How High Gas Prices Triggered the Housing Crisis
Republican presidential candidate Rick Santorum made headlines last week when he suggested that high gas prices made mortgages unaffordable, causing the recent housing bubble to burst and sending the economy into recession. It may sound far-fetched, but it is precisely the theory that I and a pair of coauthors presented in a working paper released five days before Santorum’s remarks.
We are actually a bit more nuanced, arguing that unexpectedly high gas prices triggered the collapse of the housing market — igniting a fire fueled by easy credit, lax lending practices, and speculation. It is a provocative claim and one with broad implications, but it is also a claim supported by economic theory and empirical evidence.
The federal government’s Financial Crisis Inquiry Commission asserted in its 2010 report that “it was the collapse of the housing bubble . . .that was the spark that ignited a string of events that led to a full-blown crisis in the fall of 2008.” And a broad, if not unanimous, consensus among economists suggests that the ongoing economic malaise was induced by a financial crisis caused by the housing crisis. Relatively less well-understood is what caused the housing crisis in the first place.
We contend that a persistent upward trend in gas prices starting in 2005 — and the doubling of gas prices between 2005 and 2008 — altered the calculus of suburban living, causing homeowners to revaluate the wisdom of long work commutes from suburban and exurban communities into city centers.
For at least half a century, economic theory has held that the price of owner-occupied housing is declining in distance from the city center — all else equal — and that ever-declining costs of transportation induce sprawl, as households trade off the time-inclusive costs of commutes for the opportunity to own homes and land.
For much of the housing boom from the mid-to-late 1990s through 2005, gas prices were relatively low and flat — under $2 per gallon in real 2011 dollars and under $1.50 in nominal terms. Housing was developed on the outskirts of cities, in part because of constraints on growth within them. Low down-payment requirements and the growth of subprime lending, combined with high expectations for housing price appreciation, attracted relatively low-income households to the housing market and induced a phenomenon known to realtors as “Drive Till You Qualify,” whereby prospective homeowners would drive out from city centers until they reached communities in which they could afford mortgages.
The boom resulted in the newest and lowest-income homeowners settling farthest from cities and gambling that rising home equity would allow them to renegotiate mortgages before rates climbed. They were most exposed to a gas price shock as they faced the longest commutes — 50 miles or more in some communities. And they were least able to absorb the costs of higher commutes. Some households couldn’t afford mortgage payments and defaulted, others found themselves underwater and preferred to walk away instead of throwing good money after bad. Foreclosures rose and the market unraveled from the outside in.
Antioch, California is one of the communities that suffered most during the collapse. A resident who commuted 45 miles to San Francisco would have seen his gas costs for work trips climb $3,000 annually at the height of the gas price shock. His total commute cost would have constituted fully 41 percent of the mean annual expenditure among U.S. households in the lowest income quartile.
There is no doubt that subprime lending and speculation fueled demand for housing assets. But these are uniquely American phenomena. The housing boom and bust is not. A similarly volatile cycle was observed in Britain, Spain, France, and Ireland, among other countries that while not exposed to the aggressive lending in the U.S. would have been affected by global energy market dynamics.
And presumably new mortgage products and easy credit were available throughout the U.S. Why then did the impact of the housing crisis vary so much by location? How then to explain that both the percent decline in home values and the increase in foreclosure rates grew in magnitude with distance from major city centers? Or that seven of the twenty metropolitan areas with the highest foreclosure rates in 2010 were California cities located in outlying areas like Modesto, Riverside, Stockton, and Merced?
Moreover, while the prevalence of risky loans made the housing market susceptible to collapse, had home prices kept rising in 2007, instead of turning down, rising home equity could have been used to renegotiate risky loans, thereby concealing and even resolving the market weaknesses.
Low interest rates assuredly made credit — and thereby housing — cheap. But the housing boom began before interest rates fell, and it persisted after they rose. And with interest rates near their lower bound, why is the housing market still in the tank?
And if you think the housing market was in a bubble, you may be right. It is true that all bubbles burst — by definition. But even the eminent bubble expert, the economist Robert Shiller, concedes we don’t know why the housing bubble burst when it did. Or do we?
With gas prices approaching $4 per gallon nationally, and the latest data on the housing front showing home prices at post-collapse lows, it would seem the housing boom of the last decade has saddled us with a housing stock ill-suited for the future we face. If consumers expect gas prices will remain high — or that climate policy will raise costs of commutes independent of energy market dynamics by raising gas taxes or imposing prices on carbon emissions — then the suburbs — home to roughly 50 percent of American households—may not soon recover from the collapse as urban living becomes relatively more attractive. With one-in-four households underwater and unable to withdraw home equity to finance consumption, a slow suburban housing recovery bodes poorly for short-run growth in aggregate demand and a broader economic recovery.