House prices in many industrial countries increased dramatically in the years prior to 2007. Countries with the largest increases in household debt relative to income experienced the fastest run-ups in house prices over the same period. During the run-up, many economists and policymakers maintained that U.S. housing market trends could be explained by fundamentals. But in retrospect, studies now mostly attribute events to a classic bubble driven by over-optimistic projections about future house prices which, in turn, led to a collapse in lending standards. A common feature of all bubbles that complicates the job of policymakers is the emergence of seemingly-plausible fundamental arguments that seek to justify the dramatic rise in asset prices. A comparison of the U.S. housing market experience with ongoing housing market trends in Norway once again poses the question of whether a bubble can be distinguished from a rational response to fundamentals. Survey evidence on people’s expectations about future house prices can be a useful tool for diagnosing a bubble. In light of the severe economic fallout from the recent financial crisis, central bank views on the use of monetary policy to lean against bubbles appear to be shifting.

House prices in many industrial countries increased dramatically in the years prior to 2007. Countries with the largest increases in household debt relative to income experienced the fastest run-ups in house prices over the same period (Glick and Lansing 2010, International Monetary Fund 2012a). Within the United States, house prices rose faster in areas where subprime and exotic mortgages were more prevalent (Tal 2006, Mian and Sufi 2009, Pavlov and Wachter 2011). In a comprehensive report, the U.S. Financial Crisis Inquiry Commission (2011) emphasized the effects of a self-reinforcing feedback loop in which an influx of new homebuyers with access to easy mortgage credit helped fuel an excessive run-up in house prices. The run-up, in turn, encouraged lenders to ease credit further on the assumption that house price appreciation would continue indefinitely. When the optimistic house price projections eventually failed to materialize, the bubble burst, setting off a chain of events that led to a financial and economic crisis. The “Great Recession,” which started in December 2007 and ended in June 2009, was the most severe U.S. economic contraction since 1947, as measured by the peak-to-trough decline in real GDP (Lansing 2011).

This article compares the U.S. housing market experience to ongoing housing market trends in Norway with the aim of considering whether a bubble can be distinguished from a rational response to fundamentals. Case and Shiller (2004) make the point that “the mere fact of rapid price increases is not in itself conclusive evidence of a bubble…The notion of a bubble is really defined in terms of people’s thinking about future price increases.” Survey evidence on people’s expectations about future house price appreciation can therefore be a useful tool for diagnosing a bubble. As was true in the United States, housing investors in Norway appear to expect high future returns on real estate even after a sustained run-up in the price-rent ratio. Such views are directly at odds with the idea that a decline in the risk premiums of rational investors is the explanation for the run-up in house prices.