The truth about the US housing market

Again, it's the same story, with the highly regulated states experiencing wild boom/bust cycles whilst prices in the market-oriented states remained relatively stable.

Economics 101:

The economic forces underpinning the above findings are perhaps best explained through basic supply and demand analysis. Consider the below chart taken from an earlier articleon this issue.

Q0 and P0 represent the initial equilibrium situation in the housing market. Initial demand is provided by D0, whereas supply is shown as either SR (restricted) or SU (unrestricted), depending on whether land supply constraints exist.

Following an increase in demand, such as a significant relaxation of lending standards, the demand curve shifts outwards from D0 to D1. When land supply is restricted, house prices rise sharply from P0 to PR. By contrast, when supply is unrestricted, prices rise more gradually from P0 to PU.

The situation works the same way in reverse. For example, if there was a sharp fall in demand following a contraction in credit availability or a sharp rise in unemployment, causing demand to fall from D1 to D0, then prices fall much further when land supply is constrained.

The key point is that increases (declines) in demand can bring sharply rising (falling) house prices when supply is constrained. However, when land supply is not regulated, it adjusts to demand and house price volatility is reduced.

These observations are consistent with those of Glaeser and Gyourko, who summarised the findings of a number of studies in this area:

Recent research also indicates that house prices are more volatile, not just higher, in tightly regulated markets.

…price bubbles are more likely to form in tightly regulated places, because the inelastic supply conditions that are created in part from strict local land-use regulation are an important factor in supporting ever larger price increases whenever demand is increasing.

...it is more difficult for house prices to become too disconnected from their fundamental production costs in lightly regulated markets because significant new supply quickly dampens prices, thereby busting any illusions market participants might have about the potential for ever larger price increases.

As long as commentators focus primarily on the demand-side of the housing market, whilst ignoring supply-side constraints, they will never fully understand the drivers of housing bubbles and busts. The resulting incorrect diagnosis will inevitably lead to poor policy prescriptions and outcomes.

By all means, let's crack down on the destructive speculation, predatory financing and financial alchemy that has fuelled the world's housing bubbles. At the same time, let's not ignore the supply-side barriers that have enabled the credit-fuelled demand to feed into skyrocketing house prices which, in the case of the United States, later collapsed once the artificial demand evaporated.

Readers seeking detailed information on issues pertaining to the supply-side of the housing market are encouraged to visit the Demographia and Performance Urban Planning websites. Also, please be advised that the 7th Annual Demograhia International Housing Affordability Survey will be released on 24 January 2011. It's sure to be another great read.