“The best Wall Street minds and their best risk-management tools failed to see the crash coming,” wrote Joe Nocera in a 2009 NYT article aptly titled “Risk Mismanagement”.

The Great Recession imparted an unwelcome lesson in humility to risk management specialists worldwide. These Wall Street minds failed to internalize the costs of the risks they undertook. Risks that, when aggregated, lead to wiped retirement accounts, job loss, poverty, and homelessness for some. Still, an interesting trend persists. According to the Case-Shiller Home Price Index (CSHPI), housing prices are increasing faster than real wages. In some hot metropolitan markets, housing prices exceed pre-recession peaks. Few people worldwide foresaw either the housing bubble or the current post-recession increase in home prices. So, maybe we should restrain our disparagement of others’ lack of perfect foresight. Even if executed without flaw, risk management suffers from two problems: the problem of of unknown unknowns, and the challenges inherent to transforming a model of microeconomic behavior into accurate predictions of macroeconomic consequences.

Given this hodgepodge of seemingly contradictory information, Ed Glaeser proposes a novel thought: “Can real estate bubbles do some good?” Glaeser asks the question of why the boom-and-bust cycle is more common in real estate markets and whether this can be good for growth. He identifies the positive wealth effects of land ownership and investment and the incentives toward human capital investment as major causal factors.


So, what explains our human tendency to invest in real estate? Land plays a critical role:

Land has been the most common store of wealth throughout human history, both because it is harder to expropriate than other assets, both intrinsically and because western law was partially built around the process of defending land ownership.

A precondition for a real estate bubble is the existence of property rights. Such a bubble can happen in places where property rights exist or are beginning to become more secure. In developing economies where significant shares of the population are experiencing wealth for the first time, property is a popular investment. Real estate ownership signals status, for one. Second, real estate defends itself better against asset depreciation and theft relative to other physical commodities. It is well-suited to serve as collateral and is an attractive passive investment. Lastly, you always need a place to live so, given the liquidity, a home is an attractive investment in developing and developed economies.

The gains from physical closeness to others encourage real estate investment too. The benefits derived from the agglomeration of firms and people in cities and industrial clusters can serve as both the cause and the effect of an uptick in real estate purchases. Glaeser reasons that human capital is the driving contributor to variation in metropolitan and urban prosperity. He found that, at the Metropolitan Statistical Area-level, a decadal growth rate of approximately one-half of one percent will follow a one percentage-point increase in the proportion of adults with college degrees, holding all else equal. For instance, assuming away the effects of supply restrictions, it is reasonable to think housing prices in D.C. proper will remain greater than those in a small, rural town, all else being equal. A productive, human-capital rich city enables the easier transmission of knowledge across space and time, the easier movement of goods, and the easier access to services. These increasing returns to scale further promote real estate investment and give cause for the belief that home prices will continue to rise.


But, the negative welfare consequences of agglomeration economies can be severe. Most domain experts, in hindsight, point to problems in the credit market as the causal mechanism for the 2007-08 financial crisis. Overconfidence led to excessive lending and excessive debt burdens, which led to the real estate bust. Poor–and even dishonest–credit risk management practices led to underwater mortgages, defaults, and foreclosures. These effects rippled through the clustered networks, too.


However, it is possible for positive changes to follow from these negative welfare and spillover effects. For instance, the Great Recession reinforced the importance of rigorous, cautious risk management practices. Wall Street investors were not exposed to much damage relative to the magnitude of the harm some of their actions generated for others. They had relatively little skin in the game. Consumers–some doing so out of ignorance, some not–who otherwise would not have been able to purchase homes did so. Their personal finances suffered, as did the portfolios of others who were not directly involved in their risky transactions. This bubble’s burst led to greater concern for the correction of this externality and other negative spillover effects. Lower homeownership rates and more prudent lending practices suggest that banks and consumers have become more risk-averse. This indicates that the current rise in home prices may be a horse of a different color. Current mortgage recipients appear to be more creditworthy and banks seem less willing to grant loans to risky applicants.


Glaeser does not discuss the regulation-related benefits of and incentives for homeownership that surely contribute to real estate asset bubbles. Of course, we have no counterfactual to assess what would, or could, have happened if mortgage-deduction effects were not in place. An area for further discussion would be the whether the need to internalize externalities exists as a consequence of subsidized mortgage lending practices. Regardless, Glaeser makes a fascinating, thought-provoking case for the welfare-enhancing effects of real estate bubbles.


Glaeser: Can real estate bubbles be welfare-inducing?