The infamous housing bubble was composed of two parts: an unprecedented, decade-long surge in U.S. home prices that began in the mid-1990s, followed by an equally unprecedented fall in prices from 2007 to 2011. The bubble was a major factor in the financial crisis associated with the Great Recession. Similar housing booms and busts in the past have repeatedly led to severe financial crises in many parts of the world. Why these booms occur is not yet fully understood, but we have recently made some progress in our understanding. In particular, it appears that changes in mortgage lending practices can contribute to the strength of booms once they get started.

A feedback loop can occur when strong demand for homes creates rising home prices and those rising prices increase demand, rather than reducing it as we would normally expect higher prices to do. This paradox occurs because home price inflation tends to make it easier for more people of varying means to get mortgages, which by boosting demand in turn further increases home prices. The reverse also holds true — falling home prices generally make mortgages harder to obtain, further decreasing demand and worsening the downturn. These phenomena are called procyclical because they tend to intensify both the booms and the busts.

Studying these phenomena — and seeing whether we can moderate them — may help us learn how to promote not only housing market stability but also general financial stability. While these procyclical movements are the normal workings of free financial markets, they may need to be constrained if we are to limit these cycles in the future.

This article appeared in the First Quarter 2014 edition of Business Review. Download and read the full issue.