Paul Krugman: No Bubble Trouble?

Paul Krugman says there is a housing bubble, a big worrisome bubble located in the Northeast Corridor, coastal Florida, much of the West Coast, and a few other locations:

No Bubble Trouble?, by Paul Krugman, Commentary, NY Times: In spite of record home prices, housing in most of America remains surprisingly affordable, thanks to low interest rates. That fact may seem to say that there's no housing bubble. But it doesn't. To see why, we need to brush up on our economic geography and economic history.

Let's start with the good news. A report in last week's Times ... found that for the nation as a whole, the cost of owning the median home is still only 23.7 percent of median family income, ... well below the peak of more than 30 percent reached in the early 1980's.

Now for the economic geography. Last summer I suggested that when discussing housing, we should think of America as two countries, Flatland and the Zoned Zone. In Flatland, there's plenty of room to build houses, so house prices mainly reflect the cost of construction. As a result, Flatland is pretty much immune to housing bubbles. ...

In the Zoned Zone, by contrast, buildable lots are scarce, and house prices mainly reflect the price of these lots rather than the cost of construction. As a result, house prices ... are much less tied down by economic fundamentals... By my rough estimate, slightly under 30 percent of Americans live in the Zoned Zone, which comprises most of the Northeast Corridor, coastal Florida, much of the West Coast and a few other locations. So ... results on affordability aren't surprising: most families live in Flatland, and haven't seen a big rise in the cost of home ownership.

But because Zoned Zone homes are much more expensive than Flatland homes, ... [b]y my estimate, more than half of the total market value of homes in the United States lies in the Zoned Zone. And ... the Zoned Zone accounts for the great bulk of the surge in housing market value over the last five years. So if we want to ask whether housing values make sense... [w]e need to focus on houses in the Zoned Zone. And there the numbers are anything but reassuring.

In the Zoned Zone, ... prices have risen so much that housing has become much less affordable. ... Even so, the current cost of owning a home in the Zoned Zone isn't entirely unprecedented. Roughly similar percentages of median family income were needed to afford houses in the early 1980's.

But that's hardly a comforting comparison, which is where the economic history comes in. You see, the unaffordability of housing in the early 1980's led to an epic collapse in the housing industry. ... And ... was one of the main factors in the worst economic slump since the Great Depression, which brought the unemployment rate to a peak of 10.8 percent at the end of 1982.

It's also worth noting that the reason housing was so expensive in 1981 and 1982 was that mortgage interest rates were extremely high. That made recovery easy, because all it took to make housing affordable again was for interest rates to return to normal levels. This time, with interest rates already low by historical standards, restoring affordability will require a big fall in housing prices.

So here's the bottom line: yes, northern Virginia, there is a housing bubble. ... Part of the rise in housing values since 2000 was justified given the fall in interest rates, but at this point the overall market value of housing has lost touch with economic reality. And there's a nasty correction ahead.

Post briefly discussing NY Times Housing story with link to Times story.

Previous (12/30) column: Paul Krugman: Heck of a Job, Bushie
Next (1/15) column: Paul Krugman: First, Do More Harm

Comments

[Winslow R.]

I respect Krugman most of the time. If interest rates stay low, is there still a bubble? Why must long-term interest rates rise? To increase affordability? So to increase affordability we will make housing unaffordable by raising interest rates?

Jan 2,2006
Krugman wrote:

" In spite of record home prices, housing in most of America remains surprisingly affordable, thanks to low interest rates. That fact may seem to say that there's no housing bubble. But it doesn't....there's a nasty correction ahead."

Krugman in
April 2004

"My calculations keep leading me to a 10-year bond rate of 7 percent, and a mortgage rate of 8.5 percent — with a substantial possibility that the numbers will be even higher. Current rates are about 4.3 and 5.8 percent, respectively; you can see why the I.M.F. is worried about "financial market disruption.""

http://www.pkarchive.org/column/042004.html

July 25, 2003

"Meanwhile, the boost from low interest rates seems to be evaporating. Mortgage rates did indeed fall briefly to historic lows, extending the home-buying and refinancing boom that has helped keep the economy's head above water. Since mid-June, however, rates have been climbing rapidly. This week rates on 30-year mortgages hit their highest level since January."

http://www.pkarchive.org/column/072503.html

March 11, 2003

"With war looming, it's time to be prepared. So last week I switched to a fixed-rate mortgage. It means higher monthly payments, but I'm terrified about what will happen to interest rates once financial markets wake up to the implications of skyrocketing budget deficits."

http://www.pkarchive.org/column/031103.html

[calmo]

Interesting little (not so reverential)PK excerpts Winslow.

