overall economy into recession or depression. Housing bubbles concentrate their impact in the home-building, materials and furnishings, real estate sales, and mortgage businesses.

On top of all that, people suffer psychological consequences as well. The people most involved in the bubble are confident, jubilant, and self-assured due to their apparently successful decision making. When the bubble bursts they lose confidence, go into despair and lose confidence in their decision making. In fact, they lose confidence in “the system,” which means they lose confidence in capitalism, and become susceptible to new political “reforms” that offer structure and security in exchange for some of their autonomy and freedoms.

The reason economic crises create fear and concession of liberty is that people do not generally know what caused the bust or economic crisis and generally do not even know that there was even a bubble in the first place. In fact, as the bubble bursts many people deny that there is a problem and believe that the whole situation will quickly return to what they consider normal. The average citizen thinks very little about what makes the economy work, but simply accepts the system for what it is, and tries to make the most of it.

The purpose of this chapter is to show how “the system” works, how it generates bubbles, why they eventually burst, and the macroeconomic effects of bubbles. Here we apply the economic understanding of bubbles derived from Austrian business cycle theory, or ABCT, to the current 2006 case of the housing bubble and show that this aspect of the housing crisis is the result of government failure — the inevitable failure of a government bureaucracy (i.e., the Fed) to manage the money supply and interest rates in an economically rational manner. However, the same reasoning can be applied to historical bubbles, from the tulip mania in seventeenth-century Holland to the dot-com tech bubble of the late 1990s, as well as to future bubbles.

What Causes Housing Bubbles?

There are three basic views of bubbles that are held by economists and the general public. The dominant view among the general public and modern mainstream economists, including the Chicago school and proponents of supply-side economics, is to deny the existence of bubbles and to declare that what are thought to be “bubbles” are really the result of “real” factors. The second view, which is espoused by Keynesians and by proponents of behavioral finance, is that bubbles exist because of psychological factors such as those captured by the phrase “irrational exuberance.” The third and final view is that of the Austrian school, which sees bubbles as consisting of real and psychological changes caused by manipulations of monetary policy. This view has the advantage of being forward looking and identifying an economic cause of bubbles. By identifying an economic cause it also directs us to policy choices that would prevent future bubbles.

Most people agree with the majority of economists that there is no such thing as a housing bubble — housing prices, they say, “never go down.” Supply siders and Chicago-school economists seem to view the declaration of a bubble as an affront to homo economicus — economically rational man — because they view it as an assertion of some psychological flaw in people that requires government intervention.1 They note that if there were a rational cause or causes of housing bubbles, or any type of bubble for that matter, then even if only some people believed it was a bubble, they could profit by selling homes at inflated prices and deflate the bubble long before it ever became overinflated and burst. Furthermore, if housing bubbles had irrational foundations, then certainly an economically rational man could profit enormously by shedding light on the erroneous psychological motivations that were causing the bubble.

Although there is much diversity in this camp, it is well illustrated by two economists from the Federal Reserve Bank of New York who examined concerns about the existence of a speculative bubble in the US housing market. While McCarty and Peach did find that a housing bubble could have a severe impact on the economy — if it existed and were to burst — they ultimately concluded that such fears were unfounded:

Our main conclusion is that the most widely cited evidence of a bubble is not persuasive because it fails to account for developments in the housing market over the past decade. In particular, significant declines in nominal mortgage interest rates and demographic forces have supported housing demand, home construction, and home values during this period.2

Furthermore they find “no basis for concern” for any severe drop in housing prices. They found that when the United States has gone into recession or experienced periods of high nominal interest rates, any price declines have been “moderate”; and they found that significant declines can only happen regionally such that they would not have “devastating effects on the national economy.”

This is essentially the view of Alan Greenspan and Ben Bernanke. In particular, Greenspan was aware of the possibility of a housing bubble, but he offered every possible reason why it did not exist, and how if one did exist it would not be a major problem. The chairman is usually difficult to interpret and at times so incomprehensible as to be almost misleading. His testimony before Congress has been labeled “Greenspam.”3 However, on the topic of the housing bubble he is clear and direct and worth quoting at length:

The ongoing strength in the housing market has raised concerns about the possible emergence of a bubble in home prices. However, the analogy often made to the building and bursting of a stock price bubble is imperfect. First, unlike in the stock market, sales in the real estate market incur substantial transactions costs and, when most homes are sold, the seller must physically move out. Doing so often entails significant financial and emotional costs and is an obvious impediment to stimulating a bubble through speculative trading in homes. Thus, while stock market turnover is more than 100 percent annually, the turnover of home ownership is less than 10 percent annually — scarcely tinder for speculative conflagration. Second, arbitrage opportunities are much more limited in housing markets than in securities markets. A home in Portland, Oregon is not a close substitute for a home in Portland, Maine, and the “national” housing market is better understood as a collection of small, local housing markets. Even if a bubble were to develop in a local market, it would not necessarily have implications for the nation as a whole.4

