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Thursday, July 29, 2004

Bubble or No, Expect House Price Declines

I'm working on a post about the housing bubble. For now, an interesting article in the NY Times, Eduardo Porter's "The Perils of Predicting Financial Bubbles," provides a good round-up of current thinking. Porter reports that Yale behavioral finance economist, and probable future Nobel Prize winner, Robert Shiller thinks we're experiencing a real estate bubble [very big pdf]. So does Dean Baker of the liberal Center for Economic Policy Research. I thought the most interesting take was Kevin Hassett's:
Mr. Hassett of the conservative American Enterprise Institute thinks housing prices will be pretty much O.K. He acknowledges there might be some bubble dynamics at play in some regions. But he argues that for the most part people are paying more for homes because their incomes are higher and interest rates are lower, reducing the cost to own a home.

Mr. Hassett expects that rising interest rates would raise this cost and home prices would then decline proportionately. But he sees no reason to expect a catastrophic decline. "I don't think a catastrophe is very likely," he says.

There are two interesting points here. First, Hassett's position is a lot like Brad DeLong's. There's may be some local bubbles, and house prices are likely to decline, but we won't see a macroeconomic disaster, like, say, Japan's decade long near-depression.

It's nice to hear that we're not facing catastrophe, but prospective homebuyers should still beware. As interest rates go up, prices are likely to decline substantially. My prediction (which I'll justify in a future post) is that when interest rates rise to more normal levels, we'll see a decline in house prices of 30% or so in real terms (adjusting for inflation).

The other interesting point is Hassett's track record as a forecaster. As the article points out, the sanguine Dr. Hassett was the guy who predicted in 1999 that the Dow would be hitting 36,000 right about now.


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