Housing bubble trouble: separating facts from fiction

First the boom, then the bust: property bubble deniers had better brace themselves. justmakeit

In a previous article, I analysed four of the common arguments used by those who deny there is a bubble in Australia’s residential property market. The bubble deniers have employed other explanations for the largest run-up in prices in Australia’s 131 years of land sales records.

Restrictive government regulations

One argument is that restrictive government regulations (RGR) limit the supply of land and timely dwelling construction through zoning controls, development, planning and building laws, driving up housing prices. This idea gained popularity in the US during the property boom, with some economists asserting that it is a substantial factor in creating a bubble.

The major difficulty is that RGR can only affect rent prices and thus the market-efficient price for land. The logic is straightforward: if RGR limits supply with demand holding constant or rising, and property prices increase, then it follows that rents too must rise proportionally as well. If rent and land prices diverge, however, this argument falls flat – as is the present case. Housing prices have experienced a far greater run-up than rents since 1996. Further, markets would have already priced the supply-side distortions into the cost of housing long before the bubble began. There is no change in RGR that could explain the increase in housing prices from 1996, skyrocketing in 2001.

The other case against this argument is that the boom-bust housing cycle has existed for centuries in many countries, far before bureaucrats perfected the art of red tape during the 20th century.

The theoretical and empirical literature provides little help with this topic. Some studies show RGR comprises a large factor, some claim a smaller impact, and others argue it results in no tangible effect, and that correlation is often confused with causation. Even the idea’s leading proponents acknowledge the benefits of RGR could well outweigh the costs.

Arguing that a greater supply of housing could limit skyrocketing prices is similar to saying that the 17th century Dutch bubble driven by tulip mania could have been mitigated if farmers had grew more tulip bulbs. The problem is not on the supply side; rather, debt is used to fuel a pyramid scheme, resulting in a tremendous demand surge that significantly raises prices.

This is not to say that RGR shouldn’t be changed; many aspects need improvement. The case for RGR causing bubble-level pricing, however, is slim to non-existent.

Low inflation and interest rates

Another explanation cited is the structural downturn in inflation and interest rates that began in the late 1990s and continues today. Interest rates peaked in 1990 when the RBA radically increased interest rates to combat inflation, culminating in the recession “we had to have”.

That year, the standard mortgage rate stood at approximately 17% and real interest rates at 11% (nominal rates were higher). Eventually, the rate of inflation fell, and interest rates followed. With cheaper borrowing costs, households could take on greater levels of mortgage and personal debt.

But the decrease in inflation and interest rates can only explain part of the increase in household debt. In 1990, the household debt to disposable income ratio was 46 per cent, rising to almost 160 per cent today. The household debt to GDP ratio jumped from 19 per cent to 86 per cent.

Even as far back as 2004, the RBA noted that the decrease in inflation and interest rates could only explain a doubling of household debt relative to incomes, and probably less. Household debt has more than quadrupled over this period.

If this argument were credible, the 1960s should have prompted an even greater household debt ratio as rates were the lowest on record throughout this decade. This did not occur.

Returns to property

That residential property provides substantial and ongoing returns to investors and owner-occupiers, based on fundamentals, is another argument.

Two types of return tempt house buyers: owning a property valued by the market at a higher price than it was purchased for (capital gain), and increases in the rental income (yield). Property owners hope that they will make a substantial capital gain when they sell, and that rental income can overtake costs over the long run.

Data from the ATO tells an interesting story. On aggregate, net real rental income has resulted in continuing losses starting at $966 million in 2000, and peaking at $8.8 billion in 2008. Rental income has not exceeded interest costs since 2000, let alone met the costs of maintenance, rates, agent fees, and property tax.

No rational investor knowingly purchases an asset that yields a negative return. Investors are sacrificing cash flow to build assets and realise eventual capital gains.

The problem with this state of affairs was explained long ago by the late economist Hyman Minsky, who showed state capitalist economies cyclically generated crises due to the interaction of financial markets with the productive economy. Minsky’s analysis revolved around describing three stages of financing.

Hedge finance: income flows from an asset is sufficient to pay down both principal and interest on the debt financing asset purchases. Prices are based upon fundamentals.

Speculative finance: income flows cover only interest, not principal, requiring debt to be continually rolled over. Asset owners may experience financial stress, but it is not widespread, and fundamentals are in kept largely in check.

The final stage is Ponzi finance: income flows cover neither principal nor interest charges. Owners are completely reliant on escalating sale prices (capital gains) to make a profit and meet the cost of the debt. Prices are completely delinked from fundamentals at this stage, resulting in the dreaded bubble.

The tipping point comes when the household sector is so overloaded with debt there exist no more ‘greater fools’ willing to commit to a lifetime of debt serfdom to purchase property. With few buyers and many sellers, prices stagnate then rapidly fall as assets are unloaded en masse onto the market. With demand falling in the housing sector, coupled to an inevitable increase in unemployment, a vicious deflationary spiral occurs. Economy activity grinds to a halt.

That Australia’s residential property market has resembled the Ponzi stage of financing for the last 11 years is nothing short of astonishing. The market would have collapsed during the GFC in 2008 were it not for another First Home Owner’s boost re-inflating asset prices to a new, higher peak.

Trusting the “experts”

Rational discussion about the state of the property market is fraught. Many outspoken bubble deniers are conflicted by their interests in industry and government. Many – not all – are employed by, consult for, manage, and/or own organisations with a direct interest in maintaining the status quo of an overvalued property (land) market. These institutions are primarily commercial lenders, investment banks, real estate intelligence firms, insurance, real estate agents, Treasury, the RBA, vote-seeking politicians, and the mass media.

Skilled and intelligent specialists, trained in neoclassical economics in leading US institutions, did not see their enormous housing bubble until it burst in front of them with horrendous consequences. What makes Australia’s “experts” any more competent?

As investor Jeremy Grantham has noted: “Bubbles have quite a few things in common but housing bubbles have a spectacular thing in common, and that is every one of them is considered unique and different.”