As the bubble approached its peak, Greenspan5 did admit that there was some “apparent froth” in some local housing markets, but overall he found that conditions in the housing market were “encouraging.” In his first speech after leaving office Greenspan said that the “extraordinary boom” in the housing market was over, but that there was no danger and that home prices would not decrease.6 The new Fed chairman, Ben Bernanke,7 admitted the possibility of “slower growth in house prices,” but confidently declared that if this did happen he would just lower interest rates. Bernanke also believed that the mortgage market is more stable than in the past. Bernanke noted in particular that “our examiners tell us that lending standards are generally sound and are not comparable to the standards that contributed to broad problems in the banking industry two decades ago. In particular, real estate appraisal practices have improved.”8

A second view of housing bubbles and bubbles in general is that they exist, but that they are fundamentally caused by psychological factors. Many people and many important economists subscribe to this view of bubbles, including Keynesian economists and proponents of behavioral finance, such as Robert Shiller. From this perspective the business cycle is seen as the ebb and flow of mass consciousness and emotions. Real factors may play a role, but the important causal factors for deviations in the business cycle are psychological. Booms develop because people become confident and then overconfident in the economy. Investors likewise are confident and increase their tolerance for taking risk. Rising profits and asset prices lead to “speculative” behavior where economic decisions are no longer based on old rules and procedures, but on the bravery instilled by a “new era.”9 As the investment mania sets in, the bubble expands. Then, for whatever reason, people begin to lose faith and new investments are exposed as disappointing. Economic reports and statistics turn sour, and stories of scandal begin to appear in the press.10 Many investors remain determined in thinking that this turn of events is only temporary, but results grow worse, prices continue to fall, and investment projects are postponed, halted, or cancelled. The mood of the market is one of gloom or even doom. The economy enters a depression.

Representing the behavioral-finance camp is Professor Robert Shiller of Yale University, who is the author of Irrational Exuberance, the first edition of which correctly predicted the stock market bubble; the second edition predicted the housing bubble, whose “ultimate causes are mostly psychological.” Like the Keynesians to follow, Shiller11 does not deny the existence of real factors; he simply downplays them in order to emphasize psychological factors. With the case of the housing bubble he finds three important factors. First, the increased risk and chaos in the world since the technology bubble and the terrorist attacks of 9/11 have caused a flight of investment into quality and safety — your own home. Second, the explosive growth in global communications has increased the glamour appeal of living in one of the world’s leading cities such as Paris, London, New York, or San Francisco. The third psychological factor is “the speculative contagion that underlies any bubble.” Here one higher price begets another, and higher prices in one city lead to higher prices in another city, and the process of higher prices simply builds on itself. Shiller declared that the first two factors will remain in effect, but the third factor cannot last forever. Once prices begin to drop, the contagion works in the downward direction and can last for years before the process is reversed again.

Representing the Keynesian camp is Paul Krugman, who is an economics professor at Princeton University and a writer for the New York Times. Krugman did not predict a housing bubble, but he did finally realize that we were in one and that it presented a big problem for the US economy. Commenting on the hectic pace of housing construction and the “absurd” housing prices Krugman drew parallels to previous investment manias: “In parts of the country there’s a speculative fever among people who shouldn’t be speculators that seem all too familiar from past bubbles — the shoeshine boys with stock tips in the 1920’s, the beer-and-pizza joints showing CNBC, not ESPN, on the TV sets in the 1990s.”12

It is also correct to connect the phenomenon of day traders of technology stocks in the late 1990s to the house flippers of the housing bubble. The real question is: what causes this irrational behavior? Krugman suggested that, with the housing bubble, the bubble builds on expectations of capital gains:

So when people become willing to spend more on houses, say because of a fall in mortgage rates, some houses get built, but the prices of existing houses also go up. And if people think prices will continue to rise, they become willing to spend even more, driving prices still higher, and so on. … [P]rices will keep rising rapidly, generating big capital gains. That’s pretty much the definition of a bubble.13

Notice that Krugman placed his emphasis on a supposedly unfounded change in taste or demand (“when people become willing to spend more on houses”) but downplayed the actual cause of the change in the demand for housing (“say because of a fall in mortgage rates”), as if anything might have ignited the bubble. The more Krugman tried to provide an economic rationale for the bubble the more he sounded like the Austrian economists who dominate the third and final view of the housing bubble. Another possible example of this is Baker and Rosnick,14 who demonstrate the case for a housing bubble and do so in a manner similar to Austrian economists; and even though they date the beginning of the bubble to 1997 they ignore the real factor that tax-law changes in that year were a catalyst to housing and higher housing prices. In fact, Krugman15 cites fellow Keynesian Paul McCulley, who did correctly predict the housing bubble and did so in the manner typical of Austrian economists, where interest rate cuts lead to higher home prices, a construction boom, and higher consumer spending all based on increased debt — and he explicitly placed the blame for the bubble on the Fed. The problem with Keynesians such as Krugman and McCulley is that their cures — discretionary monetary and fiscal policy — usually make matters worse. Even if they could be made to work perfectly it would create a conundrum for Keynesian economists because a highly stabilized economy desensitizes investors to risk and makes them “irrationally exuberant” and thus creates the prerequisite for bubbles. Even Alan Greenspan16 has warned, in his own convoluted way, that “history has not dealt kindly with the aftermath of protracted periods of low risk premiums.”

