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Friday, November 22, 2013

Restrict and Stimulate

A patchwork of U.S. housing policies caused a bunch of little bubbles

Randal O’Toole. American Nightmare: How Government Undermines the Dream of Home Ownership. Washington, D.C.: Cato Institute, 2012. 302 pages.

At some point, the American dream became an American nightmare. The master narrative of the housing boom and bust is often about greedy bankers and consumer ignorance. The true story is far more complicated.

In Randal O’Toole’s book American Nightmare: How Government Undermines the Dream of Home Ownership, we learn that the fundamental cause of the U.S. housing bubble and subsequent crash—along with its severe financial consequences—was a conflict between state and local policies restricting housing expansion and federal policies trying to increase housing demand.  

American Nightmare begins with the detailed backstory—that is, an extensive history of the housing market in America—including many aspects that most teachers of urban economics are not aware of. O’Toole uses this backstory to show how the seeds of destruction were sewn. Then he turns to the analysis of the housing nightmare itself. 

First, he focuses on government policies that altered the supply side of the housing market. These include the evolution of zoning; regional growth management; tax increment financing; unpredictable, expensive, and time-consuming permitting processes; expanding the pool of legal challenges; impact fees; mandated housing set asides; and more. These burdensome, government-imposed housing restrictions artificially reduced housing supply, making it more inelastic (that is, it became far harder to expand the housing stock in response to increasing demand).

And yet, at the same time, federal policies artificially stimulated the demand side of the housing market, according to O’Toole. These stimuli include the Community Reinvestment Act, expanded requirements for lenders to accommodate lower-income borrowers, reduced down-payment requirements, the growth of no-documentation “liar” loans, failings by credit agencies (made into a legal oligopoly by SEC rules), the Basel Accord, Fannie Mae’s and Freddie Mac’s subsidies, artificially low interest rates, and more.

The effects of state and local housing-supply restrictions and federal housing-demand stimulus are combined in chapter 11, “The Housing Market,” which is at heart an application of Econ 101 logic.  

When demand increases, where housing supply is relatively unrestricted and therefore elastic—relatively responsive to changes in demand (as in Houston, for example)—the housing stock quickly expands and there was no bubble (or ensuing bust). However, where government restrictions make housing supply inelastic—relatively unresponsive to changes in demand (as in San Francisco)—a similar increase in housing demand will lead to a large housing-price bubble with little change in the housing stock (and serious house-price deflation when the bust comes).

O’Toole then demonstrates empirically how there was not a national housing bubble, but many local bubbles, and that the differing stringency of land use regulations and restrictions offers the best explanation of both when and where housing bubbles formed and then burst. In his words, “a close correspondence exists between regions with growth-management planning and regions that have seen a major housing bubble. Without growth management . . . there would have been no major housing bubbles, no credit crisis, no need for a bank bailout, and no worldwide recession.”  

O’Toole goes beyond the recent housing bubble to find that the same political supply restriction explanation can account for earlier housing bubbles in California and recent housing patterns in the rest of the world.

American Nightmare also debunks many alternative explanations for the housing bubble and bust. For example, claims that the house-price bubble was primarily due to changing demand, not to supply restrictions, cannot stand up to the fact that nationwide demand-increasing factors can explain bubbles in some housing markets but not others (home prices jumped in some places where population growth and new construction fell). The book also offers evidence for why the housing bubble was not caused by low-income borrowers, greed, excessive bonuses, deregulation, or low interest rates.  

In the final chapter of American Nightmare, O’Toole offers a summary and 10 proposals for reform that would prevent future nightmares, almost all of which involve reducing the heavy hand of government interventions that are not just unjustified, but that often act at cross-purposes to one another. They follow from his analysis and make sense, but suffer from the same disadvantage of all such proposals: They involve undoing what gave politicians and regulators more power, which makes the likelihood of implementation (e.g., eliminating zoning as now practiced) very low.  

Randal O’Toole’s American Nightmare merits consideration from anyone seriously concerned with understanding the housing boom and bust and preventing a recurrence. Unlike the large number of books of dire predictions and urgent recommendations without salient factual or analytic basis, O’Toole’s book rests on thorough—and well-documented—research. It does demand that readers pay attention. But in a world full of political blame shifters and “trust me” claims and solutions, backed by what Henry Hazlitt called “the best buyable minds,” the book rewards that attention amply.


  • Gary M. Galles is a Professor of Economics at Pepperdine University and a member of the Foundation for Economic Education faculty network.

    In addition to his new book, Pathways to Policy Failures (2020), his books include Lines of Liberty (2016), Faulty Premises, Faulty Policies (2014), and Apostle of Peace (2013).