Krugman and DeLong misinterpret the "price" of housing

In response to another article by Krugman (assisted by DeLong): http://krugman.blogs.nytimes.com/2010/01/13/percents-and-sensibility/#comment-281761

Krugman and DeLong argue that holding interest rates 2% too low for 3 years would impact the price of a long-duration asset like housing by 6%, so even if you have a lot of positive feedback trading built, in that shouldn't be enough to create a bubble.

However, if I'm not mistaken, if the interest rate elasticity of demand for money is in the vicinity of 1, and we held rates at ~4% instead of ~6%, that would mean demand for goods - including houses - would be in the range of 30-50% too high. Isn't that reasonably reflective of what happened? You don't need some ridiculous elasticity of housing demand to cause this bubble as it occurred. If the "price" of a mortgage is its interest rate, and you held interest rates 33% lower than they should be, of course demand is going to go through the roof. Maybe in terms of principal the interest is a small piece, but in terms of attractiveness of a mortgage to someone looking to profit instead of looking to live there, the interest is everything. So yes, the real estate bubble was driven by speculators, and yes, financial markets are schizophrenic (and there are some excellent accounting regulations and regulations on minimum down payments on mortgages to deal with it) but you can't blame the private sector as dysfunctional - it reacted rationally (if hyperbolically discounted in some way) to a dysfunctional Fed Funds Rate.


EDIT: I thought of another problem with their interpretation - not all mortgages are adjustable rate mortgages; many are fixed rate. If most mortgages are long term (30 years), and they have been constantly fixed at a rate 33% lower than they should have been, then the value of the mortgage, by simple DCF, should be 25-30% higher than they should be. Thus, even a situation with no speculators ends up in an asset bubble. Krugman and DeLong should know better.