Why did we have a housing bubble in the 00s? Why not Tulips or something else?
The real difference seems to lie not in housing becoming a better target for investment, but in real goods and services becoming less attractive ones. Why? Surely this is something that deserves considerably greater scrutiny than it’s gotten. Why did investors no longer think that the returns from investing in the real world portion of the American economy looked very compelling? Why was demand for real world goods and services not high enough to provide ample investment opportunity? This seems like a core question of the past decade that hasn’t gotten enough attention.
I’m not sure the distinction between “real estate got more attractive as an investment” and “other investments got less attractive as an investment” is all that conceptually rigorous. But I think there is, in fact, reason to believe that the causation involves real estate starting to look more attractive. In particular, we had a lot of “innovation” in mortgage finance that both expanded the number of people who could (apparently) afford to own a home and expanded the number of people who could viably engage in real estate speculation. I don’t think it’s all that surprising that this entrance of new market participants could have started a bubble scenario or that once the bubble was underway it kept attracting more and more money. We’re herd animals and there’s always a preference for getting in on the latest investment fad than for whatever else is on the table.
One answer to Kevin’s question is because of the terrorist attacks on 9/11, and the financial scandals of Enron and Worldcom, bond markets were scared out of their minds that they might be lending to the next Worldcom. Noah Millman has an excellent description of that situation on the ground related to the beginning of the wave of structured finance. Worldcom is early 2002; people are spooked about the next landmine, and housing always seemed like a safe bet for both consumers, and because of some financial innovations and excellent ratings, for investors.
To go deeper, I think it’s useful to distinguish between supply and demand here. Many financial institutions, because of all kinds of financial innovation, deregulation, ratings agency’s behavior and changes in the repo markets, wanted to give out more housing loans than before. That’s supply. Where did demand come from? Why did consumers buy so much real estate? The quick answer is that supply creates its own demand, or that demand stayed still while supply moved enough to cause what we’ve seen.
Another answer is behavioral-style herd behavior. Now mind you, as opposed to me stockpiling tulips, which doesn’t effect you unless you envy my tulips or feel status externalities to my tulips etc., me bidding up housing in a neighborhood does effect you if you are my neighbor, as neighborhood value drives a part of housing value. And with early 1980s banking deregulations, my ability to bid on housing is unconstrained by law.
Though it may be a rounding error, or it may have some interesting stories in it, I’ve written before on the idea that demand for housing intersects with a dismantling of the social safety net. To deal with rising health insurance premiums you get a credit card, and to deal with the debt you can borrow against your home – housing equity as the new social contract. In Massachusetts, 60% of all subprime defaults were mortgages that started with a prime mortgage, terms that usually imply something other than consumption smoothing. As for all the talk about the embedded option of getting a tax refund in a mortgage (as your interest can be written off), which is something that should be phased out, the real embedded option in housing is schooling – the option to send your kids to the local public school. As the robustness of educational meritocracy became a hot button issue in the 00s, the value of this embedded option must have skyrocketed. Not to mention gentrification issues, as well as exurbs that were implicitly dependent on cheap gas prices. That’s not the whole story of what was going on, but I think it’s worth some empirical research.