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Monday, August 28, 2006

Why? Why? Why?

This is an index of housing prices from 1890 through 2006. The index suggests that the price of housing is dramatically larger than its historical norm and that the dramatic increase since 2000 is likely not a sustainable equilibrium.

I have wondered exactly why the price of housing in so many cities has increased so much. It might be a bubble - characterized by unreasonable confidence that prices will continue to increase. Such episodes have occurred in the past, but they are few in number and represent some form of mass hypnosis that is very difficult to explain as consistent with rational behavior.

One reason prices might be increasing is because the amount of undeveloped land in urban/suburban areas is simply being exhausted. On the margin, the undeveloped land has a greater real option value and therefore housing that is placed on these marginal units might carry a high price. Undeveloped land in the hinterland or exurbs might be available but are distant from jobs and other amentities and therefore might hold less appeal. In other words, there might be a natural limit to the urban sprawl, much like there was a natural limit to the size and inefficiency of the new automobile.

On the other hand, the price of housing might increase if the population is growing faster than the stock of new and existing housing. This might be happening in certain cities in the country as people flock from the country to the cities. Additionally, there might be regulatory and zoning reasons that the stock of housing is not increasing as fast as it could. This seems especially the case in California, but it might also be playing a role in states like New Jersey, Georgia, and Massachussets.

There is, of course the cheap money argument. With interest rates reaching a low that our parents can only shake their head at, the real demand for housing might have increased. This, coupled with any restrictions on supply, might have contributed to the increase in housing prices. However, the price elasticity of housing is estimated to be near unity and the supply of housing is likely relatively inelastic. Therefore, the demand shock necessary to generate a 82% increase in house value from 2000 through 2006 would be substantial, perhaps beyond reason.

A final reason that the price of housing could be increasing so dramatically is if the new housing is simply of much higher quality than old housing. Much like automobiles are much more fun to drive, are safer, and have more amenities than automobiles in the past, and therefore we are willing to pay more for them in real terms today than we did in the past, so too might housing be improving in quality to such an extent that people are willing to pay more for new housing than they did in the past. While possible, this doesn't seem all too likely.

Looking at the World War dip, the first "explanation" that comes to mind -- more of a direction for further exploration, really -- is the Baby Boomers. Is there _anything_ we can't flippantly explain by referring to them and waving our hands around? :-)
I don't know... It's a tempting path to take, although I'm sure that others have tried.
With that said, though, it sure does look like a bubble.
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