"Housing Supply and Housing Bubbles"

Edward Glaeser, Joseph Gyourko, and Albert Saiz construct a model of housing bubbles that is consistent with movements in housing prices and quantities during the two most recent housing bubbles (the current episode and the prior episode in the 1980s). Looking at the data, they note that areas with inelastic housing supply had large price run-ups and subsequent long, drawn out crashes in both episodes. However, "The fact that highly elastic places had price booms is one of the strange facts about the recent price explosion." Because it is unprecedented, there is considerable uncertainty about how much prices might fall in the areas where supply is elastic. However, using the model as a guide, they find that "If these markets return to their historical norm..., then they will experience further sharp price declines," though there is a lot of uncertainty surrounding this prediction.

Maybe another way to think about this is that in some areas, those areas where supply is termed inelastic, the quantity response is essentially symmetric -- housing supply moves sluggishly whether prices are rising or falling. However, other areas could have housing supply that responds elastically when prices are rising (though sometimes there can be bubbles in these markets anyway - see below), but inelastically when prices are falling. In these markets, housing comes online relatively easily when prices are rising, but quantity responds much more sluggishly when prices fall, and the response could be similar to the symmetrically inelastic cases.

Why might the two sets of markets have similar responses on the down-side? Think about the inelastic markets where supply cannot increase due to geographic limitations (they use a geographic measure to sort the data). Geography limits the expansion of housing, but when there is an oversupply of housing, geography does not prevent the supply from falling, so it must be something else that prevents quantity adjustment and whatever it is could certainly be present in markets where geography is not an issue  (i.e. the markets that are elastic when prices rise). If this is right, then there's reason to believe that the two sets of markets will generate similar responses for price and quantity on the down-side, and this would explain the finding in the paper that "elasticity was uncorrelated with either price or quantity changes during the bust" (so long as other factors such as regulation are similar, e.g., it's equally easy to replace a house with a restaurant after remodeling in the two markets). This would mean that - as predicted (with qualifications) in the paper - the elastic markets may mimic the inelastic markets and be in for a sharp price decline.

One more note from the paper about elastic markets, "Even though elastic housing supply mutes the price impacts of housing bubbles, the social welfare losses of housing bubbles may be higher in more elastic areas, since there will be more overbuilding during the bubble." Thus, it's possible for markets with sharp price adjustments to fare better in a welfare sense than markets where price changes are more muted. Here's some of the introduction from the paper [can anyone find an open link?] [Update: Richard Green: Mark Thoma thinks housing supply elasticities may be asymmetric ... I have reason to think Mark is right. My 2005 paper with Mayo and Malpezzi found evidence of this; cities that appeared inelastic included Pittsburgh, Toledo, Albany, Buffalo and Providence. None of these cities had upward pressure on housing production; rather, they were losing population and the housing stock took a long time to adjust to the loss.]:

Housing Supply and Housing Bubbles, by Edward L. Glaeser, Joseph Gyourko, and Albert Saiz, NBER WP 14193, July 2008: Introduction In the 25 years since Shiller (1981) documented that swings in stock prices were extremely high relative to changes in dividends, a growing body of papers has suggested that asset price movements reflect irrational exuberance as well as fundamentals (DeLong et al., 1990; Barberis et al., 2001). A running theme of these papers is that high transactions costs and limits on short-selling make it more likely that prices will diverge from fundamentals. In housing markets, transactions costs are higher and short-selling is more difficult than in almost any other asset market (e.g., Linneman, 1986; Wallace and Meese, 1994; Rosenthal, 1989). Thus, we should not be surprised that the predictability of housing price changes (Case and Shiller, 1989) and seemingly large deviations between housing prices and fundamentals create few opportunities for arbitrage.

The extraordinary nature of the recent boom in housing markets has piqued interest in this issue, with some claiming there was a bubble (e.g., Shiller, 2005). While nonlinearities in the discounting of rents could lead prices to respond sharply to changes in interest rates in particular in certain markets (Himmelberg et al., 2005), it remains difficult to explain the large changes in housing prices over time with changes in incomes, amenities or interest rates (Glaeser and Gyourko, 2006). It certainly is hard to know whether house prices in 1996 were too low or whether values in 2005 were too high, but it is harder still to explain the rapid rise and fall of housing prices with a purely rational model.

