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Summary

U.S. housing prices increased by 6.9% in 2002 and 38.3% in the past 5 years. These increases look small in comparison to the behavior of house prices in certain regions of the country: prices in New England increased by 10.6% in 2002 and 62.9% in the past 5 years, while prices in California increased by 11.5% in 2002 and 67% in the past 5 years. In a number of local markets in those areas, prices have risen by more than 70% in the past 5 years. Recalling the behavior of the stock market in late 1990s, some analysts fear that the recent appreciation in housing prices points to a bubble, or a rise in house prices that cannot be explained by fundamentals. ("Fundamental" explanations for a rise in housing prices include falling interest rates, inflation, and rising incomes.) Recent changes in a few economic factors suggest reasons why house prices could be rising without a bubble being present. Yet statistical simulations performed in this report predict housing prices to be 12.722.9% lower than actual prices in 2002, indicating that a bubble may be present. But when the data are examined at a regional level, the major cause for concern is the large price increases in California and New England. House price appreciation in the rest of the country has been much more moderate. The problem with bubbles is that they cannot be identified with any confidence. If bubbles could be accurately identified, they would never develop in the first place because people would respond to the emergence of a bubble by selling the asset to avoid future losses, thereby eliminating the bubble. Indeed, economists who believe in the rationality and efficiency of the marketplace use this logic to argue that bubbles never exist. Even if the rise in housing prices cannot be explained by the factors identified in this report, it is possible that other unidentified "fundamentals"are driving prices up, rather than a bubble. If housing prices were being driven by a bubble, there is a chance that they could suddenly collapse, with adverse effects on the U.S. economy. Residential investment could fall significantly. A decline in housing wealth could depress consumption, thereby depressing aggregate spending in the short run. A sudden collapse in housing prices could also affect the health of the financial sector if financial institutions are not adequately safeguarded. All of these possibilities give Congress a cause for concern, yet effective policy responses to a bubble are difficult. If house prices were to decline in some regions, it would not be the first time this occurred. The report examines previous price declines in California, New England, and Texas. Encouragingly, those declines were much smaller than the prior increase in prices. A belief that there is no housing bubble does not rule out the possibility that house prices could fall in the near future. For example, interest rates are likely to rise in the next few years, placing downward pressure on prices, all else equal. But from a macroeconomic perspective, a fall in house prices is an independent economic concern only in the presence of a bubble. For instance, if interest rates rose sharply because of stronger economic growth, a resulting fall in housing prices would not be a cause of concern for the economy as a whole. This report will be updated as events warrant.

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