Competing hypotheses on what caused the housing bubble

I. Low interest rates

A. Global Saving Glut

1. Correlation of housing appreciation with current account deficit

VoxEU: "In the period from 1999 to 2006 house prices rose by more in countries with larger current-account deficits. This negative correlation suggests an important link between the current-account balance and the housing sector, but the direction of causality is unclear."

2. Bernanke (2005)

"Over the past decade a combination of diverse forces has created a significant increase in the global supply of saving—a global saving glut—which helps to explain both the increase in the U.S. current account deficit and the relatively low level of long-term real interest rates in the world today. ... A particularly interesting aspect of the global saving glut has been a remarkable reversal in the flows of credit to developing and emerging-market economies, a shift that has transformed those economies from borrowers on international capital markets to large net lenders. ...

"After the stock-market decline that began in March 2000, new capital investment and thus the demand for financing waned around the world. Yet desired global saving remained strong. ... The weakening of new capital investment after the drop in equity prices did not much change the net effect of the global saving glut on the U.S. current account. The transmission mechanism changed, however, as low real interest rates rather than high stock prices became a principal cause of lower U.S. saving. In particular, during the past few years, the key asset-price effects of the global saving glut appear to have occurred in the market for residential investment, as low mortgage rates have supported record levels of home construction and strong gains in housing prices. ...

"The countries whose current accounts have moved toward deficit have generally experienced substantial housing appreciation and increases in household wealth..."

B. Federal Funds Rate too low for too long

1. John Taylor (2007)

"During the period from 2003 to 2006 the federal funds rate was well below what experience during the previous two decades of good economic performance—the Great Moderation—would have predicted. Policy rule guidelines showed this clearly. ...

"Many have argued that these low interest rates—or the provision of large amounts of liquidity that they required—helped foster the extraordinary surge in demand for housing. ... With low money market rates, housing finance was very cheap and attractive—especially variable rate mortgages with the teasers that many lenders offered. ...

"The surge in housing demand led to a surge in housing price inflation which had already been high since the mid 1990s.

"While saving rates were high in some countries during this period, the global saving rate was not. According to IMF data, global saving was 21 percent of GDP in 2003-2005 compared with 25 percent in the early 1970s."

2. Federal Funds Rate vs. the Taylor Rule

The Taylor Rule is a guide as to what the Fed Funds Rate should be. It suggests the Fed Funds Rate was too low from 2002-2006.

C. Rebuttal: Glaeser, Gottlieb, and Gyourko (2010)

Interest rates do influence house prices, but they cannot provide anything close to a complete explanation of the great housing market gyrations between 1996 and 2010. Over the long 1996-2006 boom, they cannot account for more than one-fifth of the rise in house prices. Their biggest predictive influence is during the 2000-2005 period, when long rates fell by almost 200 basis points. That can account for about 45% of the run-up in home values nationally during that half-decade span. However, if one is going to cherry-pick time periods, it also must be noted that falling real rates during the 2006-2008 price bust simply cannot account for the 10% decline in [housing] indexes those years.

II. Mass psychology

Bubbles usually have an initial fundamental cause (a spark, such as low interest rates), but then a mass get-rich-quick mentality takes over, causing prices to divorce from the fundamentals.

A. Case-Shiller (2004)

"A tendency to view housing as an investment is a defining characteristic of a housing bubble. Expectations of future appreciation of the home are a motive for buying that deflects consideration from how much one is paying for housing services. That is what a bubble is all about: buying for the future price increases rather than simply for the pleasure of occupying the home. And it is this motive that is thought to lend instability to bubbles, a tendency to crash when the investment motive weakens. ... The apparent attractiveness of housing as an investment is further enhanced if the buyer perceives that the investment entails only very little risk.

"Expectations about the future price performance of homes were high in both 1988 and 2003. In both of these housing booms, roughly 90 percent or more of respondents expected an increase in home prices over the next several years, and the average expected increase over the next twelve months was very high, even surpassing 9.8 percent in San Francisco in 2003.

"But it is the long-term (ten-year) expectations that are most striking. When asked what they thought would be the average rate of increase per year over the next ten years, respondents in Los Angeles gave an average reply of 13.1 percent (versus 14.3 percent in 1988); in San Francisco they were even more optimistic, at 15.7 percent (14.8 percent in 1988); in Boston the answer was 14.6 percent (8.7 percent in 1988); and in Milwaukee it was 11.7 percent (7.3 percent in 1988). Note that even a rate of increase of only 11.7 percent a year means a tripling of value in ten years. ...

"The number who admitted to being influenced by "excitement" about home prices was still high, close to 50 percent in Los Angeles, but lower than in 1988."

B. Television shows

1. Flip This House (2005-present)

2. Flip That House (2005-2008)

3. Property Ladder (2005-2007)

"Would you like to make more money in a few months than you could in a whole year?"

Bankers didn't make people watch these shows. They appeared at the peak of mass home buyer euphoria.

III. Subprime lending: Cause or effect?

A. Conventional wisdom

Completely unscientific web poll: "Was subprime lending a cause or an effect of the housing bubble?"

It was a cause: 67%
It was an effect: 26%
Neither: 7%

B. When the bubble occurred

Home prices began outpacing rent prices in 1998. By 2001 we were in mild bubble territory.

C. When the subprime lending occurred

Subprime lending took off in late 2003, several years after the start of the housing bubble. This suggests extensive subprime lending was an effect of the housing bubble, not a cause. Conventional wisdom is getting cause and effect backwards.

1. Subprime only

2. Subprime combined with liar loans

D. Glaeser, Gottlieb, and Gyourko (2010)

There is no convincing evidence from the data that approval rates or down payment requirements can explain most or all of the movement in house prices either. The aggregate data on these variables show no trend increase in approval rates or trend decrease in down payment requirements during the long boom in prices from 1996-2006. However, the number of applications and actual borrowers did trend up over this period (and fall sharply during the bust), which raises the possibility that the nature of the marginal buyer was changing over time.

IV. Summary

A. Likely chain of events

I believe the chain of events likely occurred as follows:

Excess saving in less developed countries combined with current account deficits in developed countries –> Money flowed into developed countries –> Interest rates fell to historically low levels –> Borrowing became cheaper –> More people tried to buy homes (i.e. demand exceeded supply) –> Prices rose rapidly –> Mass get-rich-quick mentality pervaded both Main Street and Wall Street –> Subprime lending allowed the bubble to last beyond its otherwise natural breaking point

B. National and metro area housing graphs