“One should ask why a housing bubble caused by low interest rates…”
His article “Will the Bailout Work?” goes on to defend the current narrative on the glorious bailout. The problem is that his above statement fails to match reality as I suspect he simply hasn’t done his homework.
This thinking is wrong. It fails to explain differences in geography and historical evidence that contradicts the logic in previous periods of falling interest rate.
Using national average mortgage rates, we find that prime mortgage rates were at a peak of 8.64% before the boom on May 19,2000 (which really began in earnest in 2001), and then hit an all time low of 5.21% on June 20, 2003. That seems dramatic, so let’s do the math. Assuming that all mortgages were at 8.64%, but were all refinanced at 5.21%. This would imply a 41% increase in purchasing power. That seems to correlate to the increasing prices, but let’s dig a little deeper.
The problem with this thinking is that it would imply no increase in the housing supply. People did not merely bid up the existing housing stock; they built new and bigger houses, remodeling older ones. Furthermore, increased purchasing power does not immediately drive up the cost of construction. In a city with ample supply of land and few development entanglements, there is no reason why an increase in debt purchasing power would be wiped out by a commensurate inflation in the price of building materials. Home construction is a very competitive market, and the price of homes should approximate the cost of construction plus a muted profit margin.
There is also the notion of cross-price elasticity. That is, when people gained debt purchasing power, many chose to refinance and pocket or spend the savings on other things. While this interest rate assumption may correlate well to housing price behavior in California, it doesn’t explain why home prices increases in Atlanta ran at a fairly smooth rate of 4% a year between 1991 and 2007 (S&P Case Shiller). Of course, in California, it also doesn’t fully explain why prices surged by 147%. In short, the cross-price elasticity effect would water down the effects of lower interest rates.
Another problem with this line of thinking is that significant drops in interest rates should have caused housing bubbles in the past. If mortgage rates dropped by 3.5% during the this decade, why wasn’t there a huge bubble after mortgage rates fell from 18% in 1981 to 10% in 1987? Or when they fell from 10% to 7% between 1990 and 1993? In fact, home prices in Los Angeles declined significantly between 1990 and 1993. There is little historical correlation between interest rates and housing price swings.
Explanations for the housing boom and bust:
Interest rate changes – Bogus
Greed – Nice and vague and conveniently impossible to measure
Deregulation – So far, I have seen few specific deregulations mentioned, so I will relegate this to ideological rhetoric until I see evidence
Government mandated sub-prime lending through the Community Reinvestment Act along with Fannie Mae and Freddie Mac – Bingo!
Local and state residential development restrictions that constrained the market and drove up prices – Bingo!