As you can see, the first view wishes to dismiss psychological reasons for bubbles to focus only on real factors, while the second view wishes to downplay real factors in order to emphasize psychological causes. The third view believes that there are changes in both real factors and market psychology during bubbles and that both are driven by the cause of the business cycle — policy manipulations by the Federal Reserve. This view of bubbles is based on Austrian business cycle theory. This is a minority view held by Austrian-school economists and some fellow travelers of the school.17

According to ABCT, if the Fed does not pursue a loose monetary policy then bubbles like the technology stock bubble of the late 1990s or the one in housing that we are now experiencing would not develop. If the Fed does follow a loose monetary policy, then a bubble can develop somewhere in the economy, whether it be in tulip bulbs, stocks, or real estate. If the new money is directed toward housing, a bubble will develop in housing. Austrian economists further emphasize that the additional resources allocated to housing are resources that are not available elsewhere in an economy, so that while more resources than normal are allocated to housing construction, fewer resources are available to other areas of the economy such as manufacturing, which will experience higher costs for its inputs such as labor and materials and will produce a proportionately smaller output. It is this mismatching of resources across industries and sectors that has to be resolved — painfully — in the inevitable bust or correction.

In a real estate bubble the price of existing homes rises. The bubble also fuels the construction of new homes so that the wages of construction workers rise and labor reallocates itself into construction and related industries. The bubble also increases the price of construction materials and land. Construction and construction-related industries are also where the most unemployment occurs and where the biggest price and wage declines occur in the inevitable bust. Another unique feature of the Austrian approach is that they do not see a need for prices to increase uniformly across markets, or for prices to increase to extreme levels in all markets. Many doubters of the housing bubble point to the smaller price increases in the center of the country compared to coastal regions, but price is only one dimension of bubbles — quantity can also increase beyond sustainable levels. In fact, one could conceptualize a bubble where prices stayed the same and all the bubble adjustment occurred only in the quantity dimension. If we doubled the number of houses and prices barely budged, we would be left with too many houses for the population and all the labor and materials that went into the production of those goods (i.e., houses) would be tied up and unavailable to serve more urgent needs after the bursting of the bubble revealed that the superfluous houses were bad investments.

Among the Austrians who identified the housing bubble is economist Frank Shostak, who defined a bubble as any activity that “springs up” from loose monetary policies: “In other words, in the absence of monetary pumping these activities would not emerge.” As a result of this pumping, a misallocation of resources develops whereby nonproductive activities increase relative to productive activities — something that seems to clearly characterize the US economy since he wrote in early 2003: “The magnitude of the housing price bubble is depicted … in terms of the median price of new houses in relation to the historical trend between 1963 and 1979. In this regard the median price stood at 73 percent above the trend in December 2002.”18

The only “problem” with his warning is that it came too soon. A year later Shostak warned that there “is a strong likelihood that the US housing market bubble has already reached dangerous dimensions.”19 While early warning maybe a problem for investors in home building stocks, the problems of predicting the timing and magnitude of bubbles and business cycles affects all forecasters, and Shostak’s warning was primarily for the purpose of judging public policy. In effect he was noting that policymakers have made a mistake that they should correct immediately and not make the situation in the housing market any worse.

Also from the Austrian camp is banker Christopher Meyer, who noted that there is always a bubble in the making in a world of fractional reserve banking and fiat currency, and that housing has often been impacted by bubble conditions in the United States and elsewhere. In the summer of 2003 he identified the current housing bubble:

The strong housing market has all the makings of being the next bubble — in particular high leverage and unsustainable price increases. While the larger economy seems to sputter along, the housing market continues to run a hot race. Low interest rates have propelled refinancing, freeing up $100 billion last year alone, according to the Wall Street Journal. Not surprisingly, the low interest rates have increased buying power and supported housing prices.20

In early 2004 I pointed investors to the on-going housing bubble and specifically that it might not be a good idea to increase your mortgage: “It might not be a good time for you to obtain a home equity loan to invest in hot tech stocks. We are going through a housing bubble.”21 I followed this up later that year with a more detailed examination of the housing bubble and found:

Signs of a “new era” in housing are everywhere. Housing construction is taking place at record rates. New records for real estate prices are being set across the country, especially on the east and west coasts. Booming home prices and record low interest rates are allowing homeowners to refinance their mortgages, “extract equity” to increase their spending, and lower their monthly payment! As one loan officer explained to me: “It’s almost too good to be true.” In fact, it is too good to be true.22

The problem with the “new era” diagnosis is that it ignores the historical fact that the housing market, and the construction of structures in general, has experienced regular cycles of boom and bust, with prices rising and falling for residential, commercial, industrial, and agricultural real estate. Likewise occupancy and lease rates, new construction, and the fate of construction firms and land speculators point us to the history of real estate bubbles. In fact, statistically, housing starts are a leading indicator of the business cycle and home construction is procyclical (i.e., home construction is positively related to changes in the overall economy, but more volatile). The Skyscraper Indicator even shows that historically the building of a record-setting high skyscraper foreshadows severe negative changes in the economy.23

