The Federal Reserve Bank of New York today released Productivity Swings and Housing Prices, the latest article in its series Current Issues in Economics and Finance.
Challenging the notion that bubbles and lax lending standards can fully explain the recent housing crisis, author James A. Kahn argues that economic fundamentals—specifically, swings in labor productivity—played a significant role in the boom and bust of residential investment.
These swings, the author explains, helped determine the price of housing through their effects on income growth and long-term income expectations. When productivity growth accelerates, consumers begin to see stronger income growth and to become more optimistic about future income—conditions that strengthen the demand for housing. This increased demand in turn drives up the price of land and hence the price of houses. The optimism of home buyers, moreover, is likely to extend to lenders, who will regard mortgages as “less risky insofar as income and house prices [are] growing more rapidly than before.”
To explore the relationship of productivity and the price of housing, Kahn uses a model that quantifies the impact of changes in productivity trends on house price movements over the 1963-2008 period. Significantly, the model is able to explain much of the timing and magnitude of the price movements in the sample period. It is particularly successful in capturing the surge in prices that occurred in the 1990s and the sharp downturn that followed in 2007.
An important component of Kahn’s model is the use of “real-time” assessments of productivity trends—that is, assessments based on the information available at the time. With the help of vintage data sets, the author is able to identify shifts in productivity growth as they were discerned by housing market participants at different points over the sample period. This approach suggests that housing market participants had reason to remain optimistic about productivity advances and their own income prospects as late as mid-2007—a fact that helps explain the continuing high expenditures on housing. With the release of revised data in 2007, however, it became increasingly clear that productivity growth was slowing, and market participants responded by curtailing their spending.
While not ruling out a role for bubbles and credit market irregularities in the housing boom and bust, Kahn nevertheless concludes that “an exclusive focus on these factors obscures the arguably equally important influence of productivity swings.”
James A. Kahn is the Henry and Bertha Kressel Professor of Economics at Yeshiva University; he was a vice president in the Macroeconomic and Monetary Studies Function of the Bank when this article was written.