Irrational Exuberance, Bubbles and the price you pay

Let's talk about houses

Let's talk about houses. The physical manifestation of our home, often associated with family, shelter, comfort, and sometimes even as an investment. For most of us, it is the biggest asset that we own, and a lot of us are willing to be in debt for decades just to get one; all of this perhaps because of what it symbolises - stability. 

Asset with far reaching consequences

The fact that there is a type of expensive asset a lot of us own, that is directly associated with homes and stability should probably ring some bells already. Unlike other types of assets that we own, such as company shares, a change in the house prices has very far reaching consequences.  

When house prices are booming, confidence rises across the entire economy. People feel richer and are more willing to spend and are able to get more cash if they choose to sell or get a mortgage equity withdrawal. However, if house prices fall or even fall below the value of their mortgage, then people become trapped in negative equity. The good thing is, it is a house after all, and you probably live in it, you don't always have to sell when the time is bad.

Increasing home ownerships and housing booms

Professor Robert Schiller, an economic professor at Yale points out that house prices tend to boom in areas where there are greater restrictions on planning and building, which increases the danger of a collapse in prices later on, or bust. With increasing world population and limited amount of land and houses in the developed cities, perhaps house prices will surely continue the upward trend if everybody wants to buy one. 

                                                                                                                      

However, this was not always the case. In the UK, up until the First World War, most houses are owned by the richest of the population. Only 1/10 of homes were owned by their occupier; it was a social norm to rent, even if you could afford to buy one. Successive post-war government policies that encouraged home ownership and the social values and benefits that comes with it probably contributed towards the shift in mentality and home ownership gradually became a talismanic social objective. 

Housing boom and bust tends to happen in countries where there is a widespread of home ownership. Based on the rules of supply and demand, when prices reach a perceived unreasonable level, demand should fall, which brings down the prices. However, if the government or the lending institutions such as banks continue to provide incentives to buy, it makes bubbles more likely to form (a good recent example would be the ever-increasing risks taken by the US mortgage giants Fanne Mae and Freddie Mac just before 2007). Countries such as Germany and Switzerland are more successful in resisting these property bubbles, as regulations makes it more financially attractive to rent than buy.

Economic bubbles

Bubbles occur when people get carried away by excitements about a particular asset and push the price higher than the reasonable worth. However, the 'right' price is subjective, hence it is difficult to distinguish bubbles from genuine price rises due to increase in demand and even more difficult to predict when the bubble will burst. 

Some (pro-cyclical) Economists suggest that bubbles are an integral part of a well functioning economy, encouraging large scale investments that would otherwise not occur (such as the massive fiber-optic links across the world during the dot-com boom in the late 1990s) and some argue that popping the bubble rids the economy of its least successful businesses. Hence many experts advice against (counter-cyclical) the clamp down on bubbles, as they are difficult to identify and also fiscal policies such as interest rate rises are likely to cause collateral damage in other parts of the economy.


Positive and negative feedback loops

When asset price rises, people feel richer, they spend more and this drives the wider economy forward. 
When asset prices fall, people are less willing to spend, which cause prices to fall further and the vicious cycle continues.

These cycles are difficult for central banks and policy makers to address, and hence a boom followed by a bust can have long lasting devastating consequences.

Controlling the bubbles
Wake-up calls: The government announces publicly the concerns of bubbles developing and measures will be taken against it. (popping it early rather than later?)

Raise interest rates: Dampen the growth of the bubble. (At the expense of slowing growth at other parts of the economy)

Regulate banks and reduce cash flow: (However, cutting off the supply of legitimate funding sources can drive people underground and be exploited by the more risky private funding sources)


All of the above measures have been taken by China in the recent years in attempts to dampen the developing housing bubble. It remains to be seen if the housing bubble will continue to develop and how China will deal with the side-effects of the fiscal measures, especially its growing shadow-banking (private lenders often charging at very high interest rates) problems.



For as long as humans are irrational and unpredictable, perhaps bubble are inevitable.