That Hissing Sound

By PAUL KRUGMAN
NYT Article Here...

This is the way the bubble ends: not with a pop, but with a hiss.

Housing prices move much more slowly than stock prices. There are no Black Mondays, when prices fall 23 percent in a day. In fact, prices often keep rising for a while even after a housing boom goes bust.

So the news that the U.S. housing bubble is over won't come in the form of plunging prices; it will come in the form of falling sales and rising inventory, as sellers try to get prices that buyers are no longer willing to pay. And the process may already have started.

Of course, some people still deny that there's a housing bubble. Let me explain how we know that they're wrong.

One piece of evidence is the sense of frenzy about real estate, which irresistibly brings to mind the stock frenzy of 1999. Even some of the players are the same. The authors of the 1999 best seller "Dow 36,000" are now among the most vocal proponents of the view that there is no housing bubble.

Then there are the numbers. Many bubble deniers point to average prices for the country as a whole, which look worrisome but not totally crazy. When it comes to housing, however, the United States is really two countries, Flatland and the Zoned Zone.

In Flatland, which occupies the middle of the country, it's easy to build houses. When the demand for houses rises, Flatland metropolitan areas, which don't really have traditional downtowns, just sprawl some more. As a result, housing prices are basically determined by the cost of construction. In Flatland, a housing bubble can't even get started.

But in the Zoned Zone, which lies along the coasts, a combination of high population density and land-use restrictions - hence "zoned" - makes it hard to build new houses. So when people become willing to spend more on houses, say because of a fall in mortgage rates, some houses get built, but the prices of existing houses also go up. And if people think that prices will continue to rise, they become willing to spend even more, driving prices still higher, and so on. In other words, the Zoned Zone is prone to housing bubbles.

And Zoned Zone housing prices, which have risen much faster than the national average, clearly point to a bubble.

In the nation as a whole, housing prices rose about 50 percent between the first quarter of 2000 and the first quarter of 2005. But that average blends results from Flatland metropolitan areas like Houston and Atlanta, where prices rose 26 and 29 percent respectively, with results from Zoned Zone areas like New York, Miami and San Diego, where prices rose 77, 96 and 118 percent.

Nobody would pay San Diego prices without believing that prices will continue to rise. Rents rose much more slowly than prices: the Bureau of Labor Statistics index of "owners' equivalent rent" rose only 27 percent from late 1999 to late 2004. Business Week reports that by 2004 the cost of renting a house in San Diego was only 40 percent of the cost of owning a similar house - even taking into account low interest rates on mortgages. So it makes sense to buy in San Diego only if you believe that prices will keep rising rapidly, generating big capital gains. That's pretty much the definition of a bubble.

Bubbles end when people stop believing that big capital gains are a sure thing. That's what happened in San Diego at the end of its last housing bubble: after a rapid rise, house prices peaked in 1990. Soon there was a glut of houses on the market, and prices began falling. By 1996, they had declined about 25 percent after adjusting for inflation.

And that's what's happening in San Diego right now, after a rise in house prices that dwarfs the boom of the 1980's. The number of single-family houses and condos on the market has doubled over the past year. "Homes that a year or two ago sold virtually overnight - in many cases triggering bidding wars - are on the market for weeks," reports The Los Angeles Times. The same thing is happening in other formerly hot markets.

Meanwhile, the U.S. economy has become deeply dependent on the housing bubble. The economic recovery since 2001 has been disappointing in many ways, but it wouldn't have happened at all without soaring spending on residential construction, plus a surge in consumer spending largely based on mortgage refinancing. Did I mention that the personal savings rate has fallen to zero?

Now we're starting to hear a hissing sound, as the air begins to leak out of the bubble. And everyone - not just those who own Zoned Zone real estate - should be worried.

E-mail: krugman@nytimes.com