What Goes Up…

ABCT demonstrates that monetary inflation has different effects depending on who receives the new money first and how it is spent. Is the new money introduced into the economy in the areas of banking and investment, consumer loans, or directly to a group of consumers or producers? Do the people who receive the money want to save it or spend it? If they save it interest rates will go down, and if they spend it interest rates will go up as entrepreneurs borrow money in order to increase production. If the money is spent, it depends on who is spending it. The economy will experience different changes if the money is given to welfare recipients instead of military generals. If the money is saved the economy will experience different changes than if it is invested in stocks rather than housing. The point here is that monetary inflation can cause bubbles and booms in the areas of the economy where it is first introduced. This foundation of ABCT comes down to us from Richard Cantillon, the founder of economic theory, who wrote in the aftermath of the Mississippi Bubble circa 1720s. Tracking the flow of monetary inflation through the economy is very difficult, and most mainstream economists just assume away the problem and declare that money is neutral on the economy.

By the end of the eighteenth century the world had converted from free banking to central banking, with the United States being the last major nation to establish a central bank in 1913. In the first treatise on monetary theory in the modern era, Ludwig von Mises produced the foundations of ABCT.24 With central banks established for the purpose of producing monetary inflation, Mises could now establish a general theory of business cycles rather than the case-by-case basis of Cantillon. By integrating the contributions of Carl Menger, Eugen von Böhm-Bawerk, and Knut Wicksell he was able to show that when the central bank — the Fed — increases the supply of money, it causes the market rate of interest to fall below the natural rate of interest that would have existed in the absence of Fed intervention. This would cause investors to borrow more money, to expand their investments, and to undertake riskier projects and more roundabout production processes. As these borrowers compete for assets, resources, and goods, price inflation inevitably occurs and the rate of interest will increase. This in turn will negatively affect the economy, and some of the riskier and more roundabout investment projects will be discovered to be bad investments. Bankruptcies can also impact previously existing investments and production processes that are caught in the wake of the bust. Mises student F. A. Hayek expanded ABCT to include capital theory and its integration into the structure of production.

According to ABCT, when a central bank makes loans or purchases government bonds from banks it is injecting bank reserves into the economy. Banks now have excess reserves that they can loan, but the existence of excess loanable funds means that banks must reduce the interest rate they charge, reduce the credit-quality requirements of borrowers, or both. The result is a greater quantity of borrowing and investing, particularly in projects that “pay off” over a long period of time. Lower interest rates also discourage savings because the return from savings is lower. In this manner the Federal Reserve drives the market rates of interest below the natural rate of interest that would have existed in the absence of Federal Reserve intervention.

Ever since the Depository Institutions Deregulation and Monetary Control Act of 1980 and Paul Volcker’s (chairman of the Fed from 1979 to 1987) war on inflation of the early 1980s, interest rates have been on a downward path. This culminated with the large reductions in the federal funds rate that followed in the aftermath of the 9/11 terrorist attack in 2001. Under Greenspan the rate was reduced from 6.5 percent in November 2000 to 1 percent in July 2003. The federal funds rate remained at 1 percent until June 2004, coinciding with the launching of the final phase of the housing bubble. The Philadelphia Housing Sector Index peaked at the end of August 2005. At this low level, interest rates were negative when price inflation is taken into account.

The federal funds rate, which is the rate that banks can borrow from other banks in order to meet their reserve requirements imposed by the Fed. The Fed “targets” this short-term rate and injects reserves into this market by purchasing government bonds from banks, thereby freeing up reserves in the banking system. This essentially is the engine of inflation because the Fed simply makes a bookkeeping entry in the bank’s account with the Federal Reserve — modern inflation is essentially an electronic bookkeeping entry. The low rates of the 1960s resulted in no recession and a booming economy, but those low rates also caused the stagflation of the 1970s, where both price inflation and unemployment were very high. This culminated in Volcker’s war on inflation of the early 1980s. By greatly reducing expectation of price inflation and deregulating the banking system, the Fed has been able to reduce interest rates and ignite a giant boom in financial and asset markets throughout the 1980s and 1990s, as well as the housing bubble of the early 2000s when rates were clearly pushed below their natural levels and when rates were negative, when adjusted for inflation.

When banks have access to bank reserves from the Fed at low rates they can offer their customers lower rates on loans. The impact of changes in the federal funds rate has a direct impact on mortgage rates: increasing during the 1970s and peaking during Volcker’s war on inflation at 18 percent, and then generally declining throughout the 1980s and 1990s and then reaching historical lows during the early 2000s. During the housing bubble interest rates on thirty-year conventional mortgages were at their lowest levels ever during the post–gold standard era. When interest rates fall, asset prices and real estate prices tend to rise, and vice versa.

