Ed Glaeser Discusses the Volatility of Housing Markets and Potential Public Policy Responses

Even when house prices were soaring, there were multiple red flags indicating potential dangers ahead for the nation’s housing market. In a talk yesterday (Feb. 18) at Bell Hall, Edward Glaeser, faculty director of the Rappaport Institute for Greater Boston and the Taubman Center for State and Local Government, reflected on the warning signs that should have alerted bankers, builders and homebuyers to the potential risks they faced.

“It’s particularly puzzling in places like Phoenix and Las Vegas where in fact there are no restrictions on housing supply,” said Glaeser. “That means that you should pretty much always think that those prices will revert back to the cost of supplying housing. So how in the world guys could convince themselves in 2005, 2006 that the price of a house in Las Vegas should be worth $350,000 I’ll never know, but it’s not compatible with a rational model.”

At one point Glaeser gave a mea culpa for not emphasizing enough the inevitable fall of astronomical housing prices, and for thinking that a housing bubble in areas like Phoenix wasn’t possible.

“I think actually in retrospect, [economists] would have done better to have actually made the point over and over again,” said Glaeser, “that prices in Phoenix and Las Vegas were utterly unsustainable, in order to counteract those entrepreneurs in the real estate industry who had very strong incentives to give the opposite opinion.”

Glaeser’s talk, titled “Housing Markets, Price Volatility, and Public Policy,” began with a discussion of the boom-bust cycle of housing markets, and the importance of both supply and demand in influencing housing prices. From 2001-06, low interest rates, subprime lending, solid income growth and “irrational exuberance” led to greater demand for housing in many areas, he said.

As demand increased, so did construction, especially in those areas with more land and fewer restrictions on growth. States such as Arizona, Florida and Nevada saw sharp increases in home construction to meet the high demand. But when the demand curtailed, Glaeser said, those markets were left with an oversupply of housing, and prices plummeted.

Looking ahead, Glaeser said he is not optimistic about plans to deal with the deluge of defaults and foreclosures. He said that further interest subsidies would be a “terrible mistake.” Given the options, he said he is a cautious proponent of tax credits for homebuyers because it would be the cheapest option. Glaeser stressed that the government should not artificially boost housing prices, since that could only serve to validate the high-risk mentality that led to the current housing crisis.

“The fact that the right response to that is to then boost housing prices feels to me as crazy as if you have a relative who’s lost his fortune betting on red in roulette, and you think the right policy is to make red come up more often in the casino in Las Vegas,” he said.