To nibble at your (slightly rhetorical?)questions:
So to increase affordability we will make housing unaffordable by raising interest rates?
Low mortgage rates have fueled housing prices driving marginal buyers to more exotic mortgages, yes? Shorter term and probable catastrophic renewels, yes? [You pretty much had to be black not to qualify for a home judging by the ownership stats from Fannie.]
With Greenspan's assurance that only a small portion of these marginal buyers are at risk, the FF rate has pushed the ARMs rate out to a point that may not be forcing significant foreclosures yet, but the national decline in resales and apparent slowing in house appreciation may be linked to the higher costs of those short term mortgages, yes?
The idea I think is to gradually (25bpily) rein in the housing industry that is financing, by and large, the rest of the economy (much more so than high tech did in the late 90s)...without stalling the economy.
There is the other idea that not everyone can afford the American dream of owning their own home, but do we want to go there?

[Bruce Webb]

Implicit in Krugman's comments is that the inhabitants of Flatland are relatively immune to the popping of the bubble. People whose retirement plans depend on double digit appreciation on that rental condo are going to be hurting, people who are putting 23.7% of their income towards owner occupied housuing get away clean. In other words this is a financial bath that is aimed right at upper middle class people, workers will for the most part not even get their feet wet.

Which is how the S&L crisis should have played out. Upper income people who were pulling down double digit returns in accounts over the insurance limits (like it is difficult to keep funds in any one account below $100,000) should have lost every bit of the overage. Risk/reward you know? But Bush I decided everybody had to be made whole and put the entire bailout on the workers' credit card.

Well it sucked to be me then, rich people got 17% guaranteed returns, I got inflation and the tab. But it is hard to see how they pull off the equivalent move this time around.

[save_the_rustbelt]

I agree with Krugman on this, but have an additional theory.

If you look at the states with economic prosperity they almost all touch an ocean (Arizona being an exception).

Federal trade and other policies are hollowing the country. As the Congressional seats shift away from the heartland this will get worse.

We are depopulating the Great Plains and gutting the Rustbelt economies, crowding tens of millions of people into coastal areas.

Certainly not all of this is government policy, but it certainly starts there.

So let the bubble pop, perhaps it will put some sanity back into our demogrpahic patterns, but probably not.

[anne]

Supposing Paul Krugman is right about a coastal housing bubble and coming nasty correction, the questions to be asked are can monetary policy effectively limit the general economic slowing that will result and what could be a proper protection for a household?

[Gavin]

I have conducted a detailed analysis of San Francisco housing prices and they graphically illustrate what Paul Krugman has said

"It's also worth noting that the reason housing was so expensive in 1981 and 1982 was that mortgage interest rates were extremely high. That made recovery easy, because all it took to make housing affordable again was for interest rates to return to normal levels. This time, with interest rates already low by historical standards, restoring affordability will require a big fall in housing prices."

See my web page

http://www.crimsonbee.com/house_graphs/sf_house_prices.html

[anne]

Affordability is the combination of price and mortgage rate, and this combination makes housing along the coasts look as expensive now as in the early 1980s. What worries me is how housing becomes more affordable. Long term interest rates are low enough to create doubt as to whether there would be a decline if the Federal Reserve reversed short term interest rate policy. Then, is there no way out than pressure on price? Short term rates could be lowered and allow for lower rates on adjustable mortgages, I suppose, but would this be enough?

[save_the_rustbelt]

We could crowd more people into the Boston, SF, San Diego and other hot areas, and housing prices will be high regardless of interest rates.

Sure it would be nice if everyone could live in a thriving metro area with great culture and/or warm weather, but this is the real world folks.

If housing prices do stay high when will business be driven to move to less expensive areas?

If housing prices stay high how will hot areas manage to keep the middle class? Try living without nurses, teachers, etc.

Not everyone can live within 25 miles of the ocean or a ski slope.

[DAH]

When you factor in that most of the Zoned Zone housing Krugman writes about is suburban, imagine the added impact of increased gasoline/fuel costs (coming to a theater near you soon) on the commuter/homeowner.

[Chris]

Rustbelt: the middle class professions which you mentioned here are for the most part doing OK here in the Bay Area. Their employers are prospering, and these workers generally get their chunk of the benefits eventually. For example, the San Jose police officers union recently negotiated a new contract where experienced officers will get a $94,000 base salary, with almost all getting weekend and holiday pay that jacks it up to $107,000, plus 90 percent retirement after 30 years service. One exception has been the nurses, who seem to get decent pay but suffer because of staffing shortages, which lead to enormous stress, which increases turnover, which leads to staffing shortages, etc. Perhaps the new staffing ratio law has helped, I don't know myself.

