Mass Delusion Led to Housing Bubble

The foreclosure crisis was caused by mass delusion, concludes a new study by the Federal Reserve Bank of Boston. The mass delusion was the belief that house prices would continue to rise at a rapid pace. After laying out 12 facts about the mortgage market and dismissing current theories about what caused the foreclosure crisis--such as asymmetric information (sellers knowing more than buyers) and financial innovation--the study concludes that a "massive and unsustainable price bubble in the U.S. housing market caused the financial crisis."

In hindsight, the mass delusion is obvious. During the bubble, economists gave little weight to any scenario in which house prices declined. The meltdown scenario was assigned only a 5 percent probability. The highest probabilities were assigned to scenarios that assumed an 8 percent annual growth rate in prices. "These optimistic price expectations encouraged buyers to offer high prices for houses, making the optimistic price expectations self-fulfilling--the hallmark of an asset bubble."

The unanswered question, the authors note, is "why this bubble occurred in the 2000s and not some other time...For now, we have no choice but to plead ignorance, and we believe that all honest economists should do the same." Demographers may have the answer: In the 2000s, the large baby-boom generation was aging into the peak years of homeownership, creating buyer frenzy. The rest is history.

Source: Federal Reserve Bank of Boston, Why Did So Many People Make So Many Ex Post Bad Decisions: The Causes of the Foreclosure Crisis