Asset Bubbles and Supply Failures

October 10, 2012

As the stock market recovers after the bubble burst, many wonder why the housing market has not experienced a similar recovery. The housing market is plagued with unsold inventories, rising rates of foreclosure and an ailing construction industry, say Bruce K. Gouldey, associate professor of finance, and Clifford F. Thies, Eldon R. Lindsey Chair of Free Enterprise and professor of economics and finance at the Harry F. Byrd, Jr. School of Business, Shenandoah University.

To understand appropriate measures to revitalize the housing industry, it is necessary to take a look at the causes of the bubble burst and its aftermath.

  • Housing prices fell 31 percent from their peak in the first quarter of 2006 to the first quarter of 2009 with no signs of improvement.
  • Asset bubbles were created as a result of increasing the flow of credit into the housing market.
  • But as all house prices fell as a result of unanticipated economic factors, the housing bubble burst.
  • Since then, 800,000 fewer households have been created annually.

Housing prices have a difficult time falling to new equilibrium prices primarily because of high loan-to-value mortgages and costly foreclosures. As a result, homeowners have a difficult time completing the sale of their house at market values. But policies that aim at maintaining house prices by keeping demand up fail to fix the supply problem.

Government attempts, such as tax credits for purchasing houses, have acted as impediments for the housing market in finding a new long-term equilibrium. Furthermore, homeowners have a difficult time selling their houses because they are drowning in mortgage loans or the houses for sale are below market prices.

The poor condition of the housing market acts as a deadweight on the economy. Rather than artificially create demand, the government should reduce foreclosure costs to lenders and borrowers would help alleviate supply side problems, which would benefit the housing market as a whole.

Source: Bruce K. Gouldey and Clifford F. Thies, "Asset Bubbles and Supply Failures: Where Are the Qualified Sellers," Cato Journal, Fall 2012.

 

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