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How Urban Planners Caused the Housing Bubble, Cato Policy Analysis No. 646

How Urban Planners Caused the Housing Bubble, Cato Policy Analysis No. 646

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Published by Cato Institute
Everyone agrees that the recent financial crisis
started with the deflation of the housing bubble.
But what caused the bubble? Answering this
question is important both for identifying the
best short-term policies and for fixing the credit
crisis, as well as for developing long-term policies
aimed at preventing another crisis in the future.

Some people blame the Federal Reserve for
keeping interest rates low; some blame the
Community Reinvestment Act for encouraging
lenders to offer loans to marginal homebuyers;
others blame Wall Street for failing to properly
assess the risks of subprime mortgages. But all of
these explanations apply equally nationwide, while
a close look reveals that only some communities
suffered from housing bubbles.

Between 2000 and the bubble's peak, inflation-
adjusted housing prices in California and
Florida more than doubled, and since the peak
they have fallen by 20 to 30 percent. In contrast,
housing prices in Georgia and Texas grew by
only about 20 to 25 percent, and they haven't significantly
declined.

In other words, California and Florida housing
bubbled, but Georgia and Texas housing did
not. This is hardly because people don't want to
live in Georgia and Texas: since 2000, Atlanta,
Dallas–Ft. Worth, and Houston have been the
nation's fastest-growing urban areas, each growing
by more than 120,000 people per year.

This suggests that local factors, not national
policies, were a necessary condition for the housing
bubbles where they took place. The most
important factor that distinguishes states like
California and Florida from states like Georgia
and Texas is the amount of regulation imposed on
landowners and developers, and in particular a
regulatory system known as growth management.

In short, restrictive growth management was
a necessary condition for the housing bubble.
States that use some form of growth management
should repeal laws that mandate or allow
such planning, and other states and urban areas
should avoid passing such laws or implementing
such plans; otherwise, the next housing bubble
could be even more devastating than this one.
Everyone agrees that the recent financial crisis
started with the deflation of the housing bubble.
But what caused the bubble? Answering this
question is important both for identifying the
best short-term policies and for fixing the credit
crisis, as well as for developing long-term policies
aimed at preventing another crisis in the future.

Some people blame the Federal Reserve for
keeping interest rates low; some blame the
Community Reinvestment Act for encouraging
lenders to offer loans to marginal homebuyers;
others blame Wall Street for failing to properly
assess the risks of subprime mortgages. But all of
these explanations apply equally nationwide, while
a close look reveals that only some communities
suffered from housing bubbles.

Between 2000 and the bubble's peak, inflation-
adjusted housing prices in California and
Florida more than doubled, and since the peak
they have fallen by 20 to 30 percent. In contrast,
housing prices in Georgia and Texas grew by
only about 20 to 25 percent, and they haven't significantly
declined.

In other words, California and Florida housing
bubbled, but Georgia and Texas housing did
not. This is hardly because people don't want to
live in Georgia and Texas: since 2000, Atlanta,
Dallas–Ft. Worth, and Houston have been the
nation's fastest-growing urban areas, each growing
by more than 120,000 people per year.

This suggests that local factors, not national
policies, were a necessary condition for the housing
bubbles where they took place. The most
important factor that distinguishes states like
California and Florida from states like Georgia
and Texas is the amount of regulation imposed on
landowners and developers, and in particular a
regulatory system known as growth management.

In short, restrictive growth management was
a necessary condition for the housing bubble.
States that use some form of growth management
should repeal laws that mandate or allow
such planning, and other states and urban areas
should avoid passing such laws or implementing
such plans; otherwise, the next housing bubble
could be even more devastating than this one.

