Blame Urban Planning

The credit crisis has led to numerous calls for bigger government. Yet the truth is that big government not only let the crisis happen, it caused it.

This truth is obscured by most accounts of the crisis. "I have a four-step view of the financial crisis," says Paul Krugman. "1. The bursting of the housing bubble."

William Kristol agrees. His account of the crisis begins, "A huge speculative housing bubble has collapsed." "The root of the problem lies in this housing correction," said Secretary of the Treasury Henry Paulson.

So it all started with the bubble. But what caused the bubble? The answer is clear: excessive land-use regulation. Yet while many talk about re-regulating banks and other financial firms, hardly anyone is talking about deregulating land.

The housing bubble was not universal. It almost exclusively struck states and regions that were heavily regulating land and housing. In fast-growing places with no such regulation, such as Dallas, Houston, and Raleigh, housing prices did not bubble and they are not declining today.

The key to making a housing bubble is to give cities control over development of rural areas -- a step that is often called "growth-management planning." If they have such control, they will restrict such development in the name of stopping "urban sprawl" -- an imaginary problem -- while their real goal is to keep development and its associated tax revenues within their borders. Once they have limited rural development, they will impose all sorts of conditions and fees on developers, often prolonging the permitting process by several years. This makes it impossible for developers to respond to increased housing demand by stepping up production.

In contrast, when cities do not have control of rural areas, developers can step outside the cities and buy land, subdivide it, and develop it as slowly or rapidly as necessary to respond to demand. The cities themselves respond by competing for development -- in other words, by keeping regulation and impact fees low. The Houston metro area, for example, has been growing at 130,000 people per year, yet it was readily able to absorb another 100,000 Katrina evacuees with virtually no increase in housing prices.

Before 1960, virtually all housing in the United States was "affordable," meaning that the median home prices in communities across the country were all about two times median-family incomes. But in the early 1960s, Hawaii and California passed laws allowing cities to regulate rural development. Oregon and Vermont followed in the 1970s. These states all experienced housing bubbles in the 1970s, with median prices reaching four times median-family incomes. Because they represented a small share of total U.S. housing, these bubbles did not cause a worldwide financial meltdown.

In the 1980s and 1990s, however, several more states passed laws mandating growth-management planning: Arizona, Connecticut, Florida, Maryland, Rhode Island, and Washington. Massachusetts cities took advantage of that state's weak form of county government to take control of the countryside. The Denver and Minneapolis-St. Paul metro areas adopted growth-management plans even without a state mandate. As a result, by 2000, prices of nearly half the housing in the nation were bubbling to four, six, and in some places ten times median-family incomes.

In the meantime, Congress gave the Department of Housing and Urban Development (HUD) oversight authority over Fannie Mae and Freddie Mac. While this was supposedly aimed at protecting taxpayers, Congress knew that HUD's main mission is to increase homeownership rates, and Congress specifically pressured HUD to increase homeownership among low income families. So HUD responded to the housing bubble by directing Fannie and Freddie to buy increasingly high percentages of mortgages made to low income families, eventually setting a floor of 56 percent. This led Fannie and Freddie to significantly increase their purchases of subprime mortgages, which legitimized the secondary market for such mortgages.

Though everyone knows that the deflation of the housing bubble is what caused the financial meltdown, few have associated the bubble itself with land-use regulation. Back in 2005, Paul Krugman observed that the bubble was caused by excessive land-use regulation. Yet nowhere in his current writings does he suggest that we deregulate land to prevent such bubbles from happening again. Such suggestions have come only from the Cato Institute, Heritage Foundation, and a few other think tanks.

We know that if the regulation is left in place, housing will bubble again -- California and Hawaii housing has bubbled and crashed three times since the 1970s. We also know, from research by Harvard economist Edward Glaeser, that each successive bubble makes housing more unaffordable than ever before -- and thus leaves the economy more vulnerable to the inevitable deflation. This is because when prices decline, they only fall about a third of their increase, relative to "normal" housing, before bottoming out.

Thus, median California housing was twice median family incomes in 1960, four times in 1980, five times in 1990, and eight times in 2006. In the next bubble, it will probably be at least ten times. This means homeownership rates will decline (as it has declined in California since 1960), small business formation (which relies on the equity in the business owners' homes for capital) will decline, and education will decline (children of families that own their homes do better in school than children of families who rent).

Worse, more states are passing growth management laws. Tennessee passed a law in 1998, too late to get into the recent housing bubble but enough to participate in the next one. Legislators in Georgia, North Carolina, and other fast-growing states are being pressured to also pass such laws. Naturally, the planners who promote such laws deny that their actions have anything to do with housing prices.

Even worse, the Environmental Protection Agency has proposed to "integrate climate and land use" -- effectively using global warming fears to impose nationwide growth management. Supposedly -- though there is no evidence for it -- people in denser communities emit fewer greenhouse gases, and growth management can be used to impose densities on Americans who would rather live on quarter-acre lots. The California legislature recently passed a law requiring cities to impose even tighter growth restrictions in order to reduce greenhouse gases -- and its implementation will be judged on the restrictions, not on whether those restrictions actually reduce emissions.

Instead of such laws, states that have regulated their land and housing should deregulate them. Congress should treat land-use regulations as restrictions on interstate mobility, and deny federal housing and transportation funds to states that impose such rules. Otherwise, hard as it may be to imagine, the consequences of the next housing bubble will be even worse than this one.