Senior Fellow Kevin A. Hassett

The smell of fear permeates Washington.

With the U.S. economy on the ropes and esteemed financial institutions such as Bear Stearns Cos. and the Carlyle Group suffering major losses, policy makers are outdoing one another in the search for creative intensive care. The irony is that the latest research suggests that government policy makers started this mess in the first place.

Mr. Hyde put us in the hospital. Dr. Jekyll has met us at the operating table.

Policies in play, from the House of Representatives bill to allow municipalities to purchase real estate to the Federal Reserve's letting financial institutions swap mortgages for Treasuries, are clearly built on the assumption that the boom and bust in housing prices are to blame for our misery.

But these policies attack a symptom. Before one can judge whether they will be effective, we need to diagnose the disease. Hardly anyone has taken that step.

The prevailing story appears to be that the housing industry has experienced a "bubble," or an irrational price swing resulting from the misbehavior of greedy home buyers and the lunacy of companies willing to lend to them using risky adjustable-rate subprime mortgages.

Without entering the technical domain, it is worth observing that this explanation is a tremendous convenience for politicians. A bubble is the explanation of a price swing that remains when all others have been rejected.

Regulation the Culprit

Yet a recent study by Cato Institute scholar Randal O'Toole that draws on broad economic literature documents that the price swings are, in fact, not so difficult to understand. Out-of-control government regulation started the mess.

For most of U.S. history, real estate prices have tended to rise with inflation. In periods when they increase faster than that, home building activity rises, driving prices back down.

If builders can put up new houses, then one should expect the price of a home to be constrained, not to be higher than whatever it might cost to replace it. Since the U.S. is flush with land, it has generally been easy for supply to respond to higher prices, and push them back down.

But in the 1960s and 1970s, California and Hawaii began a movement that sought to limit this normal supply response with "Growth Management Planning." These states effectively drew a line around a city, and allowed building inside the line, but not outside. Over time, such regulation has spread dramatically.

"A Regular Cycle"

When land use is constrained, supply can't respond to higher prices, forcing prices to climb even higher. This is exactly the impetus that can start a catastrophe like the current episode. "It's a regular cycle," O'Toole told me last week. "States adopted land-use regulations, and then their real estate prices skyrocketed and then crashed. Early movers like California have seen the cycle a number of times."

The problem is, this cycle is no longer confined to California and Hawaii, and the fluctuations can now bring down the whole economy.

"In 2006," O'Toole reports in his study, "the price of a median home in the 10 states that have passed laws requiring local governments to do growth-management planning was five times the median family income in those states." In contrast, a median home in the 22 states that have no growth-management laws or institutions cost only 2.7 times the median family income.

Low Rates

To be sure, there are a number of other reasons for the housing-price appreciation that began in the late 1990s and lasted until 2006. Low long-term interest rates and increased availability of credit for less-qualified households through subprime mortgages undoubtedly played a part.

Diminishing interest rates on mortgages made housing investment increasingly attractive compared with other investment opportunities. As home ownership rates increased and prices appreciated, mortgage lenders were more willing to do business with less-qualified home buyers, confident that even if the borrower defaulted on the loan, the price appreciation of real estate would more than cover the lender's losses.

But a recent study by University of Washington economist Theo S. Eicher concluded that "the estimated increase in housing prices associated with regulations is, on average (over 250 cities), substantially larger than housing demand effects."

Matter of Time

The evidence is clear. Regulations that inhibit the supply response to higher prices are the primary culprit in this mess.

As Congress and the Fed administer aid to financial institutions that ignored the history of past cycles, policy makers around the country must change regulations that are targeted at aesthetically displeasing urban sprawl, but create harmful price volatility.

Getting us out of this mess requires short-term solutions, and the Fed is probably taking steps in the right direction by loosening liquidity constraints. For the long term, draconian land-use regulations must be reconsidered by local and state governments.

If not, it will only be a matter of time before we experience this all over again.

Kevin A. Hassett is a senior fellow and director of economic policy studies at AEI.