However, the asset pricing literature long ago showed how difficult it is to confirm the presence of a bubble (e.g., Flood and Hodrick, 1990). Our focus here is not on developing such a test, but on examining the nature of bubbles, should they exist, in housing markets.

House price volatility is worthy of careful study in its own right because it does more than just transfer large amounts of wealth between homeowners and buyers. Price volatility also impacts the construction of new homes (Topel and Rosen, 1988), which involves the use of real resources that could involve substantial welfare consequences. When housing prices reflect fundamentals, those prices help migrants make appropriate decisions about where to live. If prices, instead, reflect the frothiness of irrational exuberance, then those prices may misdirect the migration decisions that collectively drive urban change.

Most asset bubbles also elicit a supply response... Models of housing price volatility that ignore supply miss a fundamental part of the housing market. Not only are changes in housing supply among the more important real consequences of housing price changes, but housing supply seems likely to help shape the course of any housing bubble. We show this is, indeed, the case in Section II of this paper, where we develop a simple model to investigate the interaction between housing bubbles and housing supply. ...

We model irrational, exogenous bubbles as a temporary increase in optimism about future prices. Like any demand shock, these bubbles have more of an effect on price and less of an effect on new construction where housing supply is more inelastic. Even though elastic housing supply mutes the price impacts of housing bubbles, the social welfare losses of housing bubbles may be higher in more elastic areas, since there will be more overbuilding during the bubble.

We also endogenize asset bubbles by assuming that home buyers believe that future price growth will resemble past price growth. Supply inelasticity then becomes a crucial determinant of the duration of a bubble. When housing supply is elastic, new construction quickly comes on line as prices rise, which causes the bubble to quickly unravel. The model predicts that building during a bubble causes post-bubble prices to drop below their prebubble levels. ...

We then examine data on housing prices, new construction and supply elasticity during periods of price booms and busts. While this empirical analysis is not a test for bubbles, much of the evidence is consistent with the conclusions of our models. For readers who resolutely do not believe in bubbles, the empirical results in the paper still provide information on the nature of housing price volatility across markets with different supply conditions.

In performing the empirical analysis, we distinguish between areas with more or less housing supply elasticity using a new geographical constraint measure developed by Saiz (2008). We also investigate differences in price and quantity behavior between the most recent boom and that which occurred in the 1980s.

During both the 1980s boom and the post-1996 boom, more inelastic places had much larger increases in prices and much smaller increases in new construction. Indeed, during the 1980s, there basically was no housing price boom in the elastic areas of the country. Prices stayed close to housing production costs. If anything, the gap in both price and quantity growth between elastic and inelastic areas was even larger during the post-1996 boom than it was during the 1980s. However, in the years since 1996, there were a number of highly elastic places (e.g., Orlando and Phoenix) that had temporary price explosions despite no visible decline in construction intensity.

The fact that highly elastic places had price booms is one of the strange facts about the recent price explosion. Our model does not suggest that bubbles are impossible in more elastic areas, but it does imply that they will be quite short, and that is what the data indicate.

While the average boom in inelastic places lasted for more than four years, the average duration of the boom in more elastic areas was 1.7 years.

Does the housing bust of 1989-1996 offer some guidance for the post-boom years that are ahead of us? During that period, mean reversion was enormous. For every percentage point of growth in a city’s housing prices between 1982 and 1989, prices declined by 0.33 percentage points between 1989 and 2006. The level of mean reversion was more severe in more inelastic places, but on average, elasticity was uncorrelated with either price or quantity changes during the bust.

Relatively elastic markets such as Orlando and Phoenix have not experienced sharp increases in prices relative to construction costs in the past, so they have no history of substantial mean reversion. Yet some insight into their future price paths might be provided by the fact that for two decades leading up to 2002-2003, prices in their markets (and other places with elastic supply sides) never varied more than ten to fifteen percent from what we estimate to be minimum profitable production costs (MPPC), which is the sum of physical production costs, land and land assembly costs, and a normal profit for the homebuilder.

