BPEA | Fall 2008

The Central Role of Home Prices in the Current Financial Crisis: How Will the Market Clear?

Fall 2008

This paper begins by describing some patterns in home price
movements over recent decades. It then discusses some distinguishing characteristics
of housing markets that will contribute to determining prices going
forward: Housing is heterogeneous, making prices hard to measure. Home
prices are subject to inertia and are sticky downward. Housing markets have
traditionally been quantity clearing markets, with excess inventories absorbed
only as new households are formed. And housing markets depend critically
on credit market conditions and monetary policy. Two opposite scenarios for
future home prices are both plausible: The first, noting among other things the
many “underwater” mortgages and unsold inventories and the likelihood of a
severe recession, foresees a slow recovery. The second observes that the market
clearing process has been orderly so far and that deep regional housing busts in
the past have sometimes been followed by quick recoveries, suggesting that a
more rapid turnaround is possible.