Around the world, newspapers trumpet a "housing bubble" about to burst. The Economist has run numerous cautionary articles with titles like "Castles in Hot Air." "Housing Prices Soar, Fueling Bubble Fears," chirped The Wall Street Journal . "The Property Bubble Menaces Growth," warned Le Monde . "Homes Bubble May go Toxic," The Sydney Morning Herald admonished.
Are such fears justified? How do we know if the housing market is in a bubble?
The term "bubble" is widely used but rarely defined. A bubble occurs when public expectations for future price increases become exaggerated, pushing prices up to unsustainable levels. When this happens, many people buy homes to rent out as investment properties, and many more who are buying homes to live in also behave like investors, fearing that if they wait, they will be priced out of the market.
During a bubble, buyers are relatively undeterred by high prices because they think that even bigger price increases will compensate them for spending too much. If expectations of rapid and steady future price increases are important motivating factors, then the price level is inherently unstable, because prices cannot rise forever. The bubble will eventually burst and prices will fall.
At least one aspect of a housing bubble is visible: rapid price increases. A surge in home prices has infected almost all advanced countries since 2000, with the exception of Germany and Japan.
But the key question is whether expectations of large future price increases are sustaining the market. If the relationship between average incomes and house prices is stable, then economic fundamentals clearly have the potential to explain prices.
The increase in housing prices during the 1980's is now viewed as the veritable model of a boom cycle turned bust. A pattern of sharp price increases, which peaked around 1990, was followed by declines in cities from Boston and Los Angeles to London, Sydney, and Tokyo, contributing to severe regional recessions. Will the current run-up in prices be followed by similar, or worse, collapses?
Evidence about a housing bubble in the 1980's was compelling. Buyers were influenced by strong expectations about future price increases, and they perceived little risk. Responses to a survey that my colleague Karl Case and I conducted in 1988 during the US boom revealed that casual word-of-mouth transmission of emotional excitement played a big role in purchasing decisions. Moreover, there was no agreement among buyers about the causes of recent price movements and no cogent analysis of fundamentals.
Earlier this year, we conducted another survey of US homebuyers who bought between March and August of 2002. For the vast majority, investment was either "a major consideration" or at least "in part" a motive for buying. But far fewer homebuyers in 2003 said that they were buying "strictly for investment purposes" than in 1988. Thus, conditions would appear to be consistent with a bubble, though less so than in the 1980's.
The US is hardly alone. In Europe, the average ratio of home prices to incomes is slightly below its long-term average, mainly because housing prices in Germany are at historically low levels by this measure. In France, Italy, and Belgium, the ratio is close to its long-term average, and in Spain, the Netherlands, and Ireland, it is 40-50% above it. Australia, too, is close to the level that preceded previous crashes.
These are averages across whole countries, but some regions are more overvalued than others. This is likely to be the case for "glamour cities" in which international celebrities, entertainment industries, world-class universities, or high technology industries are located. Home prices in these cities are high as well as volatile.
The surveys in 1988 and 2003 showed that the central issue is the role of price expectations. In both booms, roughly 90% of respondents in the US expected an increase in home prices over the next several years, with large expected increases over the next 12 months, surpassing 15% in San Francisco in 2003. Longer-term expectations were almost as high.
Indeed, word-of-mouth transmission of excitement about real estate prices is nearly as prevalent now as in 1988. In "glamour cities," newspaper articles feature stories of homes that sold well above asking price, and 45% of respondents in the 2003 survey reported selling at above asking prices in San Francisco. More than 20% of sellers in all markets surveyed felt that that their property would have sold as quickly if they had charged 5% or 10% more.
Even so, the 2003 survey indicates that US homebuyers are not as confident of real estate prices now as before the 1980's bubble burst. This may mean that buyers will not allow prices to rise like last time, but it could also mean that owners will be more ready to exit from the market. This may amplify any price declines, especially in "glamour cities" and those with weakening economies.
The consequences could be severe, and not only in the US, where 21% of mortgages last year were for more than 90% of a home's purchase price, up from 7% at the peak of the boom in the late 1980s. Australian household debt over the past decade has soared from 55% to 130% of personal disposable income. It has almost doubled, to 180%, in the Netherlands, where the average mortgage is 110% of home values, because lenders are happy to finance all the purchasing costs.
Judging from the historical record, housing price declines fortunately tend to be relatively local, and nationwide drops are unlikely. This should blunt the macroeconomic impact of bursting bubbles. The bad news, though, is that the run-up of personal debt means that many households will be left with liabilities exceeding the value of their homes, implying a rising number of bankruptcies.