Those three factors sum to well under $200,000 in these markets. If these markets return to their historical norm of prices matching these costs, then they will experience further sharp price declines. ...

Comments

[save_the_rustbelt]

Back in the 80s, seeing life from an accounting perspective, I developed a theory on predicting recessions, which I called "stupid money."

The SM theory says that when developers and contractors are building homes and motels and offices simply because they need something to do and money is available, the SM theory is in effect.

One key indicator is the construction of motels and hotels at interstate highway exits where there are already too many lodging rooms.

So far I predicted the recession in the early 90s and in about 2000. I predicted a recession for the 3rd quarter of 2007, and while I may have been technically incorrect the burst of the housing bubble seems to vindicate my theory somewhat.

I doubt this will get me an endowed chair in economics.

[John Thacker]

It's an interesting paper. They admit that it's a simple model; I'd like to see a model that considers housing markets that are short term inelastic but long term elastic on the way up. I'm talking about markets where the regulatory environment doesn't prevent much proposed housing from entering supply, but it does make the process more time-consuming and adds a couple years to the amount of time to get permits and the like.

In such a market, it seems to me that sometimes the results would be the worst of both markets-- higher prices in the run up because it takes longer for supply to respond to demand, but still the great crash in home prices once all the extra housing gets finished. In some cases the overbuild might even be worse, as developers choose to finish housing starts that began the regulatory process before the bubble popped.

[robertdfeinman]

This thread and the prior one on oil lead me to ask whether there have ever been any "bubbles" which weren't associated with loose credit?

Where did all the money come from to buy the tulips or the shares in the South Sea Co?

There would seem to be some acknowledgment that there is a relationship, since margin rates were raised after the collapse of 1929 and this tool has been used since then to cool off markets. If this is a well-known enabler of bubbles then one has to ask who was asleep at the switch while the housing bubble was allowed to grow? Or was it a case of throwing some doped meat to the guard dog as one broke into the home?

[cm]

STR: Not to trivialize your achievement, but doesn't it pretty much boil down to "money is (made) available"?

Which speculative bubble (in either financial instruments or surplus commercial activity) has NOT been associated with an explosion of money or debt issuance?

Judging by my limited exposure to 19th century literature, the theme of businesses models financed through bills of exchange going south, actual or looming bankruptcies, or rivals buying up people's private debt (B/E's) to control them has been figuring prominently.

[save_the_rustbelt]

cm:

We achievement was trivial.....

Yep, follow the money.

[Michael F. Martin]

Could you guess at a microeconomic mechanism that would explain the asymmetry in elasticity? How about liquidity?

In "inelastic" markets, there is less asymmetry in liquidity between rising and falling prices because wealth effects are relatively smaller compared to "elastic" markets.

Another way of saying this is that liquidity may be a function of the size of the transaction. If so, that might account for some of the asymmetry in elasticity.

Of course changes in money supply might have similar effects...

[Long Live Elasticity]

"The model suggests that rational bubbles can exist when the supply of housing is fixed, but not with elastic supply and a finite number of potential home buyers."

The average price of homes in inelastic CA is maybe twice what it is in the rest of the country. Why should only the rich be able to afford homes?

"The fact that highly elastic places had price booms is one of the strange facts about the recent price explosion."

The solution is to avoid creating bubbles with too easy credit, not make homes unaffordable to Joe average so that bubbles don't create too many homes. Only the recent NINJA absurdity created a significant problem in elastic areas. Get rid of NINJA, and keep elasticity.

[Jumbo NINJAs]

"..if there is a housing bubble in a very inelastic market such as greater Boston, prices may swing a lot..."

This is exactly what puts the credit system at such risk. Large NINJA mediated price swings in inelastic areas create out-sized losses for banks when loans go bad. Prices are so high in inelastic areas that only non conforming jumbo loans can service them, and they are unmarketable on the securitized bond market. The other states are being asked to bail out inelastic areas by increasing GSE loan size for just inelastic areas, which requires large taxpayer bailout of GSEs.