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Published by: Cato Institute on Sep 22, 2009
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Everyone agrees that the recent financial crisisstarted with the deflation of the housing bubble.But what caused the bubble? Answering thisquestion is important both for identifying thebest short-term policies and for fixing the creditcrisis, as well as for developing long-term policiesaimed at preventing another crisis in the future.Some people blame the Federal Reserve forkeeping interest rates low; some blame theCommunity Reinvestment Act for encouraginglenders to offer loans to marginal homebuyers;others blame Wall Street for failing to properly assess the risks of subprime mortgages. But all of these explanations apply equally nationwide, whilea close look reveals that only some communitiessuffered from housing bubbles.Between 2000 and the bubble’s peak, infla-tion-adjusted housing prices in California andFlorida more than doubled, and since the peakthey have fallen by 20 to 30 percent. In contrast,housing prices in Georgia and Texas grew by only about 20 to 25 percent, and they haven’t sig-nificantly declined.In other words, California and Florida hous-ing bubbled, but Georgia and Texas housing didnot. This is hardly because people don’t want tolive in Georgia and Texas: since 2000, Atlanta,Dallas–Ft. Worth, and Houston have been thenation’s fastest-growing urban areas, each grow-ing by more than 120,000 people per year.This suggests that local factors, not nationalpolicies, were a necessary condition for the hous-ing bubbles where they took place. The mostimportant factor that distinguishes states likeCalifornia and Florida from states like Georgia and Texas is the amount of regulation imposed onlandowners and developers, and in particular a regulatory system known as
 growth management 
.In short, restrictive growth management wasa necessary condition for the housing bubble.States that use some form of growth manage-ment should repeal laws that mandate or allow such planning, and other states and urban areasshould avoid passing such laws or implementingsuch plans; otherwise, the next housing bubblecould be even more devastating than this one.
 How Urban Planners Caused the Housing Bubble
by Randal O’Toole
_____________________________________________________________________________________________________
 Randal O’Toole is a senior fellow with the Cato Institute and author of 
The Best-Laid Plans: How GovernmentPlanning Harms Your Quality of Life, Your Pocketbook, and Your Future
.
Executive Summary 
No. 646October 1, 2009
 
Misconceptions aboutthe Housing Bubble
In 2005, both Alan Greenspan and BenBernanke argued that there was “no housingbubble” and that people need not fear that sucha bubble would burst. Greenspan admittedthere was “froth” in local housing markets butno national bubble. Bernanke argued thatgrowing housing prices “largely reflected strongeconomic fundamentals” such as growth in jobs, incomes, and new household formation.
1
How could they have gone so wrong?“Bubble deniers point to average prices for thecountry as a whole, which look worrisome butnot totally crazy,” Princeton economist PaulKrugman wrote in a 2005 newspaper column.“When it comes to housing, however, theUnited States is really two countries, Flatlandand the Zoned Zone.” Flatland, he said, hadlittle land-use regulation and no bubble, whilethe Zoned Zone was heavily regulated and was“prone to housing bubbles.”
2
Krugman’s choice of terms is unfortunatebecause most of “Flatland” is in fact zoned.What makes the Zoned Zone different is notzoning but
 growth-management planning 
, a broadterm that includes such policies as urban-growth boundaries, greenbelts, annual limitson the number of building permits that can beissued, and a variety of other practices.
Growth control 
, which limits a city’s growth toa specific annual rate, is a form of growth-man-agement planning that was popular in the 1970s.
Smart growth
, which discourages rural develop-ment and encourages higher-density develop-ment of already developed areas, is another formthat is more popular today. No matter what theform, by interfering with markets for land andhousing, growth-management planning almostinevitably drives up housing prices and is closely associated with housing bubbles.Harvard professor Harvey Mansfield criti-cizes economists for failing to foresee the hous-ing bubble.
3
But, in fact, many economists didsee the bubble as it was growing and predictedthat its collapse would lead to severe hardships.For example, as early as 2003
The Economist 
observed, “The stock-market bubble has beenreplaced by a property-price bubble,” and point-ed out that “sooner or later it will burst.”
4
By 2005, it estimated that housing had become“the biggest bubble in history.” Because of theeffects of the bubble on consumer spending,
The Economist 
warned, the inevitable deflationwould lead to serious problems. “The wholeworld economy is at risk,” the newspaper point-ed out,
5
adding, “It is not going to be pretty.”
6
 Although
The Economist 
did not predict thecomplete collapse of credit markets, it was cor-rect that the bubble’s deflation was not pretty. After home-price deflation led to the creditcrisis, it became “conventional wisdom that Alan Greenspan’s Federal Reserve was respon-sible for the housing crisis,” notes HooverInstitution economist David Henderson in a column in the
Wall Street Journal 
.
7
 AlthoughHenderson disagreed with this view, severalother economists writing in the same issueagree that by boosting demand for housing,the Federal Reserve Bank’s low interest ratescaused the housing bubble. “The Fed ownsthis crisis,” charges Judy Shelton, the author of 
 Money Meltdown
.
8
Other people blame the crisis on theCommunity Reinvestment Act and other fed-eral efforts to extend homeownership to low-income families.
9
Those policies, along withunscrupulous lenders, fraudulent homebuy-ers, and greedy homebuilders—all of whomhave also been blamed for the housing cri-sis—have two things in common. First, they focus on changes in the demand for housing.Second, they are all nationwide phenomena.National changes in demand should havehad about the same effect on home prices inHouston as in Los Angeles. But they did not. As this paper will show, just as prices rosemuch more dramatically in Krugman’s ZonedZone than in Flatland, prices later fell steeply in most of the Zoned Zone but—except forstates where home prices declined because of the collapse of the auto industry—prices hard-ly fell at all in Flatland. As late as the fourthquarter of 2008, home prices remained stablein many non-bubbling parts of the country.This suggests that the real source of the bub-
2
As late as thefourth quarter of 2008, home pricesremained stablein many parts of the country.
 
