Housing Bubble At Maximum

In California, a middle-class family with two earners each making $50,000 a year now owns, on average, an $830,000 home. In the late 80s, the last time these eight states saw price-to-income ratios this high, the real estate market collapsed.

Only in about 20 metro areas, mostly located in eight states, does the relationship of home price to income defy logic. The bad news is that those areas contain roughly half the housing wealth of the country. In California, the price of a home stands at 8.3 times the annual family income of its occupants; in Massachusetts, the ratio is 5.9:1; in Hawaii, a stunning, 10.1:1. To some extent, there are sound and basic economic reasons for this anomaly: supply and demand. Salaries in these areas have been going up faster than in the nation as a whole. The other is supply: These metro areas are "built out," with zoning ordinances that limit the ability of developers to add new homes. But at some point, incomes simply can't sustain the prices. That point has now been reached.

One index of housing inflation is the difference between house prices and rents. In a healthy market, driven by demand, rents and sale prices ought to track roughly together. But while sale prices have soared, rents have stayed flat; and in some of the most overheated markets, like San Francisco and Seattle, they have actually been declining. Such a gap, the economist and New York Times columnist Paul Krugman has written, suggests "that people are now buying houses for speculation rather than merely for shelter," evidence that he called a "compelling case" for a housing bubble. "Within the next year or so," The Economist argued in a May 2003 editorial, these regional "bubbles are likely to burst, leading to falls in average real home prices of 15-20 percent" across America. And, of course, in the most heated markets the drop is likely to be steeper yet.

When housing bubbles burst, they can hurt more than their sector of the economy. Studies have shown that they exercise twice the effect on consumer spending as comparable declines in stock prices. So, a 20 percent drop in housing prices would have the same, shriveling effect on the economy as a 40 percent crash in the stock market. When investors lose value in their houses, many of them pull money out of other investments, like stocks. Then, too, jobs in construction, real estate, and other fields that depend on new home sales die off.