NYT/Krugman: No Bubble Trouble?

Op-Ed Columnist
No Bubble Trouble?

By PAUL KRUGMAN
Published: January 2, 2006

In spite of record home prices, housing in most of America remains
surprisingly affordable, thanks to low interest rates. That fact may
seem to say that there's no housing bubble. But it doesn't. To see why,
we need to brush up on our economic geography and economic history.

Let's start with the good news. A report in last week's Times
summarized the results of a study by Moody's Economy.com, a research
company, comparing the cost of home ownership with family incomes.

The study found that for the nation as a whole, the cost of owning the
median home is still only 23.7 percent of median family income, which
is higher than a few years ago but well below the peak of more than 30
percent reached in the early 1980's.

Now for the economic geography. Last summer I suggested that when
discussing housing, we should think of America as two countries,
Flatland and the Zoned Zone.

In Flatland, there's plenty of room to build houses, so house prices
mainly reflect the cost of construction. As a result, Flatland is
pretty much immune to housing bubbles. And in Flatland, houses have, if
anything, become easier to afford since 2000 because of falling
interest rates.

In the Zoned Zone, by contrast, buildable lots are scarce, and house
prices mainly reflect the price of these lots rather than the cost of
construction. As a result, house prices in the Zoned Zone are much less
tied down by economic fundamentals than prices in Flatland.

By my rough estimate, slightly under 30 percent of Americans live in
the Zoned Zone, which comprises most of the Northeast Corridor, coastal
Florida, much of the West Coast and a few other locations. So
Economy.com's results on affordability aren't surprising: most families
live in Flatland, and haven't seen a big rise in the cost of home
ownership.

But because Zoned Zone homes are much more expensive than Flatland
homes, the Zone looms much larger in the housing story than its share
of the population might suggest. By my estimate, more than half of the
total market value of homes in the United States lies in the Zoned
Zone.

And because home prices have risen much more rapidly in the Zone than
in the rest of the country, the Zoned Zone accounts for the great bulk
of the surge in housing market value over the last five years.

So if we want to ask whether housing values make sense, data on the
median house nationwide are irrelevant. We need to focus on houses in
the Zoned Zone. And there the numbers are anything but reassuring.

In the Zoned Zone, the story that rising home prices have been offset
by falling interest rates is all wrong: prices have risen so much that
housing has become much less affordable. According to Economy.com, the
cost of owning a home in the New York metropolitan area went from 25
percent of median income in 2000 to 38 percent today. In Miami, the
numbers were 21 percent and 42 percent, respectively; in Los Angeles,
31 percent and 55 percent.

Even so, the current cost of owning a home in the Zoned Zone isn't
entirely unprecedented. Roughly similar percentages of median family
income were needed to afford houses in the early 1980's.

But that's hardly a comforting comparison, which is where the economic
history comes in. You see, the unaffordability of housing in the early
1980's led to an epic collapse in the housing industry. Housing starts
fell from more than 2 million in 1978 to only 1.06 million in 1982. And
the housing implosion was one of the main factors in the worst economic
slump since the Great Depression, which brought the unemployment rate
to a peak of 10.8 percent at the end of 1982.

It's also worth noting that the reason housing was so expensive in 1981
and 1982 was that mortgage interest rates were extremely high. That
made recovery easy, because all it took to make housing affordable
again was for interest rates to return to normal levels.

This time, with interest rates already low by historical standards,
restoring affordability will require a big fall in housing prices.

So here's the bottom line: yes, northern Virginia, there is a housing
bubble. (Northern Virginia, not Virginia as a whole. Only the
Washington suburbs are in the Zoned Zone.) Part of the rise in housing
values since 2000 was justified given the fall in interest rates, but
at this point the overall market value of housing has lost touch with
economic reality. And there's a nasty correction ahead.