Friday, June 17, 2005

Economist on global housing bubble

Informed readers are already familiar with the situation, but the Economist as usual does a wonderful job of summarizing. In the first figure, note the oscillation of price/rent about the long-term average. In the second figure, you see a possible decades-long unwinding of the bubble, as in Japan.

Robert Shiller (quoted in the article) has called this the biggest bubble of all time, and the Economist agrees. In addition, his research shows only a tiny (.4% per year) real return on US house prices over the last century, contrary to conventional wisdom.

The most compelling evidence that home prices are over-valued in many countries is the diverging relationship between house prices and rents. The ratio of prices to rents is a sort of price/earnings ratio for the housing market. Just as the price of a share should equal the discounted present value of future dividends, so the price of a house should reflect the future benefits of ownership, either as rental income for an investor or the rent saved by an owner-occupier.

Calculations by The Economist show that house prices have hit record levels in relation to rents in America, Britain, Australia, New Zealand, France, Spain, the Netherlands, Ireland and Belgium. This suggests that homes are even more over-valued than at previous peaks, from which prices typically fell in real terms. House prices are also at record levels in relation to incomes in these nine countries.

...To bring the ratio of prices to rents back to some sort of fair value, either rents must rise sharply or prices must fall. After many previous house-price booms most of the adjustment came through inflation pushing up rents and incomes, while home prices stayed broadly flat. But today, with inflation much lower, a similar process would take years. For example, if rents rise by an annual 2.5%, house prices would need to remain flat for 12 years to bring America's ratio of house prices to rents back to its long-term norm. Elsewhere it would take even longer. It seems more likely, then, that prices will fall.

A common objection to this analysis is that low interest rates make buying a home cheaper and so justify higher prices in relation to rents. But this argument is incorrectly based on nominal, not real, interest rates and so ignores the impact of inflation in eroding the real burden of mortgage debt. If real interest rates are permanently lower, this could indeed justify higher prices in relation to rents or income. For example, real rates in Ireland and Spain were reduced significantly by these countries' membership of Europe's single currency—though not by enough to explain all of the surge in house prices. But in America and Britain, real after-tax interest rates are not especially low by historical standards.

...Another mantra of housing bulls in America is that national average house prices have never fallen for a full year since modern statistics began. Yet outside America, many countries have at some time experienced a drop in average house prices, such as Britain and Sweden in the early 1990s and Japan over the past decade. So why should America be immune? Alan Greenspan, chairman of America's Federal Reserve, accepts that there are some local bubbles, but dismisses the idea of a national housing bubble that could harm the whole economy if it bursts. America has in the past seen sharp regional price declines, for example in Boston, Manhattan and San Francisco in the early 1990s. This time, with prices looking overvalued in more states than ever in the past, average American prices may well fall for the first time since the Great Depression.

But even if prices in America do dip, insist the optimists, they will quickly resume their rising trend, because real house prices always rise strongly in the long term. Robert Shiller, a Yale economist, who has just updated his book “Irrational Exuberance” (first published on the eve of the stockmarket collapse in 2000), disagrees. He estimates that house prices in America rose by an annual average of only 0.4% in real terms between 1890 and 2004. And if the current boom is stripped out of the figures, along with the period after the second world war when the government offered subsidies for returning soldiers, artificially inflating prices, real house prices have been flat or falling most of the time. Another sobering warning is that after British house prices fell in the early 1990s, it took at least a decade before they returned to their previous peak, after adjusting for inflation.


ECCL10-2 said...

This link gives some price history over 345 years in Holland. Average real growth: 0.2%

Anonymous said...

I've heard of claims like those mentioned by ECCL10-2, and I'm not sure I believe them.

First, note that the article is talking about price appreciation, not some kind of notional "total return," which would include the "dividend" of an investment in residential housing (namely, the rental value of the unit, implicit in the case of owner-occupied housing).

Second, the price appreciation figure seems to imply that Ricardian land rent in residential sites, as a fraction of GDP, has shrunk dramatically over the centuries. (Assuming that real GDP has grown at rates that we usually think of, e.g. 1--3% per annum.)

I find this very difficult to believe.

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