My notice of Alex Tabarrok's post on bubblemania is a few days overdue -- hey, it's summertime, and the blogging ain't easy -- but what he has to say is too good to pass without comment:
Is there a housing bubble? Some say yes, some say no. I say who cares? The real question is not whether there is a bubble the question is, What are the chances that housing prices will fall dramatically? Contrary to popular belief, knowledge of whether prices are following fundamentals or a bubble tells us very little about this question.
An efficient market is not necessarily a stable market. Indeed, an efficient market can be as or even more volatile than a market plagued by bubbles.
My thoughts exactly. Alex provides a quick overview of why arguing about bubbles or not-bubbles is such a dubious exercise, relying on some straightforward economic theory:
Consider the stock market - the price to earnings ratio can be written (using the Gordon Growth Model) as P/E=D/E*(1+g)/(r-g) where g is the growth rate of dividends and r is the discount rate. Since r and g are small a small change in g can have a large effect on the P/E ratio - so much in fact that it is very difficult to reject a model of stock prices based solely on fundamentals (see my paper with Gary Santoni or the Barsky and DeLong classic Why Does the Stock Market Fluctuate (JSTOR).)
The principles are similar with respect to the housing market.
Here's a simple numerical exercise, applying the Gordon Growth Model to the pricing of a stock that returns a dollar in dividends next year, which then grow at rate g every year in the future:
Thus, Alex concludes:
When the supply is inelastic (as it is on the coasts) and demand is fairly inelastic (as it is for most people who like to live where they work) small changes in either demand or supply can change the marginal price dramatically. Thus, even if house prices are at fundamental values today and will be at fundamental values tomorrow a small change in say interest rates or the economy could make tomorrow's price considerably lower than today's.
Right. If I had my way, we would banish the bubble red herring from the conversation entirely, and focus on the real issue at hand, which is the balance sheet exposures of borrowers and lenders.
Also of note: PGL comments on Alex's post at Angry Bear. Calculated Risk has a bunch of related posts: here, here, here, here.
UPDATE: Jim Hamilton provides his usual lucid commentary on the issue:
What has changed-- and stands out like a sore thumb-- is that (1) the housing "bubble" occurred at a time when mortgage rates have been at the lowest levels of the last quarter century, and (2) house prices are going up most in those communities where population and income have grown relative to the available stock of housing. Looking at the market fundamentals solution above, is it really that surprising that H goes up when [r] goes down and g goes up?
It may be a good idea to take a hard look at any possible moral hazard problems lurking in our present financial institutions. But economic fundamentals look to me like the more obvious place to start in trying to understand exactly what's happened to U.S. house prices over the last 5 years.