The people who are really getting hammered are the working poor--the restaurant, retail, and other service workers who often make little more than minimum wage. Almost nobody but immigrants works those jobs here, and they often have a very rough time of it. For most of the boom they haven't been hurt too badly because rents were not rising nearly as fast as housing prices, but that seems to be changing now.

[Winslow R.]

Calmo wrote:

"With Greenspan's assurance that only a small portion of these marginal buyers are at risk,"

Yes, tempt the little guy to buy a house then beat him over the head. Krugman references Greenspan's encouragement to go variable at the wrong time, typical banker. This is why no CB is truly independent of government control though they would like to think they are.

"the FF rate has pushed the ARMs rate out to a point that may not be forcing significant foreclosures yet, but the national decline in resales and apparent slowing in house appreciation may be linked to the higher costs of those short term mortgages, yes? "

If you have info on dollar amounts (not percentages) of variable vs fixed rate mortgage amounts, I'd like to see it.

I believe the slowing in the housing market appreciation has more to do with long-term fixed rates which have stopped falling combined with incomes not rising.

Long-term rates have stopped falling because the carry-trade is no longer profitable for the primary dealers (Countrywide, Citigroup etc). Institutional investors (China CB etc.) have continued to lend because of their structural control of dollar flows soon possibly inverting the yeild curve.

"The idea I think is to gradually (25bpily) rein in the housing industry that is financing, by and large, the rest of the economy (much more so than high tech did in the late 90s)...without stalling the economy."

We agree, my framework for understanding economic growth has its foundation in understanding debt growth. Without debt growth (public or private sector) you do not have economic (GDP) growth, period. When debt growth slows there is a direct correlation to a slowing and inversion in economic growth.

Debt growth is 'natural' in a usury system. Look at Z1 or H8 at Fed if anyone doesn't believe. Banker's seem to ignore that debt eventually cannot grow (once interest rates hit zero and asset markets are fully leveraged) without income growth.

[calmo]

For most of the boom they haven't been hurt too badly because rents were not rising nearly as fast as housing prices, but that seems to be changing now.
Renting was/is relatively cheap while the prospect of owning was made attractive by the cheap financing, so one could argue that the payback period lies ahead with increasing rents in response to rising demand.
But it seems to me, roughly, the people who don't own, are not participating in the only growth the economy has to offer.
The owners and renters are not equal participants of course --even in this democracy, but it does seem more lopsided lately, no?

[simon]

What does Paul actually believe? It is not clear what he actually believes. I do understand why he is so often wrong.

His errors begin when he feels, like all of us practicing “real” world economics, justified in making inferences based upon logic derived from highly stylized theories developed in tightly specified nomological networks. That is, once he leaves the comfortable and well defined world of our journals where our deductive logic is so compelling and conclusive, he finds that it leads to no where and every where at the same time. His (our) deductive logic simply is no match for the dynamic system of which he speaks.

I would offer that we economists have not paid sufficient attention to theory development and threats to validity. We seldom speak of internal validity, construct validity, or external validity. We have developed statistical validity to a high art. Consequently, we have little understanding of when and how our theories apply to the “real” world.

In summary, Paul’s many misses reflect more the limitations inherit in how we economists build and test theories than his intellect or moral character.

[dryfly]

Nice article... there definitely is a difference in markets between the Zone & Flatland. I live in Flatland and my home would make a decent down payment for a home in 'The Zone'.

However I agree with Bruce W that the little folks - even those out where the deer and the antelope play - will get crunched too. Everyone will enjoy this party.

Housing is a major driver for domestic manufacturing... I've been told by appliance makers to look to housing starts & resale for an indicator as to demand in their biz. Think windows & doors, building materials, appliances, lawn & garden equipment, processing of financial services, even lawn & garden service industries.

I mean look where a lot of these plants are:

Windows & doors... Pella Windows, Anderson Windows, Marvin Windows, Peechtree Windows & suppliers - combined for many tens of thousands of employees, almost all in 'Flatland'. Midwest & SE US mostly. Same with almost all the other building supply producers.

Look at the appliance builders Whirlpool-Maytag, Electrolux, GE - almost all the plants in 'Flatland'. Especially heavy in the Midwest.

Look at lawn & garden equipment - Briggs, Tecumseh, MTD, Deere Consumer, Honda - almost all in 'Flatland'. Midwest & SE USA...