Naturally, lower rates for home mortgages have stimulated borrowing for real estate purposes. Total real estate loans first exceed $1 trillion in early 1995, reached $2 trillion in late 2002 and reached $3 trillion in early 2006 (the maximum for the bubble occurred in mid-2009 at $3.8 trillion). In addition to the Fed, there were other factors that helped direct all this new credit money into real estate. First, in 1997 homeowners were given a $250,000 exemption ($500,000 for couples) for capital gains that resulted from the sale of their house, adding greatly to the tax benefits of homeownership. This tax break could be said to have lit the fuse of the housing bubble. Second, government-sponsored credit corporations such as Fannie Mae and Freddie Mac, which can acquire capital at a subsidized rate because of the implicit assumption that the federal government will bail them out, began to collateralize home mortgage debt on a grand scale so that lenders could quickly and easily resell the loans they make. These government-sponsored agencies have helped stimulate the flow of credit to riskier borrowers who might not otherwise have access to credit, and have therefore helped to lower the credit standards of lending institutions. The problem with these institutions is so large that even Alan Greenspan has publically scolded them.25 In truth, the original problem lies with Alan, not Fannie or Freddie.

The artificially low rates generated by the Fed also have the effect of discouraging people from saving money and encouraging them to borrow more for consumption and speculation. The impact of monetary pumping by the Fed has driven down the personal savings rate throughout the 1980s and 1990s, and during the early 2000s it has driven the rate to zero — and even below — which means people are spending more than they earn. Contributing to the problem of the low personal savings rate are the artificially inflated asset and real estate prices which naturally make people feel wealthier and allow them to “cash out” equity from their homes when they refinance their home mortgages. During the housing bubble many Americans used their homes as a kind of giant ATM to withdraw cash from the equity in their homes. Others used the “magic checkbook” from second mortgages to spend the equity they had in their homes.26

At this point one should be wondering — how could borrowing be going up and savings going down? One answer to the question is that America was borrowing money from overseas in the form of the trade deficit, but the main answer is monetary pumping by the Fed. By artificially lowering rates via increases in the money supply the Fed created a giant gap between borrowing and saving. MZM (money of zero maturity) is a relatively new measure of the money supply and one that is close to the Austrian-school definition of money, which is that it is immediately redeemable at par. MZM includes currency, demand deposits — that is, checking accounts — traveler’s checks, savings deposits, and deposits in money market mutual funds. During the period from January 1959 to August 1971 (11.7 years), when Nixon took the United States off the gold standard, the money supply grew by 82.2 percent for an average annual growth rate of 5.26 percent. Between August 1971 and 1984, when complete decontrol was established from the Depository Institutions Deregulation and Monetary Control Act of 1980 (13 years), the money supply increased by 180.4 percent for an average annual growth rate of 8.25 percent. Ever since 1984 (16.6 years) the money supply as measured by MZM grew by 390.1 percent, or an average annual growth rate of 10 percent. It would seem that all this new money first went into the New York Stock Exchange, especially during the 1980s, then the NASDAQ stock market during the late 1990s, and finally into the housing market after the dot-com bust in 2000.

A large part of the increase in the money supply found its way into the market for home mortgages. Since the recession of 2001 the increase in mortgage debt was about equal to the increase in MZM. This one stylized fact probably best illustrates the housing bubble and its cause. Another measure of the housing bubble is the amount of real private residential fixed investment. Investment in housing was low during the Great Depression and WWII, but beginning in the mid-1940s investment in housing, adjusted for price inflation, has shown a positive trend, which is based on economic and population growth over that same period. The cycle in housing investment was less severe before we went off the gold standard, more severe on the fiat standard, and even more severe after monetary deregulation in 1980. Most noteworthy is that investment in housing hit a boom high during the dot-com bubble of the late 1990s and then “jumped higher off the historical trend” during the recession of 2001, when historically it would have retreated back toward recessionary trend levels. It therefore seems clear that in terms of investment value there has been a housing bubble since at least the recession of 2001.

ABCT does not rely on measuring the cycle or bubble, but empirical measures do often help illustrate the approach. The next such measure is the number of homes built (apartments and other multiunit structures are not included here). Typically there are sharp downturns in the number of housing starts often coincide with the beginnings of recessions and that the sharper the drop the longer the recession. For example, in the late 1970s the number of housing starts fell from an annual rate of over 1.5 million to a rate of barely 0.5 million in the early 1980s, which was a severe recession. Since the recession of 1991 the trend in new housing starts has been steeply upward, and there was no noticeable downturn in housing starts during the recession of 2001 — the only recession on record where that did not occur. Instead housing starts continued to increase and have set several new records over the last few years. In terms of this quantity dimension the United States has been in a housing bubble since the early 2000s.

