Housing Boom and Bust More About Productivity than Bubbles

Many economists, myself included, refer to the recent boom and bust in house prices as a bubble, whose foundation lay in a combination of credit market excesses and human imperfections. Fundamentals certainly played a role as well, but bubble forces were particularly important.

In a short paper recently published by the New York Federal Reserve (.pdf), Jim Kahn makes a very different argument: that the boom and bust in house prices can largely be explained by a boom and bust in productivity growth:

The housing boom and bust of the last decade, often attributed to “bubbles” and credit market irregularities, may owe much to shifts in economic fundamentals. A resurgence in productivity that began in the mid-1990s contributed to a sense of optimism about future income that likely encouraged many consumers to pay high prices for housing. The optimism continued until 2007, when accumulating evidence of a slowdown in productivity helped dash expectations of further income growth and stifle the boom in residential real estate.

Jim’s argument depends on several related lines of reasoning:

• First, he notes that productivity drives long-term income growth and that incomes determine how much families can pay for homes. He then argues that the demand and supply for housing are inelastic and, as a result, rising incomes imply rising house prices. Putting these pieces together, he concludes that faster productivity growth implies faster house price appreciation.

• Second, he notes that productivity growth accelerated in the mid-to-late 1990s and then slowed around 2004. The productivity acceleration thus began shortly before house prices took off, and the productivity slowdown began shortly before house prices began to collapse.

Jim’s chart shows his estimate of whether the United States is in a high-productivity-growth regime over time. That probability was essentially zero in the early 1990s but jumped to 100% by the late 1990s. It then fell close to zero again in the mid-2000s.

• Third, Jim argues that it takes time for people to recognize that a productivity shift has occurred. Although the recent productivity slowdown began, according to his estimates, in 2004, observers wouldn’t recognize that for some time. His model suggests, in fact, that observers wouldn’t have been able to figure out that productivity had slowed until the release of revised data in the summer of 2007. Forecasts before then (see the blue line labeled June 2007) would likely have continued to presume solid productivity growth. But subsequent forecasts (the orange line labeled August 2007) would have assumed lower productivity growth.

In his view, that recognition lag explains why house prices continued to grow rapidly for a few years after the productivity slow down began. In short, where many observers see bubble-like thinking, he sees a time lag in understanding the state of the economy.

P.S. Jim’s paper also provides some interesting projections of productivity growth. The following graph, for example, shows the difference between projections that assume the U.S. is in a high-productivity-growth regime (blue line from June 2007) and projections that assume we are in a low-productivity-growth regime (orange and green):

Comments

[ron_paulite:]

"he notes that productivity drives long-term income growth and that incomes determine how much families can pay for homes."

nice try. there was little or no income growth since 2000 and yet property prices keep going up. in fact, the 2000 to 2007 are the years property prices went up like crazy.

sure productivity growth plays a part in bubble building ... that's common sense. but low interest rates play an even more important role.

Jul 13 03:16 PM

[Crocodilian:]

Its a good argument, and probably applies most to the most desirable areas, with proximity to the high value added occupations.

We've seen pretty much that scenario: Manhattan and Atherton haven't fallen much, Stockton and Tampa have. Places that seem likely to continue to attract the most valuable professionals will do better than those which don't.

Its important to include demographics into the equation: the nation is aging, and household formation is falling. The median age in the US is now 39 -- which means that "the median American" has already had, or will soon have, their last child . . . a major drag on demand for housing.

Jul 13 04:06 PM

[sunbakd1:]

There will be little productivity and Jobs growth. Most of these jobs that have been lost (6mil) will NOT be replaced with similar jobs. Not to mention, US companies is continuing to outsource cheaper labor in emerging markets countries.

America has lost it's competitive edge in almost every sector and will continue to slide as a world power, unless our Green initiatives (wind, solar, natural gas, clean coal), technology advancements and biosciences take off. America needs to return to innovation. give me a thumbs down, but you know it is truth.

Jul 13 04:28 PM

[Moon Kil Woong:]

Low productivity and a lot of base money tends to equal monetary disconnect, more money than goods and services, and rising interest rates even if goods and services don't increase meaning stagflation.

