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Economic News, Data and Analysis

Housing Price Bubble?

The Run-Up in Home Prices: Is It Real or Is It Another Bubble?, by Dean Baker, CEPR.
This is the article referenced by Krugman in his latest editorial. It makes a compelling argument that the recent increase in housing prices is likely to be unsustainable.
In short housing prices might go up because: 1. there is a fundamental increase in people’s preferences for housing, 2. there are changes in the factors that determine housing demand (such as incomes or interest rates, and/or 3. there is a speculative bubble, since houses are also long-lived assets.
Baker rules out #2 by looking at historical evidence on the determinants of housing prices and shows that the current situation deviates.
In principle it is hard to rule out changes in preferences (#1). However, if people had suddenly decided to consume more housing, then we would expect home rental prices to increase at the same pace as owner costs.
However, one of the most interesting observations in the paper is that the cost of owning relative to renting has deviated significantly from historical norms. Baker suggests that this might mean that housing purchases might be the result of purchasing for investment reasons and not primarily for a place to live.
(Perhaps the decline in the stock market has permanently shifted asset allocations – in which case the price increase may not be a bubble?)
So, by ruling out fundamentals, the increase may indeed be a bubble.
How long will high prices last?
Baker notes “A sharp slowdown in the rate of inflation in rental cost index in the last six months, and a record high rental vacancy rate, suggests that demand for rental housing is lagging, which could precipitate the collapse of the bubble.”
In addition, housing starts have been down the last two months (by 5.4%).
If it collapses? Baker estimates that there could be between $1.3 trillion and $2.6 trillion decline in housing wealth. Ouch.

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