Naysayers, the housing bubble was obvious
I keep a bunch of articles on my blog’s sidebar as a reminder of what was being said about the housing bubble, when and by whom. One article I omitted is from The Economist, warning of a ‘global’ housing bubble and illustrating residential property price increases across a swathe of countries. As this warning came in June 2005, bubble naysayers have no excuse.
It has been quite evident in a number of countries for quite some time that housing prices were — how can you say — bubblicious. I certainly understood this to be the case in all of the countries where the bubble has since popped: the US, the UK, Spain and Ireland. As far back as 2003-2004, many were complaining about the Federal Reserve’s easy money policy under Alan Greenspan and the effect it was having on residential property.
Going back to 2005, which markets had seen the largest increases in house prices over the past decade? The US: up 73%, The Netherlands: up 76%, Sweden: up 84%, France: up 87%, Australia: up 114%, Spain: up 145% Britain: up 154%, Ireland: up 192, and South Africa: up a massive 244% (see chart). These are funny money increases that, in some cases continued into 2006 and 2007.
The article begins:
Never before have real house prices risen so fast, for so long, in so many countries. Property markets have been frothing from America, Britain and Australia to France, Spain and China. Rising property prices helped to prop up the world economy after the stockmarket bubble burst in 2000. What if the housing boom now turns to bust?
According to estimates by The Economist, the total value of residential property in developed economies rose by more than $30 trillion over the past five years, to over $70 trillion, an increase equivalent to 100% of those countries’ combined GDPs. Not only does this dwarf any previous house-price boom, it is larger than the global stockmarket bubble in the late 1990s (an increase over five years of 80% of GDP) or America’s stockmarket bubble in the late 1920s (55% of GDP). In other words, it looks like the biggest bubble in history.
The alarm bells were ringing pretty clearly, not only in the UK, Ireland, Spain and the US, but also in a number of other markets, South Africa principally amongst them. The two most obvious questions are why did they rise so quickly, and what can we expect in the individual markets going forward.
Why did prices rise?
My answer as to why prices rose so quickly has to do with excess monetary stimulus, principally in Japan and the US. We live in a global economy were economic agents can borrow money in various forms, in various currencies, in a host of countries. They can then invest these monies anywhere they so please. What this means for asset and consumer prices is that easy money in one market easily spills over into other markets. While the Fed and the Bank of Japan wanted to stimulate their moribund economies earlier this decade, their monetary stimulus reached far and wide, helping to create bubbles across the globe.
In the chart to the left as of September 2005, around the time of the Economist article, one can clearly that the Fed had only raised rates to 3.75%. Yet the annual inflation rate in the U.S. in September 2005 was 4.7%. That means anyone borrowing in dollars and investing in dollars was seeing the real cost of their loan decrease by nearly 1% annually. It’s like being paid 1% to borrow money. Who wouldn’t jump at that?
And it was this incentive to lever up, for individuals and companies alike that created asset bubbles, not only in housing, but in a multiplicity of asset classes. In fact, the incentive to borrow at negative real rates was so large that house price gains were outstripping rent increases by a large margin. The cost of ownership, particularly in hot markets, often greatly exceeded the cost of renting. One should ask, why would anyone buy a house that could be rented for much less? The only possible reason is the incentive of negative real rates and the attendant house price appreciation.
So, by most traditional measures — house prices to rent ratio, house price increases to inflation, house prices as a percentage of GDP, house prices to disposable income ratio — house price increases were not justifiable across a number of locations. What I find most most interesting is that consumers would engage in this type of behavior despite having just been savaged in another vicious asset boom-bust in equities just a few years earlier.
So, where do we go from here?
I am conducting a poll on my site in the sidebar (now over), asking people to estimate the likely fall in U.S. house prices from their peak. It will be interesting to see how prescient we collectively are in predicting where things are headed.
My personal view is that we are headed much lower in prices. Why? Leverage. I see the housing bust as a deleveraging situation. Individuals and the financial services industry must reduce risk because the level of debt to assets they own is making them susceptible to bankruptcy. There’s nothing like a recession to focus one’s mind on potential downside scenarios. And so it is in 2008. Caution is necessary to prevent potential bankruptcy. This requires one to shed assets, increase savings and reduce debt. This is exactly what individuals are doing and what lenders are doing.
However, deleveraging means credit contracts, which, over the short-term, reduces ecoomic growth. That means that prices must come down until the economic uncertainty and deleveraging period are finished, so that people feel confident enough to take on increased levels of risk. This will not happen for a number of years.
The one other question I have is about those housing markets yet to fall. France, the Netherlands, Australia and Sweden all had house price increases that outstripped the US, the first domino to fall in the global housing bust. What is going to happen in these markets? My best guess is that they too will succumb in some measure to the bust as well in due course.
The Economist has the best conclusion to this issue, using Japan as a base case.
The housing market has played such a big role in propping up America’s economy that a sharp slowdown in house prices is likely to h
ave severe consequences. Over the past four years, consumer spending and residential construction have together accounted for 90% of the total growth in GDP. And over two-fifths of all private-sector jobs created since 2001 have been in housing-related sectors, such as construction, real estate and mortgage broking.
One of the best international studies of how house-price busts can hurt economies has been done by the International Monetary Fund. Analysing house prices in 14 countries during 1970-2001, it identified 20 examples of “busts”, when real prices fell by almost 30% on average (the fall in nominal prices was smaller). All but one of those housing busts led to a recession, with GDP after three years falling to an average of 8% below its previous growth trend. America was the only country to avoid a boom and bust during that period. This time it looks likely to join the club.
Japan provides a nasty warning of what can happen when boom turns to bust. Japanese property prices have dropped for 14 years in a row, by 40% from their peak in 1991. Yet the rise in prices in Japan during the decade before 1991 was less than the increase over the past ten years in most of the countries that have experienced housing booms (see chart 3). And it is surely no coincidence that Japan and Germany, the two countries where house prices have fallen for most of the past decade, have had the weakest growth in consumer spending of all developed economies over that period. Americans who believe that house prices can only go up and pose no risk to their economy would be well advised to look overseas.
These are very prescient words, delivered exactly three years ago in June 2005.
Update: 24 Jun 2008, 15:55
Calculated Risk posted a graph of the house price to median income in the United States. Very illuminating.