Evans On The Economy -- Ignore The Bubble Babble

Oct. 18, 2005
Despite what the alarmists contend, U.S. housing prices will continue to rise in 2006 and 2007.

U.S. housing prices, on average will rise 2% to 3% next year, the same as the rate of inflation. In 2007, they will rise 4% to 5%. These projections are obviously well below the average rise in housing prices of the past four years. But they don't constitute the bubble-bursting scenario being put forth by many alarmists.

Some people would argue that while national average prices won't decline, there will have to be some sharp corrections in the areas of the country where prices have doubled over the past four years. Maybe that's true in Las Vegas. But looking at prices in the other areas that have posted 100% increases -- Boston; New York; Washington, D.C.; South Florida; Los Angeles and San Francisco -- we find basically the same phenomenon. High housing prices have caused many people to move to the outer fringes of these areas, with commutes of an hour and a half to two hours each way no longer uncommon. Suppose that housing prices in closer-in areas did start to decline, either because would-be buyers decided they couldn't afford the asking prices, or existing homeowners started defaulting on their funny-money mortgages. There is an enormous reserve of buyers just waiting to snap up these properties and reduce those tortuous commutes. As a result, prices will decline hardly at all even in these currently "overpriced" areas.

Economists like graphs. And a graph of the ratio of the average monthly housing payment -- crudely defined as the purchase price times the mortgage rate -- relative to per capita disposable income is likely to surprise many. As it turns out, the current ratio -- in spite of the so-called housing "bubble" -- is near all-time lows. Indeed, a good part of the reason housing prices have risen so rapidly is because income has risen rapidly at the same time that mortgage rates have declined. In the past, rapid growth in the economy was always accompanied by higher interest rates; lower rates occurred only during times of economic slack or outright recession.

The one thing that could cause the U.S. housing boom to end, and prices to decline, is sharply higher interest rates. However, that won't happen for at least the next two years. In spite of record oil prices, core inflation remains well under control, and will average 2% to 2.5% during the next two years. The steady drumbeat of increases in the federal funds target rate since June 2004 has actually been accompanied by lower bond rates and lower mortgage rates. Meanwhile, incomes continue to grow at above-average rates, and the overall demand for housing remains strong. The rate of homeownership is at record highs, and foreign demand for housing as an investment remains strong -- factors that have also contributed to the double-digit increases in housing prices in recent years.

Economists, like generals, are very good at fighting the last war. Because we had a tremendous Internet bubble that was followed by almost an 80% decline in the NASDAQ average, some would-be analysts figure the same sort of thing "must" happen to the housing market. In fact the two have very little in common. Stock prices were ridiculously overvalued; even the staid S&P 500 sold at a price/earnings ratio of 36 at its peak, double the normal level for low inflation. On the other hand, housing prices, relative to income and interest rates, are not particularly overvalued. While they will slow down, an actual decline in price -- except perhaps in gambling capitals -- is simply not in the cards.

Michael K. Evans is chief economist for American Economics Group, Washington, D.C., and president of the Evans Group, an economics consulting firm in Boca Raton, Fla.

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