Housing Supply and Housing Bubbles
|August 21, 2008|
Jed Smith, Managing Director, Quantitative Research
Housing Supply and Housing Bubbles|
Working Paper 14193, NBER
A recent paper from the National Bureau of Economic Research (NBER) examines housing prices during boom-bust housing cycles. The authors construct theoretical economic models of the housing markets, but some of their conclusions appear to be relevant in providing insight on current housing market trends. The authors indicate that the extraordinary nature of the recent housing market boom and the associated irrational exuberance appeared to have resulted in large deviations between the actual level of housing prices and the level of housing prices that could be supported by the underlying market fundamentals: put differently, the recent increase in housing prices was excessive. The paper seems to indicate that recovery occurs after major market declines; this seems to substantiate the general belief that recovery in the real estate markets should occur in the foreseeable future.
The authors note that in order to understand boom-bust housing cycles, one must incorporate the concept of housing supply in the analysis. Locations with an inelastic supply of housing are characterized by the relative lack of increased housing availability as price increases; for example, one thinks of Manhattan Island as an example of inelastic supply. Conversely, locations with an elastic supply of housing are characterized by a relative increased availability of housing as price increases; this would appear to be much of Middle America. The authors conclude that locations with a relatively elastic housing supply have fewer and shorter housing bubbles along with smaller price increases than is the case for places with an inelastic supply of housing.
The authors also note that post-bubble prices can drop below pre-bubble levels, reflective of an historical norm of prices matching production costs. The authors indicate that after a bubble, housing prices tend to move backwards towards construction costs. In addition, when a bubble ends, housing prices fall below what they would have been if the bubble had not happened. The price crash represents both the end of the over-optimism and the increased extra supply that was built during the high price bubble period. The extra supply of housing results in lower prices and subsequent lower construction levels. In cases where a lot of additional housing was not built during the bubble-i.e., supply was inelastic-the post-bubble impact will be less. Holding-out for one's price may mean that the individual will need to hold the property for a long time. Realistic pricing is important in moving the product.
The paper is highly theoretical, and the empirical analysis is less definitive than one would wish, for example in terms of timing and measured levels of price and transaction changes. However, the paper does provide an important concept: prices that rise to boom inspired heights decline, possibly below their initial levels, and towards reproduction cost. Using the concepts advanced in the paper one could conclude that prices in much of the country which were minimally affected by the recent housing boom are probably stable or positioned to advance. In the case of the twenty Case/Shiller metropolitan locations, the price trajectories experienced to date are consistent with the propounded model: prices have declined to a greater degree than one might have expected. On the basis of the paper's theoretical hypotheses one could conclude that recovery in the housing markets should occur in the foreseeable future.
1 Edward Glaeser, Joseph Gyourko, Albert Saiz, "Housing Supply and Housing Bubbles," Working Paper 14193, NBER.