Wednesday, September 9, 2009

Lessons From The Housing Boom And Bust

In an article by Harvard economics professor Ed Glaeser, he discusses the takeaways from the recent boom and bust in the housing market. He also outlines some policy changes that could help prevent future bubbles, if we can learn from our past mistakes. See the following post from Economist's View for more.

Ed Glaeser explains some of the lessons he's learned from the recent crash of housing markets:

What We’ve Learned: Ugly Truths About Housing, by Edward L. Glaeser: ...What have we learned from the great housing bubble and crash of the aughts? Most obviously, we have learned that housing prices can be extraordinary volatile. This was less obvious from previous housing cycles. ...

So let no one ever again say foolish things like housing prices never fall. In the current drop, eight of the 20 Case-Shiller areas had housing price drops of 40 percent of more. ... Buyers and bankers should never again think that an area’s recent price increases are the sign of a strong market where prices have nowhere to go but up. In the long run, price increases are followed by price drops, and special caution, by regulators as well, needs to be taken in booming markets.

In places like Las Vegas and Phoenix, there are no fundamental constraints on building new homes — like a shortage of land or onerous restrictions on construction... I once thought that this obvious lack of limits on building meant that such open areas would sit bubbles out,... but I was wrong. The logic of supply and demand can be ignored for longer than I thought, but it ultimately reasserts itself.

The second lesson of the housing debacle is that there is extraordinary pain in both housing price busts and booms. When housing prices soared, ordinary Americans found it increasingly hard to afford a house. ... [This] logic pushed me to boo when housing became outrageously expensive. During the boom, I hoped that housing prices would stop rising and even decline.

Yet I didn’t understand the terrible impact that declining housing prices would have on our financial sector. While rising housing prices weren’t particularly good for America, declining housing prices were particularly bad for the country. The lesson seems to be that large swings in housing prices, in either direction, can be extremely painful.

The third lesson is that American housing policy has been monumentally foolish. We have used public resources to encourage ordinary Americans to bet all they could on highly risky housing markets. Fannie Mae and Freddie Mac, the home mortgage interest deduction, even the willingness to bail out financial firms..., can all be seen as policies that encourage ordinary people to risk it all on real estate.

I had once thought that these policies were misguided, but not terrible. We now know that encouraging buyers and lenders to bet on housing can impose vast costs on the country. ...

I think that we have not yet fully faced the fact that our tax code encourages people to finance their homes with as much debt as possible, and that our financial regulations abet irresponsible lending.

Now that we have backed away from the abyss, we can consider making much-needed reforms, like reducing the upper cap on the home mortgage interest deduction, that could depress housing prices in the short run, but make future housing bubbles and crashes less likely.

I don't think much of the blame for the crisis can be placed on the home mortgage interest deduction, there was no big change in this deduction that corresponds to the start of the bubble. As for eliminating the deduction, though it's possible to make an argument that there are positive externalities to home ownership such as taking better care of the property, something that benefits surrounding properties, or having more involvement in the community, I don't think the case is very strong, particularly when the inequity between owners and renters is taken into consideration.

This article has been republished from Mark Thoma's blog, Economist's View.

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