Around the world, newspapers trumpet a "housing bubble" about to burst. The Economist has run numerous cautionary articles with titles like "Castles in Hot Air." "Housing Prices Soar, Fueling Bubble Fears," chirped The Wall Street Journal . "The Property Bubble Menaces Growth," warned Le Monde . "Homes Bubble May go Toxic," The Sydney Morning Herald admonished.
Are such fears justified? How do we know if the housing market is in a bubble?
The term "bubble" is widely used but rarely defined. A bubble occurs when public expectations for future price increases become exaggerated, pushing prices up to unsustainable levels. When this happens, many people buy homes to rent out as investment properties, and many more who are buying homes to live in also behave like investors, fearing that if they wait, they will be priced out of the market.
During a bubble, buyers are relatively undeterred by high prices because they think that even bigger price increases will compensate them for spending too much. If expectations of rapid and steady future price increases are important motivating factors, then the price level is inherently unstable, because prices cannot rise forever. The bubble will eventually burst and prices will fall.
At least one aspect of a housing bubble is visible: rapid price increases. A surge in home prices has infected almost all advanced countries since 2000, with the exception of Germany and Japan.
But the key question is whether expectations of large future price increases are sustaining the market. If the relationship between average incomes and house prices is stable, then economic fundamentals clearly have the potential to explain prices.
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The increase in housing prices during the 1980's is now viewed as the veritable model of a boom cycle turned bust. A pattern of sharp price increases, which peaked around 1990, was followed by declines in cities from Boston and Los Angeles to London, Sydney, and Tokyo, contributing to severe regional recessions. Will the current run-up in prices be followed by similar, or worse, collapses?
Evidence about a housing bubble in the 1980's was compelling. Buyers were influenced by strong expectations about future price increases, and they perceived little risk. Responses to a survey that my colleague Karl Case and I conducted in 1988 during the US boom revealed that casual word-of-mouth transmission of emotional excitement played a big role in purchasing decisions. Moreover, there was no agreement among buyers about the causes of recent price movements and no cogent analysis of fundamentals.
Earlier this year, we conducted another survey of US homebuyers who bought between March and August of 2002. For the vast majority, investment was either "a major consideration" or at least "in part" a motive for buying. But far fewer homebuyers in 2003 said that they were buying "strictly for investment purposes" than in 1988. Thus, conditions would appear to be consistent with a bubble, though less so than in the 1980's.
The US is hardly alone. In Europe, the average ratio of home prices to incomes is slightly below its long-term average, mainly because housing prices in Germany are at historically low levels by this measure. In France, Italy, and Belgium, the ratio is close to its long-term average, and in Spain, the Netherlands, and Ireland, it is 40-50% above it. Australia, too, is close to the level that preceded previous crashes.
These are averages across whole countries, but some regions are more overvalued than others. This is likely to be the case for "glamour cities" in which international celebrities, entertainment industries, world-class universities, or high technology industries are located. Home prices in these cities are high as well as volatile.
The surveys in 1988 and 2003 showed that the central issue is the role of price expectations. In both booms, roughly 90% of respondents in the US expected an increase in home prices over the next several years, with large expected increases over the next 12 months, surpassing 15% in San Francisco in 2003. Longer-term expectations were almost as high.
Indeed, word-of-mouth transmission of excitement about real estate prices is nearly as prevalent now as in 1988. In "glamour cities," newspaper articles feature stories of homes that sold well above asking price, and 45% of respondents in the 2003 survey reported selling at above asking prices in San Francisco. More than 20% of sellers in all markets surveyed felt that that their property would have sold as quickly if they had charged 5% or 10% more.
Even so, the 2003 survey indicates that US homebuyers are not as confident of real estate prices now as before the 1980's bubble burst. This may mean that buyers will not allow prices to rise like last time, but it could also mean that owners will be more ready to exit from the market. This may amplify any price declines, especially in "glamour cities" and those with weakening economies.
The consequences could be severe, and not only in the US, where 21% of mortgages last year were for more than 90% of a home's purchase price, up from 7% at the peak of the boom in the late 1980s. Australian household debt over the past decade has soared from 55% to 130% of personal disposable income. It has almost doubled, to 180%, in the Netherlands, where the average mortgage is 110% of home values, because lenders are happy to finance all the purchasing costs.
Judging from the historical record, housing price declines fortunately tend to be relatively local, and nationwide drops are unlikely. This should blunt the macroeconomic impact of bursting bubbles. The bad news, though, is that the run-up of personal debt means that many households will be left with liabilities exceeding the value of their homes, implying a rising number of bankruptcies.