Did Credit Market Policies Cause the Housing Bubble?

Abstract

Between 2000 and 2006, the CaseShiller/Standard and Poor’s Housing Price Index increased by 74 percent in real terms, as America experienced a massive housing bubble. Moreover prices in some metropolitan areas grew even faster. Prices in Los Angeles, for example, rose by 130 percent during this period while prices in greater Tampa rose by 97 percent over this time. As the bubble burst, that index dropped by a third and major financial institutions became insolvent, at least partially because of housing-related losses. What caused this great boom-bust cycle that tore through America’s housing markets?

Many economists have argued that aspects of the credit market, including low interest rates, can explain the boom. According to this view, aggressive mortgage approvals and easy mortgage terms encouraged buyers to bid more for housing. During the boom, this logic led some to argue that home prices were appropriately higher. After the bust, this logic has led others to blame Alan Greenspan, former chairman of the Federal Reserve Board, and his successor Benjamin Bernanke for causing the bubble by spreading easy money.

There is certainly some circumstantial evidence indicating a role for credit markets in this boom. Mortgages became more widely available and cheaper along a number of important dimensions from around 2001 through the peak of the housing market. There was a flood of global credit, much of which came to the U.S. Many buyers who took advantage of subprime loans paid top dollar for housing and are now delinquent on their mortgages.

The evidence summarized in this Policy Brief casts doubt on the view that easy credit can explain the bubble. It isn’t that low interest rates don’t boost housing prices. They do. It isn’t that higher mortgage approval rates aren’t associated with rising home values. They are. But the impact of these variables, as predicted by economic theory and as estimated empirically over many years, is too small to explain much of the housing market event that we have just experienced.