Why Housing Is About to Go "Pop!"

Too many red alerts are flashing for investors and the Fed to remain in denial when so much is at stake. If this bubble bursts, watch out

By Mark Weisbrot

If you still need proof that a bubble is building in the housing market take a look at the findings of my economist colleague Dean Baker at the Center for Economic Policy & Research in Washington, D.C. He has tracked national housing prices going back to 1951. Prices pretty much track the rate of inflation up until 1995. But since then, average prices on new and existing homes have soared more than 35 percentage points beyond the overall rate of inflation. Is that unusual? You bet it is.

This sudden increase has no plausible explanation other than a bubble, in my view. Part of the bubble's expansion is explained by the enormous wealth the stock market generated in the late '90s, which spilled over into real estate, as happened in Japan during the '80s. Even after the stock market crashed in 2000-02, financial "experts" -- the same ones who mistakenly counseled unfortunate 401(k) investors that there was "no way" anyone investing in the stock market for the long run could lose -- recommended housing as the next big thing.

Of course, that's exactly what a bubble is -- people buy an asset because its price is rising, and that pulls more buyers into the market. Prices rise further, and the cycle continues, without regard to the real value of the asset -- whether it's stocks, housing, or tulip bulbs in the 17th century.


  All bubbles must eventually burst, although it's very difficult to predict the timing. The stock market bubble could conceivably have continued for years longer than it did. To see an example of what that would have looked like, consider Japan: In 1989, their Nikkei stock index hit a bubble peak at 39,000. Today, more than 14 years later, it's less than 12,000. Imagine the Dow dropping to less than a third of its peak value and still sitting there 14 years later.

We do know that the longer a bubble persists and the bigger it grows, the more likely it is to burst sooner rather than later. In the case of the housing bubble, I think the signs are that it's getting close to breaking. One is the large divergence between the rise in rental prices vs. home prices. This can't persist for long, because people can choose whether to buy or rent.

Over the last year, housing prices increased by 8%, while rental prices rose by only about 2%. In some of the bubble areas, such as Seattle and San Francisco, rents are actually falling. And rental vacancy rates are at a record high nationally. These are indications that the bubble's end is near.


  A rise in long-term interest rates, which would push up mortgage rates, could collapse the housing bubble faster than anything else. Even after the recent jump in interest rates -- from 3.65% to 4.20% on the 10-year Treasury note -- long-term rates are still very low by historical standards. But inflation has been rising: The consumer price index is now running at a 3.7% compound annual rate over the past three months, as compared to 1.7% over the last year.

And the dollar's decline portends more inflation in the near future, especially as the greenback remains historically quite overvalued (another bubble) -- as witness the U.S. current-account deficit, which stands at more than 5% of gross domestic product.

The Federal Reserve Board has been uncharacteristically indifferent to the prospects of increasing inflation. It has not only kept short-term rates at a 46-year low of 1% but in its last statement, the Fed's rate-setting committee said the risk of "an unwelcome fall in inflation" now "appears almost equal to that of a rise in inflation." Chairman Alan Greenspan has also denied the existence of the housing bubble. It's hard to imagine that he really believes either of those two things.


  Surely, Greenspan would like to minimize the impact of a housing bubble bursting. But look at what he did when he discerned signs of a stock market bubble: After a brief comment about "irrational exuberance" at the end of 1996, he retreated and allowed that bubble to expand enormously, with the Dow growing by 80% and the Nasdaq nearly quadrupling before the crash.

I think Greenspan could have prevented the stock market bubble from reaching its distended proportions, simply by explaining the basic arithmetic to the public. A number of political leaders from either party presumably could have done the same.

The collapse of the equity bubble caused a recession in 2001, followed by a recovery of unprecedented weakness in the labor market. The U.S. is still experiencing the fallout, which included a corporate crime wave that contiues to work its way through the courts. Millions lost much of their retirement savings. The government's latest household survey of employment report last week showed that people over 55 accounted for an incredible 103% of jobs gained over the last year. Many have no choice: They can no longer afford to retire as planned.


  Economists at the International Monetary Fund -- which to its credit has been warning about America's housing bubble for some time -- have estimated that a collapse could have as much as twice the negative impact on the U.S. economy as did the stock market crash in 2000-02.

It makes no sense to remain in denial when so much is at stake. Even from the most libertarian, "free-market" approach to policy, there's a public interest in disseminating accurate information so that markets can function efficiently. Bubbles are not examples of markets operating efficiently. In fact, they're the opposite. And the bigger they grow, the harder they burst.

Weisbrot is co-director of the Center for Economic & Policy Research, a liberal think tank in Washington, D.C. You can read an opposing view on the housing bubble issue at the center's Web site

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