houses houses everywhere, but no one to live in them

I read two articles today so i could prove a friend wrong. we had a discussion, on the way to the inauguration, about housing prices. My position was that housing prices have been way above historical averages for the last 20 years and need to be reset to those levels. Her position was that housing bubble doesn't need to be deflated back 20 years, but to the start of this bubble. I felt a little vindicated when i searched on google for the info i was looking for: historical prices of houses. The graph below has them both adjusted for inflation and not.
You'll see that 20 years ago was the little blip right before the stock market crash of '89 and the ensuing recession for the next five years. One of my arguments was that the low interest rates of the last few years fueled a lot of people trying to buy houses that they just couldn't afford, or to use the presence of cheap money to flip houses, further pushing up the price of housing for everyone.

She said that the market needs to correct so that people can buy houses at their current prices. And for this to happen they need low interest rates for them to do this. This was the point in the conversation where i said "if they can't afford it at eight percent, they can't afford it at four". It's my opinion after reading a little from Ludwig Von Mises of the Austrian School of economics that the variation in interest rates is what creates boom and bust cycles. The pedal and brake that Greenspan expertly applied to speed up or slow down the economy caused it to spin out of control.

So it's my opinion that what should be happening is that we actually let the housing market tumble. You may think the alternative is to let the 'economy slide' and unemployment go rampant. Somewhere embedded in trying to stop the fall of housing prices is to stick people with mortgages they can't afford! This can then turn into another bubble being burst. I'd rather stick with one long one than two a couple years apart. The question isn't when we reach the bottom, but do we make a pit stop on the way down?

The other article that i read was about the decline in housing starts. The gist of the article is that we've build way more houses than we have people. We have about 1.3 million vacant homes. that is with no bodies to fill them. Even if everyone bought the home they are in, we'd have the vacant homes. So what we have to do is to stop building so many new houses and let the people we have (through going out on their own and immigration) fill the houses through sheer population growth. This means that with the slide in about 700,000 houses per year, we would expect the contsruction market to catch up at about early 2011.

One thing on this i mentioned to my brother is that our new president should instruct his agencies to give preferential lending and treatment to building for density and not sprawl. With the considerations of energy running rampant, we find it much easier to support urbanization than sprawl (which promotes gas guzzling long trips to stores and work). This may in the short term have as much an impact on hybrids and electric cars.

So what i would like to see in the mean time is a slow pre-emptive creeping back up of the Fed's prime rate. If banks aren't lending because money is cheap, they won't lend if money is expensive. We might as well set a stable number for interest rates for the next five years so people can plan around it.