The bond rally late last week signals that investors now believe the U.S. economy is heading for a rough patch. With companies flush with cash, this can only mean one thing: The drag from the housing-market slowdown is turning deeply troubling.

Resident Scholar Kevin A. Hassett

The economics literature has a surprising answer: Ditch the commute.

For my money, the best paper on the economics of housing markets was published by Professor James Poterba of the Massachusetts Institute of Technology more than 20 years ago in the Quarterly Journal of Economics. Poterba shows that understanding the market requires modeling the response of housing investment to current prices, and then projecting the impact of current investment on future prices.

The intuition is quite simple. Prices are determined by the entire stock of housing in existence, and that stock changes over time as new construction occurs. If prices of existing homes are high today, and it is relatively cheap to build a new house, then builders will flood the market with new homes and drive prices down. Since houses can take some time to be constructed, the impact of new construction on prices can take time as well.

Irrational Builders

Moving from the simple predictions of the model to the real world, one can see how problems can erupt. If people invest heavily in new homes, they will increase the supply sharply and potentially drive down prices. However, builders might not be fully rational about the impact of their own activity on future prices, and build so many houses that prices drop precipitously.

A look at recent data suggests such a pattern may well have occurred. As existing-home inventories piled up during the past 1 1/2 years, housing starts continued pretty much at the same pace. Inventories were up 40 percent in July from a year before, while new home construction had only fallen off 14 percent.

This mild slackening is striking considering what was going on with prices: The average sales price in July 2006 was the same as in 2005. A year ago, home prices were growing at annual rates of 10 percent or more. With sales unchanged and inventories rising, builders were still putting up new houses.

So what can a homeowner do?

Sit Tight

The first thing is to remember that sitting tight is, for most people, going to be the best policy. It might be great to think about selling your house before prices collapse, and then buying back after the drop. Such a move could make you hundreds of thousands of dollars in many metropolitan areas.

The problem is nobody knows exactly when the price swing might occur. Plus, transaction costs for buying and selling homes are so high that the swing will have to be very large indeed--perhaps on the order of 15 percent--to make a well-timed move profitable.

But if you are tempted to be aggressive, economic reasoning suggests a simple path to take. Since a prime impetus driving down prices is the massive increase in supply that can occur when prices soar, it is likely that there will be significant geographic variation in housing-price declines. That variation can help identify opportunities.

The key is this: You are far more likely to be in trouble if the region you live in has seen a surge of building in recent years. If you live in a suburban area that was mostly farm country 10 years ago and is moonscaped with McMansions today, then your area has seen a sharp increase in supply. If your neighborhood was fully built up 10 years ago and has seen no new construction, then the price threat from new supply will be a lot lower.

Old vs New

These differences, however, can only be significant if there is some reason why the "old neighborhood" houses are different from the "new neighborhoods." In Washington, where I live, homes in the city are quite different from homes in the suburbs for one big reason: The commute in and out of the city is hellacious.

Thus, there are different trends in prices for homes inside and outside the city, since urban and suburban homes are poor substitutes for one another. If the commute were trivial, then the increase in supply in the suburbs would have a big impact on prices in the inner city as well. In Washington, the construction explosion for single-family homes has been mostly a suburban phenomenon.

Accordingly, if there is to be pain, it will likely be worse out there.

If you are someone who has been wondering whether sitting in your car on the way to work for an hour each way is worth all the hassle, it might be a good time to consider trading your McMansion for a place in the city. If you make that move, you get the immediate dividend of more time with your family and the longer-run dividend of insuring yourself somewhat against the supply-induced collapse of housing prices.

Kevin A. Hassett is a resident scholar and director of economic policy studies at AEI.