This paper explains the basic facts about the current housing market. It lays out the evidence that the rise in housing prices constitutes a housing bubble - and explains what can be expected when it inevitably collapses.

Dean Baker

English

Research Papers in Economics

Center for Economic and Policy Research
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Since 1996, 
house prices 
have risen by 
more than 45 
percent after 
adjusting for 
inflation.
Every week, 
approximately 
140,000 U.S. 
families buy a 
house, a majority 
of them at 
bubble-inflated 
prices. 
Dean Baker is co-director of the Center for Economic and Policy Research.
BY DEAN BAKER
The Housing Bubble Fact Sheet
ISSUE BRIEF   July 2005 
1. The unprecedented rise in house prices has dangerous 
implications for the economy. 
The generalized bubble in housing prices is comparable to the bubble in stock 
prices in the late 1990s. The eventual collapse of the housing bubble will have 
an even larger impact than the collapse of the stock bubble, since housing 
wealth is far more evenly distributed than stock wealth. 
2. The housing bubble has created more than $5 trillion in 
bubble wealth, the equivalent of $70,000 per average family of 
four.
Through the post-war period 1950 to 1995, house prices grew at 
approximately the same rate as the prices of other goods and services, like 
cars, gas, and healthcare. Since 1996, however, house prices have risen by more 
than 45 percent after adjusting for inflation. This unprecedented run-up in 
house prices has generated more than $5 trillion in housing bubble wealth, 
which is the difference between the current market value of housing and the 
value if house prices had followed their historic trend and kept pace with 
inflation.  
3. The increase in house prices is not being driven by 
fundamental factors in the housing market, such as income 
and population growth. 
The increase in home prices cannot be explained by fundamental factors, such 
as rising incomes and population growth. The growth in income over this 
period has not been especially rapid. The rate of income growth is 
considerably slower than in the years from 1950 to 1973, when the rise in 
home prices just kept pace with the overall rate of inflation. The growth in 
population over this period has not been especially rapid. The most rapid 
growth in the number of new households actually took place in the 1970s and 
early 1980s, when the huge baby boom cohort was first forming their own 
households.
1The economy is 
building over 2 
million housing units 
annually, while the 
number of 
households is 
growing by about 1.4 
million a year.
Ratio of home 
equity to home value 
stands at near-record 
lows.
Most importantly, there has been no significant increase in rents, which would 
be expected if the run-up in house prices were explained by the fundamentals 
of the housing market. Rents and home sale prices have always moved closely 
together, since families can freely switch between renting and owning 
depending on the relative prices, and landlords can sell off rental property if 
home sale prices rise substantially relative to rents. Rents had increased 
somewhat more rapidly than the overall rate of inflation from 1998 to 2002, 
but actually have been falling behind inflation in the last two years. This 
indicates that the run-up in house prices is not being driven by fundamental 
factors in the housing market. 
4. The housing bubble regions are large enough to have a 
major impact on the national economy.
There are many areas of the country in which house prices have not diverged 
far from their historic patterns, increasing only slightly more than the overall 
rate of inflation. However, the bubble regions -- some of which have seen 
home prices increase more than 60 percent after adjusting for inflation -- are 
large enough to have a major impact on the national economy. These regions 
include most of the East Coast north of and including Washington, DC, 
especially New England; much of the Pacific Coast region; and many pockets 
in between. Not all of the run-up in prices in these regions will necessarily be 
reversed in the downturn (there are reasons why these areas have become 
more attractive places to live), but most of the run-up in house prices will 
likely be reversed in most areas. The bubble areas are far too large to be 
explained merely by the fact that they have become more attractive relative to 
other regions.
In assessing whether house prices in a particular area make sense, it is useful 
to think of higher-than-average house prices as comparable to a tax. Cities 
like San Francisco, Los Angeles and New York City have features that make 
them more desirable than other places, so people are willing to pay a 
premium to live there. However, there is a limit to how much people will pay. 
Housing costs comprise approximately 30 percent of the average family's 