Inelastic price rises are just not worth the systemic credit risk. All 50 states are suffering for the inelastic few that trashed the nation's mortgage credit reputation.

[Lafayette]

LLE: The average price of homes in inelastic CA is maybe twice what it is in the rest of the country. Why should only the rich be able to afford homes?

Why should the entire state of CA be inelastic?

Some cities can be inelastic, and due to the resulting price inelasticity in the inner city it creates urban sprawl. If residential housing cannot be built vertically in a city, where zoning has height limits, it must be built horizontally.

[Welfare]

"The supply of homes for sale includes new homes produced by developers and old homes sold by existing homeowners. All homes are physically identical."

This is what messes up the welfare argument. Higher prices result in more homes being built in elastic areas, but the new homes are not identical to older homes. Homes have an average shelf life of about 75 years, so a new home is inherently more valuable than a 70 year old home.

New homes tend to be built in safer areas, where most people prefer to live. An older home in an area with high violent/property crime will probably not command as high a price when new homes in safe neighborhoods are made available. People normally move away from these areas in a gradual fashion. Bubble engendered construction tends to speed up the process, but does not cause it. High crime, pollution from factories, and depreciation of existing stock cause the gradual switch.

The process is more orderly when it is gradual, but the optimum way to keep it gradual is to prevent NINJA type credit bubbles. An even better solution would be a program to eliminate violent/property crime in affected areas. People would then simply upgrade in place, rather than moving.

[LLE]

"Why should the entire state of CA be inelastic?"

Its not uniformly inelastic, of course. However, the average price within a single state can still be significantly higher than the rest of the nation if a significant number of localities within the state zone restrictively. Localities carry out their function under state guidelines, so state policy has a large effect.

In our country, cities have no Constitutional standing, only states do. Cities are considered to be administrative districts set up by the state, and the state grants them any authority they have. A state can charter, or uncharter a city at any time.

[cm]

Welfare: "New homes tend to be built in safer areas, where most people prefer to live."

Like what, flood plains, hill sides, landfills, half-deserts without water, and isolated developments served by a single road that is clogged up twice every work day and on Sunday evening?

In many "desirable" areas that have a local economy, most of the "good" space is already built out or zoned out, and new developments are in increasingly marginal or remote (from business and jobs) areas, including in "subpar" neighborhoods or proximate to low-key industry -- not necessarily as bad as it is commonly portrayed, but it may be a "new reality" for the US that it has to grapple with like other "developed" countries, "integrated living" if you will.

With increased gas prices, the "remote bedroom community" paradigm is coming under pressure. Telecommuting works only for a not very large subset of jobs.

[Welfare]

"In many "desirable" areas that have a local economy, most of the "good" space is already built out or zoned out.."

Zoning out is a problem mostly in inelastic areas. Elastic areas tend to have more desirable areas that can be built on. High gas prices will certainly have an impact, but it can take a very long time for gas savings to compensate for several hundred thousand dollars in extra housing cost.

[cm]

Welfare: I don't know what zoning has to do with inelastic areas (if I even understand that term correctly). What I mean is that you cannot just build a residential development in between two factories, or in an area that does not have the infrastructure, or provision to install infrastructure, that is needed for residences. Most zoning is for reason, even when the specter of zoning is invoked for allegations of nimbyism or environmentalism.

And I'm not sure I buy the gas savings vs. housing cost argument -- usually when people buy a house their housing cost goes up not down. They would previously have rented, or lived in a smaller house/condo (or with their parents, if it's a move-out situation). But even when moving out from the parents, renting locally is usually cheaper than buying a house/condo -- of course you will "live smaller" and "piss away your money on rent". Unless "suitable" local rentals are really maxed out, which has happened on occasion.

It's all a question of financing being available. If you cannot "afford" to buy a house, you simply won't. The recent real estate buildout has happened for no other reason than that at the time the arithmetic seemed to work (if you don't look too closely and assume house prices always go up). Now you get the double whammy of falling or at best stagnating house prices (no more equity extraction) plus higher transportation cost.

