Crises in the Housing Market:

Causes, Consequences, and Policy Lessons

April 17, 2019

Project Summary

As the largest source of wealth for most people, housing has always played an outsized role in economic life. To help better understand housing crises, this research from Carlos Garriga and Aaron Hedlund reviews the latest research regarding the causes, consequences, and policy implications of housing crises. Fundamentals like household income and construction costs explain much of the dynamics of house prices over longer time horizons. Evolving mortgage credit conditions, driven by both economic and policy changes, also play a major role during boom-bust episodes.

The Long-Run Role of Fundamentals

  • The long-run path of house prices is driven mostly by income, demographics (including migration), productivity, and construction costs.
  • House prices and rents tend to move in concert over the long run, whereas boom-bust episodes often feature large swings in the price-to-rent ratio.

Mortgage Credit, Boom-Bust Episodes, and their Broader Economic Consequences

  • Over the past 30 years lower interest rates, the shift from a credit rationing model of lending to risk-based pricing, looser borrowing limits, and the availability of new “exotic” mortgages have contributed to increases in mortgage credit.
  • Contrary to conventional wisdom, the credit expansion was not confined to the subprime market as prime borrowers accounted for a significant fraction of mortgage defaults during the 2006 – 2011 housing bust.
  • Housing has a significant impact on the broader economy. Larger county-level house price declines during the most recent crisis contributed to steeper drops in employment and consumer spending.

Lessons from Emergency Policy Interventions

  • Interventions that front-load cash-flow relief through payment reductions are more effective at boosting house prices and consumption than are policies which only increase wealth (e.g. by reducing outstanding principal) without alleviating strain on monthly household budgets.
  • Attempts to either forcibly delay banks from instituting the foreclosure process on delinquent borrowers (e.g., judicial requirements) or to soften the consequences of default (e.g., abolishing deficiency judgments) often do more harm than good by inducing a contraction in the supply of credit and lengthening unemployment spells.
  • Policies that stimulate home purchases create long-lasting increases in sales, house prices, and, in light of abundant evidence on spillovers, higher consumer spending as well.
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