WAS THERE A HOUSING BUBBLE?….Alex Tabarrok takes a look at housing prices today and makes a seemingly odd argument about whether we’re really in the midst of a housing bubble:

The clear implication of the chart is that normal prices are around an index value of 110, the value that reigned for nearly fifty years (circa 1950-1997). So if the massive run-up in house prices since 1997 was a bubble and if the bubble has now been popped we should see a massive drop in prices.

But what has actually happened? House prices have certainly stopped increasing and they have dropped but they have not dropped to anywhere near the historic average….If we don’t see the massive drop back to “normal” levels then the run up in prices should be described as a shift to a new equilibrium — much as happened during World War II — see the chart. (It’s an important question to ask what changed and why?). In the shift to the new equilibrium there was some mild overshooting, especially due to the subprime over expansion, but fundamentally there was no housing bubble.

But doesn’t this depend on whether the overshoot really does turn out to be “mild”? I too don’t expect to see home prices go down to their historical levels, but if the housing index goes from 110 to 200 and then crashes back to 160, what would you call that? I’d call it both a new equilibrium and a bubble.

As for what changed to produce this new equilibrium, I don’t know. But here’s my guess: it’s mostly a delayed reaction to growing real incomes. In the past, lenders and buyers both believed that families couldn’t afford to spend more than about 20-25% of their income on housing. And maybe that used to be true. Today it’s not, and I think that in the late 90s everyone finally internalized the fact that the average family can, in fact, afford to spend more like 30% of their income on housing. Maybe even a bit more. Unfortunately, a few years later everyone started internalizing numbers more like 40% or 45%, and then the trouble started.

Result: a bubble that took the housing index up to 200, followed by a pop that will take us down to a new equilibrium around 160 or so. That’s my hunch, anyway. Housing prices may be sticky downward, but eventually they’ll unstick. We’re nowhere near done with the housing bubble yet.

UPDATE: A reader points out that falling interest rates were obviously one of the drivers of the bubble too. That’s true. More efficient credit markets helped as well (though those markets turned out not to be quite as efficient as everyone thought). But even if interest rates eventually go back up to historical levels, I suspect that housing prices won’t go down to theirs. We’re probably still going to end up at a higher equilibrium than in the past.

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