Editors' Summary

The Brookings Panel on Economic Activity held its eighty-first conference in Washington, D.C., on March 30 and 31, 2006. This issue of the Brookings Papers includes the papers and discussions presented at the conference. The first paper takes a new approach to assessing the boom in home prices, using a model that parallels the one commonly used to value assets such as stocks. The second analyzes labor force participation and its determinants and projects future labor force growth. The third examines changes in wealth by age group and relates them to changes in law and the economy and to demographic characteristics. The fourth examines the present defined-benefits pension system and considers how to reform its regulation and insurance by the federal government.

In financial markets the hallmark of a bubble is an asset that is priced far above its fundamental value, which depends on the discounted stream of future cash flows—earnings, dividends, or interest. Differences of opinion about whether or not a bubble exists reflect differences of opinion about the fundamental value of the asset. In the case of owner-occupied housing, there is no readily available, easily estimated analogue to cash flow, and therefore opinions about fundamental value can differ widely. Many observers and market participants have instead focused on the behavior of prices themselves as a way of assessing whether "irrational exuberance" exists in the housing market. During the past five years housing prices have more than doubled in some metropolitan markets and have risen by 50 percent for the United States overall, leading many to conclude that there is a speculative bubble in housing. Those holding this view cite as evidence the sheer magnitude of the price increases, the rise in the ratio of average housing prices to average income, and the more rapid growth of home prices than of rents. In the first article of this volume, Margaret Hwang Smith and Gary Smith argue that all of these are flawed indicators of a housing bubble because they do not measure prices relative to fundamental values. Using data they have collected on individual homes in ten metropolitan areas, they calculate such a measure from the capitalized value of the stream of services that a home provides. They conclude that, in nearly all the markets they study, home prices remain near or below fundamental values.

The authors note that many of the features associated with a bubble as the term is commonly used—prices rising rapidly, a speculative focus on future price increases rather than the asset's cash flow, and the likelihood of an eventual price collapse—could also be present in a bubble defined relative to fundamental values. But not necessarily. Prices can increase rapidly for a considerable period and still remain below fundamental values, as they are likely to do when a significant, unexpected drop in mortgage rates both increases fundamental values and leads to rapid price increases. The authors stress that housing prices are not determined in a smoothly functioning, efficient market rooted in fundamentals. Instead they are influenced importantly by "comps," or the prices of recently purchased comparable homes; appraisers, real estate agents, and buyers and sellers themselves all rely heavily on data from these "comps." In this situation, speculative behavior can lead to rapid price increases or to price declines, and the corrective pull of fundamentals may be very weak. Hence the authors see their calculations as most directly relevant to individuals deciding whether to buy or rent, rather than to those deciding whether to buy or sell now rather than later. They themselves believe that short-run price movements are hard to predict, irrespective of the relationship between current prices and fundamental values, so that market timing is quite risky.

The authors provide an extensive discussion of what they call "bub-blemetrics," arguing that most of the measures commonly used to label the current housing situation a bubble are flawed. These include the pervasive use of aggregate measures that ignore the heterogeneity of homes, differences in location and quality, and the use of overly simple measures of affordability. They note that the conclusions of more sophisticated regression models depend on the implicit...