Wednesday, December 24, 2008

The Housing Bubble

Russell Roberts recaps how government policies created the housing bubble and bust that have caused all the problems in the credit markets.

There are four factors that helped drive up the price of real estate in the United States and create the housing bubble: The GSEs (Fannie and Freddie), the Community Reinvestment Act, expansionary monetary policy starting in 2001, and the 1997 Taxpayer Relief Act that for the first time let people avoid capital gains on home price appreciation without having to rollover the gains into a bigger house.

All of these factors pushed up the demand for real estate. But by how
much? Over the last few weeks I have been focusing on the capital gains change
because the run-up in housing prices began in either 1997 or 1995 depending on
which data you use.

This New York Times article from today is the first one I've seen that focuses on
the role of the 1997 tax change in the mortgage mess:

By itself, the change in the tax law did not cause the housing
bubble, economists say. Several other factors — a relaxation of lending
standards, a failure by regulators to intervene, a sharp decline in interest
rates and a collective belief that house prices could never fall — probably
played larger roles.

But many economists say that the law had a noticeable impact, allowing
home sales to become tax-free windfalls. A recent study of the provision by an economist at the Federal Reserve suggests that the number of homes sold was almost 17 percent higher over the last decade than it would have been without the law.

Vernon L. Smith, a Nobel laureate and economics professor at George
Mason University, has said the tax law change was responsible for “fueling the mother of all housing bubbles.”

By favoring real estate, the tax code pushed many Americans to
begin thinking of their houses more as an investment than as a place to
live. It helped change the national conversation about housing. Not only did real estate look like a can’t-miss investment for much of the last decade, it was also a tax-free one.

The authors do a nice job looking at the politics and some of the
economics. But they miss one key point. They did not look at prices, and focused
instead on sales. But it is prices where the impact is going to start and it is
the increase in prices that made all of the other mistakes possible.

Follow the link to read the rest.

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