The Housing Bubble in Real-Time: The End of Innocence
Peláez, Rolando F., Journal of Economics and Finance
Abstract Market agents suffering through unanticipated boom-bust cycles would find extremely useful analytical techniques capable of serving as an early warning system. Unobserved components models and cointegration analysis are valuable in this respect. The stylized facts from unobserved components models alone do not suffice, but coupled with results from the Johansen cointegration test provided early evidence of the housing bubble and of its denouement. The paper uses real-time data vintages and shows that by 1998 the relationship between the smoothed growth rates of house prices and of per capita income was in uncharted territory. Moreover, the actual growth rates are cointegrated. This is important, as it establishes that any disequilibrium between the two becomes less tenable as its magnitude increases. By 2003, the disequilibrium was spectacular, yet it grew for another 4 years. In effect, we did not have to wait until 2008; the gruesome ending was predictable ex ante. Ironically, the greatest financial delusion of all occurred in an age that revered rationality, market efficiency, and the financial enlightenment of the TBTF actors. The empirical findings of this paper are a major problem for the rational expectations hypothesis and the remnants of the EMH.
Keywords Cointegration . Unobserved Components . Rationality . Market Efficiency
JEL Classification C220 . G010 . D8
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The conventional view holds that bubbles are only recognizable ex post; otherwise, they would not occur (Kindleberger and Aliber 2005). However, Reinhart and Rogoff (2009), Borio and Lowe (2002), and Shiller (2000, 2003), document cases in the early stages of financial bubbles when deviations from empirical regularities signaled the looming disaster. It is extremely important to develop empirical methodologies capable of identifying asset price booms before they mature into fullblown bubbles.
This paper shows that an early warning system was available that could have probably averted the greatest destruction of wealth in history. The data and analytical techniques were available in real time as the bubble inflated. As early as 2001-02 the relationship between the growth rates of house prices and of income deviated sharply from the historical pattern of more than 25 years. Moreover, the quarterly growth rates of the house price index and of per capita disposable personal income are cointegrated. Therefore, as the disequilibrium grew the more certain and violent the correction had to be. Tragically, we did not have to wait until 2008 to know the denouement. The empirical findings cannot be reconciled with the rational expectations hypothesis or the efficient markets hypothesis (EMH).
By 2003, the disequilibrium was unprecedented, yet it would grow for another 4 years of delirious speculative fever. It is important to show that the crisis was not a random event like an unpredictable 100-year flood; instead, as the disequilibrium grew the more predictable was the disaster. The bubble swept into the graveyard of ideas the last remaining illusion about financial market macro-efficiency, vindicating Samuelson's (1998) dictum.
The plan of the work is as follows. Section 1 describes the data and its sources. Section 2 describes a basic structural time series model. Sections 3 shows the smoothed growth rates that market participants could have used to formulate expectations about the growth of house prices in real time. Section 4 shows that the growth rates of the house price index and of disposable personal income per capita are cointegrated. The final section concludes.
This paper is about inflation in house prices, thus clearly all variables are nominal. The Federal Housing Finance Agency (http://www.fhfa.gov) publishes quarterly and monthly house price indices for the USA, nine U.S. Census divisions, 50 states and the District of Columbia. …