Real Estate Speculation and American History

There are many similarities between the most recent boom and previous events: rising prices reflected optimistic expectations, and credit market conditions played a supporting role.

Between January 2000 and March 2006, the Case-Shiller 20-city real estate price index rose by 76 percent in real terms. Between March 2006 and May 2009, it declined by 36 percent. In A Nation of Gamblers: Real Estate Speculation and American History (NBER Working Paper No. 18825), Edward Glaeser studies nine historical episodes from the frontier lands of the 1790s to today, drawing key lessons from the past that help to explain recent real estate price movements.

He finds that the swings in house prices and construction that occurred between 1996 and 2010 have many precedents in U.S. history. Americans often speculate heavily on real estate, with vast fortunes won and lost. And, there are many similarities between the most recent boom and previous events: rising prices reflected optimistic expectations, and credit market conditions played a supporting role. As in many previous situations, optimistic expectations seemed justifiable based on coincident experience or cross-regional comparisons of land prices and rents.

In the most recent boom, an optimistic assessment of future house price growth was needed to justify paying high prices for real estate. Glaeser points out that the expectation of a promising future also was critical to the rural land booms on the New York frontier in the 1790s and in Iowa in 1910, and to the urban booms of Chicago in the 1830s and Los Angeles in the 1880s and 1980s.

Booms end when optimistic projections fail to materialize, at least in the short run. In many cases, however, these developments, which seem to shock some market participants, should have been predictable based on the power of long-run elastic housing supply. For example, a sufficiently well informed buyer in Alabama in 1819 might have forecast that world-wide cotton supply would push prices there down, just as a skyscraper builder in 1920s Manhattan might have foreseen that abundant office space should decrease apartment rents dramatically. In the recent boom, the question is why well informed buyers in cities like Las Vegas did not recognize that the abundance of desert space would ultimately limit the long-run value of homes on the urban fringe of such metropolitan areas.

While hindsight is always helpful in assessing asset market bubbles, the difficulties in forecasting the impact of supply are both understandable and hard to arbitrage. The cognitive requirements needed to forecast the impact of global supply conditions on local property values are large. After the fact, the drop in cotton prices after 1819 may seem highly predictable, but why should that have been true among cotton farmers on America's frontier?

This paper notes that periods of excessive optimism in real estate markets can have broad implications in financial markets, because real estate loans represent an important component of bank balance sheets. When prices drop, as they did recently, it can trigger distress throughout the financial system.

--Lester Picker