This post from Economics of Contempt looks at the relationship between price bubbles and regulation in housing markets, and poses an hypothesis about how regulation could have influenced the housing bubble. The argument is that regulation causes larger and more sustained swings in prices, and, on the upside of the cycle, the larger more sustained increase in prices helps to fuel the perception that prices will keep going up, a key factor in the propagation of bubbles:
Land Use Regulations and the Housing Bubble, Economics of Contempt: Mark Thoma, while linking to an article on the cost of land use regulation, expresses doubt about the idea that land use regulations contributed to the housing bubble by raising housing prices. So I guess this is as good a time as ever for me to make the case that land use regulations probably contributed to the housing bubble. ...
To be clear, I'm not saying that land use regulations definitely did contribute to the housing bubble. I'm only saying that based on the existing empirical literature on the relationship between land use regulations and housing prices, it's likely (very likely, in my opinion) that land use regulations contributed to the housing bubble in a not-insignificant way.
First, a very crude summary of the theory underlying the link between land use regulations and housing prices.
Land use regulations raise housing prices by restricting the supply of developable land, and thus new housing construction. Such regulations generally take the form of minimum lot sizes or explicit growth controls (which limit the number of building permits that can be issued). Local governments adopt these land use regulations because homeowners -- who absolutely dominate local politics (see pg. 15) -- have a strong interest in maintaining high housing prices (see pg. 9) by restricting the supply of developable land. (Berkeley economists John Quigley and Larry Rosenthal published a very thorough description of the existing empirical literature here, although I agree with Bob Ellickson that Quigley and Rosenthal were far too timid in their conclusions. See also William Fischel here)
Now to the link between land use regulations and housing bubbles. Ed Glaeser, Joseph Gyourko, and Raven Saks provide a nice illustration of the effect that land use regulations will have on housing prices in the face of a demand shock:
The most persuasive evidence comes from a 2006 paper by Min Hwang and John Quigley, "Economic Fundamentals in Local Housing Markets: Evidence from U.S. Metropolitan Regions". Hwang and Quigley's model is based on data from 74 metropolitan areas (MSAs) from 1987-1999. Using a well-known Regulation Index (developed by Stephen Malpezzi), which measures the restrictiveness of an MSA's land use regulations, Hwang and Quigley are able to simulate the impact of restrictive land use regulations on housing price appreciation across MSAs.
First, they take 3 MSAs with different levels of land use regulation "restrictiveness": Houston (least restrictive), Tucson (medium restrictiveness), and San Jose (most restrictive). Here's the effect that an unexpected income shock has on housing prices in each MSA:
As Hwang and Quigley explain, "After an initial shock, lagged market responses play an important role in the development of equilibrium prices."
Second, they take Denver, the MSA with the least restrictive land use regulations:
"This simulation is reported in the same manner as those reported for Houston, Tuscon, and San Jose. We also report a second simulation for Denver, but with one counterfactual. In this second simulation, we assume that Denver's regulation of new construction is as stringent as that of San Francisco, the market with the most stringent building regulations in our sample."
As you can see, more restrictive land use regulation leads to larger and more sustained house price appreciation.
Additionally, here's Harvard economist Raven Saks in a 2005 paper:
"To identify metropolitan areas where the supply of housing is constrained, I assemble evidence on housing supply regulations from a variety of sources. In places with relatively few barriers to construction, an increase in housing demand leads to a large number of new housing units and only a moderate increase in housing prices. In contrast, for an equal demand shock, places with more regulation experience a 17 percent smaller expansion of the housing stock and almost double the increase in housing prices."
The fact that the house price appreciation in MSAs with restrictive land use regulations is so long in duration would give realtors and homebuyers the impression that (stop me if you've heard this one already) "housing prices always go up!" In other words, the sustained house price appreciation lays the groundwork for a speculative housing bubble. The length of the price appreciation, I think, assures people of the stability of the upward trend, thus inducing them to borrow over their means in order to buy.
That's my take, anyway. I really just wanted to write it down.
Land Use Regulations and Housing Bubbles: Part Deux: I outlined the argument and presented some of the empirical evidence supporting the idea that land use regulations played a key role in the housing bubble... I want to expand on that argument, as well as provide more empirical evidence...
First, Goodman and Thibodeau (2008), in a paper titled "Where Are the Speculative Bubbles in US Housing Markets?", find:
"We estimate housing supply elasticities for 133 metropolitan areas and conclude that although areas on the East Coast and in California had large observed price increases, they owe much of their house price increases to inelastic supplies of owner-occupied housing."
This is, I think, the key point: it was housing supply inelasticity more than anything that led to the housing bubble.
What role do land use regulations play? Not surprisingly, it is land use regulations that lead to inelastic housing supply. In a 2005 American Economic Review paper, Quigley and Rosenthal report:
“For the growth in the overall housing stock, we find a significant and positive supply elasticity for unregulated cities and a negative and significant negative effect for regulated cities.”
Quigley and Rosenthal then turn to the effects on housing prices, finding:
“We find a positive relationship between the degree of regulatory stringency and housing prices for both owner-occupied units and rental units.”
Thus, restrictive land use regulations -- which make housing supplies inelastic -- turn a demand shock into a bubble because they lengthen the duration of price appreciation. This argument that land use regulations turn demand shocks into bubbles was bolstered by a recent paper by Dusansky and Koc (2007):
"We find that an increase in housing prices increases the demand for owner-occupied housing services. Thus, housing's role as investment asset with its potential for capital gains dominates its role as consumption good, which alone would produce a downward sloping own demand curve rather than one which is upward sloping."
Housing's dual role as an investment and a consumption good is what makes it more susceptible to bubbles. When house price appreciation is fast enough and lasts long enough, consumers don't demand less of it, as they would with normal consumer goods, because the expected capital gains from the house price appreciation, in the minds of consumers, offsets the higher price for housing as a consumption good. Moreover, the belief that house price appreciation will continue -- which is reinforced by the long duration of the price appreciation -- leads consumers to overestimate the expected capital gains.
This is why, I think, land use regulations were likely a key factor in the housing bubble.