Check out Sioux Falls, Des Moines, Omaha - lots of financial services processing done there, thousands employed. The execs might work in San Fran, Chicago, NYC but the grunt & paperwork is often done in places like Sioux Falls.

When housing slows, the asset declines will show up in 'The Zone' but a lot of the layoffs and pain will be 'exported' to 'Flatland'. Bank on it.

[nate]

"So here's the bottom line: yes, northern Virginia, there is a housing bubble. ... "

Virginia and Maryland have a big federal govt influence. This is arguably somewhat recession-proof and may dampen volatility in housing prices in the region. And given adverse selection, parts of Virginia and Maryland may attract a bunch of risk-averse people; this, in turn, may also make a bubble and bubble-burst less likely in parts of Virginia and Maryland.

[ilsm]

Low interest rates make monthly mortgage payments easier to 'make'.

The attraction is find someone who makes a purchase decision from pay check to pay check, convince them they can afford it and they will usually bite.

They will not look at the price nor consider the risk as long as it looks lik the monthly payments are "make-able".

That I learned in Marketing 101 in the '60's. I thought it unethical then to sell all not talk risks and paybacks.

But..............

[slink]

god i hate to use it

but at the margin isn't macro
yes the early 80's was a bitch if you got a mortgage during those years most households didn't

to make real forecasts we need to look at total interest payments over total income
then now and anytime

paul has become an entertainer since he got his column gig

and he makes the real point deep into his article

its easier to reduce interest rates
then house lot prices
with easy credit high mortgages get refi-ed
but houses under water with negative equity are in a very different kind of purgatory indeed

[meno]

chris,

How nice that police officers in San Jose earn US$90K+
Now, tell me how much they make in Oakland.

It's the wonder of your uniquely US system of paying for infrastructure (police, schools) out of local taxes. That cops in the centre of (famously rich) Silicon Valley are well paid doesn't tell us much.

But regards rents and property prices: first the property bubble has to burst (or deflate) to put a stop on construction. Then wait a year for construction to actually stop. Then rents will rise. The "two property markets" of rent vs buying are linked, but the linkage is based on partly on the way that property prices feed into demand for construction, which feeds into supply for rentals.

Meanwhile rents can stay lower because illusions of capital gains dance in investor's heads - until the bubble bursts. Then they ask "how much more rent can I get for this shack?"

So they relate, but there can be a lag. I'd love to find an example where the lag was just the right size to mean that they went counter-cyclic (like those predator-prey graphs) but I've never seen any data that clean.

[save_the_rustbelt]

Chris:

Certainly the low income will get whapped, they always do.

The middle is more critical because they are harder to replace. I know Boston has struggled with healthcare labor for years, due largely to housing prices.

(I'm married to an RN so I know all about the stress-shortage-more stress cycle in nursing.)

For selfish reasons I would prefer the bubble NOT burst, housing continue to be even more ridiculous so business would have to think about moving jobs away from the high cost areas.

The idea that almost everyone can live near an ocean or mountain isn't going to work forever.

[ilsm]

Nate,

Beltway land is not immune to layoffs. Why should the fed be different than states and cities?

When the deficit is an issue fed jobs and all the contractors babysitting the feds will begin to fade.

There is a huge bill of contractor support which can be reduced easily iof the PAC money can be ignored.

[anne]

Remember bond funds. Should the coastal real estate markets continue to slow past winter, and slow enough to effect the general economy, bonds will prove a fine protective investment. Through the last 25 years professional and household investors have continually failed to properly use the bond market defensively, though we have had the finest bull market in bonds of the century even in relation to stocks.

[anne]

I specify bond funds, and Vanguard bond funds more precisely, because no matter the size of a portfolio, developing a better bond portfolio than Vanguard will provide through low cost, high quality, call protected funds is darn hard and seldom, in my experience, done.

Few mutual fund investors have gained the stock returns over the last 25 years, though they should have easily done so, that they could have gained in Vanguard's long term investment-grade bond fund.

[anne]

Frankly, I cannot make up my mind how significant the economy problem Paul Krugman presents may be. I have however always found Krugman adept at economic or investment insight, and pay close attention. Citigroup attended closely when Krugman alone was worried about a seemingly forever booming Asia before 1998. Then, there was the time, remember the time, when AOL bought Time Warner :) I had best always listen.

[anne]

Also, Krugman was right on locking in a fixed rate long term mortgage when the long term Treasury was at 4%. But, as with most internationally minded economists Krugman has seemingly failed to see that the long term bond market could hold and hold. Domestic minded economists have been more sanguine about long term bonds. But, interestingly, the places to have been these last years were investments that anticipated bond and currency trouble.