Why a Housing Bubble?

Kevin Drum wonders why we got a housing bubble:

But why did capital fail to flow to productive investments? Saying that housing was the “path of least resistance” doesn’t explain anything. In some sense, housing (or property in general) has always been the path of least resistance for investment dollars.

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.

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.


The odd thing is that even where policymakers seemed to recognize the problem, they didn’t do anything about it. On May 20, 2005 Alan Greenspan said “Without calling the overall national issue a bubble, it’s pretty clear that it’s an unsustainable underlying pattern.” That would have been a good time for major bank regulators like Alan Greenspan to say “given the unsustainable trend, we should force banks to apply lending standards that are higher than usual, rather than laxer than usual.” But he didn’t. And nobody from the Bush administration was urging anyone to do this. And you didn’t hear Nancy Pelosi and Harry Reid urging them to do it either.

All that said, it’s worth emphasizing that the mere existence of an asset-price bubble and its subsequent collapse doesn’t necessarily lead to a years-long recession. A worse policy response than the one we got could have saddled us with Depression conditions, but a better one could have avoided a ton of the human suffering we’re seeing right now.