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Some people say that we couldn’t have known there was a real estate bubble. But quite a few economists pointed out well before the crash that the “price/rent” ratio — that is, the average cost of owning a house/apartment divided by the average cost of renting — was well outside of historical norms. This led economist Paul Krugman and others to declare in 2007 that there was a real estate bubble on the verge of popping, and that it was going to bring down the economy.
The reason why this sort of analysis works is this — people pay rents based on what they can afford. People buy houses based on what they can afford, plus some expectation of making money on the sale of the house.
But that expectation of making money on a house implies that there is someone that can afford that house. If the mortgage cost gets much higher than the rental cost, it indicates a speculative bubble — people are buying houses more expensive than they can afford based only on the expectation of an unsustainable future profit. Or to put it more simply, home prices are much higher than the homes are worth.
Questions:
1. Filter out variation and compute the average price/rent ratio for January 2000 to January 2006.
2. Compute the price/rent ratio at the peak of the housing bubble in late 2007.
3. These prices are not controlled for inflation. Why does that matter less in this circumstance than usual?
