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Study puts new spin on the housing bubble

Researchers say low interest rates, easy credit not to blame; but no solution is offered

By Robert Gavin
Globe Staff / May 5, 2010

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Low interest rates and easy credit were not the primary causes of the recent housing bubble, which ultimately burst and led the nation into a deep recession, according to a study to be released today at a conference at the Federal Reserve Bank of Boston.

The study, by researchers from Harvard University and the University of Pennsylvania, analyzed home prices, interest rates, and credit conditions during the housing bubble of the last decade and found that low rates and lax lending standards could only explain a relatively small part of the rapid rise in housing prices.

Based on historical data, the study estimated that the inflation-adjusted decline in interest rates between 2000 and 2006 should have increased home prices by about 10 percent. Instead, national home prices soared by about 70 percent.

“We’re not saying that interest rates didn’t matter. We’re not exculpating the Fed,’’ said Edward L. Glaeser, the Fred and Eleanor Glimp professor of economics at Harvard. “But if you’re trying to explain the incredible housing market, you just can’t explain what America had to live through with interest rates alone.’’

Many analysts have argued that low interest rates and lax lending standards greatly expanded the universe of home buyers, leading to strong demand that drove prices to unsustainable levels.

The chief culprit in this dynamic: the Federal Reserve, which cut interest rates to historic lows and held them at that level.

The Fed held its key interest rate at what was then a historically low 1 percent from 2003 to 2004. At the time, policy makers were trying to revive an economy struggling in the aftermath of the 2001 terrorist attacks, a recession, and the launching of the Iraq war.

The study cast doubt on this widely held view that low interest rates are mainly to blame. Boston Fed president Eric Rosengren has also argued against the idea that Fed interest rate policies caused the bubble. In a speech in March, Rosengren said the chief drivers were the expectations of buyers, lenders, and investors that home prices would only continue to rise.

“Lower interest rates lead to higher prices,’’ he said, “but they do not necessarily lead people to expect continued increases in asset prices — that key characteristic of a bubble.’’

In addition to low interest rates, another common explanation of the housing bubble is easy credit. Home buyers could get mortgages with little or no money down. But the study shows that credit conditions did not change appreciably between the beginning and end of the bubble, and certainly not enough to explain the surge in prices.

In 1998, the median down payment was 16 percent of the home’s value, according to the study. In 2006, it was 12 percent.

“What we are groping toward is trying to understand the mechanics of bubbles,’’ Glaeser said. “But what we don’t understand is what in the world led people to believe that we were heading toward a constantly higher plateau.’’

The study by Glaeser and his coauthors — Joshua Gottlieb, a doctoral fellow at Harvard’s Taubman Center for State and Local Government, and Joseph Gyourko, a professor at the University of Pennsylvania’s Wharton School — doesn’t make conclusions on the major cause of the housing bubble. Instead, Glaeser said, it aims to show that there are no easy answers to what went wrong and refute “the easy but comforting notion that we understand what happened.’’

Robert Gavin can be reached at rgavin@globe.com.