Harvard and UPenn economists: Credit market policies didn't cause the housing bubble

Two Harvard economists and one University of Pennsylvania economist say most of what is popularly believed about the growth of the housing bubble isn't true:

Contrary to the assertions of many economists and others, the boom and bust in housing over the last decade was not primarily caused by low interest rates, reduced downpayment requirements, or laxer underwriting standards, conclude Edward Glaeser, Joshua Gottlieb, and Joseph Gyourko in “Did Credit Market Policies Cause the Housing Bubble?” a new Policy Brief...

“It isn’t that low interest rates don’t boost housing prices. They do,” write Glaeser, a professor of economics who directs the Rappaport Institute and the Taubman Center, and his colleagues, Joshua Gottlieb, a doctoral student in economics at Harvard; and Joseph Gyourko, a professor of real estate at the Wharton School.

“It isn’t that higher mortgage approval rates aren’t associated with rising home values. They are,” they add. “But the impact of these variables, as predicted by economic theory and as estimated empirically over many years, is too small to explain much of the housing market event that we have just experienced.” Specifically, the authors found that the 1.3 percentage point drop in real interest rates between 2000 and 2006 was responsible for only a 10 percent rise in prices, about a third of the average price increases nationally during that time...

Glaeser, Gottlieb and Gyourko did find that the price effect of interest rates was greatest in metropolitan areas such as Boston, San Francisco, New York, and Seattle that have less land, more regulation and/or topography that is not conducive to new buildings. However, that impact was not enough to explain the full magnitude of the housing bubble in those places. ...

The authors also found that contrary to the assertions of many analysts, including Benjamin Bernanke, chairman of the Board of Governors of the Federal Reserve System, reduced downpayment requirements did not greatly contribute to the housing bubble. Rather, they found that on average the share of the purchase price covered by a mortgage was basically unchanged over the course of the boom...

You might want to take what these economists say with a grain of salt. Edward Glaeser is associated with Harvard's Joint Center for Housing Studies, which routinely denied the existence of the housing bubble until it burst, although to be fair, his name never appeared on any of the annual studies that denied the bubble's existence. It does suggest, however, that Harvard economists are not the cracker-jack financial wizzes that they are supposed to be.

CNBC's Diana Olick has more on this study.

I have long believed that fundamental factors spark all bubbles, but then a get rich-quick-mentality takes over in the minds of buyers as they watch asset prices rise. As they buy up assets in a quest to chase the market, this increased demand pushes prices up even more, which then convinces more people that they can get rich quick by jumping in. Thus a feedback loop develops where the get-rich-quick mentality becomes a self-fulfilling prophecy, until something finally breaks the cycle. Then the cycle reverses itself.

I believe this is how all bubbles happen, not just housing bubbles. However, I have been attacked by many Bubble Meter readers for this belief that buyers largely have themselves to blame for the bubble. Despite the fact that bidding wars often broke out during the bubble, in which buyers frequently bid above the asking price of the house, it is far easier for people to lay all the blame on a small group of Wall Street bankers than spread the blame over a large swath of the American public.

If Glaeser et al's study is correct, it doesn't mean that credit market policies are blameless for the bubble. However, the major factor in the growth of the bubble, which they were unable to identify, could easily be the get-rich-quick feedback loop. This type of short-term irrationality is something that traditional economic theory does not recognize. Economic man, after all, is purely rational.