The final dimension of the housing bubble presented here is the price of houses. Doubters of the housing bubble claim that housing prices are rising on the East and West Coasts, but are not rising by bubble proportions in much of the center of the country. Of course housing prices have increased faster in the West and Northeast compared to the Midwest and South, but ABCT theorists would be shocked if home prices were rising uniformly across the country — after all the whole theory is based on changing relative prices, not uniform increases or decreases in a price level. There are microeconomic and public policy reasons why home prices rise more dramatically and are always at a higher level in, for example, California than they are in Alabama. These issues are explored in many of the other contributions to Powell and Holcombe.27 However, the same could be said about stock prices during the technology bubble — rare stocks in tight supply (e.g., dot-coms) did much better than widely held stocks (e.g., stocks in the DJIA). The same was true of tulip bulbs during the tulip mania that happened in seventeenth-century Holland — rare species were affected more by monetary conditions than ordinary species, but they all went up in price.28

ABCT expects prices in general to rise, but not to rise uniformly. The extent of the rise depends on both where the money is being injected and the flexibility of the supply side of the markets where the injections are taking place. However, if we look at the national price index for the typical 1996 one-family house between 1998 and 2005 we find that prices have increased by 45 percent, which is a 125 percent larger increase compared to the increase in the Consumer Price Index. According to the Bureau of the Census, the price of the average house, as opposed to the “typical” house, has been increasing even faster, which indicates that people are buying bigger, more expensive homes as well. The price dimension — while muted somewhat by the economy’s ability to produce greater quantities of housing — still indicates a large increase in the real price of housing. We should also remember that new housing is generally built on lower-priced land, that house-building technology has reduced building costs, and that the large influx of labor from Mexico has also helped hold down costs.

… Must Come Down

ABCT shows that it is government failure that started the housing bubble in the first place. This is where resources are allocated in an incorrect and ultimately unsustainable fashion. In a housing bubble too many houses are built, houses of the wrong sort are built, and houses are built in the wrong locations based on the underlying fundamentals of the economy and people’s real desires for housing not artificially stimulated by monetary inflation by the Fed. While most people are very happy during boom times, the Austrian economists view the boom as the real problem because this is where resources are misallocated. This is also when people become financially overextended and engage in excessive luxury spending.29 Inflationary periods tend to be when the rich get richer and the poor get poorer.

The bubble must come to an end because it is based on an irrational allocation of resources caused by the Fed’s misleading interest rate policy. Money that is tied up in an asset bubble initially prevents monetary inflation from being revealed as price inflation as measured by the Consumer Price Index. However, if the monetary pumping is used to purchase assets like stocks, bonds, or real estate then the inflation is revealed in the price of those assets, which will rise even though the underlying earnings of the assets have not improved. When money begins to leak out of asset bubbles into consumption, then the price of goods that are used to determine price indexes will begin to rise. The asset bubble is popped or deflated when interest rates rise. This can occur when either the market raises rates due to rising inflation premiums on loans or when the Fed tries to curtail increases in the Consumer Price Index by preemptively raising rates.

The bursting of the bubble reveals the cluster of errors in the housing market and related industries and begins the process of reallocating resources to their best uses by changes in prices, buying and selling, relocation, bankruptcy, and unemployment. The macroeconomic effect of deflating the bubble is that it causes the economy to go into recession or depression. However, the effects of the bubble will also be concentrated as it deflates. Note that the bubble in employment in the construction industry began in 1997 when it rose above a trend level, which dates back to the end of WWII. Note too that the trend in construction employment has always been negative during recessionary periods — even the recession of 2001 — and that the negative trends often extend beyond the periods identified as recession. Given that the trends in construction employment have been so strong for so long during the housing bubble, it would not be surprising that the negative impact of the bubble would take on a similar but negative effect on construction employment and spending, and that these effects would spread beyond to the construction-materials industry, mortgage lending, real estate sales, furniture, appliances, and household-goods items.

Another natural concern about the bursting of the housing bubble is the indebtedness of the average American. As we previously have shown, the personal savings rate of Americans has been declining for many years, in part because Americans have felt wealthier due to the rising price of their real estate properties. This is then coupled with the rising debt of the average American household. Total household debt was less than $500 billion when the United States went off the gold standard in 1971. It first exceeded $5 trillion in 1996 and $10 trillion in 2004. In October 2005, the last reported period, total debt exceeded $11.5 trillion. Certainly these figures could be adjusted for inflation, population, and economic growth, but that does not negate the fact that Americans have taken on a large amount of debt, but have not set aside a similar amount of savings to offset this debt or to insulate themselves from periods of economic distress.

As the economy goes into recession and unemployment increases, homeowners with large mortgages will have a difficult time making their monthly payments and may face the possibility of bankruptcy. This “squeeze” will be compounded by the fact that many homeowners have taken equity out of their homes in recent years, increasing the size of their mortgage. Further difficulties are presented by the fact that a large percentage of borrowers have taken out variable-rate mortgages rather than fixed-rate mortgages, which means that their monthly payment will rise and will rise substantially when interest rates increase. There are variable-rate mortgages where the payment stays the same, but this entails the principal on the loan increases when rates rise, which could place these borrowers “upside down” or “underwater” on the homes, which means the mortgage would be much larger than the value of the home. Lenders have also been providing mortgage loans based on much smaller down payments, in percentage terms, with some lenders even providing loans that exceed 100 percent of the price of the house. All of this points to the likelihood of a large number of foreclosures and bankruptcies. This in turn points us to the stability of the banking and mortgage-lending industries and the likelihood of a taxpayer bailout of banks and government-sponsored institutions such as Freddie Mac that buy mortgage loans from lenders.

