I recently wrote about the potential for activity in the junk bond market to trigger a large-scale financial crisis in the United States—and around the world. Soon after, I began getting correspondence from readers who pointed to what they saw as similar speculative excesses in the mortgage market. These readers are not wrong. Financial media outlets are already covering the dizzying increase in house prices across the U.S. What's missing, however, is a systematic breakdown of how big this bubble could be, and its implications.
Bubbles in housing markets are first and foremost caused by the overvaluation of homes. Two of the most popular ways to measure housing valuation are inflation-adjusted house price indices and house price-to-median income indices.
Inflation-adjusted house price indices show us how much house prices have risen relative to prices in the economy as a whole. Right now, this index is flashing bright red: it is giving us a reading of 94.6. This is the highest in history—the previous high being 92.3 in March 2006. The house price-to-median income index measures the affordability of housing relative to the average person's salary. It is flashing red too: it is giving us a reading of 6.7, just below the previous high of 7 in November 2005.
Based on these measures, it is safe to say that the U.S. housing market is as overvalued as it ever has been in history. So there is little reason to doubt that a large bubble has inflated in this market.
Why did this happen? Much for the same reason that there are bubble dynamics in the junk bond markets. In 2020, in response to the lockdown-generated recession, the Federal Reserve stepped into the mortgage market and gobbled up a huge number of mortgage-backed securities (MBS). Seemingly oblivious to the lessons it should have learned in 2008, the Fed made up around 30 percent of the entire market by September 2020. Naturally, MBS issuance soared in response. In the first half of 2021, it was growing at around 25 percent per year—by far the fastest growth rate on record since statistics began.
Before moving on to explore the implications of this trend, let us briefly reflect on why the Fed did what it did. After the crash of 2008, there was a general feeling amongst economic policymakers of "never again." Commentary from the time suggested a whole generation of policymakers had learned the dangers of financial bubbles, much as the generation that grew up in the Great Depression had learned all those years ago. Many assumed that this knowledge would bring an era of economic and financial peace and stability.
That has clearly not happened. Why? Frankly, our elites seem jittery and distractible in a way the Greatest Generation was not. They rush from one "crisis" to the next, like a drug addict in need of a fix. If you hang around policy people long enough, you start to question whether this isn't a sort of game to them. More crises mean more for them to do and more for them to gossip about—this is clearly a group of people raised on television and social media, always needing another dopamine hit.
The net result is that lessons hard learned are soon forgotten. As soon as a public health crisis like COVID-19 emerges, all those warnings from the financial crisis a decade previous are thrown in the trash like so many unloved toys. Borrowing statistics become passé; case numbers and deaths are in vogue now. It's policymaking as fad and fashion.
Back to the situation at hand. How much damage could this housing bubble do? Housing bubbles affect the real economy through their impact on residential construction investment and employment. Construction firms see that prices—and, with them, profits—are rising, so they borrow and invest. As of the second quarter of 2021, residential construction investment is growing at around 35 percent per year—its highest rate in the past 30 years. Like the housing market, the construction sector is running hot. If prices fall, it seems likely that investment will go into hard reverse.
How many jobs are at risk? At around 5 percent of total employment, construction employment is slightly off its peak of 5.6 percent in mid-2006—but it is still plenty high. If property prices decline and construction investment dries up, many of these workers will lose their jobs. Those of us over the age of 30 have lived through this before. It is not pretty.
But now consider the problems in the junk bond market. This is a double bubble. We have a bubble in the junk bond market allowing bankrupt businesses to keep their lights on, and a bubble in the housing market driving record rates of residential construction investment. It is hard to come to any other conclusion: the next financial crisis could make 2008 look like a dress rehearsal.
Philip Pilkington is a macroeconomist with nearly a decade of experience working in investment markets, he is the author of the book The Reformation in Economics: A Deconstruction and Reconstruction of Economic Theory.
The views expressed in this article are the writer's own.
