The upward momentum of home prices in cities such as Los Angeles, Las Vegas, New York or Boston has seemed so incredibly strong that it has been hard to imagine what could stop it.
But we have to exercise our imaginations a little more. The reality is that double-digit price increases cannot go on indefinitely because they would eventually put home prices out of reach of ordinary mortals.
What do most people think might stop the momentum? Interest rate increases come to mind first. These factors can certainly play a role, but often they are not enough. After the boom of the 1970s, even after the 30-year mortgage rates surpassed 16% in the spring of 1980, Los Angeles home prices still managed to go up another 10% for the succeeding year.
An economic recession also comes to mind. Certainly, the busts after the last two booms, in the late 1970s and the late 1980s, were accompanied by recessions. But in reality, the direction of home prices does not correspond very accurately to times of recession. Home prices topped off and showed signs of falling in many cities by the late 1980s, but the recession did not come until 1990-1991; prices kept falling for years after the recession was over.
So what really causes price drops?
Bubbles grew and burst long before there was a Federal Reserve setting interest rates, long before the U.S. was collecting data on recessions.
It is useful to think back to the first major real estate bubble in Southern California, which took place in the 1880s. This bubble, which peaked in early 1887 and afflicted all of the region, notably Los Angeles, is well documented in the Los Angeles Times of that time: "People poured in by thousands and prices of land began to climb. Everybody that could find an office went into the real estate business.... Desk room was hired in stores, in hallways, wherever room could be found.... Tracts of lands were cut up into lots, the further enormous rise in values was predicted, auction sales were announced, band of music, free lunch, lively auctioneer, magnificent country, delightful climate, home of the orange, garden spot of the Earth, sanitarium of the world, rattle off the lots and have another sale."
So what brought this bubble to an end in the fall of 1887? It cannot have been the Fed raising interest rates -- there was no monetary authority then. Nor was it a major economic disruption. There was a short national recession from March 1887 to April 1888, but not a notable one.