I think most of the foreclosures are in recently (around 2005 or later) purchased "marginal" housing where mortgage cost/adjustment probably figures most prominently, but it's always the sum of all costs relative to income that pushes it over the edge.

[Lafayette]

Restraint of supply

LLE: the average price within a single state can still be significantly higher than the rest of the nation if a significant number of localities within the state zone restrictively. Localities carry out their function under state guidelines, so state policy has a large effect.

This is tantamount to restraint of supply, which is typically the effort of rich communities to protect asset value. Restraint of supply is (usually) just as illegal as restraint of trade. Maybe CA is different in this matter. ;^)

It would take one helluva lot of such communities, restricting Supply, for this to have an effect statewide.

[cm]

Lafayette: But note that demand for housing and property is not uniform -- it is higher in established areas that have "something going for them".

And one person's nimbyism is another's preservation -- here in the "Silicon Valley" we have enough commercial buildings and properties standing empty and slowly rotting away with no sign of upkeep other than perhaps an annual fallen leaves cleanup that had been erected on orchards and fields that had to make space for commercial development. That is mostly in the "back alleys" but also right on busy streets.

It would appear to me that much of the newer commercial construction is larger and more "modern" looking buildings, likewise on previously "fallow" land. OTOH there are a lot of smaller companies or departments who could use but apparently forgo those dumps in less choice addresses. But I presume somebody used them "back then".

[Lafayette]

cm, all that your recount is perhaps very true and very unfortunate. But it is mostly about a very special and peculiar place, called Silicon Valley.

It has its highs and its lows. When SV is on a roll, a lot of people make one helluva lotta money. When it is stuck in the mud, a lot more people make a lot less. These latter learn what is meant by "coping with life".

Frankly, if you had a choice, would it be the roll of the dice and a chance to make a mindless amount of money? Or, would you just rather an interesting and challenging job that motivates you, but pays for a decent and durable living (whatever that may mean, but in nominal and not extravagant terms)?

[Lafayette]

Typo: "... but in not extravagant terms".

[cm]

Lafayette: Whenever money can be "made" anywhere, there will be "new development" and business/people will move in. How is "Silicon Valley" different? You can see similar things in all kinds of cities, former cities, and bedroom communities that certainly don't command a "high tech" cachet and which may have had their big waves of development in the past, not now.

Most of the "Silicon Valley" seen from popular roads quite frankly looks like garden-variety commercial sprawl without much in the way of distinctive features. Every wave of development has left behind its debris that can be seen in the form of derelict properties, boarded up buildings, and "installations" on operational buildings that beg questions about local building codes.

This is not meant as a complaint, but as a mostly factual assessment of what I have seen. I was merely reacting to your "illegal supply restraint" thesis. OK, let me rephrase this -- to an extent it's zoning vs. overdevelopment. There are always "special interests" involved in the details of zoning decisions, but as long as things are pointing "up", the buildout and sprawl will continue to excess, unless limits are imposed. And it appears that for several reasons, in boom times new construction appears to be preferred to reusing and refurbishing old infrastructure. I guess it's the same effect as with housing.

Of course there is no objective judge of what constitutes excess, this like everything else has to be negotiated in some "social process" based on aggregate "values".

[Lafayette]

cm: How is "Silicon Valley" different?

People are there for the money. One cannot say the same of Peoria or Biloxi or Schenectady.

SV is not the nicest place to live. In fact, it is rather banal. It was prettier with its old fruit orchards. But, that's just my opinion.

[cm]

Lafayette: Along the lines of my prior "ifs, buts, caveats" remark, do I really have to point out that I'm comparing "Silicon Valley" to major metro areas???

Point me to a metro area where people are not "there for the money" (other than those who grew up there, of which we have quite a few in "Silicon Valley" too). And don't point to artists, which we don't have here, they are all in San Francisco (to a good approximation).

Duh! (Struggling to stay polite here.)