The Housing Bubble?

Benjamin Wallace-Wells has predicted the impending bursting of the housing bubble and has both Kevin Drum and Matthew Yglesias convinced. I’m a bit more skeptical. Indeed, Wells doesn’t provide much proof. The most convincing bit is:

One index of housing inflation is the difference between house prices and rents. In a healthy market, driven by demand, rents and sale prices ought to track roughly together. But while sale prices have soared, rents have stayed flat; and in some of the most overheated markets, like San Francisco and Seattle, they have actually been declining. Such a gap, the economist and New York Times columnist Paul Krugman has written, suggests “that people are now buying houses for speculation rather than merely for shelter,” evidence that he called a “compelling case” for a housing bubble. “Within the next year or so,” The Economist argued in a May 2003 editorial, these regional “bubbles are likely to burst, leading to falls in average real home prices of 15-20 percent” across America. And, of course, in the most heated markets the drop is likely to be steeper yet.

While certainly not unprecedented, the rationale for such a collapse isn’t clear. The economy is finally heating up, even on the jobs front. Housing is an item for which demand is rather inelastic–pretty much everyone wants a place to live, after all, and buying is much more advantageous than renting for anyone who’s not a transient. The only thing likely to cause the housing market to cool off is the fact that mortgage interest rates are remarkably low right now and, presumably, are more likely to go up than come down. Still, absent significant inflation–which we haven’t had in two decades now–there’s no reason that rates should go up all that much.

Housing bubbles tend to be local. For example, prices in the greater Washington, D.C. area are sure to go up for many years to come. People are moving further and further into the suburbs–many commuting more than 90 minutes to work–in order to find affordable housing. The area where I live is growing at a phenomenal rate. There’s a long waiting list for new homes and pre-existing houses are still selling within a day or two of going up for sale. Indeed, Wells seems to be predicting something rather localized:

Only in about 20 metro areas, mostly located in eight states, does the relationship of home price to income defy logic. The bad news is that those areas contain roughly half the housing wealth of the country. In California, the price of a home stands at 8.3 times the annual family income of its occupants; in Massachusetts, the ratio is 5.9:1; in Hawaii, a stunning, 10.1:1. To some extent, there are sound and basic economic reasons for this anomaly: supply and demand. Salaries in these areas have been going up faster than in the nation as a whole. The other is supply: These metro areas are “built out,” with zoning ordinances that limit the ability of developers to add new homes. But at some point, incomes simply can’t sustain the prices. That point has now been reached. In California, a middle-class family with two earners each making $50,000 a year now owns, on average, an $830,000 home. In the late 80s, the last time these eight states saw price-to-income ratios this high, the real estate market collapsed.

Now, granted, those ratios are inordinately high. But someone is buying those houses now. Indeed, the “bubble” continued during the longest economic slump in the last quarter century. With the economy on the upswing, it seems odd that the bottom would fall out of the market now.

The side argument in Well’s piece is what a crazy loon Alan Greenspan is to suggest that people get into Adjustable Rate Mortgages (ARMs). Whether an ARM is a good idea depends, not just on the likely direction rates will take in the future, but expected lifestyle choices. Most ARMs aren’t adjustable right away. I bought my townhouse with an ARM (actually, two of them) last October because I was able to get a rate nearly 2 points lower that way. But the rate is fixed for the first five years. It’s a reasonable assumption that I’ll either move or refinance before then. Since most of what one pays during the first few years of any mortgage goes towards interest, it makes sense to get the lowest monthly payment possible when buying a home that one is going to sell within a short period. “Locking in” a fixed rate is smart only if 1) rates are low and 2) you’re planning to stay in the house longer than the fixed period of available ARMs.

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James Joyner
About James Joyner
James Joyner is Professor and Department Head of Security Studies at Marine Corps University's Command and Staff College. He's a former Army officer and Desert Storm veteran. Views expressed here are his own. Follow James on Twitter @DrJJoyner.


  1. Blogeline says:

    I completely agree with you.
    When we were thinking about buying in the DC area we knew we would not have a problem reselling it in the next years.
    This area is funny and a little unique I think because of the large military population. Those people come and go, and so houses are being sold and bought all of the time.
    I also agree on the point you made about ARMs. We did the same mainly because of the fact that we will be in this house for about three years. For people planing on selling the house in the near future this is the way to go. It saved us about $400 a month.

  2. Kevin Drum says:

    I think you’re missing the point about Greenspan. It’s not really a question of whether ARMs are good or not, the question is why Alan Greenspan was recommending them. Giving consumer loan advice is not normally something the Fed chairman does.

    So what’s his interest in trying to keep the refinancing binge alive?

  3. James Joyner says:


    I’m not sure, to be honest. I didn’t see/hear the speech, so I don’t know what motivated it.

    Greenspan seems to go off the reservation on occasion, acting as the economic Yoda. This may well be along the lines of his “irrational exubberance” comments years ago on the stock market. After all, the Fed doesn’t have anything to do with the stock market, either. Maybe he’s just trying to break the conventional wisdom that people over 40 have that ARMs are bad?

  4. David Sucher says:

    So, Kevin, why do YOU think Greenspan advocated ARMs?

    Neither the WA Monthly article actually grappled with that one except by conconcting a solution which violates Occam’s Razor.

  5. R Gardner says:

    DC Metro is a strange puppy for real estate, particularly “Inside the Beltway.” One massive fact is that many career civil servants will be retiring in the next decade, and much of their net worth is in their home in Annandale or Bethesda. The home they bought for $40-80K in 1980 is now $700K. But their replacements can’t afford $300k.

    So when all the retiring civil seervants dump their homes on the market, planning a move to Florida, there won’t be enough new buyers to support the prices.

    I don’t see a problem for the under $500K, or over 2M properties, but severe problems for the inflated mid-priced places.

    Just my two cents.

  6. David Fitelson says:

    I am neither an economist nor any other sort of mystic, but I am mystified by Wells’ argument about the disparity between rental rates and house prices, and particularly by Krugman’s view that this disparity suggests a looming bubble. Last time I looked, the expectation that one’s real estate assets will appreciate over time did not necessarily make one a speculator. Given the current national ratio of births/immigration to deaths, along with the well-worn truism that no more land is being produced, this expectation seemed altogether reasonable. Besides, are there not other good financial reasons to own rather than rent, not the least being the way the federal tax structure discriminates in favor of ownership? I guess I just don’t get it. Somebody straighten me out, please.