I did not mean to suggest in my post on bubbles that the Great Panic of 2008 could have happened without restrictive land-use regulations, exotic securities, lax lending practices or the other likely culprits. I did mean to suggest that bubbles don't need bad regulation, sleazy lenders, or loose monetary policy. They develop spontaneously even in simple financial markets where the participants have perfect information.
Although bubbles may be inevitable, they don't normally cause the collapse of the real estate industry and credit markets (and who knows what else). I'm sure that 100 years from now economists will still be debating the causes of this bubble.
Too much leverage and bad risk models bear at least some of the blame. But tight land-use regulations in California and the northeast played a role, too. Economists Ed Glaeser and Joseph Gyourko demonstrated in this May 2006 paper that restrictive land-use controls are associated with more volatile home prices:
In today's still solid housing market, we may have forgotten the historical correlation between housing price growth in one period and decline over subsequent periods. For example, Joseph Gyourko and I have found that if an area has a $10,000 dollar increase in housing prices during one period, relative to national and regional trends, that area will lose $3,300 in housing value over the next five-year period, again relative to national and regional trends (Glaeser and Gyourko, forthcoming). Such housing cycles occur almost everywhere, but the dollars involved are far bigger in metropolitan areas with restricted housing supply such as many parts of California, New York, and Boston. Illustratively, booms and busts in the Atlanta region have been relatively modest while in Boston, the last boom was followed by a 30 percent drop in housing values between 1988 and 1994. Moreover, this boom-bust cycle was associated with significant dislocation in the regional economy.
It's not hard to figure out why home prices are more volatile in tightly-regulated jurisdictions. When the supply of new housing is severely limited, even a small increase in demand will cause a spike in home prices. This spike, when combined with the perception that prices will continue to rise, lures other buyers into the market who want a piece of the windfall, which causes a larger spike, and so on, until the Ponzi scheme comes crashing down. Tight land-use regulations thus pull double duty: They cause the initial spike by constraining supply and they reassure buyers that supply will be constrained in the future. This is why the bubble started in places like California and Boston rather Houston or Dallas.
I admit this can't be the full story, though, because Phoenix and Las Vegas were eventually swallowed by the bubble even though it's easy to build new housing in both cities. And this does not explain why lenders were so willing to extend credit to bad risks, or why investors were so willing to buy arcane financial instruments that they did not understand, or why sophisticated companies like AIG so grossly miscalculated the risk of default of the securities they insured.
Hopefully we can figure these things out to avoid economy-crashing bubbles in the future. Given the experimental evidence, though, we will have bubbles no matter what we do; the best we can hope for is to limit their size and the damage they cause.