A very basic model of the economy would suggest that the overall price of real estate should stay very flat over time. Land should get more expensive as more people try to live in a particular metro area since building more land, though possible, is difficult to undertake. But you can always just build taller buildings. And since buildings are built out of a wide array of materials, the price of construction tends over the long term to converge to the overall price level. That’s not to say real estate prices should never rise, but just to say that increases should be temporary. Neighborhood A gets pricey, so people start building taller buildings there, which causes prices to fall. Supply and demand, equilibrium, etc.
In the real world, however, we see two things. One is development restrictions. Lots of them. The other is price bubbles. Lots of them. Is there a link? Intuitively, the argument seems clear. Thanks to development restrictions, it really is possible for real estate prices in a given area to reach a semi-permanent new plateau. As the DC Metropolitan Area has grown, houses in nearby and pleasant Arlington County, VA have gotten more and more expensive since outside of a couple of corridors it’s not allowed to build denser. This sort of phenomenon becomes the grain of truth on which speculative dreams are hung.
In a sample covering more than 300 cities in the US between January 2000 and July 2009, we find that more restrictive residential land use regulations and geographic land constraints are linked to larger booms and busts in housing prices. The natural and man-made constraints also amplify price responses to an initial positive mortgage-credit supply shock, leading to greater price increases in the boom and subsequently bigger losses.
Consider this another reason to believe that we need to think harder about our regulation of land in this country. Some land-use restrictions—those that aim to preserve undeveloped natural land—have a clear environmental rationale that should be weighed against the economic cost. But most land-use restrictions don’t prevent development, they just force it to be inefficiently low-intensity. Such laws are bad for the environment, chewing up space and wasting energy, as well as economically harmful.