Economists predicting housing market crash: Optimists vs Pessimists vs Agnosts

This is a must read paper from Boston Fed economists. If there is one paper you have to pick to understand US housing market crash. This is it. It summarises the debate which economists had before the crisis. Some economists said there is a bubble, some said there isn’t and others just presented facts without taking a view.

Kristopher S. Gerardi, Christopher Foote, and Paul Willen say:

Understanding the evolution of real-time beliefs about house price appreciation is central to understanding the U.S. housing crisis. At the peak of the recent housing cycle, both borrowers and lenders appealed to optimistic house price forecasts to justify undertaking increasingly risky loans. Many observers have argued that these rosy forecasts ignored basic theoretical and empirical evidence that pointed to a massive overvaluation of housing and thus to an inevitable and severe price decline. We revisit the boom years and show that the economics profession provided little such countervailing evidence at the time.

Many economists, skeptical that a bubble existed, attempted to justify the historic run-up in housing prices based on housing fundamentals.

Other economists were more uncertain, pointing to some evidence of bubble-like behavior in certain regional housing markets. Even these more skeptical economists, however, refused to take a conclusive position on whether a bubble existed.

The small number of economists who argued forcefully for a bubble often did so years before the housing market peak, and thus lost a fair amount of credibility, or they make arguments fundamentally at odds with the data even ex post. For example, some economists suggested that cities where new construction was limited by zoning regulations or geography were particularly “bubble-prone,” yet the data shows that the cities with the biggest gyrations in house prices were often those at the epicenter of the new construction boom.

We conclude by arguing that economic theory provides little guidance as to what should be the “correct” level of asset prices —including housing prices. Thus, while optimistic forecasts held by many market participants in 2005 turned out to be inaccurate, they were not ex ante unreasonable.

So, in one paper you get all the broad ideas that existed on housing market before the crash.

I wanted to cover this paper in detail but am unable to because of lack of time.

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