Released October 30, 2009

RALEIGH, N.C. -- There is agreement among economists and non-economists alike that the recession began in the housing market. We had an enormous run-up in housing prices, housing construction and home buying during the early and middle part of this decade. The collapse of this bulging housing market - beginning in 2006 - is widely cited as the event that pushed the economy into a recession a year later.

What set up the housing market for its fall?

What motivated builders to build, lenders to lend and buyers to buy so many homes? The conventional answer - heard in many quarters - is greed, incompetence and a focus on short-run gains at the expense of long-run losses. The explanation given is that home buyers snapped up cheap mortgages offered by lenders who were out to make a quick buck, and builders simply tried to keep up with the demand by constructing more homes.

Economists have two problems with this explanation. First, why would greed - which, we argue, is very difficult to measure - suddenly show up this decade and in the housing market? Our training tells us that the motivating factor for businesses - profit - always exists, and we assume any business wants to make as much profit as quickly as it can. Likewise, buyers will make decisions that they believe will lead to greater happiness for them.

Instead, for the housing market to become the Incredible Hulk of the decade there had to first be a spark to start the transformation, and then the fuel to complete it. The spark came in 1997 when the income tax code was changed for home sellers. Before, for the home seller to escape tax on any profit made from the sale, the seller had to purchase a home of equal or comparable value within 18 months.

In 1997 the requirement for buying another home was removed. Now, when a person sold his home, all profits automatically were kept tax-free. There were some upper limits on the gains, but they were beyond the reach of most sellers.

People began looking at homes much more as a tax shelter. Almost immediately, home sales began to rise, as did home prices. But for the spark to really catch, fuel had to be added in the form of cheap money and plenty of it.

And after the modest recession of 2001, that fuel came courtesy of two sources - the Federal Reserve and foreign investors. Standard operating procedure during a recession is for the Federal Reserve (aka the Fed) to lower interest rates and pump money into the economy. Beginning in 2001, the Fed did this.

But there was a difference. Although the production side of the economy began recovering in 2002, jobs didn't start to come back until mid-2003. So the Fed kept its foot on the money accelerator well into 2004. This provided ample cash and credit - fuel - for the now booming housing market, and the increased home buying and price appreciation that resulted kept renewing the spark.

Another source of money for the housing machine was from foreign investors. Globalization has enriched many foreign countries, and in some of these countries - China is an example - saving rates are extremely high. So such countries generated huge pools of new funds, and since housing in the U.S. appeared to be such a good investment, many of these funds made their way to the U.S. in the form of mortgage investments. This action made the housing spiral go higher and higher. The average home in the country was now appreciating at double digit rates annually.

So what ultimately pulled the housing spiral down? In a word - concern - concern at the Fed that the housing market had reached levels that weren't sustainable. Ultimately, the Fed pulled the plug on the housing market by increasing interest rates and limiting credit availability. The Fed thought there would be an orderly retreat in the housing market, with housing appreciation rates settling down to normal levels of between 2 and 3 percent. Instead, optimism in the housing market quickly turned to pessimism, and the retreat became a rout.

What are the lessons? First, things always look different with the benefit of hindsight. Many mortgages that look bad now looked good at a time when credit was cheap and plentiful and home values were skyrocketing. Second, motivations are important, but there has to be support - fuel - for continuing trends. Which leads to the question - are we putting these lessons to good use today? You decide!

Related audio files are at http://www.ncsu.edu/waldenradio/

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http://www.ncsu.edu/project/calscommblogs/news/archives/2009/10/you_decide_what_13.html

Source: Mike Walden, 919.515.4671 or michael_walden@ncsu.edu