One of the most discussed topics in recent economic history is whether or not there exists a bubble in the housing market. It has been discussed by researchers and commentators, first neglected but then discussed by central bankers and now the concern has spread out to the public through the media without any visible effect on prices.
When defining a bubble it is extremely important to make sure that there is no chance to misunderstand it, since it will be crucial for the conclusion. I will define a bubble by using some of the most referred definitions, but then refining it to integrate it into my setup of economical analysis. By doing so empirical evidence will clarify if a bubble exists or not.
2.1. Definition of bubble
Kindleberger (1987) defined a bubble as: ‘A bubble may be defined loosely as a sharp rise in the price of an asset or a range of assets in a continuous process, with the initial rise generating expectations of further rises and attracting new buyers - generally speculators interested in profits from trading rather than in its use or earning capacity. The rise is then followed by a reversal of expectations and a sharp decline in price, often resulting in severe financial crises, which is when the bubble bursts.’
Stiglitz (1990) refined the definition by stating; ‘There exists a bubble if house prices are high today because of market participators expect that house prices are higher tomorrow and if the fundamental value at the same time cannot justify such price.’
Both definitions have primarily been focusing on the share market. After the stock market crash many researchers have found different aspects of the concept by focusing on: rapidly rising prices (Baker, 2002); unrealistic expectations of future price increases (Case, 2003); the departure of prices from fundamental value (Garber, 2001); the drop in prices after the bubble pops or how often the bubbles occur (IMF, 2003) and how to deal with them.
The distinction between the two definitions is whether it is possible to observe a bubble before it bursts. It is not possible to observe the decline in prices when following Kindlebergers definition, whereas it is only possible to discover a bubble ex post. By taking Stiglitz definition it is unnecessary to observe any declines in house prices, whereas the bubble can be observed ex ante if the specified characteristics exist. The definition can be clarified from an investor’s perspective when focusing on the market prices of a certain asset (e.g. real estate) and how far it rises above the present value of the anticipated cash flow from the asset. A bubble exists if the traded price has driven too far away from the present value.
When focusing on an ideal real estate market for an investor, the price dynamics (Pt) would tend to converge towards a standard rate of return, adjusted for perceived risk (it). The price of a house at time t would be equal to the expected discounted present value of the rents accruing to real estate owner (rt), plus the price of the house at which it could be sold at time t+1. More formally:
1 1
( )
(1 )
t t t
t
E r P
P i
+ + +
= +
When generalizing this result for an infinite number of expected future prices by using the law of iterated expectations we get:
1
This is often referred to as the market fundamentals price, which is simply the expected discounted present value of all future rents accruing to the real estate owner. Thus, any house price deviation from the fundamental price can be thought of as including some "bubble component" in its valuation. By introducing B, which represents the deviation from the Market Fundamental Price it is possible to have prices that are not in equilibrium.
1
If several houses in the real estate market are priced with a non-zero one-sided (either positive or negative) value for B, then one may say that the market is away from the fundamental value and contains a bubble element. As discussed previously then at some point the price will have to return to the correct price (equilibrium), whereas B eventually has to drop to zero.
If or when this happens, the bubble bursts (Steimetz, 1999).
This definition is related to the existence of two choices: renting or owning and that the relative relationship between the two possibilities will remain stable over time. If they divert from each other there will be automatic stabilizers bringing the relation back to the fundamental ‘equilibrium’.
It is possible for asset prices to rise rapidly if fundamental values and hereby the cash flow of the asset changes. In this way even expectations of future higher cash flow can be interpreted in the setup as long as they can be justified as realistic. Smaller deviations from a strict equilibrium can be justified by shocks to the system.
When comparing real estate and shares then house prices do not fluctuate as much as share prices, because rents are relatively stable. Individual shares, in contrast, are instantaneously being influenced by changes in the market together with the frequent reporting of earnings that gives the market the possibility to adjust to new information.
For an individual house, there is no reporting of earning, (rents are considered relatively stable), and no quick adjustment. However, these definitions are mainly focusing on the share market where several bubbles have occurred and influenced the market substantially with large price volatility. In the housing market the earnings are not stated on a quarterly basis and they do not fluctuate as much. This is because they are typically based on long contracts making earnings more stable. Moreover the houses are not publicly traded, nor is the market constantly pricing the specific asset.
Relative to the share market, the housing market is not experiencing the same fluctuations over time and deviations from ‘equilibrium’ in general, but that is also one of the reasons why real estate prices divert from values to such extent that they can be named bubbles.
Differences also exist between real estate and shares, which Case (2003) emphasizes by stating that it is possible to reach ‘a situation in which excessive public expectations for future price increases cause prices to be temporarily elevated. During a period of house price increases homebuyers with adaptive expectation think that a home that normally would be considered too expensive could be acceptable due to expectations of further price increases.
They will not save as much as they otherwise might, since they expect the increased value of their game to do the saving for them. First time buyers may not worry about decreasing prices during a housing bubble that if they do not buy now, they will not be able to afford a house later. Furthermore, the expectations for high price increases may have a strong impact on demand if people think that home prices are very unlikely to fall, and certainly not all for long, so there is little perceived risk associated with investment in homes.’ (Smith, 2005).
IMF (2003) has identified a weak association between booms and busts; First the distress phase at the end of a boom, where some investors suffer from being financially overextended, which may be long-lasting but economic activity remaining largely unaffected in the absence of a large shock (possible to burst later due to vulnerability). Second, large enough adverse shocks rendering previously healthy balance sheets. Besides these observations IMF (2003) has used a practical definition of bubbles by defining a house price contraction exceeding 14% a bubble. This view is in line with Kindleberger’s definition, because it is depending on house price decreases.
A bubble will on the basis on the above discussion be defined to be observable (ex ante) in accordance to previous findings and described: There exists a bubble in real estate exists if house prices are above what fundamentals can sustain and if market participators in general
have unrealistic positive belief in future house price increases, which is characterized by attracting new buyers in the form of speculators interested in profits from trading rather than its use or earning capacity.
The practical problem arise if fundamentals can explain most of history, but not the current situation. The reasons could be that a structural change has occurred, a certain unidentified or immeasurable shock that has to be implemented, that the assumptions needed to quantify the expected future value of fundamentals are hard to judge, whereas it is hard to justify the existence of a bubble. Another possibility is that explaining has influenced the market by investors just being ‘rational’ gamblers (Anderson, 1997) or that problems has occurred, which require policy intervention (Shiller, 2000 and IMF, 2003).