Bram

Summary: Are Home Prices The Next Bubble?

Jonathan McCarthy and Richard W. Peach start their assessment of a potential housing bubble by
mapping out the negative effects it could have on the U.S. economy. This validates the necessity of the
paper, and furthermore leads to the complicated but crucial point of measurement of home prices. The
authors point out that real estate accounted for about 28 percent of household assets in 2003, which
was roughly $14.6 trillion or 130 percent of U.S. GDP. In the event of a housing bubble, residential
investment, wealth and credit market conditions could arguably be effected negatively by initial high
prices followed by sharp falls. Having said that, declining house prices up until 2004 had hardly
caused a devastating effect on the economy.
There are four principal price indexes McCarthy and Peach assess for determining the existence of a
housing bubble. Out of these four, they seem to favor the constant-quality new home price index for
their study because it reflects changes in quality over time as opposed to the other three indexes.
Cumulative increase of all four home price indexes from 1977 to 2003 indeed shows that the increase
in home prices moves in accordance with home quality improvement.
Evidence of a bubble is derived from high prices without justification from fundamental factors. For
this reason, the increase in the rate of U.S. national home prices should be adjusted for affordability
and the implicit rent received as a homeowner. Affordability is measured by constructing a ratio of the
median home price to the median household income, which had reached a higher level in 2003 than
the previous peak around 1980. Implicit rent can be either the rent a homeowner would have to pay for
his own home (or similar housing unit), or the rent he would receive for his home. This rent-to-price
ratio reached a historic low in 2003, meaning that a fall in home prices (the denominator) would
restore the ratio to normal heights.1
Although both measurements reinforce the evidence of a housing bubble, the authors criticize the
measurements for not incorporating interest rates and using the wrong home price index. They argue
that single-family homes should have still been affordable due to home prices increasing at a rate for
which declining mortgage rates and increasing median family income compensated. As for the rent-toprice ratio, the deceleration of expected future price appreciation was more or less in line with overall
inflation.
To compare home prices to economic activity, McCarthy and Peach created a structural model of the
housing sector reflecting the rate of gross addition given by the equilibrium price per unit of housing
established in the market of the existing stock. Although the model has shown a steady rise of
equilibrium prices since 1994, they are supported but strong underlying economic growth in the
1

Normal being the average ratio of Owners Equivalent Rent to OFHEO Index between
1984 and 2003, given in year-over-year percentage change.

1990s. Rising interest rates contributed to increasing equilibrium prices. But because of their positive
relationship with stronger employment and income growth, rising interest rates would probably hold
the ratio of increasing equilibrium price to economic strength fairly constant.
Last, the regional markets are analyzed to determine whether certain volatility in particular states can
be justified by regional economic growth. Evidence was found that states with higher appreciation of
home prices went hand in hand with relatively unresponsive supply to increasing demand due to
improved economic conditions (implying increase in income). This indicated inelastic supply of
houses.