Summary and Conclusions

There are three views of the housing bubble. The mainstream view does not believe in bubbles and attributes such changes in the economy to real factors such as technology shocks, and believes there is nothing the government can do to solve such real problems. The Keynesian view is that bubbles exist because of psychological instabilities in the economy, not real factors, and that countercyclical policies of the government should be used to tame the business cycle. ABCT incorporates real and psychological changes into a view where bubbles are caused by the policy manipulation of the Federal Reserve.

The housing bubble that began in the late 1990s is a classic example of government failure as applied to the housing crisis. Inflation of the money supply that accompanied the Fed’s cheap-credit policy led to a borrowing and building binge of an unprecedented scale. The number of new homes built, the price of new and existing homes, and the total amount of real estate investment all indicate that the Fed policy, combined with a favorable tax policy and taxpayer-subsidized lending practices, created the housing bubble.

The bubble is not just a bunch of hot air. Real resources are involved, which have been misdirected during the bubble and which will cause painful adjustments in the aftermath of the bubble. This will involve unemployment, foreclosure, and bankruptcy for many people, especially those in the construction and construction-related industries. The macroeconomy will be sent into a recession or depression, which could be of a lengthy duration because of the slowness of the housing market as compared to the stock market, which can process very large changes in value within the period of one market day.

The lesson of the housing bubble is that what at first appeared to be the government’s trying to help improve homeownership for Americans has been a giant government failure and will have the unintended effect of economically scaring many homeowners, particularly those who bought houses at the peak of the bubble. Others have been fooled into extracting equity from their homes, increasing their mortgages, and taking loans, such as variable-rate loans, that they believed were necessary to qualify to buy houses at inflated prices. Similar trends in housing have occurred in countries around the world as many of the world’s central banks have been engaged in monetary pumping that has been injected into their housing sectors.

The policy lesson of the housing bubble, as provided by ABCT, is that the Fed is responsible for the housing bubble as well as the normal booms and busts in the economy, that it must be relieved of its authority to set what are in effect price controls on interest rates, and also be relieved of its control over the money supply. Furthermore, all federal policy toward housing should be guided by the principles of neutrality, laissez-faire, and do no harm.

Postscript — August 8, 2009

The housing and financial crisis discussed in this chapter is now well underway and we may well have entered the worst global economic crisis of this generation. The question of how economic policy will address these problems has also been revealed in that the Federal Reserve and the US Treasury have initiated aggressive and unprecedented policy responses. Under the cover of preventing a financial market meltdown, these policy responses are really attempts to bailout the owners of large financial business. They will do little to help the housing market and will increase the overall economic harm of the housing bubble.

Will policy responses continue to be aggressive and unprecedented in the direction of greater government centralization and power as the economic crisis worsens? The importance of this question goes beyond any measure of economic harm because it can result in fundamental changes in society. It could of course result in correct economic reforms such as the abolition of the Federal Reserve, the restoration of the gold standard, and the abandonment of Federal government subsidies to housing, but as I wrote in the initial draft of this chapter in June of 2006, which the editors asked me to remove:

On top of all that, people suffer psychological consequences as well. The people most involved in the bubble are confident, jubilant, and self-assured by their apparently successful decision making. When the bubble bursts they lose confidence, go into despair and lose confidence in their decision making. In fact, they lose confidence in the “system,” which means they lose confidence in capitalism and become susceptible to new political “reforms” that offer structure and security in exchange for some of their autonomy and freedoms.

In this manner, great nations of people have given away their liberties in exchange for security. The Russians submitted to Communism and the Germans submitted to National Socialism because of economic chaos. In 20th century America, economic crises — and fear more generally — provided the justification for the adoption of “reforms” such as a central bank (i.e. the Federal Reserve), the New Deal, the Cold War, and even fiat money during the economic crisis of the early 1970s.30

Fear of terrorism after 9/11 resulted in a massive transfer of power to government at the expense of individual liberty.31 Submission of liberty and individual autonomy in exchange for security and the “greater good” is now often referred to as choosing the dark side.32

The reason economic crises create fear and submission of liberty is that people do not generally know what caused the bust or economic crisis and generally do not even know that there was even a bubble in the first place. In fact, as the bubble is bursting many people will deny that there is a problem and believe that the whole situation will quickly return to what they consider normal. The average citizen thinks very little about what makes the economy work, but simply accepts the system for what it is, and tries to make the most of it.

Increased government intervention in housing markets and the virtual socialization of the Government-Sponsored Entities (GSEs such as Fannie Mae), and the risk of mortgage-backed securities indicates that this dangerous trend will continue.