We should listen to Donald Marron's very good insight. If productivity remanins in the gutter pumping money into a broken pipe will only cause a mess somewhere we don't want it to.

Jul 13 05:45 PM

[Socialism c...:]

Kahn is onto something, but he is seeing a tree, instead of the forest. What has happened is that during that mid-90s "productivity boom" we had a "tool" that radically changed the orders of efficiency for transactions: the internet. So Kahn is somewhat correct in seeing this productivity boom/bust cycle as coincident with the creation of the housing bubble, however, it was merely incidental as a force that allowed the debt bubble and its effects to be pushed off a bit further into the future. Had we acted appropriately we could have used that growth cycle to somewhat pare down the problem, but we didn't. Nor, if we had, would it have eliminated the problem, since it is due to two seemingly unchangeable core factors: 1) population demographics, and 2) ever-larger behemoth entitlement government without a cap on spending to fund said entitlements.

Jul 13 06:27 PM

[derryl:]

I would question whether there existed any real productivity growth in the periods mentioned. Output is measured as GDP and the bubbling periods saw massive 'productivity gains' in the financial sector which accounted for up to 40% of GDP, without producing a single real economic good. In the go-go days a single banker could probably generate a billion dollars annually of GDP by creating and selling CDS. How productive!

Offshoring also reduces costs for firms while maintaining domestic output levels so it looks like you're making more with less when in fact you're just making the same but paying less labor for it. High domestic labor costs encourage companies to replace labor with machines so you get some real productivity growth here, but I don't think this was an overweight trend of the period in question. A lot of jobs that weren't offshored were replaced with computerization which also increases productivity. It's hard to see how a real estate bubble can form with so many American workers being replaced with machines or foreigners, unless an easy credit policy lowers lending standards.

Now that former BIS chief economist Michael White's repeated and urgent warnings about the bubbles to Greenspan and the world's other central bankers is coming to light, the New York Fed is trying to obfuscate the cause of the bubbles. Bubbles happen when excessive credit expansion drives up asset prices. Ignoring White's advice, Greenspan et al kept their eyes focused on CPI inflation and saw "all is well". In fact a classic credit-asset bubble was inflating under their noses.

I don't give this productivity theory of bubbles any credence at all. It looks like a snow job to me.

Jul 14 02:02 AM

[cynewulf:]

HAVE YOU EVER WATCHED A GOOD MAN USE A GOOD NAILGUN? A worker in an old folks home still take the same time to change a diaper as before and nails are more frequently used in houses then diapers. Case closed.

Jul 14 09:04 AM

[xmplary:]

Work harder till you realize that you have built up enough equity to retire... when the prices fall and go underwater, have to work like a slave to avert foreclosure and bankruptsy... all tools of Capitalism to motivate the workers. Unfortunately, its the work like a slave phase now.

Jul 14 11:09 AM

[Optimisto:]

median income did not grow...aggregate income grew. There were more people who had enough income to purchase a home, even if they were lower earners. Consistant with median income stagnation but housing market expansion.


On Jul 13 03:16 PM ron_paulite wrote:

> "he notes that productivity drives long-term income growth and that
> incomes determine how much families can pay for homes."
>
> nice try. there was little or no income growth since 2000 and yet
> property prices keep going up. in fact, the 2000 to 2007 are the
> years property prices went up like crazy.
>
> sure productivity growth plays a part in bubble building ... that's
> common sense. but low interest rates play an even more important
> role.

Jul 14 12:06 PM

[ron_paulite:]

don't quite understand your point.
if median income (meaning the income at the middle of the distribution) did not grow, how can the lower income earners have more income?

i can understand the lower income earners could afford to purchase a home because of low interest rates or/and lax lending standards, but i can't understand why they could have enough income to purchase a home when the median income did not grow.

could it be the aggregate income grew because the top earners, e.g., bank executives, lawyers, were earning more. the medium income did not grow because the lower income earners did not earn more?


On Jul 14 12:06 PM Optimisto wrote:

> median income did not grow...aggregate income grew. There were more
> people who had enough income to purchase a home, even if they were
> lower earners. Consistant with median income stagnation but housing
> market expansion.

Jul 14 10:36 PM