Last month at an International Monetary Fund conference, former Obama economic advisor Lawrence Summers harshly criticized outgoing Federal Reserve Board Chairman Ben Bernanke for comments he made this summer. Bernanke had raised the possibility of tapering the Fed’s purchase of treasury bonds, which would cause interest rates to rise. With the economy facing a prolonged slump, Summers argued, Bernanke should not even have talked about raising interest rates.
While Summers is correct that the economy remains far below its capacity, and therefore policy should be focused on boosting employment for the foreseeable future, there was actually a real problem that may have sparked Bernanke's taper talk. The housing market was again approaching the price levels seen during the housing bubble, whose collapse six years ago precipitated the downturn and the financial crisis.
At the end of the second quarter of this year, the inflation-adjusted value of the Case-Shiller national home price index was more than 20 percent above its pre-bubble level. It was only 8 percent below its 2002 level, the point at which economists first began warning of a housing bubble.
More important than the current level of prices was the rate of change. House prices nationwide were up 10.1 percent from their level a year ago. In several markets prices were rising considerably more rapidly, with rates of price increase of more than 30 percent. Even if house prices were not yet out of line with fundamentals by the time of Bernanke's taper talk, they soon would be in the markets showing rapid double digit price increases.
Even worse, these markets were mostly the ones that had taken the biggest hit in the housing crash. The bottom third of the market in cities like Phoenix and Las Vegas were showing especially rapid rates of price increase, as were many of the price of homes in the central valley of California.
The price run-ups in these markets appear to have been largely driven by investors. Homeowners, however, inevitably get caught up in the frenzy. And this is one of the reasons why it is incumbent on policymakers to take bubbles seriously. It is a financial catastrophe when someone takes their life's savings and borrows every penny they can to buy a home for $300,000 only to see it selling for $200,000 two years later.