By David F. Seiders. The housing sector helped the economy get through the recent recession not only by generating high levels of home sales and production but also by contributing high rates of home price appreciation that fueled consumer spending. But has this strong house price performance generated a bubble that could burst and seriously damage the recovering U.S. economy? The answer is no, contrary to a drumbeat of stories emanating from analysts and media friendly to Wall Street.

Price bubbles in asset markets involve rapid price increases fueled by speculative fervor or unrealistic expectations that ultimately prove unsupportable by economic fundamentals. The explosion of the stock market's high-tech component is the most recent example of irrational exuberance on the upside, and the subsequent collapse when earnings expectations came back toward reality. Generation of such a bubble, and the subsequent bust, require massive inflows and outflows of investment capital over short periods of time.

Housing vs. securities

Federal Reserve chairman Alan Greenspan, who has been extolling the benefits to the economy of capital gains on housing for several years, recently told Congress not to worry about a bubble in house prices despite well-publicized concerns. Greenspan focused on major differences between stock and housing markets that show the practical impossibility of a national house price bubble.

He stressed, first of all, the substantial financial and emotional costs to homeowners of selling, buying, and moving; in this context, he noted that the low turnover rate of single-family homes is "scarcely tinder for speculative conflagration." He also stressed that the opportunities for successful "arbitrage" are quite limited, since housing markets are localized and few people can (or will) jump from market to market to pursue house price gains or to avoid price declines. In this regard, Greenspan noted that "the underlying demand for living space tends to be revised very gradually."

The fundamentals

Greenspan did not rule out development of house price bubbles in local markets, although he suggested that even these are not likely to be large. And the points he made about housing demand, along with the fact that housing inventories can't be shifted around in pursuit of higher prices, suggest that any local price bubbles will tend to be confined to those markets and deflate only gradually.

Generation of local price bubbles requires house price increases that soar above the fundamental foundations of housing demand in an area, including household income growth and mortgage interest rates. This can happen when unrealistic income and financial wealth expectations generate a huge surge in demand, or when a collapse of the economic fundamentals in an area leaves house prices hanging at unreasonably high levels. Recent examples include areas driven by high-tech fervor followed by high-tech collapse (such as San Jose/San Francisco).

Bottom line

There is no national house price bubble, although house prices recently climbed to unsustainable levels in a limited number of local markets. These isolated problems naturally take some time to iron out, but a recovering economy and a positive interest rate environment will speed the process. Annual home price appreciation in the 4 percent to 5 percent range seems a reasonable prospect for the United States in the next few years. While that's lower than recent years, it's still well above general consumer price inflation, largely because land use controls are placing persistent upward pressure on lot prices in places where housing demand and home building are concentrated. In the long run, prices of both new and existing homes tend to converge toward the replacement cost of homes.