Housing Bubbles are Contagious

by: Ryan Avent

Mike at Rortybomb is seeking to understand an interesting phenomenon -- the extremely un-bubbly nature of Texas housing markets. He posts a chart comparing price behavior in Dallas with that in Phoenix, using data from the Case-Shiller home price index. The difference is remarkable; Phoenix's series, like the nation's as a whole, is a mountain while Dallas' is a plain. How to explain the divergence? Mike writes:

I've thought about this a lot, and have come to a simple three word conclusion: "No prepayment penalties." Right there in their state law:

§ 343.205. PREPAYMENT PENALTIES PROHIBITED. A lender may not make a high-cost home loan containing a provision for a prepayment penalty.

I think that state laws concerning mortgage structure and borrower rights can have a big effect on the fallout from a bubble collapse, but can they explain the emergence of the bubble in the first place? Well, consider this -- the Case-Shiller price series for Charlotte, Atlanta, and Denver are practically identical to Dallas', while North Carolina, Georgia, and Colorado have very different mortgage rules, some of which allow prepayment penalties. What links these markets is an extremely elastic housing supply. It's very easy to build in these metropolitan areas, such that small price increases translate directly to large growth in supply, which serves to keep prices level. Or as Paul Krugman put it a few years ago:

When it comes to housing, however, the United States is really two countries, Flatland and the Zoned Zone.

In Flatland, which occupies the middle of the country, it's easy to build houses. When the demand for houses rises, Flatland metropolitan areas, which don't really have traditional downtowns, just sprawl some more. As a result, housing prices are basically determined by the cost of construction. In Flatland, a housing bubble can't even get started.

But in the Zoned Zone, which lies along the coasts, a combination of high population density and land-use restrictions - hence "zoned" - makes it hard to build new houses. So when people become willing to spend more on houses, say because of a fall in mortgage rates, some houses get built, but the prices of existing houses also go up. And if people think that prices will continue to rise, they become willing to spend even more, driving prices still higher, and so on. In other words, the Zoned Zone is prone to housing bubbles.

This view reflects the extensive work of Harvard's Ed Glaeser, who has documented the connection between restrictions on housing supply (regulatory and NIMBY-oriented) and housing costs. A recent example is this paper (PDF) in which Glaeser and co-authors write:

If we are going to understand boom-bust housing cycles, we must incorporate housing supply. In this paper, we present a simple model of housing bubbles which predicts that places with more elastic housing supply have fewer and shorter bubbles, with smaller price increases.

Though interestingly, they find that the welfare costs of bubbles may be more severe in elastic markets, where exuberance translates into excess inventory rather than price increases. There's a problem lurking in this argument, however, which some of you may have already noticed -- Phoenix built like Dallas. Given the rapid rate at which Phoenix and Las Vegas added new homes, price bubbles should have been impossible to inflate. But new research (PDF) from Rangan Gupta and Stephen Miller may offer an explanation -- Vegas and Phoenix caught the bubble from Southern California. In effect, there was one large local housing market that stretched from Santa Monica to Mesa. The bubble wasn't just unhealthy, it was also contagious.

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