Since the foreclosure crisis, there’s been understandable anxiety about housing prices going up or down in still-fragile markets across the country, and cities would be smart to keep an eye on their neighbors for signs of price upticks (whether to anticipate an economic boost or note the warning signs of another bubble) as well as the reasons behind shifts. A new growing industry might create housing demand in more than one market, or credit lenders successful in one area might reinvest their profits in a neighboring town. Yet, as a team of Wharton economists points out in “The Role of Contagion in the Last American Housing Cycle,” these more obvious — “rational” in economist-speak — sources don’t always explain the patterns of how a housing boom spreads geographically.
The team dissected more than 23 million observations about home sales to find an explanatory factor for how behavioral, psychological or other unknown forces might have accounted for how housing price trends jumped from market to market before and after the foreclosure crisis.
“The patterns that [the Wharton researchers] describe in their findings were not contradictory to what I had been observing throughout that period,” says Kevin Gillen, a Fels Institute of Government research consultant. “What they did was try to explain them, rather than characterize them.”
The researchers compiled data from 99 different metropolitan areas from 1993 to 2009 and searched for evidence where rational “fundamental factors,” like the upswing in income from a new industry, did not account for the way the housing boom spread.
They observed that “irrational exuberance” could be found as early as 1997-1999 when housing prices first began to rise on the West Coast and mid-New England region. Pricing trends that started in coastal California flowed inland and to neighboring states to the north and east. On the East Coast, prices swelled in other New England markets and caused spillover effects in Florida markets.
The report cites Silicon Valley as an example of how a region can go from rational to irrational. The tech-sector-fuled jobs growth created a demand for housing that is driven in part by a future expectation of continued economic expansion. However, this type of income shock can cause a “contagion” that infects neighboring areas — and not always justifiably.
“Residents in those neighboring markets may be right to think that some type of positive income spillover will occur from the Silicon Valley boom, but they may incorrectly predict its magnitude,” the report’s authors warn. Behavioral or psychological factors might lead to abnormally large spillovers in the central valley and San Francisco, based on unrealistic expectations for the future.
“Our results indicate that contagion played a statistically and economically meaningful role in the timing and magnitude of the spread of housing booms across metropolitan areas.” They found the strongest evidence in their data of contagion affecting physically close neighbors and when the boom spread from a geographically large area to smaller markets. There was also an indication that at least some of the diffusion had to do with forces that weren’t analyzed in the paper.
“The interesting thing about housing from the perspective of an economist is that it’s a very unusual thing,” Gillen says. “Housing markets aren’t nearly as efficient as other markets, because you have emotion, consumption and aesthetic decisions involved. There’s a lot of money at stake in buying a house and it involves both rational decision-making as well as emotional satisfaction. It’s where you’ll spend the happiest moments of your life, presumably, so you have an interesting confluence of logic and emotion mixing.”
The study also looked at the housing bust from mid-2005 through early 2008, but there isn’t enough evidence to conclude that contagion played the same role in the bust as it did in the boom. They observed that the bust began with more a more national scope. The concentrated timeframe of the downturn — just 18 months — also may have disrupted the transmission of the “contagion.”
If irrational forces or mistaken expectations are still leading to speculation, the authors write that, “the relevance of our results for policy makers is increased, as they well may want to reevaluate their past practice of not intervening in response to asset booms in housing markets.” One of the authors, Joseph Gyourko, says that the current government policy “is not to try to prick bubbles.” But if contagion continues to play as much a role in housing booms, over economic fundamentals, “that could change the calculus about whether it is appropriate to intervene.”
Gilllen adds, “The reason the government should be reluctant to prick bubbles is because you can’t protect people from themselves. People have to learn that if you’re bad at guessing about the future, and [taxpayers] bail you out for your bad guesses, therefore you only get rewarded for your good guesses, you might become sloppy in your analysis and your guesses about the reality of the future. If bubbles happen for emotional reasons and people being irrational, then there might be the suggestion for cause for action, because it’s not just the case of incorrect analysis; there’s now human emotion involved.”
The Equity Factor is made possible with the support of the Surdna Foundation.
Alexis Stephens was Next City’s 2014-2015 equitable cities fellow. She’s written about housing, pop culture, global music subcultures, and more for publications like Shelterforce, Rolling Stone, SPIN, and MTV Iggy. She has a B.A. in urban studies from Barnard College and an M.S. in historic preservation from the University of Pennsylvania.