What does history tell us about the new housing bubble?

Written by John Fry on . Posted in Opinion

Ours is a nation obsessed with house prices. The simple truth is that housing matters. Housing is typically the major asset in household portfolios and as we have seen, can have major implications for the health of the economy. The banking sector is particularly exposed to the housing market and house-price crashes tend to affect the economy much more than stock-market crashes.

Given recent price rises, the question on many peoples’ lips seems to be are we already in, or about to enter a new housing bubble? As a mathematician specialising in the modelling of speculative bubbles I’m afraid my rather boring answer is that it is simply too early to tell.

Protagonists of bubbles might assume that prices were equal to fundamental values historically before under-going a period of rapid growth. This is less likely to be the case here after the crash of 2008. Opponents might argue that prices were too low historically and recent price increases may simply represent an adjustment to a long-term ‘fair’ value. Given the financial crisis of 2008 this view clearly has some merit.

Historically UK house prices have been subject to various bubble and antibubble (bust) episodes over the years. Most recently, using a model I developed, we found formal statistical evidence of a speculative bubble from 2000-2008 and, more pertinently, formal statistical evidence of an antibubble from 2008-11. However, using our model, it would not have been possible to identify the bubble that ran from 2000-2008 until 2003 at the earliest. It thus takes some time to properly establish whether the growth that occurs is part of the readjustment from the last economic cycle, and growth that would be expected to occur anyway, or a genuine bubble. So at the moment, it is simply too early to tell.

The historical context here is key. Over the last three decades UK house prices have shown themselves to be intrinsically volatile (see the figure below). Alongside this graphic we found formal statistical evidence for bubbles in UK house prices from 1983-89 and from 2000-08. We also found evidence of antibubbles from 1990-96 and from 2008-11. To a certain extent, prices may simply be rising up out of the last cycle. However, it is still too early to be sure.

Again the historical context provides some guidance. In their evocatively titled book ‘This time it’s different: eight centuries of financial folly’, Carmen Reinhart and Kenneth Rogoff exhaustively document various booms and crashes that have occurred as far back as the default of Dionysius of Syracuse in Greece in the Fourth Century B. C. Sadly, things are never ‘as different’ as people imagine and the bubble eventually bursts. Financial booms and busts doubtless go back even further into human history and it seems that they will probably always be with us.

How do boom and busts occur? Are people just stupid? The short answer is sometimes yes but mostly no.

Whilst modelling bubbles is difficult both economically and statistically one of the themes that has emerged from the literature over the last 30 years is that despite clear instances of hysteria there is no requirement for mass irrationality in order for bubbles to occur. Financial markets fundamentally work by balancing risk and return. This simple statement is surprisingly subtle and has out-foxed both mathematicians and non-mathematicians alike. This simple truism has also brought down many people better and brighter than myself, so a cool head and a good dose of humility are clearly called for here.

Under so-called rational bubble models most market participants take a ‘calculated risk’ balancing the underlying risks against the possibility for future reward. However, whilst doing so, most people are probably over-confident. During the internet bubble people recognised that the new technologies afforded genuinely profitable opportunities but over-estimated the extent of the potential rewards. Similarly, during the housing bubble, people recognised that housing represented a good financial investment in ways not previously considered. However, collectively, the market over-exaggerated the scale of the potential gains available.

In summary, being linked to evolutionarily-stable human preferences for risk, return and over-confidence it seems that financial booms and busts will always be with us.

As an academic interested in bubbles, it turns out that housing markets are a very interesting place to look. This is partly because the risks and rewards associated with housing are so great. Furthermore, being based on consumption, rather than investment, market inefficiencies mean that house prices are particularly prone to bubbles. Academic studies have found evidence for house-price bubbles in many different countries throughout the world. The UK’s is not an isolated experience; housing markets just seem particularly prone to bubbles and more so than say stock markets.

Global economic history, past UK house prices, housing markets, and the fallible human beings that make up that housing-market, all point to one inescapable fact. The next housing bubble will come. The only question is when. When it finally arrives the next bubble will raise difficult equity issues. This is particularly true if more people lose out in busts than gain in bubbles.

 

The views expressed in the Opinion section of StatsLife are solely those of the original authors and other contributors. These views and opinions do not necessarily represent those of The Royal Statistical Society.

Finance & The Economy House prices

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