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Bubbles & the Housing Casino

by Edward L. Glaeser, Professor of Economics, Harvard University

Between 2001 and 2006, America experienced a housing market tsunami.  According to the Case-Shiller Index, housing prices soared by 64 percent during the five years before May 2006, and fell by 32 percent over the three years since then.  The housing bust did enormous damage to the financial system, but the boom was also no blessing either.  The vast increase in housing prices made housing in places like Boston increasingly unaffordable to ordinary Americans.  Our nation, and our state, would surely be better off with less housing price volatility.

The great boom-bust cycle did not hit all of America equally.  Some places, like Dallas and Charlotte, North Carolina, had modest price growth during the boom and price declines of less than 10 percent since the peak.  Their price stability reflects the power of flexible housing supply to limit extreme swings in price.

Joseph Gyourko, Albert Saiz and I have examined the relationship between housing bubbles and limitations on growth. We use data on both regulations and natural barriers to building, such as hilliness, to classify metropolitan areas as places where builders face few limits, like Houston, and regions where builders are extremely restricted, like Boston.  There is a strong link between housing bubbles and restrictions on development.

During the boom-bust cycle of the 1980s and early 1990s, the 26 most restricted areas in our sample had real price increases of almost 30 percent.  The 28 least restricted areas saw real price increases of less than four percent.  During the boom that lasted from 1996 to 2006, real prices soared by an average of 94 percent in the most restricted places.  Price growth in the least restricted places averaged less than 30 percent.

The economics explanation for these facts is simple.  If building is relatively unrestricted, then rising demand for housing leads to more construction which in turn sates demand and limits price growth.  In places, like Boston, where construction is restricted, an upsurge in demand translates directly into higher prices.  Massachusetts’ bevy of land use restrictions limits the supply that could limit the booms in prices.

Of course, abundant supply is not a perfect vaccine against housing bubbles.  Both Phoenix and Las Vegas experienced extraordinarily painful price swings, despite their essentially unlimited ability to build homes.  During the boom, buyers just forgot that these places have vast amounts of land and few regulatory limits on development.  Yet the experience of these two cities was typical neither of places with flexible supply during the recent boom nor their own longer histories.  During previous housing booms, Phoenix and Las Vegas had always avoided extreme price swings.

The connection between price volatility and housing supply provides yet another reason to rethink Massachusetts’ rules restricting new development.  Those rules make our state unnecessarily expensive, and they also make the Massachusetts housing market more of a casino than it needs to be.  Eliminating unnecessary rules that restrict new development would make the Bay State more affordable and less volatile.     

(Edward L. Glaeser, a professor of economics at Harvard University, is director of the Rappaport Institute for Greater Boston).