House Prices and Fundamentals:

This paper examines the long run relation between prices and rents for houses in Amsterdam from 1650 through 2005. We first demonstrate that these series are cointegrated, a necessary condition for studying movements of the rent-price ratio. We then estimate the deviation of house prices from fundamentals and find that these deviations can be persistent and long-lasting. Lastly, we look at the feedback mechanisms between housing market fundamentals and prices, and find that market correction of the mispricing occurs mainly through prices not rents. This correction back to equilibrium, however, can take decades. Recently, an extensive debate raged over the question of whether a “housing bubble” existed in the United States and many other countries in the world. Numerous academic articles and popular press accounts pointed to mounting evidence of a U.S. housing bubble as house prices increased on average more than 5 percent per year from 2000 to 2006. On the local level, some markets experienced yearly price increases of more than 20 percent. As a result, even the former chairman of the Board of Governors of the Federal Reserve System, Alan Greenspan, noted that some local markets showed signs of speculative activity. The same holds for other countries. South Africa, for example, saw average house prices increase 244 percent between 1997 and 2005, while that number was 192 percent for Ireland. The worry of economists and policy makers is that asset price bubbles may quickly turn into busts, resulting in economic contraction. For example, Helbling and Terrones (2003) document 20 severe housing market declines in fourteen countries over the period 1970 to 2002. They also note that these housing market declines generally overlapped or coincided with recessions, and that recessions coinciding with housing market declines resulted in output losses roughly twice as big as those associated with severe equity market declines. For example, they document that the average annual GDP growth rate before a ‘Housing Price Bust’ was 3.4 percent, but declined to 0.8 percent after the ‘Housing Price Bust’. For ‘Equity Price Busts’ the comparable numbers were 4.0 percent and 2.6 percent, respectively. Clearly large housing market movements have a significant impact on the economy.