Dean Baker's View of the Housing Bubble

From a paper written in May by Dean Baker of the Center for Economic Policy Research:

The housing bubble in the United States grew up alongside the stock bubble in the mid-90s....

The stock wealth induced consumption boom also led people to buy bigger and/or better homes, since they sought to spend some of their new stock wealth on housing. This increase in demand had the effect of triggering a housing bubble because in the short-run the supply of housing is relatively fixed. Therefore an increase in demand leads first to an increase in price. As prices began to rise in the most affected areas, prices increases got incorporated into expectations. The expectation that prices would continue to rise led homebuyers to pay far more for homes than they would have otherwise, making the expectations self-fulfilling....

As the house prices grew further out of line with fundamentals, the financial industry adopted more sophisticated financial innovations to support its growth. A key part of the story was the growth of non-standard mortgages....

The bubble began to unravel after house prices peaked and began to turn down in the middle of 2006. This led to rapid rises in default rates, especially in the subprime market....

[The] financial meltdown also has important feedback effects on the housing market. On the supply side, the flood of foreclosures ensures that a large supply of housing will be placed for sale, since banks are generally anxious to sell properties on which they have foreclosed....On the demand side the growing stress in financial markets has helped to dampen demand, since banks are far more reluctant to make loans than had been the case two years ago....The continued flow of houses for sale, coupled with the sharp cutback in demand, is leading to rapid declines in house prices in many markets....

Through the run-up of both the stock bubble and the housing bubble, the Fed took the view that financial bubbles are natural events, like the weather, which cannot be prevented. In fact, financial bubbles can be contained and there is nothing more important that the Fed or any central banks can do than to ensure that they do not grow to such dangerous proportions.