spending. So if house prices are twice as high in bubble areas as in the rest of 
the country, it is equivalent to a tax of 30 percent on residents of these 
regions. If house prices go even higher in these areas, then the effective tax 
rate becomes even higher. 
At some point, the economies of these bubble regions will not work -- the 
rest of the country and the world will pay no more for the legal services, 
financial services, apparel, or whatever else is produced in these areas than it 
will for the same items produced in Peoria, Illinois or Bangalore, India. House 
prices that are too disproportionate with the prices elsewhere will simply 
make the economies in the bubble areas uncompetitive, leading these regional 
economies to contract until house prices fall back to a level where these 
regions can again be competitive in a national and world market.    
The Housing Bubble Fact Sheet  25. The collapse of the housing bubble will throw the 
economy into a recession, and quite likely a severe recession.
Housing construction is equal to approximately 5 percent of GDP. 
Construction of new homes has been going on at a near-record pace over the 
last few years, in response to the run-up in housing prices. Home 
construction could easily fall back 40 percent (this was the drop off in the 
1981-82 recession), which would imply a direct loss in demand equal to 2 
percentage points of GDP. 
In addition, the large wealth effect associated with the housing bubble, which 
has spurred a consumption boom in the last few years, will go into reverse as 
housing prices plummet. Research from the Federal Reserve Board shows that 
a dollar in additional housing wealth leads to 4 to 6 cents of annual 
consumption. This implies that a loss of $5 trillion in housing wealth would 
lead to a decline in annual consumption of between $200 billion and $300 
billion. This loss in consumption is equivalent to 1.6 to 2.5 percentage points 
of GDP. 
Combining the 2 percentage point drop in demand due to a falloff in housing 
construction with the 1.6 to 2.5 percentage point drop in demand due to the 
reversal of the housing bubble's wealth effect leads to a falloff in demand of 
between 3.6 and 4.5 percentage points of GDP. If employment fell in the 
same proportion, this would imply the loss of between 5.0 million and 6.3 
million jobs. Since the federal government is already running a large deficit, 
and the country is running a very large trade deficit, the government's ability 
to use fiscal and monetary policy to boost the economy out of the recession 
will be severely restricted.
6. The collapse of the housing bubble is likely to put major 
strains on the financial system and require a federal bailout 
of the mortgage market.   
The collapse of the housing bubble is likely to lead to record levels of 
mortgage defaults. The ratio of home equity to home value stands at near-
record lows, even though the run-up in home prices translates directly into 
additional equity. The reason for the low ratio of equity to value is that many 
homeowners have been quick to borrow against the new equity created by the 
housing bubble. This means that when home prices fall, many homeowners 
will find that their mortgages equal or exceed the value of their house, giving 
them a strong incentive to default on their mortgage and simply turn over 
their house to the mortgage holder.
The market in 
mortgage-
backed security 
currently 
exceeds $6 
trillion.
The housing 
bubble collapse 
could lead to a 
loss of 3.6 to 
4.5 percentage 
points of GDP 
due to a drop in 
housing 
construction and 
reversal of the 
bubble's wealth 
effect.
The Housing Bubble Fact Sheet  3Of course, if the economy is in a recession, then many homeowners will have 
no choice but to default on their mortgages. Rising house prices have led many 
homebuyers to stretch themselves as far as possible to be able to afford 
monthly mortgage payments. Losing a job or being forced to take a new job at 
lower pay will leave many recent homebuyers unable to make their payments. 
Similarly, if interest rates rise, as virtually all economists expect, homebuyers 
with adjustable rate mortgages will find themselves paying much more on their 
monthly mortgages. Many homeowners will be unable to make these higher 
payments.
If there is a large increase in the rate of mortgage defaults, then the mortgage 
holders will experience big losses. While many banks and financial institutions 
still hold large amounts of mortgage debt, most mortgages become the basis 
for mortgage-backed securities, a market that now exceeds $6 trillion. This 
market will be put in danger by a large wave of defaults following the collapse 
of the housing bubble. It is likely that the federal government will have to bail 
out the market in mortgage-backed securities to prevent a cascading series of 
defaults. 
7. The sooner house prices drop, the less economic damage 