1Homo economicus is the model of the rational economic person that economists use to build their models and theories about the economy. This assumption asserts that people are rational and will always attempt to maximize their utility. This is a source of contention and misunderstanding among economists and between economists and other social scientists.
2Jonathan McCarthy and Richard W. Peach, “Are Home Prices the Next ‘Bubble’?” FRBNY Economic Policy Review (December 2004): 2.
3Mark Thornton, “Surviving GreenSpam,” LewRockwell.com, February 16, 2004.
4Alan Greenspan, “Monetary Policy and the Economic Outlook,” Testimony before the Joint Economic Committee of the US Congress, April 17, 2002.
5Alan Greenspan, “Mortgage Banking.” Speech to the American Bankers Association Annual Convention, Palm Desert, CA, September 26, 2005.
6Joe B. Bruno, “Former Fed Chair Says Housing Boom Over,” Associated Press, May 19, 2006.
7Ben Bernanke, “Reflections on the Yield Curve and Monetary Policy.” Remarks before the Economic Club of New York, March 20, 2006.
8Ben Bernanke, Speech to the Independent Community Bankers of America National Convention and Techworld, Las Vegas, NV, March 8, 2006.
9All of our actions involve some speculation about the future. Here “speculative” behavior refers to actions that involve great risks which are unwarranted based on the normal or known fundamentals of the economy. For example, betting on a round of golf with your friend involves some speculation and uncertainty, but past experience provides some guidance to the risks you are taking. Here, betting on a round of golf with Tiger Woods would be “speculative.”
10It is a common misconception that corporate scandal is the source of bubbles and that it was companies like Enron and WorldCom that tricked investors during the late 1990s to bid up the stock markets to such high levels. It is true that scandal is a common feature of bubbles, but scandal could never account for more than a small percentage of bubbles, and in reality scandal is caused by the same source as the bubble itself — the existence of cheap and abundant credit that must be allocated to increasingly risky and suspect investments.
11Robert Shiller, “Are Housing Prices a House of Cards?” Project-Syndicate.org. September 2004.
12Paul Krugman, “Running Out of Bubbles,” New York Times, May 27, 2005.
13Paul Krugman, “That Hissing Sound,” Ocala Star-Banner, May 22, 7, 2004. New York Times, August 8, 2005.
14Baker and David Rosnick, Will a Bursting Bubble Trouble Bernanke? Evidence for a Housing Bubble (Washington, DC: Center for Economic and Policy Research, November, 2005).
15Krugman, “Running Out of Bubbles.”
16Alan Greenspan, “Reflections on Central Banking,” speech given at a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, WY, August 26, 2005.
17A fellow traveler is someone who sympathizes with or supports various tenets of the Austrian school without being an acknowledged member or embracing all aspects of Austrian economics.
18Frank Shostak, “Housing Bubble: Myth or Reality?” Mises Daily, March 4, 2003.
19Frank Shostak, “Who Made the Fannie and Freddie Threat?” Mises Daily, March 5, 2004.
20Christopher Mayer, “The Housing Bubble,” Free Market 23, no. 8 (August 1, 2003).
21Thornton, “Surviving GreenSpam.”
22Thornton, “Housing: Too Good to Be True.”
23Mark Thornton, “Skyscrapers and Business Cycles,” Quarterly Journal of Austrian Economics 8, no. 1 (Spring 2005): 51–74.
24Ludwig von Mises, The Theory of Money and Credit (Indianapolis, IN: Liberty Classics [1908] 1981).
25Kathleen Hays, “Greenspan Steps Up Criticism of Fannie: Fed Chief Says Company and Freddie Mac Have Exploited Their Relationship with the Treasury,” CNN.com, May 19, 2005.
26Carol Lloyd, “Home Sweet Cash Cow: How Our Houses Are Financing Our Lives.” SFGate.com, March 10, 2006.
27Holcombe and Powell, Housing America: Building Out of a Crisis.
28Douglas E. French, “The Dutch Monetary Environment during Tulipmania,” Quarterly Journal of Austrian Economics 9 (Spring 2006): 3–14.
29Thomas Kostigen, “Skewed Views: If the Rich Are Doing So Well, How Much Worse Off Are the Rest of Us?” MarketWatch, May 23, 2006.
30Robert Higgs, Crisis and Leviathan: Critical Episodes in the Growth of American Government (New York: Oxford University Press, 1987) shows how crisis (such as war or depression) lead to large increases in the size of government that were only partially offset by cutbacks after the crisis was over. On the final page of the book Higgs correctly predicted that future crises would include terrorism in addition to war and depression.
31Robert Higgs, Resurgence of the Warfare State: The Crisis Since 9/11 (Oakland, CA: Independent Institute, 2005) correctly predicted (in the days immediately after 9/11) that among other things that government would greatly expand its power “particularly surveillance of ordinary citizens.”
32A crisis is a crossroad or turning point where the decision maker can make the correct or incorrect choice. The wrong, fear-driven choice is now often referred to as choosing the “dark side” à la Star Wars movies. See Mark Thornton, “What Is the ‘Dark Side’ and Why Do Some People Choose It?” Mises Daily. May 13, 2005.