Understanding Housing Bubbles
By Hugh Pavletich
Co author Demographia International Housing Affordability Survey
Demographia
August 10, 2008
The Press (Christchurch, New Zealand) article Leaky homes and the housing bubble - New Zealand news on Stuff.co.nz (Saturday, August 9) provides an excellent example of how too many economists
and property commentators appear unfamiliar with the "Law of Supply and Demand" and the nature and phases of urban
property bubbles.
It would appear that this is because of their training - and the influence of Professor Paul Samuelson (Economics 101),
as outlined by Mark Skousen's The Perseverance of Paul Samuelson and Alan Ebenstein's The Poverty of Samuelsons Economics . Ebenstein states -
"There is in academic economic theory a growing unease, an unease that the entire approach of the field may be in error.
This unease is reflected in the growing criticism of the prevailing method of 'doing' academic economics - the great
emphasis placed on complex and difficult mathematical formulas to express economic activity.
Paul Samuelson is still perhaps the pre-eminent representative of the contemporary approach in academic economic theory.
Is Samuelson's mathematical method of presenting economic theory of value, or should it be placed on the trash heap of
history?
There is a difference between intelligence and relevance of intellectual academic output. The most brilliant individuals
- individuals whose intelligence far outstrips the rest of us - can be completely wrong in their factual appraisals of
the world....In short, Samuelson is a great mathematician, but he knows little about economic activity. He does not
understand how the market works."
The 5th through 11th Editions of Samuelson's standard textbook "Economics 101" incorporated a graph showing that
economic growth in the Soviet Union was catching up on the United States. The 1988 12th Edition provided a table
declaring that between 1928 and 1983, the Soviet Union had grown at a remarkable 4.9% annual growth rate, illustrating
that GDP per capita would soon surpass that of the United States.
The Soviet Union and communism collapsed within 12 months. It was subsequently learnt that the Soviet Unions GDP was
smaller than that of the Netherlands.
Just another serious Samuelson blunder - one that should have sent shock waves through the profession of economics 20
years ago.
Within the above article "Leaky homes and the housing bubble" - Neville Bennett, a retired lecturer of Canterbury
University and Cameron Bagrie, an economist with ANZ National Bank New Zealand, make no reference whatsoever to the
structural drivers of the housing market. They choose instead to mention peripheral matters - such as immigration and
unsophisticated investors. Bagrie - it would appear - is "confused" why increased interest rates by the Reserve Bank did
not dampen speculative activity (who cares about a 25 basis point rise in the OCR if one is making 100% a year by debt
loading and flicking property).
The Annual Demographia Surveys (4 annual editions to date - with links to numerous other reputable international research),
coupled with the JCHS Harvard University US Metros Median Multiple Tables should be sufficient evidence - for both Bennett and Bagrie and
other economists - that firstly, the linkage between household incomes and house prices is of critical importance - and
secondly, that housing prices should not exceed three times gross annual household income.
Should housing prices exceed three times annual household incomes - this is proof that there is some structural
impediment to the supply of affordable housing.
These matters are further explained within the writers' paper Getting performance urban planning in place .
Unfortunately Bagrie and Bennett make no mention of the relevance of "scarcity" in the formation of urban housing
bubbles and fail to explain why the urban markets - for example - high growth (in population and economic activity
terms) - of Houston, Dallas Fort Worth and Atlanta did not create housing bubbles. Yet Los Angeles inflated to 11.5
time's household earnings (currently collapsing - with Sydney Australia now being the worst in the Anglo world - refer
Sydney houses worlds least affordable ), with many other urban markets throughout the Anglo world inflating, as illustrated
within the Annual Demographia Surveys.
It would appear too - that there is an urgent need for retraining of economists and property appraisers / valuers with
respect to the difference between "inflation" and "growth". As part of this retraining - the important differences
between a "boom" and a "bubble" need to be taught as well.
Urban housing bubbles cannot form - if affordable new supply is allowed to meet increased demand. Just like computers,
cars and any other household item.
If affordable new supply is impeded as demand "kicks in" - this "scarcity" triggers inflated prices (fake value) - a
bubble.
There are three phases to an urban housing bubble - firstly, a ramping up of prices - secondly, a plateau - and thirdly
a collapse, as fake value is wrung out of the system. All urban housing bubbles behave slightly differently - depending
on the intensities of demand and supply. The 1990 Japanese bubble collapse and current Californian one - are excellent
"real life" lessons.
During the ramping up of a bubble, both lenders and purchasers convince themselves that prices will inflate forever and
normal market risks are ignored (a speculative frenzy and phony boom). Lending institutions discard "cash flow based
lending" and instead engage in "inflation based lending". They are essentially forced to - to maintain market share.
Both parties convince themselves that in the event of default, they will be able to sell the property at a higher
inflated price. So "losses' are a thing of the past.
As the bubble nears a "plateau" - where all parties become anxious about the inflated prices and household incomes
become more stressed with excessive debt loads and defaults - both purchasers and lenders realize there will no longer
be any inflation to protect them.
During the "plateau phase" - lenders become increasingly nervous, knowing that the protection of inflation is no longer
there for "inflation based lending" and suddenly revert back to "income based lending". Sales volumes then fall - as the
supply of "easy finance" dries up and property owners attempt to hold prices at inflated values.
Eventually the third phase is reached - as property owners can no longer "hold out" and purchasers and their lenders
become increasingly unwilling to pay "fake values" (above three times household incomes).
While the finance sector was happy to privatize the profits during the upside of the bubble, its focus through the
collapse - is to socialize the losses - by pleading for government / taxpayer welfare, as fake value is wiped out. Too
often builders and real estate interests (note the US NAR and NAHB advocacy) actively plead for taxpayer welfare as
well, in a vain and "money wasting" endeavor to prop up the fake value of bubbles.
This simply distracts policymakers from dealing with the real structural issues. Governments at National, States and
Local level already have enough problems of their own in these bubble markets (having created them in the first place) -
as they have been proliferate spenders during the upside of the bubble - only to find that their revenues fall through
the downside. Again - California is an excellent "real life" lesson in this regard. Others will inevitably follow.
The current global housing bubbles are unprecedented with respect to their intensity and scale - and their scope for
creating substantial political, social and economic disruption.
When these massive and indeed unnecessary "disruption costs" become more obvious - and most importantly experienced -
regrettably the economics profession will not likely have the necessary skills to assist in working through "real life"
solutions - to ensure that urban housing bubbles do not get underway again.
Economists urgently need to start living in the real world - by focusing on the structural urban issues.
This explains why people from the planning world - such as Professor Shlomo (Solly) Angel of New York University ( Housing Policy Matters - UN and World Bank Urban Indicators Programs), Professor Robert Bruegmann , University of Illinois at Chicago and Joel Kotkin of Los Angeles - are making the most constructive contributions in exploring solutions to these issues.
ENDS