Bursting our bubble.

• Author: O'Toole, Randal
• Position: Life in America

EVERYONE AGREES that the nation's financial crisis started with the deflation of the housing bubble, but what caused the bubble? Answering this question is important for identifying the best short-term policies and for fixing the credit crisis, as well as for developing long-term policies aimed at preventing another crisis in the future.

Some people blame the Federal Reserve for keeping interest rates low or the Community Reinvestment Act for encouraging lenders to offer loans to marginal homebuyers. Others fault Wall Street for failing to assess properly the risks of subprime mortgages. Yet, all of these explanations apply equally nationwide, while a close look reveals that only some communities suffered from housing bubbles.

Between 2000 and the bubble's peak, inflation-adjusted housing prices in California and Florida more than doubled and, since the peak, they have fallen by 20% to 30%. In contrast, housing prices in Georgia and Texas grew by only about 20% to 25%, and they have not declined significantly. In other words, California and Florida housing bubbled, but Georgia and Texas housing did not. This hardly is because people do not want to live in Georgia and Texas; since 2000, Atlanta, Dallas-Ft. Worth, and Houston have been the nation's fastest-growing urban areas, each growing by more than 120,000 people per year.

This suggests that local factors, not national policies, were a necessary condition for the housing bubbles where they took place. The most important factor that distinguishes states such as California and Florida from states like Georgia and Texas is the amount of regulation imposed on landowners and developers and, in particular, a regulatory system known as growth management.

In short, restrictive growth management was a necessary condition for the housing bubble. States that use some form of growth management should repeal laws that mandate or allow such planning, and other states and urban areas should avoid passing such laws or implementing such plans; otherwise, the next housing bubble could be even more devastating than this one.

In 2005, both Alan Greenspan and Ben Bernanke of the Federal Reserve argued that there was "no housing bubble" and that people need not fear that such a bubble would burst. Greenspan admitted there was "froth" in local housing markets, but no national bubble. Bernanke argued that growing housing prices "largely reflected strong economic fundamentals" such as growth in jobs, incomes, and new household formation.

How could they have gone so wrong? "Bubble deniers point to average prices for the country as a whole, which look worrisome but not totally crazy," Princeton economist Paul Krugman wrote in a 2005 newspaper column. "When it comes to housing, however, the United States is really two countries, Flatland and the Zoned Zone." Flatland, he said, had little land-use regulation and no bubble, while the Zoned Zone was heavily regulated and was "prone to housing bubbles." Krugman's choice of terms is unfortunate because most of "Flatland" is, in fact, zoned. What makes the Zoned Zone different is not zoning but growth-management planning, a broad term that includes such policies as urban-growth boundaries, greenbelts, annual limits on the number of building permits that can be issued, and a variety of other practices.

Growth control, which limits a city's growth to a specific annual rate, is a form of growth-management planning that was popular in the 1970s. Smart growth, which discourages rural development and encourages higher-density development of already developed areas, is another form that is more popular today. No matter what the form, by interfering with markets for land and housing, growth-management planning almost inevitably drives up housing prices and is closely associated with housing bubbles.

After home-price deflation led to the credit crisis, it became "conventional wisdom that Alan Greenspan's Federal Reserve was responsible for the housing crisis," notes Hoover Institution economist David Henderson in a column in the Wall Street Journal. Although Henderson disagreed with this view, several other economists writing in the same issue agree that, by boosting demand for housing, the Federal Reserve Bank's low interest rates caused the housing bubble. "The Fed owns this crisis," charges Judy Shelton, the author of Money Meltdown.

Other people blame the crisis on the Community Reinvestment...