ble was limits on supply that exist in someparts of the country but not in others.In response to the crisis, some have sug-gested that the federal government shouldbuy surplus homes and tear them down orrent them to low-income families. This mis-reads the crisis, which is not due to a surplusof homes but to an artificial shortage createdby land-use regulation. This shortage pushedup home prices to unsustainable levels, butthat doesn’t mean that there is no demandfor housing at more reasonable prices.Related to this are increased claims thatthis crisis signals the last hurrah for suburbansingle-family homes. “The American suburbas we know it is dying,” proclaims
Time
maga-zine.
10
The
 Atlantic Monthly
frets that suburbswill become “the next slums.” Both articlesquote a demographic study that claims that“by 2025 there will be a surplus of 22 millionlarge-lot homes (on one-sixth of an acre ormore) in the U.S.”
11
Ironically, articles such asthese promote an intensification of the kindof land-use regulation that created the hous-ing bubbles.
A Theory of theHousing Bubble
Bubbles have characterized recent econom-ic history, as institutional and other majorinvestors have sought high-return, low-riskinvestments. These investments have turnedinto speculative manias that eventually comecrashing down. The last decade alone has seenthe telecom bubble, the nearly simultaneousdot-com bubble, the housing bubble, andmost recently, the oil bubble—all of which ledthe satirical newspaper,
The Onion
, to report,“Nation Demands New Bubble to Invest In.”
12
Of these, the housing bubble is the mostsignificant. On one hand, consumer spendingfed by people borrowing against the temporar-ily increased equity in their homes kept theworld economy going after the high-tech andtelecom bubbles burst in 2001. On the otherhand, the eventual deflation of the housingbubble caused far more severe economic prob-lems than the deflation of the telecom andhigh-tech bubbles would have caused if thehousing bubble had not disguised them. A
bubble
has been defined as “trade in high volumes at prices that are considerably at vari-ance with intrinsic values.”
13
Bubbles are essen-tially irrational, so they are difficult to describewith a rational economic model. However, thepreliminaries to the housing bubble can beexplained using simple supply-and-demandcurves.Charles Kindleberger’s classic book
 Manias, Panics, and Crashes
describes six stages of a typi-cal bubble. First, a 
displacement 
or outside shockto the economy leads to a change in the valueof some good. Second, new 
credit instruments
aredeveloped to allow investors to take advantageof that change. This leads to the third stage, a period of 
euphoria
, in which investors come tobelieve that prices will never fall. This oftenresults in a period of 
 fraud
, the fourth stage, inwhich increasing numbers of people try to takeadvantage of apparently ever-rising prices.Soon, however, prices do fall, and, in the fifthstage, the market
crashes
. In the sixth and finalstage, government officials try to impose new regulation to prevent such bubbles from tak-ing place in the future.
14
 All of these stages areapparent in the recent housing bubble. The key point of this paper is that because growth con-trols did not allow heightened demand forhousing to dissipate through new supply, theresult was an immense price bubble in stateshousing nearly half of the nation’s population.Housing markets include both new andused housing. New housing accommodatespopulation growth and replaces both worn-out older housing and housing in areas thatare being converted to other uses. The price of used housing is set by the cost of new housing.If the price of new housing rises, sellers of existing homes will respond by adjusting theirasking prices. Thus, to understand the price of housing, we must focus on the supply anddemand curves for new housing.The steepness of those curves—whicheconomists call
elasticity
—describes the sensi-tivity of prices to changes in demand or sup-ply. A flat or elastic supply curve, for example,
3
Claims that thesuburbs are dyingare made tosupport thepolicies thatcreated thehousing bubblesin the first place.

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