there will be.
Given how far out of line house prices have grown from fundamentals, there 
is no way to avoid enormous economic damage when the bubble collapses. 
However, the quicker house prices revert to more normal levels, the less 
damage there will be. 
As long as prices remain high, more people will buy into homes at bubble-
inflated prices. Every week, approximately 140,000 families across the country 
buy a house. Most of these home purchases occur in the bubble regions. 
Homeowners who see the price of their home soar in the bubble and then fall 
back in the crash are not harmed (although they may be unhappy that they 
didn't sell at the peak). On the other hand, people who buy a home at a 
bubble-inflated price - and then see the price plummet in the crash - may lose 
much or all of their savings. The sooner the bubble bursts, the fewer the 
number of people who will be in this situation.
In addition, if people are borrowing against the bubble-inflated value of their 
homes, they may come to regret the level of debt they have acquired once they 
realize that the equity in their home is less than they thought. The baby boom 
cohort, currently ages 41 to 59, is nearing retirement. Many baby boomers 
have done very little saving because they believe that they have a large amount 
of equity in their home. The sooner the bubble bursts, the less borrowing will 
occur, leaving people better prepared to pay for their retirements. 
Rents increased 
slightly faster than the 
overall rate of 
inflation from 1998 to 
2002, but have been 
falling behind 
inflation in the last 
two years.
Nationwide vacancy 
rental rate is at all-
time high. 
The Housing Bubble Fact Sheet  4Also, the longer the bubble persists the greater the number of questionable 
mortgage loans. The future rate of mortgage defaults will be higher the 
longer it takes to burst the bubble. For these reasons, and others, it would be 
better for the economy if house prices adjusted quickly to more normal 
levels.
8. The housing bubble could pop from higher interest rates, 
but it could also deflate even if interest rates stay low.
The fact that mortgage rates fell to a fifty-year low, and have stayed low, has 
been an important factor in propelling the bubble. The low mortgage 
interest rates of 2003 were largely the result of deliberate action by the 
Federal Reserve Board to prop up the economy in the wake of the stock 
market crash. However, mortgage rates have remained low, even as Alan 
Greenspan has raised interest rates, primarily because the Japanese and 
Chinese central banks have intervened in the U.S. treasury market to offset 
the Fed's actions. By purchasing hundreds of billions of dollars worth of 
long-term bonds, these central banks have completely offset the Fed's 
efforts to affect the mortgage market. If the Japanese and Chinese central 
banks reduce their intervention, or other factors put substantial upward 
pressure on long-term interest rates, then the housing bubble is likely to 
unwind. 
However, the bubble could begin to deflate even if interest rates do not rise 
appreciably. The economy is building over 2 million new housing units 
annually. The demand for housing from new households or second home 
purchases is probably in the neighborhood of 1.5 million a year. As long as 
house prices remain at their bubble-inflated levels, construction will stay at 
its current level or possibly even increase. At the moment, the excess supply 
of housing is being absorbed by speculators who are convinced that the 
prices will rise in the future and also by a record nationwide rental vacancy 
rate. Both sources of demand are limited. There is a limit to the number of 
people who are willing to speculate in real estate. Also, as excess rental 
capacity develops, it will put more downward pressure on rental prices, 
leading more potential homebuyers to rent and causing many landlords to 
sell off rental units.  
It is impossible to say what set of events will cause housing prices to turn 
(in the absence of a rise in mortgage interest rates), just as it was impossible 
to determine the set of events that finally led to the bursting of the stock 
bubble in 2000. However, with supply persistently outstripping demand, it is 
only a matter of time before house prices eventually adjust. 
  The value of residential housing is taken from the Federal Reserve Board's Flow of 
Funds, Table B102, line 4. The increase in house prices is taken from the Office of Federal 
Housing Price Oversight's House Price Index, with the CPI-URS being the measure for 
overall rate of inflation. (June 2004)
Some regions of 
the U.S. have 
experienced a 60 
percent increase in 
real home prices. 
The Housing Bubble Fact Sheet  5 
1

The Housing Bubble Fact Sheet

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The Housing Bubble Fact Sheet

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