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Sunday, September 01, 2002


It seems a preoccupation with bubbles and their aftermaths is all the rage. This weekend a number of emminent economic lumineries have been huddled in closed session for the annual Jackson Hole symposium organised by the Kansas Federal Reserve. Apart from Greenspan's scarcely credible observation that bubbles are difficult to identify in advance, there was his rather more credible acknowledgement that once in motion they are extremely difficult to halt without risking even more damage from the remedy. But talk of bubbles has to bring us right back to the housing market and in particular to the UK, Australia and Spain, if the housing price index which appears in this timely piece on the economist global site is anything to go by:

FOR all the newspaper space devoted to stockmarkets, households around the world have far more of their wealth tied up in property than in shares. American households' shareholdings briefly surpassed the value of their houses in the late 1990s. Now they have about $11 trillion-worth of shares (held directly or in mutual funds), compared with almost $14 trillion in housing. In other countries, housing is even more important. In rich countries as a whole, individuals own $23 trillion in equities, but perhaps $40 trillion in property.

Almost everywhere, house prices continue to outpace inflation. The exceptions are Japan, where house prices are now in their 11th year of decline, and Germany, where prices have been more or less flat since 1992. Britain has risen to the top of the house-price inflation league, with prices up by over 20% in the year to July, double the pace of a year ago. Australia, Canada and Spain have also all seen price gains of at least 10%. Average house-price inflation in America has slowed to around 7%, from 9% in mid-2001—a rise, still, of more than 5% in real terms. American house prices have risen by more in real terms since 1997 than in any previous five-year period since 1945. The National Association of Realtors says that house-price inflation has accelerated strongly in many cities in the second quarter. New York, Washington DC and Los Angeles all saw rises in median house prices of 18-22% over a year earlier.

There are reasons to think that the increased interest in property as an investment is here to stay. Yet there is also a big risk that investors, burnt by the stockmarket, are now overinvesting in housing. The market for housing is almost as prone to irrational exuberance as the stockmarket. And a housing bubble is more dangerous than a stockmarket bubble, because it is associated with more debt. A steep fall in house prices would harm the global economy far more than a slump in share prices. The best gauge of whether house prices are overvalued is the ratio of house prices to average disposable income—the equivalent, as it were, of the price/earnings (p/e) ratio for shares. In America and Britain, this ratio is now close to its peak of the late 1980s, and the ratio is flashing red in some cities, such as London and Washington, DC. In Ireland and the Netherlands, the ratio is at a record high.

All this means that house prices might continue to rise for a while yet. But the higher they climb, the more households' debt will swell. The real housing bubble in America and Britain is not the rise in house prices, but the growth in mortgage debt, which is at record levels in relation to incomes. The optimistic view is that, with interest rates at 40-year lows, households can afford to borrow more. Still, home buyers may be underestimating the true cost. Interest rates are low because inflation is low. But that means that borrowers can no longer rely on inflation to erode their debts, as it did in the past. At the very least, households hoping that ever-rising house prices will provide generous nest eggs are likely to be disappointed. At worst, the risk is that prices in many countries may take a tumble. Falling house prices, massive debts and low inflation: now that really would be an unpleasant cocktail to contemplate.

Allen Sinai was also at pains to make a similar point at the Jackson Hole get-together according to this report from Yahoo News:

"We are looking at the biggest stock asset deflation since the 1930s," economist Allen Sinai of Boston-based Decision Economics Inc. said after the invitation-only meeting ended. "It's severe and significant, it is some $7 trillion of loss, maybe $7-1/2 trillion of lost net worth to Americans in equities, so far offset by an increase in residential real estate asset wealth,"

Sinai said he sees some dark parallels between the stock-price run-up in the 1990s, which led to companies using debt excessively, and to home-price surges that has led homeowners to leverage themselves with more debt and to flock to real estate purchases after bailing out of stocks. "It's a bit of the gold rush, tulip craze, dot-com psychology," he said, referring to buying behavior in real estate markets. "That's what I mean by bubble-like ... I'm very concerned about that as a risk to the economy."

Sinai is very concerned about it and me too. It's still too early to say how this one will end, but it certainly doesn't look either stable or sustainable. The happiest outcome would be a stronger recovery in the broader economy producing a rise in interest rates and a consequent adjustment downwards in house prices, which as well as being a function of earnings must also be a function of monthly repayment schedules. But failing this, and right now the possibility of a strong recovery doesn't seem too evident in the short term, it remains to be seen for exactly how much longer there will be buyers coming up to the plate to pay next months higher prices. Remember this increase is speculative to the extent that people are investing in housing since they believe that the prospects of a continuing rise make today's prices realistic. If that confidence disappears, then what happens next?

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