Wednesday, February 5, 2014

When Is A Bubble A Bubble?

This post will have me both on well-trodden ground AND thin ice, to hopelessly mix my metaphors. There's loads of economic and popular literature on bubbles out there, with a wide range of opinions. Scott Sumner generally dismisses their existence. I don't agree, since I think complex adaptive systems do occasionally lend themselves to bubble-like phenomena. Let's for the sake of argument that bubbles do happen, by which I mean an asset price increases out of line with its fundamentals. The next question is rightly "When do we know that increases are unjustified?" You can go wrong for all kinds of reasons. In 2009, I mistakenly thought that the rise in the stock market was unsustainable because I didn't understand the effect of looser monetary policy on earnings and the discount rate on equities. (By 2010, I started to realize that the market monetarist model seemed to work better empirically than my Internet Austrianism.)

As with most things, I'm no expert on property prices, but I've lived recently in London, New York and Singapore, all places where prices have risen strongly since 2008, are high on a per square foot basis, and where the topic figures frequently in conversation. In fact, in London, home prices are such a hot topic that it dominated a recent Mark Carney press conference. I'm in the process of learning more about the intricacies of real estate as an asset class, and will perhaps post when I have better data, but for the time being, let's say there are several possibilities in the London market, just to take one example:

1) Prices are being bid up by speculators, who think prices will continue to rise and allow them to enjoy capital appreciation.
2) Prices are being bid up by nervous homeowners who fear that prices are going to continue rising, and if they don't act now, they'll never own homes, much less their dream homes. They feel compelled to take on leverage to do so.
3) Investors think that rents are going to rise, which will justify the prices being paid.
4) Investors are demanding lower yields on property assets. This is a variety of the safe asset shortage problem described by David Beckworth among others. 

My social circle naturally informs my purely anecdotal impressions, but I hear a lot of (4), with a little bit of (2). I've had Singaporean friends say to me "Central London property always holds its value", which sounds to me like "The asset has low volatility of returns", or more simply, "It's a safe asset." I think reasons (1) and (2) would be cause for concern, (3) depends on whether there is some basis for those beliefs, and (4) is a secular change that has to be respected. (And please, I'm not suggesting that London property is therefore a good buy, since that depends on investor preferences at various yields).

This may be horribly naive, but maybe... we could just ask people. We use well-designed surveys for lots of things, so why not here? I know there are flaws: people may not understand their true reasons, or may be hesitant to explain those reasons, particularly if they're institutional investors. It may also be more or less appropriate for specific asset classes. But hey - sometimes the best way to know why someone is doing something is to ask them!  It seems like some economists and finance professionals spend an awful lot of time creating models and speculating about various indicators and not enough time understanding what exactly is going on in investors' heads (I'm sure real estate consultancies do this sort of work, though I bet few central bankers deign to listen to them). If bubbles do exist, we'll do a hell of a lot better responding to them if we just talk to people and understand what's driving them. And if they don't exist at the moment, then we'll certainly do better not to shoot at imagined ghosts in the night. Tampering with monetary policy to stem imagined bubbles would be an unfortunate ricochet.

1 comment:

  1. This is what Robert Shiller did w/r/t the late US housing bubble. He did surveys asking what people thought the rate of house price appreciation would over xyz number of years. The fact that people were looking for 10%+ annual price appreciation indefinitely fed Shiller conclusion: bubble.