Real Estate Bubbles and Urban Development

Real estate booms have regularly occurred throughout the world, leaving painful busts and financial crises in their wake. Real estate is a natural investment for more passive debt investors, including banks, because real estate's flexibility makes it a better source of collateral than production facilities built for a specific purpose. Consequently, passive capital may flow disproportionately into real estate and help generate real estate bubbles. The preference of banks for more fungible real estate assets also explains why real estate is so often the source of a financial crisis. Real estate bubbles can be welfare enhancing if cities would otherwise be too small, either because of agglomeration economies or building restrictions. But given reasonable parameters, the large welfare costs of any financial crisis are likely to be higher than the modest benefits of extra building. The benefits of real estate bubbles are welfare “triangles,” while the costs of widespread default are welfare “rectangles.